The insurance hypothesis and auditor limited liability

This study investigates the relation of auditor liability status and the prices of securities in the initial public offering (IPO) market. Existing research has proposed that auditors provide implicit insurance to investors through the ability of investors to recover damages from audit firms. During the 1990's, many audit firms have converted to limited liability forms of practice thus limiting the potential insurance value of audits. If there is an insurance element associated with the audit function, then the value of a security should include the amount of this insurance function. This study examines differences between the valuations of securities based upon whether the associated audit firms have limited their liability. The IPO market was selected for this study because that market is characterized by less outside information available to investors, a higher level of financial risk, and securities laws favorable to investors.; Based on prior research, this study uses initial market underpricing as the primary measure of valuation decisions made in the IPO market. It is expected that underpricing is greater when non-limited liability auditors are associated with IPO securities than when audit firms with limited liability are associated with the IPO. Contrary to expectations, this study provides evidence of greater underpricing of IPO securities after the Big Six audit firms converted to limited liability. This study does not find similar evidence with non-Big Six audit firms.; This study also examines the effect of IPO firms' financial conditions on the relationship between IPO underpricing and the associated auditor's liability status. If investors incorporate the implicit insurance into valuation decisions, the value of the implicit insurance should be greater for riskier investments. There is limited, positive evidence that there is some insurance pricing associated with the auditor liability for higher financial risk IPO companies.; This dissertation contributes to the literature on the economic role of auditors. Overall, the findings do not support that the insurance premium can be measured by traditional IPO underpricing. It may be associated with the initial offering prices of the stocks, but tests were not able to measure that dimension.