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  • Jennifer M Mueller-Phillips
    State Liability Regimes within the United States and Auditor...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 09.0 Auditor Judgment, 09.04 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    State Liability Regimes within the United States and Auditor Reporting
    Practical Implications:

    These results imply that auditors are more likely to render modified GC opinions for clients subject to regimes that hold auditors liable to a larger class of third parties and impose joint-and-several liability for third-party damages, both of which reflect greater liability exposure. The higher incidence of GC opinions accompanying stronger state-level litigation threats could reflect higher audit quality, but it could also stem from excessively conservative auditors protecting their interests by avoiding costly civil lawsuits, which could undermine audit quality in some circumstances. 

    Citation:

    Anantharaman, D., J. A. Pittman, and N. Wans. 2016. State Liability Regimes within the United States and Auditor Reporting. The Accounting Review 91 (6): 1545 – 1575.

    Keywords:
    auditor litigation risk, state common law, and going-concern opinions
    Purpose of the Study:

    The authors of this study analyze the relation between state regimes governing auditor liability and auditors’ propensity to modify their opinion to express uncertainty on financially distressed clients’ ability to continue as a going concern.  Extant research implies that auditors have strong incentives to conduct high-quality audits in order to reduce the litigation examining consequences stemming from an alleged audit failure; however, the bulk of this research focuses on auditor liability arising under federal statutory laws, not state laws. This study delves into the issue of state laws, including if and to what extent litigation exposure under state common law affects auditors’ reporting decisions. 

    Design/Method/ Approach:

    A previous study developed a state-level score that captures third-party liability standards, which the authors of this study rely on to measure auditor litigation exposure stemming from third-party liability standards. To evaluate variation in liability-sharing standards across states, the authors closely read the relevant law to construct a state-level index that identifies whether each state follows a joint-and-several approach or a proportional approach to liability sharing. The authors assign to each client firm the highest of the liability indices dependent on the states in which the firm does business, and they measure audit outcomes with the propensity to issue going-concern (GC) opinions to financially distressed clients. 

    Findings:
    • The authors find that auditors are significantly more likely to issue a GC opinion to clients from states applying:
      • A more expansive third-party liability standard, or
      • The joint-and-several liability (JSL) rule for apportioning damages among defendants.
    • The authors find that liability regimes primarily affect auditor reporting for clients that are inherently more likely to be sued, reinforcing the conclusion that state-level liability regimes matter more when litigation exposure is higher.
    • The authors find some suggestive evidence that the higher expected legal costs arising from state-level liability regimes have a stronger impact on Big 4 auditors that are more sensitive to litigation threats. 
    Category:
    Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Going Concern Decisions, Litigation Risk
  • Jennifer M Mueller-Phillips
    The Effect of Information Choice on Auditors’ Judgments a...
    research summary posted October 12, 2016 by Jennifer M Mueller-Phillips, tagged 05.0 Audit Team Composition, 05.05 Diversity of Skill Sets e.g., Tenure and Experience, 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 09.0 Auditor Judgment, 09.10 Prior Dispositions/Biases/Auditor state of mind, 11.0 Audit Quality and Quality Control, 11.09 Evaluation of Evidence in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Effect of Information Choice on Auditors’ Judgments and Confidence
    Practical Implications:

     Implications for the practicing audit community are developed from the findings that less experienced auditors are susceptible to the information choice effect. In situations where litigation risk is low (high) and the auditor has less experience, auditors place greater (lower) significance on information given to them by an external party than information they sought out themselves. More experienced auditors are not subject to the information choice effect. Additionally, more experienced auditors are confident in judgments based on information sought themselves, even in a setting with elevated litigation risk. The results of this study may interest audit clients providing information to auditors, auditors reviewing the work of less (more) experienced colleagues, auditors performing a critical self-review, and regulators reviewing the work of auditors.

    Citation:

     Smith, S. D., W. B. Tayler, and D. F. Prawitt. 2016. The Effect of Information Choice on Auditors' Judgments and Confidence. Accounting Horizons 30 (3): 393–408.

    Keywords:
    information choice, litigation risk, confidence, experience, judgment impact
    Purpose of the Study:

    During the course of an audit, auditors choose what information they need to search for; however, they obtain both sought and unsought information.  These auditors must then use the information obtained to make judgements and decisions that ultimately lead to an audit opinion.  Thus, the weight auditors place on the information obtained when making judgements and the auditors’ confidence in those judgements has important implications for audit quality.  The authors of this paper investigate whether it matters if information is gotten by the auditor or given to the auditor.  Understanding that the way in which information is received affects information processing, the authors examine how the auditors’ receipt of additional sought or unsought information impacts the auditors’ judgment and confidence in that judgement given judgements with different levels of importance (e.g., high vs. low litigation risk) and auditors with different levels of experience (e.g., high vs. low).

