The effect of limiting statutory auditors’ civil liability on financial reporting quality : Empirical evidence on liability caps and earnings management in Europe

Abstract

The European Commission has recommended that EU member states limit the civil liability of statutory auditors. This paper examines the effect of the existence of a liability cap on financial reporting quality, which is measured by the magnitude of earnings management in audited financial statements. The results from a sample of 1,306 listed companies in six European countries in 2008 indicate that liability caps lead to lower financial reporting quality when a large company is audited by a non-Big 4 auditor. This is consistent with that large companies are more likely to be affected than small and medium size companies because of the fixed threshold nature of the liability caps. As to the auditor type, the findings are consistent with earlier research on the effects of auditor type on financial reporting quality. The findings should be useful when assessing the implications of introducing similar liability limitations.