This study is important to audit practice as it provides an initial view into the effects of outsourcing and offshoring on juror perceptions of the due care exhibited in supervising audit work performance as embodied in assessed damage awards, while also providing perceptions on the expected quality and risk associated with these relationships. The results may be of particular interest to the profession given that this study examines audit work outsourced and/or offshored to India, the country cited as conducting the most outsourced audit work for North American CPA firms. Interestingly, the professional bodies (i.e., NASBA) have chosen not to grant reciprocity of practice for Indian charted accountants (i.e., Mutual Recognition Agreements). India has been denied multiple times while reciprocity has been granted to CPAs/CAs in Australia, Canada, Hong Kong, Ireland, Mexico, and New Zealand (NASBA 2012). The juror perceptions of quality and risk of audit work outsourced offshore, as shown in this study, parallel the concerns expressed by professional bodies.
For more information on this study, please contact Alex Lyubimov.
Lyubimov, A., V. Arnold, and S.G. Sutton. 2013. An Examination of the Legal Liability Associated with Outsourcing and Offshoring Audit Procedures. Auditing: A Journal of Practice and Theory 32 (2): 97-118.
Accounting firms have steadily increased the use of outsourcing and offshoring of professional services including independent audit procedures. While firms suggest that the work is of higher quality and similar litigation risk, questions remain as to whether public perceptions may be more negative. The purpose of this study is to examine the effect of outsourcing and offshoring of audit work on juror’s perceptions of auditor legal liability when an audit failure occurs. More specifically, this paper examines liability associated with an audit failure when work is performed by another office of the same firm or outsourced to a separate firm, and whether the work is performed domestically or in another country. Theory suggests that outsourcing and offshoring of those outsourced audit procedures has the potential to erode the perceived professionalism of auditors’ work as embodied through decreases in perceptions of work quality, increases in perceptions of associated risk, and ultimately more severe damages assessed against auditors during litigation.
An experiment was conducted using a 2 (insource vs. outsource) X 2 (onshore vs. offshore) design. The experiment was delivered through an internet application to facilitate the use of a diverse national sample of jury eligible participants. Participants, representing a broad demographic base, were individuals who were over the age of 18, jury-eligible in the US, had no legal or auditing experience, and not CPA’s. Data were collected over a four-day period in December, 2010.
Results indicate that choosing to outsource audit work to another audit firm is associated with higher compensatory damages in case of an audit failure. Furthermore, when this third party audit firm is located in a different country (offshoring), outsourcing leads to significantly higher punitive damages. Surprisingly, jurors assess higher than expected litigation awards for a failure by another domestic office of the firm for punitive damages. This result suggests that the close proximity in terms of both geography and organizational distance of the domestic office of the firm leads jurors to find the audit failure less understandable. Post hoc analyses indicate that potential jurors perceive that work completed by another domestic office of the firm has the highest expected quality and lowest risk, while work that is outsourced offshore is expected to be lowest quality and highest risk—consistent with proximity theory.
The results of this study are important for firms to consider given the recent and historical problem of rising litigation costs. Firms are likely to be targets of lawsuits following the revelation of fraud within a client’s financial statements regardless of whether the firm was complicit in the fraud. Even lawsuits that are settled quickly result in high litigation costs, and the reputational costs to the firm can be just as problematic as the monetary costs. Very few audits are “perfect,” particularly when examined in hindsight. This study suggests that there are benefits to a firm being honest and apologetic about any deficiencies in an audit when the deficiencies do not relate to the fraud itself.
For more information on this study, please contact Jason Rasso.
Rasso, J. T. 2014. Apology accepted: The benefits of an apology for a deficient audit following an audit failure. Auditing: A Journal of Practice & Theory 33 (1): 161-176.
This paper examines the use of an apology for conducting a deficient audit that indirectly leads to an audit failure. Audit failures can be costly to accounting firms in terms of litigation costs and reputational harm. These costs are potentially much higher when the audit failure stems from a deficient audit. The author tests whether the use of an apology containing various components (expression of sympathy, acceptance of responsibility, and/or promise to refrain) is beneficial or harmful to an accounting firm. The results reveal that only the expression of sympathy has an effect on assessments of punishment. However, combining all three apology components leads to a significantly higher perception of the accounting firm’s reputation. This paper is one of very few papers that examines mechanisms that can help protect firm’s reputations.
