Looking Beyond Accounting: The Effect of Clients' Operating Lawsuits on Audit Fees and Audit Quality

• In Event: Client and Auditor Litigation

Abstract

Companies are often involved in lawsuits stemming from alleged misconduct involving operating issues that are unrelated to the financial reporting process (i.e., operating lawsuits). Ex-ante, the impact of the occurrence of operating lawsuits on audit fees and audit quality is unclear. We explore whether and how the occurrence of clients' operating lawsuits affects audit pricing and audit quality. Based upon a large sample of public company operating lawsuits for the years 2000 to 2016, we find that the occurrence of client operating lawsuits is positively associated with audit fees and negatively associated with the likelihood of misstatements. The misstatement results indicate that the increase in fees is not purely a risk premium and at least partially driven by additional audit effort, suggesting that auditors assess higher misstatement risk when operating lawsuits occur. Additional analysis finds that auditors are more responsive to operating lawsuits with longer duration. We also find that the negative association between the occurrence of operating lawsuits and the likelihood of misstatements is stronger for Big N audit clients or clients of audit offices with recent operating lawsuit experience. Our research provides evidence that auditors consider the occurrence of an operating lawsuit as an important economic event that impacts the auditor-client relationship. Our findings should be informative to regulators and investors who have expressed increasing concerns about public companies engaging in alleged misconduct related to their operations.

Authors

• Feng Guo, Iowa State University

• Steve Kaplan, Arizona State University - Tempe

• Lili Sun, University of North Texas

• Qian Wang, Iowa State University