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

SynopsisThe research problemThis study examines whether and how the increase in auditors’ legal liability affects their clients’ stock price crash risk.MotivationPrevious studies have shown that auditors have the incentive to reduce potential litigation risk by improving clients’ financial reporting quality, which in turn limits their clients’ ability to withhold bad news; however, the literature does not provide direct evidence on the relationship between auditor litigation risk and client crash risk. Besides, most studies have focused on auditors’ impact on clients’ financial statements but seldom have investigated auditors’ impact on clients’ other information-disclosure channels. This study attempts to provide evidence showing that auditor legal liability could indirectly affect clients’ crash risk by influencing clients’ conservatism in accounting practices and optimism in information disclosure.The test hypothesesH1: Clients experience declines in future stock price crash risk after their auditors change from the limited liability company (LLC) form to the limited liability partnership (LLP) form.H2: After changing to the LLP form, auditors enhance clients’ accounting conservatism and decrease clients’ optimism in management earnings forecasts and MD&A disclosures, thereby lowering clients’ future stock price crash risk.Target populationThis study should be of interest to auditors, firm managers, investors, and policy makers.Adopted methodologyWe adopted Ordinary Least Squares (OLS) regressions and path analysis.AnalysesWe utilized the staggered organizational transformation of Chinese audit firms — i.e., from LLCs to LLPs — to identify the increase in auditors’ legal liability. Using a sample of Chinese public-listed firms, we performed cross-sectional regressions to examine how clients’ crash risk changes after their auditors transform to LLPs. Next, we conducted a path analysis to show how auditor litigation risk affected client crash risk.FindingsWe found that after auditors transform into LLPs, their clients demonstrate lower crash risk. We further found that accounting conservatism, optimism in management earnings forecasts, and optimism in management discussion and analysis (MD&A) disclosures explained the negative relationship between auditor legal liability and client crash risk.