Skip to main content
SpringerLink
Log in

Real effects of auditor conservatism

  • Published:
Review of Accounting Studies Aims and scope Submit manuscript

Abstract

We examine the effect of auditor conservatism on corporate innovation. We hypothesize that, because conservative auditors constrain income-increasing accounting discretion, managers may sacrifice long-term investments in innovation to boost current earnings and meet short-term performance targets. Exploiting state-level auditor legal liability shocks as a means of identification, we find evidence consistent with this hypothesis. Cross-sectional analyses reveal that the negative effect of increased auditor conservatism on corporate innovation is more pronounced when the client firms are under greater equity- and debt-market pressures, when the client firms are exposed to greater litigation risk, and when the client firms are audited by large auditors. Our study highlights how auditors, as external monitors, can affect not only the financial reporting quality of their clients but may also induce alterations in their real operations.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Fig. 1

Similar content being viewed by others

Notes

  1. Kausar et al. (2016) find that clients’ voluntary choice to engage an auditor acts as a signaling device that alleviates adverse selection problem. Specifically, firms obtaining voluntary audit increase their debt, investment, and operating performance and become more responsive to their investment opportunities. Bae et al. (2017) find that auditor knowledge and resources aid clients in enhancing investment efficiency. Cai et al. (2016) show that common auditors between merging firms facilitate the flow of information throughout the acquisition process, thereby enhancing the efficiency of merger and acquisition (M&A) outcomes. Their findings are also corroborated by Dhaliwal et al. (2016), who find that shared auditors lead to a greater likelihood of M&A transactions and lower deal premiums.

  2. In our setting, the changes in auditor conservatism are induced by regulatory changes, rather than chosen by the client firm. For example, switching to another less conservative auditor, an endogenous response by the client to auditor conservatism, may not be easy in our setting, because the new auditor may still be subject to increased legal liability for ordinary negligence.

  3. “The rights and liabilities of the parties with respect to an issue in tort are determined by the local law of the state which, with respect to that issue, has the most significant relationship to the occurrence and the parties.”- Section 145 of the Restatement (Second) Conflict of Laws.

  4. Studies mostly use NBER patent and citation data (Hall and Jaffe 2001). Kogan et al. (2017) correct and improve upon the existing NBER dataset.

  5. In our sample period, 356 firms change their state of headquarters, but no firm changes the state of incorporation.

  6. Our inferences are unaffected if we do not apply this sample filer.

  7. States of headquarters reported in Compustat may be misstated because Standard and Poor’s backfills firms’ previous headquarters locations with the most recent business addresses. To mitigate this problem, we use the states of business location listed in firms’ 10-K filings with the SEC’s EDGAR. Because the SEC did not require electronic filings of 10-K until May 1996, we backfill firm-headquarters states from the first instance of business-location appearance in 10-K filings.

  8. Auditor engagement office/location data are not available before 1999. Anantharaman et al. (2016) suggest that, besides client state of headquarters/incorporation, auditors could be subject to legal liability in the state of the auditor engagement office when the auditor engagement office is located in a different state than client headquarters state. For the sample of firms that have client headquarters in a different state than auditor engagement office state, if the client engagement office has higher liability than client state of location, then our coding may potentially underestimate the treatment effect as some treatment firms will be coded as control firms.

  9. Note that consistent with the innovation literature (He and Tian 2013; Atanassov 2013), we count patents and citations in the year of application, not in the year when such application is granted. To illustrate, suppose a firm files for a patent in 1990 but the application is granted in 1993. In our coding of patent, we code the innovation to have occured in 1990, not in 1993. All subsequent citations accruing to this patent are likewise counted in 1990.

  10. We include both HHI and HHIsquared as control variables because Aghion et al. (2005) show that industry competition has a nonlinear effect on firm innovation.

  11. One could argue that Poisson or Negative Binomial estimation methods should be used, instead of OLS, given the count nature of patent/citations. Similarly, for binary outcome variables (such as issuance of a going-concern opinion), Logit/Probit regression could also be employed. However, inclusion of a large number of fixed effects in Logit/Probit/Poisson/Negative Binomial models may result in inconsistent estimates due to the incidental-parameter problem (Lancaster 2000). Inferences are unaffected if these methods are used.

  12. Inferences remain unaffected if we apply different clustering choices. See Section 5.5 for sensitivity analyses on alternative clustering choices.

