Litigation Risk and Abnormal Accruals

Abstract

In this paper, we examine the relation between auditor litigation risk and abnormal accruals over the 1989-2007 time period. We address potential endogeneity in prior studies by jointly modeling abnormal accruals and litigation risk in a simultaneous equation system. Our findings suggest that client-specific litigation risk affects auditor incentives to acquiesce to client demands for earnings management, i.e., the higher the risk of auditor litigation, the greater the auditor’s restraining influence on the abnormal accruals reported by the client. We also find evidence that abnormal accruals increase the likelihood of auditor litigation. We also document that the 1995 Public Securities Litigation Reform Act (PSLRA) lowered the client-specific risk of auditor litigation. Litigation reform remains a topic of ongoing interest. Our findings contribute to a better understanding of the effects of litigation reform (and related changes in legal exposure) on auditor incentives and earnings management.

Keywords: Litigation Risk, Abnormal Accruals, Auditor Incentives