Federal Judge Ideology and the Converging Reporting Incentives of Big 4 and non-Big 4 Auditors

Abstract

The thresholds auditors use when issuing going concern modified audit opinions to clients are of interest to both policymakers and financial statement users. Because a going concern opinion requires a forecast of a future event (i.e. client business failure), this reporting decision involves considerable uncertainty and a trade-off between possible Type I and Type II reporting errors. The relative costs of these errors will depend on the level of litigation risk. We analyze whether variations in litigation risk arising from the ideology of U.S. federal judges affect auditors’ going concern reporting behavior. The prior literature shows that the ideology of federal judges in the circuit where a company is headquartered is an important ex-ante determinant of litigation occurrence and outcomes. We find that in circuits with more liberal judges, hence greater litigation risk, Big 4 and non-Big 4 auditors tend to converge in their reporting decisions. This is caused by the greater effect of judge ideology on non-Big 4 auditors than on Big 4 auditors. Consistent with previous international studies, we also find that audit fees of Big 4 and non-Big 4 auditors converge in circuits with more liberal judges. We do not find a statistically significant relationship between federal judge ideology and auditor choice. Our results are robust to several matched samples, and contribute to an understanding of the importance of federal legal liability in determining the audit quality differences between Big 4 and non-Big 4 firms.