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Loss Aversion, Audit Risk Judgments, and Auditor Liability

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  • Jochen Bigus

Abstract

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.

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  • Jochen Bigus, 2015. "Loss Aversion, Audit Risk Judgments, and Auditor Liability," European Accounting Review, Taylor & Francis Journals, vol. 24(3), pages 581-606, September.
    • Handle: RePEc:taf:euract:v:24:y:2015:i:3:p:581-606
    DOI: 10.1080/09638180.2014.899920
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    Cited by:

    1. Jochen Bigus, 2015. "Auditor Reputation Under Different Negligence Regimes," Abacus, Accounting Foundation, University of Sydney, vol. 51(3), pages 356-378, September.
    2. Jani Saastamoinen & Hannu Ojala & Kati Pajunen & Pontus Troberg, 2018. "Analyst Characteristics and the Level of Critical Perception of Goodwill Accounting," Australian Accounting Review, CPA Australia, vol. 28(4), pages 538-555, December.
    3. Díez-Esteban, José María & García-Gómez, Conrado Diego & López-Iturriaga, Félix Javier & Santamaría-Mariscal, Marcos, 2017. "Corporate risk-taking, returns and the nature of major shareholders: Evidence from prospect theory," Research in International Business and Finance, Elsevier, vol. 42(C), pages 900-911.
    4. Ranjan Das Gupta & Rajesh Pathak, 2018. "Firm’s Risk-Return Association Facets and Prospect Theory Findings—An Emerging versus Developed Country Context," Risks, MDPI, vol. 6(4), pages 1-32, December.
    5. Ritzer-Angerer Petra, 2020. "Was bedeuten die Vertrauensguteigenschaften der Jahresabschlussprüfung für die Regulierung der Wirtschaftsprüferhaftung?," Zeitschrift für Wirtschaftspolitik, De Gruyter, vol. 69(2), pages 89-119, August.
    6. Konstantinos Eleftheriou & Iliya Komarev & Paul Klumpes, 2023. "Regulating the Market for Audit Services: A Game Theoretic Approach," Abacus, Accounting Foundation, University of Sydney, vol. 59(3), pages 697-734, September.
    7. Ritzer-Angerer Petra, 2020. "Was bedeuten die Vertrauensguteigenschaften der Jahresabschlussprüfung für die Regulierung der Wirtschaftsprüferhaftung?," Zeitschrift für Wirtschaftspolitik, De Gruyter, vol. 69(2), pages 89-119, August.

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