  13. Compustat provides data on auditor opinions only from 1988, so our tests relating to ModGC use the sample period from 1988 to 1998. Furthermore, Compustat codes auditor opinions in a range between 1 and 5, where 1 is unqualified opinion. Anantharaman et al. (2016) use Compustat variable auop = 4 as indicating going-concern opinions. We follow their procedure.

  14. We collect all Chapter 7 and Chapter 11 filings from Chava and Jarrow (2004) and Chava et al. (2011).

  15. Because we do not have within-firm variations in auditor-liability shocks in this period, we replace firm fixed effects with industry (SIC three-digit) fixed effects.

  16. For the audit-fee test, we only have cross-sectional variations in More_Aud_Liab in the 1999–2017 sample period, making the test less powerful. Further, an increase in audit fees involves bargaining between the auditor and the client firm in which the client firm must agree to increased fees (DeFond and Zhang 2014). When faced with a conservative auditor who is more likely to issue modified going-concern opinions or constrain accrual discretion, the client may be reluctant to pay higher audit fees.

  17. We cannot estimate the effect of More_Aud_Liab on restatements in the treatment state only sample in Table 5 (and the evolution of treatment effect in Table 6), because the restatement test is based on a recent sample period with no time-series variations in More_Aud_liab.

  18. For a clean test, we drop firms in California (New Jersey) after 1992 (1995), when California (New Jersey) decreased auditor legal liability.

  19. The number of observations in these cross-sectional analyses varies due to data limitation.

  20. We use the DealScan database to construct High_Debt_Pressure. We use bank loans to measure debt market pressure, because debt covenants in bank loans are more intensely monitored than corporate bonds. Further, almost all bank loans contain covenants whereas bond issues may come without covenants (Christensen and Nikolaev 2012; Nikolaev 2010).

  21. BigN takes 1 if a firm is audited by one of the large auditors and zero otherwise. Arthur Andersen, Arthur Young and Co., Coopers and Lybrand, Ernst and Whinney, Deloitte Haskins and Sells, Peat Marwick Mitchell/KPMG, Price Waterhouse, Touche Ross (and later the resulting mergers) constitute the Big-N firms in the sample. All other audit firms are Non-BigN.

  22. In untabulated analyses, we also confirm that auditors become less conservative following a decrease in auditor legal liability. Further, we conduct the parallel-trend test with Less_Aud_Liab (t = −2) and Less_Aud_Liab (t = −1), which equal one if the firm is located or incorporated in a state that will decrease auditor legal liability in two years or one year, respectively, and zero otherwise. The estimated coefficients for these variables are statistically indistinguishable from zero, suggesting that the parallel-trends assumption is satisfied. Finally, the evolution of treatment effect for the negative-shock sample are generally consistent with the results in Table 6.

  23. We drop Hawaii from the sample because it does not have any contiguous neighbors.

  24. In untabulated analyses, we also consider other windows such as four or eight years. Inferences remain unaffected.

  25. However, it would be too strong to interpret the absence of significant results in these tests as evidence that changes in auditor conservatism or auditor legal liability do not affect client’s decision to switch to a less conservative auditor. The reason is that our empirical setting is not particularly well suited for examining the effect of auditor liability changes on auditor turnover, because the new auditor could still be subject to the same legal liability, even if the new auditor operates from an engagement office in a different state.

  26. In this sensitivity analysis, the coefficient estimates are smaller than the main results. This could be due to two reasons. First, we lose nearly 55% of the observations, leading to loss of power. Second, although Delaware does not receive treatment, firms incorporated in Delaware are often located in other states. As such, when we drop Delaware firms, many treated firms also drop out if they are located in a treatment state. Despite the loss of observations and power, it is reassuring to see that our inferences are not sensitive to dropping Delaware-incorporated firms.

  27. We limit the sample to 2005 because the patent and citations data in Kogan et al. (2017) end in 2010. We require five years of data after 2005 because it may take several years for patents to accumulate citations.

  28. The auditor engagement office is usually located in the client business location state. For example, the Audit Analytics database shows that 79% of firms incorporated and located in the United States have their auditor engagement offices in the same state as their headquarters during the period 1999–2017.

  29. Rhode Island was the first state to expand auditor’s legal liability formally in 1968 (Rusch Factors, Inc. v. Levin, 284 F. Supp. 85, D.R.I. 1968). We do not use this precedent, because Compustat data on R&D expenditures are not available for the sample of firms used in the paper before 1970.

