Do Auditors Accurately Predict Litigation and Reputation Consequences of Inaccurate Accounting Estimates?

Abstract

To effectively manage audit risk, auditors must correctly predict the potential litigation and reputation consequences associated with inaccurate accounting estimates. Accurate predictions are critical because underestimation of negative consequences leads to excess legal exposure and overestimation leads to overauditing. Our paper examines whether auditors correctly anticipate these litigation and reputation outcomes. We provide manager‐ and partner‐level auditors with case facts from an auditor negligence lawsuit and ask them to predict the proportion of juries that will return verdicts against their firm. We then compare auditors' predictions to the actual verdicts we observe when we provide the same set of case facts to mock jurors who deliberate as part of juries. We find that auditors overestimate the likelihood of negligence verdicts, especially when audit quality is relatively high. Our supplemental measures help explain the reasons for this overestimation: auditors tend to underestimate jurors' perceptions of audit quality and willingness to attribute inaccurate estimates to situational factors. Finally, we examine auditors' predictions about how a news article about the litigation will affect their reputation with the general public. Similar to our litigation results, we find that auditors tend to overestimate the article's negative impact on auditor reputation. Collectively, our findings suggest that auditors overestimate litigation and reputation consequences resulting from inaccurate accounting estimates. This overestimation is consequential as it leads to inefficient allocation of audit resources.

Experts’ Collective Judgments and Learning in Analytical Review

“…Unlike those two studies, Gimbar and Mercer (2021) found that auditors' judgments are more conservative than the desirable level inferred from actual court decisions for alleged misstatement trials. A higher threshold level is hinted by the study.…”

“…An incorrect probability assessment may cause auditing to be either inefficient or risky (Kinney, 1987;Gimbar & Mercer, 2021). Consequently, the manner that auditors use information when making probability judgments is of interest and importance.…”

Effects of regulatory enforcement style and audit firm remedial actions on investors' perceptions of audit quality

“…This is particularly important in the auditing context, where an audit firm as the seller of a service, the quality of which is often at times difficult to observe (Rothenberg, 2020, p. 371), to the extent that stakeholders are likely to directly associate the quality of the audit work with the reputation of the audit firm. In other words, given reputation is an important asset for an audit firm (Barton, 2005;Gimbar & Mercer, 2021;Hennes et al, 2014;Rothenberg, 2020), it serves as a salient cue that the work the audit firm performs is of high audit quality. Moreover, research has shown that a reputable firm attracts more clients (Skinner & Srinivasan, 2012;Weber et al, 2008) and is able to charge a higher audit fee (Ferguson et al, 2003;Francis et al, 2005), which supports the general perception that reputable firms perform higher quality audit work.…”

“…Therefore, due to this mismatch between the responsibility attributed and the responsibility the audit firm accepts, we expect that investors observing the interactions between the regulators and the audit firm will instead perceive the defensive actions as a cue that the audit firm has self-serving incentives to lessen the impact of the crisis (Ege et al, 2020;Martinow et al, 2020). 13 On this basis, we expect this will cause investors to view the audit firm's reputation negatively and to perceive inherent deficiencies in the audit process, leading to a lower perception of audit quality (Gimbar & Mercer, 2021;Rothenberg, 2020;Weber et al, 2008).…”