Auditor Liability Research Articles

The Effects of High Estimate Uncertainty in Auditor Negligence Litigation*

We examine how jurors' negligence judgments and attorneys' out‐of‐court settlements are differently impacted by two features of a materially misstated accounting estimate—the amount of estimate uncertainty and whether the misstated account is disaggregated into its own line‐item or aggregated with other accounts into a single financial statement line‐item. We predict and find that jurors and attorneys react to estimate uncertainty in opposite directions under common conditions. This finding is important because when jurors' judgments and attorneys' settlements differ, research into juror judgments alone may not capture a complete picture of auditor liability because the vast majority of audit litigation is resolved by attorneys in out‐of‐court settlement without ever going to trial. Consistent with attribution theory, results from our first experiment show that jurors hold auditors more responsible for misstatements of lower estimate uncertainty when the misstated account is disaggregated, as opposed to misstatements that are of higher uncertainty and/or aggregated with other, accurate accounts. However, in a second experiment we find that attorneys negotiate auditor settlements under the incorrect assumption that jurors will hold auditors more responsible for failing to prevent misstatements of higher uncertainty. Our results illustrate that accounting research should not focus solely on juror judgments in the study of how specific factors impact auditor liability, and that attorneys would benefit from a better understanding of juror decision making.

Beyond Risk Shifting: The Knowledge‐Transferring Role of Audit Liability Insurers*

ABSTRACTRegulators and researchers tend to focus primarily on the risk‐shifting benefits of audit liability insurance. We obtain field data from the US audit insurance industry (16 interviews and 83 survey responses) to examine whether insurers also possess characteristics favorable to transferring their private risk management knowledge to the audit firms they insure. Possessing such characteristics would enable insurers to use their relative knowledge advantage to provide a benefit to audit firms beyond risk shifting. Thus, examining this issue helps broaden our understanding of insurers' role in auditing. We examine our data through the lens of the knowledge transfer theory and find evidence that audit liability insurers have the motivation and capacity to accumulate and transfer risk management knowledge to the audit firms they insure. We find that audit firms, particularly the small resource‐constrained firms (i.e., non–Big 4 and non‐second‐tier), rely on and benefit from their insurers' risk management knowledge. We also find that insurers transfer such knowledge through multiple mechanisms, including free consultative services, policy premium incentives, and continuing professional education classes. Our results highlight the important role of audit insurers as transferors of risk management knowledge to audit firms. Broadly, our results extend knowledge transfer theory and suggest areas for future research in US and international contexts.

The Effect of Form AP on Auditor Liability when Engagement Partner Disclosure Shows a History of Restatements

SYNOPSIS Engagement partner disclosures required by Form AP allow litigants to associate audit partners with both current and past restatements. We investigate how this information and audit firm interventions to restore audit quality impact audit firm liability in litigation stemming from a partner's second client restatement. Interestingly, we do not find that a partner's association with a current and past restatement alone increases audit firm liability. However, we do find that jurors interpret firm interventions to restore audit quality as indicators that the partner contributed to the second audit failure and that firm oversight was inadequate. Specifically, we find that both requiring a probationary engagement co-partner after an initial restatement and partner dismissal after a second restatement increase juror assessments of firm liability. Collectively, our findings suggest Form AP presents a catch-22, whereby firm interventions to restore audit quality are expected by regulators but increase liability in subsequent litigation settings. Data Availability: Available upon request from the authors.

Auditing in the time of COVID – the impact of COVID-19 on auditing in New Zealand and subsequent reforms

Purpose This special issue paper aims to describe the early effects of COVID-19 on auditing in New Zealand, and the subsequent reforms that the authors expect will follow. Design/methodology/approach The authors use published sources to discuss the impact of COVID-19 on auditing, and potential reforms. Findings COVID-19 was at first expected to have a substantial impact on audit outcomes such as audit opinions. The effects that eventuated have been much less substantial so far. Nevertheless, the authors expect reforms to auditing to take place, especially including non-audit services, reports on inspections of auditors and more reporting on going concern issues by directors, followed by increased responsibility for auditors. In future, there may be further changes including reform to the liability of auditors, reporting on internal control, more responsibility for fraud and changes to corporate governance. Research limitations/implications Limitations include the ongoing nature of the COVID-19 crisis. Further effects may yet eventuate. Practical implications Financial report users and auditors should anticipate changes. Originality/value This paper provides early evidence of the impact of COVID-19 on New Zealand auditing and predicts changes to the regulation of auditing.

