Journal of Accounting, Auditing & Financeschwert.ssb.rochester.edu/heitzman/DGHM_JAAF08.pdfter monitoring. Additionally, firms pay nonaudit fees for expert advice that has the potential

http://jaf.sagepub.com/Finance

Journal of Accounting, Auditing &

http://jaf.sagepub.com/content/23/1/1The online version of this article can be found at:

DOI: 10.1177/0148558X0802300103

2008 23: 1Journal of Accounting, Auditing & FinanceDan S. Dhaliwal, Cristi A. Gleason, Shane Heitzman and Kevin D. Melendrez

Auditor Fees and Cost of Debt

Published by:

http://www.sagepublications.com

On behalf of:

School of BusinessSponsored by The Vincent C. Ross Institute of Accounting Research, The Leonard N. Stern

can be found at:Journal of Accounting, Auditing & FinanceAdditional services and information for

http://jaf.sagepub.com/cgi/alertsEmail Alerts:

http://jaf.sagepub.com/subscriptionsSubscriptions:

http://www.sagepub.com/journalsReprints.navReprints:

http://www.sagepub.com/journalsPermissions.navPermissions:

http://jaf.sagepub.com/content/23/1/1.refs.htmlCitations:

What is This?

- Jan 1, 2008Version of Record >>

at UNIV OF ROCHESTER LIBRARY on September 21, 2012jaf.sagepub.comDownloaded from

http://jaf.sagepub.com/

http://jaf.sagepub.com/content/23/1/1

http://www.sagepublications.com

http://w4.stern.nyu.edu/ross/research.cfm?doc_id=1746

http://jaf.sagepub.com/cgi/alerts

http://jaf.sagepub.com/subscriptions

http://www.sagepub.com/journalsReprints.nav

http://www.sagepub.com/journalsPermissions.nav

http://jaf.sagepub.com/content/23/1/1.refs.html

http://jaf.sagepub.com/content/23/1/1.full.pdf

http://online.sagepub.com/site/sphelp/vorhelp.xhtml


Auditor Fees and Cost of Debt

DAN S. DHALIWAL* CRISTI A. GLEASON** SHANE HEITZMAN*** KEVIN D. MELENDREZ****

Using a sample of 560 new debt issues, we investigate the relation between audit, nonaudit, and total auditor fees and firms’ cost of debt. The Securities and Exchange Commission (SEC) argues that fees from nonaudit services weaken auditor independence, reduce financial statement reliability, and increase firms’ cost of capital. To test this assertion, we examine the association between auditor fees and the cost of debt, as well as the effects of auditor fees on the relation betweenfinan- cia1 statement information and the cost of debt. We find evidence that nonaudit fees are directly related to the cost of debt for investment- grade issuers. Our results are robust to controlling for auditor tenure and firm governance. We also find evidence that the association between earnings and the cost of debt decreases as audit fees increase. We find no evidence that auditor fees directly affect the cost of debt for the non- investment-grade firms, but we do find that the association between earnings and the cost of debt decreases as nonaudit fees increase.

Keywords: Auditor independence, cost of capital, bonds

1. Introduction In Financial Reporting Release No. 56, the Securities and Exchange Com-

mission (SEC) outlines the potential benefits of the new rule that bans auditors from providing certain nonaudit services and requires auditor fee disclosure. It states, “Issuers should be able to attract capital at lower rates of return.” The SEC posits that a reduction in the cost of capital will result from both the prohibition of certain services and increased disclosure regarding auditor fees. This suggests that cross-sectional differences in the cost of capital may be related to differences in audit fees or in auditor-provided nonaudit service fees. Our study

*University of Arizona **University of Iowa ***University of Rochester ****New Mexico State University We wish to thank Lil Mills and William Schwartz, as well as three anonymous reviewers, for

valuable input.

1



2 JOURNAL OF ACCOUNTING, AUDITING & FINANCE

provides evidence on the extent to which audit and nonaudit fees directly affect f i i s ’ cost of debt, as well as whether such fees affect the association between accounting-based measures of both profitability and leverage and the cost of debt.

Despite the SEC’s assertions, a growing body of research finds no evidence that auditor independence is impaired by the provision of nonaudit services. Recent studies test the effect of fees on auditor decisionmaking using a variety of proxies for impaired auditor independence. Some of these proxies include earnings management via accruals, earnings surprises, accounting restatements, and the auditor’s propensity to issue a going-concern qualification (Antle, Gor- don, Narayanamoorthy, & Zhui [2006]; DeFond, Raghunandan, & Subramanyan [2002]; Frankel, Johnson, & Nelson [2002]; Ashbaugh, LaFond, & Mayhew [2003]; Chung & Kallapur [2003]; Kinney, Palmrose, & Scholz [2004]; Larker & Richardson [2004]; Gleason & Mills [2006]). Related studies examine the determinants of a given firm’s expenditures on auditor services, and find that f i s with stronger corporate governance and higher agency costs purchase more audit services and fewer nonaudit services (e.g., Parkash & Venable [1993]; Firth [1997]; Carcello, Hermanson, Neal, & Riley [2002]; Abbott, Parker, Peters, & Raghunandan [2003]).

