The Effects of Accounting Standard Precision, Auditor Task Expertise, and Judgment Frameworks on Audit Firm Litigation Exposure Free

Prior research highlights potential unintended consequences of the global movement toward less precise accounting standards including increased litigation exposure for auditors (Donelson, McInnis, and Mergenthaler 2012). Essentially, imprecise standards leave considerable room for interpretation, which makes it easier for triers of fact (e.g., judges, juries) and regulators (e.g., PCAOB inspectors) to second-guess auditors' professional judgments (PCAOB 2008; Cornell, Magro, and Warne 2017). Even more troubling, auditor objectivity could be undermined if they respond to the increased litigation exposure by herding to industry norms as a way to limit second-guessing of their professional judgment (Kadous and Mercer 2012).

A recent study, “The Effects of Accounting Standard Precision, Auditor Task Expertise, and Judgment Frameworks on Audit Firm Litigation Exposure” (Grenier, Pomeroy, and Stern 2015; hereafter, the study), predicts and finds that audit firms can reduce litigation exposure arising from such second-guessing in two ways: (1) assigning recognized technical experts in relevant accounting rules to the engagement team (e.g., experts on the accounting for leases); and (2) providing team members with a framework for making high-quality professional judgments. Although both are effective in reducing second-guessing, judgment frameworks are likely a cost-effective alternative for firms, as assigning technical experts to all engagements is not practicable. It is important for an auditor's defense team to convince jurors that the auditor used the judgment framework when they formed their professional judgment. As long as jurors are convinced that a framework was used, it will provide incremental protection from litigation relative to other persuasive evidence of adherence to auditing standards and other decision support tools (e.g., automated decision aids; see Dowling and Leech [2007] for an in-depth discussion of audit support systems and decision aids). These implications also likely apply to internal and external engagement reviews where audit quality is being evaluated on a post hoc basis. However, since the study was conducted in the litigation context, future research should validate the applicability to other settings.

The current article summarizes the theory underlying these predictions, the methodology and the results of the study's two experiments, and the implications of the findings for audit firms seeking to mitigate litigation exposure arising from imprecise (versus precise) accounting standards.

When considering juror evaluations of auditor negligence, many studies use motivated reasoning theory (Kunda 1990) as a theoretical framework (Kadous 2000, 2001; Cornell, Warne, and Eining 2009). This framework maintains that, to maintain their belief in a just world (Walster 1966), jurors are motivated to evaluate evidence in such a way that they arrive at their preferred conclusion—which is that the audit firm is responsible for the negative outcomes arising from purported audit failures. Even so, jurors' motivation to engage in such a biased reasoning process is subject to reasonableness constraints that prevent them from drawing arbitrary, unreasonable conclusions (Pyszczynski and Greenberg 1987). The study likens a firm's efforts to defend auditors' judgments to imposing reasonableness constraints on jurors' motivated reasoning. It then asserts that the efficacy of such efforts to defend auditors' judgments depends on the precision of the accounting standards in question.

Unlike precise accounting standards, imprecise standards afford auditors and their clients a greater range of reasonable interpretations and applications. Consequently, this fosters ambiguity for auditors attempting to evaluate the appropriateness of their client's accounting choices. In turn, this increases the possibility that their conclusions are second-guessed (Kadous and Mercer 2012). Specifically, jurors tend to perceive standards as the primary source of guidance that should be used to evaluate the appropriateness of a company's accounting. However, when imprecise standards do not provide specific decision rules, jurors consider the consistency of a company's accounting with industry norms as a secondary source of guidance. Hence, imprecise standards can expose audit firms to elevated litigation risk when their client's accounting under imprecise standards diverges from industry norms (Kadous and Mercer 2012).

It is this setting that the study focuses on, and in H1 the study predicts that “the increase in juror negligence assessments under imprecise relative to precise accounting standards is mitigated when engagements are staffed with technical experts rather than general experts” (Grenier et al. 2015, 339). The rationale underlying H1 is that audit firms can defend against elevated litigation exposure arising from imprecise standards by making resource allocation decisions that impose reasonableness constraints on jurors' motivated reasoning. Specifically, assigning technical experts to audit engagements (versus general experts) makes it difficult for jurors to second-guess auditors' professional judgments (i.e., to conclude that another auditor would have arrived at a more appropriate judgment).

