Headed for trial? Gies research suggests auditors should prepare for the worst

While some believe that an audit opinion is a guarantee – a 100% assurance – that financial statements are accurate, an audit is actually designed to provide reasonable assurance of accuracy. Audits are looking for big problems that could impact financial statements; they don’t necessarily catch every error. And that misconception can be a real liability for auditors, a concept studied in a new research paper coauthored by Gies professors Mark Peecher and Dan Zhou.

Even if an audit firm follows all the standards for a high-quality audit, they can be sued if their client believes the firm made a mistake. This can include errors, fraud, or miscommunication. And that can be a big financial risk for audit firms. In the paper, “How Trial Preparation Factors Influence Audit Litigation Outcomes: Insights from Audit Litigators,” Peecher, Zhou, and their coauthors Eldar Maksymov (Arizona State University) and Jeffrey Pickerd (University of Mississippi) suggest that auditors may underestimate how those audits are viewed through a legal lens and explore the different factors that affect trial outcomes.

“Even a squeaky-clean audit doesn't guarantee you're going to avoid litigation,” said Peecher (right), the Deloitte Professor of Accountancy and executive associate dean of faculty and research. “You can have an audit that's technically sound, but there are a number of other factors that can significantly impact the outcome of a case. These factors really come into focus during trial preparation, and it’s critical that auditors better understand them.”

In the study, which was published in The Accounting Review, the researchers interviewed 39 audit litigators with an average of 31 years of experience. The pool was composed of 25 attorneys, 12 trial consultants, and two expert witnesses. Peecher and his coauthors explore three related questions: what factors do audit litigators consider in preparing for trial? How do they expect these factors to affect litigation outcomes? And how and to what advantage do they attempt to leverage these factors?

“Our paper finds that audit litigators manage potential trial outcomes by maneuvering three main variables: trial venue, potential jurors’ characteristics, and the technical complexity/emotionality of case arguments,” said Zhou, an assistant professor of accountancy at Gies.

“We explored trial preparation factors through the lens of the Elaboration Likelihood Model (ELM), which essentially explains how people – in this case, judges and juries – are persuaded,” Peecher said. “High elaboration means thinking critically about the facts and the evidence, whereas low elaboration means going more with your feelings, emotions, and intuition.”

The first factor – the trial venue – can play a major role in how these cases are argued. Federal courts typically include a judge with a background in business law – a judge who has likely seen a lot of complex financial cases. Interview evidence suggests these judges are less likely to be swayed by emotional arguments. On the other hand, state courts typically present judges who are less familiar with the technicalities of auditing. They might resort to being more open to emotional appeals, which can sometimes tip the scales in the plaintiff's favor.

Next are the jurors themselves, and they’re considered through three lenses: sophistication, business orientation, and hometown bias. Jurors with high levels of education and business acumen are far more likely to understand the technicalities of the audit process and be less swayed by emotional arguments. Similarly, jurors with a strong hometown bias could be less objective and more likely to rule in favor of a hometown firm.

“This is key because plaintiff litigators are the ones who file in course, and they often choose the location,” said Peecher. “For example, they know local juries tend to view hometown firms – and the neighbors they employ – more favorably and could be less swayed by complicated accounting or audit arguments. Through the lens of ELM, we see that the plaintiff doesn’t want juries to get ‘into the weeds’ and compare what the auditor did to a specific audit principle or rule; plaintiffs want juries to process more emotively and process the auditing itself at a more shallow depth, using broad strokes.”

The third major factor is the arguments themselves. Attorneys for both plaintiffs and defendants are thinking very carefully about how their arguments are being perceived and whether those arguments are more technically complex or more emotional in nature. Auditing standards are inherently complex and full of technical language. Defense lawyers often face the challenge of explaining to a jury that auditors’ work adheres to the standards in a clear and comprehensible way, whereas the plaintiffs can leverage this complexity to their advantage by keeping things simple and focusing only on the big picture.

“While the attorney for a defendant is trying to explain technical concepts, an attorney for a plaintiff might say, ‘Look, this company lost millions of dollars. The auditor should have caught it,’” Peecher said. “It’s a nice, straightforward argument that plays to jurors’ prior misconceptions of what an audit does. And we find that plaintiff litigators prefer lower elaboration so that judges and jurors rely more on the nontechnical information.”

From the defendants’ side, it is imperative that litigators increase juror elaboration levels because jurors typically lack capacity and/or motivation to think critically and accurately about such technical information, and jurors generally – and incorrectly - exaggerate the scope of auditors’ responsibility.

“Although higher-quality audits can help avoid litigation by mitigating errors, strong audits won’t necessarily reduce the effects of some trial preparation factors,” Peecher said. “Jurors’ verdicts and damage awards often come from being persuaded by nontechnical (low elaboration) arguments. One way auditors can manage this is by thinking, ‘When I audit this company, in which location would we hold a trial if I were to be taken to court?’”

While these findings describe the factors that affect only trial outcomes, they’re especially relevant for cases that don’t go to trial.

“While most audit litigation ends in a settlement, attorneys base their settlement negotiations on the likelihood and uncertainty of securing a favorable verdict and on estimates of potential damages they may owe if the case proceeds to trial,” Zhou (left) said. “The findings from our paper could assist audit firms and litigators in developing more accurate verdict expectations to inform their settlement strategies.”  

“Given that auditors can’t be sure which cases will end up at trial in the future, it’s important that they proactively consider these factors with their audit clients,” Peecher said. “Are some potential audit clients going to be associated with venues or judges who are less business oriented and more prone to emotional persuasions? Do some clients’ books have particularly high complexity and would make a defense particularly vulnerable to a less sophisticated jury? Based on our findings, it is critical that auditors begin exploring ways to assess their risk factors before accepting a client into their audit portfolio and incorporate these factors into audit fee calculations, well before any case enters the court system. A client whose audit is likely to be litigated in federal court among a business-savvy set of jurors poses less risk than one likely to be litigated in state court among jurors unfamiliar with business and who have a home-town bias that makes them defend auditee management but throw the auditor under the bus.”