Theoretical research in accounting has resulted in competing predictions about the effect of auditor fees on the cost of capital and firm value. On one hand, audit and nonaudit fees paid to the auditor can create an economic bond between the auditor and the client. This economic bond reduces the auditor’s willingness to act independently, thus lowering the quality of financial statement information (DeAngelo [ 1981a, 1981bl; Magee & Tseng [ 19901). Alternatively, recent literature suggests that higher levels of audit fees are associated with better monitoring. Additionally, firms pay nonaudit fees for expert advice that has the potential to increase firm value (Carcello et al. [2002]). To maximize the value of the firm, managers should weigh the benefits of acquiring additional audit and nonaudit services (either through increased audit scope or consulting arrangements) with the costs incurred because of investors’ belief that auditor independence is impaired.

There is limited evidence about whether market participants believe that auditor independence is impaired by the practice of providing nonaudit services. For example, Frankel, Johnson, and Nelson (2002) find a significant negative relation between abnormal stock returns and nonaudit fees as measured on the date the f i files the proxy statement containing fee information. However, Ashbaugh, LaFond, and Mayhew (2003) find no relation between nonaudit fees and stock returns when they control for the prior-year reaction to the proxy statement. In this paper, we focus on the question of how audit and nonaudit services, as represented by auditor fees, are viewed by investors.

We argue that the acquisition of audit and nonaudit services from the auditor can affect the firm’s cost of debt capital in two ways. First, auditor fees can directly affect the cost of debt by influencing investors’ expectations of future cash flows. When financial statements are less reliable, for example, information



AUDITOR FEES AND COST OF DEBT 3

about fees could affect expected monitoring costs. This information also can affect how investors assess the strength of corporate governance and the quality of management. Second, if high audit or nonaudit fees affect the reliability of financial statements, they also may affect the association between accounting information and the cost of debt. To test these predictions, we regress the firm’s cost of debt on audit and nonaudit fees and the interactions between the auditor fee variables and accounting variables. We first consider the effect of auditor fees in isolation. This test is conducted to determine whether disclosed fees are associated, on average, with the firm’s cost of debt. To test the extent to which fees affect bondholders’ perceptions of financial statement reliability, we expand the regression to include interactions between auditor fees and both profitability and leverage, two widely accepted accounting-based determinants of default risk.

We focus on the bond setting for three reasons. First, bondholders are an economically important set of capital providers who rely on publicly available financial statements for investment decisions. Second, the bond market permits cleaner inferences relative to the equity market. Mansi, Maxwell, and Miller (2004) argue that because bond payouts are limited to the face value of the security, bond pricing models are better specified and less subject to the criticism that the results are driven by misspecification of the equilibrium asset pricing model than are stock pricing models. Finally, Holthausen and Watts (2001) suggest that bondholders’ focus on debt values and default probabilities reflects a difference in how bondholders perceive the relevance of accounting information compared with how stockholders perceive it. Thus, studies on the significance of accounting information in debt markets add to our knowledge, even if previous research has examined equity markets.

Our sample consists of 560 new bond issues from 2001 to 2003. For the sample as a whole, we find a direct positive relation between nonaudit fees and the cost of debt. We then partition the sample based on whether a firm’s debt is rated above or below investment grade. We find that the association between total and nonaudit fees and the cost of debt is driven by the investment-grade sample, and this result is consistent with the notion that reduced accounting reliability is less important when firm risk is high.

For the subsample of firms with investment-grade debt, we also find that the negative relation between return on assets (ROA) and the firm’s cost of debt is stronger (weaker) for firms with high levels of nonaudit (audit) fees. The results for audit fees are consistent with debt investors viewing ROA as less reliable in the presence of high audit fees; however, the finding that nonaudit fees make ROA more reliable is difficult to reconcile with extant theory. For firms with non-investment-grade debt, our evidence suggests that the association between ROA and the cost of debt is mitigated when the firm has higher nonaudit fees. This is consistent with the notion that investors perceive ROA to be less reliable in the presence of high nonaudit fees.

Our results contribute to the literature on the effects of auditor fees, and specifically nonaudit fees, on auditor independence. We focus on the notion of




perceived independence by examining the direct and indirect associations between auditor fees and the cost of capital charged by lenders. We also contribute to the stream of literature on cost of debt. Our evidence suggests that information about auditor-provided services does influence the pricing decisions of lenders.

In Section 2, we discuss prior research on audit and nonaudit fees and their value to firms. We describe the research design that we employ to examine the relation between auditor independence and firms’ cost of debt. In Section 3, we present our sample and data. In Section 4, we present and analyze our results. We conclude in Section 5.

2. Prior Literature and Research Design

2.1 Auditor Fees and the Cost of Debt

The intent of the SEC’s auditor fee disclosure rules is to provide investors with the information needed to evaluate auditor independence. Its primary arguments for fee disclosures center on the potential for auditor independence to be impaired in fact or in appearance, as indicated by this section of the rule:

First, the more the auditor has at stake in its dealings with the audit client, the greater the cost to the auditor should he or she displease the client, par- ticularly when the nonaudit services relationship has the potential to generate significant revenues on top of the audit relationship. Second, certain types of nonaudit services, when provided by the auditor, create inherent conflicts that are incompatible with objectivity. (part III(c)2)

As the quote illustrates, both audit and nonaudit fees have implications for investor perceptions of auditor independence. The effect of auditor fees on the cost of debt may be direct or indirect if they affect the association between financial statement information and the cost of capital. Below we discuss the various implications of audit, nonaudit, and total auditor fees.

