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    Litigation Risk and Audit Firm Characteristics.
    research summary posted October 20, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk 
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    Title:
    Litigation Risk and Audit Firm Characteristics.
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    audit failure, audit firm characteristics, litigation risk
    Purpose of the Study:

    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. 

    Design/Method/ Approach:

    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.

    Findings:

    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.

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Litigation Risk