  30. United States v. Arthur Young and Co., 465 U.S. 805, 104 S. Ct. 1495, 79 L. Ed. 2d 826 (1984).

References

  • Acharya, V., Baghai, R., & Subramaniam, K. (2013). Wrongful discharge Laws and Innovation. Review of Financial Studies, 27(1), 301–346.

    Article  Google Scholar 

  • Aghion, P., Bloom, N., Blundell, R., Griffith, R., & Howitt, P. (2005). Competition and innovation: An inverted-U relationship. Quarterly Journal of Economics, 120(2), 701–728.

    Google Scholar 

  • Aghion, P., Van Reenen, J., & Zingales, L. (2013). Innovation and institutional ownership. American Economic Review, 103(1), 277–304.

    Article  Google Scholar 

  • Anantharaman, D., Pittman, J. A., & Wans, N. (2016). State liability regimes within the United States and auditor reporting. The Accounting Review, 91(6), 1545–1575.

    Article  Google Scholar 

  • Aobdia, D. (2019). Do practitioner assessments agree with academic proxies for audit quality? Evidence from PCAOB and internal inspections. Journal of Accounting and Economics, 67(1), 144–174.

    Article  Google Scholar 

  • Atanassov, J. (2013). Do hostile takeovers stifle innovation? Evidence from antitakeover legislation and corporate patenting. The Journal of Finance, 68(3), 1097–1131.

    Article  Google Scholar 

  • Baber, W., Fairfield, P., & Haggard, J. (1991). The effect of concern about reported income on discretionary spending decisions: The case of Research and Development. The Accounting Review, 66(4), 818–829.

    Google Scholar 

  • Bae, G. S., Choi, S. U., Dhaliwal, D., & Lamoreaux, P. (2017). Auditors and client investment efficiency. The Accounting Review, 92(2), 19–40.

    Article  Google Scholar 

  • Baker, C. R., & Prentice, D. (2008). The origins of auditor liability to third parties under United States common law. Accounting History, 13(2), 163–182.

    Article  Google Scholar 

  • Bertrand, M., & Mullainathan, S. (2003). Enjoying the quiet life? Corporate governance and managerial preferences. Journal of Political Economy, 111(5), 1043–1075.

    Article  Google Scholar 

  • Bhojraj, S., Hribar, P., Picconi, M., & Mcinnis, J. (2009). Making sense of cents : An examination of firms that marginally miss or beat analyst forecasts. Journal of Finance, 64(5), 2361–2388.

    Article  Google Scholar 

  • Bradley, D., Kim, I., & Tian, X. (2017). Do unions affect innovation? Management Science, 63(7), 2251–2271.

    Article  Google Scholar 

  • Brav, A., Jiang, W., Ma, S., & Tian, X. (2018). How does hedge fund activism reshape corporate innovation. Journal of Financial Economics, 130, 237–264.

    Article  Google Scholar 

  • Burgstahler, D., & Dichev, I. (1997). Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics, 24, 99–126.

    Article  Google Scholar 

  • Burnett, B., Cripe, B., Martin, G., & McAllister, B. (2012). Audit quality and the trade-off between accretive stock repurchases and accrual-based earnings management. The Accounting Review, 87(6), 1861–1884.

    Article  Google Scholar 

  • Bushee, B. (1998). The influence of institutional investors on Myopic R&D Investment Behavior. The Accounting Review, 73(3), 305–333.

    Google Scholar 

  • Bushee, B. (2001). Do institutional investors prefer near-term earnings over long-run value? Contemporary Accounting Research, 18(2), 207–246.

    Article  Google Scholar 

  • Cahan, S., & Zhang, W. (2006). After Enron: Auditor conservatism and ex-Andersen clients. The Accounting Review, 81(1), 49–82.

    Article  Google Scholar 

  • Cai, Y., Kim, Y., Park, J. C., & White, H. D. (2016). Common auditors in M&a Transactions. Journal of Accounting and Economics, 61(1), 77–99.

    Article  Google Scholar 

  • Chang, X., Hilary, G., Kang, J.-k. & Zhang, W.. (2015). Innovation, managerial myopia, and financial reporting. Working paper.

  • Chava, S., & Jarrow, R. (2004). Bankruptcy prediction with industry effects. Review of Finance, 8(4), 537–569.

