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    Litigation Risk, Audit Quality, and Audit Fees: Evidence...
    research summary posted May 7, 2012 by The Auditing Section, last edited May 25, 2012, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 14.0 Corporate Matters, 14.01 Earnings Management 
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    Title:
    Litigation Risk, Audit Quality, and Audit Fees: Evidence from Initial Public Offerings
    Practical Implications:

    This study provides a more precise analysis of pre- versus post-IPO accruals levels than previous research and the results are consistent with the effects an increase in litigation exposure should have on auditor incentives. That is, both audit quality and audit fees are higher in a higher-litigation regime.

    Citation:

    Venkataraman, R., J. P. Weber, and M. Willenborg. 2008. Litigation risk, audit quality and audit fees: Evidence from initial public offerings. The Accounting Review 83 (5): 1315-1345

    Keywords:
    Abnormal accruals; audit committees; audit fees; audit quality; auditor litigation; earnings management; initial public offering.
    Purpose of the Study:

    Auditors’ responsibilities and exposure to litigation risk vary depending on applicable federal securities laws. For example, when companies register for their initial public offering (IPO) they file under the Securities Act of 1933. However, after going public, they file under the Securities Exchange Act of 1934. Because litigation risk exposure is higher under the 1933 Act than the 1934 Act,  auditors should provide higher quality and receive higher fees for IPO audits.   In spite of this, prior research suggests that issuers engage in pre-IPO earnings management in an effort to inflate IPO prices. However, the prior literature does not use pre-IPO inancial statements to compute accruals levels, but instead infer pre-IPO accruals levels using financial statements from issuers’ first 10-K.  This paper uses pre-IPO audited  financial statements to compute pre-IPO accruals to investigate whether: 

    • Pre-IPO accrualsare significantly positive or negative, and
    • Pre-IPO accruals are less than post-IPO accruals 

    The authors use differences between litigation liability regimes to investigate whether a higher-litigation regime influences audit quality, as measured by audited accruals, and whether there is any effect of litigation risk on auditor compensation.

    Design/Method/ Approach:

    The authors use publicly available data on companies that went public between January 1, 2000 and December 31, 2002 and compare pre- and post-IPO accruals measures. 

    Findings:
    • The authors find that pre-IPO audited accruals are negative and less than post-IPO audited accruals (i.e. audit quality is higher in the higher litigation risk pre-IPO period)
    • The authors find that auditors earn higher fees for IPO engagements than for post-IPO engagements
    Category:
    Risk & Risk Management - Including Fraud Risk, Corporate Matters
    Sub-category:
    Earnings Management, Litigation Risk, Earnings Management
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