Auditor Litigation Research Articles

Institutional investor inattention and audit quality

We hypothesize and provide empirical evidence that higher institutional investor inattention is associated with lower audit quality. We employ an inattention measure that captures the extent to which institutional investors are distracted by attention-grabbing events irrelevant to the focal firm. Results suggest that a higher degree of institutional investor inattention is associated with a lower propensity of a going-concern opinion, a lower probability of the auditor reporting a material internal control weakness, and a higher likelihood of the audit client misstating the financial statements. Further analyses show that these associations vary by auditor litigation risk, their workload pressure, auditor industry expertise, and analyst coverage. Overall, our findings reveal that while institutional investors play an important monitoring role, the distractions they face undermine the quality of monitoring they provide.

Factors Affecting the Outcomes of Legal Claims against Auditors

SUMMARY Maksymov, Pickerd, Lowe, Peecher, and Reffett (2020b) draw insights based on interviews with 27 prominent audit litigation attorneys about the factors affecting the initiation of legal claims against auditors and how such factors affect settlement outcomes. We summarize their key findings and discuss important implications for audit practitioners. Specifically, we focus on the key factors that affect plaintiff attorneys' willingness to pursue legal claims against auditors, including the merits of the claim, size of alleged economic damages, auditors' ability to pay, and the expected cost to pursue the claim. We also discuss the reasons why most audit disputes settle (as opposed to resolving at trial) and the factors affecting settlement outcomes. We hope the insights provided enhance audit practitioners' understanding of litigation and the settlement process to allow them to manage claims in a less intimidated and ultimately more strategic manner.

The effect of auditor litigation risk on clients' access to bank debt: Evidence from a quasi-experiment

We exploit staggered state-level shocks to third-party auditor legal liability in the U.S. to test whether auditor litigation risk affects client companies' access to private debt markets. We find that an exogenous increase in auditor litigation risk leads to an increase in both clients' likelihood of receiving bank loans and the average amount of the bank loans that clients receive. In support of our proposed mechanism that auditor litigation risk leads to improvements in clients' audit and financial reporting quality, we find that these same shocks lead to a reduction in accruals, an increase in going-concern opinions, a decrease in restatements, and an improvement in accruals' ability to predict future cash flows. We also find that increased auditor litigation risk leads to an increase in the contractibility of clients’ accounting numbers, as proxied by the use of debt covenants, and a decrease in the cost of borrowing.

Drivers of juror's malpractice assessments in auditor litigation involving offshoring and overtime: Generation and a management Mindset

The Center for Audit Quality (CAQ) estimated audit firms' lawsuit costs roughly equaled 15% of their 2008 annual revenues, and auditors still remain frequent targets of shareholder litigation today. However, settlements have declined following two critical Supreme Court rulings. Higher standards of liability in Janus v. First Derivatives have changed the landscape; audit firms are much more willing to litigate, sensing a greater likelihood to prevail. In this environment, the importance of juror perceptions of audit quality is critical. Simultaneously, juror perceptions of audit firm motives are equally important, as standards related to scienter remain ambiguous (Tellabs v. Makor). Our research manipulates variables directly germane to both perceptions of audit quality and scienter. Our research is also important because the accounting profession still provides no clear standards of audit quality. Without standardized measures, we expect jurors to seek easily understood information when tasked to assess audit quality and inferring scienter. We examine how jurors use their prior experiences to assess overtime and offshoring practices in rendering verdicts in instances of alleged “audit failures”. Specifically, we hypothesize (and find) more youthful jurors (who face more pressure to work more hours than did prior generations) interpret excessive overtime practices more negatively; and jurors with more managerial experience (who reflect a more high-level construal mindset focused on goals) interpret offshoring practices more favorably.

The Effect of Auditor Litigation Risk on Client Access to Bank Debt: Evidence from a Quasi-Experiment

We exploit staggered state-level shocks to third-party auditor legal liability in the U.S. to test whether auditor litigation risk affects client companies’ access to private debt markets. We find that an exogenous increase in auditor litigation risk leads to an increase in both clients’ likelihood of receiving bank loans and the average amount of the bank loans that clients receive. In support of our proposed mechanism that auditor litigation risk leads to improvements in clients’ audit and financial reporting quality, we find that these same shocks lead to a reduction in accruals, an increase in going-concern opinions, a decrease in restatements, and an improvement in accruals’ ability to predict future cash flows. We also find that increased auditor litigation risk leads to an increase in the contractibility of clients’ accounting numbers, as proxied by the use of debt covenants, and a decrease in the cost of borrowing.

