Auditor Litigation Research Articles

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

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 of our first experiment, in which the CAM relates to a more complex account, highlight a quandary auditors could face in the years subsequent to reporting a CAM such that removal of a CAM that had been reported for multiple years increases auditor liability. Results of our second experiment, in which the CAM relates to a less complex account, provides limited support that CAM removal increases liability. Our results should be of interest to academics, practitioners, and regulators regarding legal implications of the new CAM standard.

The Changing Landscape of Auditor Litigation and Its Implications for Audit Quality

We provide a comprehensive overview of shareholder litigation against auditors since the passage of the PSLRA. The number of lawsuits per year has declined, dismissals have increased, and settlements in recent years have declined. Our study asks why. Because we find that the likelihood an auditor is sued following a severe restatement has significantly declined in recent years, it does not appear that the decline can be attributed solely to increases in audit quality. Instead, we consider whether the Supreme Court cases limiting the scope of Rule 10b-5 against private actors may have led to the decline. To study this possibility, we focus on the Supreme Court’s 2007 and 2011 rulings in Tellabs v. Makor and Janus v. First Derivative, respectively. Our analysis provides strong evidence that the higher liability standards imposed by Janus significantly reduced auditors’ liability exposure, but we find only limited evidence that the pleading standard imposed by Tellabs had a significant effect.

Short Sales Mechanism, Litigation Risk and Audit Fees

This paper examines how the short sales mechanism affects firms' audit fees through the changes in litigation risk, based on the natural experiment of securities margin trading in China. It comes to the conclusions that the introduction of short sales mechanism reinforces the pressure of the fall in stock prices and strengthens the incentive of investors to search bad news of companies, leading to the increase in audit litigation risk of companies and higher audit fees required by accounting firms. Further analysis suggests that the short sales mechanism plays a more obvious role in the increase in audit fees of state-owned enterprises, owing to poor information disclosure environment in state-owned enterprises; due to stronger compensation capacities of Big Four, the short sales mechanism significantly results in the rise in audit fees of Big Four; as for enterprises located in areas with poorer legal environment, because the management has the motivations to hide bad news, their audit fees significantly increase because of the existence of the short sales mechanism.

Auditor Litigation Risk and the Number of Institutional Investors

SUMMARYWe investigate whether auditors are sensitive to litigation risk related specifically to having greater numbers of institutional investors that hold the common stock of a given client. Our findings suggest that audit fees are higher when the number of institutional investors holding stock in the company is greater. Additional tests corroborate our inference that the association between audit fees and the number of institutional investors is related to litigation risk. The importance of improving our understanding of auditors' sensitivity to factors that increase litigation exposure is highlighted by the number and magnitude of lawsuits filed against auditors relating to the audits of public clients.

The Settlement Norm (and Exceptions) in Audit Legal Disputes: Insights from Prominent Attorneys

Prior 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 (e.g., Abbott 1988; Power 2004). 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.

Audit Profession Development and Bank Loan Pricing

This study examines the relation between country-level audit profession development and bank loan pricing around the world. Using a sample of bank loan contracts from 36 countries during 2002–2010, we find that stronger audit profession development is associated with lower loan spreads, and such effect is observed for Big 4 clients and firms in countries with strong rule of law. Further analysis suggests that creditors view auditor litigation environment as the most relevant aspect of audit profession development in their lending decisions. Our results are robust to a battery of sensitivity tests.

The contextual nature of the association between managerial ability and audit fees

