The Settlement Norm in Audit Legal Disputes: Insights from Prominent Attorneys

Abstract

Prior research indicates that most audit legal disputes settle. There is, however, little evidence of the factors that drive the settlement norm and its exceptions in audit legal disputes. To better understand these factors, we rely on theory related to how professionals manage risks and, as a result, how professions defend jurisdictional claims. We use this theoretical lens to help motivate four research questions that we probe by interviewing 27 prominent attorneys experienced in audit litigation. Consistent with our lens, our interview data indicate that attorneys manage their risks, including the risk of reputational loss, by settling based on their expectations of trial verdicts. Unlike trials, settlements simultaneously enable attorneys on both sides to limit costs and avoid catastrophic jury verdicts and, by doing so, claim “wins” for their clients. Attorneys also stress that they settle many audit disputes without any legal filings. Thus, a large subset of disputes is invisible to the public and researchers. Attorneys characterize trials as exceptions to the settlement norm that emerge due to abnormal conditions sometimes present in disputes. However, trial verdicts in these abnormal conditions help attorneys justify the use of settlements to clients, as attorneys stress that by settling they can avoid the dreaded possibility of extreme unfavorable verdicts. We conclude that as individual attorneys manage their risks, especially the risk of reputational loss, their profession maintains its public image and thereby defends its jurisdictional claims. Among the many questions we pose for future research is whether the settlement norm reduces society's ability to monitor the audit profession and, more generally, whether this norm's benefits outweigh its drawbacks.

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

“…Due to the importance of auditor reputation, audit firms are motivated to avoid reputational loss. For example, Maksymov et al (2020) find that audit firms settle lawsuits against them to avoid negative publicity and associated reputational damage.…”

“…Specifically, firms with stronger reputations attract more clients (GAO 2003) and are able to charge higher audit fees (Ferguson et al 2003; Francis et al 2005; Donelson et al 2019), and firms that experience declines in reputation lose clients to other audit firms (Weber et al 2008; Skinner and Srinivasan 2012). Recent research suggests that concerns about potential reputation loss lead audit firms to settle lawsuits (Maksymov et al 2020). In order for auditors to make optimal settlement decisions, they must be able to accurately predict potential reputational consequences.…”

“…loss lead audit firms to settle lawsuits (Maksymov et al 2020). In order for auditors to make optimal settlement decisions, they must be able to accurately predict potential reputational consequences.…”

“…1 1 The majority of lawsuits do not go to trial, but auditors and their attorneys consider expected trial outcomes when making decisions about settlements (Palmrose 1991; Maksymov et al 2020). Settlement decisions are made by the national office rather than by individual auditors.…”

When Are Audit Firms Sued for Financial Reporting Failures and What Are the Lawsuit Outcomes?

“…Trials are rare because it is less costly and less risky for plaintiffs and defendants to negotiate a settlement instead of proceeding to trial (Galanter ; Maksymov et al ).…”