Limiting Auditors' Liability: The Potential Consequences

The recent revival of interest in the issue of limiting auditors' liability raises questions about the potential effect of such a limitation on auditors' performance. This paper considers the consequences of limited liability from the perspectives of contracting theory and economic arguments. We examine the potential effect of a reduction in auditors' liability on the standard of care or quality of service they provide, emphasising the "calculus of negligence" concept used by Australian courts. We consider the potential impact of reduced liability on the auditor's decision to shirk responsibilities (the moral hazard problem) and on the value placed on audit services. The analysis shows that placing a statutory cap on auditors' liability has the potential to reduce the effectiveness of bonding mechanisms; provide an avenue for divergent behaviour; lower the level of care provided by auditors; and decrease the value of audit services.     

Auditors’ Liability,Investments, and Capital Markets: A Potential Unintended Consequence of the Sarbanes‐Oxley Act

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

The influence of litigation risk and internal audit source on reliance decisions

External auditor reliance on the work of internal auditors in an integrated audit of the financial statements and internal control is an important audit planning procedure that can impact audit efficiency and effectiveness. The purpose of this study is to examine how perceived auditor litigation risk and internal audit source affect external auditors' reliance decisions in an integrated audit environment under varying levels of risk of material misstatement. In an experimental study using 89 practicing Big 4 auditors, this study finds that auditors who perceive low litigation risk from placing reliance on the work of internal auditors will rely more on outsourced internal auditors than in-house internal auditors. The results also show that auditors' reliance decisions are sensitive to the level of account risk consistent with the risk-based approach to the integrated audit encouraged by the PCAOB.     

The effects of trust, client importance, and goal commitment on auditors' acceptance of client-preferred methods

The purpose of this study is to extend our understanding of the factors that impact auditor judgment and decision-making. Specifically, we investigate how two factors, client importance and auditor trust, impact auditors' directional goal commitment and decision-making at the transaction level. We find no impact of client importance on the auditors' goal commitment or acceptance of a client preferred accounting treatment. However, we find that trust in client's management is positively related to the commitment to the goal of supporting the client's preferred method of recognizing revenue. Further, we find that auditors' goal commitment is positively related to their acceptance of a client preferred accounting treatment.     

Capping auditor liability: The German experience

There are serious concerns in some Western countries that methods should be found to resolve what is commonly referred to as the auditing profession's liability crisis. A number of legislative-based proposals to limit auditors' liability have been suggested. However, anxiety has been voiced relating to the inherent uncertainties attached to such apparently untested reforms. In this respect it is interesting to note that for more than sixty years the German auditing profession has operated within a regulatory environment in which liability is restricted by a legislatively sanctioned universal cap. We document the German experience and consider whether their form of liability restricting mechanism can provide a contribution to the debate concerning the efficacy of proposals to reform auditor liability elsewhere. We draw attention to the fact that at this time when the auditing professions in other countries are campaigning for reductions in liability exposure, it is interesting to observe that the German auditing profession has recently campaigned for increases in exposure. We use this and related events to suggest that the German experience illustrates that it is unlikely that the liability crisis can be resolved by simply changing the legal basis upon which financial penalties for auditors are assessed. We argue that a necessary precursor to a redesign of penalty mechanisms is a need to obtain measured consensus concerning identification of the constituency of claimants that should have rights to pursue auditors in the courts. Such an identification process needs to be firmly based within a model of corporate governance which reflects what can reasonably be expected from and provided by the auditing profession. In this respect we support the application of the intermediate form of corporate governance which until relatively recently characterized the German system. Within this system auditors were ascribed a less influential role than was envisaged in Anglo-American traditions. This arose since they acted principally as information agents to an influential supervisory board rather than as shareholders' representatives.     

