Review of Accounting Studies, 8, 105–131, 2003  C 2003 Kluwer Academic Publishers. Manufactured in The Netherlands. Evidence of Fraud, Audit Risk and Audit Liability Regimes EVELYN PATTERSON ∗ evpatter@buffalo.edu School of Management, State University of New York at Buffalo, Buffalo, New York 14260 DAVID WRIGHT University of Michigan Business School, University of Michigan, Ann Arbor, MI 48109-1234 Abstract. We investigate the effectiveness of proportionate liability in reducing the probability of fraud and audit risk relative to joint and several liability in two strategic audit settings: one that provides conclusive evidence of fraud and one that provides inconclusive evidence of fraud. In both settings the auditor makes an audit effort choice, but in the second setting the auditor also evaluates the audit evidence. Our results show that when the auditor chooses only effort, a proportionate liability rule with large marginal liability relief decreases audit risk. However, when the auditor also evaluates the audit evidence this result no longer holds. Keywords: legal liability regimes, strategic auditing, proportionate liability, fraud JEL Classification: D4, K13, M14 The audit profession contends that legal practices treat auditors unfairly. Until recently, they have been held jointly and severally liable for undetected material misstatements and have had to pay their own legal fees whether or not they prevail in court. 1 Under a joint and several liability regime the auditor pays damages that are often unrelated to his level of due care because other defendants are incapable of paying their share. For example, being 1% at fault for causing plaintiffs’ damages is not necessarily related to paying 1% of the damages because the auditor is a “deep pocket.” This issue is discussed by Arthur Andersen & Co., et al. (1992) who state that the joint and several liability system: . . . functions primarily as a risk transfer scheme in which marginally culpable or even innocent defendants too often must agree to coerced settlements in order to avoid the threat of even higher liability, pay judgments totally out of proportion to their degree of fault, and incur substantial legal expenses to defend against unwarranted lawsuits. By contrast, a proportionate liability regime allows the court to determine the percent of auditor damages based on the percentage of fault in causing those damages irrespective of the other defendants’ ability to pay. The Private Securities Litigation Reform Act of 1995 adopts a limited form of proportionate liability, and the Securities Litigation Uniform Reform Act of 1998 preempts state law for class action suits involving nationally traded securities. However, actions against auditors that are not class action suits may be filed under state common law and litigated under joint and several liability. In addition, controversy still exists ∗ Corresponding author.