Another way to defend auditors' judgments against the threat of increased litigation exposure under imprecise accounting standards is to use a judgment framework (cf. CIFiR 2008; Ranzilla, Chevalier, Herrmann, Glover, and Prawitt 2011). Like assigning accounting technical experts to audit engagements, providing auditors with such a framework imposes constraints on jurors' motivated reasoning by demonstrating the audit firm's commitment to support auditors in making high-quality professional judgments. Given that jurors would already recognize technical experts for their ability to arrive at appropriate judgments in their area of specialization, the reasonableness constraint imposed by auditors' framework use is likely to be stronger for general experts. Thus, under imprecise standards, the study predicts in H2 that “use of judgment frameworks (relative to when no frameworks are used) constrains juror negligence assessments more when used by general experts than when used by technical experts” (Grenier et al. 2015, 339).

Experiment 1 uses a 2 × 2 × 2 between-participants design in which 559 undergraduate student participants assume the role of mock juror and assess the negligence of an audit firm that allegedly failed to detect a material misstatement. The case involves an audit of a fictional car rental company, Zoom Cars Inc. (ZCI), with a distinct business model involving curbside pickup and drop-off. ZCI accounted for a leased fleet of vehicles with an accounting method that differed from industry norms under the argument that their leases are of a much shorter term than those of its competitors, thereby justifying operating lease accounting. Participants review information about ZCI and its lease accounting method, the audit firm, and the lease accounting standards. In all cases, the SEC alleges that ZCI's accounting method for the lease has caused a material understatement of its liabilities. After reviewing their assigned version of the case, participants assess the negligence of the audit firm (Negligence) on an 11-point scale from 0 (“certainly not negligent”) to 10 (“certainly negligent”).

Three factors are manipulated: Standard Precision, Task Expertise, and Judgment Framework. Standard Precision is based on the criteria from the capital lease accounting standard found in the Statement of Financial Accounting Standards (SFAS) No. 13. The level Imprecise contains all four of the same criteria as Precise, however it describes them as “factors to consider” and removes quantitative thresholds (i.e., bright-lines). The audit partner's Task Expertise is manipulated at two levels (Technical Expertise versus General Expertise) based on their familiarity with lease accounting, while holding rank and years of professional experience constant.¹ The factor Judgment Framework is manipulated at two levels: FPJ-Treatment, in which the audit partner uses a Framework For Professional Judgment (FPJ), and FPJ-Control, in which the case does not mention a framework. Neither a specific FPJ nor its components are specified in the case text, increasing the generalizability of the study's findings. See Appendix A for the wording of the manipulations.

Results, depicted graphically in Figure 1, support the study's hypotheses. Consistent with H1, when no FPJ is mentioned in the case (FPJ-Control), the increase in Negligence when moving from Precise to Imprecise is greater for General Expertise (see the positive slope of the line from A to B in Figure 1) versus Technical Expertise (see the negative slope of the line from C to D). This supports the study's prediction that assigning technical experts (versus general experts) to the audit engagement mitigates the increased litigation exposure arising from imprecise standards. A follow-up test reveals that when standards are Imprecise and no FPJ is mentioned (FPJ-Control), participants' perceptions of the extent to which ZCI's lease accounting conforms with GAAP are higher in Technical Expertise than General Expertise, but there is no difference when standards are Precise. This finding suggests that, under imprecise (but not precise) standards, participants perceive judgments made by technical experts to be higher quality than those made by general experts.

Consistent with H2, when the accounting standards are Imprecise, the reduction in Negligence when moving from a setting where no FPJ is mentioned to one where auditors use an FPJ (FPJ-Control versus FPJ-Treatment) is greater for General Expertise (see points B and H Figure 1) than for Technical Expertise (see points D and F). Importantly, when the accounting standards are Imprecise and auditors use a judgment framework, the study finds no difference in Negligence across levels of expertise (FPJ-Treatment; points H and F in Figure 1).This pattern supports the study's prediction that providing audit team members a framework for making high-quality professional judgments will allow firms to compensate for staffing audit engagements with general experts rather than recognized technical experts.

Experiment 2 modifies some of the design choices made in Experiment 1 to enhance the generalizability of the results. First, as undergraduate university students, participants' responses in Experiment 1 may not be representative of the broader jury-eligible population. Experiment 2 addresses this limitation by recruiting participants from the general population using an online crowdsourcing platform. Second, perceptions of FPJs might be different if participants were informed of their specific components rather than provided a general description. As such, Experiment 2 describes the components of the FPJ. Finally, Experiment 2 helps differentiate the litigation protection benefits of FPJs from (1) other types of decision support tools used by auditors, and (2) other persuasive evidence that auditors adhered to auditing standards.

