EMPIRICAL EVIDENCE ON AUDITORS’ LEGAL LIABILITY CAP AND AUDIT QUALITY

Abstract

The study examines the relationship between auditor legal liability cap and audit quality. Using a matched sample of 298 firm-year observations over the period 2001-2007, I provide evidence that limiting or reducing auditor’s legal liability caps against clients as disclosed in the engagement letters is associated positively and significantly with audit fees, a measure of audit quality. This study also finds that liability firms are either very large or very small in size measured by total assets. Liability firms are less profitable, highly leveraged, audited by Big 4 auditors and are concentrated in the services, manufacturing, computer, and pharmaceutical industries. The results documented herein have important implications in the debate over auditor’s legal liability reforms.