Auditors work in a high-risk environment in which there is a constant threat of litigation due to audit failure (Lowe, Reckers, & Whitecotton, 2002). Litigation costs can force audit firms to downsize or declare bankruptcy (Palmrose, 1988) threatening the sustainability of the auditing profession. The concern led the U.S. Treasury Department to commission an Advisory Committee on the Auditing Profession to explore and make recommendations (Advisory Committee on the Auditing Profession, 2008). Although the Commission failed to reach a consensus on auditor liability, it did note that the threat of litigation impacts the audit process "by causing overly cautious audits or "defensive" auditing" (Advisory Committee on the Auditing Profession, 2008, p. VII: 28).
Support for this conjecture can be found in research as increases in litigation exposure have been shown to cause auditors to be more conservative in the audit process (Venkataraman, Weber, & Willenborg, 2008). Using client characteristics such as financial condition, asset structure and sales growth as proxies for litigation risk, research has shown that auditors respond to increases in litigation risk by increasing audit hours (Stice, 1991) and audit fees (e.g., [Pratt and Stice, 1994] and [Simunic, 1980]). Increased planned audit investment (i.e., amount of audit evidence needed) in the face of increased litigation risk were found in situations involving potential overstatements of financial performance (Barron, Pratt, & Stice, 2002) and accounting irregularities (Houston, Peters, & Pratt, 1999). Some results suggest that the more conservative approach is appropriate as research shows that the approach leads to higher audit quality as measured by abnormal accruals (Venkataraman et al., 2008).
Litigation risk can influence the decision making process of auditors during the audit (Palmrose, 1988). The threat of litigation forces auditors to focus on making not only accurate decisions ([Gomma et al., 2008] and [Palmrose, 1988]) but also decisions that can be defended in court as providing due professional care (Lowe & Reckers, 2000). This is especially true when the audit process is not a required but a suggested procedure in the auditing standards like reliance on the work of internal auditors. Research has already examined the influence of litigation risk on another voluntary audit process, reliance on the results of a decision aid (Messier,1995). Research found that auditor reliance on the results of a reliable decision aid not only increase decision accuracy (Messier, 1995) but is also a defensible judgment in the eyes of jurors (Lowe et al., 2002). Thus, auditors rely more on decision aids when there is a higher cost of audit failure (Boatsman et al., 1997) or when litigation risk is high even if they lack confidence in the decision (Gomma et al., 2008). Research also suggests it was the auditors' awareness of the legal defensibility of reliance on a decision aid that led to increased reliance in a high litigation risk audit (Gomma et al., 2008). Thus, research suggests that auditors employ prospective rationality cognition in which decisions are made with the foresight knowledge that they may need to be defended in the future (Staw, 1980).
Like the choice to rely on a decision aid, auditor reliance on the work of internal auditors is an audit decision that may need to be defended in the case of audit failure. Prospective rationality cognition theory predicts that auditors will try to identify the most defensible decision during the audit planning process (Rose, 2007) and because reliance on the work of internal auditors is strongly suggested but not required by audit standards, the most "justified" decision for an external auditor may be to do the work themselves rather than rely on the work of internal auditors (Gramling & Vandervelde, 2006). Thus, auditors who perceive higher litigation risk from relying on the work of internal auditors will decrease their planned reliance on the work of internal auditors to increase the defensibility of their actions to jurors leading to the following hypothesis:
H1
Increases in auditor perceptions of litigation risk will lead to lower levels of planned reliance.
