How Auditor Legal Liability Influences the Detection and Frequency of Fraudulent Financial Reporting

In today's legal environment, auditors who fail to detect fraud face potentially extreme liabilities because of the possibility of biased juries and other factors that can result in extreme legal liabilities for auditors. This paper summarizes a recent study (“The Impact of Audit Penalty Distributions on the Detection and Frequency of Fraudulent Reporting”; Burton et al. [2011]), which used an experimental economics research method to investigate how the legal liability for failing to detect fraud influences auditors' efforts to detect financial reporting fraud and auditees' commission of such fraud. The experiments show that a penalty system that is not subject to extreme legal liabilities for the auditor, but has the same expected value (i.e., average penalties) as a system that is subject to extreme liabilities, increases auditors' effort to detect fraud and decreases fraudulent reporting by auditees.