Auditor Liability, Litigation Risk, and Corporate Tax Avoidance: Evidence from a Quasi-Experiment in the U.S.

Abstract

Exploiting the staggered changes in state-level auditor third-party liability in the U.S. as an exogenous shock, we examine the role that auditor litigation risk plays in shaping corporate tax avoidance. We find that firms significantly reduce their tax avoidance after an exogenous increase in their auditors’ litigation risk. The impact of increased auditor litigation risk on corporate tax avoidance is stronger for firms audited by Big N auditors, firms with higher ex ante litigation risk, firms covered by more analysts, and court rulings relating to tax account misrepresentation. Additional evidence implies that the reduction in corporate tax avoidance after an increase in auditor litigation risk is associated with improvements to firms’ financial reporting transparency and information environment. We document a plausibly causal effect of auditor litigation risk on corporate tax policies.

Keywords: Auditor Liability; Corporate Tax Avoidance; Litigation Risk

JEL Classification: H26; K40; M42