The research evidence is collected in the time period 2011 – 2012. The author collected responses from the general public via Amazon Mechanical Turk. The participants read about the history of an accounting firm, then read a newspaper article identifying a major accounting fraud in which the accounting firm is named as the auditor. The participants then read an apology that contains one, two, or all three of the apology components (one group does not read an apology) and then are asked to rate their support for a lawsuit against the firm, the level of fine they would recommend for the firm, and their perceptions of the firm’s reputation.
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.
This study provides an important implication for audit firms in maintaining their worldwide brand name reputation. The results suggest that, for global audit firms, the damage to auditor reputation in one country may spill over and cause concern among investors about the quality of their services in other countries. Further, the damage to reputation is greater where the demand for auditing and assurance is higher.
Cahan, S. F., D. Emanuel, and J. Sun. 2009. Are the Reputations of the Large Accounting Firms Really International? Evidence from the Andersen-Enron Affair. Auditing: A Journal of Practice and Theory 28 (2): 199-226.
The Big 4 accounting firms market themselves as global firms that deliver a uniform level of service across countries. While such a global reputation helps build worldwide demand for high-quality audits, it also creates risks if service quality becomes questionable in one of the countries in which a firm operates. Questionable audit practices in one of the countries, especially in the home jurisdiction, may raise doubts as to whether sub-standard audits also occur in other countries.
This study examines whether the damage to the name brand of Arthur Andersen following the Andersen-Enron scandal in the U.S. spilled over into other countries. The study focuses on two key event dates leading up to Andersen’s demise: (1) January 10, 2002, when Andersen announced it had shredded documents related to the Enron audit, and (2) February 4, 2002, when Enron’s board released the Powers report that was critical of Andersen and when Andersen announced the establishment of an Independent Oversight Board (IOB) to investigate the firm’s audit policies and procedures. This study investigates the market reaction to Andersen’s clientele base around these two dates to determine whether:
The authors use data on publicly-traded companies audited by Arthur Andersen in 2001 to examine whether there is a negative market reaction to Andersen’s non-U.S. clients around the two event dates discussed above.
The uncertainties surrounding material weaknesses, the difficulty of auditing around some types of weaknesses, and the fact that the auditor must explain why it issued a clean report on the financial statements when it had issued a MWO, may cause the auditor to become conservative in its GCO decision, which is fairly ambiguous to start with. The study has particular relevance for policy makers and a need for a broader evaluation of the effects of SOX 404.
Goh, B. W., Krishnan, J., & Li, D. 2013. Auditor Reporting under Section 404: The Association between the Internal Control and Going Concern Audit Opinions. Contemporary Accounting Research 30 (3): 970-995.
Section 404 of the Sarbanes-Oxley Act of 2002 (SOX) requires companies’ independent auditors to provide an opinion on their clients’ internal control over financial reporting, in addition to the opinion on their clients’ financial. The purpose of Section 404 was primarily to provide information on the internal controls, thus enhancing investor understanding of the quality of firms’ financial reporting. The PCAOB also issued AS2 and AS5, which require an “integrated audit of internal control and financial statements” because the “objectives of and work involved in performing both an attestation of management’s assessment of internal control and an audit of the financial statements are closely interrelated.”
In this paper, the authors explore the association between the two audit opinions by examining whether the issuance of an adverse internal control material weakness opinion (MWO) influences, other things equal, the issuance of a going concern audit opinion (GCO) for financially stressed companies. Although the two opinions are the result of an integrated audit process, they serve different purposes. The GCO reflects the auditor’s view of the financial condition of its client, indicating whether (in the auditor’s opinion) the client will continue to be a going concern for a period of 12 months beyond the financial year end. The MWO reflects the auditor’s opinion on whether there are material weaknesses in internal control and therefore the likelihood that material misstatements in the financial statements will not be detected or prevented. Despite this difference, the two opinions could be connected.
The authors examine the association between the MWO and the GCO, using a sample of 1,110 financially stressed firms that reported internal control and audit opinions under SOX Section 404. They start with all public firms on COMPUSTAT with year-ends from 2004 to 2009, for which the authors could compute the Altman financial distress Z-score.
This study sheds light on why auditors choose to resign from auditing particular clients. The authors find that public information about audit risk, business risk, and litigation risk as well as private information about audit risk and business risk all play a role in the auditor’s resignation decision. This is useful for audit firms and regulators to consider.
