Audit Standards and Auditor Liability: A Theoretical Model

Abstract The business of auditing is heavily regulated. Auditor regulation exists through licensing, professional standards and liability. The auditor's liability for losses to financial statement users from audit failure is subject to a test of negligence. What constitutes due audit care is, however, not generally well-specified. Furthermore, reviews of litigation against auditors conclude that compliance with professional audit standards does not always act as a complete defence to allegations of negligence. The current situation can be described as one where (ex ante)—from the point of view of the auditor—uncertainty exists about the ‘legal’ standard of due audit quality (as seen by the courts in the event of litigation). This uncertainty about legal standards fundamentally affects audit behaviour in ways that are not immediately intuitive. This paper draws on insights from the economics and law literature (e.g., Kolstad et al., 1990; Shavell, 1984a, 1984b and 1987; Calfee and Craswell, 1984 and 1986) ...