    Article  Google Scholar 

  • Chava, S., & Roberts, M. (2008). How does financing impact investment? The role of debt covenants. Journal of Finance, 63(5), 2085–2121.

    Article  Google Scholar 

  • Chava, S., Stefanescu, C., & Turnbull, S. (2011). Modeling the loss distribution. Management Science, 57(7), 1267–1287.

    Article  Google Scholar 

  • Che, L., Hope, O.-K., & Langli, J. C. (2020). How Big-4 firms improve audit quality. Management Science, 66(10), 4552–4572.

    Article  Google Scholar 

  • Christensen, H., & Nikolaev, V. (2012). Capital versus performance covenants in debt contracts. Journal of Accounting Research, 50(1), 75–116.

    Article  Google Scholar 

  • Chy, M., De Franco, G. & Su, B. (2020). The effect of auditor litigation risk on client access to Bank debt: Evidence from quasi-experiments. Working paper.

  • Cohen, D., & Zarowin, P. (2010). Accrual-based and real earnings management activities around seasoned equity offerings. Journal of Accounting and Economics, 50(1), 2–19.

    Article  Google Scholar 

  • Cohen, D., Dey, A., & Lys, T. (2008). Real and accrual-based earnings Management in the pre- and Post-Sarbanes-Oxley Period. The Accounting Review, 83(3), 757–787.

    Article  Google Scholar 

  • DeFond, M., & Francis, J. (2005). Audit research after Sarbanes-Oxley. Auditing: A Journal of Practice & Theory, 24(supplement), 31–40.

    Article  Google Scholar 

  • DeFond, M., & Jiambalvo, J. (1994). Debt covenant violation and manipulation of accruals. Journal of Accounting and Economics, 17(1–2), 145–176.

    Article  Google Scholar 

  • DeFond, M., & Subramanyam, K. R. (1998). Auditor changes and discretionary accruals. Journal of Accounting and Economics, 25(1), 35–67.

    Article  Google Scholar 

  • DeFond, M., & Zhang, J. (2014). A review of archival auditing research. Journal of Accounting and Economics, 58(2–3), 1–159.

    Google Scholar 

  • DeFond, M., Lim, C., & Zang, Y. (2016). Client conservatism and auditor-client contracting. The Accounting Review, 91(1), 69–98.

    Article  Google Scholar 

  • Degeorge, F., Patel, J., & Zeckhauser, R. (1999). Earnings management to exceed thresholds. The Journal of Business, 72(1), 1–33.

    Article  Google Scholar 

  • Dhaliwal, D., Lamoreaux, P., Litov, L., & Neyland, J. (2016). Shared auditors in mergers and acquisitions. Journal of Accounting and Economics, 61(1), 49–76.

    Article  Google Scholar 

  • Dou, Y., Khan, M., & Zou, Y. (2016). Labor unemployment insurance and earnings management. Journal of Accounting and Economics, 61(1), 166–184.

    Article  Google Scholar 

  • Dube, A., William Lester, T., & Reich, M. (2010). Minimum wage effects across state Borders: Estimates using contiguous counties. Review of Economics and Statistics, 92(4), 945–964.

    Article  Google Scholar 

  • Dulle, J, R. (1987). The last step in the expansion of accountant liability. Missouri Law Review 52 (3).

  • Ewert, R., & Wagenhofer, A. (2005). Economic effects of tightening accounting standards to restrict earnings management. The Accounting Review, 80(4), 1101–1124.

    Article  Google Scholar 

  • Faleye, O., Hoitash, R., & Hoitash, U. (2011). The costs of intense board monitoring. Journal of Financial Economics, 101(1), 160–181.

    Article  Google Scholar 

  • Ferreira, D., Manso, G., & Silva, A. (2014). Incentives to innovate and the decision to go public or private. Review of Financial Studies, 27(1), 256–300.

    Article  Google Scholar 

  • Francis, J. R., & Krishnan, J. (1999). Accounting accruals and auditor reporting conservatism. Contemporary Accounting Research, 16(1), 135–165.

    Article  Google Scholar 

  • Gaver, J., Paterson, J., & Pacini, C. (2012). The influence of auditor state-level legal liability on conservative financial reporting in the property-casualty insurance industry. Auditing: A Journal of Practice & Theory, 31(3), 95–124.

    Article  Google Scholar 

  • Gigler, F., Kanodia, C., Sapra, H., & Venugopalan, R. (2014). How frequent financial reporting can cause managerial short-termism : An analysis of the costs and benefits of increasing reporting frequency. Journal of Accounting Research, 52(2), 357–387.

