An Analysis of Auditor Litigation and Audit Service Quality

This study compares litigation activities of independent auditors to assess litigation as a means for making quality distinctions among auditors. The study provides a framework suggesting auditors with relatively low (high) litigation activity represent higher (lower) quality suppliers. The empirical analysis examines a sample of legal cases (n = 472) and resolutions for these cases (if available, n= 183). The cases involve audit-related litigation against both Big Eight and large non-Big Eight firms during 1960-1985. The results indicate that nonBig Eight firms as a group have higher litigation activity than Big Eight firms. This result is consistent with existing research supporting the Big Eight as quality-differentiated auditors. Comparisons among Big Eight firms reveal some significant differences. However, identification of particular Big Eight firms as low (high) litigation activity auditors appears sensitive to the type of analysis. T HISstudy compares litigation activities among the largest U.S. independent audit firms. Litigation against auditors typically involves a process, from initial discovery of potentially false or misleading financial statements, to filing of lawsuits, and eventual resolution of such suits. In investigating differences in litigation among auditors, the study utilizes data on both litigation occurrences and resolutions. The primary objective of the comparisons is to assess litigation as a means for making quality distinctions among independent audit firms. Previous empirical research on auditor litigation (Kellogg [1984]; Palmrose [1987]; and St. Pierre and Anderson [1984])1 and on audit quality (Francis and Simon [1987]; Nichols and Smith [1983]; Palmrose Financial assistance of the University of California at Berkeley Professional Accounting Program and the research assistance of Hay Young Chung, Changyong Ham, and Richard Taylor are gratefully acknowledged. I would like to thank Mike Duffy and Robert Kellogg for contributions during the data-gathering process. In addition, I would like to acknowledge the helpful comments of various individuals and groups including, William L. Felix, Jr., Marcia Niles, Kent St. Pierre, participants in workshops at the University of Washington and the University of Arizona, and especially William R. Kinney, Jr. ZoeVonna Palmrose is Assistant Professor at the School of Business Administration, University of California at Berkeley. Manuscript received February 1987. Revision received July 1987. Accepted August 1987. *Editor's Note: "Taxes and Off-Balance-Sheet Financing: Research and Development Limited Partnerships" by Terry Shevlin that appeared in the July 1987 issue of