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  • Jennifer M Mueller-Phillips
    Auditor Resignation and Risk Factors.
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 02.06 Resignation 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:
    Auditor Resignation and Risk Factors.
    Practical Implications:

    This study sheds light on why auditors choose to resign from auditing particular clients. The authors find that public information about audit risk, business risk, and litigation risk as well as private information about audit risk and business risk all play a role in the auditor’s resignation decision. This is useful for audit firms and regulators to consider. 

    Citation:

    Ghosh, A. and C.Y. Tang. 2015. Auditor Resignation and Risk Factors. Accounting Horizons 29 (3): 529-549.

    Keywords:
    auditor resignations, litigation risk, audit risk, business risk
    Purpose of the Study:

    While prior research has suggested litigation risk as the main reason for auditor resignations, the competing explanations of audit risk and business risk have not been tested concurrently to discover their incremental importance. Furthermore, prior research has not been able to isolate the auditor’s private information from public information about these risks. The authors attempt to close this gap in the literature by studying whether and how much the auditor’s private information about future audit risk, business risk, and litigation risk impacts the auditor’s resignation decision.

    Design/Method/ Approach:

    The authors use data from publicly-traded companies that switched auditors during the 1999-2010 time period. First, they compare auditor resignations to auditor dismissals based on pre-switch audit risk, business risk, and litigation risk. Then they test whether auditor resignations predict post-switch audit risk (e.g. internal control problems), business risk (e.g. delisting from stock exchange), and litigation risk (e.g. class-action lawsuits).

    Findings:
    • Compared to clients from which auditors have been dismissed, clients from which auditors resigned tend to have greater litigation risk, audit risk, and business risk before the change in auditors, but greater audit risk and business risk after the change.
    • The litigation risk, business risk, and audit risk existing before an auditor chooses to resign from an engagement all impact the auditor’s resignation decision, with litigation risk having the largest impact and audit risk the smallest.
    • Clients whose auditors have resigned are more likely to experience class-action lawsuits, internal control problems, and delisting from a stock exchange.
    • Auditor resignations reveal no private information about future litigation risk.
    • Auditor resignations reveal private information about future audit risk and future business risk, especially when one of the Big 4 audit firms resigned.
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Business Risk Assessment (e.g. industry - IPO - complexity), Client Risk Assessment, Litigation Risk, Resignation Decisions
  • 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
    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
    Do Going Concern Audit Reports Protect Auditors from...
    research summary posted September 14, 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, 12.01 Going Concern Decisions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Do Going Concern Audit Reports Protect Auditors from Litigation? A Simultaneous Equations Approach.
    Practical Implications:

    The results should be of interest to auditing practitioners. Generally, managers of public companies prefer that the audit report does not contain a going concern paragraph. In this regard, researchers have found that issuing a going concern audit report increases the likelihood of management-initiated auditor switches. These results highlight the expected benefits to auditors from issuing a going concern report to their financially stressed clients. Specifically, better controlling for endogeneity, the evidence indicates that issuing a going concern report lowers the likelihood of investors naming the auditor in a class action lawsuit.

    Citation:

    Kaplan, S. E., and D. D. Williams. 2013. Do Going Concern Audit Reports Protect Auditors from Litigation? A Simultaneous Equations Approach. Accounting Review 88 (1): 199-232.

    Keywords:
    audit reports, auditor litigation, auditor litigation settlements
    Purpose of the Study:

    An important aspect of the auditors’ environment is state and federal laws that allow third parties such as investors to sue auditors in an effort to recover damages. Historically, these litigation-related costs have been substantial. Potentially, auditors may be able to reduce their exposure to litigation when auditing a financially stressed client by issuing a going concern report. Under current auditing standards, a going concern audit report is required when an auditor has substantial doubt about the client’s ability to remain a going concern for a reasonable period of time. Whether a going concern report actually protects auditors against lawsuits is an open question.

    The study applies a simultaneous equations approach to examine the relation between auditor going concern reporting and investors’ decisions to sue auditors. Importantly, this approach takes into account the endogeneity between the auditor’s going concern reporting decision and ex ante litigation risk. The authors explicitly recognize two separate aspects of the relation between going concern reporting and auditor litigation.

    Design/Method/ Approach:

    The sample consisted of 1,211 securities class action lawsuits filed against the auditors between 1986 and 2009. 147 firms comprise the final auditor litigation sample. The authors determined whether a securities class action lawsuit had been filed against the auditors by examining the databases constructed by Palmrose (1999), the Stanford Class Action Securities Clearinghouse, Audit Analytics, LexisNexis, Westlaw, CASEmaker, ISS Securities Class Action Services, and the popular press. 

