Fraud and error misstatements and auditor liability: The moderating role of the evaluator’s auditing knowledge

Although a restatement is usually assumed to result from fraudulent behavior, Plumlee and Yohn (2010) studied whether a restatement might be attributed to both errors in the corporation’s internal controls and intentional misrepresentation. Moreover, prior research supports the notion that investors, regulators, boards, and other stockholders differentiate between fraud and error (Hennes et al., 2008). This study provides a preliminary understanding of how undetected fraud and error misstatements affect auditor liability, given the same outcome severity. A 2x2 between-subject experiment was conducted using undergraduate accounting students to represent evaluators who have high levels of auditing knowledge and nonaccounting students to represent evaluators with low levels of auditing knowledge. The results from the experiment indicate that evaluators with high auditing knowledge assess auditors as less liable in cases of undetected misstatements due to fraud rather than an error. In contrast, less knowledgeable evaluators rate auditors as being more liable in such cases. The findings of this study provide some insights that benefit the audit profession, standard setters, and the Security and Exchange Commission (SEC) concerning the auditor’s responsibility relating to fraud by demonstrating that different types of misstatements (i.e., fraud and error) contribute to differences in auditor liability judgments, especially when misstatements are evaluated by evaluators with different levels of auditing knowledge. This finding also suggests that the auditor litigation risk created by the expectation gap will remain despite any attempt to minimize it.