Can Identifying and Investigating Fraud Risks Increase Auditors’ Liability?

Abstract

Legal scholars and accounting practitioners have expressed concern that the U.S. legal system might, in cases of undetected fraud, effectively penalize auditors for identifying and investigating fraud risks (AICPA 2004; Coffee 2004; Golden et al. 2006). This study draws on counterfactual reasoning theory to provide experimental evidence indicating that this concern is warranted. Consistent with counterfactual reasoning theory, I find that evaluators in a natural (i.e., between-participants) environment are more likely to hold auditors liable for failing to detect fraud when the auditors investigated for the perpetrated fraud, relative to when the auditors did not investigate for the fraud. Findings from a less natural within-participants experiment, however, indicate that the between-participant findings likely were unintentional: That is, the same evaluators, when later asked to judge alternative levels of fraud investigation simultaneously, are less likely to hold auditors liable for failing to detect fraud when the auditors investigated for the fraud, relative to when the auditors did not investigate for the fraud.

The Sound of Silence: What Does a Standard Unqualified Audit Opinion Mean Under the New Going Concern Financial Accounting Standard?

“…Research also demonstrates that negative outcomes cause juries to judge the auditor more harshly in cases of auditor negligence (Kadous 2000). Additionally, research documents that jurors unintentionally penalize auditors with more negligence verdicts in fraud cases when the auditor investigated the matter than when they did no investigation at all (Reffett 2010). However, none of the existing research examines juror judgments in the going concern context.…”

Points to Consider When Self‐Assessing Your Empirical Accounting Research

“…Reffett () illustrates how within‐subject information can be used to supplement the findings of a between‐subjects experiment. He examines a setting in which a fraud was not detected by auditors.…”

No Good Deed Goes Unpunished? Recent Evidence on the Effects of Identifying and Investigating Fraud Risks on Auditors' Litigation Exposure

“…Imagining such adjustments to the auditors' procedures, however, is more difficult when the auditors did not investigate for the fraud. This is important because evaluator awareness of specific actions that, if implemented, would have allowed the auditors to detect the fraud increases evaluators' belief that the fraud should have been detected (McMullen et al 1995;Roese 1997), which increases the severity of their assessments of auditor liability (Kadous 2000;Reffett 2010). …”

“…1 Second, a forensic accounting guide, created by a partner in a Big 4 forensic accounting practice, warns that enhancing audit procedures to meet the public's heightened expectations of auditors to detect fraud may further raise expectations and the accompanying risk of litigation (Golden et al 2006). Finally, John Coffee (Columbia Law School professor and noted securities law scholar) claims that a common auditor defense in cases of undetected fraud is ignorance, such that auditors have an incentive not to inquire too closely-lest one acquire information to put one on notice (Coffee 2004;Reffett 2010).…”

“…In this article, I summarize a recent study titled ''Can Identifying and Investigating Fraud Risks Increase Auditors' Liability'' (hereafter, ''the study'' or ''my study '') (Reffett 2010). Specifically, I discuss the study's motivation, method, primary results, and implications.…”