PurposeThis study examines whether auditors’ pricing decisions on managerial ability are affected by auditor litigation risk (financial distress or financial crisis), auditor’s familiarity with their client or regulatory changes in the post-Sarbanes–Oxley Act of 2002 (SOX) era.Design/methodology/approachBuilding on the extant audit fee literature, this study constructs an audit fee determinants model to examine how context affects auditors’ pricing of managerial ability.FindingsAuditors offer a larger fee discount to more able client management teams when auditors face lower litigation risks or are more familiar with the client. Furthermore, managerial ability has a more pronounced effect on audit fees in the post-SOX era when managers are mandated to play more active roles in financial reporting (i.e. certification of financial statements required by SOX 302).Research limitations/implicationsBased on the audit risk model (Simunic, 1980), Krishnan and Wang (2015) show that the managerial ability of an audit client is relevant and important to auditors’ pricing decisions. This study demonstrates that managerial ability exhibits a non-linear relationship with audit fees and contextual factors, such as litigation risk, and that auditors’ familiarity with managers can alter the negative association between audit fees and managerial ability. This study extends Krishnan and Wang’s study by offering additional insights into auditors’ use of soft information such as managerial ability. Furthermore, the findings add to the literature on the impact of SOX on audit fees by suggesting that SOX has not only increased overall audit fees (Ghosh and Pawlewicz, 2009; Huang et al., 2009), it has also increased auditors’ price sensitivity to soft information (e.g. managerial ability).Practical implicationsThis study provides insights for audit firms and client companies who are interested in understanding audit fee-pricing decisions. The findings also suggest that auditors need to be sensitive and responsive to various contextual factors when making pricing decisions.Originality/valuePrevious studies have not addressed the non-linear relationship between audit fees and soft information about managerial ability.

Audit Firm Characteristics and Litigation Risk in Nigeria

Audit Firm Characteristics and Litigation Risk in Nigeria

Securities Class Actions in the United States and Canada Against Chinese Companies and Their Auditors: An Empirical Investigation

Chinese companies have accessed the public capital markets of the US and Canada more frequently in recent years. This paper provides for the first time empirical evidence documenting the characteristics of private securities class action lawsuits (filed in the US and Canada) against Chinese companies and their auditors.Analysis of lawsuits worldwide shows that Chinese companies are positively associated with auditors being named defendants and experiencing a negative outcome (for example, related government enforcement actions and/or settlement payments to terminate class actions). A group of companies from countries outside the US and Canada was compared to the Chinese companies. For the comparison group, the factors that were associated with auditors being named defendants and experiencing a negative outcome are consistent with those that have been found in prior auditor litigation research. Conversely, the Chinese companies are characterized by a different pattern of litigation. Among the traditional factors, only fraud is associated with auditor litigation. In addition, the use of a small CPA firm auditor with the local audit engagement team office physically located in the US or Canada (as opposed to the local audit engagement team office being physically located in the People’s Republic of China (“PRC”)) is associated with auditor litigation. We find limited evidence that the use of a reverse merger to go public is positively associated with auditor litigation.We analyzed the Chinese lawsuits’ settlements. Aggregate settlement amounts are positively associated with the occurrence of an auditor settlement and with the class period length. Auditor settlement amounts are positively associated with the use of a large CPA firm auditor with the local audit engagement team office physically located in the US or Canada (as opposed to the local audit engagement team office being physically located in the PRC), class period length, and fraud. These findings suggest that the amount of litigation settlements of large CPA firms with the local audit engagement team office physically located in the PRC may have been reduced by their refusal to provide audit documentation requested by the Securities and Exchange Commission.

Regulation, Auditor Litigation and Settlements

This paper aims to understand the determinants of lawsuits against auditors in securities class action litigation and the settlement pattern by auditors when the suit is not dismissed. The issues we consider are: (i) when are auditors named as defendants (ii) when do auditors choose to settle and (iii) what proportion of the settlement do auditors pay in relation to the settlement by all the other parties; and (iv) differences in settlement strategies among the big-n firms. We also want to understand how these suit and settlement patterns have changed following the enactment of major regulation such as the Private Securities Litigation Reform Act (PSLRA), Sarbanes Oxley Act (SOX). Following prior literature, we first establish that auditors are more likely both to be named and to settle in cases involving restatement of earnings, accusations of violation of GAAP or accounting improprieties. We then show that the likelihood of suit and settlement increase in a measure that we construct measuring the complexity of litigation. We then examine differences in settlement patterns across periods preceding and after the passage of PSLRA and SOX. We find that auditors are named less often in the post PSLRA period (relative to the pre-PSLRA period), settle with the same frequency in both periods but pay less proportional damages. The same set of comparisons show that auditors are just as likely to be sued post-SOX as pre-SOX, but settle with lower frequency and pay the same proportion of damages. Overall this study documents the beneficial role of both PSLRA and SOX on reducing the litigation burden on auditors. With regard to settlement strategies, we document the varying strategies employed by the Big-n firms that settle at different rates, vary in their aggressiveness and time to settle signaling the willingness to fight or cooperate in the settlement.

