Litigation risk is the probability that due to some reasons legal actions will be taken against corporation or individual. In some cases companies undertake actions in environment in which interpretation of legislation acts changes (e.g. new government interprets some articles of tax legislation differently). In most cases it is impossible to stop operation of the company until full analysis of changes will be finished. Thus the only way is to take risk and operate in unstable environment. Litigation risk analysis helps to determine possible results of such decision.
In other cases companies try to improve their results by using methods of bookkeeping that are disputable (e.g. creative accounting). They assess what is the possibility of litigation in those cases.
Pricing litigation risk
An important obstruction in development the mechanism connected with risk defensive transfer which is a real challenge regarding pricing the litigation risk. It is expected that insurance companies would customarily have litigation risk insurance in their offer, similarly to offering other types of insurance for a different type of risk. If only pricing wont be a hidrance (J.T. Molot 2009, p. 380).
Finding capital to cover litigation risk
Obtaining capital necessary for absotption the litigation risk that's one of the things lawyers have to do if they want to create a market in terms of litigation risk. The lawyer cant release the respondent from the risk when the lawyer cant guarantee the respondent that he owns the money in order to pay a judgement at a price higher than expected. Single lawyers and big law offices usually don't have working capital in order to pay unfavorable litigation judgments about the size that their corporate customers are afraid of. In that case lawyers are forced to contact third parties to provide venture capital and joint risks. If it comes to managing and pricing litigation risk, the lawyers can deal with this in the best way. But they will fail in transformation the customer advisers into market members if they aren't able to collect the necessary risk capital (J.T. Molot 2009, p. 392).
For many years constant problem for auditors has been an auditor litigation risk. Previous studies about auditor litigation concentrate on identifying the components which may have an effect on the probability of occurrence of auditor litigation. "St.Pierre and Anderson (1984) analyze 129 cases that were filed against auditors."(J. Sun, L. Guoping 2011, p. 6). According to research when auditors cope with new clients, the legal risk get bigger. This risk doesn't get bigger when auditors stiffly accept conservatism which brings them to mistakes in under-valuing assets. The one who analyzes the relationship between features of customer involvement before audit and further accusation of the auditor was Stice in 1991. He thinks that there is a valid connection between auditor litigation and inventory, receivables ratios to total assets, also financial situation and market value are directly connected with auditor litigation.
- Khurana, I. K., & Raman, K. K. (2004). Litigation risk and the financial reporting credibility of Big 4 versus non-Big 4 audits: Evidence from Anglo-American countries. "The Accounting Review", 79(2), 473-495.
- Kim I., Skinner D. J. (2012). Measuring securities litigation risk, "ScienceDirect", Vol.53, p. 290-310
- Koh P.S., Qian C., Wang H. (2014). Firm Litigation Risk and the Insurance Value of Corporate Social Performance, "Strategic Management Journal", Vol. 35, p. 1464-1482
- Molot J. T., (2009). Market in Litigation Risk, "The University of Chicago Law Review", Vol. 79, No. 1, p. 367-439
- Sun J., Guoping L. (2011). Client‐specific litigation risk and audit quality differentiation, "Emerald", Vol. 26, Issue: 4, p. 300-316
Author: Karolina Korbut