On Auditors and the Courts in an Adverse Selection Setting

We study the role an auditor plays in distinguishing among different bankruptcy-risk classes in a setting in which a lender cannot observe the bankruptcy probability of a borrower. The auditor strategically chooses her work intensity as well as her report. Either the lender or the borrower may sue the auditor whenever he doubts the latter’s veracity. We establish a demand for auditing, characterize the resulting equlibria, and contrast these equilibria with those arising when the auditor is non-strategic. We also study how the size of the damages affects equlibrium outcomes. We find that, for any given level of damages, increasing damages improves the lender’s information about he borrower’s bankruptcy risk, and consequently, causes borrowing costs to move closer to perfect-information costs. Thus, there may be a rationale for courts to impose penalties on the auditors that exceed t he actual losses experienced by the borrower or the lender.