Litigation risk is a significant and increasing concern for U.S. public accounting firms. Ernst & Young's recent $400 million settlement with the FDIC is an indication of the magnitude of the problem facing the Profession. A recent survey conducted by the AICPA shows that malpractice insurance premiums for CPA firms other than ''Big 6'' have increased 300 percent since 1985, while deductibles have increased almost six times. Forty percent of those firms surveyed are ''going bare'' due to the high cost of liability insurance.1 In addition, partners from Laventhol & Horwath, previously the seventh largest accounting firm in the U.S., cited litigation claims against their firm in their decision to declare bankruptcy, and Palmrose (1988) notes that litigation against an audit firm can impair its reputation by providing a negative signal about the quality of the firm's audit services. In an effort to combat the increasingly litigious business environment, the ''Big 6'' recently issued a Statement of Position which has been distributed to audit clients, accounting faculty, state and federal legislatures, and members of selected government organizations.2 In such an environment, it is important that auditors be able to effectively screen potential clients and accurately assess litigation risks. Indeed, many accounting firms already appear to be more carefully screening new clients and rejecting some who, prior to the litigation explosion, would have been accepted. The purpose of this study is to examine this screening process, and to determine whether auditor judgments of litigation risk and their recommendations for the preliminary audit plan and client fees are influenced by certain client characteristics that have been empirically related to audit litigation in the accounting literature. Specifically, we hypothesize that client financial condition, asset structure (proportion of receivables and inventory to total assets), sales growth, market value of equity, and variability in stock price returns relate to auditor judgments of litigation risk, to their recommendations for the amount of evidence required to reduce the risk of a material misstatement to an acceptable level, and to client fees. The hypotheses are tested in a field experiment where 243 audit partners and managers of four ''Big 6'' firms from offices throughout the U.S. were each asked to review a single case describing a prospective audit client, and then (1) assess certain elements of litigation risk associated with the engagement, (2) evaluate the financial condition of the client, and make recommendations for (3) the required amount of audit evidence and (4) client fees. Asset structure, sales growth, firm market value, and stock return variability were each assigned two levels (high/median) in the between-subjects experimental design, giving rise to 16 versions of the case which were distributed randomly across the subject sample. The results indicate that the client's overall financial condition is the primary consideration in the auditor's assessment of litigation risk and recommendations for the audit plan and fees. Poorer financial condition was associated with higher levels of litigation risk, more audit evidence, and higher audit fees. The results for asset structure (receivables and inventory as a percentage of total assets) were generally consistent with the hypotheses and with the results for financial condition, though much weaker. Client market value and sales growth were generally unrelated to litigation risk, and the variability of the client's stock price was either ignored or viewed as relating negatively to litigation risk. Additional tests suggest that audit fees reflect both the amount of audit evidence collected and an additional premium to cover litigation risks. That is, auditor assessments of a client's overall litigation risk explained a significant amount of the variance in audit fees over and above the amount explained by audit evidence, suggesting that auditors may be charging clients to insure against future litigation losses. The evidence does suggest, however, that the portion of the audit fee constituting the insurance premium is unrelated to the client characteristics examined in this study. Identifying the client characteristics that relate to the insurance premium may be an important area for future research. In the next section, prior research is reviewed and its relationship to the design of the reported study is explained, followed by descriptions of the theoretical model and related hypotheses. The data collection and analysis procedures are then described, and the paper closes with a discussion of the results and implications.
