Auditor Legal Liability and Stock Price Crash Risk: Evidence from Organizational Transformation of Chinese Audit Firms

Abstract

We utilize Chinese audit firms' organizational transformation to identify the increase in auditors’ legal liability and find that after auditors transform into limited liability partnerships (LLPs), their clients demonstrate lower future stock price crash risk. Using the path analysis, we find that accounting conservatism, optimism in management earnings forecasts, and optimism in management discussion and analysis (MD&A) disclosures explain the negative relationship between auditor legal liability and client crash risk. The results are less pronounced for auditors finishing the transformation in an early stage than for auditors subject to the mandatory transformation in 2013, as the former generally has a larger size and higher audit quality before the transformation. Overall, this study complements the existing literature on litigation risk and the auditor’s monitoring role in the client information environment.

Keywords: auditor litigation risk, auditor organizational transformation, stock price crash risk, accounting conservatism, management earnings forecasts, MD&A

JEL Classification: G14, M42, M48