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.

• Negatively signed relation between client-specific auditor litigation risk (as an independent variable) and the abnormal accruals reported by the client.
• Higher litigation risk lowers the auditor’s incentive to acquiesce to client demands for earnings management.
• Auditors believe that information markets are not perfect, i.e., auditors believe that users of accounting information are either unable or unwilling to unravel the effects of earnings management.
• The authors find evidence that abnormal accruals (as an independent variable) increases the likelihood of auditor litigation.
• The findings suggest that despite the notion that Big N auditors are often sued more for their “deep pockets” than for their culpability for wrongdoing, there may be a link between abnormal accruals and litigation.
• The results suggest that earnings management is related to litigation.
• The results show that the client-specific auditor litigation risk decreased after the 1995 Litigation Reform Act.
• The results suggest that the 1995 Reform Act did not have a direct, across-the-board effect in terms of increasing earnings management.
• The findings suggest that the increase in abnormal accruals in the post-1995 Act time period occurred indirectly through the decrease in client-specific litigation risk.

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