This dissertation has two objectives. The first is to provide a framework for understanding strategic interactions between an auditor and investors in a competitive rational expectations economy. The second is to provide a welfare analysis of auditor litigation in a costly legal environment. We present a model which captures the following aspects: (i) investors in a competitive capital market form rational expectations about their future litigation opportunities against auditors; (ii) auditors compete for potential clients, and they strategically consider the threat of litigation; (iii) the audited firm's production decision depends on audit quality; and (iv) trial is a costly process, and litigants have settlement opportunities. The market price of the firm and audit quality are endogenized. The welfare analysis provides a rationale why society maintains a legal system which provides an incentive for the investors to recover their ex post financial loss from the auditor through a costly legal process, even if they can price-protect themselves ex ante with or without such a mechanism. We interpret the court system as a decentralized disciplinary mechanism for the auditor moral hazard problem, which enables the potential auditee to use an auditor as a commitment device. We examine the economic consequences of legal policies which potentially influence the size of legal costs. When audit failure is clearly defined, an increase in the auditor's legal costs decreases social welfare. An increase in the investors' legal costs has a more complex impact on the actions of economic agents upon which the social costs and benefits of an audit crucially depend. We also study the economic impact of a change from an American to a British rule of allocating legal costs, which was recently proposed by the accounting profession in the U.S. In contrast to the practitioners' common belief, we demonstrate that the British rule might increase the frequency of lawsuit. Therefore, regulators must be very careful in evaluating the accountants' proposal of the British rule, and it should not replace the American rule unless a careful analysis indicates that the net benefit of audits under the British rule is larger than that under the American rule.

This dissertation has two objectives. The first is to provide a framework for understanding strategic interactions between an auditor and investors in a competitive rational expectations economy. The second is to provide a welfare analysis of auditor litigation in a costly legal environment. We present a model which captures the following aspects: (i) investors in a competitive capital market form rational expectations about their future litigation opportunities against auditors; (ii) auditors compete for potential clients, and they strategically consider the threat of litigation; (iii) the audited firm's production decision depends on audit quality; and (iv) trial is a costly process, and litigants have settlement opportunities. The market price of the firm and audit quality are endogenized. The welfare analysis provides a rationale why society maintains a legal system which provides an incentive for the investors to recover their ex post financial loss from the auditor through a costly legal process, even if they can price-protect themselves ex ante with or without such a mechanism. We interpret the court system as a decentralized disciplinary mechanism for the auditor moral hazard problem, which enables the potential auditee to use an auditor as a commitment device. We examine the economic consequences of legal policies which potentially influence the size of legal costs. When audit failure is clearly defined, an increase in the auditor's legal costs decreases social welfare. An increase in the investors' legal costs has a more complex impact on the actions of economic agents upon which the social costs and benefits of an audit crucially depend. We also study the economic impact of a change from an American to a British rule of allocating legal costs, which was recently proposed by the accounting profession in the U.S. In contrast to the practitioners' common belief, we demonstrate that the British rule might increase the frequency of lawsuit. Therefore, regulators must be very careful in evaluating the accountants' proposal of the British rule, and it should not replace the American rule unless a careful analysis indicates that the net benefit of audits under the British rule is larger than that under the American rule. / Business, Sauder School of / Graduate