Accounting Irregularity, Improper Revenue Recognition and Auditor Litigation

Nana Yamfo Amoah, Isaac Bonapa

Abstract

This study investigates whether accounting irregularity and improper revenue recognition are associated with the probability that an auditor will be sued for a defective audit of a client. We focus on accounting irregularity and improper revenue recognition given that they are accounting misstatement characteristics that could have severe valuation consequences on shareholder wealth and signal intentional misstatement. Using litigation data from the Stanford Securities Class Action Clearinghouse database and logistic regressions, we find that external auditors are more likely to be sued when audit clients improperly recognize revenues and the accounting misstatement is due to an accounting irregularity. We also find that external auditors are more likely to be sued by shareholders when the Securities and Exchange Commission (SEC) initiates an enforcement action through a court filing or an administrative proceeding. Our results suggest that revenue misstatement, accounting irregularity and SEC enforcement actions appear to be indicators of audit failure. Our results also imply that auditors could reduce the risk of litigation by averting accounting irregularity and improper revenue recognition in audited financial statements. The results should be of interest to regulators and other stakeholders who are concerned with improving audit quality.