The Impact of Non-Accounting Related Lawsuits against Audit–Clients on Audit Quality: Distraction Spillover Effects and Distance Dynamics

Abstract

We seek to address a gap in the existing literature by examining a frequently overlooked factor: non-accounting related lawsuits (distraction event) against audit client-firms. We consider these lawsuits as exogenous shock that shifts auditors’ attention towards the sued client to test how non-accounting lawsuits can cause a spillover effect on other non-sued clients that share the same auditor as the sued client. We identify clients as being more prone to be affected by the spillover effects if the client is in a different city (distant) than the audit office city. Using a difference-in-difference design, we show that distant clients experience more restatements and missed internal control weaknesses when the audit office is distracted as compared to same city clients and to the time that the audit office is not distracted. Our results hold for stronger distraction events and for alternative audit quality proxies, such as Type II error and Big R restatements. Results suggest that the negative spillover effects evident in distant clients are directly related to the interaction between the level of distraction of an audit office and the distance of the client’s office from the audit office. Overall, our findings suggest that lawsuits unrelated to accounting have significant implications that extend beyond the firms directly involved in the litigation process. They also inform regulatory bodies about the potential implications of the complementary relationship between distraction and distance.

Keywords: Audit quality, Restatements, Non-accounting lawsuits, Distracted auditors, Distance

JEL Classification: M40, M41, M42, M49, K15