Association between Big 4 auditor choice and cost of equity capital for multiple‐segment firms

Prior studies document a negative association between Big 4 auditor choice and the implied cost of equity capital, suggesting that Big 4 auditors mitigate information asymmetry (IA) between shareholders and managers. This study extends this line of research and reports that the negative association is more pronounced in multiple‐segment firms, where IA is more severe than in single‐segment firms. We also find that the association between Big 4 auditor choice and the cost of equity capital becomes more negative as the number of segments increases. Taken together, our findings suggest that the role of Big 4 auditors in reducing the cost of equity capital becomes more significant when greater IA exists.     

Auditor Choice in Politically Connected Firms

We extend recent research on the links between political connections and financial reporting by examining the role of auditor choice. Our evidence that public firms with political connections are more likely to appoint a Big 4 auditor supports the intuition that insiders in these firms are eager to improve accounting transparency to convince outside investors that they refrain from exploiting their connections to divert corporate resources. In evidence consistent with another prediction, we find that this link is stronger for connected firms with ownership structures conducive to insiders seizing private benefits at the expense of minority investors. We also find that the relation between political connections and auditor choice is stronger for firms operating in countries with relatively poor institutional infrastructure, implying that tough external monitoring by Big 4 auditors becomes more valuable for preventing diversion in these situations. Finally, we report that connected firms with Big 4 auditors exhibit less earnings management and enjoy greater transparency, higher valuations, and cheaper equity financing.     

Demand for fair value accounting: The case of the asset revaluation boom in Korea during the global financial crisis

When the fair value accounting (FVA) option for property, plant, and equipment was introduced in the midst of the global financial crisis, a significant proportion of Korean firms elected FVA. We attribute this unusual boom in asset revaluations to the nation's culture of government intervention and civilian compliance, which was particularly espoused during this period of financial turmoil, and a foreseeable option to switch back to historical cost accounting. We find that among those firms whose debt‐to‐equity ratios are low, public firms opt for the FVA option more often than private firms, suggesting that the need to communicate fair value information with diversified equity holders is more important than the need to do so with creditors. In contrast, among those firms whose debt‐to‐equity ratios are high enough to warrant such unfavorable dispositions as new debt freezes and monitoring by regulators, we find no difference in the FVA choice between private and public firms. These findings imply that during the global financial crisis, private firms that rely heavily on debt financing have a strong incentive to utilize FVA to comply with government guidelines for the debt‐to‐equity ratio and to ease a potential hold‐up problem by influential creditors.     

The cost of debt when all-equity firms raise sfinance: The role of investment opportunities, audit quality and debt maturity

This paper investigates the effect of investment opportunities, audit quality and debt maturity on the interest paid by all-equity firms. Debt holders are likely to charge higher interest to price-protect themselves because of the under-investment and asset substitution problems. All-equity firms, however, could reduce interest charge by employing Big 4 auditors to increase the reliability of audited financial statements or using short-term debt to allow more frequent monitoring of their financial condition by lenders and re-pricing of debt. The results show that interest charge is positively related to investment opportunities of all-equity firms. This relationship is weaker when the firms have Big 4 auditors or a higher proportion of debt due in the next year over total debt. In addition, the above results do not hold for highly levered firms since the lenders are constantly monitoring the financial condition of their borrowers.     

Private family firms,generations and bank debt

This paper focuses on the use of bank debt by private family firms and whether it is higher for the first generations of family businesses than for their descendants and subsequent generations. We use a unique hand-collected data set of 4,041 private Spanish firms for the years 2004 to 2013. We find statistical evidence that family-controlled firms make greater use of bank credit. Moreover, we show that first-generation family firms acquire more bank debt than those of second and subsequent generations. Furthermore, during financial crises, family-controlled firms were subjected to less rationing, with increased bank financing for first generations.     

