How Engagement Letter Clauses Affect Overall Risk

• In Event: Breakfast and Research Forum
  In Roundtable Session: Table 18: Audit Failures

Abstract

Our study examines auditors’ responses, through evidence-gathering and fees, to changing engagement letter clauses in normal and unusual risk scenarios. We further test if auditor behavior to risk changes follows our defined insurance or litigation concepts. According to the insurance hypothesis, third parties assume that auditors indemnify users against losses sustained by those relying upon financial statements. Prior research has not examined whether auditor risk-mitigating behavior distinguishes between litigation risk arising from auditing riskier clients and their insurance risk. We define litigation risk as the probability of incurring costs due to litigation in cases where audit failures arise. Litigation risk is seen as controllable because auditors can mitigate the risk by increasing their sample size, changing the timing of their procedures and adopting stronger audit procedures. Comparatively, we define insurance risk as the probability of incurring costs due to litigation in cases independent of audit failure. We deem those risks as uncontrollable because they cannot be mitigated by collecting additional evidence, but can be insured against through higher fees.

We surveyed 209 CPAs to assess the response to increasing risk across three engagement letter clauses that have the potential to change the level of auditor risk exposure. The engagement clauses include (1) alternative dispute resolution (ADR), (2) holding CPAs harmless from liability, and (3) limiting client's recovery of damages in civil dispute cases. We use ADRs as a baseline clause because they change how auditors and clients resolve risk, but do not mitigate or reduce risks. Our results show that CPAs increase both the quantity of evidence gathered and their engagement fees in response to increasing risk. This finding suggests that CPAs’ responses follow the litigation risk hypothesis. Auditors further respond to an engagement’s aggregate risk in the presence of risk-reducing clauses.

Authors

• Alan Reinstein, Wayne State University

• Brian Patrick Green, University of Michigan–Dearborn

• Philip Beaulieu, University of Calgary