2.1.1 Audit Fees

In keeping with the SEC’s primary arguments, DeAngelo (1981a, 1981b) and Magee and Tseng (1990) reason that economic rents from audit fees can increase the bond between client and auditor. When the economic bond increases, so does the firm’s incentive to acquiesce to client pressure. In this context, we expect that investors will perceive the auditor’s independence to be impaired and the firm’s financial statements to be less reliable when the audit fee charged by the auditor is large relative to the size of the firm. Alternatively, Carcello et al. (2002) suggest that many independent boards purchase larger audits to provide increased monitoring. In this context, high audit fees should imply that a firm’s financial statement information is reliable. Consistent with




this reasoning, Carcello et al. find that audit fees are positively related to the per- centage of outside directors on the board and the number of board meetings held during the year.

These alternatives lead to competing hypotheses on the relation between audit fees and the cost of debt. Perhaps, as Carcello et al. (2002) claim, high audit fees are a product of strong corporate governance, which could signal to lenders that financial statements are reliable and that default risk is small. In this scenario, audit fees should have a direct impact by decreasing the cost of debt. Alternatively, if high audit fees increase the economic bond between auditor and client and decrease auditor independence, the greater risk associated with relying on the financial statements should be associated with an increased cost of debt. These alternative rationales also have implications for the association between the financial statement information and the cost of capital. If audit fees increase financial statement reliability, the association between accounting information and the cost of debt will be stronger. If audit fees decrease financial statement reliability, then the association will be weaker.

2.1.2 Nonaudit Fees

We define nonaudit fees as those fees paid to a firm’s auditor that are related neither to the audit services performed for the purposes of financial statement, nor to the review services that are customary under generally accepted auditing standards.’ Nonaudit fees include fees for information technology consulting, tax assistance, pension and benefit plan auditing, SEC filing services, and mergers and acquisitions support, among other services.2

Much of the concein surrounding the provision of nonaudit services centers on how the presence of these fees may affect investors’ perception of auditor independence. While it can be argued that audit fees alone affect this bond, the economic bond derived from nonaudit services has been of greater concern to regulators. Prior research argues that when the profit an auditor gains from providing nonaudit services is greater than could be earned elsewhere, the auditor has an incentive to remain with that particular client. This incentive is likely to arise from nonaudit services, where “knowledge spillovers” from the audit reduce the cost of providing the nonaudit services (Simunic [1984]; Parkash & Venable [ 19931).

1. See http://www.sec.gov/fo/accountants/audindep/audinfaq.htm. 2. The SEC initially required firms to report the amount of fees paid for information technology

(IT) consulting separately from audit fees and other nonaudit services, and we group IT and other nonaudit fees together to be consistent with research using this data. In Financial Reporting Release No. 68, the SEC implemented provisions of the Sarbanes-Oxley Act, which specifically prohibits the auditor from performing certain nonaudit services. As a result, the fee disclosure categories were con- solidated. Our results are robust to excluding the sixtyeight f m s that reported IT fees from our tests.




If, as the SEC contends, investors lower their confidence in the reported numbers when nonaudit fees are high, the increased cost associated with monitoring the firm should translate into a higher return demanded by investors. Investors, however, may perceive other economic effects based on the acquisition of nonaudit services. For example, nonaudit services could indicate that the firm is acquiring value-increasing expertise in the form of merger and acquisition advice or cost studies. Alternatively, the high levels of nonaudit services could signal to the market that such services are substituting for managerial talent.

As with audit fees, we consider the direct effect of nonaudit fees on the cost of debt as well as the indirect effect of nonaudit fees on the association between financial statement information and the cost of debt. If investors believe that nonaudit fees reduce the reliability of financial statements, the association between accounting information and the cost of debt should be a function of nonaudit fees paid to the auditor.

2.1.3 Total Fees

Under the argument that the economic bond implied by audit and nonaudit fees impairs independence, total fees should theoretically represent the strongest measure of auditor independence. Kinney and Libby (2002) assert that the economic bond between clients and auditors is the main threat to auditor independence, and that total fee level is an appropriate measure of this bond. As with audit and nonaudit fees, we include both the main effect of total auditor fees on the cost of debt and the effect of total auditor fees on the relation between financial statement information and the cost of debt.

Our setting addresses some of the limitations of prior research by focusing on the cross-sectional variation in auditor fees and their implication for contract- ing costs faced by the firm. By testing investors’ perceptions of financial statement reliability as reflected in cross-sectional differences in the cost of debt, we avoid the need for a well-specified measure of the amount of discretion present in financial statement numbers. Furthermore, bondholders are an important con- stituency, who, although different from equity holders, still provide an appropriate market setting in which to conduct cross-sectional tests.3

2.2 The Direct Effect of Auditor Fees on the Cost of Debt

To examine the relation between audit and nonaudit fees and the cost of debt, we follow prior research and model the cost of debt as a function of firm

