The impact of voluntary audit on credit ratings: evidence from UK private firms

Abstract

After a long period of universal mandatory audit, the UK reduced the regulatory burden of private firms by introducing size-based audit exemption in 1994; the size thresholds have subsequently been progressively increased. Both accounting bodies and credit-rating agencies (CRAs) have expressed reservations about this policy, arguing it could diminish user confidence in reported accounting numbers, and lead to a reduction in financial statement quality and credit ratings. Prior research, however, suggests that the managers of small UK companies do not perceive there to be an association between financial statement audit and firm credit score. To provide evidence of any effect on user confidence of making audit optional, we examine the credit scores and financial reporting quality of a large sample of UK private firms which qualified for audit exemption after major threshold changes in 2004. We find that, even though they report lower average profits, companies which retain a voluntary audit enjoy significantly higher credit scores than those which opt out of audit. The results of both conservatism and accruals-based tests indicate that opting out of audit is associated with less conservative financial reporting, consistent with the concerns of the accounting bodies and the CRAs, and providing an explanation for why opt-out firms report higher profits but receive lower credit scores. This study contributes to an important policy debate by providing large sample evidence that the audit does confer benefits to private firms in terms of financial reporting quality, assurance and the credit scores generated from the financial reports.

Keywords:

• small companies
• voluntary audit
• credit ratings
• financial reporting quality

Acknowledgements

The paper has benefited from the comments of participants at the British Accounting Association conference, 2010; the conference of the Accounting & Finance Association of Australia & New Zealand, 2011; and from seminar participants at the University of Bath, University of Warwick and University of Sydney. Improvements were made following helpful suggestions from Clive Lennox, Graham Loomes, Stuart McLeay, Andy Stark and Geoff Whittington. The efforts of two anonymous reviewers in the development of the paper are gratefully acknowledged. Any errors belong to the authors.

Notes

Caparo Industries plc v Dickman 1990 2 AC 605.

To illustrate, the initial audit exemption threshold in respect of annual turnover was set at £90,000 in 1994; raised to £300,000 in 1997; increased to £1m in 2000 then to £5.6m in 2004 (Davies 2008).

BERR (2004).

ICAEW (2009), finding 3.7.

ICAEW (2009), finding 2.2.

ICAEW (2009), finding 3.2.

‘ICAEW Slams Threshold Rise’, Accountancy magazine online, 19 November 2003.

‘Audit Aftershock’, in Accountancy magazine, 20 December, 2006

Financial Analysis Made Easy.

There is some tension in the literature as a few papers argue for audits to be voluntary rather than mandatory (e.g., Melumad and Thoman 1990, Sunder 2003, Lennox and Pittman 2011). Their main argument is that the voluntary audit signal enables the market to distinguish between good and bad types of firms (in terms of their credit risk) holding everything else constant including the assurance value of audits. In contrast, in our paper, we argue that auditing provides a minimum level of assurance to the market which is beneficial to its users. Empirical tests of the signalling argument are highly dependent on identifying a clean setting where the assurance value of audits remains constant. However, in practice it is difficult to find such a setting as the expected assurance level will fall when the audit regime changes from mandatory to voluntary as some firms will forego the audit i.e., the ceteris paribus assumption is unlikely to hold.

To be classed as small by the regulator, companies must satisfy two out of three size criteria over a period of two years, the first two criteria being the same as the turnover and total asset audit exemption thresholds and the third being a maximum average number of employees of 50 (Davies 2008).

It should be noted here that our data requirements preclude the inclusion in our sample of firms which opted to file abbreviated accounts.

These tests potentially suffer from a bias caused by firms self-selecting into audit. We address this issue by estimating a Heckman-type, 2-stage model, the untabulated results of which are reported in Section 5. (The results remain unchanged.)

UK GDP rose from £1140 bn in 2003 to £1203 bn in 2004; inflation was around 3% over this time period; one- and three-year survival rates for new businesses were increasing and peaked in 2003 (source: UK Dept for Business, Innovation & Skills). In untabulated tests on larger private firms in the same time period, which are all subject to mandatory audit, we observe an average increase in Qui Score between 2003 and 2004, consistent with a general rise in optimism in the economy.

Clatworthy et al. (2009) and Lennox et al. (2012) point out that the Heckman procedure in the context of audit fee models is highly sensitive to changes in sample selection and model specification. However, we find that our second stage results are not sensitive to the voluntary audit model specification.