When Do Auditor Defense Tactics Increase Rather Than Decrease Perceived Auditor Negligence? Free

This article summarizes the previously published study titled “Speak Up or Shut Up? The Moderating Role of Credibility on Auditor Remedial Defense Tactics” (Grenier et al. 2012; hereafter, “the study”). Specifically, this article discusses the study's motivation, method, primary results, and practical implications for audit firms involved in litigation pertaining to alleged auditor negligence.

Litigation, particularly litigation stemming from undetected financial statement fraud, continues to be a significant concern for audit firms (Golden et al. 2006; Melnitzer 2007; Cornell et al. 2009). It therefore is important for audit firms to develop effective methods of defense in cases of undetected fraud. Although PCAOB Auditing Standard No. 3 states that if audit work is not documented, then it is presumed to not have been performed (PCAOB 2004), audit firms are not entirely constrained by the content of their work papers. One method that many audit firms or their defense teams use is to make general statements—either prior to or during trial—regarding the quality of their work, or other statements intended to decrease evaluators' (e.g., jurors') assessments of auditor negligence. Prior research finds that these methods of defense (hereafter, “defense tactics”) can be successful in reducing auditor litigation exposure (e.g., Kadous 2001; Clarkson et al. 2002; Cornell et al. 2009). For example, Cornell et al. (2009) find that audit firms can decrease jurors' negligence assessments by either apologizing or providing justifications for an alleged audit failure.

Prior to Grenier et al. (2012), however, little was known about the situational factors that impact the effectiveness of defense tactics. That is, research had not considered situations in which defense tactics might decrease, have no effect, or even increase an audit firm's litigation exposure. Consequently, we believe that the results of Grenier et al. (2012) will help audit firms accused of negligence design more effective methods of defense that take into account specific case facts.

Audit firms have a wide variety of defense tactics to choose from in cases of alleged audit failure. The specific defense tactic examined by Grenier et al. (2012) involves an audit firm presenting the results of an internal inspection, which indicates that the engagement team auditors complied with professional auditing standards and did not have knowledge of the fraud prior to issuing an audit opinion. Discussions with a partner in the general counsel office of a Big 4 firm indicated that this defense tactic is commonly used in cases of undetected fraud. For example, after being accused of negligence in performing the New Century Financial audit (Gittelsohn 2009), a KPMG spokesperson stated that: “KPMG acted in accordance with professional standards … any claim that we acquiesced to client demands is unsupportable.” The same partner also stated that plaintiffs' attorneys generally focus on allegedly poor audit procedures and rarely allege that the auditors were aware of the fraud. Thus, the examined defense tactic generally is not a rebuttal to plaintiff allegations, but rather is preemptive and therefore discretionary in nature. Because the tactic is used frequently and is intended to be preemptive, it is important to investigate the conditions under which it is helpful or harmful for audit firms to use the defense tactic.

Prior research indicates that the effectiveness of defense tactics likely depends on their credibility. Specifically, defense tactics likely will reduce jurors' assessments of auditor negligence if perceived as credible (e.g., Cornell et al. 2009). However, psychology theory indicates that statements that lack credibility often backfire (Schlenker 1997; Schlenker et al. 2001; Shaw et al. 2003), thereby increasing perceived auditor negligence. Based on this research, Grenier et al. (2012) predicted that the examined defense tactic (i.e., explicitly stating that audit firm complied with standards and did not have knowledge of the fraud) would decrease (increase) perceived negligence when jurors perceive the defense tactic to be credible (not credible).

One factor that likely affects defense tactic credibility is a client's importance to the audit firm. Brandon and Mueller (2006) report that mock jurors view auditors as less objective, more blameworthy, more deserving of punishment, and more likely to acquiesce to client demands when client importance is high versus low. Thus, defense tactics likely are perceived as less credible when client importance is high. A second factor that likely affects defense tactic credibility is the tactic's source. Specifically, by distancing the tactic from the local office, whose partners likely have stronger incentives to appease their clients, defense tactics likely are perceived as more credible when implemented by a firm's national as opposed to its local office. Thus, Grenier et al. (2012) predicted that defense tactics would be effective (i.e., decrease jurors' negligence assessments) when client importance is low and when implemented by the firm's national office, but would backfire and increase negligence assessments when client importance is high, regardless of the defense tactic's source (national versus local office).

To test their predictions, Grenier et al. (2012) conducted an experiment in which 210 undergraduate students assumed the role of a juror for a negligence lawsuit against an audit firm stemming from undetected fraud. Participants read a case about the audit of a fictional mining company (adapted from Kadous [2000, 2001]), the details of an undetected fraud, and the transcript from a subsequent lawsuit. After reading the case information, participants indicated two primary negligence assessments: (1) whether the audit firm was negligent (Verdict), and (2) the amount of compensatory and punitive damages the audit firm should pay to the plaintiff (Damages).

