Accounting Irregularity, Improper Revenue Recognition and Auditor Litigation

By Amoah, Nana Yamfo; Bonaparte, Isaac et al. | Academy of Accounting and Financial Studies Journal, July 1, 2018 | Go to article overview

Accounting Irregularity, Improper Revenue Recognition and Auditor Litigation


Amoah, Nana Yamfo, Bonaparte, Isaac, Kelly, Muniratu, Makawwi, Bilal, Academy of Accounting and Financial Studies Journal


INTRODUCTION

Auditors, by the nature of their fiduciary relationship with investors, are required to design their audits to provide reasonable assurance that financial statements are not materially misstated. This duty of care of the auditor notwithstanding, many instances of audit failure have been recorded, which have resulted in huge losses in investor capital and lowered investor confidence in the capital markets (Chaney and Philipich, 2002; Lys and Watts, 1994; Stice 1991). Extant literature documents a high incidence of lawsuits against auditors, some of which have resulted in substantial auditor settlements (Choi and Pritchard, 2012; Fafatas, 2010; Ramseyer and Rasmusen, 2013; Stice, 1991; Public Accounting Report, 1985)1.

In this study, we examine whether improper revenue recognition and accounting irregularity are associated with the probability that an auditor will be sued for a defective audit of a client. We focus on improper revenue recognition and accounting irregularity as they are accounting misstatement characteristics that could have adverse valuation consequences on shareholder wealth and signal intentional misstatement. Revenues provide critical information to market participants in their decision-making process (Ou and Penman, 1989; Jegadeesh and Livnat, 2006; Stubben, 2010) and improper revenue recognition could trigger severe valuation consequences on the shareholders of an audit client (Hennes et al., 2008). Moreover, improper revenue recognition and accounting irregularity increase the likelihood that the financial statements of an audit client might have been intentionally misstated (Palmrose and Scholz, 2004). Accordingly, we examine whether improper revenue recognition and accounting irregularity are considered by shareholders as an indication of audit failure, thereby triggering a lawsuit against the auditor.

We use logistic regressions and litigation data from the Stanford Securities Class Action Clearinghouse database over the 10-year period after the Private Securities Litigation Reform Act of 1995 (PSLRA), that is, 1996 to 2005, to examine whether accounting irregularity and improper revenue recognition are associated with the probability of auditor litigation. We find that auditors are more likely to be sued when accounting misstatements are due to irregularities, and revenues are improperly recognized. Our study provides insights into the legal liability of external auditors given that:

1. Foster et al. (2007) argue that the PSLRA has not curtailed frivolous lawsuits against auditors.

2. Choi, Nelson, and Pritchard, (2009) and Pritchard (1999) note that lawsuits are settled for nuisance amounts after the PSLRA.

3. Many firms are unable to properly recognize revenues (Bloom and Schirm, 2001).

Given that misstatements due to accounting irregularity and improper revenue recognition could be perceived as sustaining a high inference of fraud, our finding that accounting irregularity and improper revenue recognition are associated with the probability of auditor litigation implies that shareholder lawsuits against auditors appear to have merit. Accordingly, our study contributes to the literature on the merits of auditor litigation in the decade after the passage of the PSLRA. Our paper also contributes to the audit quality literature by highlighting accounting misstatement characteristics that are considered by shareholders as indicators of audit failure. Finally, our results imply that auditors could reduce the risk of litigation by averting accounting irregularity and improper revenue recognition in audited financial statements.

The rest of the study proceeds as follows: Section 2 provides the literature review and hypothesis development. Section 3 presents the methodology and Section 4 reports the empirical results of the study. The conclusion follows in Section 5.

LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

Opportunistic behavior of managers is a major concern to researchers, investors, and regulators (Watts and Zimmerman, 1986). …

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