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The Potential for Catastrophic Auditor Litigation

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  • Dain C. Donelson

Abstract

Audit firms continue to lobby for legal liability limits based on their contention that catastrophic civil litigation is a realistic possibility. However, others disagree that catastrophic litigation is a viable threat to the audit firms and oppose legal reform at this time. To inform this debate, this study estimates the probability that a Big Four audit firm will face catastrophic litigation. Estimates are based upon recent disclosures by audit firms regarding settlements, litigation cost, and internal financial information. The results indicate that the likelihood of catastrophic liability is low in absolute terms. Assuming liquidation only when liability reaches a threshold that includes annual income, retirement benefits, and windup costs for the firm, the likelihood of at least one Big Four firm facing litigation substantial enough to trigger voluntary liquidation is ∼0.6% over a 5-year period. These findings are consistent with auditors being able to sustain litigation under the current legal system. However, the probability would increase dramatically if firms changed their financial structures to remove partner retirement benefits. In such a case, I estimate that the likelihood of catastrophic litigation is as high as 2.8% over a 1-year period and 14.1% over a 5-year period, depending on the level of variable associated litigation costs assumed. Copyright 2013, Oxford University Press.

Suggested Citation

  • Dain C. Donelson, 2013. "The Potential for Catastrophic Auditor Litigation," American Law and Economics Review, American Law and Economics Association, vol. 15(1), pages 333-380.
    • Handle: RePEc:oup:amlawe:v:15:y:2013:i:1:p:333-380
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    File URL: http://hdl.handle.net/10.1093/aler/aht001
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    Citations

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    Cited by:

    1. Sellers, R. Drew & Fogarty, Timothy J. & Jadallah, Jadallah, 2020. "Has the new world order taught the big four to manage client portfolio risk? Examining extreme loss occurrences before and after Sarbanes Oxley," Advances in accounting, Elsevier, vol. 51(C).
    2. Goodson, Brian M. & Grenier, Jonathan H. & Maksymov, Eldar, 2023. "When law students think like audit litigation attorneys: Implications for experimental research," Accounting, Organizations and Society, Elsevier, vol. 104(C).
    3. Henock Louis & Thomas C. Pearson & Dahlia M. Robinson & Michael N. Robinson & Amy X. Sun, 2019. "The Effects of the Extant Clauses Limiting Auditor Liability on Audit Fees and Overall Reporting Quality," Journal of Empirical Legal Studies, John Wiley & Sons, vol. 16(2), pages 381-410, June.
    4. Al-Hadi, Ahmed & Taylor, Grantley & Monzur Hasan, Mostafa & Eulaiwi, Baban, 2023. "Third-party auditor liability and financial restatements," The British Accounting Review, Elsevier, vol. 55(2).
    5. Preeti Choudhary & Kenneth Merkley & Katherine Schipper, 2019. "Auditors’ Quantitative Materiality Judgments: Properties and Implications for Financial Reporting Reliability," Journal of Accounting Research, Wiley Blackwell, vol. 57(5), pages 1303-1351, December.
    6. Brown, Timothy & Majors, Tracie M. & Peecher, Mark E., 2020. "Evidence on how different interventions affect juror assessment of auditor legal culpability and responsibility for damages after auditor failure to detect fraud," Accounting, Organizations and Society, Elsevier, vol. 87(C).
    7. Chy, Mahfuz & De Franco, Gus & Su, Barbara, 2021. "The effect of auditor litigation risk on clients' access to bank debt: Evidence from a quasi-experiment," Journal of Accounting and Economics, Elsevier, vol. 71(1).
    8. Eldar Maksymov & Jeffrey Pickerd & D. Jordan Lowe & Mark E. Peecher & Andrew Reffett & Dain C. Donelson, 2020. "The Settlement Norm in Audit Legal Disputes: Insights from Prominent Attorneys$," Contemporary Accounting Research, John Wiley & Sons, vol. 37(3), pages 1400-1443, September.

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