    Article  Google Scholar 

  • Graham, J., Harvey, C., & Rajgopal, S. (2005). The economic implications of corporate financial reporting. Journal of Accounting and Economics, 40(1–3), 3–73.

    Article  Google Scholar 

  • Hall, B. & Jaffe, A.. (2001). The NBER patent citations data file: Lessons, insights and methodological tools. NBER Working Paper Series 8498.

  • He, J., & Tian, X. (2013). The Dark Side of Analyst Coverage: The Case of Innovation. Journal of Financial Economics, 109(3), 856–878.

    Article  Google Scholar 

  • He, J., & Tian, X. (2018). Finance and corporate innovation: A survey. Asia-Pacific Journal of Financial Studies, 47(2), 165–212.

    Article  Google Scholar 

  • Huang, R. R. (2008). Evaluating the real effect of Bank branching deregulation: Comparing contiguous counties across US state Borders. Journal of Financial Economics, 87(3), 678–705.

    Article  Google Scholar 

  • Kaplan, S., & Williams, D. (2013). Do going concern audit reports protect auditors from litigation? A simultaneous equations approach. The Accounting Review, 88(1), 199–232.

    Article  Google Scholar 

  • Kausar, A., Shroff, N., & White, H. (2016). Real effects of the audit choice. Journal of Accounting and Economics, 62, 157–181.

    Article  Google Scholar 

  • Kim, I., & Skinner, D. J. (2012). Measuring securities litigation risk. Journal of Accounting and Economics, 53(1–2), 290–310.

    Article  Google Scholar 

  • Kim, J.-B., Chung, R., & Firth, M. (2003). Auditor conservatism, asymmetric monitoring, and earnings management. Contemporary Accounting Research, 20(2), 323–359.

    Article  Google Scholar 

  • Klasa, S., Ortiz-Molina, H., Serfling, M., & Srinivasan, S. (2018). Protection of trade secrets and capital structure decisions. Journal of Financial Economics, 128(2), 266–286.

    Article  Google Scholar 

  • Kogan, L., Papanikolaou, D., Seru, A., & Stoffman, N. (2017). Technological innovation, resource allocation, and growth. Quarterly Journal of Economics, 132(2), 665–712.

    Article  Google Scholar 

  • Koh, P. S., & Reeb, D. (2015). Missing R&D. Journal of Accounting and Economics, 60, 73–94.

    Article  Google Scholar 

  • Lancaster, T. (2000). The incidental parameter problem since 1948. Journal of Econometrics, 16(1), 391–413.

    Article  Google Scholar 

  • Lennox, C., & Kausar, A. (2017). Estimation risk and auditor conservatism. Review of Accounting Studies, 22, 185–216.

    Article  Google Scholar 

  • Levitt, A. & Nicolaisen, D.. (2008). Final report of the advisory committee on the auditing profession to the U.S. Department of the Treasury.

  • Li, X., Moshirian, F., Tian, X. & Zhang, B.. (2016). The real effect of financial disclosure: International evidence. Working paper.

  • Lobo, G. J., Xie, Y., & Zhang, J. H. (2018). Innovation, financial reporting quality, and audit quality. Review of Quantitative Finance and Accounting, 51(3), 719–749.

    Article  Google Scholar 

  • Lu, T., & Sapra, H. (2009). Auditor conservatism and investment efficiency. The Accounting Review, 84(6), 1933–1958.

    Article  Google Scholar 

  • Lys, T., & Watts, R. (1994). Lawsuits against auditors. Journal of Accounting Research, 32(1994), 65–93.

    Article  Google Scholar 

  • MacKey, T.. (1993). Note: Accountants’ liability after Bily v. Arthur Young & Co.: A More Equitable Proposal for Third Party Recovery. Hastings Law Journal November.

  • Mackinnon, J., & Webb, M. (2017). Wild bootstrap inference for wildly different cluster sizes. Journal of Applied Econometrics, 32(2), 233–254.

    Article  Google Scholar 

  • Manso, G. (2011). Motivating innovation. Journal of Finance, 66(5), 1823–1860.

    Article  Google Scholar 

  • Narayanan, M. P. (1985). Managerial incentives for short-term results. Journal of Finance, 40(5), 1469–1484.

    Article  Google Scholar 

  • Nikolaev, V. (2010). Debt covenants and accounting conservatism. Journal of Accounting Research, 48(1), 51–80.