Audit office size,audit quality and audit pricing: evidence from small- and medium-sized enterprises

Using Swedish data, we investigate how audit quality and audit pricing vary with audit firm and office size. In contrast to prior studies, we use disciplinary sanctions issued against auditors not meeting the quality requirement as the measure of audit quality. We find no significant differences in the likelihood of sanctions between Big 4 audit firms and the fifth and sixth largest audit firms in Sweden (Grant Thornton and BDO). We refer to these collectively as ‘Top 6’. However, we find that the probabilities of warnings or exclusions from the profession are much higher for non-Top 6 auditors in Sweden than for Top 6 auditors. Furthermore, we find a strong negative association between the likelihood of sanctions and audit office size for non-Top 6 auditors. This association is insignificant for Top 6 audit firms. Audit fees follow a similar pattern and indicate that larger audit firms and offices put in more effort or have greater expertise. These results suggest that audit quality is differentiated in the private segment market. However, contrary to prior studies, our results suggest that the important dimensions are Top 6 versus non-Top 6 and the office size of non-Top 6 audit firms.     

The endogenous relationship between audit-report type and business termination: evidence on private firms in a non-litigious environment

This study provides evidence on the relationship between audit-report type and subsequent business termination for private companies in a non-litigious environment. The results show that an endogenous relationship exists between bankruptcy and audit-report type, and between voluntary liquidation and audit-report type. A non-clean opinion is typically issued when firms face financial difficulties, which in turn become more severe after the receipt of a non-clean audit opinion. We find evidence that, even without a litigation deterrent in Belgium, financial performance has a similar impact on audit-report type as in litigious environments. We find that the self-fulfilling prophecy hypothesis holds for bankruptcy but not for voluntary liquidation. Our study also provides some evidence on audit reporting differences between Big 6 and non-Big 6 auditors in the Belgian audit market. When financial difficulties are obvious, as is the case when a company is about to go bankrupt, both Big 6 and non- Big 6 auditors are as competent and/or independent to assess and report going-concern problems. However, when financial difficulties are less apparent, as is the case for firms that voluntarily decide to liquidate, our results indicate that Big 6 auditors are more likely to issue a non-clean audit opinion than non-Big 6 auditors.     

Causes and Consequences of Improvements in the Information Environment for Swedish Small and Mid-Sized Firms

We investigate improvements in the information environment and financing decisions for Swedish small and mid-sized firms. These firms are required to file audited annual reports. We create an index capturing accounting standards choices, auditor quality, and board size reflecting information environment improvements. We find an association between increased short-term financing and information environment improvements: The most common actions are to switch to a Big 4 auditor or a chartered accountant and to add independent board members as opposed to changing the accounting standards used. These improvements are associated with a switch to long-term debt and a reduction of cost of debt. Our findings are relevant for the ongoing discussion on accounting regulation for private firms both in the USA and Europe since they show that (Swedish) private firms use other ways to improve the information environment in order to access to less costly long-term bank debt besides adopting International Financial Reporting Standards.     

The Informational Role of Short Sellers: The Evidence from Short Sellers’ Reports on US‐Listed Chinese Firms

Using US‐listed Chinese firms as the setting, this paper studies a novel channel through which investors can acquire information about firms’ financial reporting quality, that is, the reports published voluntarily by short sellers. I find that short sellers tend to target firms that have financial reporting red flags and that exhibit ‘good’ operating performance and stock valuations. Targeted firms experience an average three‐day cumulative abnormal return (CAR) of ?6.4%, and ?13.6% for initial coverage of the firm, and the CARs are more negative when the reports allege more severe misconduct of the firms. Non‐targeted firms also experience losses in value following short seller reports, especially when they hire the same non‐Big 4 auditors as targeted firms and when their earnings quality is poor. In comparison, analysts fail to perform proper due diligence and are much less effective than short sellers in exposing misreporting risk in Chinese firms.     

Financial Restatements, Cost of Debt and Information Spillover: Evidence From the Secondary Loan Market

Abstract:  In this paper, we investigate the effect of financial restatements on the debt market. Specifically, we focus on the secondary loan market, which has become one of the largest capital markets in the US, and ask the following: (1) whether financial restatements increase restating firm's cost of debt financing and (2) whether the information about restatements arrives at the secondary loan market earlier than at the stock market? Using 176 restatement data, we find significant negative abnormal loan returns and increased bid-ask spreads around restatement announcements. Furthermore, this negative loan market reaction is more pronounced when the restatement is initiated by either the SEC or auditors, and when the primary reason for restatement is related to revenue recognition issues. Additionally, we find restatement information arrives at the secondary loan market earlier than at the equity market, and that such private information quickly flows into the equity market. We also show that stock prices begin to decline approximately 30 days prior to the restatement announcements for firms with traded loans. However, we do not find such informational leakage for firms without traded loans. Collectively, the results of this paper suggest: (1) increased cost of debt financing after restatements and (2) superior informational efficiency of the secondary loan market to the stock market.     

