I received a couple of comments on yesterday's posting about the capping of auditor responsibility for failed audits. First, a correction, courtesy of John A., about my attribution to Mark Twain about the prospect of hanging:

'Twas Samuel Johnson, via Boswell: "Depend upon it, sir, when a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully." -- Boswell: Life

I stand corrected. Must have been thinking about Mark Twain's famous quote, "The rumors of my death have been greatly exaggerated." (At least I think it was Mark Twain.)

From accounting doctoral student, Steve S., in California:

I just finished reading about Sun Microsystems in "Capping Responsibility" and your comments about the benefits (or lack thereof) of liability caps to investors. Won't firms pay less for liability-capped audits? And isn't that a benefit to investors? The question is who bears the risk. If investors are well diversified and accounting firms are not, then it might make sense for investors to bear the risk of audit failure rather than the accounting firms, assuming investors are compensated for doing so by way of lower audit fees. Not to mention your point about firms taking financial reporting more seriously. The remaining question, I think, is whether these liability caps reduce the quality of audits since auditor liability is reduced.

I can't agree with very much in this, Steve, but let's start with the "remaining question": whether these liability caps reduce the quality of audits since auditor liability is reduced. That really is the only question, as far as I'm concerned, and what the whole issue is about. So turn it around: just how much inferior quality is acceptable in order to get a lower price on the audit fee? Ask an investor who has a significant stake in a firm and treats it as ownership, not rent. Accepting less quality to save a few bucks would not work in the interests of investors who work in such a "concentrated" style. Not all investors seek diversification.

Of course that's an argument for "well-diversified" portfolios - but if all firms accept shoddier audit work to save on audit fees, does diversification eliminate the blow-up risk? Doubtful; not if all firms systemically have lower-quality financials. Diversification won't help.

Another issue: "investors are well-diversified, and accounting firms are not." In the post-Sarbox era, I think that investors automatically believe that accounting firms do nothing but audits, and that they've given up on consulting services. Wrong. The accounting firms are reaping more audit fees, and they've been barred from consulting for clients - but they are still very active in consulting. It's just not as visible because we don't see any consulting fees paid by audit clients. They're more diversified than you might think - and able to absorb audit risk.

Wouldn't firms pay less for liability-capped audits? Well, they should - they're receiving less for their money. But they probably wouldn't - not if there's very little choice in who will be the auditor. It's tough to negotiate a price down when there aren't many choices to play off the current supplier of services. I'm not suggesting that there's cartel pricing in the auditing world, but you can't deny that pricing and negotiations are tougher when there are fewer alternatives.

Lower audit fees a benefit to investors? I don't think of this as the same thing as raising your deductibles on your insurance. There's a public benefit to having high quality audits: it's called confidence in the markets. Maybe firms would report higher earnings (and I don't think that matters as much as others - more in a minute) if audit fees were lower for liability-capped audits, but markets might demand compensation in the form of lower multiples.

As for the dollar benefit of lower audit fees, lower audit quality: I don't believe audit fees aren't as bad as you might be conditioned to believe by all the griping in the press about higher audit costs after Sarbanes-Oxley. In 2004, after firms should have incurred the brunt of the increased audit vigilance, only 38 firms in the S&P 500 had after-tax audit fees that were greater than 2% of diluted EPS. And 318 S&P 500 firms - 64% of them - have zero impact on EPS from after tax audit fees. So, I'd be less than thrilled as an investor if audit fees went down just because I'm shouldering more risk; there just isn't much bang for the buck.

In fact, maybe auditors should scrap the caps and keep fees and quality high. Now that's a novel idea.