This paper presents a model in which a firm's owner, an auditor, and outside investors strategically interact. The owner's investment in the quality of the firm's internal control system and the auditor's effort jointly affect the informativeness of the auditor's report on the firm's financial statements. If the auditor's legal liability to investors is large, then an efficiency loss arises because the owner underinvests in the internal control system and the auditor overinvests effort. On the other hand, if the liability is small, then an efficiency loss arises from the owner's overinvestment and the auditor's underinvestment. Regulators can improve allocative efficiency by changing the auditor's legal liability. However, in our model, it is impossible to completely eliminate the efficiency loss by changing the auditor's liability alone, because no damage award can induce both the owner and auditor to make socially optimal investments in the internal control system and audit effort. We also interpret recent changes in the regulatory environment in the context of our model.

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Major accounting firms in the United States have singled out elimination of joint and several liability as one of the most needed legal reforms in the country. The recent legislation of the Private Securities Litigation Reform Act of 1995 replaced joint and several liability with proportionate liability. This paper develops a simple model to analyze the economic consequences of such a change in the legal environment facing public accountants. In particular, we examine the incentive effects induced by the proportionate liability rule on the auditor's effort and financial statement users' litigation decisions. Our analysis demonstrates that replacing joint and several liability with proportionate liability can decrease the equilibrium audit effort, lawsuit probability, market price of the firm, and audit fee. More important, even though the proportionate liability rule reduces the equilibrium audit effort, we show that it can actually increase social welfare.