Does Public Firms’ Mandatory IFRS Reporting Crowd Out Private Firms’ Capital Investment?

We investigate how the mandatory adoption of International Financial Reporting Standards (IFRS) by publicly listed firms in the European Union affects peer private firms. We find that private firms’ capital investment decreases significantly after the IFRS mandate, relative to public firms. Private firms also display decreased investment when benchmarked against firms relatively insulated from the impact of the IFRS mandate, but the magnitude of the effect is smaller in this case. These results are consistent with the hypothesis that mandatory IFRS reporting (combined with other reforms), while increasing public firms’ financing and investment, crowds out funding for private firms. The effect is more pronounced for larger private firms and in industries where public peers have greater external financing needs. Our evidence suggests that financial reporting regulations cause shifts in resource allocation in an economy.     

Determinants and consequences of voluntary switches to Chinese auditors in Hong Kong

Hong Kong market regulators have permitted 12 large Chinese accounting firms to audit the financial statements of Chinese firms that cross list in Hong Kong (i.e., H-share firms) since 2010. This paper examines the characteristics of H-share firms that voluntarily replaced their Hong Kong (HK) auditors with Chinese auditors, and the market reaction to auditor switches following this policy. We find that 38 out of 147 H-share firms voluntarily switched to Chinese auditors during 2011–2013. Switching firms are larger in size and are less likely to use Big4; they also have less need for external financing, a longer cross listing history, and a lower percentage of foreign revenue. We also find that investors negatively react to the auditor switches from HK non-Big4 to China non-Big4, but do not react to the auditor switches from HK Big4 to China Big4. This suggests that investors perceived lower audit quality for China non-Big4.     

Government quality,auditor choice and adoption of IFRS: A cross country analysis

We examine the association between country-level government quality and firms' choice of external auditors. Using a cross-sectional sample of 142,193 firm-year observations from 46 countries over 1998–2007, we show that the government quality of a country has a significant positive effect on the likelihood of choosing Big 4 auditors by firms in that country. We also show that firms in countries with strong governments that have adopted IFRS are more likely to choose Big 4 than non-Big 4 auditors. To our knowledge, this is the first study of its kind to provide direct evidence on the role of government quality in firms' choice of external auditors. Choice of a Big 4 auditor may be regarded as a proxy for the demand for high quality financial reporting, and thus the results provide insights for policy makers on the importance of government quality toward improving financial reporting quality in a country.     

Institutional arrangements and debt financing

I find that institutional arrangements have an impact on the real economy by affecting firms’ choice between private and public debt and the subsequent financing costs. Using new debt issued by firms in 26 non-US countries, I find, after controlling for firm characteristics predicted by debt agency and information asymmetry theories, that the level of financial market development, the efficiency of bankruptcy procedure, the integrity and enforceability of laws, and the transparency of financial information have significant impacts not only on firms’ debt choice and yield to maturity in domestic debt market, but also their issuance choice in the international debt market.     

Compliance with pension‐related mandatory disclosures and debt financing

Using hand‐collected data on the level of pension‐related mandatory disclosures required by International Accounting Standard 19 Employee Benefits, we test whether compliance levels with these disclosures convey information that affects firms’ access to the public instead of the private debt market, as well as the cost of their new debt issues. We document a higher tendency to access the public debt market for firms with higher levels of pension‐related disclosure. Furthermore, we find that firms with higher levels of pension‐related disclosure enjoy a lower cost in terms of issuance of public debt, but not a lower cost for private debt issues. Thus, the benefits of disclosure in reducing information risk are only realisable when creditors rely heavily on financial statements in their decision making, due to the limited access to private information. Additional tests reveal that high compliance levels effectively mitigate the negative effect of pension deficits on the cost of public debt. These findings provide novel evidence in the extant literature on the role of mandatory (and, in particular, pension‐related) disclosures on firms’ debt financing. They also have important policy implications.     

