Vague Auditing Standards and Ambiguity Aversion

Abstract

SUMMARY I model unilateral auditor liability under the assumption that the auditor has an aversion to uncertainty about probability (ambiguity aversion). A vaguely defined negligence standard implies an ambiguity situation. There are two characteristics of ambiguity aversion: pessimism and likelihood insensitivity. The former improves the auditor's overall incentives to avoid the worst outcome possible (certainty effect). The latter impairs the auditor's marginal incentives because taking additional care is perceived to be partly futile (futility effect). The futility effect prevails with low damage payments; the certainty effect is dominant with high damage payments. Even with low incentives to sue, an ambiguity-averse auditor exerts excessive care when damage payments are sufficiently large. With strict liability, there is no ambiguity situation and, hence, there are no distortions from ambiguity aversion. Ambiguity aversion affects auditor care in a different way to loss aversion or risk aversion because there is no futility effect with the latter. JEL Classifications: M42; K13; D81.