Auditing Section Research Summaries Space

A Database of Auditing Research - Building Bridges with Practice

This is a public Custom Hive  public

research summary

    Can Identifying and Investigating Fraud Risks Increase...
    research summary posted December 3, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk 
    266 Views
    Title:
    Can Identifying and Investigating Fraud Risks Increase Auditors’ Liability?
    Practical Implications:

    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.

    Citation:

    Reffett, A.B. 2010. Can identifying and investigating fraud risks increase auditors’ liability?  The Accounting Review 85 (6): 2145-2167.

    Keywords:
    fraud risks; auditor liability; counterfactual reasoning theory; negative affect
    Purpose of the Study:

    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.

    Design/Method/ Approach:

    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.

    Findings:
    • Jurors experienced more intense thoughts of what the auditors could have done differently to detect the fraud when the auditors identified the perpetrated fraud as a fraud risk and performed audit procedures to explicitly investigate for the fraud (versus otherwise).
    • Jurors’ emotional reactions to the case were less favorable to the auditors when the auditors identified the perpetrated fraud as a fraud risk and performed audit procedures to explicitly investigate for the fraud (versus otherwise).
    • Jurors were more likely to find the auditors negligent when the auditors identified the perpetrated fraud as a fraud risk and performed audit procedures to explicitly investigate for the fraud (versus otherwise).
    • Supplemental analysis indicates that the above effects are subconscious. That is, despite their pattern of judgments to the contrary, jurors do not consciously believe that auditors who investigate for, but fail to detect fraud are more liable than auditors who do not investigate for (and fail to detect) fraud. 
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Litigation Risk