Liability exposure is now such a major concern for auditors that any discussion of equilibrium audit fee structures needs to take account of the expected costs of liability exposure. We develop a model of audit litigation risk and then proceeds to apply insights gained from the application of finance theory to show how liability exposure is related to guarantee provision. Given auditors' will wish to incorporate the expected cost of guarantees' when planning and pricing services, we apply contingent claims analysis to derive valuation issues. Whereas the above analysis assumes stable legal liability rules, we subsequently consider the auditor incentive effects of parametric variation in the rules. Since the quality of audits is unobservable, we consider how the rules could be set so as to ensure auditors are not tempted to provide a low degree of care and collude with management. To illustrate the usefulness of this approach we consider whether recent proposals to reform auditor liability to a proportional basis will always provide appropriate incentives.
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