    Findings:
    • The evidence indicates that for auditors’ going concern reporting decisions as well as for investors’ decisions to sue auditors, the results differ between the two methods.
    • While the relation between the risk of an auditor lawsuit and going concern reporting decisions is consistently positive, the lawsuit coefficient is larger and significant using simultaneous equations but insignificant using probit analysis.
    • The results also show that the relation between going concern reports and investors’ lawsuit decisions is consistently negative.
    • However, and perhaps more importantly, the going concern coefficient is larger and significant when using simultaneous equations but insignificant when using probit analysis. That is, the simultaneous equations results indicate that going concern reports significantly deter investors from suing auditors.
    • The evidence showing that going concern reports deter investors from filing class action lawsuits against auditors is important, in that it suggests that going concern reports are useful to investors.
    • When investors see a going concern report for financially stressed companies, they are less likely to sue the auditor for their investment losses.
    • Issuing a going concern report offers the auditor protection against claims of negligence due to reporting, but not other claims of auditor negligence.
    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
    Auditor Reporting under Section 404: The Association between...
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 12.0 Accountants’ Reports and Reporting, 12.06 Consequences of Adverse 404 Opinions in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Reporting under Section 404: The Association between the Internal Control and Going Concern Audit Opinions.
    Practical Implications:

    The uncertainties surrounding material weaknesses, the difficulty of auditing around some types of weaknesses, and the fact that the auditor must explain why it issued a clean report on the financial statements when it had issued a MWO, may cause the auditor to become conservative in its GCO decision, which is fairly ambiguous to start with. The study has particular relevance for policy makers and a need for a broader evaluation of the effects of SOX 404.

    Citation:

    Goh, B. W., Krishnan, J., & Li, D. 2013. Auditor Reporting under Section 404: The Association between the Internal Control and Going Concern Audit Opinions. Contemporary Accounting Research 30 (3): 970-995.

    Keywords:
    internal control, going concern, material weakness, ligation risk, SOX 404
    Purpose of the Study:

    Section 404 of the Sarbanes-Oxley Act of 2002 (SOX) requires companies’ independent auditors to provide an opinion on their clients’ internal control over financial reporting, in addition to the opinion on their clients’ financial. The purpose of Section 404 was primarily to provide information on the internal controls, thus enhancing investor understanding of the quality of firms’ financial reporting. The PCAOB also issued AS2 and AS5, which require an “integrated audit of internal control and financial statements” because the “objectives of and work involved in performing both an attestation of management’s assessment of internal control and an audit of the financial statements are closely interrelated.

    In this paper, the authors explore the association between the two audit opinions by examining whether the issuance of an adverse internal control material weakness opinion (MWO) influences, other things equal, the issuance of a going concern audit opinion (GCO) for financially stressed companies. Although the two opinions are the result of an integrated audit process, they serve different purposes. The GCO reflects the auditor’s view of the financial condition of its client, indicating whether (in the auditor’s opinion) the client will continue to be a going concern for a period of 12 months beyond the financial year end. The MWO reflects the auditor’s opinion on whether there are material weaknesses in internal control and therefore the likelihood that material misstatements in the financial statements will not be detected or prevented. Despite this difference, the two opinions could be connected.

    Design/Method/ Approach:

    The authors examine the association between the MWO and the GCO, using a sample of 1,110 financially stressed firms that reported internal control and audit opinions under SOX Section 404. They start with all public firms on COMPUSTAT with year-ends from 2004 to 2009, for which the authors could compute the Altman financial distress Z-score.  

    Findings:
    • The results suggest that the MWO issued under SOX Section 404 does increase the likelihood of a GCO, while the existence of material weaknesses in the Section 302 disclosures does not. Thus, auditors seem to respond to the uncertainties surrounding a material weakness by issuing a GCO only when they have to issue a MWO.
    • Fifty-six percent of the material weaknesses are classified as company-level weaknesses.
    • If an auditor is aware that the client is in the process of remediating the weakness, it is less likely to issue a GCO.
    • Firms with MWOs raise less capital in the subsequent financial year than firms without
      MWOs, providing some evidence that the issuance of a MWO does impair the firm’s ability to raise capital.
    • To examine whether it is the material weakness opinion rather than the presence of the material weakness that drives auditor behavior, the authors examine whether Section 302 material weakness disclosures are similarly associated with the GCO, but find no association.
    • Heightened concerns about litigation may be driving auditors to issue the GCO when they also issue a MWO.
    Category:
    Accountants' Reporting, Internal Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Consequences of Adverse 404 Opinions, Impact of 404 on Fees and Financial Reporting Quality, Litigation Risk, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
  • Jennifer M Mueller-Phillips
    An Examination of the Legal Liability Associated with...
    research summary posted November 10, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 11.0 Audit Quality and Quality Control, 11.01 Supervision and Review – Effectiveness in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    An Examination of the Legal Liability Associated with Outsourcing and Offshoring Audit Procedures
    Practical Implications:

