Financial Reporting and Auditing under Alternative Damage Apportionment Rules Revisited
Dr. Derek CHAN
Associate Professor of Accounting
BBA (A&F) Programmes Coordinator
School of Business
The University of Hong Kong
This paper re-examines the model of Hillegeist (1999) in which an owner’s financial reporting decision, an auditor’s audit quality choice, and investors’ pricing decisions, as well as the strategic interactions among them, are influenced by the damage apportionment rule. Hillegeist (1999) establishes that which damage apportionment rule leads to the lowest audit failure rate hinges on whether the low-type owner’ reporting strategy varies with the legal environment. He attributes this result to the change in the low-type owner’s reporting strategy responding to the change in the damage apportionment rule more than offsets the change in the audit quality. I show that his result is flawed because he fails to fully consider the strategic options available to the low-type owner. Because of this negligence, he understates (resp., overstates) the expected cost (resp., benefit) of misreporting when analyzing the low-type owner’s cost-benefit calculations. By contrast, I find that replacing the joint-and-several liability by a hybrid proportionate liability rule always decreases the audit quality and increases the audit failure rate. These results hold irrespective of whether the low-type owner increases, decreases or maintains the same misreporting probability responding to the change in the damage apportionment rule.