Auditors' liability with overcompensation and reputation losses

This paper contributes to the theoretical literature by analyzing the effect of two empirically relevant characteristics of auditor liability. First, we endogenize a loss of reputation whenever an accounting scandal occurs, even if no lawsuit is brought against the auditor. Second, we model the fact that damage compensation payments usually exceed the investors' social loss (overcompensation) since some investors benefit from wrong financial statements. Under a vaguely defined negligence rule, both phenomena tend to induce excessive care when investors are sufficiently likely to bring a lawsuit. If reputation losses are sufficiently high, a Nash equilibrium in pure strategies evolves where investors do not sue and auditors do not exert suboptimal care. Litigation costs are then saved. A properly defined liability cap mitigates excessive care caused by overcompensation or reputation losses.