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  • Jennifer M Mueller-Phillips
    Fraud Risk Awareness and the Likelihood of Audit Enforcement...
    research summary posted October 12, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Fraud Risk Awareness and the Likelihood of Audit Enforcement Actions
    Practical Implications:

     This paper sheds light on the implications of a going concern opinion, specifically in the context of litigation against the auditor. While prior research has established that a going concern opinion reduces the likelihood of shareholder litigation in bankruptcy proceedings, this study shows that going concern opinions potentially open up the auditor to increased SEC litigation if the financial statements are found to be fraudulent. The authors suggest this should be taken into consideration when auditors are determining the extent of necessary documentation for fraud risk assessment, especially when the client is likely receiving a going concern opinion.

    Citation:

     Eutsler, J., E.B. Nickell, S.W. Robb. 2016. Fraud Risk Awareness and the Likelihood of Audit Enforcement Action. Accounting Horizons 30 (3): 379-392.

    Purpose of the Study:

     The authors aim to examine whether documented awareness of fraud risk affects the likelihood of SEC enforcement action against the auditor in cases of undetected fraud. They acknowledge that financial distress provides incentive for fraudulent activity, and therefore consider the possibility that a going concern represents information that may affect SEC assessment of the auditor’s fraud risk assessment. This study aims to address concern that regulator investigation of audited fraudulent financials may be biased by economic factors or other information that was unknown at the time of the audit. This concern contradicts prior research, which shows that going concern opinions deter litigation against auditors when the client subsequently goes bankrupt.

    Design/Method/ Approach:

     The authors review Accounting and Auditing Enforcement Releases (AAERs) issued by the SEC for companies alleged to have engaged in fraudulent activity between January 1995 and August 2012. They identify 314 instances of alleged fraud, of which 34 received a going concern opinion and 54 had auditor-involved sanctions.

    Findings:

     The authors find that awareness of fraud risk—specifically noting a going concern issue—exposes the auditor to additional scrutiny of regulators when the financials are subsequently found to be fraudulent. Additionally, this paper points out an interesting contrast in the implications of a going concern opinion. Prior research has shown that auditors are less likely to be sued when a client with a going concern opinion subsequently goes into bankruptcy; however, the results in this paper show that auditors giving a going concern opinion are more likely to be sued when those financial statements are subsequently found to be fraudulent.

    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Going Concern Decisions, Litigation Risk
  • Jennifer M Mueller-Phillips
    Insider Trading, Litigation Concerns, and Auditor...
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Insider Trading, Litigation Concerns, and Auditor Going-Concern Opinions.
    Practical Implications:

    The study offers two primary contributions. First, it provides insight into the incentive effect of corporate insider trading on auditor behavior. The study helps to fill this gap by providing evidence on the relationship between managers’ incentives and auditors’ opinions. Second, this study adds to the literature on insider trading. The evidence extends this literature by showing that insiders’ incentives to sell and their desire to avoid litigation can influence auditors’ reports.

    Citation:

    Chen, C., X. Martin, and X. Wang. 2013. Insider Trading, Litigation Concerns, and Auditor Going-Concern Opinions. Accounting Review 88 (2): 365-393.

    Keywords:
    going-concern opinion, insider tracking, litigation risk, SOX
    Purpose of the Study:

    The authors investigate whether managers’ litigation concerns about insider selling affect the likelihood of firms receiving going-concern opinions. Prior studies show that managers face the risk of trade-related litigation around news events. To reduce their risk exposure, managers have at least two options. First, they can abstain from trading before notable events.  Alternatively, when managers do choose to trade, they can attempt to alter the information flow in the post-trading period to avoid price swings and escape regulators’ scrutiny. The authors focus on this option with respect to the association between managers’ insider sales and auditors’ going-concern modifications.

    At least two reasons motivate the focus on insider selling. First, the information content of the two types of auditor opinion is asymmetric. First-time going-concern opinions induce significantly negative market reactions, while clean opinions do not generate positive market reactions. Insiders are therefore less concerned about buying and the subsequent receipt of a clean opinion. Second, Roulstone (2008) argues that bad-news disclosures are more likely to trigger investor lawsuits that allege inadequate disclosure by management. Such lawsuits usually use pre-disclosure insider selling to indicate management’s foreknowledge of bad news. Thus, in contrast to insider purchases ahead of good news, insider sales ahead of bad news carry a significant legal risk.

