The Price of Stock Liquidity: The Effect of Investor Disagreement on Audit Risk
64 Pages Posted: 5 Sep 2018 Last revised: 22 Mar 2019
Date Written: March 18, 2019
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). However, 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. In this study, we examine how auditors respond to a client’s stock liquidity. We provide evidence of a positive relation between stock liquidity and audit fees, suggesting that stock liquidity increases audit 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, investor information demand 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. Taken together, our findings suggest that stock liquidity is positively associated with auditor risk because of its effect on audit litigation risk and investors’ demand for disclosure.
Keywords: Stock Liquidity, Investor Disagreement, Internal Governance, Audit Risk
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