Articlegreen2016

Fraud Risk Awareness and the Likelihood of Audit Enforcement Action

Jared Eutsler · Erin Burrell Nickell · Sean W. G. Robb

29 citations0/0 files storedAccounting Horizons

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Auditing, Earnings Management, Governance Accounting and Financial Management Corporate Governance and Financial Management

Abstract

SYNOPSIS Prior research indicates that issuing a going concern opinion to financially stressed clients generally reduces the risk of litigation against the auditor following a bankruptcy (Kaplan and Williams 2013; Carcello and Palmrose 1994). However, we propose that a going concern report may indicate prior knowledge of financial distress, an important fraud risk factor, and this may have repercussions for the auditor if a fraud is subsequently uncovered. Consistent with counterfactual reasoning theory, experimental research suggests that a documented awareness of fraud risk actually increases the likelihood of litigation against the auditor following a fraud (Reffett 2010). This concern has been echoed by the professional community (AICPA 2004; Golden, Skalak, and Clayton 2006) and may be exacerbated by the current outcome-based regulatory environment (Peecher, Solomon, and Trotman 2013). To examine this issue we review Auditing and Accounting Enforcement Releases (AAERs) issued by the Securities and Exchange Commission (SEC) for alleged financial reporting frauds between 1995 and 2012. Results suggest that going concern report modifications accompanying the last set of fraudulently stated financials are associated with a greater likelihood of enforcement action against the auditor. This finding is consistent with counterfactual reasoning theory and suggests that, from a regulatory perspective, auditors may be penalized for documenting their awareness of fraud risk when financial statements are later determined to be fraudulent.

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References

1968FINANCIAL RATIOS, DISCRIMINANT ANALYSIS AND THE PREDICTION OF CORPORATE BANKRUPTCY 2010New Evidence on Measuring Financial Constraints: Moving Beyond the KZ Index 1973The processes of causal attribution.1967Attribution theory in social psychology 1998The Effect of Audit Quality on Earnings Management*1980The Pricing of Audit Services: Theory and Evidence 2011Predicting Material Accounting Misstatements*1999The Role of Big 6 Auditors in the Credible Reporting of Accruals

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