State Liability Regimes within the U.S. and Auditor Decision-Making

• In Event: Accounting Errors and Auditor Litigation

Abstract

We examine how state liability regimes affect auditors’ pricing and reporting decisions. We exploit variation across U.S. states in the extent to which auditors can be held liable by third parties for ordinary negligence. We find that auditors charge higher fees from clients operating and/or incorporated in high litigation-risk states than from clients in low litigation-risk states, possibly due to the higher audit effort expended on these firms, or the fee premia necessary to compensate for higher expected legal costs. We find also that auditors are more likely to issue a going concern report to financially distressed clients when they are from high-litigation risk states, and similarly more likely to report material weaknesses in such clients’ internal controls. Overall, we find that state liability regimes and the consequent variation in litigation exposure affect auditor effort and reporting decisions. These findings add to our understanding of how litigation risk affects auditor behavior; they also document an important source of variation in litigation risk within the U.S. that has been little studied to date.

Authors

• Divya Anantharaman, Rutgers, The State University of New Jersey, Newark

• Nader Wans, Memorial University of Newfoundland