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    The Effect of Auditor Quality on Financing Decisions
    research summary posted May 7, 2012 by The Auditing Section, last edited May 25, 2012 by James L Fuehrmeyer, tagged 11.0 Audit Quality and Quality Control, 11.07 Attempts to Measure Audit Quality 
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    Title:
    The Effect of Auditor Quality on Financing Decisions
    Practical Implications:

    This study provides a theoretical model and empirical analysis on the relationship between quality-differentiated audits and companies’ financing decisions.  The study extends prior results from the IPO setting, suggesting that audit quality has a first-order effect on debt-equity choices.

    Citation:

    Chang, X., S. Dasgupta, and G. Hilary. 2009. The Effect of Auditor Quality on Financing Decisions.  The Accounting Review 84 (4): 
    1085-1117. 

    Keywords:
    Auditor quality, financial decisions, adverse selection, capital structure
    Purpose of the Study:

    Theoretical models suggest that companies’ financing decisions are affected by the information asymmetry that exists between well-informed companies and relatively less-informed investors. The integrity of companies’ financial statements plays an important role in reducing this asymmetry.  Similarly, because financial statements are jointly produced by the companies and their external auditor, the auditor plays a critical role in assuring the integrity of the financial information.  Big N auditors are widely perceived to provide higher-quality audits than non-Big N auditors. Thus, the higher-quality audits provided by Big N auditors should better reduce the information asymmetry between informed managers and uninformed investors and thus affect companies’ financing decisions. This study investigates companies’ timing and choice of securities issuances to determine whether:

    • Companies with a Big N auditor are more likely to issue equity as opposed to debt than are companies with non-Big N auditors;
    • The size of equity issues will be larger for companies with Big N auditors;
    • The size of equity issues will be larger following good recent stock performance; and
    • The gap in the average equity issue size between companies with and those without Big N auditors will be smaller subsequent to good recent stock price performance. 
    Design/Method/ Approach:

    The authors develop a theoretical model based on the idea that the quality of the auditor can reduce information asymmetry, which subsequently affects debt versus equity decisions. They then test the model using data on publicly-traded companies for the years 1985 to 2005. Identifying equity and debt issues using cash flow statement data, they examine whether auditor quality affects the probability of debt-equity choices of companies in a given year. The size, timing, and market conditions of the debt-equity issues are also analyzed.

    Findings:

    The authors suggest that differences in information asymmetry associated with high quality auditors affect the financing choices of companies in the following ways: 

    • Companies audited by Big N auditors are more likely to issue equity as opposed to debt and to have more equity in their capital structures. 
    • Companies audited by Big N auditors tend to issue larger amounts of equity when they do issue.
    • Companies tend to issue larger amounts of equity when market conditions are favorable; however this association is significantly weaker for companies audited by Big N auditors.
    • Debt ratios of companies audited by Big N firms are less affected by market conditions.           

    The authors suggest that their findings provide evidence that high-quality Big N auditors reduce information asymmetry, and conclude that audit quality is relevant for companies’ financing decisions.  

    Category:
    Audit Quality & Quality Control
    Sub-category:
    Attempts to Measure Audit Quality
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