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  • 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
  • Jennifer M Mueller-Phillips
    Can Reporting Norms Create a Safe Harbor? Jury Verdicts...
    research summary posted September 19, 2013 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk, 15.0 International Matters, 15.02 IFRS Changes – Impacts in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Can Reporting Norms Create a Safe Harbor? Jury Verdicts against Auditors under Precise and Imprecise Accounting Standards
    Practical Implications:

    The results of this study are important for audit firms to prepare for the adoption of IFRS and/or less precise standards under U.S. GAAP. The results indicate that a move to less precise standards will not necessarily result in more verdicts against auditors. There is only one condition in which an imprecise standard leads juries to return more verdicts against the auditor: when the client’s reporting complies with the precise standard and is inconsistent with the industry reporting norm. The results suggest that auditors can reduce this liability by ensuring that their client’s reporting is consistent with industry reporting norm.

    For more information on this study, please contact Kathryn Kadous.
     

    Citation:

    Kadous, K., and M. Mercer. 2012. Can Reporting Norms Create a Safe Harbor? Jury Verdicts against Auditors under Precise and Imprecise Accounting Standards. The Accounting Review 87 (2):565-587.

    Keywords:
    Audit litigation, principles versus rules, jury decision making, IFRS
    Purpose of the Study:

    The transition from U.S. GAAP to International Financial Reporting Standards (IFRS) has been a topic of debate among regulatory bodies, standard-setters, firms, and their auditors. IFRS tend to provide less precise guidance than current U.S. accounting standards, so their application requires more professional judgment. Auditors have expressed concern that the adoption of IFRS will result in increased legal liability. This paper addresses this concern by investigating how the level of precision in accounting standards affects jury verdicts in auditor negligence lawsuits. Based on legal studies and the psychology literature, this paper studies how the effect of accounting standard precision on jury verdicts depends on two factors:

    • The aggressiveness of the audit client’s reporting choice
    • Whether the audit client’s reporting choice is consistent with the industry reporting norm
       
    Design/Method/ Approach:

    The authors collected their evidence prior to September 2010.  They use a group of undergraduate students to act as jurors in a simulated auditor negligence case. The participants deliberate in juries of six persons. Each jury is asked to assess the auditor’s conduct and to provide a verdict.  

    Findings:
    • The authors find that effect of accounting standard precision on jury verdicts depends on both the aggressiveness of the client’s reporting choice and on the industry reporting norm. Jurors use a hierarchy of decision rules. When the accounting standard does not provide a clear decision criterion, jurors seek other decision rules such as whether the client’s accounting is consistent with the industry reporting norm. 
    • The authors find that when the client’s accounting is more aggressive and violates the precise standard, a majority of juries return verdicts against the auditor, regardless of whether the industry reporting norm is met. When the client’s reporting is less aggressive and does not violate the precise standard, juries rarely return verdicts against the auditor, regardless of whether the reporting is consistent with the industry reporting norm. 
    • The authors find that when the accounting standard is imprecise, compliance with the industry reporting norm is a stronger predictor of jury verdicts. In particular, under the imprecise standard, no juries find against the auditor for allowing the more aggressive client reporting when the reporting is consistent with the industry reporting norm; when the reporting norm is violated, about half of the juries find the auditor negligent.
       
    Category:
    International Matters, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    IFRS Changes – Impacts, Litigation Risk
  • 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
  • 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
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  • The Auditing Section
    Are the Reputations of the Large Accounting Firms Really...
    research summary posted April 23, 2012 by The Auditing Section, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications, 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:
    Are the Reputations of the Large Accounting Firms Really International?
    Practical Implications:

    This study provides an important implication for audit firms in maintaining their worldwide brand name reputation. The results suggest that, for global audit firms, the damage to auditor reputation in one country may spill over and cause concern among investors about the quality of their services in other countries. Further, the damage to reputation is greater where the demand for auditing and assurance is higher.

    Citation:

    Cahan, S. F., D. Emanuel, and J. Sun. 2009. Are the Reputations of the Large Accounting Firms Really International? Evidence from the Andersen-Enron Affair.  Auditing: A Journal of Practice and Theory 28 (2):  199-226. 

    Keywords:
    Auditor reputation, international audit markets, Arthur Andersen, Enron, auditor selection and auditor changes
    Purpose of the Study:

    The Big 4 accounting firms market themselves as global firms that deliver a uniform level of service across countries. While such a global reputation helps build worldwide demand for high-quality audits, it also creates risks if service quality becomes questionable in one of the countries in which a firm operates. Questionable audit practices in one of the countries, especially in the home jurisdiction, may  raise doubts as to whether sub-standard audits also occur in other countries. 

    This study examines whether the damage to the name brand of Arthur Andersen following the Andersen-Enron scandal in the U.S. spilled over into other countries. The study focuses on two key event dates leading up to Andersen’s demise: (1) January 10, 2002, when Andersen announced it had shredded documents related to the Enron audit, and (2) February 4, 2002, when Enron’s board released the Powers report that was critical of Andersen and when Andersen announced the establishment of an Independent Oversight Board (IOB) to investigate the firm’s audit policies and procedures. This study investigates the market reaction to Andersen’s clientele base around these two dates to determine whether: 

    • the events caused investors to reassess the reputation of Andersen’s non-U.S. audit units. 
    • investors’ reevaluation of Andersen’s reputation is more pronounced in cases where there is a higher demand for audit quality or credible financial statements. 
    • the effect is due to the perceived assurance or insurance value of an audit. The assurance value relates to an auditor’s ability to communicate with investors about the overall quality of client financial statements, while the insurance value relates to an auditor’s legal and financial liability for an audit failure.
    Design/Method/ Approach:

    The authors use data on publicly-traded companies audited by Arthur Andersen in 2001 to examine whether there is a negative market reaction to Andersen’s non-U.S. clients around the two event dates discussed above.

    Findings:
    • The authors document that an adverse market reaction to Andersen’s clients exists in non-U.S. countries, which suggests that the damage to Andersen’s reputation and audit quality in the U.S. spilled over to other countries.  
    • The market reaction is more negative in countries where there is a greater demand for high-quality auditing and credible financial reporting. More specifically, more-pronounced adverse market reactions are observed in common law (compared to code law) countries where investor protection is higher, ownership is more dispersed, and conflicts of interest between owners and managers are more likely to occur. 
    • The authors find that the market reaction for the shredding event is more negative for Andersen’s non-U.S., cross-listed clients than for Andersen’s non-U.S., non-cross-listed clients. This suggests that the shredding event may have been anticipated by the U.S. market as triggering lawsuits against Andersen and reducing its ability to pay for possible legal claims. 
    • The authors also report a similar market reaction for Andersen’s non-U.S., cross-listed clients and Andersen’s U.S. clients, suggesting similar levels of perceived audit quality across Andersen as a whole.
    Category:
    Auditor Selection and Auditor Changes, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise), Litigation Risk
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