Edward B. Douthett, Jr.
We investigate whether auditors can detect shareholder expropriation by the parties in control of the firm’s resources at the time of an initial public offering (IPO). Our tests are conducted on a unique sample of IPOs where illegal laddering arrangements have been explicitly identified by regulators in Securities and Exchange Commission settlement agreements. Protecting clients against resource diversion occurring in these transactions is beyond the auditor’s formal auditing responsibilities. However, providing this protection is consistent with a hypothesis that self-interested auditors will play a protectionist role to avoid potential legal costs and reputational damages associated with inappropriate resource diversion by corporate insiders. Our findings indicate that higher assurance service levels are associated with laddering cases and the probability that a laddering arrangement has been made is associated with lower audit quality. Overall, the results suggest that auditors may play an investor protection role beyond the verification of financial statement information in the market for new issues.