This study is relevant for practitioners, investors, and regulators. It demonstrates to firms that the effectiveness of high audit quality as a defense in litigation may be decreased depending on the timing of jurors’ assessment of SOC. One way to try and lower the probability of jurors’ assessing SOC after receiving audit knowledge is to warn the jury about the potential affects. Simply changing the jurors’ instructions has been found to mitigate the outcome effects.
Maksymove, Eldar M., and M. W. Nelson. 2017. “Malleable Standards of Care Required by Jurors When Assessing Auditor Negligence”. The Accounting Review. 92.1 (2017): 165.
In court cases against auditors due to audit failure, often times the main defense used is that there was a high audit quality. This is true if the audit was performed at a level similar to what prudent auditors would have done in the same circumstances, also known as standard of prudent care (SOC). This study examines whether jurors’ definition of SOC is malleable based on the timing of the SOC assessment in accordance with the jurors’ exposure to the audit quality of the case. Specifically, whether or not the juror learns of audit quality first and then assesses SOC, or vice versa.
The research project contains four experiments. The first experiment is a simulation where 125 participants, found using Amazon’s Mechanical Turk (AMT), are asked to assume the role of jurors who are considering a case of alleged auditor negligence. The level of audit quality and the timing of jurors’ SOC assessments are manipulated. In the subsequent three experiments 60-63 of the previous participants were asked to determine SOC based on the level of audit quality being manipulated and a change in some of the background information.
Overall, the authors find that the timing of the SOC assessment in accordance with the jurors’ exposure to the audit quality of the case does in fact change the outcome of the SOC assessment. Therefore, the results indicate the jurors SOC assessments are malleable.
The authors find the following:
http://commons.aaahq.org/groups/e5075f0eec/summary
The results of this study are important for both regulators and auditors alike. Despite auditor concerns that a requirement to disclose CAMs would increase litigation risk, the results of this study indicate that they may actually reduce, or at the very least, have no effect on litigation risk. This is the case even when the subsequently identified misstatement is not related to the risks documented in the CAM. Furthermore, standard setters should take comfort in these findings as they weigh the potential benefits of adopting a CAM disclosure requirement because the results indicate that the implementation of CAMS would not increase the risk of litigation to auditors.
Brasel, K., M. M. Doxey, J. H. Grenier, and A. Reffett. 2016. Risk Disclosure Preceding Negative Outcomes: The Effect of Reporting Critical Audit Matters on Judgments of Auditor Liability. The Accounting Review 91 (5): 1345-1362.
The PCAOB has proposed a change to the standard audit reporting model to include the disclosure of critical audit matters (CAMs). While there is evidence that investors support additional auditor disclosures like CAMs, many other stakeholders oppose the implementation of a requirement to produce such ex ante risk disclosures. The opposition, which includes audit firms, academics, and attorneys, assert that this type of requirement would increase litigation against auditors.
However, CAMs require disclosure of increased risk prior to a subsequently revealed misstatement. This feature of the proposed disclosure also makes it possible that CAMs may reduce litigation risk because jurors will view the plaintiff as being forewarned of an increased risk. To the extent that jurors view a misstatement as having been more foreseeable to the plaintiff, this study predicts that jurors will experience less negative affect when considering plaintiff losses because the plaintiff was forewarned. Below are two objectives the authors address in their study:
The authors conducted an experiment with jury-eligible participants to examine their research questions. The study included four different disclosure conditions: (1) control – no mention of CAMs, (2) disclosure of a CAM related to the subsequently revealed misstatement, (3) disclosure of a CAM that is unrelated to the misstatement, (4) an explicit statement that the auditors did not identify any CAMs. Additionally, two different types of misstatements were examined to determine whether the type of misstatement affected the jurors’ propensity to find the auditor negligent: (1) an overstatement of inventory, (2) an understatement of an environmental restoration liability. Participants read a case study about an audit that failed to detect a material financial statement fraud and then assessed auditor negligence.
These results imply that auditors are more likely to render modified GC opinions for clients subject to regimes that hold auditors liable to a larger class of third parties and impose joint-and-several liability for third-party damages, both of which reflect greater liability exposure. The higher incidence of GC opinions accompanying stronger state-level litigation threats could reflect higher audit quality, but it could also stem from excessively conservative auditors protecting their interests by avoiding costly civil lawsuits, which could undermine audit quality in some circumstances.
