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Companies may be defendants in lawsuits that are unresolved at year-end. This paper aims to consider whether the financial statements of companies facing litigation claims (pending litigation) are more time-consuming to audit due to the complexity and subjectivity of contingent liabilities associated with pending litigation. The authors consider whether auditors tailor their approach to pending litigation based on two distinct factors in the Chinese business environment: the client’s government ownership status and the legal development of the region in which the company is based.

Data on litigation against companies and their audit report lags were obtained for 18,029 firm-year observations of Chinese companies from 2008 to 2017. The sample was subsequently divided based on whether the company was a state-owned enterprise (SOE) and based on whether the company was based in a region of China with a more-developed and more market-oriented legal system.

The overall results indicate that audits of companies with pending litigation take 2.9 days longer than those of companies without pending litigation. For companies with multiple pending claims, each additional claim is associated with 1.9 more days of audit report lag. These effects are weaker for SOEs and for companies in regions of China with less developed legal systems. The results are consistent with the idea that auditors tailor their response to pending litigation based on the risk profile of the client, including consideration of SOE status and regional legal development.

This paper is the first to consider the potential effect of pending litigation (including claims not disclosed or recognized in financial statements) on audit report lags and how environmental business factors can influence this relationship.

This study aims to address the following four research questions: first, whether auditors report critical audit matters (CAMs) to shield themselves against possible litigation; second, whether reporting quality affects auditors’ propensity to report CAMs; third, whether auditors’ tenure length – reflecting familiarity with clients’ financial reporting – affects their likelihood to report CAMs; and fourth, whether auditors’ conservatism increases the likelihood of CAMs reporting.

Data are manually collected from audit reports including CAMs in 10-K, then financial data are collected from the Capital IQ database, and market data are collected from the CRSP database. Using propensity score matching, the initial sample of companies with CAMs is matched with companies without reported CAMs. Performance adjusted discretionary accruals, real earnings management proxy, Khan and Watts’ (2009) C-score, propensity to issue a going concern opinion, Dechow et al.’s (2011) F-Score, Rogers and Stocken’s (2005) model and Houston et al.’s (2010) model are used to measure reporting quality, auditor conservatism, misstatement risk and litigation risk, respectively.

The results do not show that auditors report CAMs opportunistically to shield themselves from litigation risk. However, the results do suggest that auditors have a greater tendency to report CAMs when reporting quality is low and when they are more conservative. On the other hand, they have less tendency to report CAMs in their first year of engagement.

The findings of this study have important implications for the auditor behavior literature as it shows that, when it comes to reporting CAMs, auditors actually behave objectively and do not report in a trite way. This study also provides early archival evidence on a standard that relates to the first major change to the auditor’s report in decades. To the best of the author’s knowledge, it is the first to provide evidence on the association between auditor conservatism and auditors tendency to report CAMs and the first to triangulate prior research on auditor litigation risk by providing the first archival evidence on the auditors “litigation-shielding” concern.

This study examines whether auditors attempt to meet the stated objective of reporting CAMs by signaling information about reporting quality. This study demonstrates that reporting CAMs is not a “boilerplate” communication. This study has implications for standards setters, as it shows that CAMs are reported in a way consistent with the objectives of the new standard, namely, via signaling information in the audit report on the quality of the financial statements.

In terms of originality, this paper uses a manually collected sample and, to the best of the author’s knowledge, is the first to focus on auditor’s behavior rather than on investors or clients reactions to CAMs. Also, this paper addresses a recently issued standard using US data and archival approach, rather than experimental. This paper also provides relevant evidence related to concerns raised earlier but were not empirically examined, such as reporting CAMS as “boilerplate” expectations. This paper provides new evidence on the auditors’ behavior with regard to litigation risk.

The practice of management having control over auditor appointment and compensation is believed to be a fundamental cause for the lack of auditor independence. While researchers propose alternative auditor appointment procedures to improve auditor independence, there are a few settings that allow researchers to examine alternative auditor appointment procedures such as regulator designation of auditors. This research aims to investigate the effects of regulator designation of auditors and litigation risk on auditor independence in a Chinese setting

This study adopts a 2 × 2 between-subjects experimental design. A total of 110 surveys were sent out and 81 were collected from eastern China.