3. Prior research examining the market reaction to auditor fee information in proxy statement filings finds mixed results. Frankel, Johnson, and Nelson (2002) document a negative association between the nonaudit fee ratio and the market reaction to proxy statement releases. Ashbaugh, LaFond, and Mayhew (2003) find that the market reaction to the proxy statement release is not significantly different from the year prior, when information on fees paid to auditors was not disclosed. Brandon, Crabtree, and Maher (2004) examine the effect of nonaudit fees on bond ratings and find a statistically significant effect, but no meaningful economic effect.




and issue-specific characteristics (in keeping with Sengupta [ 19983; Reeb, Mansi, & Alee [2001]; Anderson, Mansi, & Reeb [2003]; Bhojraj & Sengupta [2003]; Shi [2003]; Mansi, Maxwell, & Miller [2004]). We then extend this model to include auditor fees:

TS’PREXD = a, + a, FEE + a2 ROA + a3 LEV + a4 LnMVE + a5 BTM

+ a, STDRET + a, RATTNG + a8 LnPRiN + a, LnMATUR

+ a,, SENDUM + a,, PUBLIC + E (1)

Where the variables are defined as follows:

TSPREAD

FEE

ROA

LEV LnMVE

BTM

STDRET

RATING

LnPRIN

LnMAT

SENDUM

PUBLIC

The yield on the first bond issue after the proxy statement filing in year t less the yield on a corresponding Treasury security of similar maturity (as reported in the SDC Global New Issues database). One of four measures of auditor fees (1) SCL-TF = total auditor fees divided by the square root of total assets. (2) SCL-AF = audit fees divided by the square root of total assets. ( 3 ) SCL-NAF = nonaudit fees divided by the square root of total assets. (4) FEERATIO =

ratio of nonaudit fees to total fees. Income before extraordinary items divided by total assets at the end of year t - 1. Long-term debt divided by total assets at the end of year t - 1. The natural log of market value of equity reported by the Center for Research in Security Prices (CRSP) at the end of year t - 1. Book value of equity at end of year t - 1 divided by market value, winsorized at 0 and 3. Standard deviation of monthly stock returns for the 24 months through the end of the last month of year t - 1. Moody’s Credit Rating in year t converted to a numerical equivalent where 1 is assigned to bonds with an AAA rating (as reported in the SDC database). The natural log of the total amount of proceeds received from the issue. The natural log of the number of years until maturity on the issue. An indicator variable equal to 1 if the debt issue is senior, 0 otherwise. An indicator variable equal to 1 if the debt is publicly traded debt, 0 if issued under SEC Rule 144a.

Consistent with existing research, we measure each firm’s cost of debt as the difference between yields on the corporate issue and a U.S. Treasury Security issue of similar maturity. FEE represents a measure of the structure or magnitude of auditor fees. We use auditor fee data collected by Standard and Poor’s (S&P)




from the most recent proxy statement preceding the bond issue. To date, there appears to be little consensus on the proper empirical specification for the FEE variable. At least three measures of the economic bond created by auditor fees have been used in the literature. Because the extant theory does not distinguish the effect of auditor fees on debt from the nonaudit fee component, we include measurements of audit, nonaudit, and total fees, as well as the ratio of nonaudit fees to total fees in our tests. Our measures of audit, nonaudit, and total fees are power transformations, following Simunic (1980, 1984) and Kinney, Palmrose, and Scholz (2004). The ratio of nonaudit fees to total fees is driven by the conjecture that investors’ perceptions of auditor independence is associated with the size of nonaudit fees relative to the total fees paid to the auditor (e.g., Parkash & Venable [ 19931; Firth [ 19971; DeFond, Raghunandan, & Subramanyam [2002]; Frankel, Johnson, & Nelson [2002]; Abbott et al. [2003]; Chung & Kallapur [2003]).

We include financial statement-based measures of profitability and leverage to capture accounting information relevant to bondholders in pricing a firm’s debt. The coefficient on ROA is expected to be negative if more profitable firms have lower default risk and benefit from a lower cost of borrowing. The coefficient on LEV is expected to be positive if leverage increases the expected default costs and the yield demanded by bondholders.

We also include other issuer characteristics consistent with prior research. The natural log of the market value of equity, LnMVE, is expected to be inversely related to the cost of debt, because large firms are expected to have lower default risk. STDRET proxies for the overall risk of the firm, and should be positively related to cost of debt. We include BTM to control for growth opportunities. If firms with more growth opportunities have a lower cost of debt, then BTM should be positively related to that cost. Finally, we include RATING (i.e., the numerical conversion of Moody’s bond ratings), a discrete variable where 1 represents an AAA-rated bond. Prior research documents a strong positive association between bond rating and the cost of debt. Including a measure of bond rating allows us to test for the incremental association of fees with the cost of debt after controlling for other firm-specific risk characteristics included in the bond rating.

