Disclosure of Internal Control Weaknesses and Auditors’ Litigation Risk

Abstract

SUMMARY We investigate whether the concern of shareholder litigation motivates auditors to disclose internal control weaknesses. We document that issuing adverse internal control opinions reduces the likelihood of auditors being named with their clients as defendants in shareholder lawsuits. This finding suggests that auditors can reduce their legal liability arising from failed financial statement audits by increasing the quality of internal control audits. Consistent with this expectation, we find that auditors are more likely to issue such opinions in a timely manner for clients with higher ex ante litigation risk. Overall, our evidence suggests that the threat of litigation provides an incentive rather than a disincentive for auditors to issue adverse internal control opinions for clients with higher litigation risk. Data Availability: The data are available from public sources indicated in the paper. JEL Classifications: M42; K41.