The results of an experiment with 81 Chinese auditors indicate that regulator designation of auditors improves auditor independence. In particular, auditors designated by the regulator feel less pressure from the audited company, perceive themselves to be more independent and are more willing to challenge the audited company’s aggressive financial reporting compared with those directly hired by the company. In addition, litigation risk moderates the effect of regulator designation of auditors on auditor independence such that regulator designation of auditors has a stronger impact on auditor independence when the litigation risk is low.

This study is also subject to limitations. First, regulator designation of auditors in China was examined. While regulator designation of auditors seems to improve auditor independence in the Chinese context, it is unclear if the same results will be observed in other economies, as China is a unique setting. For example, the majority of listed companies in China are under the control of government-related agencies. Consequently, the government has significant power in influencing auditor appointment policy. In contrast, the majority of other economies are more market-oriented with less government influence. Future studies in other markets will further enrich the understanding on regulator designation of auditors. Second, only regulator designation of auditors for state-owned enterprises was examined. It is unclear how regulator designation of auditors would affect non-state-owned enterprises. Moreover, future research could investigate the designation of auditors in other forms such as the designation of auditors by investors. Third, auditor appointment procedure may affect perceived risk of loss of client which in turn influences auditor independence. Future research could further investigate the mechanism through which regulator designation of auditors affect auditor independence.

Results of an experiment with 81 Chinese auditors show that regulator designation of auditors can improve auditor independence. In a decision context where auditors must provide judgments relating to a proposed audit adjustment that is quantitatively material and will affect the client’s ability to meet debt covenants, auditors designated by the State-Owned Assets Management Bureaus are more resistant to management pressure and are less willing to accept the management’s aggressive financial reporting practice than those directly hired by the company.

We examine the role of past litigation in the selection of independent auditors. Using a sample of persons typically involved in auditor selection, we find that any litigation announcement alleging audit improprieties greatly reduces the auditor’s likelihood of hire regardless of the type of legal action announced or the degree of direct involvement by the auditor. Based on these findings, litigation imposes an indirect (and potentially substantial) cost by impeding the CPA’s ability to attract new clients.

This study aims to investigate whether accounting-related litigation is associated with a break in the client’s earnings string and the auditor’s response to a break in the earnings string.

The authors use regression models on a sample of publicly-traded USA companies with earnings strings.

The authors find that clients’ earnings string breaks are associated with increased accounting litigation risk and audit fees. The results are more prevalent for larger breaks.

The findings suggest auditors anticipate string breaks by clients which implies that audit fee research should consider earnings string characteristics in the fee models.

The auditor’s access to private information allows them to anticipate string breaks and potential increase in litigation risk.

An earnings string break represents a convergence of concerns highly relevant to the auditor: more users relying on the financial statements with greater expectations, increased likelihood of losses to those users, an environment where the likelihood of misstatement may increase, and explicitly stated professional responsibilities in response to the latter. Despite that, and a rich earnings string literature, prior studies have not directly examined auditors’ response to a client’s string break.

The purpose of this paper is to examine whether client‐specific litigation risk affects the audit quality differentiation between Big N and non‐Big N auditors. Specifically, the authors examine whether higher quality audits of Big N auditors relative to non‐Big auditors is more pronounced for clients with high litigation risk than for clients with low litigation risk.

The authors develop the hypothesis based on auditors' potential monetary and reputational losses, collect the data of US listed companies from the Compustat and CRSP databases, and conduct regression analyses.

The authors find that the higher effectiveness of Big N auditors over non‐Big N auditors in constraining earning management is greater for high litigation risk clients than for low litigation risk clients, suggesting that clients' high litigation risk can force big auditors to perform more effectively.

This paper contributes to the literature by providing novel evidence on the effect of client‐specific litigation risk on the audit quality differentiation between Big N and non‐Big N auditors. The authors' findings complement the extant research on the relationship between the audit quality differentiation and country‐level litigation risk.

The purpose of this paper is to compare the effect of corporate governance variables and fraud litigation on audit fees both before and after the implementation of the Sarbanes‐Oxley (SOX) Act in 2002.

