Auditor Legal Liability and Stock Price Crash Risk: Evidence from Organizational Transformation of Chinese Audit Firms

Abstract

Synopsis The research problem This study examines whether and how the increase in auditors’ legal liability affects their clients’ stock price crash risk. Motivation Previous studies have shown that auditors have the incentive to reduce potential litigation risk by improving clients’ financial reporting quality, which in turn limits their clients’ ability to withhold bad news; however, the literature does not provide direct evidence on the relationship between auditor litigation risk and client crash risk. Besides, most studies have focused on auditors’ impact on clients’ financial statements but seldom have investigated auditors’ impact on clients’ other information-disclosure channels. This study attempts to provide evidence showing that auditor legal liability could indirectly affect clients’ crash risk by influencing clients’ conservatism in accounting practices and optimism in information disclosure. The test hypotheses H1: Clients experience declines in future stock price crash risk after their auditors change from the limited liability company (LLC) form to the limited liability partnership (LLP) form. H2: After changing to the LLP form, auditors enhance clients’ accounting conservatism and decrease clients’ optimism in management earnings forecasts and MD&A disclosures, thereby lowering clients’ future stock price crash risk. Target population This study should be of interest to auditors, firm managers, investors, and policy makers. Adopted methodology We adopted Ordinary Least Squares (OLS) regressions and path analysis. Analyses We utilized the staggered organizational transformation of Chinese audit firms — i.e., from LLCs to LLPs — to identify the increase in auditors’ legal liability. Using a sample of Chinese public-listed firms, we performed cross-sectional regressions to examine how clients’ crash risk changes after their auditors transform to LLPs. Next, we conducted a path analysis to show how auditor litigation risk affected client crash risk. Findings We found that after auditors transform into LLPs, their clients demonstrate lower crash risk. We further found that accounting conservatism, optimism in management earnings forecasts, and optimism in management discussion and analysis (MD&A) disclosures explained the negative relationship between auditor legal liability and client crash risk.