Perceived Changes in Audit Quality and Firm Value : Evidence From Investors’ Reaction to the Revelation of Limiting Liability Agreements in Audit Engagement Letters

We examine the value of changes in U.S. investors' perceptions of audit quality by analyzing the market reaction to the first public revelation of liability limiting agreements (LLAs) in audit engagement letters of publicly traded firms. The revelation of the existence of LLAs in audit engagement letters of publicly traded firms results in substantial losses in their values and lower shareholders' approval of their auditors. Consistent with investors' reaction to the revelation being associated with concerns about audit quality, the loss in value is strongly related to clients' incentives and opportunity to misreport. Specifically, the loss is more pronounced when a firm's earnings quality is low, the firm's recent reported earnings barely meet the average analyst earnings forecast, the firm has recently issued stocks, and the managers have recently sold stocks on their own accounts. The loss is also attenuated when outsiders constitute a super-majority of the firm's board of directors. Overall, the evidence suggests that investors attribute a substantial premium to external audits and that investors' negative perception of audit quality significantly increases issuers' cost of capital and, consequently, adversely affects firm value