Experiment 2 employs a 2 × 4 between-participants design in which 739 participants from Amazon's Mechanical Turk assume the role of mock jurors and assess audit firm negligence. The case is the same as the one used in Experiment 1. Two factors are manipulated: the same Standard Precision factor as Experiment 1, and a new factor called Judgment Quality Signal (FPJ-GAAS, versus ADA-GAAS, versus GAAS, versus None). Participants in FPJ-GAAS and ADA-GAAS are informed that, in addition to following GAAS, the audit partner used a judgment framework (in FPJ-GAAS) or an automated decision aid (in ADA-GAAS; a computer program that provides auditors a recommendation on the appropriate accounting for a lease). Participants in GAAS are informed that the partner followed GAAS, but no mention is made of an FPJ or an ADA. No mention of GAAS or any decision support tool (FPJ or ADA) is made to participants in None. The partner's expertise is held constant at General Expertise in all versions of the case. Negligence is measured with both a binary (Verdicts) and continuous measure (Negligence). See Appendix B for the wording of the manipulations.

Results depicted graphically in Figure 2 suggest the findings from Experiment 1 are robust to the design modifications made in Experiment 2. First, Negligence is lower when the partner uses an FPJ or ADA and demonstrates compliance with GAAS (see points E2, F2, G2, and H2 for FPJ-GAAS and ADA-GAAS) compared to when they only demonstrate compliance with GAAS or when no mention of a decision support tool is in the case (see points A2, B2, C2, and D2 for GAAS and None). This indicates that use of an FPJ or ADA mitigates the increased litigation exposure arising from imprecise standards beyond demonstrating compliance with audit standards. However, the difference in Negligence between FPJ-GAAS and ADA-GAAS is not statistically significant. This absence of a difference is observed despite a follow-up test indicating that participants perceive the FPJ as a more credible signal of judgment quality than the ADA. Importantly, findings suggest that an FPJ outperforms an ADA in terms of reducing audit firm litigation exposure, but audit firms need to engage in more effort to convince jurors that the auditor followed the general guidance from an FPJ than they do to convince them that the auditor followed specific recommendations from an ADA.

This study provides insights relevant to audit firms seeking to defend their professional judgments against negligence claims in an environment of heightened litigation exposure stemming from the adoption of imprecise accounting standards. The study finds that this elevated risk is manageable and provides examples of actions that firms can take to mitigate it. For example, defense teams can emphasize the firm's decision to assign technical experts in the relevant accounting methods to evaluate the client's interpretation of imprecise standards. If firms conclude that assigning more technical experts to all their audit engagements is not practicable, then they can provide the members of their engagement teams with a framework for making high-quality professional judgments. Both actions serve to mitigate litigation exposure arising from imprecise standards by making it difficult for jurors to second-guess auditors' judgments. However, auditors and their defense teams should be aware that jurors need to be convinced that auditors actually used a framework when making their professional judgments.

Standard setters and regulators can make practical use of the study's findings. For example, the results could inform regulators' responses to comments on exposure drafts of proposed accounting standards that express concerns about audit firms' increased litigation exposure and/or herding to industry norms. The results of the study indicate that these effects are unlikely as auditors are well equipped to handle the increased litigation exposure arising from imprecise standards without herding to industry norms. Given recent evidence that use of professional judgment frameworks improves auditor judgment quality (Backof, Bamber, and Carpenter 2016), regulators should consider encouraging their use for particularly challenging audit tasks, such as evaluating the reasonableness of management's accounting estimates. Likewise, the PCAOB can seek to incorporate framework use into its inspection process and its project on audit quality indicators (PCAOB 2015).

The study's findings are relevant to practice and will continue to be relevant domestically and internationally even as standards converge, because individual standards will still differ in their specificity and precision. The study offers guidance for further research and suggests additional inquiry into the success of managing elevated litigation exposure in practice, improving evaluations of audit quality by regulators (e.g., during PCAOB inspections) and triers of fact (e.g., judges and juries), and the improvement of judgment frameworks to enhance judgment quality and defensibility.

[Precise] GAAP uses four criteria to evaluate the economic substance of a lease and determine whether it should be classified as a capital lease or an operating lease. Meeting any of the four criteria results in classifying the lease as a capital lease; otherwise, the lease is treated as an operating lease:

ZCI management concluded that the lease with AKI did not meet any of these criteria and therefore, consistent with GAAP, classified the lease as an operating lease.

[Imprecise] There are several factors to consider when evaluating the economic substance of a lease and determining whether it should be classified as a capital lease or an operating lease.

