April 10, 2010
Abstract The purpose of this paper is to examine the value relevance of the perceived audit quality in terms of who audits, as well as the audit outcomes in terms of the auditor’s opinion and accruals quality, in the pricing of debt capital for privately-held firms by examining a large sample of privately-held Finnish firms. The findings indicate that Big 4 audits and joint audits with more than one responsible auditor are associated with a decreased cost of debt capital. Also, firms with modified audit reports and those with lower-quality accruals have a higher cost of debt capital. The findings suggest that both the perceived audit quality and audit outcomes are relevant in the pricing of debt capital for privately-held firms. Additional analysis suggests that, while the outcomes of an audit are important in the pricing of debt regardless of a firm’s size, the perceived audit quality is more important for larger privatelyheld firms. JEL classification: M42
Keywords: Audit quality, auditor’s opinion, accruals quality, cost of debt, private firms Correspondence: Jukka Karjalainen, Department of Business, University of Eastern Finland, PO Box 1627, FIN-70211 Kuopio, Finland e-mail: firstname.lastname@example.org 1
Electronic copy available at: http://ssrn.com/abstract=1482939
The value relevance of audits to investors in both equity and debt has been extensively studied in the context of publicly-held firms, and the issue has recently gained increasing research attention also in the context of privately-held firms. The existing studies on privately-held firms have tested the debt pricing implications of auditing per se, the auditor’s opinion, accruals quality, and audit quality proxied by the audit firm’s reputation (i.e., Big 4 vs. non-Big 4)1 and auditor certification (Blackwell et al., 1998; Hyytinen & Väänänen, 2004; Hyytinen & Pajarinen, 2007; Kim et al., 2007; Cano et al., 2008; Gill-de-Albornoz & Illueca Muñoz, 2006; Fortin & Pittman, 2007). Consistent with evidence on publicly-held firms, these studies suggest that the incremental audit quality attributable to audits by the Big 4 auditors decreases the cost of private debt capital for privately-held firms. However, one limitation of the existing research is that it does not differentiate between the debt pricing effects of perceived audit quality in terms of who audits and the outcomes of an audit in terms of the auditor’s opinion, and the resulting level of accruals quality. Therefore, the question as to which is more relevant in pricing debt capital for privately-held firms—the perceived audit quality or the outcomes of an audit—remains to be explored. The purpose of this paper is to address this question by examining the value relevance of perceived audit quality, the auditor’s opinion, and the accruals quality in the pricing of debt capital for privately-held firms. For this purpose, a large sample of privately-held Finnish firms is examined. The following features make the Finnish setting interesting for exploring the research question. First, almost all companies, regardless of size, are required by law to prepare public financial statements which are subject to a full audit. This makes it possible to estimate an interest rate on borrowing and an accruals quality metric from financial statement data for all-sized privately-held companies. Second, in addition to the auditor’s opinion, audit reports include information about the individual auditors: the names of the responsible signing auditors, their professional certifications, and names of the audit firms they represent. Given that perceptions of audit quality may depend on this auditorspecific information in audit reports, the Finnish setting enables us to move beyond the traditional Big 4 vs. non-Big 4 dichotomy and...