    Design/Method/ Approach:

    The authors obtain insider trading data from Thomson Reuter. They obtain information about audit opinions and audit fees from Audit Analytics for the period 2000 through 2007. They then match the audit opinion data with the Compustat industrial annual file, the Center for Research in Security Prices (CRSP) database, and the Insider Trading database. The final sample retains 12,329 firm years, consisting of 801 observations with first-time going-concern opinions and 11,528 observations with clean opinions.

    Findings:
    • The authors find evidence that a higher level of insider selling is associated with a lower likelihood of receiving a first-time going-concern report.
    • For a one standard deviation increase in insider selling, the probability of receiving going-concern reports decreases by 1.39 percent.
    • The negative relation between insider selling and the probability of receiving a going-concern opinion is stronger for firms that are more economically important to their auditors but weaker for firms whose auditors have greater concerns about litigation exposure and reputation loss and for firms with more independent audit committees.
    • Auditors who issue clean opinions for clients with higher levels of insider selling have a lower frequency of dismissals in the subsequent year.
    • These results are consistent with the notion that management influences auditors’ opinions but are inconsistent with the notion that insiders reduce their selling in anticipation of going-concern reports.
    • The negative relation between insider selling and the likelihood of receiving a going-concern opinion holds for the pre- and post-SOX periods but is significantly weaker in the post-SOX period.
    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk, Standard Setting
    Sub-category:
    Going Concern Decisions, Going Concern Decisions, Impact of SOX, Litigation Risk
  • Jennifer M Mueller-Phillips
    Litigation Risk and Abnormal Accruals.
    research summary posted October 13, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Litigation Risk and Abnormal Accruals.
    Practical Implications:

    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 19892007, 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).

    Citation:

     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.

    Keywords:
    abnormal accruals, auditor incentives, litigation risk
    Purpose of the Study:

    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 managementto avoid future litigationis 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).

    Design/Method/ Approach:

    The authors obtain their sample of Big N auditor lawsuits over the 19892007 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.

    Findings:
    • 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.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Litigation Risk
  • Jennifer M Mueller-Phillips
    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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
  • The Auditing Section
    Litigation Risk, Audit Quality, and Audit Fees: Evidence...
    research summary posted May 7, 2012 by The Auditing Section, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 14.0 Corporate Matters, 14.01 Earnings Management in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
    Home:
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  • Jennifer M Mueller-Phillips
    Malleable Standards of Care Required by Jurors When...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 06.09 Litigation Risk, 11.07 Attempts to Measure Audit Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Malleable Standards of Care Required by Jurors When Assessing Auditor Negligence
    Practical Implications:

    This study is relevant for practitioners, investors, and regulators. It demonstrates to firms that the effectiveness of high audit quality as a defense in litigation may be decreased depending on the timing of jurors’ assessment of SOC. One way to try and lower the probability of jurors’ assessing SOC after receiving audit knowledge is to warn the jury about the potential affects. Simply changing the jurors’ instructions has been found to mitigate the outcome effects.

    Citation:

    Maksymove, Eldar M., and M. W. Nelson. 2017. “Malleable Standards of Care Required by Jurors When Assessing Auditor Negligence”. The Accounting Review. 92.1 (2017): 165.

    Keywords:
    auditor liability; jury; audit quality; mediation; anchoring; sample size; audit adjustment
    Purpose of the Study:

    In court cases against auditors due to audit failure, often times the main defense used is that there was a high audit quality. This is true if the audit was performed at a level similar to what prudent auditors would have done in the same circumstances, also known as standard of prudent care (SOC). This study examines whether jurors’ definition of SOC is malleable based on the timing of the SOC assessment in accordance with the jurors’ exposure to the audit quality of the case. Specifically, whether or not the juror learns of audit quality first and then assesses SOC, or vice versa. 