Grenier at al. (2012) manipulated two factors in the experiment: (1) Client Importance and (2) Defense Tactic. For Client Importance, approximately half of the participants were told that the client was of high economic importance to the audit firm (in terms of audit fees), whereas the other half were told that the client was of low economic importance. There were three versions of the case for Defense Tactic. In two of the versions, the audit firm explicitly stated, based on the results of an internal investigation, that the auditors complied with professional auditing standards and did not have prior knowledge of the fraud. These two versions differ in terms of whether the defense tactic was implemented by the audit firm's local or national office. In the third version, the defense attorney asserts that the auditors exercised due professional care and thus were not negligent (the same as in the other two versions), but the defense does not explicitly mention the results of an internal inspection conducted by the audit firm (i.e., a control condition in which there was not an explicit defense tactic). To test the predictions, Grenier et al. (2012) compared Verdict and Damages for the following six versions of the case: (1) High Client Importance/No Defense Tactic, (2) Low Client Importance/No Defense Tactic, (3) High Client Importance/Local Office Defense Tactic, (4) Low Client Importance/Local Office Defense Tactic, (5) High Client Importance/National Office Defense Tactic, and (6) Low Client Importance/National Office Defense Tactic.

Consistent with the predictions, the effectiveness of the defense tactic in terms of reducing participants' negligence assessments depended on their perceptions of the tactic's credibility, as evidenced by statistically significant negative correlations between perceived credibility and both measures of auditor negligence: Verdict and Damages. Essentially, when perceived as credible, the defense tactic successfully decreased perceived negligence, but when perceived as not credible, the defense tactic backfired and increased perceived negligence.

The results of the experiment also indicate that the effect of the defense tactic on participants' negligence assessments depended on the client's importance to the audit firm. In particular, when client importance was low, the defense tactic successfully decreased both Verdict and Damages (see Figure 1 for descriptive statistics and a depiction of the results), but only when it was implemented by the audit firm's national office. Specifically, when client importance was low, the percent of negligent verdicts dropped from 58.8 percent (with damages of $6.1M) in the control condition to 36.4 percent (with damages of $3.5M) when the defense tactic was employed by the national office. In contrast, when client importance was high, the national office employing the defense tactic increased the percent of negligent verdicts from 52.9 percent (with damages of $5.7M) to 68.8 percent (with damages of $6.4M).¹ A similar increase in perceived negligence resulted from the defense tactic being employed by the local office (70.1 percent negligent verdicts with damages of $6.8M).

Finally, it is important to highlight that high client importance in and of itself did not increase participants' negligence assessments. In particular, when the audit firm did not use the defense tactic, the client's importance (high versus low) to the audit firm did not influence participants' negligence assessments. In contrast, when the audit firm did use the defense tactic, negligence assessments were higher when client importance was high, as compared to when it was low. In addition, when the audit firm used the defense tactics, participants perceived auditors of high-importance clients as significantly less credible, more likely to have knowledge of the fraud, and less competent than auditors of low-importance clients. Grenier et al. (2012) speculate that this pattern of results is attributable to the defense tactic calling participants' attention to the greater incentives auditors might have to acquiesce to management when the client is of high as opposed to low importance to the audit firm. Cumulatively, our results indicate that audit firms should use extreme caution when using defense tactics in cases where the audit client could be perceived as highly important to the audit firm, so as to not inadvertently increase perceptions of auditor negligence.

Grenier et al. (2012) offer important practical implications that could assist audit firms in preparing their defense in auditor negligence lawsuits. Results indicate that audit firms can reduce negligence assessments by utilizing various defense tactics (e.g., preemptively denying prior knowledge of an undetected fraud), but must be cognizant of factors that compromise their credibility before implementing such tactics. Essentially, the advisability of implementing the commonly used defense tactic examined in Grenier et al. (2012), and potentially other defense tactics, likely varies between clients, depending on situational factors such as the client's perceived importance to the audit firm and the source of the defense tactic. As such, when negligence is alleged on high-importance clients, audit firms should be cautious about using defense tactics to avoid inadvertently increasing jurors' negligence assessments by calling attention to the firm's incentives to appease management (e.g., high audit fees). For example, if New Century Financial is a highly important client to KPMG, then KPMG might have inadvertently increased its litigation exposure by preemptively denying that it acquiesced to New Century's management (Grenier et al. 2012). In such cases, audit firms likely would benefit from procuring external firms or expert witnesses that may be perceived as more credible. In addition, results indicate that defense tactics are more credible when implemented by the national, as opposed to the local office. Thus, if possible, audit firms likely would benefit from implementing defense tactics at the national level and instructing local office partners about the potential inadvisability of making pre-trial statements about the case.

Finally, the study has implications for client acceptance and retention decisions, as well as the assessment of engagement risk. Specifically, results suggest that for high client importance to increase assessments of auditor negligence, other information (such as denying prior knowledge of an undetected fraud) that raises the possibility of auditor malfeasance must be present. Thus, audit firms' assessed levels of engagement risk need not necessarily increase for high-importance clients.