The effect of earnings management on auditor litigatio

Litigation against auditors is a major concern for the accounting profession. Many lawsuits against auditors allege that the audit failed to uncover impending financial difficulties. Indeed, many believe that one of the principal roles of financial statements is to provide early warning of financial difficulties. Thus, steps taken to mitigate early warning of financial difficulties should increase the risk of litigation to the client and to the auditor. Research has shown that one way to delay the revelation of financial difficulties is through earnings management. Therefore, this study addresses the issue of whether evidence of earnings management by the client increases the risk of litigation to the auditor.;This study empirically examines the relation between auditor litigation and earnings management, specifically earnings management through the estimation and application of discretionary accruals. The study employs a sample of 50 client firms where their auditor has been named in a lawsuit and 50 control firms. The sample covers a period from 1969 to 1994 and is analyzed using a logit regression model. Discretionary accruals are estimated using the Modified Jones Model. The results indicate that evidence of earnings management through income-increasing discretionary accruals increases the auditor's risk of litigation. In addition, the risk of litigation increases when the client firm is larger and in weaker financial condition. Results also show that nondiscretionary accruals are not related to auditor litigation.;This study provides evidence of a relation between earnings management and auditor litigation using an explicit measure of earnings management, i.e., discretionary accruals. The results indicate that the managed portion (discretionary accruals) of total accruals but not the unmanaged portion (nondiscretionary accruals) is associated with auditor litigation. Furthermore, the evidence suggests that stakeholders view the financial statements as a source of early warning about impending financial difficulty and that they hold the auditor responsible when that warning is mitigated through earnings management.