Do Audited Financial Reports Mitigate (or Exacerbate) Stock Market Crashes?

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Abstract
Does audit assurance mitigate stock market crashes? We find this is not the case, contrary to conventional wisdom. Building on confirmation bias theory, we predict that audited financial statements may give investors a false sense of security regarding the firm’s fundamental value, potentially amplifying bubbles and crashes. To test this prediction, we compare stock price changes of firms with and without external audits around the Wall Street Crash of 1929––an important event that motivated the audit mandate in the Securities Exchange Act of 1934. Diverging from prevailing belief, we find that audited firms experienced more severe price declines than unaudited firms. Furthermore, we document larger bubbles for audited firms relative to unaudited firms, as reflected in higher valuation multiples, corroborating the confirmation bias view. Our evidence has important implications for audit regulation in many emerging disclosure areas, such as crowdfunding, cryptocurrencies, and ESG disclosures.

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