Law students help shed light on audit litigation

An ASU professor found an accessible and affordable way to research audit litigation and disputes.

Auditors are invaluable for ensuring that financial information is accurate, giving stakeholders and investors the confidence to make decisions based on the audited financial reports.

But sometimes — through miscommunication, errors, or, in rarer cases, fraud — a dispute arises over an audit's compliance with the audit standards, and the auditing firm gets sued. Most of these lawsuits are settled out of court, and settlement payments have reached record highs in recent years.

"Auditing firms spend huge amounts of their revenue on audit litigation. In extreme cases, it can even destroy a firm," says Eldar Maksymov, associate professor of accountancy.

Naturally, auditing firms would like to know more about the factors driving these lawsuits to better prepare for potential litigation. But out-of-court settlements keep most of that information sealed from the public. According to legal experts, these settlements do not always provide an optimal resolution to a dispute.

"I've talked to prominent litigation attorneys on both sides who tell me the system gets it right only about 75% of the time," Maksymov says.

He adds that litigation can have a particularly devastating effect on smaller auditing firms.

"Litigation can damage a firm's ability to perform audits and is particularly harmful for smaller firms. So, you could remove some of these smaller players from the market, making audits in this market more expensive and thus less affordable for smaller companies that need audits. Moreover, auditors must pay huge fees to protect them against litigation claims, which leaves less capital to improve the business."

Some researchers, including Maksymov, have interviewed audit litigation attorneys to give auditing firms, regulators, and other stakeholders a clearer picture of the audit litigation environment. However, the number of practitioners in this specialized field is limited, and most don't want to participate in continuing research studies. As a result, a more profound understanding of the factors that drive audit litigation has mainly been out of reach for researchers.

Testing a new approach

The situation may change thanks to a novel idea pursued by Maksymov and his colleagues Brian Goodson of Clemson University and Jonathan Grenier of Miami University. Instead of trying to pry information from busy audit litigation attorneys about how they make settlement decisions, what if researchers asked more accessible (and less expensive) law students instead? Though they lack practical experience, could their technical knowledge serve as a reasonable proxy for the thinking of legal practitioners on some matters?

Maksymov admits the idea initially generated his skepticism.

"Law school students making decisions about complex audit cases? Something feels wrong about it. It seems like you would be cutting corners by viewing students' decisions as proxies for experienced attorneys' decisions," he says.

However, the researchers cut no corners in testing their theory, culminating with the article, "When Law Students Think Like Audit Litigation Attorneys: Implications for Experimental Research," published in January by Accounting, Organizations, and Society.

First, they surveyed 17 law professors and had them rank the three critical case settlement decisions according to how much each decision depends on strategic knowledge (the kind lawyers gain from experience) versus technical knowledge (the kind law students have). The three key decisions are whether a plaintiff's attorney should accept a case in the first place, the minimum settlement amount the plaintiff's attorney would advise their client to accept, and whether the plaintiff's attorney would advise the auditor to accept a settlement offer from the auditor.

The researchers also analyzed prior audit litigation research, identifying 20 factors attorneys consider when making the three key decisions.

Then, they surveyed 15 experienced audit litigation attorneys and 76 law students, asking participants in each group how they would evaluate the 20 factors for each of the three case settlement decisions. Finally, they compared the results of the lawyers to those of the students.

Evaluating the results

The researchers' findings confirmed their theory: For the two key elements that relied most heavily on technical knowledge — deciding whether to accept a case and arriving at a minimum settlement amount — the law students' thinking aligned very well with that of experienced audit litigation attorneys.

For the third essential element — deciding whether to recommend the predetermined minimum settlement or try to get more — the two groups' thinking diverged significantly. That's because this decision relies on strategic thinking acquired through audit litigation experience. For example, attorneys consider factors such as whether the jury in a particular jurisdiction would most likely side with the suing company or the auditors, whether litigators could obtain expert testimony against the auditors, and how easy or difficult explaining the case to a jury would be. Attorneys also consider the auditing firm's insurance policies and their ability to carry on expensive litigation in deciding whether pursuing the case would be worthwhile. These strategic nuances aren't learned in law school.

What the research means

The findings suggest that academic researchers can use law students as proxies for audit litigators in future studies with reasonable confidence, delving into details about why lawyers go after some auditors but not others or what minimum amounts audit firms can expect to pay for various types of disputes. Slowly but surely, the information that has been out of reach for academics — at least for these two decisions — will be revealed.

That's excellent news for academic researchers and audit firms, but they aren't the only beneficiaries, Maksymov says. Company executives and directors would gain more knowledge about the arcane discipline of audit law, helping them see disputes with a cooler eye and make better judgments about whether and how to pursue legal recourse. Regulators, too, could learn from the research, perhaps making some of their rules clearer to help auditors avoid unnecessary exposure to litigation. Financial journalists would gain new insights and disseminate them throughout the business community, helping to demystify an essential but poorly understood facet of commercial law.

Perhaps, as more people understand the audit litigation process better, the rate of suboptimal settlements of audit disputes that today's lawyers complain about could start to decrease.

"We hope that work in this field will prepare a generation of audit professionals in our field to fulfill their missions better," Maksymov says.