Abstract
This article investigates the impact of legal environment on the relationship between leverage and auditor choice in 10 European countries. We demonstrate that the relationship between the choice of a high-quality auditor and firm leverage varies significantly across countries. This finding suggests the absence of a systematic demand for auditing to mitigate agency problems between insiders and debtholders. These differences are explained through legal environment indicators. We create in this aim an index to measure auditor liability exposure. Our results provide evidence that the stronger the protection of creditor rights and disclosure requirements, the higher the demand for audit quality by highly-leveraged companies. Inversely, the auditor liability exposure has a negative impact on the link between leverage and auditor choice.
Notes
1The Commission issued a Recommendation on ‘Quality Assurance for the Statutory Auditor in the EU’ in 2000 and a Recommendation on ‘Statutory Auditors’ Independence in the EU’ in 2002.
2Our empirical study is based on data from the year 2000, before the Enron collapse and the end of Arthur Andersen. At this period of time, the Big Five auditors were leaders in the European audit markets, and particularly in the 10 European countries of our study.
3We also use the survey realized by the EC in 1996 to obtain information for Norway, and for the liability regime applicable in each country.
4A similar constraint exists in Austria and Germany.
5This is also the case in Italy and Portugal. Besides, in Portugal, a small number of shareholders is allowed to act against auditors on behalf of the entire group of shareholders (class actions).
6But a legal liability cap is established in Austria, Germany and Greece.
7Choi and Wong (Citation2002) examine auditor choice across 39 countries. They find a significantly negative coefficient for the leverage variable. This finding, contrasting with our results, can be explained by two reasons. First, they only examine listed companies, which are likely to have a particular behaviour regarding auditor choice. Second, leverage has a significantly negative relationship with the choice of a Big Five auditor in many non-European countries, such South Africa, India, Malaysia. Regarding the European countries used in our sample, their results seem similar to ours.
8These authors also find a fee premium for Big Five auditors in Ireland and the UK.
9The same test has been realized by dividing our national samples into four classes of size, in order to check the possible effect of size on the relationship between the DPROFIT variable and the auditor choice. We then observe the same result of a higher proportion of loss-making firms associated with a Big Five auditor than with a Non Big Five auditor for all classes of size in each country, except for the smallest companies in Luxembourg, and the Netherlands, and for the greatest companies in Finland, Luxembourg, and the Netherlands. Consequently, these tests tend to support our conclusion that the supply-side effect is not dominant in the investigated countries.
10Another limit to this supply-side argument is that, if litigious environment is supposed to impose higher audit fees, the incremental fees of high-quality auditors are not necessarily higher than the incremental fees of lower-quality auditors. According to Simunic and Stein (Citation1990), the Big Five auditors are more able than smaller auditors to diversify firm-specific risk. Consequently, the risk premium of a Big Five auditor is not necessarily higher than a lower-quality auditor in countries with stronger liability exposure.