The Effect of Limiting Auditors' Liability on Audit Quality

Abstract

The need for uniform financial information has brought about efforts to harmonise accounting and audit regulation in the European Union. The European Commission has recommended that the EU member states should limit the civil liability of statutory auditors. It is argued that limiting auditors’ liability could lead to lower audit quality as a result of smaller liability risk. It is also argued that Big 4 auditors produce more consistent audit quality than other auditors regardless of legal environment, meaning that limiting the liability affects the audit quality produced by Big 4 auditors less than other auditors. This study examines the effect of the existence of a liability cap for statutory auditors on audit quality measured by the magnitude of earnings management. Abnormal working capital accruals are used for estimating earnings manipulation. The effect of a liability cap is also examined by comparing companies audited by Big 4 auditors to those that are not. The study examines the financial data from 2008 of 1,174 listed companies in six European countries. The results of univariate and multivariate analyses provide no evidence that the existence of a liability cap affects audit quality as measured by the magnitude of earnings management or that this effect differs between companies audited by Big 4 auditors and non-Big 4 auditors.