How Do Remote Audits Impact Auditor Liability Exposure? Exploring Jurors’ Perceptions of Interview Evidence Collected during the COVID-19 Pandemic

The COVID-19 Pandemic has arguably accelerated auditors’ shifts to 100% remote audits, with unknown consequences on auditor liability exposure. In this experimental study, a moderated-mediation model is proposed and tested to explore the joint effects of the modality of auditors’ interview evidence collection and the COVID-19 Pandemic on jurors’ perceptions of auditors’ intentions to collect high quality evidence and auditor liability. 158 jury eligible participants read a case that manipulated the client interview modality (face-to-face vs. remote/virtual) and the timing of the audit (before vs. during the COVID-19 Pandemic) in a 2x2 between-subjects experiment examining jurors’ perceptions of auditors who failed to detect collusion. After reading the case, participants provided their perceptions of auditors’ intent to collect high quality evidence and auditor liability for shareholder losses. Results indicate that, while the risks are likely to be lessened during the COVID-19 Pandemic time period, auditors may be exposed to increased risk of liability for collecting interview evidence virtually outside of the COVID-19 Pandemic time period.

Auditor Liability and Excess Cash Holdings: Evidence from Audit Fees of Foreign Incorporated Firms

Auditors of foreign cross listed firms face liability arising from the nature of the institutional monitoring framework of legal claims that can potentially be brought against the auditor in both the home country and the US. This paper is the first to document the relationship between auditor liability and auditor pricing of excess cash holdings for foreign firms cross-listed in the US. Our findings indicate that auditors demand a fee premium for foreign incorporated clients with greater excess cash holdings, consistent with auditors recognizing the potential for legal exposure to agency conflict arising from foreign listed US traded clients. Furthermore, we examine aspects of foreign capital market protections, such as disclosure requirements, the strength of legal enforcement, and the strength of shareholder rights to better understand auditor perception of the liability they incur due to the agency costs associated with excess cash holdings. We find that there is a significant positive association between audit fees and excess cash holdings for firms where the country of incorporation permits greater liability of auditors in criminal and civil litigation. In addition, auditors assign higher audit fees to firms holding greater excess cash incorporated in countries with greater required accounting disclosure, stronger legal enforcement and stronger shareholder rights.

Key audit matter and auditor liability: evidence from auditor evaluators in Thailand

PurposeThis study examines the effects of key audit matter (KAM) disclosures in auditors' reports on auditor liability in cases of fraud and error misstatements using evaluators with audit experience.Design/methodology/approachThe experiment is conducted using 174 professional auditors as participants.FindingsThe participating auditors assess higher auditor liability when misstatements are related to errors rather than when they are related to fraud. In addition, the results also demonstrate that KAM disclosures reduce auditor liability only in cases of fraud and not in cases of errors. Together, the results support the view that KAM reduces the negative affective reactions of evaluators, which in turn, reduce the assessed auditor liability.Research limitations/implicationsThis study did not analyze the setting in which auditors who act as peer evaluators had an opportunity to discuss the case among their peers, which may have affected their judgments.Practical implicationsThe results of KAM disclosures on auditor liability in cases of error and fraud misstatements inform auditors that, different from the auditors' concern that disclosing KAM may increase auditors' legal risk, it tends to decrease or at least have no impact on the liability judgment.Originality/valueThis study contributes to the accounting literature by adding findings on another aspect of KAM in different audit settings, particularly, in the Thai legal environment with different types of undetected misstatements. The current conflicting results on how KAM disclosures affect auditor liability warrant further investigation of this issue in other audit contexts in different countries.

The Role of Key Audit Matters in Assessing Auditor Liability: Evidence from Auditor and Non-auditor Evaluators

Abstract Manuscript type: Research paper Research aims: This study examines the effects of key audit matter (KAM) disclosures in the auditor’s report on auditor legal exposure in cases of fraud and error misstatements. Design/Methodology/Approach: The experiment is conducted with the 133 professional auditors from Big 4 audit firms and 134 MBA students as the participants. Research findings: This KAM effect manifests in different ways for different groups. Specifically, auditor participants assess higher auditor liability when misstatement relates to error than when it is connected to fraud. KAM reduces assessed auditor liability only in cases of fraud but not of error. For nonprofessional investor participants, the auditor liability is rated higher in the case of fraud than for error misstatement. Unfortunately, KAM appears to have a nonsignificant impact on auditor liability. Together, the results support the view that instead of increasing legal exposure, as audit practitioners fear, KAM disclosures could actually mitigate and at least do not change auditors’ risk of legal exposure. Theoretical contribution/originality: This study contributes to accounting literature by adding the findings another aspect of KAM in different audit settings: fraud and error misstatements. Moreover, the conflicting evidence on how KAM affect auditor liability warrants further investigation of other audit settings that could alter the impact of KAM disclosures on the assessment of auditor liability. Practitioner/Policy implications: The findings of this study, especially, the nonsignificance of KAM disclosures as evaluated by nonprofessional investors should inform policymakers and related parties that investors need to be educated and better informed about the KAM disclosure and its objectives. Research limitations/Implications: The design of this study did not accommodate setting where the auditors had the opportunity to communicate with peers, which could affect their judgment. This is a general limitation of the experiment, which could be considered somewhat unrealistic because discussions are encouraged among committee members or in a courtroom when making judgments.

