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Litigation Risk and Auditor Conservatism: A UK-US Comparison

Research output: Working paper

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Abstract

This paper investigates the association between auditor quality and the level of conservatism in reported earnings. Prior work has suggested auditor conservatism is influenced by auditors’ desire to prevent litigation and/or incurring reputational costs. To tease out the relative importance of the litigation versus reputational concerns of large audit firms as reasons for greater auditor conservatism, we conduct a comparative study for UK and US firms. In contrast to the US, the UK is a comparatively low litigation environment. Our results show that (1) large auditors are not associated with greater conservatism after the clients’ level of financial distress has been taken into account in the two countries; (2) the client profiles of large and small audit firms differ in key dimensions and these play a significant role in determining the incremental influence of audit firm size on the earnings conservatism of their clients. Therefore, rather than auditor quality driving the level of earnings conservatism, it appears to be the case that it is the underlying client characteristics which dictate the level of auditor conservatism. Failure to allow for such differences can result in misleading inferences being drawn about the effects of audit firm size on earnings conservatism.