Save Money to Lose Money? Implications of Opting Out of a Voluntary Audit Review for a Firm’s Cost of Debt*

ABSTRACT

An audit review (AR) is a mechanism used by boards to assess the quality of interim financial reports on a timely basis. In Canada, the AR is voluntary, with listed firms mandated to disclose when they choose to not purchase additional audit verification. Given the relatively low cost of an AR, opting out of it can be regarded as a negative signal, especially in the context of lenders’ sensitivity to downside risk. Using a sample of 7,585 firm-year observations from 1,616 public firms in Canada over the period 2004-2015, we document that firms without a voluntary AR have a higher cost of debt than firms with an AR. Furthermore, after firms opt out of the AR, the increase in the cost of debt is accompanied by a rise in discretionary abnormal accruals and managers’ stock-based compensation. Moreover, no-AR firms are more likely to reduce post-switch private borrowing and have lower equity analyst following. Our study is the first to document that although listed borrowers that opt out of an AR have a higher cost of debt financing, they are concurrently able to engage in more earnings management and grant their managers higher stock-based compensation because of lower external monitoring.

Disclosure statement

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

Supplemental data

Supplemental data for this article can be accessed at https://doi.org/10.1080/09638180.2022.2087706

Notes

1 For example, Allee and Yohn (2009) find that, for small privately held businesses, the voluntary AR provides higher access to credit but has an insignificant impact on loan rates. Moreover, Minnis (2011) uses a similar sample and finds that the AR is not associated with reduced risk for creditors.

2 Section II provides more details about the AR in the Canadian setting.

3 We replicate the analysis of (Bédard & Courteau, 2015) for our sample and confirm that AR firms pay significantly higher audit fees rtelative to no-AR firms.

4 More specifically, stock returns of firms that choose timely ARs are more strongly correlated with contemporaneous quarterly earnings than those of firms that choose retrospective ARs.

5 In contrast, Bédard and Courteau (2015) document no significant benefits of the AR in terms of reduced abnormal accruals in the interim or the fourth quarter. Our study differs from theirs, as we consider only the listed Canadian firms with access to the debt market. This is an important difference since prior literature stresses the increased relevance of auditing for firms that access the debt market (Chen, 2016). Moreover, given our longer sample period, relative to Béedard and Courteau (2015), we can identify not only the AR and no-AR firms, but also the firms that switch between AR and no-AR. We, therefore, are better able to assess the effect of the choice to not purchase additional audit verification.

6 Moreover, anecdotal evidence suggests that ARs are important for borrowers to obtain bank lending (Forbes, 2016).

7 Extant literature that assesses the debt market benefits of auditing concludes that annual financial statements’ verification is important for the cost of debt. For example, Blackwell, Noland, and Winters (1998) suggests that financial statement audits reduce creditors’ information gathering costs and interest rates on loans. In a similar vein, Kim, Simunic, Stein, & Yi (2011a) and Lennox and Pittman (2011) indicate that firms with voluntary audits are perceived as less risky and are compensated by banks with lower interest rates. Finally, Robin, Wu, and Zhang (2017) find that individual auditor quality and financial covenants in debt contracts are negatively associated. Although we build on this emerging stream of literature, our study differs from previous research by focusing on the impact of the AR on quarterly financial statements from both the private and the public debt market perspective.

8 According to Section 7060, ‘Auditor Review of Interim Financial Statements’ prepared by the Auditing and Assurance Standards Board (AASB) in 2014, ‘members of audit committees have indicated that the guidance on interim review procedures is particularly useful. Similarly, many practitioners have commented that carrying out interim review procedures has assisted them in identifying financial reporting matters to management and audit committees on a timely basis.’

9 It is also possible that firms discontinue the AR because the extra cost of audit fee is too high. Untabluated tests show that the reduction of the audit fee is immaterial to the negative switchers’ net income.

