Legal Liabilities, Audit Accuracy and the Market for Audit Services

In quality‐differentiated audit markets with client‐firms of unknown types, insider‐managers of client firms strategically select auditors who respond to legal liabilities to decide their care level. In this signaling game, uninformed‐investors use the audit report and the auditors' identity for firm valuation. The analysis shows that increased legal liability increases the auditor's effort and audit accuracy but reduces the demand for high quality auditing because, apart from the increased audit costs, the adverse selection benefit of the worse type reduces with increased accuracy. Furthermore, alternative legal regimes and damage allocation rules alter informational efficiency of the financial market.