An Exploratory Examination of Auditor Liability Caps

Abstract

There have been calls for auditor liability reform in U.S. and international markets. A frequent recommendation is to place a ceiling, or cap, on auditors’ potential liabilities. Despite the interest in liability caps, a lack of publicly available data has precluded researchers from studying these agreements. We examine a unique sample of 111 companies that publicly disclose auditor liability caps during 2005 and 2006, a time period in which there was uncertainty in the regulatory guidance regarding the impact of auditor liability caps on auditor independence. Our analysis addresses two research questions. First, does the presence of auditor liability caps vary depending on client risk characteristics? We find some evidence of heightened risk in companies with liability caps. Relative to a control sample, our liability cap sample is more concentrated in high-litigation risk industries and reports internal control weaknesses with greater frequency. Second, does the presence of an auditor liability cap impact audit fees? Consistent with the insurance hypothesis for audit pricing, we find a negative relation between audit fees and companies with liability caps.