Can Audit Committee Expertise Increase External Auditors' Litigation Risk? The Moderating Effect of Audit Committee Independence

ABSTRACTThis study examines whether the perceived independence and financial expertise of audit committee members affect external auditors' exposure to legal liability. We use an experiment in which potential jurors make judgments about auditor independence and legal liability for a case involving an audit failure. We find that perceptions of audit committee independence from management are positively associated with judgments of auditor independence and negatively associated with auditor liability. However, financial expertise of audit committee members can be a double‐edged sword. Our experiment finds that judgments of auditor liability are higher when the audit committee is perceived to have higher financial expertise but lower independence from management. In assessing litigation risk of current and prospective clients, auditors may want to carefully consider the independence of audit committee members from management, particularly when audit committee members have financial expertise. In the event of an audit failure, the financial expertise of nonindependent audit committee members can negatively affect jurors' perceptions of auditor independence and liability.

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.

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.

Key audit matters and their implications for the audit environment

This paper sets out to investigate how the new auditing standard ISA 701: key audit matters addresses issues historically presented by audit reports. The extensive literature around audit reporting highlights that past reforms resulted in a lack of success and the continued existence of the audit expectation gap. Increased auditor liability is one of the major concerns raised by practitioners with the new standard expanding the audit report to include key audit matters. Through a qualitative content analysis examination of the most recent audit reports of the top 100 listed companies on the NZX, ASX and FTSE, key audit matters were identified. The results of the study found that goodwill and intangibles, revenue recognition and taxation were the most common key audit matters. Overall, the results of these findings suggest that these key audit matters may go a long way to addressing the audit expectation gap and issues presented by audit reports.

Audit Data Analytics and Jurors' Assessment of Auditor Negligence: The Effects of Follow-up Procedures and the Lack of a Standard

While auditors are increasingly using audit data analytics (ADA), research is limited on whether this new technology will affect auditor liability. This study examines the effects of how auditors follow up on the large number of exceptions often identified by ADA, and the lack of a standard on the use of ADA, affects jurors’ assessments of auditor negligence. Consistent with the algorithm aversion literature, we find that jurors assess higher negligence when auditors use Artificial Intelligence (AI) to identify a sample of exceptions for follow up testing than if human audit team members identify exceptions for follow up. Higher perceptions of causation and foreseeability in the AI condition mediate this effect. We also find an interaction such that negligence is highest when auditors use AI to select exceptions for follow up testing and there is no ADA standard. To our knowledge, ours is the first study to consider algorithm aversion in the juror-auditor setting and to apply the culpable control model to emerging audit technologies.

The Interrelation between Audit Quality and Managerial Reporting Choices and Its Effects on Financial Reporting Quality

ABSTRACTTwo distinct lines of research have been dedicated to empirically testing how financial reporting quality (measured as the earnings response coefficient or ERC) is associated with management's choice of reporting bias and with audit quality. However, researchers have yet to consider how ERCs are affected by either the auditor's reaction to changes in the manager's reporting bias or the manager's reaction to changes in audit quality. Our study provides theoretical guidance on these interrelations and how changes in the manager's or the auditor's incentives affect both reporting bias and audit quality. Specifically, when the manager's cost (benefit) of reporting bias increases (decreases), we find that expected bias decreases, inducing the auditor to react by reducing audit quality. Because we also find that the association between expected audit quality and ERCs is always positive, changes in managerial incentives for biased reporting lead to a positive association between ERCs and expected reporting bias. When the cost of auditing decreases or the cost of auditor liability increases, we find that expected audit quality increases, inducing the manager to react by decreasing reporting bias. In this case, changes in the costs of audit quality lead to a negative association between ERCs and expected reporting bias. Finally, we demonstrate the impact of our theoretical findings by focusing on the empirical observations documented in the extant literature on managerial ownership and accounting expertise on the audit committee. In light of our framework, we provide new interpretations of these empirical observations and new predictions for future research.

The Sound of Silence: What Does a Standard Unqualified Audit Opinion Mean Under the New Going Concern Financial Accounting Standard?

