Litigation Risk and Audit Firm Characteristics

Abstract

SUMMARY: This study examines the association between certain audit firm characteristics and audit firm litigation risk. Previous research shows a link between audit client characteristics and audit firm litigation risk. However, insurance companies do not make extensive use of financial information about individual audit clients to make risk assessments. Instead, they primarily use information about the audit firms themselves. Using data from a large insurance company, we examine the link between several audit firm characteristics and audit-related litigation. Based on a dichotomous measure of risk (existence of a lawsuit), we find that larger firms, firms experiencing rapid growth, firms that sue their clients, and firms with a history of problems all face greater litigation risk. Introducing a continuous measure of the cost of litigation we find, in addition to the previously mentioned risk factors, that firms with a prior history of regulatory problems and firms that choose smaller deductibles are more risky to the insurance company. However, our proxies for independence and expertise are not associated with litigation risk.