Audit firms’ risk of being sued has historically been an important factor driving audit quality and firm valuation in U.S. capital markets. Investors have traditionally targeted auditors in class action suits as “deep pockets” with a greater ability to pay damages than the firms they have audited. Thus, the risk of litigation, and paying high damages, has provided a strong incentive for auditors to perform careful audit work and not take on excessively risky clients.

It is difficult to study the direct effects of changes in auditor litigation risk on audit firm behavior because, generally, changes to litigation risk are often entangled with changes in auditor reputation. The auditor reputation effect posits that auditors strive to provide high-quality audits to protect their reputation, which can be damaged by an audit failure, thereby reducing the demand for audit services. Thus, an audit failure, which may lead to litigation, also damages auditor reputation, and therefore the effects of that change in litigation risk may be driven by the damage to auditor reputation.

A 2008 U.S. Supreme Court case, StoneRidge Investment Partners v. Scientific Atlanta, provides a unique opportunity to study the effects of changes in auditor litigation risk separate from changes in auditor reputation.StoneRidge holds that secondary actors, such as accountants and investment banks, cannot be held liable under Section 10(b) of the Securities Exchange Act of 1934 unless their conduct satisfies all six elements specified in the decision. Therefore, many legal experts believe StoneRidge decreased the ability of investors to seek damages from auditors in class action lawsuits. Auditor litigation risk therefore likely decreased substantially after the StoneRidge ruling, with no corresponding change to auditor reputation.

In a recent article, we find that investors perceived auditor litigation risk as decreasing after StoneRidge for Big Four auditors and other industry leading auditors. This is consistent with investors’ (1) placing a premium on their ability to extract damages from such auditors through class action suits, and (2) perceiving this ability to extract damages as decreasing after StoneRidge. We next find that these results are strongest for audit firms with clients that already had high litigation risk, received going-concern opinions, or had little excess cash. These findings are consistent with investors placing an especially high value on their ability to extract damages from auditors with deep pockets when the client firms are especially risky or have little ability to pay damages.

Next, we examine how audit firms react to this decrease in litigation risk. We find that Big Four auditors are more likely to accept new high-litigation-risk clients and less likely to drop high-litigation-risk clients, after StoneRidge. These results are consistent with an increase in Big Four auditors’ risk tolerance. We also find that audit fees are lower for high-litigation-risk clients after StoneRidge. As there is generally a fee premium charged to risky clients, this decrease is consistent with a decrease in auditor litigation risk and an increase in auditor risk tolerance following StoneRidge. Finally, we find that auditors issue fewer going-concern opinions for high-litigation-risk clients following Stoneridge, consistent with lower audit quality for risky clients.

Overall, our results are consistent with auditor litigation risk decreasing as a result of StoneRidge, especially for Big Four auditors and other leading auditors with clients that have higher litigation risk and less ability to pay damages. We find that auditors respond to this change in litigation risk by taking on riskier clients and becoming less likely to drop risky clients, charging lower fees to risky clients, and lowering the quality of their audit work for risky clients. These results should be of interest to policy makers in determining the importance of litigation risk as a mechanism for protecting investors. While StoneRidge decreased the use of class action litigation against auditors in the United States, more foreign countries are permitting class action suits against auditors as a way to enhance shareholder protection. Both the incidence and amount of auditor penalties in class action lawsuits outside the U.S. have increased substantially in recent years. Our study offers new insights on how decreasing auditor litigation risk affects investors’ perceptions of value as well as auditor selection of clients and fees and audit quality.

This post comes to us from Anna Bergman Brown at Clarkson University’s David D. Reh School of Business, Nicole M. Heron at Suffolk University’s Sawyer Business School, Hagit Levy at Baruch College’s Zicklin School of Business, and Emanuel Zur at the University of Maryland’s Smith School of Business. It is based on their recent article, “StoneRidge Investment Partners v. Scientific Atlanta: A Test of Auditor Litigation Risk,” available here.