    Design/Method/ Approach:

    The research project contains four experiments. The first experiment is a simulation where 125 participants, found using Amazon’s Mechanical Turk (AMT), are asked to assume the role of jurors who are considering a case of alleged auditor negligence. The level of audit quality and the timing of jurors’ SOC assessments are manipulated. In the subsequent three experiments 60-63 of the previous participants were asked to determine SOC based on the level of audit quality being manipulated and a change in some of the background information.

    Findings:

    Overall, the authors find that the timing of the SOC assessment in accordance with the jurors’ exposure to the audit quality of the case does in fact change the outcome of the SOC assessment. Therefore, the results indicate the jurors SOC assessments are malleable.

    The authors find the following:

    • In situations where SOC is determined prior to jurors learning about the audit quality of the case, the verdict better discriminates between high and low-quality auditors. This is due to the fact that the audit quality of the case cannot affect the jurors’ decision of what SOC should be.
    • On the other hand, when SOC is assessed after jurors learn about the audit quality of the case, it can cause SOC assessments to vary. This leads to inconsistent rulings of whether or not the auditor was negligent.
    • The reasoning behind the second situation is as follows. The jurors’ knowledge of higher audit quality in the case directly lowers the negligence judgment. However, when doing the SOC assessment after learning about the higher audit quality, the jurors raise SOC. This then increases the negligence judgment. The authors refer to this effect as competitive mediation. 
    Category:
    Audit Quality & Quality Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Attempts to Measure Audit Quality, Litigation Risk
    Home:

    http://commons.aaahq.org/groups/e5075f0eec/summary

  • Jennifer M Mueller-Phillips
    Nonaudit Services and Independence in Appearance: Decision...
    research summary posted October 19, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Nonaudit Services and Independence in Appearance: Decision Context Matters.
    Practical Implications:

    An implication of the findings from experiment one is that restricting the auditor’s provision of NAS may lead to fewer lawsuits and, importantly, a reduction in the deadweight costs associated with litigation. But such restrictions mean that companies forgo the potential benefits (e.g., knowledge spillovers) of acquiring NAS from the auditor. Based on the findings from experiment two, participants perceive that the potential benefits of NAS outweigh the potential costs, notably when performing a conventional assessment of asset value. The net benefits are lost when the auditor is prohibited from providing NAS. The authors encourage future study to examine the net effect of restricting the auditor’s provision of NAS on social welfare.

    Citation:

    Church, B. K., and P. Zhang. 2011. Nonaudit Services and Independence in Appearance: Decision Context Matters. Behavioral Research in Accounting 23 (2): 51-67.

    Keywords:
    auditor independence, auditor litigation, decision context, nonaudit services
    Purpose of the Study:

    Following the Enron and WorldCom scandals, the Sarbanes-Oxley Act of 2002 (SOX) prohibited the auditor’s provision of many nonaudit services (NAS). The passage of SOX suggests that regulators and legislators believe that certain NAS impair auditor independence and, in turn, lower financial reporting quality. Archival data, however, provide scant evidence of a relation between NAS and audit quality (independence in fact). Notwithstanding, auditors must still maintain independence in appearance for their reports to be credible.

    The fundamental question is whether users’ perceptions of NAS differ across decision contexts; that is, whether NAS are viewed as detrimental in one context and beneficial in another. By examining the effect of decision context on users’ assessments, the authors seek to identify an important factor that may account for some of the mixed findings documented elsewhere. The authors suggest that decision context influences users’ motives, such that the auditor’s provision of NAS is interpreted opportunistically—in a manner that best suits users’ self-interest. If that is the case, then users’ assessments of independence are malleable, which can be problematic for regulators; the challenge of prescribing rules to ensure independence in appearance becomes quite daunting. Because auditor independence is a cornerstone of auditing, regulators may opt to err on the side of caution and mandate strict rules. Yet, such rules may not be socially optimal.

    Design/Method/ Approach:

    The authors design two experiments to investigate. For experiment one, the authors recruited 27 students from a large university to participate in the experiment. The authors recruited 37 students from a large university to participate in experiment two. All the students were in at least their third year, and all but one were pursuing a program of study in business or economics. The evidence was gathered prior to November 2011.

