Loss Aversion, Audit Risk Judgments, and Auditor Liability

Jochen Bigus

Free University Berlin, Department Accounting and Finance

February 11, 2014

European Accounting Review, Forthcoming

I investigate how different legal regimes affect auditor’s effort and investors’ investment decisions when the auditor is subject to probability weighting and loss aversion, which are two important characteristics of Prospect Theory. Probability weighting encourages an auditor to overrate the audit risk and the likelihood of damages leading to inflated audit fees which could help to explain the BigN audit fee premium. With loss aversion, an auditor is sensitive to the risk of damage compensation and, thus, tends to exert excessive caution which also generates excessive audit fees. Consequently, investors may choose not to hire an auditor and, as a result, may forego an otherwise profitable investment. These effects are more intense with a strict liability regime than with a negligence rule because with the latter, the auditor is not held liable when due care has been exerted. This removes the risk of incurring losses. The paper highlights the robustness of the negligence regime when preferences are unobservable.

Number of Pages in PDF File: 41

Keywords: auditor liability, audit risk, probability weighting, loss aversion, negligence rule

JEL Classification: M42, K13, D81

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Date posted: February 12, 2014  

Suggested Citation

Bigus, Jochen, Loss Aversion, Audit Risk Judgments, and Auditor Liability (February 11, 2014). European Accounting Review, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2394120

Contact Information

Jochen Bigus (Contact Author)
Free University Berlin, Department Accounting and Finance ( email )
Kaiserswerther Str. 16-18
Berlin, Berlin 14195
++49-30-83852509 (Phone)
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