Academic journal article Academy of Accounting and Financial Studies Journal

CPAs' AWARENESS OF LITIGATION RISK

Academic journal article Academy of Accounting and Financial Studies Journal

CPAs' AWARENESS OF LITIGATION RISK

Article excerpt

ABSTRACT

This study examines CPAs' awareness of the litigation risk imposed by audit services. Using CPAs from selected states, I compare perceptions of litigation risk to three objective measures of litigation risk. The first measure is an important legal provision of audit litigation which is assumed to influence litigation risk. Litigation activity reported by the Department of Justice are used for the other two objective measures: frequency of litigation and the level of damages.

Based on these comparisons, I find that the CPAs are not well informed about the litigation risk they face for audit services. Although CPAs provided perceptions consistent with the allegedly important legal standard, a strong majority of CPAs had perceptions that were inconsistent with the Department of Justice statistics about litigation frequency and damage awards. In each case, the misperceptions followed a systematic pattern.

This finding suggests that CPAs may be facing more risk than they thought or incurring more costs than necessary. The finding calls into question the effectiveness of the civil liability system to deter audit improprieties and leads to several questions for future research.

INTRODUCTION

Audit litigation is an important topic to practitioners and academicians as evidenced by the number of articles in their literature (see Latham and Linville, 1998 and Palmrose, 1997 for a review of the literature). Reinforcing the idea that audit litigation is important to practicing CPAs, the American Institute of Certified Public Accountants (AICPA) and the state societies of Certified Public Accountants labored to ease litigation risk faced by CPAs (von Brachel, 1996). These efforts included successful lobbying of Congress for the passage of the Private Securities Reform Act of 1995 and the Securities Litigation Uniform Standards Act of 1998. The effectiveness of these reforms to curb lawsuits against the accounting profession is still an unanswered question (see Investor Relations Business of February 1, 1999 and March 29, 1999 for reports of increasing securities litigation) which suggests that litigation remains a topic of interest.

One issue that has not been addressed in the literature is the accuracy of the CPAs' perceptions of the litigation risk imposed by performing audits. Latham and Linville (1998) discuss the purposes of civil liability and one important purpose is deterrence. By imposing a potential cost through civil liability, the CPA should be reluctant to perform an inappropriate act. However, if the CPA has no understanding of the potential liability or a mistaken understanding of the potential risk, much of the desired deterrence effect could be lost or be counter-productive. The purpose of this paper is to determine if CPAs have accurate perceptions of the liability imposed on them by auditing. The accuracy of the CPAs' perceptions is determined by comparing the perceptions to three objective standards.

In comparing perceptions and objective measures of the litigation risk imposed, I find that CPAs have little understanding of the litigation risk present. Although their perceptions about litigation risk correspond to an (allegedly) important legal standard in audit litigation, their perceptions are inconsistent with the measures of litigation severity provided by the Department of Justice. As discussed later, unintended costs could be imposed on the individual CPAs and society by the CPAs misunderstanding of the litigation risk imposed by auditing services.

The remainder of this paper is organized as follows. In the next section, I discuss the collection of the perceptions about litigation risk and issues of the research instrument. In the third section, I discuss the determination of objective standards. Also, in this section, I discuss the process for designating perceptions as accurate or inaccurate. In the fourth section, the results of the study are presented. …

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