    This study is important to audit practice as it provides an initial view into the effects of outsourcing and offshoring on juror perceptions of the due care exhibited in supervising audit work performance as embodied in assessed damage awards, while also providing perceptions on the expected quality and risk associated with these relationships. The results may be of particular interest to the profession given that this study examines audit work outsourced and/or offshored to India, the country cited as conducting the most outsourced audit work for North American CPA firms. Interestingly, the professional bodies (i.e., NASBA) have chosen not to grant reciprocity of practice for Indian charted accountants (i.e., Mutual Recognition Agreements). India has been denied multiple times while reciprocity has been granted to CPAs/CAs in Australia, Canada, Hong Kong, Ireland, Mexico, and New Zealand (NASBA 2012). The juror perceptions of quality and risk of audit work outsourced offshore, as shown in this study, parallel the concerns expressed by professional bodies.

     

    For more information on this study, please contact Alex Lyubimov.

    Citation:

    Lyubimov, A., V. Arnold, and S.G. Sutton. 2013. An Examination of the Legal Liability Associated with Outsourcing and Offshoring Audit Procedures. Auditing: A Journal of Practice and Theory 32 (2): 97-118.

    Keywords:
    outsourcing; offshoring; audit quality; litigation risk; juror decision-making; auditor liability; counterfactual reasoning.
    Purpose of the Study:

    Accounting firms have steadily increased the use of outsourcing and offshoring of professional services including independent audit procedures. While firms suggest that the work is of higher quality and similar litigation risk, questions remain as to whether public perceptions may be more negative. The purpose of this study is to examine the effect of outsourcing and offshoring of audit work on juror’s perceptions of auditor legal liability when an audit failure occurs.  More specifically, this paper examines liability associated with an audit failure when work is performed by another office of the same firm or outsourced to a separate firm, and whether the work is performed domestically or in another country.  Theory suggests that outsourcing and offshoring of those outsourced audit procedures has the potential to erode the perceived professionalism of auditors’ work as embodied through decreases in perceptions of work quality, increases in perceptions of associated risk, and ultimately more severe damages assessed against auditors during litigation.

    Design/Method/ Approach:

    An experiment was conducted using a 2 (insource vs. outsource) X 2 (onshore vs. offshore) design. The experiment was delivered through an internet application to facilitate the use of a diverse national sample of jury eligible participants. Participants, representing a broad demographic base, were individuals who were over the age of 18, jury-eligible in the US, had no legal or auditing experience, and not CPA’s. Data were collected over a four-day period in December, 2010.

    Findings:

    Results indicate that choosing to outsource audit work to another audit firm is associated with higher compensatory damages in case of an audit failure.  Furthermore, when this third party audit firm is located in a different country (offshoring), outsourcing leads to significantly higher punitive damages.  Surprisingly, jurors assess higher than expected litigation awards for a failure by another domestic office of the firm for punitive damages. This result suggests that the close proximity in terms of both geography and organizational distance of the domestic office of the firm leads jurors to find the audit failure less understandable. Post hoc analyses indicate that potential jurors perceive that work completed by another domestic office of the firm has the highest expected quality and lowest risk, while work that is outsourced offshore is expected to be lowest quality and highest risk—consistent with proximity theory.

    Category:
    Audit Quality & Quality Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Litigation Risk, Supervision & Review – Effectiveness
  • Jennifer M Mueller-Phillips
    Apology Accepted: The Benefits of an Apology for a Deficient...
    research summary posted October 20, 2014 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:
    Apology Accepted: The Benefits of an Apology for a Deficient Audit Following an Audit Failure
    Practical Implications:

    The results of this study are important for firms to consider given the recent and historical problem of rising litigation costs. Firms are likely to be targets of lawsuits following the revelation of fraud within a client’s financial statements regardless of whether the firm was complicit in the fraud. Even lawsuits that are settled quickly result in high litigation costs, and the reputational costs to the firm can be just as problematic as the monetary costs. Very few audits are “perfect,” particularly when examined in hindsight. This study suggests that there are benefits to a firm being honest and apologetic about any deficiencies in an audit when the deficiencies do not relate to the fraud itself.

     

    For more information on this study, please contact Jason Rasso.