We also include control variables for issue-specific characteristics. We measure the amount borrowed as the natural log of the proceeds, LnPRIN. The magnitude of the bond issue affects the cost of debt in two ways. First, LnPRIN is inversely related to the cost of debt because of economies of scale in underwrit- ing. Second, the size of the issue is mechanically correlated with the extent of increase in leverage. If the increase in leverage induced by the issue negatively affects bondholders, then they will require higher yields. As a result, we have no prediction on the sign of the coefficient of LnPRIN. Bonds with longer maturities impose greater liquidity risk exposure for bondholders. If interest rates increase over the life of the bond, the value of the bond is discounted by the market until its yield is equal to the market rate of interest. Term risk is captured in Treasury yields, which are deducted from the total yield to obtain our cost of-capital




measure, or TSPREAD. We use LnMAT to capture any remaining effects of dura- tion, and we expect this value to be positively related to cost of debt. Finally, senior debt issues take priority in liquidation, reduce bondholder risk, and generally result in a lower cost of borrowing; therefore, we expect the coefficient on SENDUM to be nega t i~e .~

We include SEC Rule 144a debt issues in our sample. Although all the f i i s in our sample are publicly traded, the Rule 144a bonds are issued to, and trad- able among, qualified institutional investors only. These bonds do not require SEC registration, and they have less stringent disclosure and reporting require- ments. Rule 144a issues typically have higher yields relative to their SEC-regis- tered counterparts. To control for differences in issuance type, we include the dummy variable PUBLIC, which equals 1 for publicly issued bonds and 0 otherwise. Consistent with prior research, we also include industry and year dummy variables in our regressions.

2.3 The Indirect Effect of Auditor Fees on the Cost of Debt

The SEC argues that nonaudit fees decrease financial statement reliability in the minds of investors, which could increase the cost of capital. To provide a test of the role that fees play in investors’ assessment of financial statement reliability, we interact the fee variables with ROA and leverage in the following model:

TSPREAD= a, +a,FEE+a,ROA+a,ROA*FEE+a,LEV + a,LEV *FEE + a,LnMVE + a,BTM + a,STDRET

+ a,RATING + a,,LnPRIN + a , , L n M T U R

+ a,,SENDUM + a,, PUBLIC + E (2)

If audit and nonaudit fees affect the extent to which investors rely on financial statements, the relation between accounting variables and the cost of debt should be a function of audit and nonaudit fees. If creditors perceive ROA to be a less reliable measure of future profitability for firms with high audit and nonaudit fees, then the coefficient on the interaction between FEE and ROA should be positive. Similar effects should be observed for the interaction between FEE and LEV.

We limited our interaction of auditor fees to the ROA and LEV variables because these are the control variables most likely to be affected by accounting quality issues. With the exception of the book-to-market ratio, none of the other control variables incorporate financial statement information. And though the book-to-market ratio does utilize accounting book values, it still represents a proxy for growth. Because the denominator of BTM already incorporates the

4. Three other important bond characteristics are call, conversion, and sinking fund provisions. We do not include controls for these variables because none of the bond issues in our sample have these characteristics.




market’s assessment of accounting quality, we do not interact BTM with auditor fee variable^.^

2.4 Investment-Grade vs. Non-Investment-Grade Firms

The importance of auditor independence may differ among firms depending on their respective levels of f i i risk. Holthausen and Watts (2001) suggest that research into the relation between accounting information and debt values may need to focus on firms with a nontrivial probability of default. Thus, we partition the sample based on whether firms have an investment-grade debt rating and then we reestimate the regressions for each partition. While we do not have an expectation for how the coefficients will vary between the two partitions, we discuss two plausible alternatives. The first is that the benefit of independent monitoring by the audit firm is greater for firms with non-investment-grade debt-that is, the cost of impaired auditor independence is greater for riskier firms. This suggests that the association between auditor fees and the cost of debt is strongest in the non-investment-grade sample. An alternative argument is that the additional risk presented by auditor independence issues may be insignificant relative to the risks already faced by holders of non-investment-grade debt. In this case, the positive relation between auditor fees and the cost of debt that we observe in the full sample should be mitigated in the non-investment-grade sample.

3. Sample and Descriptive Statistics

3.1 Sample

We initially identify 2,496 public and SEC Rule 144a bond issues and their characteristics from the SDC Global New Issues database. We focus on new issues because Shiller and Modigliani (1979) argue that yields on new issues are a more accurate measure of a firm’s cost of debt than yields on seasoned issues. We limit our sample period to bonds issued between February 5, 2001, when the SEC requirement to report fees took effect, and December 31, 2003. We obtain data on audit and nonaudit fees from S&P. We eliminate 205 observations that lack auditor fee information, three observations from firms without bond ratings, and 1,505 observations on financial institutions, consistent with prior research.6 To reduce the effect of cross-sectional correlation in the error terms, we limit our sample to the first bond per firm issued after the proxy statement containing audit fee information was filed. This restriction eliminates an additional 223 observations, resulting in a total sample of 560. We use auditor fee and company-level financial information from the most recent fiscal year ending before the bond was issued. Table 1 summarizes our sample selection process and describes industry- and issue-year distribution within the sample.

5. In untabulated robustness tests, we interacted BTM with auditor fee variables. The interactions

6. Most of the firms that do not report auditor fees are domiciled in foreign countries. are not significant, and the other tabulated results are robust to interacting BTM with auditor fees.




