Auditor Litigation: Deterrence Implications for Non-Sued Auditors

Abstract

Litigation poses a significant business risk for auditors. We argue that auditors learn from other auditors’ litigation events and examine the consequences of such events for future accounting misstatements. Using a hand-collected sample of auditor litigation events, we find a significant subsequent decrease in misstatement frequency in within-industry audits conducted by auditors who did not face litigation. This industry-based across-auditor effect is further supported (a) by an increase in audit fees; (b) an increase in auditor going concern opinions; and (c) is robust to a battery of controls including the use of a difference-in-difference approach. By showing that auditor litigation leads to lower, rather than higher, misstatements across an industry, the findings expand our understanding of misstatement contagion evidenced in other studies. We find no evidence of region-based across-auditor learning. Overall, this study, by demonstrating a deterrence effect of litigation for non-sued entities significantly enhances the impact of litigation beyond just the sued entity.

Keywords: Securities, Financial Institutions