The Association Between Stock Liquidity and Financial Reporting Risk
65 Pages Posted: 5 Sep 2018 Last revised: 23 Sep 2019
Date Written: September 19, 2019
In this study, we examine the association between stock liquidity and financial reporting risk, using audit pricing as a proxy for financial reporting risk. Higher levels of stock liquidity can reduce firm misstatement risk by enhancing corporate governance through, for example, the increased possibility of an exit by blockholders (e.g., Edmans 2009). On the other hand, liquidity may also impede internal governance via the loss of active blockholders (Bhide 1993; Back et al. 2015). In addition, higher stock liquidity might be associated with higher information demand from investors as well as higher expected litigation costs. We provide evidence of a positive relation between stock liquidity and audit fees, suggesting that – on average – stock liquidity increases financial reporting risk. These results hold using an instrumental variables approach, using stock splits as exogenous shocks, and using alternative liquidity measures. The effect of stock liquidity on audit fees is more pronounced for firms with weaker internal governance and firms with smaller (non-Big N) auditors. Path analysis indicates that auditor litigation exposure, annual report readability, and misstatement risk play a mediating role. Additional analysis indicates that higher stock liquidity is associated with more costly non-audit service fees, a higher issuance of going concern opinions, and lower financial reporting quality from the client. Taken together, our findings suggest that the net benefits of stock liquidity may be lower than previously thought after considering the effect of stock liquidity on firms’ financial reporting risk and quality.
Keywords: Stock Liquidity, Investor Disagreement, Internal Governance, Audit Risk
Suggested Citation: Suggested Citation