The Price of Stock Liquidity: The Effect of Investor Disagreement on Audit Risk

Abstract

Prior research finds that the liquidity of a firm’s equity shares is associated with that firm having more aggressive discretionary accruals and revenues, suggesting that firms face pressure to make more aggressive accounting decisions when liquidity is high. However, the literature has yet to examine whether the effects of liquidity on financial reporting quality are severe enough to impact audit risk. We address that gap in the literature and offer three main findings. First, we find a positive association between the liquidity of a firm’s equity shares and the probability of a financial statement restatement, as well as the likelihood it receives a going concern opinion. These findings suggest that the pressures from liquidity to engage in aggressive reporting decisions are severe enough to result in outcomes that would increase audit risk. Second, we find a positive association between the liquidity of a firm’s equity shares and audit fees, suggesting that auditors appear to incorporate the increased audit risk from liquidity into their pricing decisions. Finally, we find that the positive association between stock liquidity and audit pricing is concentrated in firms with poor corporate governance mechanisms. Overall, our results suggest that the effects of liquidity on financial reporting incentives are strong enough to result in outcomes that increase audit risk, that auditors appear to recognize this fact in their pricing decisions, and that these effects are diminished when firms have otherwise strong corporate governance mechanisms.