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Reading the warning signs: assessing the risk of litigation in audit engagements.

Lawsuits against auditors are a continuing source of concern for members of the public accounting profession. For example, Coopers & Lybrand recently settled a $200 million judgment against their firm relating to the audit of Miniscribe Corp. In addition, partners with Laventhol & Horwath cited litigation claims against their firm as a major factor in the decision of the nation's seventh largest accounting firm to file for bankruptcy protection.

A common source of litigation against auditors arises when a business fails. Robert K. Elliott, a partner with PMM, noted the following relationship between litigation and business failure:

Litigation alleging audit failure arises in nearly all cases in which the auditee fails and in almost no other. Owners and creditors who lost money typically proceed against the auditor as virtually the only "deep pocket" available after the failure.

When a business fails, users often equate the business failure with an audit failure. Even though the majority of lawsuits against auditors associated with business failures are dismissed, there are still costs to contesting litigation. Reputation effects, escalating malpractice premiums and increasing legal fees combine to make litigation avoidance an area of interest for the accounting profession.

This article presents a model to aid in assessing the risk of litigation to the auditor presented by a client. The article begins by demonstrating how a financial distress model can be used in assessing the likelihood of a particular audit engagement resulting in a lawsuit against the auditor. The model is then expanded with additional variables related to lawsuits against auditors to demonstrate that their inclusion can improve the ability to successfully identify high-risk audit engagements. Specifically, information relating to a firm's ratio of accounts receivable to total assets, its market value, and/or its growth in sales increase the ability of a financial distress model to predict lawsuits against auditors. These results demonstrate that while the financial condition of the client may be important in assessing the risk of litigation faced by the auditor, additional client characteristics should be considered when assessing the risk of litigation presented by a potential audit engagement.

Financial Condition and the Legal Environment

Auditors have a specific obligation regarding the detection of errors and irregularities in the financial statements. SAS 53 states "the auditor should design the audit to provide reasonable assurance of detecting errors and irregularities that are material to the financial statements." While the occurrence of an error in the audited financial statements does not necessarily coincide with an audit failure, an awareness of an error does cause interested parties to question the quality of the audit.

Prior research in this area has identified two findings related to financial condition and its role in litigation involving the auditor. First, laws relating to the auditor's legal liability require plaintiffs to demonstrate that damages have been incurred for a substantive lawsuit to be filed. Damages, i.e., declining stock price, default on loans, etc., associated with client bankruptcy or other significant client losses often result in plaintiffs initiating a search for errors made in the presentation of the financial statements.

Second, companies in poor financial condition have significantly more errors in their financial statements than do other companies. Thus, the financial statements of firms in poor financial condition are more likely to contain errors and these same financial statements are subject to additional scrutiny by financial statement users. Because of the increased likelihood of discovering errors in these types of financial statements, auditors of these firms can expect a higher incidence of litigation.

Given that weak financial condition is associated with lawsuits being filed against auditors, then a model that predicts a client's financial condition should also be able to predict the auditor's risk of litigation associated with that client. However, the literature associated with auditor litigation has identified other factors as also being associated with lawsuits against auditors. These factors, when evaluated along with financial condition, may improve a model's ability to predict lawsuits against auditors.

Ratio of Accounts Receivable to Total Assets

Numerous studies provide empirical support for the argument that accounts receivable are particularly susceptible to the occurrence of errors. This account typically represents a large percentage of a client's total assets and a small percentage error in an account with a relatively large balance can result in a material misstatement. In addition, accounts receivable generally require some subjective judgment on the part of the auditor in determining the appropriate amount to report on the financial statements.

Rate of Growth in Sales

SAS 47 recognizes that the effectiveness of the client's internal control system affects the likelihood of material errors occurring in the financial statements. If a firm's control procedures are not designed to anticipate changes in the environment in which the firm operates, the possibility of errors or irregularities increases. A significant change in a firm's growth rate could materially affect the control system's ability to properly process transactions, thereby increasing the likelihood of errors.

Client Market Value

Most securities-fraud lawsuits relate damage claims to declines in market value. The larger the decline in market value, the larger the potential claim against the auditor. As noted in a recent Wall Street Journal article(1), "any company whose stock price declines is open to a class-action suit." Past research provides evidence of a positive relationship between the amount of damages incurred by shareholders resulting from alleged errors and client firm size.

Variables Included and Sample Selection

Numerous financial distress models have been developed. For this article, the Altman Z-score is used to measure the client's financial condition. The Z-score uses five financial ratios to determine the likelihood of a particular firm going bankrupt in the near future. The five ratios used in calculating the Z-score are as follows:

* working capital/total assets

* retained earnings/total assets

* earnings before interest and taxes/total assets

* market value of equity/book value of total debt

* sales/total assets

Information relating to these ratios was obtained for each of the firms included in this study. In addition, information relating to the ratio of accounts receivables to total TABULAR DATA OMITTED assets, a firm's growth rate and a firm's market value was also obtained.

Forty-nine firms whose auditors were involved in litigation were identified. Because of the fundamental noncomparability of many financial statement items, cases involving financial and service firms were excluded from the analysis. A control sample of 49 firms was also selected matched on time period and industry.

