Faculty Scholarship 1994 - Present

Market Reactions to Big Six's Announcements of Conversion to Limited Liability Partnership

Facing tremendous liability exposures, the public accounting profession lobbied for change to a limited liability status, achieving success in 1994 when firms were permitted to change to limited liability partnerships (LLPs). All the Big 6 converted to LLPs in this year. Wallace (1980) had proposed that the demand for auditing arose because of three factors: the need for reliable information, a monitoring mechanism (monitoring hypothesis), and an insurance against distorted information (insurance hypothesis). Previous studies could not test for the effect of the insurance hypothesis alone since the effect of the monitoring hypothesis confounded the results. The formation of LLPs affords a basis to test for the insurance hypothesis since the quality of the audit process (the monitoring hypothesis) is not affected by the LLP formation, at least in the short term. Our study thus tests for market reactions to the decision to convert to LLPs by the Big 6 and finds a significant negative reaction around the date of formation. In addition, we also find that the weaker and riskier clients of the Big 6 show a significant and negative reaction to the formation of the LLPs. Since the insurance protection provided by the audit firms is of greater relevance to the investors in these companies, the fact that some of the personal assets of the firms' partners are shielded with the LLP formation affects the total assets available. Hence, the returns of these companies securities' are negatively affected around the date of formation of LLP by the audit firms. This also proves the insurance hypothesis as proposed by Wallace (1980).