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Litigation Severity and Its Effect on Auditor Behavior

Research Introduction

Due to evolving corporate governance policies, the auditing profession functions in a more detailed setting of increased regulatory review and changing stakeholder expectations. Auditors have had to try to manage the growing risk of litigation in recent years and uphold professional standards because shareholders dispute, regulators enforce, and labor or environmental groups make claims. Audit quality is affected by these pressures now. It has long been acknowledged that legal risk is a major factor in auditor behavior, impacting audit pricing models and limiting decision-making (Donelson, 2013; Kang, Lee, Mande, & Woo, 2019).

Many elements of audit practice are linked to litigation concerns, as evidenced by an expanding body of research. For instance, revealing internal control flaws raises client risk and the possibility of legal action (Chen & Chen, 2023). Similarly, high-uncertainty accounting estimates increase litigation risk, impact jurors' and attorneys' views of auditor accountability, and encourage more conservative reporting from auditors (Fingland, Pickerd, & Piercey, 2023). Litigation risk also affects the choice of auditors because managerial exposure to lawsuits affects the choice of audit firms. This means that litigation is linked to both audit results and the nature of the relationships between auditors and clients (Li, Monroe, & Coulton, 2023).

The severity of litigation exposure is further shaped by broader institutional and societal factors. For example, it has been discovered that judicial ideology influences the probability of litigation success, which in turn influences auditor behavior and risk assessments (Li, Qi, & Zhang, 2024). Furthermore, conflicts pertaining to ESG, especially those involving labor and environmental issues, present new reputational risks for auditors because client disputes frequently cast doubt on their auditors' credibility (Asante-Appiah & Lambert, 2022). These changes demonstrate that litigation risk is coming from a wider range of sources than just traditional shareholder claims.

A large portion of the auditing literature still views litigation risk as a general, undifferentiated concept despite these developments. Most studies either look at individual lawsuits in isolation, without making a distinction between categories or severities of claims, or they rely on aggregate measures of litigation exposure (Lennox & Li, 2020). Comprehension of how auditors modify their tactics, this lack of specificity is something that hampers comprehension of responses to litigation pressures. Shareholder lawsuits, regulatory enforcement actions, labor disputes, also ESG-related claims strain auditor-client relationships in different ways.

In today's auditing environment, it is both timely and essential to examine the effects of litigation severity. Auditors are under increasing pressure, with varying scopes and consequences, as corporate accountability expectations rise and ESG-related risks multiply. In addition to strengthening engagement risk assessment, improving audit quality, and guiding more efficient regulatory oversight, a better understanding of litigation risks can also strengthen theoretical frameworks of auditor judgment.

Research Problem

Although auditor behavior has long been recognized to be influenced by litigation risk, the complex consequences of litigation severity are still not well understood. Earlier research examined litigation as a general risk factor without making a distinction between shareholder lawsuits, regulatory enforcement actions, and labor or environmental disputes. The potential that different types of litigation severity may have distinct effects on important facets of audit practice, such as reporting conservatism, auditor-client relationships, and audit pricing, is obscured by this broad approach.

This is why the issuance of going concern opinions and the accuracy of financial reporting are frequently at the heart of shareholder litigation. Auditors may use more cautious reporting techniques to avoid negative legal and reputational effects when litigation is severe (Dhaliwal, Liu, Xie, & Zhang, 2017). It is unclear, nevertheless, whether this conservatism is motivated by the severity of the litigation itself, separate from financial distress. Similar to this, labor and environmental disputes, which have become more significant as ESG accountability has grown, may put a special strain on the relationships between auditors and clients, which could raise the risk of auditor turnover.

However, litigation-induced turnover has received little attention in the literature on auditor changes, which has mostly focused on fee disputes and opinion shopping. Lastly, since auditors frequently base engagement prices on anticipated legal expenses, the intensity of regulatory litigation presents a distinct set of financial incentives. Not much proof separates the impact of regulatory litigation severity from other types of legal exposure, despite earlier research linking litigation exposure to audit fees (Simunic, 1980; Choi, Kim, & Zang, 2010).

The importance of this research assists auditors faced with increased litigation risks, coupled with these risks, including new ESG disputes. Regulators are at risk of misinterpreting audit quality and are missing important oversight tools. If they do, they will not understand just how the various litigation levels impact auditor judgment.

Hypothesis

H1: Shareholder litigation severity is positively associated with the likelihood of going-concern opinions, reflecting more conservative auditor reporting.

H2: Environmental and labor (ESG) litigation severity increases the probability of auditor turnover due to heightened reputational and engagement risk.

H3: Regulatory litigation severity is positively associated with audit fees as auditors price engagements to account for expected legal exposure and compliance costs.

Research Questions and Objectives

Research Question 1: Does shareholder litigation severity influence the issuance of going concern opinions?

• Objective: To evaluate whether heightened shareholder litigation severity leads auditors to adopt more conservative reporting strategies by increasing the likelihood of going concern opinions.

Research Question 2: Does environmental and labor litigation severity affect the probability of auditor changes?

• Objective: To examine whether disputes related to labor and environmental issues, which often carry ESG implications, increase auditor-client turnover due to heightened reputational and engagement risk.

Research Question 3: Does regulatory litigation severity affect audit fees?

• Objective: To investigate whether auditors incorporate regulatory litigation severity into engagement pricing by charging higher audit fees to compensate for anticipated legal exposure.

These research questions collectively seek to distinguish between the ways in which auditor behavior is impacted by various levels of litigation severity. The goals are to increase both theoretical and practical understanding of litigation risk in auditing by elucidating the ways in which shareholder, ESG, and regulatory disputes impact auditor reporting conservatism, client relationships, and audit pricing.