Low Balling, Legal Liability and Auditor Independence

Posted: 27 Jan 1999

See all articles by Chi-Wen Jevons Lee

Chi-Wen Jevons Lee

Tulane University - A.B. Freeman School of Business; Tsinghua University - School of Economics & Management

Zhaoyang Gu

Chinese University of Hong Kong - School of Accountancy

Abstract

We construct a dynamic multi-agent moral hazard model to analyze the interactions among the firm owner, the manager and the auditor. Moral hazard may arise in hierarchical agency because a rational monitoring agent may accept a side payment from the monitored agent for misrepresenting information to the principal. This multi-agent moral hazard problem is the essence of the concern for auditor independence. We show that a ?low-balling? compensation scheme and the auditor's legal liability constitute an efficient dynamic contracting mechanism for hierarchical agency. In particular, low balling serves as a substitute for legal liabilities for maintaining auditor independence. Low balling reduces the transaction costs associated with the audit engagement relative to the flat-fee structure and can actually improve auditor independence.

JEL Classification: M49, D40

Suggested Citation

Lee, Chi-Wen Jevons and Gu, Zhaoyang, Low Balling, Legal Liability and Auditor Independence. Available at SSRN: https://ssrn.com/abstract=147791

Chi-Wen Jevons Lee (Contact Author)

Tulane University - A.B. Freeman School of Business ( email )

7 McAlister Drive
New Orleans, LA 70118
United States
504-862-8485 (Phone)

Tsinghua University - School of Economics & Management ( email )

Beijing 100084
China
86-10-6277-2942 (Phone)

Zhaoyang Gu

Chinese University of Hong Kong - School of Accountancy ( email )

Shatin, N.T.
Hong Kong

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