Ghosh, A. and C.Y. Tang. 2015. Auditor Resignation and Risk Factors. Accounting Horizons 29 (3): 529-549.
While prior research has suggested litigation risk as the main reason for auditor resignations, the competing explanations of audit risk and business risk have not been tested concurrently to discover their incremental importance. Furthermore, prior research has not been able to isolate the auditor’s private information from public information about these risks. The authors attempt to close this gap in the literature by studying whether and how much the auditor’s private information about future audit risk, business risk, and litigation risk impacts the auditor’s resignation decision.
The authors use data from publicly-traded companies that switched auditors during the 1999-2010 time period. First, they compare auditor resignations to auditor dismissals based on pre-switch audit risk, business risk, and litigation risk. Then they test whether auditor resignations predict post-switch audit risk (e.g. internal control problems), business risk (e.g. delisting from stock exchange), and litigation risk (e.g. class-action lawsuits).
The results of this study suggest that the current negligence system of auditor liability could, in certain circumstances, penalize auditors for investigating specific fraud risks. As such, results of this study suggest that the current system of liability for auditors could provide disincentives for auditors to expand the scope of their fraud detection audit procedures. That said, it is important to note that this study does not indicate that auditors should restrict fraud detection procedures. Specifically, at least two factors drive the expected litigation cost of an audit: (1) the probability of being sued; and (2) the expected loss if sued. This study only examines the expected loss if sued for negligence and thus does not examine the overall litigation cost.[1]
For additional information on this study, please contact Andrew Reffett at reffeta@miamioh.edu.
[1] The purpose of this study and the practical implications of this study are based on, and discussed in more detail in a practitioner summary of Reffett (2010). The citation for that summary is as follows: Reffett A. 2011. No Good Deed Goes Unpunished? Recent Evidence on the Effects of Identifying and Investigating Fraud Risks on Auditors’ Litigation Exposure. Current Issues in Auditing Vol. 5 (2): 1-8.
Reffett, A.B. 2010. Can identifying and investigating fraud risks increase auditors’ liability? The Accounting Review 85 (6): 2145-2167.
Various groups including legal scholars and audit practitioners have expressed concern that investigating specific fraud risks could, in the event that the auditors fail to detect a perpetrated fraud, increase auditors’ litigation exposure. The objective of this study was to provide theory and experimental evidence to inform these concerns. The study relies on counterfactual reasoning theory to predict that when auditors fail to detect fraud, lay evaluators (e.g., jurors) will have more intense thoughts of what the auditors could have done differently to detect the fraud, and thus will be more likely to find the auditors negligent when the auditors identified the perpetrated fraud as a fraud risk and investigated for the fraud compared to when the auditors did not identify the fraud as a fraud risk (and did not investigate for the fraud). Support for the study’s hypotheses would be disconcerting because such results would suggest that the current negligence system of auditor liability could, in certain circumstances, provide disincentives for auditors to expand the scope of their fraud detection audit procedures.
The experimental data was collected in 2007-2009. Participants were undergraduate students at two Midwestern U.S. public universities. Participants, who proxied for jurors, were given a case to read and complete. The case packet provides background information regarding the nature and purpose of financial statements and financial statement auditing. The case then describes a fictional mining company, the details of a fraud the auditors failed to detect, and the transcript from a fictional negligence trial. The case manipulates between-participants whether or not the auditors identified the perpetrated fraud as a fraud risk and performed audit procedures to explicitly investigate for the fraud. After reading the case, participants indicate whether they believed the auditors were negligent, and, if so, the amount of damages the auditors should pay to the plaintiff. After answering questions about auditor negligence and liability, participants answered several follow-up questions including the intensity of their thoughts of what the auditors could have done differently to detect the fraud.
The results of this study are important for audit firms to prepare for the adoption of IFRS and/or less precise standards under U.S. GAAP. The results indicate that a move to less precise standards will not necessarily result in more verdicts against auditors. There is only one condition in which an imprecise standard leads juries to return more verdicts against the auditor: when the client’s reporting complies with the precise standard and is inconsistent with the industry reporting norm. The results suggest that auditors can reduce this liability by ensuring that their client’s reporting is consistent with industry reporting norm.
For more information on this study, please contact Kathryn Kadous.
