Fraud Type and Auditor Litigation: An Analysis of SEC Accounting and Auditing Enforcement Releases

TLDR

The study investigates whether specific types of financial reporting fraud increase the probability of litigation against independent auditors, hypothesizing that auditors are more likely to be sued for failing to detect common frauds or those stemming from fictitious transactions. Using SEC Accounting and Auditing Enforcement Releases, the authors classify each fraud as common and/or arising from fictitious transactions and test its association with auditor litigation while controlling for client, auditor, and case characteristics. The analysis confirms that auditors face higher litigation risk when the financial statement frauds are common or originate from fictitious transactions.

Abstract

This study examines whether certain types of financial reporting fraud result in a higher likelihood of litigation against independent auditors. We expect that auditors are more likely to be judged responsible for failing to detect commonly occurring frauds or those that stem from fictitious transac- tions. We examine companies with SEC Accounting and Auditing Enforcement Releases and designate whether each fraud present in their financial state- ments is common and/or arises from fictitious transactions. We then examine whether these types of fraud are related to auditor litigation in analyses that control for various client, auditor and case characteristics. Our results provide some support for our two primary hypotheses-auditors are more likely to be sued when the financial statement frauds are of a common variety or when the frauds arise from fictitious transactions.