Perceived Audit Quality and Firm Value: Evidence From Investors’ Reaction to the First Disclosure of Limiting Liability Agreements

• In Event: Litigation Risk

Abstract

We observe a substantial decrease in the market value of US firms after the disclosure of the existence of liability limiting agreement (LLA) clauses in audit engagement letters of publicly traded firms. Consistent with institutional investors being more efficient in processing information than individual investors, the negative reaction is driven mainly by firms with high institutional ownership. The reduction in the market value of US firms is also significantly larger for the Big 4 than for the non-Big 4 clients, which is consistent with the fact that the LLA practice was directly associated to three of the Big 4 audit firms (EY, Deloitte & Touche, and KPMG) and the fact that the Big 4 auditors have presumably more to lose from a loss of confidence in the audit process. The market loss is also more pronounced for the clients of the three audit firms that were directly linked to the LLA practice. Auditors’ approval rates also decreased after the LLA practice was publicized, with the reduction being driven mainly by the clients of the audit firms that admitted to the practice. Overall, the empirical evidence suggests that US investors attribute a significant premium to the audit opinion and that investors’ negative perception of reporting quality has an adverse effect on firm value.

Authors

• Amy Sun, UH

• Henock Louis, The Pennsylvania State University

• Dahlia M. Robinson, University of South Florida