Does the Business Press Influence Equity Investors’ Perception of Big 4 Audit Quality?

We investigate whether the business press influences equity investors’ perception of the credibility of the Big 4 for providing high-quality audits. We find that the extent of audit-related negative business press coverage of a Big 4 is associated with lower earnings response coefficients (ERC) for clients, negative client abnormal returns on the days of the news release, and a higher percentage of votes against auditor ratification. Importantly, these results are robust to controlling for other information sources such as client news, audit quality indicators (restatements and auditor litigation), and regulator press releases. Also, the extent of Big 4 negative business press coverage is associated with a lower probability of gaining new clients and a greater probability of client misstatements, suggesting that coverage is diagnostic of audit quality. The effects for ERCs and abnormal returns are concentrated in clients with low dedicated institutional ownership and high earnings uncertainty. Overall, this evidence is consistent with the business press influencing investors’ perception of Big 4 audit quality.

When Are Audit Firms Sued for Financial Reporting Failures and What Are the Lawsuit Outcomes?

ABSTRACTWe examine how often audit firms are sued in a large sample of accounting lawsuits that allege financial reporting failures. We find an insignificant relation between the likelihood of auditor litigation and restatements, but the likelihood of auditor litigation is strongly related to the types of alleged accounting deficiencies. We also find that the auditor's type influences the probability of the auditor being sued and the size of the payouts from auditor and nonauditor defendants. In particular, the Big N firms are approximately 7 percent less likely than non–Big N firms to be named as co‐defendants, and the auditor's contribution to the plaintiff's payout is significantly larger when a Big N firm is sued. Overall, our findings suggest that auditors are rarely blamed when there are allegations of financial reporting failures, but the types of accounting deficiencies and the auditor's type significantly influence the probability of the audit firm being sued and the outcomes of the lawsuits.

The impact of the Social Security Fund on auditor litigation risk

In this study, we examine the effect of the Social Security Fund on auditor litigation risk. Using audit fees as a proxy for auditor perceptions of litigation risk, we find that the Social Security Fund significantly reduces auditor litigation risk. Furthermore, we show that the Social Security Fund influences auditor litigation risk through reducing both the audit risk and the business risk of public companies. In addition, the impact of the Social Security Fund for reducing auditor litigation risk is more obvious in the group of firms with low levels of internal governance, which indicates that the Social Security Fund plays an important governance role as a high-quality institutional investor. In summary, we verify that the Social Security Fund, when acting as an institutional investor, plays an important role in corporate governance, and that it helps to reduce auditor litigation risk. Our results provide empirical support for expanding the governance role of the Social Security Fund as an institutional investor in China’s A-share market.

The Settlement Norm in Audit Legal Disputes: Insights from Prominent Attorneys

ABSTRACTPrior research indicates that most audit legal disputes settle. There is, however, little evidence of the factors that drive the settlement norm and its exceptions in audit legal disputes. To better understand these factors, we rely on theory related to how professionals manage risks and, as a result, how professions defend jurisdictional claims. We use this theoretical lens to help motivate four research questions that we probe by interviewing 27 prominent attorneys experienced in audit litigation. Consistent with our lens, our interview data indicate that attorneys manage their risks, including the risk of reputational loss, by settling based on their expectations of trial verdicts. Unlike trials, settlements simultaneously enable attorneys on both sides to limit costs and avoid catastrophic jury verdicts and, by doing so, claim “wins” for their clients. Attorneys also stress that they settle many audit disputes without any legal filings. Thus, a large subset of disputes is invisible to the public and researchers. Attorneys characterize trials as exceptions to the settlement norm that emerge due to abnormal conditions sometimes present in disputes. However, trial verdicts in these abnormal conditions help attorneys justify the use of settlements to clients, as attorneys stress that by settling they can avoid the dreaded possibility of extreme unfavorable verdicts. We conclude that as individual attorneys manage their risks, especially the risk of reputational loss, their profession maintains its public image and thereby defends its jurisdictional claims. Among the many questions we pose for future research is whether the settlement norm reduces society's ability to monitor the audit profession and, more generally, whether this norm's benefits outweigh its drawbacks.