TABLE 1

Sample Selection and Industry and Year Distribution for a Sample of 560 Bonds Issued from 2001 through 2003

Panel A: Sample selection

Number of bond issues with available Compustat and CRSP data Missing auditor fee data or bond ratings Financial institutions (SIC 6000-6999) Issues following first issue of year

Final Sample

Panel B: Distribution by industry

Frequency Percent

1 2 3 4 5 6 7 8 9

10 12

Nondurables Durables Manufacturing Energy Chemicals Business Equipment Telecommunications Utilities Shops Health Other

39 14 89 40 29 34 29

101 59 24

102

6.96% 2.50

15.89 7.14 5.18 6.07 5.18

18.04 10.54 4.29

18.21

560 100.00%

Panel C: Distribution by year

Frequency Percent

2001 2002 2003

136 194 230

560 -

24.29% 34.64 41.07

100.00%

3.2 Descriptive Statistics

We present descriptive data for the sample in Table 2. The median audit fee in our sample is $1.1 million, slightly smaller than the median nonaudit fee of $1.34 million. The mean audit fee ($2.1 million) and nonaudit fee ($4.35 million) are much larger than the median, and this indicates that both audit and nonaudit fees are highly skewed. Ashbaugh, LaFond, and Mayhew (2003) report significantly lower median audit ($0.19 million) and nonaudit ($0.20 million) fees, but they use a more comprehensive sample that is not limited to the larger debt issuers we examine. The average yield spread (TSPREAD) is 279 basis points,



TABLE 2

Descriptive Statistics for 560 Bonds Issued between 2001 and 2003

Standard Mean Deviation 25 % Median 75%

Audit Fees 2.10 3.30 0.49 1.10 2.51 Nonaudit Fees 4.35 9.07 0.42 1.34 3.83 Total Fees 6.44 11.20 1.05 2.82 6.66 FEERATIO 0.53 0.21 0.38 0.54 0.69 TSPREAD 279.32 198.90 120.00 22 1.75 406.43 ROA 0.04 0.06 0.01 0.04 0.06 LEV 0.38 0.16 0.27 0.37 0.47 MVE 12,488.44 34,357.13 807.82 2,522.12 8,719.52 BTM 0.64 0.56 0.3 1 0.53 0.79 STDRET 0.13 0.06 0.09 0.12 0.15 PRIN 281.98 1,288.18 32.45 80.61 185.00 MAT 10.05 6.14 7.00 10.00 10.00 SENDUM 0.88 0.33 1 .oo 1 .00 1 .00 IGRADE 0.61 0.49 0.00 1 .oo 1 .oo RATING 9.82 3.84 7.00 9.00 13.00 PUBLIC 0.61 0.49 0.00 1 .00 1 .00

Total fees paid to auditors for audit work in year t - 1 Audit fees Nonaudit fees Total fees FEERATIO TSPREAD

ROA LEV MVEa PRIPP MATa STDRET

BTM

SENDUM IGRADE

RATING

PUBLIC

Total fees paid to auditors for nonaudit and audit-related work in year t - 1 Sum of audit and nonaudit fees paid to auditors in year t - 1 Nonaudit fees divided by total fees in year t - 1 The yield on the first bond issue after the proxy statement filing in year t less the yield on a corresponding Treasury security of similar maturity (as reported in the SDC Global New Issues database) Income before extraordinary items divided by total assets at the end of year t - 1 Long-term debt divided by total assets at the end of year t - 1 Market value of equity reported by CRSP at the end of year t - 1 The total amount of proceeds received from the issue The number of years until maturity on the issue Standard deviation of monthly stock returns for the twenty-four months through the end of the last month of in year t - 1 Book value of equity at end year t - 1 divided by market value, measured in fiscal year-end month), winsorized at 0 and 3. An indicator variable equal to 1 if the debt issue is senior, 0 otherwise Indicator variable equal to 1 if the firm’s Moody’s Credit Rating in year r (as reported in the SDC database) is Baa3 or better Moody’s Credit Rating in year t converted to a numerical equivalent where 1 is assigned to bonds with an AAA rating (as reported in the SDC database) Indicator variable equal to 1 if the debt is publicly traded and 0 if it is an SEC Rule 144a bond issue.

a W E , PRIN, and MAT information is provided only for sample characteristics. In the regressions, the log of these values (LnMVE, LnPRIN, and LnMAT) is used.




and is higher than the spread of 193 basis points reported by Klock, Mansi, and Maxwell (2005) for the 1990-2000 sample period. This difference is due to the inclusion of SEC Rule 144a issues; the average yield spread for publicly issued debt in our sample is 183 basis points, while the average spread for Rule 144a privately issued debt is 428 basis points. The average and median return on assets is 4 percent. The mean (median) level of debt is 38 percent (37%) of assets. The mean (median) firm in our sample has market value of equity of $12.5 billion ($2.5 billion), which is greater than the Ashbaugh, LaFond, and Mayhew (2003) sample mean (median) of $2.8 billion ($0.16 billion). The mean (median) book-to-market ratio for the sample is 0.64 (0.53). The median is similar to the median of 0.56 reported in Ashbaugh, LaFond, and Mayhew (2003), but our sample mean is larger, suggesting that extreme firms in our sample have lower growth opportunities than those in Ashbaugh, LaFond, and Mayhew (2003). Most of the bond issues in our sample (61%) have investment-grade bond ratings. As indicated above, we include Rule 144a private bond issues for publicly traded firms. These issues represent 39 percent of the sample.

Table 3 presents Pearson correlation coefficients. The correlations between the auditor fee variables are all positive and significant, with the exception of audit fees scaled by the square root of total assets (SCL-AF) and FEERATIO. We also show the correlations among our dependent variable, TSPREAD, and explanatory variables. Consistent with existing debt literature, TSPREAD has a strong positive relation with LEV, BTM, and STDRET. We also find an expected negative relation between TSPREAD and the ROA, LnMVE, LnPRIN, LnMAT, SENDUM, IGRADE, and PUBLIC variables, respectively.

