Auditor Reputation Losses, Legal Liability, and Standards

• In Event: Drivers and consequences of audit choices

Abstract

This paper studies the effect of legal liability due to negligence on the quality of audited earnings when an auditor also faces reputation losses. The auditor is concerned about the loss of future clients due to a decline in the client market’s perception about his ability, which motivates the auditor to supply high audit effort. With legal liability and negligence in the case of an investor lawsuit, auditing standards provide the level of due care necessary to avoid negligence. Thus, the auditor has a choice to comply with standards or to violate standards. With compliance, if standards are lax, audit effort is higher than the minimum threshold because of reputation concerns. In equilibrium this is costly to the auditor because the market is not fooled and discounts high audit effort. With noncompliance, the auditor has lower costs, but incurs expected legal liability damages. If the damages are low, the auditor prefers noncompliance, which allows the auditor to commit to a lower audit effort and lower audited earnings quality. Further, when considering preferences for the strictness of standards, investors always prefer stricter standards than the auditor, but reputation losses can dampen the difference in preferences.

Author

• Naomi Rothenberg, University of Alberta