The Implications of Alternative Litigation Cost Allocation Systems for the Value of Audits

When an auditor's effort is not observable, auditor liability becomes an important mechanism for motivating the auditor to exert an appropriate level of audit effort. However, although the presence of legal liability helps to preserve the value of an audit to investors, some aspects of the liability system may motivate suboptimal behavior and perhaps, ultimately, detract from investors' welfare. This paper seeks to contribute to the analysis of litigation-related issues by examining the effects of alternative legal cost allocation systems—the so-called American versus British rules—on the value of audits. Using a game theoretic model, the paper characterizes investors' and an auditor's equilibrium strategies in pretrial negotiation and the auditor's effort decisions. The paper finds that the American system (where the parties pay their own litigation costs) provides a higher audit value than the British system (where the loser of a case pays the winner's litigation costs), although the auditor's total expected costs are higher in the American system than in the British system.