Why Auditors Need to Think Like Litigators for Risk Management

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

Our recent research, published in The Accounting Review, suggests 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 party believes they made a mistake. This includes honest errors, fraud they didn’t catch, or misperceptions about what an audit actually covers. Even a squeaky-clean audit won’t immunize an auditor from litigation, and there are several factors that can affect the outcome of a case.

To better understand the risks involved with audit litigation, we, along with our other research colleagues, interviewed 39 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. What we learned from these interviews is that auditors can benefit from approaching their audits through a legal lens. Simply put, auditors need to start thinking like litigators—here’s why.

The Case for Thinking Like a Litigator

The Elaboration-Likelihood Model (ELM) from psychology research provides a helpful way to think about thinking like a litigator. It explains how people—including judges and juries—are persuaded, depending on how deeply they think about the information they’re given. The ELM explains that people with “high elaboration” think critically about the evidence and facts of a case, while people with “low elaboration” go more with their gut feelings and emotions.

Our research supports this model’s framework. We found that 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’ve caught that.” This kind of argument preys on the misconception that many jurors have—an audit is a guarantee of accuracy or future business success.

In contrast, our research found that defense attorneys 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’ll work.

The Venue and Jury Matter

The trial’s venue and jury pool are also really important, and like litigators, auditors should consider these factors as part of their risk management processes. For example, 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 suggests that if a client and the case is located in a city with a lot of college graduates with white-collar jobs, a runaway jury is less likely.
  
• Jurors with strong hometown bias are unlikely to be objective and 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.

Applying the Legal Lens to Your Audits

So, what can auditors do with this information? According to our research, there are several key steps auditors can take from this courtroom logic and apply it to their own risk management processes. For instance:

• During client acceptance, consider the potential trial venue and jury pool. It’s a little morbid to think about, but ask yourself these questions: “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?”
  
• 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’re doing, what you’re not doing, and the limitations of the 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.
  
• Consider engaging with trial consultants. This can 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 what auditors do (and don’t do), the less likely they are to make unreasonable demands and file frivolous lawsuits.

Overall, the insights from our research make one thing abundantly clear: Focusing on compliance with auditing standards isn’t enough to protect auditors or their firms. To truly protect yourselves, your firms, and the public interest, 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, communicative, and 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. In doing so, you can continue to provide valuable services to your clients and protect the integrity of the financial reporting system.

Mark Peecher, Ph.D., is the executive associate dean of faculty and research and Deloitte professor of accountancy at Gies College of Business at the University of Illinois Urbana-Champaign.

Dan Zhou, Ph.D., is an assistant professor of accountancy and co-coordinator of the Gies Business Research Lab at Gies College of Business at the University of Illinois Urbana-Champaign.