Auditor Litigation Risk: A Review of Past Perspectives, Recent Developments, and Emerging Issues

This review synthesizes key perspectives and trends in research and practice on the topic of auditor litigation, beginning with the immediate post-SOX era and ending in 2019. Although fears of catastrophic auditor liability in this period have not yet materialized, audit firms may be facing new vulnerabilities. This paper provides a summary of emerging concerns for the near future, with a focus on the outcome of recent court cases, SEC enforcement actions, increased litigation and insurance costs, changes in audit reporting standards, technological advancements, and cybersecurity. Future research is suggested to explore these topics.

Who Is to Blame for Fraud? Lawyer Perspectives on Auditor Liability

This study examines how disclosures impact lawyers’ perceptions of independent auditors being sued for failure to detect fraud; specifically whether the auditor’s opinion and disclosures required by the Sarbanes-Oxley Act of 2002 may be deemed to be red flags and deter litigation. A 3x1 between-subjects experiment was conducted using 100 lawyers specializing in securities or business law. The lawyers reviewed a case in which the auditor had issued an unqualified audit opinion on financial statements of a company that ended up declaring bankruptcy. The lawyers reviewed the auditor’s opinion on internal controls which was manipulated as unqualified, unqualified with description of significant deficiencies, or adverse with description of material weakness. Results of this study indicate that the auditor’s report on controls has the potential to decrease the litigation exposure of auditors, as auditors providing an adverse opinion on internal controls were assessed most favorably by lawyers. However, voluntary disclosures of significant deficiencies in internal controls did not significantly influence auditor litigation exposure, indicating that the stronger message provided by an adverse Section 404 opinion is necessary to decrease litigation exposure. Overall, results of this study provide valuable insights on how audit disclosures influence potential litigators’ decisions and recommendations concerning auditor negligence lawsuits.

Audit Trial Preparation and Why It Matters: The Other Side of the Story

Prior research is unclear on the role of case merits in resolution of legal audit disputes. Using the Elaboration Likelihood Model (ELM) as a lens, we examine their role based on interviews of 42 audit litigation attorneys and trial consultants. Our results indicate that the role of case merits systematically differs between the two sides of audit litigation. Auditors’ (plaintiffs’) litigators believe they can achieve favorable outcomes by increasing the role of merit-relevant (merit-irrelevant) information in juror resolutions using trial venues, jurors, arguments, and argument delivery tactics. Litigators emphasize that this difference arises from the unique features of audit litigation. Our results validate a framework we developed based on ELM. The framework outlines how litigators believe they could increase the likelihood that jurors will use merit-relevant (merit-irrelevant) information in case resolutions. We discuss implications and suggest multiple venues for future research.

Audit Firm Attributes and Auditor Litigation Risk

This study examines the association between auditors' litigation risk and audit firm attributes. Using professional liability insurance premiums as a proxy for auditors' litigation risk, we present evidence that the risk is lower in audit firms having: (1) separate non‐audit and audit divisions; (2) a higher proportion of partners; and (3) a higher annual growth in number of CPAs employed. Additionally, we find that the risk is higher in audit firms having: (1) operating losses; and (2) high revenue growth. Our results are consistent with the idea that audit firms' financial condition and organizational structure affect their independence/ expertise, and, in turn, their litigation risk. Our results are broadly supportive of the PCAOB's (2015) and US Department of Treasury's (2008) views that investors, audit committees, management, and other regulators could benefit from having access to financial and organizational information about audit firms.

Does Big N matter for audit quality? Evidence from Japan

PurposeThere has been growing concern worldwide regarding audit quality in Japan after the Kanebo and Olympus accounting scandals. The purpose of this paper is to examine the Japanese audit market from 2001 to 2011 to determine whether audit quality differs between Big N and Non-Big N audit firms and whether this difference, if existed, changed during 2007 when the number of big audit firms declined from four to three and the requirements of audit quality became more rigorous.Design/methodology/approachThis study employs a sample of Japanese listed firms from fiscal year 2001 to 2011. Five proxy variables for audit quality are used and the data are analyzed using the propensity score matching method.FindingsThe authors show that irrespective of their size, all audit firms in Japan provide the same quality of service, when controlling for client characteristics including keiretsu, foreign sales ratio and bankruptcy risk measured in Japan. Additionally, the results suggest that although only three major audit firms remain in the Japanese audit market after the dissolution of PricewaterhouseCooper’s Chuo-Aoyama firm in 2007, the audit quality difference between Big N and Non-Big N remained unchanged before and after 2007.Originality/valueThe study contributes to the lack of existing empirical evidence on audit quality in Japan, a country characterized with low audit litigation risk and more emphasis on auditor reputation, given the influence of the notable change in Japanese audit market competition from Big 4 to Big 3. The study’s research design contributes to the extant literature by using multiple proxies of audit quality.