10 The Canadian setting is characterized by ample debates on whether the AR should be mandated (Crawford Committee, 2003; Auditing and Assurance Standards Board of Canada (AASBC), 2014). Critics of this proposed regulatory change highlight the lack of empirical evidence regarding the benefits of an AR.

11 According to Kajüter et al. (2016), the review verifies whether the reported numbers in financial statements are plausible or not.

12 While an audit provides a positive assurance, i.e., an indication that the financial statements are prepared, in all material aspects, in accordance with the applicable Generally Accepted Accounting Principles (GAAP), the review provides a negative assurance, i.e., an indication of no evidence to assume that the financial statements are not presented in accordance with the applicable GAAP (Gay, Schelluch, & Baines, 1998). For example, Barton, Hodder, and Shepardson (2015) find for a sample of firms in the financial industry, the audit review is associated with reduced likelihood of bank failure.

13 This is consistent with Bharath, Sunder, and Sunder (2008), who find a negative association between the quality of accounting information and the cost of debt.

14 According to the National Instrument 51–102 ‘Continuous Disclosure Obligations’, Canadian firms are mandated to disclose in their quarterly reports if their auditors do not perform an audit review (OSC, 2004).

15 Our sample composition is consistent with previous literature, as no-AR observations make up 37 per cent of the overall sample, compared with 41 per cent for Bédard and Courteau (2015).

16 Over the period 2004-2015, 2,170 loan facilities from 345 Canadian firms are available on Dealscan. However, spread all-in-drawn information is only available for 431 loan facilities and 148 firms. Finally, out of 431 loan facilities, we exclude 73 facilities pertaining to firms with missing reviews, firm characteristics, and auditor information.

17 Using the average interest rate as a proxy for the real interest rate on loan facilities may introduce measurement error (Kim et al., 2011a; Pittman & Fortin, 2004; Francis, Khurana, & Pereira, 2005a; Francis, LaFond, Olsson, & Schipper, 2005b). If the dependent and independent variables are systematically correlated, the measurement error may result in biased coefficients and inflated significance levels (Greene, 2003). Given that we use econometric models that address the selection bias of our test variable, No_Review, it is unlikely that the average interest rate is systematically correlated with No_Review because of measurement error.

18 We do not use a benchmark-adjusted interest rate spread in our main sample. Because the overall maturity structure of a firm’s debt is unavailable, it is difficult to select benchmark interest rates with appropriate maturities. In unreported tests, we obtain robust results when adjusting the average interest rate by the rates on Canadian government bonds of different maturities. These results are available upon request.

19 Kim et al. (2011a) and Bharath et al. (2008) indicate that spread all-in-drawn on a loan facility captures the lenders’ perceived level of risk on a specific loan in all aspects and is a more comprehensive measure of loan pricing.

20 Under National Instrument 51–102 ‘Continuous Disclosure Obligations,’ starting from the fiscal years on or after January 1, 2004, no-AR firms need to disclose a notice in their quarterly financial statements indicating that they have not been reviewed by an auditor (OSC, 2004). Thus, if the firm does not disclose a notice indicating that ‘the interim financial statements have not been reviewed by an auditor,’ we assume that an external auditor reviews the firm’s interim financial statements.

21 We also employ the Heckman (1979) two-stage estimation procedure and add the inverse Mills ratio to our main model to address concerns related to a potential selection bias in our sample. Untabulated results show that our inferences remain the same after including the inverse Mills ratio. The first-stage model in the Heckman procedure is the same as the audit choice model used in the PSM in Table 4.

22 We control industry- and year-fixed effects and use standard errors clustered by auditor in our main analyses. In additional tests, we use AltmanZ and InfAsym as additional controls in our matched full sample, and for the bond and loan samples. Moreover, in a separate test, we repeat our analysis after controlling for auditor opinion on internal controls. Untabulated results are statistically similar to those presented in Table 5.

