Abstract

Litigation against auditors has increased dramatically in recent years. Besides potential liability payments, the litigation can damage auditor's reputation. Therefore, auditors are trying to search for ways to minimize the potential losses from litigation. Some prior studies have shown that auditors can offset litigation risk in many ways, including improved audit quality, increases in audit fees and increases in the issuance of modified opinion. Auditors can also manage litigation risk by becoming more cautious in their choice of new clients and by withdrawing from high－risk engagement. Generally, litigation against auditors arises from situations where investors rely on financial statements and subsequently incur losses as a result of alleged audit failure. In other words, the litigation arises on the assumption that financial statement was manipulated by management and audit failure existed. If the two conditions were not satisfied, auditors don't indemnify investors for damages even though investors bring a lawsuit against auditors. Therefore, auditors are most interested in the possibility of material omission or misstatements in the financial statement and the major function of an audit is to detect any material error in the financial statement and report the error. Choi and Choi(2003) developed a model to select which firms should be reviewed by the Financial Supervisory Service(FSS). The explanatory variables included in their model are as follows；(1) dummy variable for net income in terms of sales, (2) cash flow from operation to current liabilities, (3) financial expense to total sales, (4) loans－related parties to total assets, (5) a portion of minority shareholders. These are variables which instigate a firm to distort financial statement. Therefore, the probability(Pr_FSCORE) produced by the model represents the magnitude of a firm's motives for accounting fraud. The stronger the motives for accounting fraud, the likelihood of material error in the financial statement being detected is higher, and other things being equal, it also leads to higher litigation risk. In this study, we regard the probability produced by Choi and Choi's model as litigation proxy and test the hypotheses that litigation risk motivates auditor to charge higher fees and to spend more time in their audit. According to prior researches, large auditors(e.g., Big 4 auditors) face higher litigation risk because they are perceived as having "deep pockets." Therefore, large auditors are expected to be more sensitive to litigation risk even though they are exposed at the same level of litigation risk as small auditors. Based upon the prior studies, we also analyze the relationship between auditor size and sensitivity to litigation risk. Our initial sample consisted of all manufacturing firms listed on the Korean Stock Exchange from 1999 to 2006. We excluded firm－years with missing data about audit hours and audit fees, resulting in the final sample of 1,997 firm－year observations. We collected data about audit hours and audit fees from annual reports manually. Our tests are based on cross－sectional regression of natural log of audit fees(audit hours) on a number of variables, including litigation risk. We include various control variables to minimize the possibility that the experimental variable proxy for some other effect. We also incorporate the interaction variable between BIG 4 and litigation risk as a experimental variable to test whether large auditors are more sensitive to litigation risk. Our results show that the auditors charge higher fees and spend more time in their audit for the firms with a higher litigation risk. However, we were not able to find out that large auditors are more sensitive to litigation risk than small auditors.

Keywords

• litigation risk
• the motives for accounting fraud
• audit hours
• audit fees

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