Anantharaman, D., J. A. Pittman, and N. Wans. 2016. State Liability Regimes within the United States and Auditor Reporting. The Accounting Review 91 (6): 1545 – 1575.
The authors of this study analyze the relation between state regimes governing auditor liability and auditors’ propensity to modify their opinion to express uncertainty on financially distressed clients’ ability to continue as a going concern. Extant research implies that auditors have strong incentives to conduct high-quality audits in order to reduce the litigation examining consequences stemming from an alleged audit failure; however, the bulk of this research focuses on auditor liability arising under federal statutory laws, not state laws. This study delves into the issue of state laws, including if and to what extent litigation exposure under state common law affects auditors’ reporting decisions.
A previous study developed a state-level score that captures third-party liability standards, which the authors of this study rely on to measure auditor litigation exposure stemming from third-party liability standards. To evaluate variation in liability-sharing standards across states, the authors closely read the relevant law to construct a state-level index that identifies whether each state follows a joint-and-several approach or a proportional approach to liability sharing. The authors assign to each client firm the highest of the liability indices dependent on the states in which the firm does business, and they measure audit outcomes with the propensity to issue going-concern (GC) opinions to financially distressed clients.
Implications for the practicing audit community are developed from the findings that less experienced auditors are susceptible to the information choice effect. In situations where litigation risk is low (high) and the auditor has less experience, auditors place greater (lower) significance on information given to them by an external party than information they sought out themselves. More experienced auditors are not subject to the information choice effect. Additionally, more experienced auditors are confident in judgments based on information sought themselves, even in a setting with elevated litigation risk. The results of this study may interest audit clients providing information to auditors, auditors reviewing the work of less (more) experienced colleagues, auditors performing a critical self-review, and regulators reviewing the work of auditors.
Smith, S. D., W. B. Tayler, and D. F. Prawitt. 2016. The Effect of Information Choice on Auditors' Judgments and Confidence. Accounting Horizons 30 (3): 393–408.
During the course of an audit, auditors choose what information they need to search for; however, they obtain both sought and unsought information. These auditors must then use the information obtained to make judgements and decisions that ultimately lead to an audit opinion. Thus, the weight auditors place on the information obtained when making judgements and the auditors’ confidence in those judgements has important implications for audit quality. The authors of this paper investigate whether it matters if information is gotten by the auditor or given to the auditor. Understanding that the way in which information is received affects information processing, the authors examine how the auditors’ receipt of additional sought or unsought information impacts the auditors’ judgment and confidence in that judgement given judgements with different levels of importance (e.g., high vs. low litigation risk) and auditors with different levels of experience (e.g., high vs. low).
Evidence was obtained during the 2010’s through an experiment using 136 auditors as participants. Participants read a case and evaluated the likelihood of obsolescence in inventory. The researchers manipulated the (1) choice to acquire relevant information (i.e., given a choice or not given a choice) and (2) litigation risk levels (i.e., high or low). Furthermore, they measured auditor experience, and classified participants as more or less experienced based on number of years in public accounting.
This paper sheds light on the implications of a going concern opinion, specifically in the context of litigation against the auditor. While prior research has established that a going concern opinion reduces the likelihood of shareholder litigation in bankruptcy proceedings, this study shows that going concern opinions potentially open up the auditor to increased SEC litigation if the financial statements are found to be fraudulent. The authors suggest this should be taken into consideration when auditors are determining the extent of necessary documentation for fraud risk assessment, especially when the client is likely receiving a going concern opinion.
Eutsler, J., E.B. Nickell, S.W. Robb. 2016. Fraud Risk Awareness and the Likelihood of Audit Enforcement Action. Accounting Horizons 30 (3): 379-392.
The authors aim to examine whether documented awareness of fraud risk affects the likelihood of SEC enforcement action against the auditor in cases of undetected fraud. They acknowledge that financial distress provides incentive for fraudulent activity, and therefore consider the possibility that a going concern represents information that may affect SEC assessment of the auditor’s fraud risk assessment. This study aims to address concern that regulator investigation of audited fraudulent financials may be biased by economic factors or other information that was unknown at the time of the audit. This concern contradicts prior research, which shows that going concern opinions deter litigation against auditors when the client subsequently goes bankrupt.
