The Formation and Role of Reputation and Litigation in the Auditor–Manager Relationship

Abstract

In light of recent changes limiting auditors' legal liabilities, we examine the role of audit reputation on the interaction between the auditor and the manager whose actions he is attesting to. This contrasts with the literature that analyses how the firm's owner uses auditor reputation as a means of signalling to external constituencies. One of the roles of auditing is the production of information that facilitates contracting between the firm's owner and its managers. Management typically has an incentive to bias reports in its own favor. This creates a demand for confirmation of the financial reports provided by managers. An auditor can provide such a confirmation, but only if the auditor himself is induced to work hard and report truthfully. We show that reputation formation by the auditor serves as a substitute for costly contracting, monitoring, and litigation by the owner. By deterring misreporting, reputation reduces the inherent risk of the audit, allowing the auditor to cut back on substantive testing without increasing the probability of biased reports. The presence of audit institutions that promote and facilitate the building of auditor reputations mitigate both the auditor's and the manager's moral hazard on actions and reports. This role of reputation has implications for auditor legal liability, because the need for penalties is tempered by the auditor's desire to maintain a reputation.