A Theory of Auditor-Client Match and Auditor Legal Liability

This paper presents a model of imperfect auditing, in which firms differ in their benefits from an audit. and auditors differ in their personal wealth exposed to potential liability. The legal environment affects auditors' expected liability in the case of audit failure. The paper provides an equilibrium analysis of how the firms and auditors match each other in a given legal environment. The analysis reveals that the economy almost always suffers from efficiency losses. A change in the legal environment induces a change in the equilibrium auditor-client match because it influences auditors' supply of audit qualities, which in turn affects firms' auditor hiring decision. It is shown that a (second-best) socially optimal legal environment is the one in which auditor liability is neither too lenient nor too stringent. Indeed. in a socially optimal legal environment. the audit market is segmented in a way that high-quality auditors provide audits to firms that benefit more from auditing and low-quality auditors serve firms that benefit less from auditing. Finally, the paper discusses some empirical implications of the equilibrium auditor-client matching process.