    Findings:
    • The results of the experiments indicate that users’ perceptions of NAS differ across decision contexts.
    • In the first experiment, participants initially perceive that NAS are associated with auditor faultin the face of a bad outcome (loss in value), NAS are perceived negatively.
    • In the second experiment, participants initially provide a higher assessment of asset value when the auditor supplies NASthat is, the net effect of NAS on asset value is beneficial.
    • In both experiments participants eventually decipher the experimental relationsthat NAS are not associated with auditor fault or asset value.
    • The findings indicate that decision context dramatically alters users’ perceptions of NAS and auditor independence.
    • Undoubtedly accounting scandals, which create significant losses for owners and creditors, can lead users to question auditor independence.
    • The findings suggest that users react in this manner for strategic reasons.
    • In responding to public outcry, regulators may overreact, for political purposes, and enact laws/rules that are excessive, potentially sacrificing social welfare.
    Category:
    Independence & Ethics, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Litigation Risk, Non-audit Services
  • Jennifer M Mueller-Phillips
    Restatement Disclosures and Management Earnings Forecasts.
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Restatement Disclosures and Management Earnings Forecasts.
    Practical Implications:

    The authors argue that such evidence adds to the growing body of research examining how companies respond to revealed accounting failures. The findings indicate that, among other changes in behavior, managers reduce propensity to forecast following restatements. This paper also contributes to the management forecast literature. This study adds to the understanding of determinants of earnings forecast propensity and characteristics. Furthermore, the authors interpret this evidence in the context of competing theories of manager forecasting behavior subsequent to financial restatements.

    Citation:

    Ettredge, M., Y. Huang, and W. Zhang. 2013. Restatement Disclosures and Management Earnings Forecasts. Accounting Horizons 27 (2): 347-369.

    Keywords:
    financial restatements, information asymmetry, litigation risk, management forecast, manager reputation repair, risk aversion
    Purpose of the Study:

    This paper examines changes in managers’ earnings forecasting behavior around earnings restatement events. As the number of restatements has increased in recent years, concerns about the quality of financial reporting have increased among investors, regulators, and analysts. Evidence suggests that some restatements reflect managers’ prior manipulation of earnings. Restatements arguably harm companies’ and managers’ reputations with respect to the financial information they provide, including forecasts. In addition to investigating the causes and consequences of restatements, researchers have investigated some actions taken by restating company managers and directors to repair their (and their firms’) reputations. The authors investigate one type of action not studied in prior research: changes in managers’ earnings forecasting behavior.

    Earnings restatement events provide managers with two powerful and competing incentives regarding voluntary disclosures such as management forecasts. One incentive, which the authors refer to as the “reputation repair” incentive, favors increased disclosure. Restatements harm companies’ and managers’ reputations as providers of reliable financial information, leading to increased information asymmetry and information risk, with attendant negative market reactions. The second managerial motive following restatements is to avoid risks arising from repeated provision of ex post unreliable financial information. A restatement draws the unfavorable attention of the Securities and Exchange Commission (SEC) and investors, leading to increased scrutiny of subsequent company disclosures.

    Design/Method/ Approach:

    Using Audit Analytics, the authors gather a sample consisting of companies that make a single restatement of their financial reports during the period 19992006, and are covered by the First Call and I/B/E/S databases. The test sample comprises 1,512 restatement events. The authors employ a one-to-one matched control sample of 1,512 non-restatement companies also covered by the First Call database.

    Findings:

    The authors find that test (restatement) firms decrease information in their management forecasts, consistent with their incentives to avert risk, rather than incentives to repair managerial reputation. This decrease takes various forms.

    First, managers of test firms decrease their propensity to issue quarterly earnings forecasts after restatements, compared to control firms. Test firms also decrease the frequency of management forecasts. Second, when the authors compare changes in forecast precision from pre- to post-periods, they find that two proxies for precision (precision form and precision magnitude) both decrease for test firms relative to control firms. These results suggest that managers are increasingly likely to issue wider-range and open-ended forecasts, rather than more precise point forecasts following restatements. Finally, the analyses indicate that managers make earnings forecasts that exhibit a decrease in optimistic bias after restatements, compared to control firms. This suggests that managers of test companies become increasingly concerned about the risk imposed by optimistic forecasts, including investor litigation risk.