Kadous, K., and M. Mercer. 2012. Can Reporting Norms Create a Safe Harbor? Jury Verdicts against Auditors under Precise and Imprecise Accounting Standards. The Accounting Review 87 (2):565-587.
The transition from U.S. GAAP to International Financial Reporting Standards (IFRS) has been a topic of debate among regulatory bodies, standard-setters, firms, and their auditors. IFRS tend to provide less precise guidance than current U.S. accounting standards, so their application requires more professional judgment. Auditors have expressed concern that the adoption of IFRS will result in increased legal liability. This paper addresses this concern by investigating how the level of precision in accounting standards affects jury verdicts in auditor negligence lawsuits. Based on legal studies and the psychology literature, this paper studies how the effect of accounting standard precision on jury verdicts depends on two factors:
The authors collected their evidence prior to September 2010. They use a group of undergraduate students to act as jurors in a simulated auditor negligence case. The participants deliberate in juries of six persons. Each jury is asked to assess the auditor’s conduct and to provide a verdict.
While the results of this study are not conclusive, both expert panels of auditors and lay jurists rely on different, legally irrelevant inputs when making assessments of auditor liability. Auditor evaluators rely more on their emotional connections to other auditors while lay evaluators focus more on plaintiff losses as evidence of negligence. This study is only a first step in determining whether expert panels of auditors would improve the judicial process.
Reffett, A., B. E. Brewster, and B. Ballou. 2012. Comparing Auditor versus Non-Auditor Assessments of Auditor Liability: An Experimental Investigation of Experts' versus Lay Evaluators' Judgments. AUDITING: A Journal of Practice & Theory 31 (3): 125-148.
Critics of the legal system argue that the use of lay jurors to judge cases of auditor negligence results in unfair and inaccurate decisions about auditor liability because lay jurors often misunderstand both the scope of an audit and the responsibilities of an auditor. Previous research studies have suggested that courts rely on panels of experienced auditors instead of lay jurors in cases regarding auditor liability. This study investigates whether and how auditors’ and lay evaluators’ judgments differ from each other. The findings should be important to standards setters and regulators as they decide whether auditors should be allowed to judge auditor liability cases.
The study was administered sometime prior to 2012 via an online experiment e-mailed to participants. The participants included 51 currently practicing auditors (average of 7.5 years of experience; 48 from Big-N firms) and 54 non-accounting undergraduate students who represented lay jurists. The experiment presented a case that presented fictional details of a mining company, a financial statement fraud at the company and a subsequent auditor negligence lawsuit. After reading the case, participants respond to questions about auditor negligence and other related issues.
The results should be of interest to auditing practitioners. Generally, managers of public companies prefer that the audit report does not contain a going concern paragraph. In this regard, researchers have found that issuing a going concern audit report increases the likelihood of management-initiated auditor switches. These results highlight the expected benefits to auditors from issuing a going concern report to their financially stressed clients. Specifically, better controlling for endogeneity, the evidence indicates that issuing a going concern report lowers the likelihood of investors naming the auditor in a class action lawsuit.
Kaplan, S. E., and D. D. Williams. 2013. Do Going Concern Audit Reports Protect Auditors from Litigation? A Simultaneous Equations Approach. Accounting Review 88 (1): 199-232.
An important aspect of the auditors’ environment is state and federal laws that allow third parties such as investors to sue auditors in an effort to recover damages. Historically, these litigation-related costs have been substantial. Potentially, auditors may be able to reduce their exposure to litigation when auditing a financially stressed client by issuing a going concern report. Under current auditing standards, a going concern audit report is required when an auditor has substantial doubt about the client’s ability to remain a going concern for a reasonable period of time. Whether a going concern report actually protects auditors against lawsuits is an open question.
The study applies a simultaneous equations approach to examine the relation between auditor going concern reporting and investors’ decisions to sue auditors. Importantly, this approach takes into account the endogeneity between the auditor’s going concern reporting decision and ex ante litigation risk. The authors explicitly recognize two separate aspects of the relation between going concern reporting and auditor litigation.
The sample consisted of 1,211 securities class action lawsuits filed against the auditors between 1986 and 2009. 147 firms comprise the final auditor litigation sample. The authors determined whether a securities class action lawsuit had been filed against the auditors by examining the databases constructed by Palmrose (1999), the Stanford Class Action Securities Clearinghouse, Audit Analytics, LexisNexis, Westlaw, CASEmaker, ISS Securities Class Action Services, and the popular press.