An Examination of Factors Driving Big 4 Audit Fee Premiums: Evidence from India's Audit Market

SYNOPSISThis study examines fee premiums earned by Big 4 auditors in India and identifies the primary reason for such fee premiums. There are three primary drivers of Big 4 fee premiums. Big 4 auditors charge a fee premium for their reputation, for providing a superior quality of audit, and for indemnifying losses for a company's stakeholders. Since the risk of auditor litigation in India is relatively low, Big 4 premiums in India would not be driven by the need for auditors to indemnify losses. The results indicate that Big 4 auditors earn significantly higher fees in India and also that their clients enjoy significantly higher earnings response coefficients compared to non-Big 4 clients. However, there is no difference in the quality of audit provided by Big 4 and non-Big 4 auditors as measured by the magnitude of reported discretionary accruals.

The Effects of Critical Audit Matter Removal and Duration on Jurors' Assessments of Auditor Negligence

SUMMARY A primary concern facing the PCAOB's requirement of disclosing critical audit matters (CAMs) is increased auditor litigation risk. Evidence with Key Audit Matters from the U.K. indicates auditors may subsequently remove a CAM or continue to report the same CAM for several years. Therefore, we investigate the effects of CAM removal and duration on jurors' assessments of auditor negligence when there is a subsequent material misstatement due to fraud in the account related to the CAM. Using the Culpable Control Model, we predict jurors will assess higher auditor negligence when a CAM is removed than when a CAM is reported and when a CAM is reported for multiple years than for one year. Results from two experiments support our expectations, although results vary depending on complexity of the misstated account. Overall, our findings highlight a quandary for audit firms, where subsequent removal of a CAM increases auditor liability.

Auditor Litigation and the Penalties on U.S. Client Firms after the Private Securities Litigation Reform Act

This study examines the relation between auditor litigation and the market and legal penalties imposed on sued audit clients after the private securities litigation reform act (PSLRA). A sample of accounting-related lawsuits is used in the regressions of three-day cumulative abnormal returns, settlement amount, and probability of settlement on auditor litigation and other variables. The results indicate a negative relation between auditor litigation and the 3-day cumulative abnormal returns around the announcement of litigation against the client firm. Another result from the study is a positive relation between auditor litigation and the legal penalty on the client firm. Specifically, the results indicate higher likelihood of settlement and larger settlement sizes for securities lawsuits in which the auditor is also sued. Our study contributes to the debate on the merit of litigation against auditors after the PSLRA. The findings imply that lawsuits against auditors appear to be a signal of audit failure and higher financial reporting risk. As audit failures erode investor confidence in the capital markets, the present study provides valuable evidence on the market and legal system’s perception of the merit of auditor litigation. The findings should be of interest to regulators and market participants given the increase in securities lawsuits against audit firms and the substantial reputational consequences of such lawsuits on audit firms and client firms.

Securities class actions of Chinese companies

This paper provides the first empirical evidence documenting the determinants and outcomes of private securities class action lawsuits filed in the US and Canada against Chinese companies and their auditors. Our findings show that, in the global context, Chinese companies are positively associated with their auditors being defendants and experiencing an adverse outcome (for example, related government enforcement actions and/or settlement payments to terminate class actions). A group of companies from outside the US with low country level audit quality, the Chinese companies, and the overall global sample were compared. For the low country level audit quality comparison group, we found that a restatement was negatively associated with auditors being defendants; this is a new finding. Two unique Chinese characteristics are that reverse mergers are positively associated with auditor litigation and bankruptcy has no association with auditor litigation. Aggregate Chinese companies’ settlements are positively associated with the occurrence of an auditor settlement and with class period length. Auditor settlements are associated with several factors. No mainland China CPA firm has ever paid to settle a private securities class action filed in the US or Canada; this also is a new finding. Several factors explain this last result.

Auditor Litigation: Deterrence Implications for Non-Sued Auditors

Auditor Litigation: Deterrence Implications for Non-Sued Auditors

Editorial note

The recent volume of the journal “Corporate Ownership and Control” is devoted to the issues of dividend policy, cost management, public sector, leadership, earnings announcements, share prices, earnings relevance, concentrated ownership, financial reporting, risk disclosures, public listing, profitability, initial public offerings, market timing, company performance, board diversity, CEO characteristics, board independence, ownership network, national intelligence, earnings management, securities class actions, auditor litigation, audit quality, reverse mergers etc.