The authors review Accounting and Auditing Enforcement Releases (AAERs) issued by the SEC for companies alleged to have engaged in fraudulent activity between January 1995 and August 2012. They identify 314 instances of alleged fraud, of which 34 received a going concern opinion and 54 had auditor-involved sanctions.
The authors find that awareness of fraud risk—specifically noting a going concern issue—exposes the auditor to additional scrutiny of regulators when the financials are subsequently found to be fraudulent. Additionally, this paper points out an interesting contrast in the implications of a going concern opinion. Prior research has shown that auditors are less likely to be sued when a client with a going concern opinion subsequently goes into bankruptcy; however, the results in this paper show that auditors giving a going concern opinion are more likely to be sued when those financial statements are subsequently found to be fraudulent.
The results of this study have implications for regulatory agencies and standard-setting bodies. As regulators contemplate whether to mandate IFRS and standard setters determine the level of implementation guidance for new standards, the litigation consequences of standard precision are an important consideration. Further, these results highlight the importance of regulators developing ways for jurors to evaluate audit judgments under imprecise standards, especially in industries and areas without precise industry reporting norms. Prior discussion on this issue has focused on how professional judgment frameworks are necessary to protect auditors and their clients from second guessing. This study suggests that judgments frameworks, if effective, may help protect auditors who make conservative judgments and also help hold auditors accountable for overly aggressive judgments.
Kadous, K., and M. Mercer. 2016. Are Juries More Likely to Second-Guess Auditors Under Imprecise Accounting Standards? Auditing: A Journal of Practice and Theory 35 (2): 101-117.
U.S. Generally Accepted Accounting Principles (GAAP) are generally viewed as more precise than International Financial Reporting Standards (IFRS) in that the former tend to contain more detail about implementation and compliance than the latter. Convergence efforts between U.S. GAAP and IFRS are on going, and have led to greater imprecision in U.S. accounting standards in areas such as lease accounting and revenue recognition. These imprecise standards require increased professional judgment by managers and auditors, which has led to concern that the adoption of less precise standards will result in more second-guessing of auditor judgments by juries and thus greater legal liability. This study seeks to address this concern and examines whether juries are more likely to second-guess auditors’ judgments under an imprecise accounting standard compared to a precise accounting standard.
The authors recruited undergraduate students enrolled in introductory accounting courses at a large university as participants for this study. Two administrations were conducted with the students who participated in a simulated case that lasted 45 minutes during their accounting lab session. Participants acted as jurors in an auditor negligence case involving revenue recognition and were given information related to SFAS No. 66 (Real Estate) to help in their evaluation. The authors manipulated the precision of the accounting guidance as either precise or imprecise. The aggressiveness of the client’s reporting choice was manipulated as either aggressive or conservative.
The results of this experiment suggest that auditors’ fear about second-guessing by juries under imprecise accounting standards is warranted. Under an imprecise standard, conservative accounting choices are more likely to be called into question and result in negligence verdicts, ex post.
These findings indicate that rather than being overly harsh, juries appear to be overly lenient when auditors allow aggressive accounting under an imprecise standard. A lack of precision appears to make it more difficult for juries to identify whether an auditor’s judgment was reasonable or unreasonable.
The primary contribution of this article is to provide the first descriptive analysis of audit firm characteristics associated with claims for audit malpractice. These findings are important because they suggest that audit firm risk can be reasonably assessed by third-party stakeholders or insurers.
Casterella, J. R., K. L. Jensen, and W. R. Knechel. 2010. Litigation Risk and Audit Firm Characteristics. Auditing: A Journal of Practice & Theory 29 (2): 71-82.
This study examines the association between audit firm characteristics and audit firm litigation risk. An estimated 4,000 claims for malpractice are filed annually against U.S. accounting firms. As a result, audit firms devote considerable attention and resources to reducing/managing such risk, and firms that are unable to protect themselves may face severe financial difficulties.