AUDITOR PREFERENCES FOR LIABILITY LIMITATION

Debate over statutorily limiting auditor civil liability has implicitly assumed auditors are homogeneous in their preferences for capping liability. This study examines the preferences of auditors for limiting auditor liability and investigates reasons for the preferences. The study uses an Australian setting in which there has been a persistent debate for a decade or more over regulatory intervention in this area. The study provides a background to the debate over this issue and addresses the effects of two factors suggested by the extant literature, namely auditor size and the business risk of an auditor's client portfolio. These factors are argued to affect the expected costs of litigation facing auditors and therefore their preferences on capping liability. Using the submissions by audit firms on an Australian Companies and Securities Law Review Committee Discussion Paper on limiting auditor liability, the study finds larger audit firms that have greater capacities to lobby and greater expected costs of litigation from unlimited liability than smaller firms, dominate the respondents on the Paper and tend to be more supportive of liability limitation than smaller audit firms. Within the array of possible methods of capping liability canvassed by the Discussion Paper, the study documents evidence of diversity in preferences among audit firms. Larger audit firm size is associated with a preference for a group of methods that provides such firms with opportunities to benefit from the capping at the expense of the smaller audit firms. The method most preferred by the larger audit firms is the multiple of fee with a prescribed minimum. Perhaps not surprisingly, this is also the preferred method of the professional accounting bodies in Australia. As to the effect of the riskiness of the client portfolio on preferences for methods of limiting liability, the study finds that higher business risk in an auditor's portfolio is associated with a preference for methods that give greater control over their liability exposure. The study has implications for the impact of regulation of capping liability on competition in the audit services market.     

Are Auditors' Analytical Procedures Judgments Affected by Receiving Management Explanations?

This paper reports the results of a computerised experiment focusing on the impact of management representations, and the timing of those representations, on auditors' performance in completing all stages of an analytical procedures (AP) task. While timing of the management explanation had an initial impact on the AP process, there was no difference in the number of correct auditor responses due to this factor. However, receiving the management explanation did affect the cause selected, with auditors receiving that explanation selecting it significantly more often than those who did not receive that explanation. The findings suggest several areas for potential improvement of the auditors' AP proces.     

Auditors' Liability, Vague Due Care, and Auditing Standards

This paper expands the set of previously considered liability rules to include a negligence liability rule with a vague specification of due care. Auditors who are negligent in conducting their audit are liable for losses that result from reliance on misstated financial statements. However, what constitutes negligence for auditors is not clearly specified in the law. Consequently, courts often resort to Generally Accepted Auditing Standards (GAAS) and Statements on Auditing Standards (SAS) as benchmarks for determining due care. A liability regime that consists of a vague negligence rule supports and amplifies the credibility of auditing standards. While auditing standards alleviate some of the vagueness that is inherent in the legal standard, they also form a lower bound on due care, since an audit of a quality that is lower than the quality that auditing standards require would be considered negligent. Thus, the vague specification of due care enables auditors to commit to audit quality as pronounced in auditing standards. This paper explores this link between professional standards and auditors' legal liability. It establishes that the commitment to auditing standards could not have been as credible as it is, if auditors' liability was determined based on the strict liability rule, or based on a negligence rule with a clearly specified due care, since under these two liability rules courts would not need to refer to auditing standards to establish fault. The paper also demonstrates that a legal regime where audit standards are used as a benchmark to evaluate negligence is not the same as a legal regime where due care is defined clearly. Therefore, previous studies that assumed a negligence regime with clear due care may have overstated the effort level that is induced by legal liability.     

The effect of auditor litigation risk on clients' access to bank debt: Evidence from a quasi-experiment

We exploit staggered state-level shocks to third-party auditor legal liability in the U.S. to test whether auditor litigation risk affects client companies' access to private debt markets. We find that an exogenous increase in auditor litigation risk leads to an increase in both clients' likelihood of receiving bank loans and the average amount of the bank loans that clients receive. In support of our proposed mechanism that auditor litigation risk leads to improvements in clients' audit and financial reporting quality, we find that these same shocks lead to a reduction in accruals, an increase in going-concern opinions, a decrease in restatements, and an improvement in accruals' ability to predict future cash flows. We also find that increased auditor litigation risk leads to an increase in the contractibility of clients’ accounting numbers, as proxied by the use of debt covenants, and a decrease in the cost of borrowing.