Audit Firm Reputational Consequences of Alleged Non-Accounting Misconduct by Clients

This study examines whether U.S. audit firms experience reputational damage when clients are accused of misconduct that does not affect auditor litigation risk. Auditors have minimal, if any, responsibility related to non-GAAP securities fraud class actions, our proxy for such misconduct, but bounded rationality suggests that auditors could still incur reputational damage from these suits. In the year after suit filing, fees are lower for the auditor’s clients in the same city-industry as the sued client, but are unchanged for clients of other auditors in the same city-industry. This effect is stronger (1) for new engagements, suggesting auditors must provide incremental discounts to win new clients, and (2) when suits are severe, likely because the negative information is more salient. Overall, these results provide evidence that reputation is an important incentive for U.S. audit firms. This study also contributes to mounting archival evidence of systematic biases and cognitive errors by corporate decision-makers.

Auditor Litigation: Deterrence Implications for Non-sued Auditors

Litigation poses a significant business risk for auditors. We argue that auditors learn from other auditors’ litigation events and examine the consequences of such events for future accounting misstatements. Using a hand-collected sample of auditor litigation events, we find a significant subsequent decrease in misstatement frequency in within-industry audits conducted by auditors who did not face litigation. This industry-based across-auditor learning effect is (a) intensified when the litigation signal is stronger; (b) is associated with an audit-fee increase; and (c) is robust to a battery of controls including the use of a difference-in-difference approach. No evidence is found for region-based across-auditor learning. Since non-sued auditors conduct a larger share of audits than the sued auditor, a deterrence effect of litigation for the non-sued auditor significantly enhances the impact of litigation beyond the sued auditor.

Relation between Auditor Quality and Tax Aggressiveness: Implications of Cross-Country Institutional Differences

SUMMARY Using an international sample of firms from 31 countries, we study the relation between auditor quality and corporate tax aggressiveness. Employing an indicator variable for tax aggressiveness when the firm's corporate tax avoidance measure is within the top quintile of each country-industry combination, we find strong evidence that auditor quality is negatively associated with the likelihood of tax aggressiveness, even after controlling for other institutional determinants such as home-country tax system characteristics. We also find that the negative relation between auditor quality and the likelihood of tax aggressiveness is more pronounced in countries where investor protection is stronger, auditor litigation risk is higher, the audit environment is better, and capital market pressure is higher. JEL Classifications: M42; M48; H20; F30.

Relation between Auditor Quality and Corporate Tax Aggressiveness: Implications of Cross-Country Institutional Differences

Using an international sample of firms from 31 countries, we study the relation between auditor quality and corporate tax aggressiveness. Using an indicator variable for tax aggressiveness when the firm’s corporate tax avoidance measure is within the top quintile of each country-industry combination, we find strong evidence that auditor quality is negatively associated with the likelihood of tax aggressiveness, even after controlling for other institutional determinants such as home-country tax system characteristics. We also find that the negative relation between auditor quality and the likelihood of tax aggressiveness is more pronounced in countries where investor protection is stronger, auditor litigation risk is higher, the audit environment is better, and capital market pressure is higher.

Does High Auditor Litigation Risk Discourage Corporate Innovation?

In this study, we examine whether and how an increase in auditor litigation risk affects client innovation. Exploiting multiple exogenous shocks that both increase and decrease legal liability for audit failures as a means of identification, we provide evidence that increased auditor legal liability has a detrimental effect on innovation as measured by patent-based metrics. The findings highlight a potential negative externality of increased auditor legal liability and provide insights into how regulation could potentially distort managerial incentives and firm investments.

