Susan McCracken


Negotiation of audit litigation settlements: an experimental study of the impact of reputational concerns and the level of merit of the suit

Read the full thesis (PDF).

Auditor litigation has become more frequent over the past ten years. Investors, lenders, etc., often sue the auditor when a company goes bankrupt because of the auditors' deep pockets or ability to pay damages. When facing these lawsuits, auditors face a difficult decision: Should they fight the case in court or should they settle out of court. This paper investigates whether there are behavioural factors that interact with economic factors when auditors are making these decisions. In particular, it investigates whether reputational concerns influence the decisions and outcomes in the litigation process, whether the level of merit of the suit brought against the auditor influences the decisions and outcomes in the litigation process, and whether the role of the litigant influences the decisions made throughout the litigation process. The importance of perceived reputation costs and opportunity costs of fighting the case and settling the case are also investigated.

These research questions are addressed through a laboratory experiment where audit partners and auditing students are randomly assigned to the roles of either plaintiff advisors or defendants. The subjects are asked to negotiate two settlements based on case facts. The reputational concerns are addressed through a public announcement manipulation where the defendant has to announce the outcome of his first negotiation to the second negotiation partner. The settlement results of this condition are compared to a condition where the defendant does not report his first negotiation outcome to the second partner. The merit level manipulation is incorporated into the cases used in the experiment. There are two cases, one of high audit quality (low merit) and one of low audit quality (high merit). The settlement outcome of the high merit case is compared to the low merit case.

The results indicate that the public announcement manipulation does influence the negotiations and settlements. Reputation appears to be important to auditors as they seem to have a more difficult time settling in the public announcement condition, but, if they do settle, it is done more quickly and for a higher amount than they do in the non-public announcement condition. The results also show that role or litigation side does influence the decisions and negotiations and that the subjects were better at distinguishing between the two levels of merit than was expected, especially the students. Finally, it seems that the costs of fighting the case in court (reputation and opportunity) are perceived to be more important or influential when involved in a litigation than the costs of settling the case out of court.