Loss Aversion, Audit Risk Judgments, and Auditor Liability

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.