ZCI management considered these factors and concluded that the lease does not transfersubstantially allthe risksandrewards of ownership to ZCI and therefore, consistent with GAAP, classified the lease as an operating lease.

[Technical Expertise] To evaluate ZCI's management's proposed accounting for the lease contract with AKI, Smith & Company assigned an audit partner with 15 years of experience. The partner is a recognized technical expert in lease accounting having made similar lease contract evaluations on hundreds of other audit engagements.

[General Expertise] To evaluate ZCI's management's proposed accounting for the lease contract with AKI, Smith & Company assigned an audit partner with 15 years of experience. The partner has some experience with lease accounting having made similar lease contract evaluations on a few other audit engagements.

Note: Participants in the FPJ-Treatment condition were provided information about a framework for professional judgment both before and after the outcome information. Participants in the FPJ-Control condition did not see either of the following passages.

To assist auditors in making high-quality professional judgments, the American Institute of Certified Public Accountants (AICPA) provides a Framework for Professional Judgment (FPJ). The AICPA's FPJ gives auditors guidance for exercising high-quality professional judgment for numerous auditing-related professional judgment tasks including deciding what accounting method is most appropriate for business transactions. The auditor partner used the FPJ in the process of making his professional judgment that operating lease accounting was appropriate.

The audit partner used the AICPA's Framework for Professional Judgment when making his professional judgment that operating lease accounting was appropriate.

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  True

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  False

To assist auditors in making high-quality professional judgments, the American Institute of Certified Public Accountants (AICPA) provides a Framework for Professional Judgment (FPJ). The AICPA's FPJ gives auditors guidance for exercising high-quality professional judgment for numerous auditing-related professional judgment tasks including deciding what accounting method is most appropriate for business transactions. An auditing expert (a member of the AICPA) reviewed the audit working papers and concluded that Smith & Company had successfully followed the FPJ in making its professional judgment that operating lease accounting was appropriate for ZCI's lease with AKI.

In addition to following GAAS, the audit partner decided to use a framework developed by Smith & Company while determining the appropriate accounting for the lease transaction.

The Framework for Professional Judgment (FPJ) provides general guidance for making and documenting high-quality professional judgments. The framework is not required by auditing standards and auditors can decide to use it on a voluntary basis when making professional judgments.

The FPJ provides an overview of factors that can lead to an unwanted influence on professional judgment. For example, poor judgments could result from time pressure, limited information, or because people take shortcuts and fail to think carefully about a problem. With these and other factors in mind, the FPJ recommends that the auditor complete the following five-step judgment process:

1. Clarify Objectives/Judgment Criteria: Before any problem can be solved, one must understand “what” it is that needs solving. Without understanding the problem, one may develop a “good solution” to the wrong problem. Once the “what” is clarified, one must identify the “why.” Why does the problem need solving? The answer to these two questions guides the rest of the judgment process.

2. Consider Alternatives: Sometimes people only use the most obvious solution or the first solution that comes to mind when solving a complex problem—but what other alternatives exist? It is very difficult to pick the best alternative when one does not know what the alternatives are. Identifying all the possible alternatives is also important for determining what information to look for and how to use the information once it has been gathered.

3. Gather and Evaluate Information: Next, gather information to help distinguish between alternatives. It is important that information be critically evaluated and not assumed to be relevant or correct. Information can be of different levels of usefulness and sometimes does not help to distinguish between alternatives.

4. Reach Conclusion: After gathering information and evaluating it, all information for all alternatives should be examined to determine what judgment alternative is best.

5. Articulate and Record Rationale: Create a record of Steps 1–4. A record helps demonstrate that a good judgment process was used, and can serve as a justification for the selected alternative.

The available evidence indicates that the audit partner used the FPJ in the process of making his professional judgment that ZCI's use of operating lease accounting was appropriate.

In addition to following GAAS, the audit partner decided to use a decision aid developed by Smith & Company while determining the appropriate accounting for the lease transaction.

The decision aid provides specific guidance for determining the appropriate accounting method for lease transactions. The decision aid is not a part of auditing standards and auditors can decide to use it on a voluntary basis when making lease accounting decisions.

The decision aid requires specific information about a lease transaction (e.g., the length of the lease in months) to be inputted into a computer program. After the inputs are entered, the decision aid compares the inputted lease information to the computer program's interpretation of the GAAP guidance for lease accounting and provides an output that includes the recommended accounting method for the transaction. The decision aid is considered reliable and has not previously led to second-guessing from the SEC or financial statement users.

The available evidence indicates that the audit partner used the decision aid and its output to make his professional judgment that ZCI's use of operating lease accounting was appropriate.