Earnings string breaks, accounting litigation risk and audit fees

Abstract

Purpose This study aims to investigate whether accounting-related litigation is associated with a break in the client’s earnings string and the auditor’s response to a break in the earnings string. Design/methodology/approach The authors use regression models on a sample of publicly-traded USA companies with earnings strings. Findings The authors find that clients’ earnings string breaks are associated with increased accounting litigation risk and audit fees. The results are more prevalent for larger breaks. Research limitations/implications The findings suggest auditors anticipate string breaks by clients which implies that audit fee research should consider earnings string characteristics in the fee models. Practical implications The auditor’s access to private information allows them to anticipate string breaks and potential increase in litigation risk. Originality/value An earnings string break represents a convergence of concerns highly relevant to the auditor: more users relying on the financial statements with greater expectations, increased likelihood of losses to those users, an environment where the likelihood of misstatement may increase, and explicitly stated professional responsibilities in response to the latter. Despite that, and a rich earnings string literature, prior studies have not directly examined auditors’ response to a client’s string break.