    Article  Google Scholar 

  • Park, K. E. (2018). Financial reporting quality and corporate innovation. Journal of Business Finance & Accounting, 45(7–8), 871–894.

    Article  Google Scholar 

  • Petersen, M. (2009). Estimating standard errors in finance panel data sets: Comparing approaches. Review of Financial Studies, 22(1), 435–480.

    Article  Google Scholar 

  • Scherl, J. (1994). Evolution of auditor liability to noncontractual third parties: Balancing the equities and weighing the consequences. The American University Law Review, 44, 256–289.

    Google Scholar 

  • St. Pierre, K., & Anderson, J. A. (1984). An analysis of the factors associated with of lawsuits against public accountants. The Accounting Review, 59(2), 242–263.

    Google Scholar 

  • Stein, J. (1988). Takeover threats and managerial myopia. Journal of Political Economy, 96(1), 61–80.

    Article  Google Scholar 

  • Stein, J. (1989). Efficient capital markets, inefficient firms: A model of myopic corporate behavior. The Quarterly Journal of Economics, 104(4), 655–669.

    Article  Google Scholar 

  • Stein, J.. (2003). Agency, information and corporate investment. Handbook of the economics of finance. Vol. 1. Elsevier science B.V.

  • Tan, L. (2013). Creditor control rights, state of nature verification, and financial reporting conservatism. Journal of Accounting and Economics, 55(1), 1–22.

    Article  Google Scholar 

  • The Harvard Law Review Association. (1958). Absence of Privity Does Not Bar Recovery by Legatee for Negligent Preparation of Will. Biakanja v. Irving (Cal . 1958). Harvard Law Review, 72(2), 380–382.

    Article  Google Scholar 

  • Tian, X., & Wang, T. (2014). Tolerance for failure and corporate innovation. Review of Financial Studies, 27(1), 211–255.

    Article  Google Scholar 

  • Vick, S. (1993). Bily v. Arthur Young & co.: Is limiting auditor liability to third parties favoritism or fair play? Loyola of Los Angeles Law Review, 26, 1335–1373.

    Google Scholar 

  • Wang, S. & D’Souza, J.. (2006). Earnings management: The effect of accounting flexibility on R&D investment choices. Cornell University Johnson School Research Paper 33–06.

  • Wiener, H. (1983). Common law liability of the certified public accountant for negligent misrepresentation. San Diego Law Review, 20(2), 233–263.

    Google Scholar 

  • Zang, A. (2012). Evidence on the trade-off between real activities manipulation and accrual-based earnings management. The Accounting Review, 87(2), 675–703.

    Article  Google Scholar 

Download references

Acknowledgements

We have received useful comments from Muhammad Azim, Stephanie Cheng, Gus De Franco, Pedro Gomez (discussant), Danqi Hu, Wei Shi (discussant), Dushyantkumar Vyas, Aida Wahid, Jingjing Wang, Paul Zarowin (discussant), Mingyue Zhang, Ping Zhang, Wuyang Zhao, Qinlin Zhong, and seminar participants at the Rotman School of Management, the 2017 Scandinavian Accounting Research Conference (Oslo), the 2017 AAA annual meeting, and the 2017 Conference on Financial Economics and Accounting. An earlier version of this paper was titled “Does High Auditor Litigation Risk Discourage Corporate Innovation?” Hope gratefully acknowledges the financial support of the Deloitte Professorship.

Author information

Authors and Affiliations

  1. Robert J. Trulaske, Sr. College of Business, University of Missouri, Columbia, USA

    Mahfuz Chy

  2. Rotman School of Management, University of Toronto, Toronto, Canada

    Ole-Kristian Hope

  3. BI Norwegian Business School, Oslo, Norway

    Ole-Kristian Hope

Authors
  1. Mahfuz Chy
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Ole-Kristian Hope
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Mahfuz Chy.

Additional information

Publisher’s note

Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.

Appendices

Appendix 1 Institutional Background on State-Level Auditor Liability

In the early 20th century, development in legal thoughts and a new understanding of social justice contributed to an expansion of legal liability of entities, such as railroads and factories, for injuries born out of negligence. For example, courts increasingly began to accept arguments that recognized damages for economic loss rather than mere physical loss (Baker and Prentice 2008).

