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The Impact of Damage Apportionment on ICS Quality and Financial Reporting Accuracy

This paper investigates how the damage apportionment between the auditor and the auditee affects (i) the quality of the internal control system (ICS), (ii) the supplied audit quality, and (iii) social welfare. The analysis takes place in a setting where the auditor is not only liable towards the primary addressees of the audited report, but assumes a public responsibility that also makes her responsible for the losses of "foreseeable third parties". Using a game-theoretic model, I show that shifting liability away from the auditor, towards the auditee can lead to higher audit quality but lower ICS quality. I provide a new argument why internal controls and external auditing can be either complements or substitutes, as it is suggested by the mixed empirical evidence. Furthermore, assigning all the damages to the auditor leads to a Pareto-effcient allocation of ICS quality and audit quality.