Auditors' Liability, Investments and Capital Markets: An Unintended Consequence of Sarbanes-Oxley

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 in a lemons market for new investments. The equilibrium analysis derives corporate reporting and investing choices by the firm, attestation opinions by the auditor, and valuation by rational investors. Three predictions emerge that are empirically testable: While increasing auditor liability decreases the audit failure rate and decreases the cost of capital for new projects, it decreases the level of new profitable investments.