Auditor Liability
The European Accounting Review 2000, 9:3, 371 385
Auditor liability rules under imperfect information and costly litigation: the welfare-increasing eΠof liability ect insurance
Ralf Ewert, Eberhard Feess and Martin Nell University of Frankfurt, Frankfurt am Main
ABSTRACT
This paper examines auditor liability rules under imperfect information, costly litigation and risk-averse auditors. A negligence rule fails in such a setting, because in equilibrium auditors will deviate with positive probability from any given standard. It is shown that strict liability outperforms negligence with respect to risk allocation and the probability that a desired level of care is met by the auditor if competitive liability insurance markets exist. Furthermore, our model explains the existence of insurance contracts containing obligations a type of contract often observed in liability insurance markets.
1. INTRODUCTION
During the last few years, remarkable modi® cations of auditor liability have been enacted in several countries. For example, the Private Securities Litigation Reform Act of 1995 in the US replaced joint and several liability by proportionate liability.1 In Germany, the `Gesetz zur Kontrolle und Transparenz im Unternehmensbereich’ (KonTraG) 2 has increased maximum liability payments for each false statement from 0.5 to 8 million DM. Though the changes are important, nowhere was the principle of negligence substituted by strict liability. Theoretically, it is somewhat surprising that auditor’ s liability is negligence based, because it is well known that strict liability is superior if problems of asymmetric information are taken into account. We consider a setting where the auditor’ s eŒ is unobservable but veri® able, and where litigation is ort costly. With these reasonable assumptions, a negligence rule is ine cient even Address for correspondence
Martin Nell, University of Frankfurt, Department of Business Administration, Mertonstr. 17, D-60325 Frankfurt
Auditor liability rules under imperfect information and costly litigation: the welfare-increasing eΠof liability ect insurance
Ralf Ewert, Eberhard Feess and Martin Nell University of Frankfurt, Frankfurt am Main
ABSTRACT
This paper examines auditor liability rules under imperfect information, costly litigation and risk-averse auditors. A negligence rule fails in such a setting, because in equilibrium auditors will deviate with positive probability from any given standard. It is shown that strict liability outperforms negligence with respect to risk allocation and the probability that a desired level of care is met by the auditor if competitive liability insurance markets exist. Furthermore, our model explains the existence of insurance contracts containing obligations a type of contract often observed in liability insurance markets.
1. INTRODUCTION
During the last few years, remarkable modi® cations of auditor liability have been enacted in several countries. For example, the Private Securities Litigation Reform Act of 1995 in the US replaced joint and several liability by proportionate liability.1 In Germany, the `Gesetz zur Kontrolle und Transparenz im Unternehmensbereich’ (KonTraG) 2 has increased maximum liability payments for each false statement from 0.5 to 8 million DM. Though the changes are important, nowhere was the principle of negligence substituted by strict liability. Theoretically, it is somewhat surprising that auditor’ s liability is negligence based, because it is well known that strict liability is superior if problems of asymmetric information are taken into account. We consider a setting where the auditor’ s eŒ is unobservable but veri® able, and where litigation is ort costly. With these reasonable assumptions, a negligence rule is ine cient even Address for correspondence
Martin Nell, University of Frankfurt, Department of Business Administration, Mertonstr. 17, D-60325 Frankfurt
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