Can audit effort (hours) reduce a firm’s cost of capital? Evidence from South Korea

ABSTRACT

In this paper, we examine the relationship between audit effort measured as audit hours and a firm’s weighted average cost of capital (WACC). Using a sample of Korean listed firms, we hypothesise a potentially bi-directional relationship between WACC and audit effort based on audit “supply”/audit “demand” theory. We find that after controlling for known determinants of firm risk, additional audit hours reduce a firm’s WACC. In our additional analysis, we continue to find that WACC reduces with audit hours based on risk partitioning for (i) Big4 clients/investment grade (IG) firms and (ii) NonBig4 clients/non-investment grade (NIG) firms. However, we find the reduction in WACC occurs at a lower rate for the less risky group compared to the riskier group. We interpret that market participants consider Big4 clients/IG firms to have lower risk, and thus, the marginal effect of greater audit hours in enhancing audit quality (reducing audit risk) is lower for Big4 clients/IG firms compared to NonBig4 clients/NIG firms. Taken together, our findings consistently demonstrate that audit hours (effort) reduce WACC based on audit hours signalling audit quality to market participants.

KEYWORDS:

• Audit effort
• WACC
• audit demand theory
• audit supply theory

JEL:

• A1
• G1
• G3
• M1
• M4

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Enron scandal 2001, WorldCom scandal 2002, Lehman Brothers scandal 2008 etc.

2 Finland (Niemi, 2005), Japan (Fukukawa et al., 2006).

3 High profile accounting mismanagement has been identified at Chaebols including SK Global, Kia, Daewoo Korea Air (see Choi et al., 2017).

4 Credit ratings are coded as below.

Credit ratings coding