    Design/Method/ Approach:

    Evidence was obtained during the 2010’s through an experiment using 136 auditors as participants.  Participants read a case and evaluated the likelihood of obsolescence in inventory.  The researchers manipulated the (1) choice to acquire relevant information (i.e., given a choice or not given a choice) and (2) litigation risk levels (i.e., high or low).  Furthermore, they measured auditor experience, and classified participants as more or less experienced based on number of years in public accounting.

    Findings:
    • In the high litigation setting, sought information is weighed more heavily than unsought information.  This result appears to be driven by auditor experience.  Specifically, when auditor experience is low and litigation risk is high, sought information is weighed more heavily than unsought information.
    • In the low litigation setting, sought information is weighed less heavily than unsought information.  This result appears to be driven by auditor experience.  Specifically, when auditor experience is low and litigation risk is low, information is weighed less heavily than unsought information.
    • Auditor confidence in their judgment of inventory obsolescence was greater when they chose to obtain additional information than when they were just given the additional information.  This result appears to be driven by auditor experience.  Specifically, more experienced auditors had greater confidence after obtaining sought information than unsought information.  This results also appears to depend on the litigation level.  In the high litigation setting, more experienced auditors had greater confidence after obtaining sought information than unsought information.
    Category:
    Audit Quality & Quality Control, Audit Team Composition, Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Diversity of Skill Sets (e.g. Tenure & Experience), Evaluation of Evidence, Litigation Risk, Prior Dispositions/Biases/Auditor state of mind
  • Jennifer M Mueller-Phillips
    The Influence of Auditor State-Level Legal Liability on...
    research summary posted September 10, 2013 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:
    The Influence of Auditor State-Level Legal Liability on Conservative Financial Reporting in the Property-Casualty Insurance Industry
    Practical Implications:

    The main implication for practicing auditors is that state-level legal liability is affecting auditor behavior and possibly audit quality. For audit firms with a national or regional presence, this may mean an increased emphasis on standardization is necessary to ensure that the quality of audits vary by state.

    Citation:

    Gaver, J.J., J.S. Paterson and C.J. Pacini. 2012. The Influence of Auditor State-Level Legal Liability on Conservative Financial Reporting in the Property-Casualty Insurance Industry. Auditing: A Journal of Practice and Theory. (31) 3:95–124.

    Keywords:
    auditor liability, accounting discretion, insurance industry, reserve management, conservatism
    Purpose of the Study:

    This study examines the issue state-level legal liability and its effect on auditors. Specifically, this paper looks at whether increased state-level liability for ordinary negligence leads auditors to push for a greater degree of conservatism.

    Design/Method/ Approach:

    The authors use 3,107 loss reserve observations spanning the years from 1993 to 2004. The sample is restricted to private insurers that operate under single state control. The authors use these observations to determine whether or not the imposition of greater legal liability on auditors leads to increased conservatism.

    Findings:

    Extant accounting literature demonstrates that litigation risk affects both auditor behavior and audit quality. However, that literature focuses exclusively on the impact of federal-level statutory law. This paper provides evidence that state-level liability standards also affect auditor behavior.

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Litigation Risk
  • Jennifer M Mueller-Phillips
    The Insurance Hypothesis: An Examination of KPMG's Audit...
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 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:
    The Insurance Hypothesis: An Examination of KPMG's Audit Clients around the Investigation and Settlement of the Tax Shelter Case.
    Practical Implications:

    This paper makes an important contribution to the literature. Using a natural institutional setting, the authors find evidence of the insurance effect in a general sample of firms in the equity market. Understanding the role of the auditor insurance function and its association with client stock prices can help auditors to better understand the pricing of audit services and it can help lawmakers in assessing the costs and benefits of professional service litigation and of proposed future litigation reform legislation. The results aid investors in understanding one of the major economic roles of the audit function.

    Citation:

    Brown, D. L., S. Z. Shu, B. S. Soo, and G. M. Trompeter. 2013. The Insurance Hypothesis: An Examination of KPMG's Audit Clients around the Investigation and Settlement of the Tax Shelter Case. Auditing: A Journal of Practice & Theory 32 (4): 1-24.

    Keywords:
    insurance hypothesis, KPMG, tax shelter
    Purpose of the Study:

    Although prior literature has suggested that independent audits provide an implicit form of insurance against investor losses (the insurance hypothesis), it has been challenging to isolate the insurance effect. In this paper, the authors use a unique setting to examine this effect. In 2002, KPMG was investigated by the U.S. Department of Justice in relation to tax shelters sold by the firm. From then until early 2005, several news reports suggested that KPMG would be indicted and suffer potentially the same fate as Arthur Andersen. However, in August of 2005 KPMG entered into a deferred prosecution agreement with the U.S. Department of Justice (DOJ), which ended widespread speculation of an impending federal indictment against the accounting firm. Because the investigation centered around tax services offered by the firm, the authors argue that the circumstances surrounding the investigation and settlement provide a natural setting to test the insurance value provided by auditors. Specifically, the authors examine the security price reactions of KPMG’s audit clients to the news of their auditor’s investigation by, and settlement with, the DOJ.

