Review of Accounting Studies, 7, 97–122, 2002
2002 Kluwer Academic Publishers. Manufactured in The Netherlands.
Scope of Auditors’ Liability, Audit Quality,
and Capital Investment
DEREK K. CHAN
School of Business, Faculty of Business and Economics, University of Hong Kong, Pokfulam Road, Hong Kong
KIT PONG WONG
School of Economics and Finance, Faculty of Business and Economics, University of Hong Kong, Pokfulam Road,
Abstract. One of the fundamental issues in the discussion of auditors’ liability is to whom auditors should be
held liable for ordinary negligence under common law. Three judicial viewpoints prevail: the restrictive privity
approach, the more liberal Restatement approach, and the most liberal foreseeability approach. To compare these
three approaches from an efﬁciency perspective, this paper develops a model that features an owner-managed
ﬁrm, an independent auditor, a continuum of unrelated lenders, and an impartial court. Double effort-incentive
problems appear for the ﬁrm and the auditor. The ﬁrm has an additional incentive problem due to the sequential
nature of its borrowing. This paper shows that the effort-incentive problem and the sequential borrowing problem
of the ﬁrm render unambiguous improvements in audit effort/quality, capital investment, and social welfare as the
judicial approach governing the scope of auditors’ liability becomes more conservative.
Keywords: Auditors’ liability, audit quality, double moral hazard, sequential borrowing, underinvestment
JEL Classiﬁcation: D62, D8, K13, L51, M41
Since Ultramares Corp. v. Touche,
a 1931 New York lawsuit, three different judicial
viewpoints have emerged regarding the scope of auditors’ liability to third parties for ordi-
nary negligence under common law.
The ﬁrst is the privity approach, which is based on
the Ultramares precedent, and conﬁnes an independent auditor to liability to third parties
speciﬁcally identiﬁed as users of the auditor’s work (referred to as primary beneﬁciary third
parties). Secondly, the Restatement approach, which originated from Section 552 of the
Restatement (Second) of Torts, expands liability to include third parties whose reliance
on the work is speciﬁcally foreseen by the auditor (referred to as foreseen third parties).
Finally, the foreseeability approach, which is the most liberal among the three, broadens lia-
bility to include even third parties whom the auditor could “reasonably foresee” as recipients
of the work for routine business purposes (referred to as foreseeable third parties).
While the scope of auditors’ liability to third parties has gone through several iterations, re-
cent court cases have indicated a trend toward more restrictive approaches (Siliciano, 1997).
In 1997, New Jersey took the rather unusual step of legislatively repealing the foreseeability
approach and replacing it with the privity approach.
Following the New Jersey legislature’s
repeal, only Mississipi and Wisconsin remain committed to the foreseeability approach,
Corresponding address: Derek K. Chan, School of Business, Faculty of Business and Economics, University of
Hong Kong, Pokfulam Road, Hong Kong.