4. Results

4.1 Direct Effect of Auditor Fees on the Cost of Debt

In Table 4, we report the results of estimating the regression of yield spread on the audit and nonaudit fee measures and the control variables described in eq. (1). Yield spreads are positively associated with scaled total fees (SCL-TF), as reported in the first column of Table 4 (coeff. = 190.21; t = 2.45). Results for nonaudit fees (column 2) and the fee ratio (column 3) suggest that the positive coefficient on total fees is driven by nonaudit fees. The coefficient on SCL-NAF (coeff. = 268.52; t = 2.80) implies that an increase of 1 standard deviation in SCL-NAF results in an increase of 14.99 basis points in the yield spread. The coefficient on scaled audit fees is not significantly different from zero.

The coefficients on the control variables generally are consistent with our expectations and are qualitatively similar to coefficients from a model that excludes fee variables (not tabulated). The cost of debt increases with the size of the bond issue (LnPRIN), which is consistent with the increase in leverage domi- nating any economies of scale already present. Contrary to our expectations, but



TA

BL

E 3

Pea

rson

Cor

rela

tion

s be

twee

n Sa

mpl

e V

aria

bles

SCL-

TF

SCL-

AF

SC

L- N

AF

FE

E R

ATI

O

RO

A

LEV

LnM

VE

BT

M

STD

RE

T Ln

PR

lN

LnM

AT

SEN

DU

M

RA

TIN

G P

UB

LIC

0.00

8 0.

174

0.00

8 0.

083

<0.

001

<0.

001

<O.O

Ol

<O.O

Ol

<O.O

Ol

0.06

3 0.

044

<0.

001

<0.

001

<0.

001

<0.

001

<O.O

Ol

<0.

001

0.92

2 <

0.00

1 <O

.OO

l <O.OOI

0.61

1 <

0.00

1 0.

008

0.00

8 0.

003

0.00

2

<0.

001

0.24

1 0.

447

0.08

7 <O

.OOI

0.

003

0.03

2 <

0.00

1 0.

013

0.10

1 0.

903

0.19

4

<0.

001

0.02

2 <

0.00

1 <O

.OOI

<O

.OOI

0.

841

<O.O

OI

0.02

5 0.

011

<0.

001

0.00

2

0.16

5 <O

.OOI

<

0.00

1 0.

002

0.39

1 <

0.00

1 0.

532

0.14

4 <

0.00

1 0.

029

<0.

001

<0.0

01

<0.

001

<0.

001

0.45

6 0.

536

0.82

5 <O

.OO

l <

0.00

1

<O.O

OI

0.03

0 <O

.OO

l 0.

142

0.53

2 0.

003

<0.

001

<0.

001

<0.

001

<0.

001

<O.O

Ol

0.12

9 <O

.OO

l <

0.00

1 <O

.OO

l

<0.

001

0.01

1 0.

781

0.03

5 <O

.OO

l <

0.00

1

0.07

3 0.064

0.00

6 <O

.OO

l <

0.00

1 Ln

PR

lN

0.02

7 0.

115

0.11

4 0.

023

0.53

0 0.

006

0.00

7 0.

586

0.20

1 0.

101

0.02

8 SE

ND

UM

0.

474

0.32

2 <

0.00

1 <

0.00

1 R

ATI

NG

0.

603

<0.

001

TSP

RE

AD

-0

.112

-0

.058

-0

.112

-0

.073

-0

.381

0.

362

-0.6

59

0.42

4 0.

535

-0.0

79

-0.0

85

-0.2

82

-0.7

69

-0.6

03

SCL-

TF

0.62

8 0.

956

0.46

9 0.

071

-0.1

67

0.34

7 -0

.160

0.

022

0.21

0 -0

.113

0.

112

0.12

3 0.

129

SC

LA

F

0.37

2 -0

.050

-0

.032

-0

.072

0.

204

-0.1

26

0.09

1 0.

150

-0.1

05

0.06

9 -0

.005

0.

055

SCL-

NAF

0.

578

0.09

7 -0

.173

0.

337

-0.1

44

-0.0

09

0.19

4 -0

.095

0.

107

0.14

9 0.

133

FE

ER

ATI

O

0.05

9 -0

.140

0.

287

-0.1

31

-0.0

36

0.19

4 -0

.026

0.

062

0.14

0 0.

092

RO

A

-0.2

87

0.34

5 -0

.386

-0

.306

0.

032

-0.0

26

0.00

9 0.

270

0.20

9

LEV

-0.3

97

0.09

2 0.

244

-0.0

62

0.02

6 -0

.124

-0

.399

-0

.190

LnM

VE

-0

.525

-0

.370

0.

469

-0.0

64

0.30

0 0.

591

0.51

8

BTM

0.

264

-0.1

06

0.01

2 -0

.089

-0

.318

-0

.289

STD

RE

T 0.

076

-0.0

78

-0.1

17

-0.5

11

-0.3

84

LnM

AT

-0.0

54

0.06

9 0.

093

Nor

e: S

igni

fica

nce

leve

ls reported in

ital

ics.

AU

vari

able

s are d

efin

ed in

Tab

le 2.



