Audit Quality and Investment Efficiency with Endogenous Information in Markets

Abstract

We study audit quality and investment efficiency when information produced by a third party, e.g., a financial analyst, can curb overvaluation, and auditors are subject to legal liability following audit failure. With the auditor's damage payment based on the price inflation caused by audit failure, the analyst's information brings prices closer to fundamentals and provides a hedge to the auditor against legal liability risk. This weakens incentives for audit quality, and the analyst responds with more information production due to the penalty for mispricing. Consequently, in equilibrium, stricter legal liability leads to higher audit quality, which reduces overinvestment, but also less information production, which increases underinvestment. Thus, stricter legal liability has a non-monotonic effect on firm value: it increases the value of high growth firms, but reduces the value of low growth firms. The results have implications for the optimal level of legal liability that maximizes the expected value of the firm.