The paper utilizes a sample of firms that had litigation proceedings filed against them for fraudulent financial reporting, and compare these firms to a sample of non‐fraud firms in the pre‐and post‐SOX period. First, the authors examine indicators of audit fees using the Simunic model. Next, the authors develop a logistic regression model with corporate governance variables and other financial control variables in order to identify the characteristics of firms that are accused of fraud in the pre‐and post‐SOX period.

The paper identifies specific components of corporate governance that are positively related to audit fees and which subsequently aid in classifying companies subject to fraud litigation. The most successful logistic regression model for 2005 (post‐SOX) is 64.4 per cent accurate in distinguishing firms litigated for fraud, while the most successful model for 2001 (pre‐SOX) is 61.4 per cent accurate in distinguishing such firms.

The research design and findings assist in providing additional evidence about the association between the effectiveness of the corporate governance structure and the external auditor in assessing the risk of fraud.

Accounting firms claim that the risk of costly litigation leads to resignations from high-risk clients, and that these resignations represent an economic inefficiency. This study examines the association between resignations, dismissals and litigation in the computer industry from 1988–1995. Resignations and dismissals appear to be similar, suggesting some dismissals are implicit resignations. Results support a relationship between risk and resignations. Since some characteristics of auditor litigation risk are also characteristic of unprofitable audit engagements, the analysis incorporates the actual litigation experience of sample companies to provide insights into claims of inefficiencies surrounding the switches.

This study examines whether auditors’ pricing decisions on managerial ability are affected by auditor litigation risk (financial distress or financial crisis), auditor’s familiarity with their client or regulatory changes in the post-Sarbanes–Oxley Act of 2002 (SOX) era.

Building on the extant audit fee literature, this study constructs an audit fee determinants model to examine how context affects auditors’ pricing of managerial ability.

Auditors offer a larger fee discount to more able client management teams when auditors face lower litigation risks or are more familiar with the client. Furthermore, managerial ability has a more pronounced effect on audit fees in the post-SOX era when managers are mandated to play more active roles in financial reporting (i.e. certification of financial statements required by SOX 302).

Based on the audit risk model (Simunic, 1980), Krishnan and Wang (2015) show that the managerial ability of an audit client is relevant and important to auditors’ pricing decisions. This study demonstrates that managerial ability exhibits a non-linear relationship with audit fees and contextual factors, such as litigation risk, and that auditors’ familiarity with managers can alter the negative association between audit fees and managerial ability. This study extends Krishnan and Wang’s study by offering additional insights into auditors’ use of soft information such as managerial ability. Furthermore, the findings add to the literature on the impact of SOX on audit fees by suggesting that SOX has not only increased overall audit fees (Ghosh and Pawlewicz, 2009; Huang et al., 2009), it has also increased auditors’ price sensitivity to soft information (e.g. managerial ability).

This study provides insights for audit firms and client companies who are interested in understanding audit fee-pricing decisions. The findings also suggest that auditors need to be sensitive and responsive to various contextual factors when making pricing decisions.

Previous studies have not addressed the non-linear relationship between audit fees and soft information about managerial ability.

The use of choice-based, matched, and other stratified sample designs is common in auditing research. However, it is not widely appreciated that the data analysis for these studies has to take into account the non-random nature of sample selection in these designs. A choice-based, matched or otherwise stratified sample is a nonrandom sample that must be analyzed using conditional analysis techniques. We review five research streams in the auditing area. These streams include work on determinants of audit litigation, audit fees, auditor reporting in financially distressed firms, audit quality and auditor switches. Cram, Karan, and Stuart (CKS) (2009) demonstrated the accuracy of conditional analysis, compared to unconditional analysis, of nonrandom samples through the use of simulations, replications, and mathematical proofs. Papers since published have continued to rely upon questionable research, however, and it is hard for researchers to identify what is the reliability of a given work. We complement and extend CKS (2009) by identifying audit papers in selected research streams whose results will likely differ if the data gathered are analyzed using conditional analysis techniques. Thus research can be advanced either by replication and reanalysis, or by refocus of new research upon issues that should no longer be viewed as settled.