Auditor Industry Expertise and the Timeliness and Usefulness of Litigation Loss Contingency Disclosures

Abstract

This paper hypothesizes and finds that firms audited by city-level industry specialists have more timely and useful disclosures of contingent losses from litigation, a result which we show is explained by the specialist auditor’s prior experience with other clients in the same industry. A closer examination reveals that auditor quality plays no role if prior disclosures exist in other disclosure channels. In addition, firms audited by city specialists are more likely to make a litigation loss accrual even if they face meet-or-beat pressures.Investors have complained for many years that public companies fail to warn them early enough, or at all, about risks relating to litigation and other claims that ultimately result in large losses. In response to these criticisms, the FASB proposed two exposure drafts in its unsuccessful attempts to improve the timeliness and usefulness of loss contingency disclosures. The SEC has now confronted the issue and is currently seeking ways to enforce greater compliance with SFAS 5 disclosure requirements. Thus, our evidence informs the ongoing regulatory debate surrounding SFAS 5 and potentially enhances the regulatory oversight strategies of the SEC and PCAOB.