    Citation:

    Rasso, J. T. 2014. Apology accepted: The benefits of an apology for a deficient audit following an audit failure. Auditing: A Journal of Practice & Theory 33 (1): 161-176.

    Keywords:
    Auditor Litigation, Apology, Reputation
    Purpose of the Study:

    This paper examines the use of an apology for conducting a deficient audit that indirectly leads to an audit failure. Audit failures can be costly to accounting firms in terms of litigation costs and reputational harm. These costs are potentially much higher when the audit failure stems from a deficient audit. The author tests whether the use of an apology containing various components (expression of sympathy, acceptance of responsibility, and/or promise to refrain) is beneficial or harmful to an accounting firm. The results reveal that only the expression of sympathy has an effect on assessments of punishment. However, combining all three apology components leads to a significantly higher perception of the accounting firm’s reputation. This paper is one of very few papers that examines mechanisms that can help protect firm’s reputations.

    Design/Method/ Approach:

    The research evidence is collected in the time period 2011 – 2012. The author collected responses from the general public via Amazon Mechanical Turk. The participants read about the history of an accounting firm, then read a newspaper article identifying a major accounting fraud in which the accounting firm is named as the auditor. The participants then read an apology that contains one, two, or all three of the apology components (one group does not read an apology) and then are asked to rate their support for a lawsuit against the firm, the level of fine they would recommend for the firm, and their perceptions of the firm’s reputation.

    Findings:
    •  An apology containing only an expression of sympathy is the only version of an apology that results in lower support for a lawsuit and a lower fine recommendation when compared with the group that does not view an apology.
    • There is a steady increase in perceptions of a firm’s reputation that can be seen as more components are added to an apology, with an apology containing all three components yielding the highest perception of the firm’s reputation.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Litigation Risk
  • Jennifer M Mueller-Phillips
    Comparing Auditor versus Non-Auditor Assessments of Auditor...
    research summary posted October 22, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 11.0 Audit Quality and Quality Control in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Comparing Auditor versus Non-Auditor Assessments of Auditor Liability: An Experimental Investigation of Experts’ versus Lay Evaluators’ Judgments
    Practical Implications:

    While the results of this study are not conclusive, both expert panels of auditors and lay jurists rely on different, legally irrelevant inputs when making assessments of auditor liability. Auditor evaluators rely more on their emotional connections to other auditors while lay evaluators focus more on plaintiff losses as evidence of negligence. This study is only a first step in determining whether expert panels of auditors would improve the judicial process.

    Citation:

    Reffett, A., B. E. Brewster, and B. Ballou. 2012. Comparing Auditor versus Non-Auditor Assessments of Auditor Liability: An Experimental Investigation of Experts' versus Lay Evaluators' Judgments. AUDITING: A Journal of Practice & Theory 31 (3): 125-148.

    Keywords:
    auditor litigation; expert jurors; lay jurors; liability assessments.
    Purpose of the Study:

    Critics of the legal system argue that the use of lay jurors to judge cases of auditor negligence results in unfair and inaccurate decisions about auditor liability because lay jurors often misunderstand both the scope of an audit and the responsibilities of an auditor. Previous research studies have suggested that courts rely on panels of experienced auditors instead of lay jurors in cases regarding auditor liability. This study investigates whether and how auditors’ and lay evaluators’ judgments differ from each other. The findings should be important to standards setters and regulators as they decide whether auditors should be allowed to judge auditor liability cases.

    Design/Method/ Approach:

    The study was administered sometime prior to 2012 via an online experiment e-mailed to participants. The participants included 51 currently practicing auditors (average of 7.5 years of experience; 48 from Big-N firms) and 54 non-accounting undergraduate students who represented lay jurists. The experiment presented a case that presented fictional details of a mining company, a financial statement fraud at the company and a subsequent auditor negligence lawsuit. After reading the case, participants respond to questions about auditor negligence and other related issues.

    Findings:
    • The authors find that auditors were much less likely to rely on plaintiff losses in making a decision about liability than were non-auditor participants.
    • Auditors are more sensitive to changes in audit quality, meaning that they assigned a higher probability of auditor negligence, on average, in situations where audit quality was supposedly low.
    • Non-auditor participants’ average probability of negligence assessments did not significantly differ between audit quality conditions, suggesting audit quality was not a factor in their decision-making.
    • When an auditor was found to be negligent, auditor participants assigned less severe punishments than non-auditor participants.
    • The authors also test how emotional connection interacts with judgment and show that auditor evaluators rely on their commonalities as audit professionals when making judgment decisions of auditor negligence.
       
    Category:
    Audit Quality & Quality Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Litigation Risk