Managerial litigation risk and auditor choice

• Published date: 01 January 2024
• Author: Leye Li,Gary S. Monroe,Jeff Coulton
• Date: 01 January 2024
• DOI: http://doi.org/10.1111/ijau.12322

ORIGINAL ARTICLE

Managerial litigation risk and auditor choice

Leye Li | Gary S. Monroe | Jeff Coulton

UNSW Business School, UNSW Sydney,

Sydney, New South Wales, Australia

Correspondence

Leye Li, UNSW Sydney, UNSW Business

School, Room 3068 Quadrangle Building,

NSW 2052, Australia.

Email: leye.li@unsw.edu.au

Funding information

No specific funding sources were used for this

project.

Our study investigates the causal relationship between managerial litigation risk and

auditor choice decisions. Exploiting the staggered adoption of universal demand

(UD) laws at the state level in the United States, we use a stacked regression

approach and find a lower propensity for affected firms to switch to higher-quality

auditors after the exogenous reduction of managerial litigation risk. This result sup-

ports the managerial entrenchment hypothesis that lower litigation risk leads to more

managerial entrenchment, which allows managers to be opaque in order to enjoy pri-

vate benefits. This negative effect is mitigated for firms with more audit committee

industry expertise and for firms that are more reliant on external finance. Our study

contributes to our understanding of how regulatory changes that have an impact on

agency problems affect firms' demand for auditing.

KEYWORDS

auditor choice, auditor switching, derivative lawsuits, shareholder litigation, universal demand

laws

JEL CLASSIFICATION

K20, M42

1|INTRODUCTION

The adoption of universal demand (UD) laws exogenously decreased

investors' ability to file derivative lawsuits against managers. We

investigate the impact of UD law adoption on firms' auditor choice.

Managerial litigation helps resolve agency problems by curbing mana-

gerial opportunism and holding mangers accountable for their actions

and decisions (La Porta et al., 2000). Prior research documents that

managers' litigation risk is associated with various aspects of corpo-

rate behaviours, such as debt contracting (Beatty et al., 2008), board

discipline (Cheng et al., 2010) and disclosure policies (e.g., Baginski

et al., 2002; Bourveau et al., 2018; Francis et al., 1994; Huang

et al., 2020; Skinner, 1994). One stream of the literature finds that

managers' litigation risk is associated with the quality of firms' finan-

cial reporting (e.g., Ball et al., 2000; Francis & Wang, 2008). However,

the way in which managers' litigation risk affects their firms' financial

reporting quality is unclear. In this study, we focus on one of the most

important corporate decisions that affects financial reporting quality—

the choice of auditor.

By providing independent assurance on the information con-

tained in financial reports provided to external financial report users,

auditors are an important monitoring and bonding mechanism that

helps to mitigate agency costs arising from the information asymmetry

between managers and investors (Jensen & Meckling, 1976). In our

study, we use agency theory to propose two competing hypotheses

regarding how a variation in managers' litigation risk affects a firm's

auditor choice decisions. Agency theory suggests that insiders may

respond to greater agency conflicts by increasing transparency and

information sharing with outsiders, which requires higher-quality

information assurance services, that is, auditing. The appointment of a

high-quality auditor not only reduces a firm's agency (financing) costs

(e.g., Kausar et al., 2016; Pittman & Fortin, 2004) but also provides a

Received: 20 December 2021 Revised: 21 April 2023 Accepted: 19 May 2023

DOI: 10.1111/ijau.12322

This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License, which permits use and distribution in any

medium, provided the original work is properly cited, the use is non-commercial and no modifications or adaptations are made.

© 2023 The Authors. International Journal of Auditing published by John Wiley & Sons Ltd.

142 Int J Audit. 2024;28:142–169.

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bonding mechanism to curb managerial opportunistic behaviours

(Choi & Wong, 2007).

1

Prior studies show that higher managerial liti-

gation risk decreases a firm's cost of capital and reduces managerial

self-dealing (Donelson & Yust, 2014; La Porta et al., 2002). As man-

agers' litigation risk decreases, investors are more likely to perceive

managerial behaviours as self-dealing because of weakened share-

holder rights and governance mechanisms and thus charge a higher

cost of capital to price-protect themselves. In this case, managers and

audit committee (AC) members have incentives to engage high-quality

auditors to increase financial reporting transparency, mitigate agency

conflicts and reduce their firms' cost of capital. We term this view the

agency cost reduction hypothesis.

On the other hand, instead of increasing information sharing with

outsiders, managers may become more entrenched when their litiga-

tion risk becomes lower, which negatively impacts the quality of

financial reporting. Entrenched managers may deliberately render the

financial statements opaque and less informative to make it easier to

expropriate wealth from outsiders and hide their actions (Ferreira &

Laux, 2007; Jin & Myers, 2006). Supporting this view, Francis et al.