23 The PSM approach used in Table 5 matches observable characteristics and aims to reduce sample heterogeneity. Therefore, to control for potential bias due to differences in unobservable firm characteristics, we follow Minnis (2011), Powers (2007), Hsu, Troy, and Huang (2015), and Ireland and Lennox (2002), and use a two-stage Heckman procedure that includes the exogenous instrument Dec_FYEnd. We posit that Dec_FYEnd satisfies the exclusion restriction because auditors may advance some procedures to less busy interim periods when they have the excess capacity by encouraging clients to use interim reviews (Hay et al., 2006; López & Peters, 2012). Therefore, Dec_FYEnd is directly related to the decision to not have an AR but not directly related to the firm’s cost of debt. Using the inverse Mills ratio from the first stage, we separately estimate coefficients for no-AR and AR firms in the second stage to capture the endogenous switching effect and predict the average interest rate for each no-AR and AR firm. Untabulated results of the endogenous switching model approach suggest that the no-AR firms are associated with higher interest rates, in line with the findings of our main test.

24 We also use the S&P’s issue rating as the proxy for the cost of public debt financing (untabulated results). The voluntary review is significantly associated with better credit ratings after controlling the determinants of credit ratings. These results are available upon request.

25 In the main tests, for the bond and loan analyses, we present the results from the unmatched samples. In additional tests, we match the no-AR firms with the AR firms based on propensity scores from the choice model presented in Equation (2)(2) $\begin{array}{rl}No\mathrm{\_}Review& ={\text{β}}_0+{\text{β}}_{1}Dec\mathrm{\_}FYEnd+{\text{β}}_{2}Big4+{\text{β}}_{3}AltmanZ+{\text{β}}_{4}InfAsym+{\text{β}}_{5}Size\\ & +{\text{β}}_{6}ROA+{\text{β}}_{7}TANG+{\text{β}}_{8}CR+{\text{β}}_{9}LEV+{\text{β}}_{10}MB+{\text{β}}_{11}NegE\\ & +{\text{β}}_{12}INVEST+{\text{β}}_{13}CrossListed+{\text{β}}_{14}BondDummy+{\text{β}}_{15}LoanDummy\\ & +IndustryandYeardummies+ϵ\end{array}$(2) . We exclude industry dummies, AltmanZ and InfAsym from the choice model to increase the number of matched firms. We employ the nearest neighbour matching approach with replacement within a calliper of 0.01. However, given the small sample size and many control variables, our final matched bond and loan samples have 65 and 34 observations, respectively. The coefficient of No_Review is still positive and significant for both samples (β = 0.014; t-value  = 2.100 for the bond sample and β = 0.012; t-value  = 2.712 for the loan sample).

26 We start with a sample of 56 unique positive switchers and 53 unique negative switchers from 2006 to 2015. The number of positive (negative) switchers for the change analysis declines to 36 (38) because we require them to have available data for the dependent and independent variables in pre- and post-switching periods.

27 To further control omitted variables that may simutaneously influence the firm’s AR decision and the cost of debt, we include additional variables, such as change in the firm’s discretionary abnormal accruals and Altman Z-score. Untabulated tests show that our findings are robust.

28 We do not use the public bond and the syndicated loan samples in the switching test because the number of observations is insufficient to draw meaningful statistical inferences. We present the characteristics of bond and loan issues of the switching and controlling firms in Appendix A2.

29 For instance, Minnis (2011) shows that voluntarily audited firms are associated with a lower interest rate ranging from 25 to 105 basis points.

30 Table A2 of the online appendix shows that after the negative switch, the number of firms with syndicated loans decreases from 5 to 3, and the overall number of loan issues decreases from 8 to 6.

31 Information asymmetry between lenders and borrowers influences lending decisions (Diamond, 1991; Aghion & Bolton, 1992; Holmstrom & Tirole, 1997). Accounting information plays a crucial role in public and private debt markets because it decreases information asymmetry and better indicates borrower quality (Chen, 2016). Low-quality public information leads to higher perceived borrower risk, affecting loan terms (Bharath et al., 2008, p. 2011). Lenders value the verification offered by auditors (Minnis, 2011) because it improves the reliability of publicly available information.