Regular Paper Litigation risk, financial reporting and auditing: A survey of the literature ☆ Ahsan Habib a, *, Haiyan Jiang a , Md. Borhan Uddin Bhuiyan a , Ainul Islam b a School of Accountancy, Massey University, Private Bag 102904, Auckland, New Zealand b School of Accounting and Commercial Law, Victoria University of Wellington, Rutherford House 23 Lambton Quay, Wellington, New Zealand A R T I C L E I N FO Article history: Available online 26 September 2014 Keywords: Securities class action lawsuits Accounting restatements Management earnings disclosures Auditor litigation A B ST R AC T This paper surveys the literature on the determinants and consequences of securities class action lawsuits against firms and auditors from a financial reporting quality perspective. The survey is motivated by the important role that law plays in protecting stakeholders’ interests against managerial misdeed. Litigation is, thus, an important topic and numer- ous studies investigate the determinants and consequences of firm and auditor lawsuits. The underlying premise of these studies is built on the notion that large financial and reputational penalties associated with successful securities class actions can discipline man- agement and deter them from future wrongdoing. The survey documents that poor quality financial reporting as evidenced in earnings restatements has been the primary anteced- ent for class action lawsuits against the firm and auditors. Lawsuits against auditors affect audit fees, audit planning decisions and client portfolio adjustment decisions. Although sig- nificant progress has been made in terms of further understanding the causes and consequences of litigation against auditors, major challenges remain in the area of proper measurement of litigation risk. © 2014 Elsevier Ltd. All rights reserved. 1. Introduction The paper surveys the literature on the determinants and consequences of securities class action lawsuits from the financial reporting and audit quality perspectives. The survey is motivated by the important role that law plays in pro- tecting stakeholders’ interests against managerial misdeed. Some of the important functions performed by the legal system include regulation of behavior (deterrence func- tion), resolution of conflict, and damage recovery (Simpson, 1988; Vago, 1988). From a financial reporting and auditing perspective, the law ensures that conflicts among participants are resolved in an orderly fashion. Shareholders demand protection from the law when self-serving managers provide misleading and biased information to maximize their personal gains (Watts & Zimmerman, 1986). While out-of-pocket monetary pen- alties have historically been minimal for officers and directors due to director and officer (D&O) insurance, liti- gation entails other costs such as loss of reputation, loss of time, and the stress associated with being a defendant in a lawsuit (Black, Cheffins, & Klausner, 2006; Klausner & Hegland, 2010). Litigation risk therefore is an important ex- ternal governance mechanism (Laux, 2010). 1 If certain industries are inherently more litigious, then litigation risk, ☆ The authors express their appreciation to the reviewers of this manu- script for their constructive feedback and suggestions. * Corresponding author. Tel: +64-09-4140800; fax: +64-06 350 5618. E-mail address: a.habib@massey.ac.nz (A. Habib). 1 For key trends in securities class action lawsuits in the US refer to 2011 litigation study by PricewaterhouseCoopers (PwC). The PwC Securities Lit- igation database contains shareholder class actions filed since 1994. A variety of information including court, circuit, company location, class period, GAAP allegations, earnings restatements, SEC investigations, and lead plaintiff type, is summarized in the database. Information come from a variety of sources including case dockets, news articles, press releases, claims administrators, and SEC filings. http://dx.doi.org/10.1016/j.racreg.2014.09.005 1052-0457/© 2014 Elsevier Ltd. All rights reserved. Research in Accounting Regulation 26 (2014) 145–163 Contents lists available at ScienceDirect Research in Accounting Regulation journal homepage: www.elsevier.com/locate/racreg