Auditing Section Research Summaries Space

A Database of Auditing Research - Building Bridges with Practice

This is a public Custom Hive  public

research summary

    Vague Auditing Standards and Ambiguity Aversion.
    research summary posted October 16, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk 
    102 Views
    Title:
    Vague Auditing Standards and Ambiguity Aversion.
    Practical Implications:

    This paper could have implications for the current debate in the U.S.A. and the European Union on whether auditors’ liability should be capped. This paper shows that a liability cap may be (but need not be) desirable when auditors’ ambiguity aversion otherwise induces excessive care. If liability caps are not warranted, accounting and auditing standard setters may consider making standards more precise in a high-liability setting. Since sharing losses seems beneficial under ambiguity aversion, auditors may find it advantageous to perform joint audits (if permitted by regulation). This paper contributes to the literature by incorporating a persistent phenomenon of boundedly rational decision-making into a model of auditor liability.

    Citation:

    Bigus, J. 2012. Vague Auditing Standards and Ambiguity Aversion. Auditing: A Journal of Practice & Theory 31 (3): 23-45.

    Keywords:
    ambiguity aversion, auditors’ liability, behavioral accounting, vague standards of due care
    Purpose of the Study:

    There is strong empirical evidence that individuals are subject to boundedly rational behavior. There is also evidence that auditors face cognitive. More specifically, auditors tend to increase care levels when confronted with ambiguous audit contexts. Many experiments have confirmed that individuals generally dislike ambiguity. This paper incorporates ambiguity aversion into a model of auditor liability. Ambiguity implies uncertainty about the probability that a future event, e.g., a future loss, will occur. With ambiguity aversion, people tend to weigh less favorable outcomes more highly, and are, therefore, more pessimistic. For instance, other things being equal, individuals usually prefer a 30 percent chance to a (imprecisely defined) chance of 1050 percent. Interestingly, individuals still prefer a certain probability to a probability range, even with training in decision-making. This immunity to persuasion leads to the belief that ambiguity aversion might, in fact, be considered rational. If, in fact, ambiguity aversion is rational, there seems to be a need to incorporate it into economic modeling.

    Design/Method/ Approach:

    The author uses a model to analyze how an auditor’s ambiguity aversion affects his level of care.

    Findings:

    The author obtains the following results, considering a risk-neutral auditor who dislikes ambiguity:

    (1) An ambiguity-averse auditor tends, on the one hand, to exert less care with low damage payments. Due to likelihood insensitivity, with low damage payments, the perceived marginal benefits of additional care are too low (futility effect).
    (2) On the other hand, an ambiguity-averse auditor may be willing to take a (very) high level of precaution in order to be certain that he will not be held liable ex post. Certainty is valuable in the event of pessimism, and becomes more valuable the higher damage payments are. If damage payments exceed a certain threshold level, the certainty effect outweighs the futility effect. Thus, the problem of excessive care becomes more serious.
    (3) Even with low incentives to sue, an ambiguity-averse auditor may exert excessive care when damage payments are sufficiently large.
    (4) Both a liability cap and liability insurance avoid excessive care, but may then induce suboptimal precaution.
    (5) With strict liability, the auditor exerts efficient care, since there is no second-order probability and no ambiguity situation. Thus, there is no distortion from ambiguity aversion. This is a new benefit of a strict liability rule.

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Litigation Risk