Managerial litigation risk and auditor choice

Abstract

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 supports the managerial entrenchment hypothesis that lower litigation risk leads to more managerial entrenchment, which allows managers to be opaque in order to enjoy private 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.