Audit engagement risk is something all auditors think about and incorporate into their decisions, but recent research suggests that they might not be thinking about it as broadly as they should. 

To better understand audit litigation risks, we joined our colleagues in interviewing 39 very experienced audit litigators, including attorneys, trial consultants, and expert witnesses. These experts averaged 31 years of experience in audit litigation and provided us with a comprehensive perspective on trial preparation. Our study, published in “The Accounting Review,” was inspired by earlier work with litigators suggesting that auditors systematically underestimate audit litigation risk because they don’t adequately understand all the factors that can affect it.

Even when auditors follow all the standards and perform a high-quality audit, they can still be sued if a client or third parties believe they made a mistake. This includes honest errors, fraud that they didn’t catch, or misperception about what an audit actually covers. Even a squeaky-clean audit won’t immunize you from litigation, and there are several other factors that can affect the outcome of a case, many of which come into focus during trial preparation. 

So, it’s not enough to focus on audit quality — it’s also critical to focus on what would happen if your work were ever to go before a judge and jury.

Think like a litigator

Based on our research, the first thing you need to do is start thinking like a litigator and learn to think about your audits through a legal lens. The “Elaboration Likelihood Model” from psychology research provides a helpful way to think about this. 

ELM explains how people — including judges and juries — are persuaded, and it depends on how deeply they think about the information they’re given. “High elaboration” means jurors are thinking critically about the evidence and the facts of the case, while “low elaboration” means they’re going more with their gut feeling and emotions.

Here’s what our research found:

• Plaintiff attorneys prefer to keep things simple and emotional, encouraging low elaboration by jurors. They know that auditing standards are complex, and most jurors don’t have the background to understand them. They’ll often use arguments like, “This company lost millions of dollars. The auditor should have caught it.” This kind of argument preys on the misconception that many jurors have — that an audit is a guarantee of accuracy or future business success.
• Defense attorneys, in contrast, want jurors to use high elaboration. To achieve that, they need to spend a lot of time educating jurors about the technical details of auditing, the relevant standards, and what an auditor’s work actually showed. They essentially have to teach a crash course in auditing, which is difficult and time-consuming, and there’s no guarantee that it will work.

The venue and jury matter

The venue of the trial and the potential jury pool are also really important and are things that auditors can consider in advance. Our research found that:

• Federal courts tend to be more favorable to auditors than state courts because federal judges are usually more sophisticated and knowledgeable about business matters.
• Jurors with high levels of education and business experience are more likely to understand the technicalities of an audit and won’t be as swayed by emotional arguments. This means that if your client is headquartered in a city with a lot of college graduates and white-collar jobs, you’re less likely to face a runaway jury.
• Jurors with a strong hometown bias are unlikely objective, and are more likely to side with a local company over an outside audit firm. This hometown bias can be a real problem, especially for smaller firms.

What can auditors do?

So, what can auditors do about all of this? The good news is that our research suggests there are several steps you can take.

During client acceptance, firms should:

• Consider the potential trial venue and jury pool. It’s a little morbid to think about, but ask yourself, “If I were to be sued over this audit, where would the trial be held? What are the demographics and sophistication of the jury pool in that jurisdiction?” Auditors should incorporate these factors into their risk assessment and management processes. 

And during the audit, you should:

• Go beyond merely complying with auditing standards to minimize the possibility of errors or misstatements that could lead to litigation. This means taking a proactive approach to risk assessment and considering factors that might increase the likelihood of a lawsuit when planning an audit engagement, even if they aren’t explicitly required by the standards.
• Be clear about the scope of the audit and your responsibilities in your engagement letter and throughout the engagement. Make sure the client understands what you are doing, what you are not doing, and the limitations of an audit. Document all communications with the client and make sure your workpapers clearly reflect the work that was done.
• Write audit workpapers with potential litigation in mind. Use clear and concise language that a layperson could understand, and explain how your work meets the relevant auditing standards.

Beyond our findings, it’s also important to:

• Consider engaging with trial consultants to help you assess your litigation risk in different jurisdictions and develop strategies for dealing with different types of juries.
• Educate the public about auditing to dispel the common misconceptions about your role and responsibilities. The more people understand about what auditors do (and don’t do), the less likely they are to make unreasonable demands and file frivolous lawsuits.

By being aware of the legal context and planning ahead, you can better manage your litigation risk. This doesn’t mean you should drop clients with higher business risk, but it does mean you need to be aware of all the factors that can contribute to audit litigation risk and assess your ability to mitigate those risks. In doing so, you can continue to provide valuable services to your clients and protect the integrity of the financial reporting system.

The insights from our research make one thing abundantly clear: Focusing on compliance with auditing standards is not enough. To truly protect yourselves, your firms, and the investing public, auditors need to broaden their perspectives and develop a sophisticated understanding of the legal and social context in which they operate. 

This requires auditors to be more proactive, more communicative, and more willing to challenge the status quo. Ultimately, the future of the profession may depend on your ability to adapt to the changing legal landscape and embrace a more holistic view of audit risk.