On the Causal Effect of Information Asymmetry on Auditor Choice

Abstract

We provide causal evidence on the agency cost explanation of the demand for high quality auditing. Using brokerage house closures/ mergers as a natural experiment to identify exogenous increases in agency costs arising from information asymmetry, we find that after experiencing exogenous reductions in analyst coverage, treatment firms are more likely to appoint external auditors of higher quality relative to a propensity-score-matched control firms. This effect is stronger for treatment firms with greater reductions in analyst coverage. In addition, we show that treatment firms appointing new auditors with higher quality experience increased stock liquidity and reduced cost of equity capital, suggesting that auditor choices have real benefits. We view our results as one of the first pieces of causal evidence supporting the theory that choosing high-quality external auditors is a bonding mechanism that firms use to reduce information asymmetry and the resultant agency costs.