To what extent can the risk of litigation against auditors be beneficial or harmful to companies? Auditors play an important role in financial contracting by certifying the credibility and reliability of financial statements that third parties rely upon. Increased risk of liability claims against auditors by third parties could result in huge financial costs and reputational damage to auditors. Therefore, from a theoretical perspective, auditors are more likely to increase their scrutiny of clients’ financial processes, leading to improved financial reporting and enhanced credibility of financial statements. Studies show that improved financial reporting, occasioned by increased risk of auditor litigation, enables firms to access more bank loans. It also leads to higher leverage ratios, lower cost of debt, and greater use of longer-term debt. The extant literature, therefore, shows that the auditor legal environment has important implications for both firm financial reporting and financing practices. However, to obtain a more holistic picture of the implications of auditor litigation risk, it is important to understand how it affects other equally important aspects of firm behavior, such as investment policy. This is important to enable policymakers and regulators to determine the right extent to which auditors should be held liable.
Our Empirical Study
Our recent empirical study uses a sample of US firms to examine the effect of auditor litigation risk on the level and efficiency of firms’ investment in both capital expenditure and labor. To measure the risk of auditor litigation, we use rulings in precedent-setting cases by US state courts that change the extent of auditor liability to third parties. Third party auditor liability in the states is based on common law, which relies broadly on three standards. The first is privity, a more restrictive standard that requires evidence of a contractual relationship between auditors and third parties. Given that very few third parties may be able to prove such a contractual relationship, the application of this standard offers the lowest litigation risk to auditors. The second is the restatement standard. Under this standard, auditors can be sued by third parties for failing to exercise diligence and reasonable care if third parties suffer any losses from relying on information certified by auditors. The third standard is foreseeability. This is the most far-reaching of the three as auditors can be sued by all possible third parties for failing to exercise due diligence. In our framework, an increase in auditor litigation risk at the state level is measured by a shift from the application of a more restrictive standard (e.g., privity) to a relatively more expansive one (e.g., restatement or foreseeability) in the rulings of state courts in precedent-setting cases.
We employ a difference-in-differences approach in our empirical analysis. This allows us to compare investment decisions by firms in states before and after the change in auditor litigation risk, relative to firms in states with no change in auditor litigation risk at all. Also, the precedent-setting cases that we use to measure auditor litigation risk at the state level occur at different points in time in the affected states. This gives us a staggered change to auditor litigation risk. We are therefore able to attribute firm investment decisions to changes in auditor litigation risk rather than other factors that may have been related to auditor litigation risk.
Our findings reveal that firms located or headquartered in states with higher auditor litigation risk are associated with increased investments in both capital expenditure and labor. This is consistent with the view that by having more access to external financing, due to improved financial reporting as shown in previous studies such as Chy et al. (2021), firms in higher auditor litigation risk environments are able to increase their levels of investments. We observe this effect to be more pronounced for firms that rely on greater external financing, based on whether their use of external financing is higher than the median for their respective industries. Intuitively, if auditor litigation risk leads to improved reporting quality and increased access to debt markets, firms with greater reliance on external financing would be able to increase their investment activities. The relationship between auditor litigation risk and corporate investments is also more pronounced for firms with more financial constraints such as smaller and younger firms. Using the Hadlock and Pierce (2010) size-age index to measure financial constraints, we find that with improved financial reporting quality, emanating from auditor litigation risk, financially constrained firms might be able to improve their access to capital markets to finance investment expenditure.
We also find that increased auditor litigation risk leads to an increase in investment efficiency in capital and labor. We measure investment efficiency based on deviations from actual investment levels using models that predict investment levels of both capital and labor from sales growth. Our findings are consistent with the view that improved audit and financial reporting quality caused by increased auditor litigation risk reduces information asymmetry between firms and capital providers, leading to more efficient investments. If firms have efficient investments, then this implies that they can embark on additional profitable projects that might improve firm performance. We find that auditor litigation risk, by improving investment efficiency, also leads to improved firm performance.
We further explore two channels through which auditor litigation risk may affect firm investment decisions, i.e., leverage and cash holdings. With respect to the leverage channel, our intuition is that if auditor litigation risk improves audit and reporting quality, this could widen firms’ access to the debt markets, which may provide firms with more opportunities to fund corporate investments. We find evidence in support of this view. On the cash holdings channel, we argue that if higher auditor litigation risk leads to improved access to external financing, then we would expect firms to decrease their level of cash holdings to pursue investment opportunities. Again, we find results that are consistent with our expectation that firms in high auditor litigation risk environment decrease their holdings of cash to finance investment.
Our study contributes to a broader understanding of the other firm-level implications of auditor litigation risk. We show how the auditor legal environment affects firm behavior by providing comprehensive and robust evidence that the impact of auditor litigation risk is not limited to only financial reporting and corporate financing decisions as documented in the literature so far. We argue that auditor litigation risk also affects both the level and quality of firms’ investment decisions.
From a policy perspective, our study adds to a growing literature that will enable policymakers and regulators to determine the extent to which auditors can be held liable. To date, most policymakers, including the US Treasury, have yet to reach a consensus on whether and to what extent auditor legal liability can be useful for financial markets in general and companies in particular. Our study adds to the empirical studies that provide robust evidence to help shape such a debate.
Kwabena Boasiako is a Research Analyst Consultant with the Independent Evaluation Group of the World Bank.
Anthony Kyiu is an Assistant Professor in Finance at the Durham Business School.
Sylvester Adasi Manu is a Senior Lecturer in Finance at the Hong Kong Metropolitan University
Bernard Tawiah is a Ph.D. student in Finance at the Victoria University of Wellington.
This post is adapted from the authors’ paper, “Auditor litigation risk and corporate investments”, available on SSRN.
The views expressed in this post are those of the authors and do not represent the views of the Global Financial Markets Center or Duke Law.