Auditor Resignation and Risk Factors

SYNOPSIS Although auditor litigation risk is considered as a leading explanation for auditor resignations, audit risk and business risk might also trigger resignations. Auditor litigation risk is defined as the risk of the auditor being involved in a lawsuit, audit risk is defined as the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated and, finally, business risk is defined as the risk associated with the client's survival and profitability. Because the three risk factors are not mutually exclusive, we examine their relevance and incremental importance using measures from the pre- and post-resignation periods. Using summary indices from the pre-resignation period, we find that all of the three ex ante risk indices are incrementally important for resignations, especially when the predecessor auditor is a Big 4 firm. Because the ex ante risk factors are prone to measurement errors and are less likely to capture the auditor's proprietary information about the client, we analyze data from the post-resignation period when the auditor's proprietary information is likely to become publicly known. We find that within a three-year period following an auditor's resignation, clients are more likely to (1) be involved in class-action lawsuits (ex post litigation risk), (2) have internal control problems (ex post audit risk), and (3) to be delisted from a national stock exchange (ex post business risk). Our research demonstrates that auditors consider all three risk factors, and not just litigation risk, in resignation decisions.

Auditor litigation: Evidence that revenue restatements are determinative

This study extends the Palmrose and Scholz (2004) general litigation and general restatements study by focusing on auditor litigation and revenue restatements. We investigate all potential accounting issues, individually, instead of by their group method, with regard to auditor litigation. The impact of the individual accounting issues implicated in restatements is of concern to auditors and audit standard setters in gauging auditor litigation risk and audit risk. It also is important for financial analysis and securities valuation because investors' losses are greater, and recovery of losses on a percentage basis is lower, when the auditor is a defendant, and especially when the auditor has a more severe, negative litigation experience (Commolli et al., 2012). We examine financial reporting lawsuits filed from 2001 to 2008 and find that revenue restatements—far more than any other kind of restatements—are associated with auditors being named defendants and also auditors experiencing a more severe, negative outcome in the litigation.

The effect of litigation risks to earnings management using audit quality as moderating variable

In agency theory, a company, which separates the functions of governance and ownership, is going to be susceptible to the agency conflicts. The arising agency conflict causes the information, which is provided by manager becoming different or can be manipulated. One of common practice done by manager is earning management, where earning management is an accounting policy choice conducted by the managers for the variety of specific purposes. This study tries to reveal whether audit qualities are able to reinforce the association between litigation risks to the earning management practice. Auditor litigation has 14 characteristics of companies being able to be auditor litigation by calculating LITSCORE. Earnings management is proxied by The Modified Jones Model while audit quality is proxied by industry specialization. This study uses financial statements data of the manufacturing companies listed in Indonesia Stock Exchange in 2010-2012. Analysis, which is used in this study, is the MRA (Moderated Regression Analysis). The results of this study suggest that there is influence between litigation risk to earnings management while audit quality as measured by specialized auditors cannot strengthen relationship between litigation risk and earnings management. This is because audit quality as measured by specialized auditors did not show a strong relationship.

Auditor Litigation: Evidence that Revenue Restatements are Determinative

This study extends the Palmrose and Scholz (2004) general litigation and general restatements study by focusing on auditor litigation and revenue restatements. We investigate all potential accounting issues, individually, instead of by their group method, with regard to auditor litigation. The impact of the individual accounting issues implicated in restatements is of concern to auditors and audit standard setters in gauging auditor litigation risk and audit risk. It also is important for financial analysis and securities valuation because investors’ losses are greater, and recovery of losses on a percentage basis lower, when the auditor is a defendant, and especially when the auditor has a more severe, negative litigation experience (Commolli et al. 2012). We examine financial reporting lawsuits filed from 2001 through 2008 and find that revenue restatements – far more than any other kind of restatements – are associated with auditors being named defendants and also auditors experiencing a more severe, negative outcome in the litigation.

Public Equity and Audit Pricing in the United States

ABSTRACTTo what degree are audit fees for U.S. firms with publicly traded equity higher than fees for otherwise similar firms with private equity? The answer is potentially important for evaluating regulatory regime design efficiency and for understanding audit demand and production economics. For U.S. firms with publicly traded debt, we hold constant the regulatory regime, including mandated issuer reporting and auditor responsibilities. We vary equity ownership and thus public securities market contextual factors, including any related public firm audit fees from increased audit effort to reduce audit litigation risk and/or pure litigation risk premium (litigation channel effects). In cross‐section, we find that audit fees for public equity firms are 20–22% higher than fees for otherwise similar private equity firms. Time‐series comparisons for firms that change ownership status yield larger percentage fee increases (decreases) for those going public (private). Results are consistent with litigation channel effects giving rise to substantial incremental audit fees for U.S. firms with public equity ownership.