Company management is responsible for preparing financial statements for investors and other external parties. Auditors are responsible for auditing those financial statements to detect material misstatements due to error or fraud. Auditors provide “reasonable” assurance to those using the financial statements. As such, auditors may not always be to blame when financial reporting failures like frauds or restatements occur.
In a study titled “When Are Audit Firms Sued for Financial Reporting Failures and What Are the Lawsuit Outcomes?” researchers poured over 2,429 accounting lawsuits between 2000 and 2015 and examined the role of the financial statement auditor as a co-defendant. The study is authored by Clive Lennox from the University of Southern California and Bing Li from City University of Hong Kong.
“It’s commonly assumed that, when there is a financial reporting failure, the auditor is sued,” says Professor Lennox. However, the research study illustrates that the audit firm is named as a co-defendant in only 20% of lawsuits alleging the misreporting of audited financial statements. “Even when the lawsuit is attached to a restatement of the financial statements, we don’t see an increase in the likelihood that the auditor is sued,” notes Lennox. Still, the study also finds that the frequency within which auditors are named as co-defendants has increased from 14% in 2000 t0 30% in 2015.
In 74% of the cases examined by the researchers, the court did not dismiss the case and the plaintiff and defense reached a settlement which resulted in a payout to the plaintiff. The average payout value in the full sample was $41.8 million. “For the sample where the auditor was sued, we saw on average that the auditor contributed only 12% of the total damages paid to the plaintiff,” says Lennox. For the 62 cases in their sample that actually proceeded to trial, the plaintiff received payouts in all but 10 of the cases.
According to Lennox, “One other surprise was how infrequently audit committee members were named as defendants in the cases in our sample.” Lennox further notes that this finding “may be useful to companies when recruiting potential audit committee members who are concerned about personal liability risk.”
The study concludes by examining the contexts under which auditors are more or less likely to be sued. The researchers observe that auditors are more likely to be included as co-defendants when the accounting allegations involve fictitious assets and/or reductions of expenses. For example, an overstatement of inventory on the balance sheet and an understatement of cost of goods sold on the income statement. Auditors are also more likely to be sued when the allegations include overvalued assets or undervalued liabilities and expenses. On the other hand, when the lawsuit relates to omitted or improper disclosures or management is accused of profiting from the misreporting, the auditors are less likely to be sued.
Author Joseph Brazel is a Jenkins Distinguished Professor of Accounting and a University Faculty Scholar at North Carolina State University.