Audit Quality and Investment Efficiency with Informed Trading

Abstract

We study how informed, strategic trading affects audit quality and investment efficiency. With the auditor's legal liability payment based on the decrease in the market price after an audit failure, informed trading provides a hedge to the auditor against legal liability risk. This weakens incentives for audit quality, causing the strategic trader to produce more information due to higher gains from trade. Stricter legal liability leads to higher audit quality and less informed trading. When both the audit report and market prices can be used to guide real investments, stricter liability can lead to higher or lower investment efficiency. For a high growth firm, the firm learns more from the audit report, and higher audit quality leads to greater investment efficiency due to less overinvestment. For a low growth firm, audit quality has no effect on investment, and with less informed trading, investment efficiency is lower due to more underinvestment.