The Association between Auditor Litigation and Abnormal Accruals

Abstract

Concern that earnings management erodes the quality of financial reporting has prompted the Securities and Exchange Commission to question the role of the external auditor. To help address this concern, this study examines the relation between earnings management and auditor litigation. While prior research on the relation between auditor litigation and total accruals has yielded inconclusive results, I find that the risk of auditor litigation is positively associated with a sharper measure of earnings management, abnormal accruals. Using a larger and more recent sample, this study provides evidence that the probability of auditor litigation increases as clients report more positive (income-increasing) abnormal accruals. This result holds in: (1) univariate analyses, (2) logit analyses that also control for auditor size, client importance to the auditor, length of the auditor-client relationship, client industry, client financial condition, client size, and client growth, and in (3) the subsample of lawsuits alleging wrongdoing in the more recent time period (1984 - 1998).

Keywords: Auditor Litigation, Earnings Management, Abnormal Accruals

JEL Classification: M40, M41