The Association between Stock Liquidity and Audit Pricing

Abstract

SUMMARY Prior research finds that firms' stock liquidity is associated with more aggressive discretionary accruals and revenues, suggesting that firms face pressure to make more aggressive accounting decisions when liquidity is high. However, the literature has yet to examine whether the effects of liquidity on financial reporting quality are severe enough to impact audit risk. We address this gap and offer three main findings. First, we find a positive association between stock liquidity and the probability of restatements, suggesting that the pressures from liquidity to engage in aggressive reporting decisions are severe enough to increase audit risk. Second, we find a positive association between stock liquidity and audit fees, suggesting that auditors at least partially incorporate the audit risk from liquidity into their pricing decisions. Finally, we find that the positive association between liquidity and audit pricing is concentrated in firms with poor corporate governance mechanisms. JEL Classifications: G12; G30; M42.