The Effect of Auditor Litigation Risk on Client Access to Bank Debt: Evidence from a Quasi-Experiment

47 Pages Posted: 24 Mar 2019

See all articles by Mahfuz Chy

Mahfuz Chy

University of Missouri at Columbia - Robert J. Trulaske, Sr. College of Business

Gus De Franco

Tulane University - A.B. Freeman School of Business

Barbara Su

Temple University - Fox School of Business and Management

Date Written: November 28, 2018

Abstract

We exploit state-level staggered shocks to third-party auditor legal liability in the U.S. to test whether auditor litigation risk affects client’s access to private debt markets. We argue that higher auditor litigation risk reduces the agency costs of debt by improving financial statement quality. Further, greater auditor litigation risk enhances the insurance value to creditors of the auditing process. Consistent with these arguments, we find that an exogenous increase in auditor litigation risk leads to both an increase in a client’s likelihood of receiving bank loans and the average amount of bank loans that the client receives. Our cross-sectional tests show that the effect of auditor litigation risk on clients’ access to debt finance is stronger when borrowers face ex-ante greater agency costs of debt and when creditors benefit more from the enhanced insurance value of auditors. Last, we also find that increased auditor litigation risk leads to an increase in the contractibility of accounting numbers, as proxied by the use of debt covenants, and a decrease in the cost of borrowing. To the best of our knowledge, we are the first to document these relations between auditor litigation risk and clients’ borrowing in a “clean” setting that ensures confidence in causal inferences.

Keywords: debt financing; auditor litigation risk; state liability laws

Suggested Citation

Chy, Mahfuz and De Franco, Gus and Su, Barbara, The Effect of Auditor Litigation Risk on Client Access to Bank Debt: Evidence from a Quasi-Experiment (November 28, 2018). Available at SSRN: https://ssrn.com/abstract=3292619 or http://dx.doi.org/10.2139/ssrn.3292619

Mahfuz Chy

University of Missouri at Columbia - Robert J. Trulaske, Sr. College of Business ( email )

331 Cornell Hall
Columbia, MO 65211
United States

Gus De Franco (Contact Author)

Tulane University - A.B. Freeman School of Business ( email )

7 McAlister Drive
New Orleans, LA 70118
United States

Barbara Su

Temple University - Fox School of Business and Management ( email )

Philadelphia, PA 19122
United States

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