Review of Accounting Studies, 8, 105–131, 2003
2003 Kluwer Academic Publishers. Manufactured in The Netherlands.
Evidence of Fraud, Audit Risk and Audit
School of Management, State University of New York at Buffalo, Buffalo, New York 14260
University of Michigan Business School, University of Michigan, Ann Arbor, MI 48109-1234
Abstract. We investigate the effectiveness of proportionate liability in reducing the probability of fraud and audit
risk relative to joint and several liability in two strategic audit settings: one that provides conclusive evidence
of fraud and one that provides inconclusive evidence of fraud. In both settings the auditor makes an audit effort
choice, but in the second setting the auditor also evaluates the audit evidence. Our results show that when the
auditor chooses only effort, a proportionate liability rule with large marginal liability relief decreases audit risk.
However, when the auditor also evaluates the audit evidence this result no longer holds.
Keywords: legal liability regimes, strategic auditing, proportionate liability, fraud
JEL Classiﬁcation: D4, K13, M14
The audit profession contends that legal practices treat auditors unfairly. Until recently, they
have been held jointly and severally liable for undetected material misstatements and have
had to pay their own legal fees whether or not they prevail in court.
Under a joint and
several liability regime the auditor pays damages that are often unrelated to his level of due
care because other defendants are incapable of paying their share. For example, being 1% at
fault for causing plaintiffs’ damages is not necessarily related to paying 1% of the damages
because the auditor is a “deep pocket.” This issue is discussed by Arthur Andersen & Co.,
et al. (1992) who state that the joint and several liability system:
...functions primarily as a risk transfer scheme in which marginally culpable or even
innocent defendants too often must agree to coerced settlements in order to avoid the threat
of even higher liability, pay judgments totally out of proportion to their degree of fault, and
incur substantial legal expenses to defend against unwarranted lawsuits.
By contrast, a proportionate liability regime allows the court to determine the percent of
auditor damages based on the percentage of fault in causing those damages irrespective of the
other defendants’ ability to pay. The Private Securities Litigation Reform Act of 1995 adopts
a limited form of proportionate liability, and the Securities Litigation Uniform Reform Act
of 1998 preempts state law for class action suits involving nationally traded securities.
However, actions against auditors that are not class action suits may be ﬁled under state
common law and litigated under joint and several liability. In addition, controversy still exists