In this article, published in ABACUS in June 2021, CAR’s Reinhard Schrank investigates how damage apportionment between auditors and auditees affects the quality of the internal control system (ICS), the supplied audit quality, and social welfare. The analysis takes place in a setting in which the audit is not only required to meet obligations towards the primary users of the audited report, but the auditor assumes a public responsibility that also makes the auditor responsible for the losses of ‘foreseeable third parties’. Using a game-theoretic model, he shows that shifting liability away from the auditor towards the auditee can induce a higher audit quality but lower ICS quality. Furthermore, assigning all the damage payments to the auditor leads to a Pareto-efficient allocation of ICS quality and audit quality. This finding supports the common ‘deep pocket’ assumption in the auditing literature.
“The Impact of Damage Apportionment on Internal Control System Quality and Financial Reporting Accuracy”