Further, the rapid transformation of the United States from an agricultural to an industrial economy in the early and mid-20th century required entrepreneurs to raise external financing from stock exchanges. Because external financing is fraught with inherent perceptions of risk and asymmetric distribution of information, professional accounting began to evolve to provide “certifications” as to the reliability of the information in financial statements generated by businesses that wanted to raise capital from external investors (Baker and Prentice 2008). A problem with this arrangement was that, while investors and creditors increasingly relied on auditors for the soundness of company-furnished financial information, they lacked privity with the auditor. As such, their only legal resort against auditors’ negligence of duty was litigation for fraud under federal securities law, which required the proof of intent to deceive. Subsequently, Judge Cardozo in Ultramares Corp. v. Touché ruled that auditors should be held liable for negligence to their clients and any third party specifically identified as a user of the report. Judge Cardozo’s decision came at a time of fast development of legal thought on tort theories that entertained prevailing ideas of social justice, rather than strict adherence to the textual understanding of precedents (Baker and Prentice 2008). The precedent set by Judge Cardozo in Ultramares Corp. v. Touché remained the norm for most courts until the 1960s (MacKey 1993). However, Judge Cardozo’s decision to enhance auditor legal liability beyond strict privity to a limited number of users of the report set the stage for subsequent expansion of auditor liability.

In a landmark verdict in 1958, (Biakanja v. Irving, 49 Cal. 2d 647, 320 P.2d 16, 320 P. 16 (1958)), the California Supreme Court expanded the liability of professional notary publics to include parties not just in privity but those affected by the notary public’s certification (The Harvard Law Review Association 1958). While Biakanja v. Irving specifically applied to the notaries public, the verdict’s principle was more generally applicable for determining whether the defendant owed a duty to the plaintiff (Wiener 1983). As a result, Biakanja v. Irving was a defining moment in the expansion of legal liability for professionals in California and signaled a new regime of legal liability for auditors. Importantly, the debate on auditors’ duty of care increasingly recognized the public role that accountants’ certification of businesses’ financial information plays (Baker and Prentice 2008). This recognition partly resulted from the expanding size of the professional accounting firms, the growth of large investment funds, and the development of legal thoughts on tort liability.

Owing to these developments, many state courts moved to an expansive regime of auditor legal liability beginning in the early 1970s.Footnote 29 In 1983, the New Jersey Supreme Court rejected both the privity and the restatement approaches, ruling that auditors could be held liable for ordinary negligence to any “reasonably foreseen” party as recipients of the statements for routine business purposes. In the same year (1983), the Wisconsin Supreme Court also favored the foreseeability approach. Continuing this trend, the U.S. Supreme court expanded auditor legal liability by supporting a foreseeability approach.Footnote 30 In 1992, in a dramatic shift of auditors’ litigation-risk exposure, the California Supreme Court reversed a decision by the Court of Appeals and limited auditors’ liability by favoring the restatement approach, thereby reducing the auditors’ expected litigation costs and litigation risks significantly. In 1995, the New Jersey legislature passed the Accountant Liability Act, which limited the auditors’ liability as per the restatement approach. Judicial decisions on auditor liability to third parties under common law often attempt to balance auditors’ public role as certifiers of businesses’ financial information and the indefinite liability that auditors could be subject to under an expansive liability regime.

To understand our identification strategy, two points are worth mentioning. First, auditors face legal liability under both federal securities law and common law. However, federal law covers only fraud or gross negligence, whereas ordinary negligence falls under common law liability governed by state courts. Second, the identification in our study depends on the concept of stare decisis or legal precedent. It refers to the policy of courts in common law to adhere to principles established by decisions in earlier cases. Under this principle, a precedent set by other courts can be either binding or persuasive. In general, decisions of a court will be a mandatory authority for any court lower in the hierarchy. Thus California Supreme Court decisions are binding for all California Court of Appeals (intermediate court) and Trial Courts (lower court), when a matter pertains to a case previously decided by the California Supreme Court. Similarly, intermediate court decisions are binding upon all trial courts.

Appendix 2

Table 9 Auditor Legal Liability Shocks (* Indicates Negative Shock)
Full size table

Appendix 3

Table 10 Variable Definitions
Full size table

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Chy, M., Hope, OK. Real effects of auditor conservatism. Rev Account Stud 26, 730–771 (2021). https://doi.org/10.1007/s11142-020-09568-3

Download citation

  • Accepted:

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s11142-020-09568-3

Keywords

Search

Navigation