Auditor Litigation Risk and Capital Structure Dynamics

Synopsis The research problem There is a long-standing debate on the appropriate level of auditor legal liability; however, there is little evidence in the empirical literature about whether limits on auditor liability will be harmful or beneficial to firms and capital suppliers in financial markets. We examine the effect of third-party auditor litigation risk on firm capital structure dynamics. Institutional setting We exploit the staggered state-level shocks to third-party auditor legal liability in the United States by using state court rulings on major precedent-setting cases. The test hypothesis Higher auditor litigation risk might lead to better auditing and financial reporting, less information asymmetry between firms and capital providers, and a lower cost of debt. As a result, firms may be more likely to take on more debt and make changes to their use of debt of different maturities. Adopted methodology To test our hypotheses, we use a difference-in-difference estimation approach. This approach allows us to compare the financial leverage of a treatment firm affected by the shock with that of a control firm not affected by the state-level shock throughout the sample period. Findings and implications We find strong evidence that an exogenous increase in auditor litigation risk leads to higher leverage ratios, a lower cost of debt, and greater use of longer-term debt. Firms in states with higher auditor litigation risk increase leverage to optimal debt levels compared with firms in states with lower auditor litigation risk. Our findings provide valuable insights into the capital market and the firm-level implications of auditor legal liability.