The Association Between Stock Liquidity and Audit Pricing
AUDITING: A Journal of Practice & Theory, Forthcoming
46 Pages Posted: 5 Sep 2018 Last revised: 1 Sep 2022
Date Written: August 23, 2022
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 this gap and offer three main findings. First, we find a positive association between stock liquidity and the probability of a financial statement restatement. This finding suggests that the pressures from liquidity to engage in aggressive reporting decisions are severe enough to result in outcomes that increase audit risk. Second, we find a positive association between the stock liquidity and audit fees, suggesting that auditors at least partially incorporate the increased audit risk from liquidity into their pricing decisions, and possibly how much audit effort to exert. 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 increase audit risk, that liquidity is positively associated with audit pricing, and that these effects are diminished when firms have otherwise strong corporate governance mechanisms.
Keywords: Stock Liquidity, Investor Disagreement, Internal Governance, Audit Risk
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