How Following Regulatory Guidance Can Increase Auditors’ Litigation Risk Exposure

Abstract

This study investigates how following explicit regulatory guidance can result, unintentionally, in increased litigation risk exposure for auditors. We do so by examining the unique and specific context where the PCAOB directly instructs auditors how to apply professional judgment - to rely on a client’s competent and objective internal audit function (IAF) during multi-location audits. Consistent with theoretical predictions based on numerosity heuristic processing and norm theory, we find that holding all other factors constant, following explicit regulatory advice not only fails to limit auditors’ litigation risk but can actually increase jurors’ assessments of auditor negligence. Because the numerosity heuristic leads jurors to believe that there is a higher likelihood of misstatement on multi-location compared to single location audits, jurors perceive that auditor reliance on the IAF during multi-location audits is not normal. Accordingly, they judge auditors to be more negligent when they rely on the IAF in multi-location audits than when they do not, but IAF reliance does not impact negligence assessments on single location audits. Our results suggest auditor reluctance to use a qualified IAF, despite client and regulatory pressure, can be a rational and defensible strategy to limit their litigation risk exposure.