(2003) provide country-level evidence that the demand for high-

quality audits is lower in countries with weaker legal environments.

Under this argument, a reduction in managerial litigation risk

decreases managers' propensity to appoint high-quality auditors. We

term this view the managerial entrenchment hypothesis.

This underlying tension in managers' auditor choice incentives

and the lack of research on this topic motivate our study. The scarcity

of empirical work is mainly due to the following two reasons. First,

the relation between managers' litigation risk and auditor choice is

endogenous. Because the choice of auditor is an important determi-

nant of a firm's disclosure quality and low-quality disclosures tend to

trigger shareholder litigation (Billings & Lewis-Western, 2016;

Skinner, 1994), it is hard to establish a causal relation between the

threat of shareholder litigation and auditor choice. Moreover, both

managers' litigation risk and auditor choice are related to managers'

own characteristics and behaviours.

2

These prevent drawing a causal

inference and calls for a setting where a variation of managerial litiga-

tion risk is due to an exogenous shock unrelated to a firm's choice of

auditor or other managers' choice variables. Second, because many

shareholder litigation cases name both the managers and auditors as

defendants, it is hard to differentiate the litigation risk of managers

from that of auditors. Litigation risk is a central consideration when

auditors supply assurance services (DeFond & Zhang, 2014;

Simunic & Stein, 1996). Thus, even if there is an exogenous variation

in litigation risk of managers and a change in auditor choice after the

shock, it is still not safe to assert that the change is a consequence of

the change in managers' litigation risk, because such a shock may

change the auditor's probability of being sued and thus alter their sup-

ply or pricing of auditor services.

3

To overcome these problems, we exploit an exogenous reduction

in managers' litigation risk introduced by the adoption of UD laws at

the state level in the United States since 1989, which makes share-

holder derivative lawsuits more difficult, if not impossible

(Appel, 2019).

4

This setting has two advantages. First, the adoption of

UD laws is a series of exogenous events beyond managers' control.

Second, UD laws only change shareholders' rights to file derivative

lawsuits, a subset of shareholder litigation that rarely target auditors.

Specifically, we show in Section 2.1 that during the 17-year period

starting from 2000, there are only 42 derivative lawsuits where audi-

tors are named as defendants, and almost all these suits were conse-

quently dismissed or denied. These derivative lawsuits represent less

than 1.5% of all the lawsuits faced by auditors as documented in the

AuditAnalytics database. Thus, we assert that the adoption of UD

laws does not substantially impact the litigation risk of auditors and

provides a setting to examine how an exogenous shock to managers'

litigation risk affects their firms' choice of auditor.

Using a sample of US firm-year observations from 2000 to 2007

and a stacked regressi on method (Baker et al., 2022), we compare

the auditor choices of firms incorporated in the states that have

adopted UD laws (treatment firms) with those of firms incorporated

in states that have neve r adopted UD laws (control firms) during t he

same period. We find that the adoption of UD l aws is associated

with a lower probability of switching to higher-qualityauditors, after

controlling for the kn own determinants of aud itor choice. These

results are robust to using a subsample of firm-year observations

with auditor switche s to control for the like lihood of changing audi-

tors, to excluding t he pre-SOX years, to removing firms that already

engage with high-qual ity auditors, to excl uding Delaware firms an d

to placebo tests. Overall, these results support the managerial

entrenchment hypot hesis that managers respond to a reduction in

managerial litigat ion risk with a decreased pr opensity to appoint

high-quality auditors.

In addition, we further explore the settings under which we

expect the managerial litigation risk-auditor choice relation to vary

cross-sectionally. We find that the negative relation between the

adoption of UD laws and the firms' propensity to engage higher-

quality auditors is less pronounced for firms with more AC industry

expertise and for firms that are more reliant on external finance.

These results suggest that the effect of UD laws could be mitigated

by better corporate governance mechanisms as well as firms' demand

for reducing information asymmetry.

Our study contributes to our understanding of the most dominant

determinant of firms' demand for auditing, that is, agency costs. Vari-

ous prior studies provide empirical evidence that heightened agency

costs increase firms' demand for high-quality auditors

(e.g., DeFond, 1992; Kang, 2014; Lennox, 2005). However, DeFond

and Zhang (2014) highlight that two of the major challenges in this lit-

erature are to identify settings where there is exogenous variation in

agency costs and to develop valid agency cost proxies. Extant studies

address these challenges by exploiting international settings (Fan &

Wong, 2005), events such as IPO and privatization that shift owner-

ship structure (Copley & Douthett, 2002; Guedhami et al., 2009) and

forced auditor changes due to the collapse of Arthur Andersen LLP

(Barton, 2005; Blouin et al., 2007). Our study focuses on another

important, but unexplored determinant of agency costs, managerial lit-

igation risk. By exploiting a change in shareholders' derivative litiga-

tion rights that arguably do not alter the litigation concern of auditors,

LI ET AL.143