A recent FASB standard requires an entity’s management to assess the entity’s ability to continue as a going concern and disclose substantial doubt about such. In contextualized experiments wherein the entity’s auditor does not issue a going concern opinion and the entity subsequently fails, we examine the effects of this new standard on jurors’ judgments of auditor liability, operationalized as auditor blameworthiness for investor losses. We find: (1) when management has not disclosed going concern issues, blame ascribed to auditors for investor losses increases under the new standard; (2) auditor blame increases further when management has disclosed going concern issues; and (3) inclusion of a going concern-related critical audit matter (CAM) in the audit report mitigates these adverse effects of the new standard on auditor liability. These findings provide insights regarding unintended consequences to auditors of the new FASB standard and the efficacy of CAMs to mitigate those consequences.

The Effects of the Extant Clauses Limiting Auditor Liability on Audit Fees and Overall Reporting Quality

Regulators and shareholders generally oppose any restriction on clients' rights to sue their auditors, believing that such restrictions would impair reporting quality. However, the evidence suggests that the opposition to limitation of liability agreements (LLAs) between clients and auditors is likely unwarranted. Specifically, the evidence indicates that LLAs are beneficial to clients by lowering their audit fees. More importantly, we find no evidence that they impair financial reporting quality in general. Hence, the extant contracts limiting clients' rights to sue their auditors appear to benefit auditors and their clients without any apparent detriment to the quality of financial reporting.

Can Audit Committee Financial Expertise Increase External Auditors’ Litigation Risk? The Moderating Effect of Audit Committee Independence

Abstract: This study examines whether the perceived independence and financial expertise of audit committee members affect external auditors’ exposure to legal liability. We use an experiment in which potential jurors make judgments about auditor independence and legal liability for a case involving an audit failure. We find that perceptions of audit committee independence from management are positively associated with judgments of auditor independence and negatively associated with auditor liability. However, financial expertise of audit committee members can be a double-edged sword. Our experiment finds that judgments of auditor liability are higher when the audit committee is perceived to have higher financial expertise but lower independence from management. In assessing litigation risk of current and prospective clients, auditors may want to carefully consider the independence of audit committee members from management, particularly when audit committee members have financial expertise. In the event of an audit failure, the financial expertise of non-independent audit committee members can negatively affect jurors’ perceptions of auditor independence and liability.

Social Audit Reform Options: Towards Auditor Liability and Multi-Stakeholder Oversight

For the social auditing regime to deliver any real protection to workers, there needs to be radical reform backed up by hard law.

The consequences of disclosing key audit matters (KAMs): A review of the academic literature

Recent years have witnessed a change in the auditor reporting model. One of these developments is the auditor’s issuance of so-called Key Audit Matters in the auditor’s report, where they disclose “those matters that, in the auditor’s professional judgment, were of most significance in the audit of the financial statements of the current period”. In this paper, we review the emerging body of academic research which examines the effects of KAM disclosures in the auditor’s report. We investigate research that has examined the effect of KAM disclosures on (1) investor behavior and market reaction, (2) auditor responses, (3) auditor liability, and (4) client management responses. The objective of this paper is to provide an overview of the existing literature and to summarize the preliminary findings and implications of 22 studies.

Deconstructing the use of REPO 105 and Repo 108 Transactions Under SFAS 140: the Case of Lehman Brothers Holding Inc. and the Liability of Ernst & Young

Prior to filing for bankruptcy in 2008, Lehman Brothers Holding Inc., [LBHI] relied upon select repurchase agreements denominated “Repo 105” and “Repo 108” for the purpose of re-casting its balance sheet to meet net leverage ratios required by money markets. SFAS 140, as then existing without the 2011 amendment, provided a mechanism to treat “ordinary borrowings” as “asset sales”. LBHI used SFAS 140 to justify Repo 105 and Repo 108 transactions to engineer its balance sheet. The accounting treatment resulted in the publication of misleading quarterly and annual Financial Statements relied upon by external users to make investment decisions. In 2011 and 2012, the Southern District of New York issued opinions in the consolidated LBHI litigation. The finding that LBHI correctly applied the criteria of SFAS 140 to justify “borrowings” as “asset sales” under Repo 105 and Repo 108 is fundamentally flawed. During the period 2000 until 2008, Ernst & Young [E&Y] served as the outside auditor of LBHI. Legal principles governing the obligations of auditors support a finding that E&Y committed professional malpractice by issuing unqualified audit opinions knowing that LBHI failed to disclose its liabilities to repurchase transferred securities under Repo 105 and Repo 108 transactions. Economic analysis of non-contractual obligations [tort] supports a reformulation of the legal standard governing auditor liability to external users of audited financial statements containing materially misleading information. The reformulated standard allocates incentives to take precautions both to the audit firm and to the external user to achieve an efficient allocation of the cost of harm ensuing from defective information products.