The Accounting Review Vol. 66 No. 3 1991
Using Financial and Market Information to Identify Pre-Engagement Factors Associated with Lawsuits against Auditors
Abstract
[The accounting profession is witnessing an increase in both the number of lawsuits against auditors and the settlements associated with those suits. As an example, partners with Laventhol & Horwath cited litigation claims against their firm as a major factor in the nation's seventh largest accounting firm's decision to file for bankruptcy protection. Disclosures by Big Eight (now Six) firms show that between 1980 and 1984 nearly 180 million dollars were paid to settle audit-related litigation (Public Accounting Report 1985). An additional cost to firms associated with this litigation is reflected in the rise of malpractice insurance rates. For example, during 1984 the AICPA's professional liability insurance plan doubled its insurance premiums while at the same time increasing deductibles and decreasing coverage (Collins 1985). Auditing firms also suffer indirect costs as a result of increasing litigation. Prior research (St. Pierre and Anderson 1984; Palmrose 1988) examined audit litigation cases and provided descriptions of characteristics of auditors in those cases. Palmrose (1988) suggests that an increasing frequency of litigation against an auditing firm is viewed as a negative signal about the quality of auditing services provided by the firm, thereby impairing its reputation. Two conditions are likely to exist in order for a lawsuit to be filed against an auditor: (1) an allegation of audit failure, and (2) legal action provides a cost-effective alternative for potential plaintiffs. This study hypothesizes that the client's financial condition, asset structure, and sales growth affect the likelihood of erroneous financial statements being issued and that the auditor's ability to detect and willingness to disclose errors are related to the probability of an audit failure. This study also suggests that the greater the market value of the client and the higher the variability of the client's returns, the more likely the auditor of that client will be a target of litigation. A matched-pairs design is used to analyze a sample of companies involved in lawsuits against auditors and a sample of companies matched with the experimental sample on industry and time period. The results provide evidence of an association between pre-audit engagement characteristics of both the client and the auditor, and the subsequent filing of a lawsuit against the auditor. After controlling for industry effects, the ratios of accounts receivable and inventory to total assets, the client's variance of abnormal returns, financial condition, and market value are found to be significantly associated with lawsuits against auditors. A test of the model's predictive ability using various relative error costs and assuming various prior probabilities of auditor litigation results in concluding that model's ability to outperform a naive strategy is sensitive to the parameters selected. However, when realistic priors and error costs are assumed, the model is effective in identifying high-risk audit engagements.]
- Volume
- 66
- Issue
- 3
- Pages
- 516-533
- Sources
- bibtex:phds-export.bib