Audit pricing and auditor industry specialization in an emerging market: Evidence from China

In this paper we examine the determinants of audit fees by focusing on auditor industry specialization and second tier auditors in the Chinese market. We find evidence of Big 4 premiums for brand name as well as industry specialization in both the statutory and supplementary market. Big 4 industry specialists earn additional premiums in the statutory market as compared to non-industry specialists. We also find that market expansion did not provide the second tier auditors any price advantage. These auditors increased their market share mainly in the mid- and small-sized clienteles. Moreover, industry experience developed by the second tier firms may have helped them gain economy of scale and reduce service fees. This may be their strategy to win future clients that seek low-priced audits.     

International evidence on economic policy uncertainty and asymmetric adjustment of audit pricing: Big 4 versus non‐big 4 auditors

By investigating the association between economic policy uncertainty and audit fees using data from eight countries, this study examines whether and how Big 4 auditors reinforce their advantages over non‐Big 4 auditors through audit pricing. We find that both Big 4 and non‐Big 4 auditors reduce their audit fees when economic policy uncertainty increases. However, while non‐Big 4 auditors adjust audit pricing asymmetrically as economic policy uncertainty changes, i.e., the magnitude of decline in audit fees when economic policy uncertainty increases exceeds the magnitude of rise when economic policy uncertainty decreases, Big 4 auditors regulate their audit pricing in a symmetric manner. Further analyses reveal that: (1) the asymmetric pricing of non‐Big 4 auditors mainly exists in countries where Big 4 auditors have dominant market share, (2) Big 4 auditors provide higher‐quality audits when economic policy uncertainty increases and (3) many firms in better financial condition turn to Big 4 auditors during uncertain years. Our findings suggest that the symmetric audit pricing helps Big 4 auditors maintain a favorable position in the audit market.     

Why do private firms adopt IFRS?

Do private firms voluntarily adopt IFRS? If so, why? Answers to these questions have been very limited so far, mainly due to the absence of financial data on private firms. In this paper, I exploit the German setting where the financial statements of private firms are widely available. I estimate multi-period logit regressions on the choice between national GAAP and IFRS for the consolidated financial statements of nearly 3000 German private firms with more than 14,000 firm-years in the period 1998–2010. My results suggest that the expected net benefits of IFRS adoption vary substantially across the group of private firms, depending on their financing needs, governance system, and organizational and informational complexity. Specifically, I find that private firms using IFRS have more growth opportunities, are more leveraged, are externally rated, seek to raise external capital by issuing public bonds or equity, are registered as a stock corporation, are characterized by private equity (PE) involvement, have more international sales and operations, and have a Big Five auditor. These insights should be of great interest to both preparers and regulators in the current debate about the future of financial reporting in private firms.     

The Silent Majority: Private U.S. Firms and Financial Reporting Choices

This study uses a comprehensive panel of tax returns to examine the financial reporting choices of medium-to-large private U.S. firms, a setting that controls over $9 trillion in capital, vastly outnumbers public U.S. firms across all industries, yet has no financial reporting mandates. We find that nearly two-thirds of these firms do not produce audited GAAP financial statements. Guided by an agency theory framework, we find that size, ownership dispersion, external debt, and trade credit are positively associated with the choice to produce audited GAAP financial statements, while asset tangibility, age, and internal debt are generally negatively related to this choice. Our findings reveal that (1) equity capital and trade credit exhibit significant explanatory power, suggesting that the primary focus in the literature on debt is too narrow; (2) firm youth, growth, and R&D are positively associated with audited GAAP reporting, reflecting important monitoring roles of financial reporting; and (3) many firms violate standard explanations for financial reporting choices and substantial unexplained heterogeneity in financial reporting remains. We conclude by identifying opportunities for future research.     

The effect of external audits of internal control over financial reporting on financial reporting for clients of Big 4, Second-tier,and small audit firms

The external audit of internal control over financial reporting (ICFR) is a very expensive and contentious aspect of the Sarbanes–Oxley Act (SOX). Larger public firms were first required to file a management report on and have an external audit of ICFR in 2004. Smaller public firms were first required to file a management report on ICFR in 2007 but are exempt from the audit requirement. Whereas most related prior research investigates the combined effect of management and auditor reports on financial reporting, this study examines the distinct effect of auditor reports on reporting quality. For companies audited by small auditors, we find evidence that financial reporting quality improves with an auditor report on ICFR. We find no evidence that auditor ICFR reports improve reporting quality for clients of Big 4 or Second-tier audit firms. Our study adds to the debate on the applicability of SOX Section 404 to smaller firms.