An empirical test of the insurance hypothesis in auditing

The primary objective of this dissertation is to test whether investors, when pricing a security, value the auditor's ability to provide an insurance role. Menon and Williams (1994) assert that the legal right to seek recovery of investment losses from auditors is valued by investors and that this value is reflected in stock prices. This assertion has been referred to in the accounting literature as the insurance hypothesis. Several market price studies find evidence consistent with the insurance hypothesis but are unable to rule out an “audit quality” explanation for the findings. This dissertation utilizes an experiment-based approach to test the insurance hypothesis. The experiment's design manipulates the legal right to seek recovery of investment losses from auditors while controlling for audit quality.; Another objective of this dissertation is to examine interactive effects of audit opinion and audit liability on stock price. Frost (1994) proposes that the issuance of a going concern opinion protects auditors from litigation. If this is true, then the value an audit's insurance component should be affected by the type of audit opinion that is issued.; An experiment was conducted that used a decision case to solicit, from financial analysts, stock price predictions based on information about a fictional company, the ability to recover investment losses from auditors and whether the auditor issued a clean unqualified opinion or a going concern opinion. Participants' stock price predictions are consistent with the predictions of the insurance hypothesis. The results also provide evidence that the going concern opinion contains value relevant information that is independent of that which affects the value of the audit's insurance component. The results do not support the hypothesized moderating effect of audit opinion on the relationship between insurance and stock price. However, the results do provide limited evidence that the level of auditor liability moderates the relationship between the audit opinion and the stock price. This latter finding supports Schwartz's (1997) assertion that audit liability may lead to over-investment in risky assets.