On Auditors and the Courts in an Adverse-Selection Setting

In this paper we incorporate a utility-maximizing auditor, as found in agency models, into a simple signaling setting composed of firms of unobservable risk types requiring loans, lenders of capital to the firms, auditors, and a court system. We consider how litigation against auditors affects the prevailing equilibria as well as the resulting welfare of the different participants when the endogenously determined interest rates and audit fee reflect players' expectations regarding future litigation results. This framework enables us to address questions such as: Why do firms hire strategic auditor? What induces auditors to work hard and truthfully report their findings? How does litigation affect the audit process How do changes in audit fees affect the employment of auditors and firms' welfare?