    Design/Method/ Approach:

    The authors use Compustat, CRSP and Audit Analytics to collect data. Depending on the event window, the sample varies from 920 for the settlement period to 920 to 1,012 for the investigation period. In addition to the event study, the authors also conduct a cross-sectional analysis. They use a smaller sample of 516 firms for this part of the analysis. The authors use data from the Summer 2002 to Summer 2005.

    Findings:

    Focusing on the KPMG tax shelter investigation and settlement, the authors provide evidence consistent with an auditor insurance function being impounded in stock prices. Specifically, they find that KPMG client firms earn significantly negative abnormal returns during the periods when news reports indicated that it was subject to government prosecution over its role in marketing tax shelter products to its clients and earn positive abnormal returns following news of a settlement. They also examine whether these abnormal returns for KPMG clients are increasing for firms with a higher probability to utilize the insurance option, i.e., those subject to higher litigation risk and more financially distressed. As expected, results show that firms in financial distress and firms with high litigation risk experienced significantly higher abnormal returns.

    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Audit Fee Decisions, Litigation Risk
  • Jennifer M Mueller-Phillips
    Vague Auditing Standards and Ambiguity Aversion.
    research summary posted October 16, 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:
    Vague Auditing Standards and Ambiguity Aversion.
    Practical Implications:

    This paper could have implications for the current debate in the U.S.A. and the European Union on whether auditors’ liability should be capped. This paper shows that a liability cap may be (but need not be) desirable when auditors’ ambiguity aversion otherwise induces excessive care. If liability caps are not warranted, accounting and auditing standard setters may consider making standards more precise in a high-liability setting. Since sharing losses seems beneficial under ambiguity aversion, auditors may find it advantageous to perform joint audits (if permitted by regulation). This paper contributes to the literature by incorporating a persistent phenomenon of boundedly rational decision-making into a model of auditor liability.

    Citation:

    Bigus, J. 2012. Vague Auditing Standards and Ambiguity Aversion. Auditing: A Journal of Practice & Theory 31 (3): 23-45.

    Keywords:
    ambiguity aversion, auditors’ liability, behavioral accounting, vague standards of due care
    Purpose of the Study:

    There is strong empirical evidence that individuals are subject to boundedly rational behavior. There is also evidence that auditors face cognitive. More specifically, auditors tend to increase care levels when confronted with ambiguous audit contexts. Many experiments have confirmed that individuals generally dislike ambiguity. This paper incorporates ambiguity aversion into a model of auditor liability. Ambiguity implies uncertainty about the probability that a future event, e.g., a future loss, will occur. With ambiguity aversion, people tend to weigh less favorable outcomes more highly, and are, therefore, more pessimistic. For instance, other things being equal, individuals usually prefer a 30 percent chance to a (imprecisely defined) chance of 1050 percent. Interestingly, individuals still prefer a certain probability to a probability range, even with training in decision-making. This immunity to persuasion leads to the belief that ambiguity aversion might, in fact, be considered rational. If, in fact, ambiguity aversion is rational, there seems to be a need to incorporate it into economic modeling.

    Design/Method/ Approach:

    The author uses a model to analyze how an auditor’s ambiguity aversion affects his level of care.

    Findings:

    The author obtains the following results, considering a risk-neutral auditor who dislikes ambiguity:

    (1) An ambiguity-averse auditor tends, on the one hand, to exert less care with low damage payments. Due to likelihood insensitivity, with low damage payments, the perceived marginal benefits of additional care are too low (futility effect).
    (2) On the other hand, an ambiguity-averse auditor may be willing to take a (very) high level of precaution in order to be certain that he will not be held liable ex post. Certainty is valuable in the event of pessimism, and becomes more valuable the higher damage payments are. If damage payments exceed a certain threshold level, the certainty effect outweighs the futility effect. Thus, the problem of excessive care becomes more serious.
    (3) Even with low incentives to sue, an ambiguity-averse auditor may exert excessive care when damage payments are sufficiently large.
    (4) Both a liability cap and liability insurance avoid excessive care, but may then induce suboptimal precaution.
    (5) With strict liability, the auditor exerts efficient care, since there is no second-order probability and no ambiguity situation. Thus, there is no distortion from ambiguity aversion. This is a new benefit of a strict liability rule.

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