There are two primary sources of litigation risk for audit firms: (1) the audit clients whom they serve, and (2) the audit firms themselves. A great deal of research has examined the characteristics of companies subject to litigation but relatively little research has considered the link between audit firm characteristics and audit firm litigation risk. The latter issue is important because insurance companies do not appear to solicit, nor make widespread use of, information about each firm’s specific audit clients. Instead, they assess risk by soliciting information about the firm, e.g., revenue base, staff composition, professional services offered, distributions of clientele, firm policies and practices, and insurance and litigation histories. This suggests that reasonable risk assessments about audit firms can be made using information about the firms themselves.
Data for this study are obtained from the underwriting and claims files of a single large insurance company that specializes in professional malpractice coverage for small and midsize accounting firms (averaging 40 professionals). The authors used a matched-pair design for this study. They first identified 68 audit-related claims filed during the period 1987 through 1999. Each observation represents a claim for which the insurance made a nontrivial settlement greater than $5,000.
Based on a dichotomous measure of risk (existence of a lawsuit), the authors find that larger firms, firms experiencing rapid growth, firms that sue their clients, and firms with a history of problems all face greater litigation risk. Introducing a continuous measure of the cost of litigation, the authors find, in addition to the previously mentioned risk factors, that firms with a prior history of regulatory problems and firms that choose smaller deductibles are more risky to the insurance company.
An implication of the findings from experiment one is that restricting the auditor’s provision of NAS may lead to fewer lawsuits and, importantly, a reduction in the deadweight costs associated with litigation. But such restrictions mean that companies forgo the potential benefits (e.g., knowledge spillovers) of acquiring NAS from the auditor. Based on the findings from experiment two, participants perceive that the potential benefits of NAS outweigh the potential costs, notably when performing a conventional assessment of asset value. The net benefits are lost when the auditor is prohibited from providing NAS. The authors encourage future study to examine the net effect of restricting the auditor’s provision of NAS on social welfare.
Church, B. K., and P. Zhang. 2011. Nonaudit Services and Independence in Appearance: Decision Context Matters. Behavioral Research in Accounting 23 (2): 51-67.
Following the Enron and WorldCom scandals, the Sarbanes-Oxley Act of 2002 (SOX) prohibited the auditor’s provision of many nonaudit services (NAS). The passage of SOX suggests that regulators and legislators believe that certain NAS impair auditor independence and, in turn, lower financial reporting quality. Archival data, however, provide scant evidence of a relation between NAS and audit quality (independence in fact). Notwithstanding, auditors must still maintain independence in appearance for their reports to be credible.
The fundamental question is whether users’ perceptions of NAS differ across decision contexts; that is, whether NAS are viewed as detrimental in one context and beneficial in another. By examining the effect of decision context on users’ assessments, the authors seek to identify an important factor that may account for some of the mixed findings documented elsewhere. The authors suggest that decision context influences users’ motives, such that the auditor’s provision of NAS is interpreted opportunistically—in a manner that best suits users’ self-interest. If that is the case, then users’ assessments of independence are malleable, which can be problematic for regulators; the challenge of prescribing rules to ensure independence in appearance becomes quite daunting. Because auditor independence is a cornerstone of auditing, regulators may opt to err on the side of caution and mandate strict rules. Yet, such rules may not be socially optimal.
The authors design two experiments to investigate. For experiment one, the authors recruited 27 students from a large university to participate in the experiment. The authors recruited 37 students from a large university to participate in experiment two. All the students were in at least their third year, and all but one were pursuing a program of study in business or economics. The evidence was gathered prior to November 2011.
This paper could have implications for the current debate in the U.S.A. and the European Union on whether auditors’ liability should be capped. This paper shows that a liability cap may be (but need not be) desirable when auditors’ ambiguity aversion otherwise induces excessive care. If liability caps are not warranted, accounting and auditing standard setters may consider making standards more precise in a high-liability setting. Since sharing losses seems beneficial under ambiguity aversion, auditors may find it advantageous to perform joint audits (if permitted by regulation). This paper contributes to the literature by incorporating a persistent phenomenon of boundedly rational decision-making into a model of auditor liability.
Bigus, J. 2012. Vague Auditing Standards and Ambiguity Aversion. Auditing: A Journal of Practice & Theory 31 (3): 23-45.