    Additional analyses suggest that the changes in manager forecasting behavior are more pronounced among companies whose restatements correct core earnings accounts than among those restating non-operating income accounts.

    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Litigation Risk, Restatements
  • Jennifer M Mueller-Phillips
    Risk Disclosure Preceding Negative Outcomes: The Effects of...
    research summary posted October 12, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Risk Disclosure Preceding Negative Outcomes: The Effects of Reporting Critical Audit Matters on Judgments of Auditor Liability
    Practical Implications:

    The results of this study are important for both regulators and auditors alike.  Despite auditor concerns that a requirement to disclose CAMs would increase litigation risk, the results of this study indicate that they may actually reduce, or at the very least, have no effect on litigation risk.  This is the case even when the subsequently identified misstatement is not related to the risks documented in the CAM.  Furthermore, standard setters should take comfort in these findings as they weigh the potential benefits of adopting a CAM disclosure requirement because the results indicate that the implementation of CAMS would not increase the risk of litigation to auditors. 

    Citation:

    Brasel, K., M. M. Doxey, J. H. Grenier, and A. Reffett. 2016. Risk Disclosure Preceding Negative Outcomes: The Effect of Reporting Critical Audit Matters on Judgments of Auditor Liability.  The Accounting Review 91 (5): 1345-1362.

    Keywords:
    audit litigation, audit report, negligence, liability, critical audit matters, disclosure
    Purpose of the Study:

    The PCAOB has proposed a change to the standard audit reporting model to include the disclosure of critical audit matters (CAMs).  While there is evidence that investors support additional auditor disclosures like CAMs, many other stakeholders oppose the implementation of a requirement to produce such ex ante risk disclosures.  The opposition, which includes audit firms, academics, and attorneys, assert that this type of requirement would increase litigation against auditors.

    However, CAMs require disclosure of increased risk prior to a subsequently revealed misstatement.  This feature of the proposed disclosure also makes it possible that CAMs may reduce litigation risk because jurors will view the plaintiff as being forewarned of an increased risk.  To the extent that jurors view a misstatement as having been more foreseeable to the plaintiff, this study predicts that jurors will experience less negative affect when considering plaintiff losses because the plaintiff was forewarned.  Below are two objectives the authors address in their study:

    • Examine whether auditors face increased litigation risk when auditors disclose a CAM that is related to a subsequently revealed misstatement.
    • Examine whether auditors face increased litigation risk when auditors disclose a CAM that is unrelated to a subsequently revealed misstatement.
    Design/Method/ Approach:

    The authors conducted an experiment with jury-eligible participants to examine their research questions.  The study included four different disclosure conditions: (1) control – no mention of CAMs, (2) disclosure of a CAM related to the subsequently revealed misstatement, (3) disclosure of a CAM that is unrelated to the misstatement, (4) an explicit statement that the auditors did not identify any CAMs.  Additionally, two different types of misstatements were examined to determine whether the type of misstatement affected the jurors’ propensity to find the auditor negligent: (1) an overstatement of inventory, (2) an understatement of an environmental restoration liability.  Participants read a case study about an audit that failed to detect a material financial statement fraud and then assessed auditor negligence.

    Findings:
    • When auditors failed to detect an overstatement of inventory, participants were less likely to find the auditor negligent when the auditor disclosed a related CAM, relative to both when there was no mention of CAMs and to when the auditor explicitly stated that there were no CAMs.  However, when auditors failed to detect the understatement of the client’s environmental restoration liability, participants were neither more nor less likely to find the auditors negligent when the auditor disclosed a related CAM.  This difference in outcomes was due to participant perceptions that the understatement of the client’s environmental restoration liability was more foreseeable than the inventory misstatement in the control condition thereby reducing the impact of the CAM.
    • Disclosing a CAM that was unrelated to the undetected misstatement did not affect jurors’ auditor liability judgments relative to current reporting standards.  However, disclosure of an unrelated CAM did reduce jurors’ negligence assessments relative to a condition in which the auditor explicitly stated there were no CAMs.
    Category:
    Accountants' Reporting, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Changes in Reporting Formats, Changes in Reporting Formats, Litigation Risk
  • Jennifer M Mueller-Phillips
    Rules-Based Accounting Standards and Litigation
    research summary posted September 26, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 12.0 Accountants’ Reports and Reporting, 12.05 Changes in Reporting Formats, 15.0 International Matters, 15.02 IFRS Changes – Impacts in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Rules-Based Accounting Standards and Litigation
    Practical Implications:

    This study exploits variation in U.S. accounting standards to study the effect of rules-based standards on litigation. It provides evidence of an association between rules-based accounting standards and a lower incidence of securities class action litigation. This evidence informs the debate about switching from a more rules-based U.S. GAAP to a more principles based IFRS.


    For more information on this study, please contact John McInnis.
     

    Citation:

    Donelson, D., J. McInnis, and R. Mergenthaler. 2012. Rules-Based Accounting Standards and Litigation. The Accounting Review 87 (4): 1247-1279.

    Keywords:
    securities litigation, safe harbor, rules-based standards, principals-based standards
    Purpose of the Study:

    There is substantial debate about whether U.S. GAAP is too rules-based and should be scrapped for a more principles-based set of standards such as IFRS. Rules-based standards, which explicitly state bright-line thresholds and have detailed implementation guidance, are often criticized because they are said to shield firms from litigation. Critics argue that when firms do not clearly admit to an error by issuing a restatement they can rely on a “safe harbor” defense provided by rules-based standards. Since detailed standards require little managerial judgment and are objectively implemented prosecutors have difficulty calling managerial discretion into question thus creating a “safe harbor” within the rules. Furthermore, critics claim that even when firms admit to a misstatement by restating their financial statements, the complex nature of rules-based standards allows firms to avoid litigation due to the difficulty in ruling out the potential for unintentional mistakes (i.e. rules based standards provide a “innocent misstatement” defense).
        On the other hand, proponents of rules-based standards argue that they provide plaintiffs a “roadmap” to successful litigation. The specificity of rules-based guidance provides plaintiffs the ability to establish intent in situations where they clearly ignored specific guidance and were forced to restate as a result. This argument is essentially the opposite of the “innocent misstatement” argument.
    This study intends to provide evidence that is pertinent to this debate. The authors attempt to determine whether rules-based standards are associated with the incidence and outcomes of securities class action litigation.
     

    Design/Method/ Approach:


    The authors exploit variation in the extent to which some U.S. GAAP standards are more rules-based and some are more principles-based. They use data on resolved securities class action lawsuits filed from 1996-2005 that allege GAAP violations as well as restatement data from the same time period. They perform three analyses with this data:

    • Using a sample of lawsuits unrelated to restatements the authors test whether plaintiffs tend to allege violations of principles-based standards in order to leverage management’s more subjective implementation.
    • Using a sample of all restating firms, the authors test whether restatements are more likely to lead to litigation if they are related to rules-based statements in order to understand if rules-based standards actually provide a “roadmap” to successful litigation.
    • Using a sample of lawsuits the authors test whether meritorious lawsuit outcomes are associated with alleged violations rules-based standards.
       
    Findings:
    • The authors find that in cases where litigation is not connected to a restatement, plaintiffs allege violations of principles-based standards more often than violations of rules-based standards. This evidence is consistent with rules-based standards providing a “safe harbor” from litigation prompting them to be cited less often in litigation.
    • The authors find that when a restatement occurs, violations of rules-based standards are associated with a lower probability of litigation. This finding does not support the idea that rules-based standards provide a “roadmap” to successful litigation. Instead it is consistent with the “innocent misstatement” argument.
    • The authors find no relationship between rules-based standards and litigation outcomes.


    These findings are indicative of rules-based standards deterring litigation. However, the authors note that the overall effect of a shift to a more principles-based accounting system is difficult to predict due to numerous additional factors that would accompany this type of change.
     

    Category:
    Accountants' Reporting, International Matters, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Changes in Reporting Formats, IFRS Changes – Impacts, Litigation Risk