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American Accounting Association2006 Midwest Region MeetingMarch 30 – April 1
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Friday, March 31, 10:20 a.m.-12:00 noon
Concurrent session 2D - SOX and Assessing Risk (Auditing)Title: Legal Damages and Their Effect on the Auditor's Efforts
Lynda Thoman
Purdue UniversityABSTRACT: Conventional wisdom holds that increasing legal penalties will motivate an audit firm to devote more time to its audits; this is the motivation behind some provisions of the Sarbanes Oxley Act (SOX). This paper argues that two key features in the audit environment may cause the conventional wisdom to be upset. First, in an audit there are many different dimensions to the firm to which the auditor must attest, and second, the auditor may examine several different dimensions of the firm simultaneously. Why might these features reverse the conventional wisdom? First, the expected damages for different outcomes are not the key in understanding auditors' effort choices; an auditor's efforts depends upon the difference, or "marginal penalty," for different outcomes. Because of the many different facets of the firm, there will be multiple marginal penalties. Increasing the legal damages for one type of error can increase one marginal penalty while reducing another; the overall impact may be that the auditor is motivated to work less hard. Second, while working hard will reduce the total number of errors, it does not insure that the number of reports with say one error will decrease. In fact as multiple errors are reduced to single errors, the number of reports with that one error may increase. Imposing additional penalties for that one type of error, might induce the auditor to work less hard. Finally, if damages are assessed on the basis of the firm's share price, when the auditor works hard, the firm's share price, and in turn the magnitude of the damages the auditor will have to pay if sued, increase. This is a third force causing auditors to rationally reduce the time they devote to an audit when there is an increase in litigation.