Auditors’ Liability with Ambiguity Aversion

Abstract

We model unilateral auditor liability under the assumption that the auditor has an aversion to uncertainty about probability (ambiguity aversion). A vaguely defined standard of due care implies an ambiguity situation. This paper shows that, compared to an expected utility framework, an ambiguity-averse auditor tends to exert less care with low damage payments but higher care with high damage payments. If investors have strong incentives to bring a law suit, auditors’ ambiguity aversion will tend to induce excessive care. A liability cap is then advisable. Even with low incentives to sue, an ambiguity-averse auditor exerts excessive care when damage payments are sufficiently large. With strict liability, there is no ambiguity situation, and hence there are no distortions from ambiguity aversion.

Keywords: auditors’ liability, ambiguity aversion, vague standards of due care, behavioral accounting

JEL Classification: M42, K13, D81