Misstatement Direction, Litigation Risk and Planned Audit Investment: a New Zealand Perspective

Abstract

The purpose of this study is to investigate whether there exists a significant difference in audit planning behaviour between US and New Zealand auditors in reaction to changes in litigation risk and misstatement direction in financial performance. The study is motivated by the fact that the litigation risk environment for auditors differs between the two countries with the US auditors facing a high litigation risk environment whilst New Zealand auditors face a comparatively milder litigation risk environment. Therefore, this study seeks to find out if the influence of a milder litigation risk environment causes New Zealand auditors to plan their audit engagements differently from US auditors. The study is based on Barron et al [2001] which was a research paper previously published in the US in which it was found that auditor assessments of litigation risk and planned audit investment were higher when potential errors overstated financial performance than when potential errors understated financial performance. The evidence also showed that the relationship was stronger when the risk of litigation in the client's industry was higher and weaker when the risk of litigation in the client's industry was lower. This study finds that New Zealand auditors assess higher levels of litigation risk upon the discovery of a material overstatement error. It shows that higher levels of litigation risk are assessed under an overstatement error condition than under an understatement error condition. It shows that the New Zealand auditors' assessments of litigation risk relates positively to the level of planned audit investment. Such a finding seems to suggest that auditors are sensitive to business risk, which might not be captured in their implementation of the audit risk model. Partial support is found for the finding in Barron et al [2001], which found that the discovery of an overstatement error would lead to higher levels of audit investment.