The Potential for Catastrophic Auditor Litigation

Audit firms continue to lobby for legal liability limits based on their contention that catastrophic civil litigation is a realistic possibility. However, others disagree that catastrophic litigation is a viable threat to the audit firms and oppose legal reform at this time. To inform this debate, this study estimates the probability that a Big Four audit firm will face catastrophic litigation. Estimates are based upon recent disclosures by audit firms regarding settlements, litigation cost, and internal financial information. The results indicate that the likelihood of catastrophic liability is low in absolute terms. Assuming liquidation only when liability reaches a threshold that includes annual income, retirement benefits, and windup costs for the firm, the likelihood of at least one Big Four firm facing litigation substantial enough to trigger voluntary liquidation is ~0.6% over a 5-year period. These findings are consistent with auditors being able to sustain litigation under the current legal system. However, the probability would increase dramatically if firms changed their financial structures to remove partner retirement benefits. In such a case, I estimate that the likelihood of catastrophic litigation is as high as 2.8% over a 1-year period and 14.1% over a 5-year period, depending on the level of variable associated litigation costs assumed.