An Economic Analysis of Auditors' Capped Liability (Zur ökonomischen Analyse der begrenzten Haftung des Abschlussprüfers)

Abstract:     
Under the German commercial code, the statutory auditor's liability is capped at an amount of EUR 1 Million (EUR 4 Million for listed companies) in cases of negligence. Similar liability caps exists in Austria. It is sometimes suggested that these rules result in underdeterrence, meaning that auditors have insufficient incentives to apply the legally required standard of care, as the auditor does not internalize damages exceeding the cap. This article points out that, under the gatekeeper and quasi-rent models of auditing, reputation (i.e. the danger of losing other audit clients as a consequence of an accounting scandal) should create an additional deterrent. It is suggested that an economic analysis of law taking into account only capped liability may give us an incomplete picture if the reputation effect is substantial. Under these circumstances, the deterrent effect of a publicized liability case may be big enough even if there is a liability cap. However, the amount of the effect depends on various factors, including media attention. The article also discusses liability to third parties, the marginal benefits of which are small where plaintiffs are close to being risk-neutral.

Keywords: auditor, auditing, liability, reputation, quasi-rents

JEL Classification: K13, K22, M41, M49

Accepted Paper Series