Auditor Litigation : Deterrence Implications for Non-sued Auditors

Litigation poses a significant business risk for auditors. We argue that litigation events involving other auditors' deter audit firms from providing low quality audits. We find a significant subsequent decrease in the misstatement frequency of financial reports in within-industry audits conducted by auditors who did not face litigation. This industry-based across-auditor effect is further supported (a) by an increase in audit fees; (b) an increase in auditor going concern opinions; and (c) is robust to a battery of controls including the use of a difference-in-difference approach. By showing that auditor litigation leads to lower, rather than higher, misstatements across an industry, the findings expand our understanding of misstatement contagion evidenced in other accounting studies. We find no evidence of region-based across-auditor deterrence effect of litigation. Overall, by demonstrating a general deterrence effect of litigation for non-sued entities, this study significantly enhances the impact of litigation beyond just the sued entity