The impact of legal responsibility of external auditors on auditing quality and investment level

Abstract

This research aims to study the effects of legal liability rules on auditing quality in order to devise and implement a guideline for the optimal liability rules that can be applied to the auditing profession within society, and thus encourage investment. In an emerging market like Kuwait state, there is a weakness in the legal system, which may cause users to place less reliance on financial reports and auditing services. This environment does not encourage investment. The position in Kuwait state will be studied as an example of how emerging economies can add to the understanding of the role of the auditor, for the purposes of improving audit quality and encouraging a greater amount of investment. Where this position can be understood, this study gives a strong impression of how the legal liability of external auditors can impact on the auditing quality and, importantly, the chances of obtaining investment. For this reason the study is applied in Kuwait state. This research differs from the other literature in several important ways. First, the study has been performed in an environment of weak governance. Second, it studies the effects of the civil legal liability system from two views at the same time, so the research is carried out in relation to two different sides: first, the demand side of the auditing services represented by the users of financial information; and second, the supply side of the auditing services represented by the auditors. This has been done through two questionnaires, one distributed for each side. The results of users' questionnaire revealed that the existence of civil legal liability will increase the demand for auditing service. Also, consideration is directed towards the main determinant of auditing quality, which is the legal liability system, more so than other factors. As well as, through increasing auditor liability, trust in financial information will be enhanced, subsequently prompting investment within society. Moreover, the users, besides their needs for auditing services, require auditors to provide collateral for their investment process in order to increase their investment level. On other side, the results of auditors' questionnaire detected that the auditors hold the view that the demand for auditing services by companies will not be affected by the existence or non-existence of the liability rules. However, auditors believe that the existence of legal liability rules will make financial statement users more trustful in financial information, thereby increasing the number of users of audited financial reports. Also, the auditors do not agree that their liability should be increased since this will make auditing services more costly through the need to collect more evidence, increase the time of auditing, increase the sample size, etc. The increase in liability will also limit their acceptance of risky clients, make them increase their efforts, and due care. Furthermore, the introduction of legal liability may cause them to reduce their supply of audit services. Finally, a statistical test is carried out to compare the answers of the two groups. It is found that there are differences in views concerning the effects of the existence of legal liability on the demand for auditing. As well as, there are differences regarding their preferences about the alternative civil legal rules. The results of this study will help legislators by comparing the effects of available legal rules on audit quality and investment level. Accordingly, legislators can select the appropriate legal structure for auditors’ liability that achieves benefits to the business environment.