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Auditors’ Liability, Investments, and Capital Markets: A Potential Unintended Consequence of the Sarbanes-Oxley Act

Authors

  • MINGCHERNG DENG,

    1. University of Minnesota
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  • NAHUM MELUMAD,

    1. Columbia Business School. Accepted by Richard Leftwich. We thank the editor, an anonymous referee, David Abody, Tim Baldenius, Shira Cohen, Frank Gigler, Jack Hughes, Chandra Kanodia, Volker Laux, Tong Lu, Paul Newman, Bugra Ozel, Haresh Sapra, Brett Trueman, Rick Young, and the participants at the Copenhagen 2008 Interdisciplinary Accounting Conference, the 2008 Carnegie Mellon University Accounting Theory Conference, and UCLA for helpful comments and suggestions.
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  • TOSHI SHIBANO

    1. Columbia Business School. Accepted by Richard Leftwich. We thank the editor, an anonymous referee, David Abody, Tim Baldenius, Shira Cohen, Frank Gigler, Jack Hughes, Chandra Kanodia, Volker Laux, Tong Lu, Paul Newman, Bugra Ozel, Haresh Sapra, Brett Trueman, Rick Young, and the participants at the Copenhagen 2008 Interdisciplinary Accounting Conference, the 2008 Carnegie Mellon University Accounting Theory Conference, and UCLA for helpful comments and suggestions.
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ABSTRACT

To restore investors’ confidence in the reliability of corporate financial disclosures, the Sarbanes-Oxley Act of 2002 mandated stricter regulations and arguably increased auditors’ liability. In this paper, we analyze the effects of increased auditor liability on the audit failure rate, the cost of capital, and the level of new investment. We focus on a setting in which, with imperfect auditing, a firm has better information than investors about its prospects and seeks to raise capital for new investments in a lemons market. The equilibrium analysis derives corporate reporting and investing choices by the firm, attestation opinions by the auditor, and valuation by rational investors. Three empirically testable predictions emerge: although increasing auditor liability decreases the audit failure rate and the cost of capital for new projects, it also decreases the level of new profitable investments.

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