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Does Litigation Experience Improve Audit Partners’ Audit Quality?

Does Litigation Experience Improve Audit Partners’ Audit
Quality?

Wen-Ching Chang, Department of Accounting, National Changhua University of Education

1. Purpose/Objective

Litigation is one of the mechanisms used by the economic system to maintain audit

quality. However, most prior studies have focused on whether litigation has deterrent
effects on the non-litigant auditors, rather than exploring whether litigation has corrective
effects on the litigants themselves. This study extends previous research by examining
whether audit partners who defend against litigation (hereafter defendant partners)
subsequently improve audit quality.

Geiger and Rama (2006) indicate that high-quality auditors are better able to
discern whether their opinions should be modified to address their clients’ going-concern
difficulties. Greater accuracy can lead to lower error rates of going-concern opinions

(GCOs), which is a measurable indicator of auditors’ high-quality reporting decisions
(Geiger and Rama, 2006; Knechel and Vanstraelen, 2007). In this study, I examine
differences in the relative proportions of the two types of GCO errors before and after
audit partners are sued: GCOs issued to clients who do not subsequently go bankrupt (Type
I errors) and GCOs not issued to subsequently bankrupt clients (Type II errors).

Prior research has presented three hypotheses to explain defendant auditors’
subsequent behavior. The contagious hypothesis posits that auditors who experience audit
failures continue to conduct lower-quality audits in subsequent years (Francis and Michas,

2013; Knechel, Vanstraelen, and Zerni, 2015; Li, Qi, Tian, and Zhang, 2017), meaning
that defendant auditors are unlikely to reduce GCO error rates in subsequent periods.
Unchanged or increased GCO Type I or Type II error rates would indicate that defendant
auditors have contagious reporting problems. The learning hypothesis suggests that
auditors learn from prior audit failures and take remedial actions to improve subsequent

audit quality (Lennox and Li, 2014). A decrease in defendant auditors’ GCO Type I or
Type II errors would support the learning hypothesis. Finally, the conservative hypothesis
holds that litigation prompts auditors to engage in more conservative behavior in all

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