Audit Quality and Investment Efficiency with Informed Trading

Abstract

We study how informed, strategic trading affects audit quality and investment efficiency. With the auditor's damage payment due to legal liability based on the decrease in the market price after an audit failure, we show that informed trading provides a hedge to the auditor against legal liability risk, and weakens incentives for audit quality. In turn, the strategic trader produces more information due to higher gains from trade that are made available by lower audit quality. Moreover, the behavior of liquidity traders affects both audit quality and the extent of informed trading, and is not monotonically related. A stricter legal liability regime leads to higher audit quality and less informed trading. However, prices can be used to guide real investments, such as corporate expansions and stricter liability might lead to lower investment efficiency because with less informed trading, market prices are less informative.