There is strong empirical evidence that individuals are subject to boundedly rational behavior. There is also evidence that auditors face cognitive. More specifically, auditors tend to increase care levels when confronted with ambiguous audit contexts. Many experiments have confirmed that individuals generally dislike ambiguity. This paper incorporates ambiguity aversion into a model of auditor liability. Ambiguity implies uncertainty about the probability that a future event, e.g., a future loss, will occur. With ambiguity aversion, people tend to weigh less favorable outcomes more highly, and are, therefore, more pessimistic. For instance, other things being equal, individuals usually prefer a 30 percent chance to a (imprecisely defined) chance of 10–50 percent. Interestingly, individuals still prefer a certain probability to a probability range, even with training in decision-making. This immunity to persuasion leads to the belief that ambiguity aversion might, in fact, be considered rational. If, in fact, ambiguity aversion is “rational,” there seems to be a need to incorporate it into economic modeling.
The author uses a model to analyze how an auditor’s ambiguity aversion affects his level of care.
The author obtains the following results, considering a risk-neutral auditor who dislikes ambiguity:
(1) An ambiguity-averse auditor tends, on the one hand, to exert less care with low damage payments. Due to likelihood insensitivity, with low damage payments, the perceived marginal benefits of additional care are too low (futility effect).
(2) On the other hand, an ambiguity-averse auditor may be willing to take a (very) high level of precaution in order to be certain that he will not be held liable ex post. Certainty is valuable in the event of pessimism, and becomes more valuable the higher damage payments are. If damage payments exceed a certain threshold level, the certainty effect outweighs the futility effect. Thus, the problem of excessive care becomes more serious.
(3) Even with low incentives to sue, an ambiguity-averse auditor may exert excessive care when damage payments are sufficiently large.
(4) Both a liability cap and liability insurance avoid excessive care, but may then induce suboptimal precaution.
(5) With strict liability, the auditor exerts efficient care, since there is no second-order probability and no ambiguity situation. Thus, there is no distortion from ambiguity aversion. This is a new benefit of a strict liability rule.
The study contributes to the literature in several ways. First, the authors address potential endogeneity in prior studies by using a simultaneous equation (a two-stage instrumental variable) approach. The research design provides a better specified test of the relation between litigation risk and abnormal accruals, and enables the authors to draw inferences about the relation with greater confidence. Second, by estimating client-specific auditor litigation risk over 1989–2007, the authors are able to directly examine whether litigation risk decreased after the 1995 Act. Third, the authors are able to directly examine both dimensions of the litigation risk-abnormal accruals relation, as well as whether abnormal accruals is a factor that increases the likelihood of the auditor being involved in a lawsuit (the litigation likelihood effect).
Boone, J. P., I. K. Khurana, and K. K. Raman. 2011. Litigation Risk and Abnormal Accruals. Auditing: A Journal of Practice & Theory 30 (2): 231-256.
The relation between auditor litigation risk and earnings management is an important topic of interest for academics, regulators, and policymakers. In this paper, the objective is to better understand the relation between auditor litigation risk and abnormal accruals (earnings management). Specifically, the authors simultaneously address two distinct but related questions: (1) does litigation risk affect auditor incentives to restrain abnormal accruals, and (2) whether abnormal accruals increase the likelihood (risk) of auditor litigation.
To control for endogeneity bias, the authors use a simultaneous equation methodology to examine the relation between abnormal accruals and litigation risk. By controlling for endogeneity, the study more clearly speaks to the issue of whether the auditor’s restraining influence on earnings management—to avoid future litigation—is greater when the risk of litigation is higher (the litigation avoidance effect), and whether earnings management increases the likelihood of auditor litigation (the litigation likelihood effect).
The authors obtain their sample of Big N auditor lawsuits over the 1989–2007 period from Palmrose and Audit Analytics. The sample of auditor lawsuit companies is formed using merged Compustat annual industrial file and return files from the Center for Research in Security Prices (CRSP). The sample consists of 67 Big N lawsuits. Since a plaintiff can allege auditor wrongdoing in multiple years, the lawsuit sample consists of 146 alleged wrongdoing company-years.