Table 1 reports the means of the variables of interest for the litigation and control sample along with a measure testing for significant differences between the two samples. As expected, the results indicate that the profiles of the two types of firms differ in a number of characteristics. The litigation firms tend to be more highly leveraged, have a lower return on assets and lower ratio of equity to debt when compared to firms in the control sample. In addition, the litigation firms have more accounts receivable as a percentage of total assets as well as a significantly higher growth rate.

The results contained in Table 1 must be interpreted with caution. The information provides an overall comparison of the two samples and identifies certain "red flags." However, what could an auditor conclude about a firm that was highly-leveraged yet had a high return on total assets? Based on the prior information, the auditor would be receiving conflicting signals. The next section discusses how additional analysis is able to accommodate these conflicting signals.

TABULAR DATA OMITTED

Data Analysis

Ordinary least squares (OLS) regression (a statistical technique found in most spreadsheet programs) is able to simultaneously evaluate all the characteristics and discriminate among those characteristics to determine their relative importance. Analyzing only the variables included in the financial distress model indicates that the ratio of retained earnings to total assets is the only characteristic significantly associated with lawsuits against auditors. Applying OLS to the variables included in the expanded distress model also identifies the ratio of retained earnings to total assets as being statistically significant. In addition, the ratio of receivables to total assets, growth in sales and client market value are each associated with lawsuits involving auditors. Thus, if an audit firm were to consider only the variables associated with financial condition, it would be excluding important variables from the analysis.

To test each model's ability to correctly classify litigation and non-litigation firms, a litigation score was computed for each firm included in the study using each model. Each of the coefficients is multiplied by the specific value for a given firm and the results for each firm are then summarized. The lower the score, the higher the risk of litigation to the audit firm.

Table 3 contains descriptive statistics regarding the litigation scores for the litigation and control samples along with p-values testing for differences between the two samples. Examining the results of the financial condition model indicates that the financial ratios used by Altman to measure a firm's financial condition are also able to differentiate between firms whose auditors are involved in litigation and those who are not. The mean litigation score for the control sample is significantly higher (p |is less than~ .10) than that of the litigation sample.

However, the results for the expanded model indicate that while a firm's financial condition is an indicator of the likelihood of the auditor's being involved in litigation related to that client, the inclusion of additional variables increase the model's ability to differentiate between litigation and non-litigation firms. The mean score of the control sample is .579, compared to an average litigation score of .426 for the sample of litigation firms. The resulting difference between means of .153 can be compared to a difference of only .044 for the financial condition model.
Table 3
Descriptive Statistics for the Litigation Scores for Both the
Litigation and Control Samples: Means, Minimums, Maximums, and
p-values
 Financial Distress Only Expanded Model
PANEL A
Control Sample
 Average Score 0.520 0.579
 Maximum 1.090 1.440
 Minimum 0.221 0.254
PANEL B
Litigation Sample
 Average Score 0.476 0.426
 Maximum 0.950 0.960
 Minimum 0.069 -.131
p-value 0.095 0.000


Conclusions

Often, the event that triggers a lawsuit against an auditor is not a negligent audit but the bad luck of an auditor in choosing to audit a client that possesses "certain litigation characteristics." As pointed out in this article, certain characteristics of an audit engagement increase the litigation risk exposure of the auditor. While the financial condition of the client provides an indication of the future litigation risk presented by the client, additional information is readily available to aid the auditor in better assessing litigation risk. Information relating to the ratio of accounts receivable to total assets, rate of change in client sales and client market value, when considered along with client financial condition, can assist the auditor in properly assessing the riskiness of a proposed audit engagement.

Auditors will find the results presented here useful when evaluating prospective and continuing clients. The model presented in this research identifies client characteristics that are significantly associated with litigation against auditors and combines those characteristics to provide an indication of the overall riskiness of the audit engagement.

While auditors may not rely exclusively on a statistical model in making the accept/reject engagement decision, the results of the model can be used as another factor for the auditor to consider. If the auditor's judgment differs from the assessment provided by the statistical model, the auditor can conduct further investigation to determine reasons for the differences.

If a high-risk audit engagement is accepted, the litigation score can be used in pricing the audit, as the risk of litigation should be reflected in the audit fee. In addition, the auditor can use the results of the research in planning and staffing an audit to minimize the risk to the audit firm of a potential lawsuit.

As long as an expectation gap exists between what auditors do and what the public and the courts perceive is their function, lawsuits against auditors will continue. A careful consideration by auditors of those characteristics enumerated in this article should aid in assessing the risks of litigation associated with an audit engagement.

References

1. Wall Street Journal, "The Class-Action Shakedown Racket," editorial page, September 10, 1991.

James D. Stice is Price Waterhouse Research Fellow and Assistant Professor at the School of Accountancy and Information Systems (SOAIS) at Brigham Young University. He holds a bachelor's and master's degree from BYU and a PhD from the University of Washington. He received the Outstanding Faculty Award from the SOAIS in 1990 and was named Teacher of the Year by the 1992 SOAIS graduating class. Articles by Professor Stice have appeared in numerous professional publications, and he serves as a consultant for companies in the computer and banking industries.
COPYRIGHT 1993 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

Article Details
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Author:Stice, James D.
Publication:The National Public Accountant
Date:Mar 1, 1993
Words:2136
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