A Tale of Two Incentives: Investigating Auditors’ Willingness to Reveal Prior Misstatements

• In Event: Litigation Risk

Abstract

Existing research suggests that the risk of litigation and reputational concerns can motivate auditors to improve audit quality in the current period. However, it is unclear how these incentives play out when auditors are facing the restatement of their previously audited, but materially misstated, work. While audit firms as a whole may be insulated from these types of risks due to their size, we purport they are salient to individual audit partners and are taken into consideration at the engagement level. We investigate the individual and joint effects of two potential incentives, litigation risk and reputation concerns, on the likelihood that auditors will encourage the subsequent restatement of materially misstated financial statements upon which they opined. We find that reputational concerns can decrease the likelihood that auditors will reveal a prior period misstatement, but only when the risk of litigation is low. In additional analysis we also find that as the extent of financing acquired in the capital markets using materially misstated financial statements increases, the likelihood of restating those misstated financial statements decreases. Our results are robust to using two well documented approaches for estimating a company’s likelihood of having a material misstatement, as well as alternative measures of litigation risk and the risk of reputational damage. These findings contribute to a better understanding of the incentives affecting auditor decision-making, and can provide important insights regarding the objectivity of the audit opinion.

Authors

• Brant Erich Christensen, Texas A&M University

• Sarah C. Rice, University of Connecticut

• Timothy Andrew Seidel, University of Arkansas