TA

BL

E 4

The

Eff

ect

of A

udito

r F

ees

on C

ost

of D

ebt

for

a Sa

mpl

e of

560

Bon

d Is

sues

fro

m 2

001

thro

ugh

2003

Dep

ende

nt V

aria

ble =

TSP

RE

AD

Inve

stm

ent g

rade

onl

y (N

= 3

43)

All firms

Non

-inve

stm

ent g

rade

(N

= 2

17)

Var

iabl

e N

ame

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

SCL-

TF

SCL-

AF

SCL-

NA

F

FE

ER

ATI

O

RO

A

LEV

LnM

VE

BTM

STD

RE

T

LnPR

IN

LnM

AT

SEN

DU

M

RA

TIN

G

PU

BU

C

Indu

stry

con

trol

s

R2

190.

21

(2.4

5)

-89.

43

(-0.

91)

10.0

4 (0

.28)

-2

8.08

(-

5.02

) 20

.99

(1.9

3)

222.

32

(2.2

3)

6.15

(1

.85)

-1

1.82

(-

1.1

9)

48.6

9 (2

.86)

27

.55

(11.

06)

-60.

84

(-4.

87)

0.70

6

- 14

2.66

(-

0.56

) 26

8.52

(2

.80)

-106

.11

(-1.

07)

10.0

9 (0

.29)

-2

7.77

(-

4.97

) 19

.68

(1.8

1)

230.

68

(2.3

1)

6.17

(1

.86)

-1

2.07

(-

1.2

2)

48.7

0 (2

.86)

27

.63

(1 1.

10)

-60.

25

(-4.

83)

0.70

6

50.7

4 (2

.11)

-1

01.5

6 (-

1.03

) 13

.00

(0.3

7)

-26.

97

(-4.

87)

21.1

0 (1

.94)

24

1.42

(2

.43)

5.

85

(1.7

6)

-13.

28

(- 1

.34)

49

.22

(2.8

8)

27.3

6 (1

0.96

) -5

9.65

(-

4.77

)

0.70

5

164.

20

(2.8

9)

-226

.58

(-2.

22)

-0.0

9 (-

0.03

) -2

8.68

22.5

8 (1

.56)

54

7.37

(4

.34)

11

.97

(5.4

1)

-2.7

8 (-

0.43

)

(-7.

20)

310.

77

(0.9

8)

148.

71

(2.2

6)

-222

.35

(-2.

17)

0.58

(0

.02)

-2

8.82

(-

7.20

) 23

.87

(1.6

2)

544.

91

(4.3

1)

11.9

8 (5

.40)

-2

.59

(-0.

40)

60.7

0 (3

.09)

-2

15.9

9 (-

2.12

) -3

.98

(-0.

12)

-28.

10

(-7.

16)

21.8

4 (1

.52)

55

9.34

(4

.45)

11

.17

(5.0

5)

-4.0

6 (-

0.63

)

-27.

25

-27.

42

-25.

23

(-2.

51)

(-2.

52)

(-2.

33)

0.44

0 0.

439

0.44

2

Incl

uded

85.2

5 (0

.43)

-258

.31

(- 1

.59)

-3

5.13

(-

0.56

) -6

4.43

(-

5.55

) -5

.62

(-0.

33)

177.

29

(1.1

9)

15.1

5 (1

.51)

- 17

9.24

(-

3.83

) 23

.15

(1.00)

-38.

03

(-1.

52)

0.39

7

Not

e: t

-sta

tistic

s in

pare

nthe

ses.

All

vari

able

s are d

efin

ed in

Tab

le 2

(the

inte

rcep

t is

supp

ress

ed fo

r bre

vity

).

-409

.12

(-1.0

0)

479.

29

(1.3

8)

-282

.20

(-1.

73)

-29.

02

(-0.46)

-65.

69

(-5.

65)

-7.6

4 (-

0.45

) 17

1.25

(1

.15)

15

.12

(1.5

1)

-176

.29

(-3.

77)

23.7

4 (1

.03)

-37.

04

(- 1

.48)

0.40

0

42.5

5 (0

.93)

-2

68.0

5 (-

1.66

) -3

1.44

(-

0.50

) -6

4.97

(-

5.70

) -6

.22

(-0.

36)

175.

08

(1.1

9)

16.0

6 (1

.61)

-1

80.1

3 (-

3.88

) 24

.10

( 1.0

5)

-36.

16

(- 1

.45)

0.39

9




consistent with Bhojraj and Sengupta (2003), we find that maturity is negatively related to the cost of debt. A difference of one step (e.g., AAA vs. AA1) results in a difference of 27 basis points in bond rating.’ Finally, the coefficient on PUBLIC implies that the yield spread on publicly issued debt is about 60 basis points lower than private debt, on average.

4.2 Investment-Grade vs. Non-Investment-Grade Firms

Thirty-nine percent of our sample bond issues are rated below investment grade. In untabulated descriptive statistics, scaled audit fees are not significantly different between the investment and non-investment-grade firms. However, we find significantly higher levels of scaled nonaudit fees and higher fee ratios for the investment-grade sample. We also observe that firms that issue non-investment- grade debt are characterized by lower ROA, smaller market capitalization, higher book-to-market values, and more volatile stock prices.

We reestimate our equations on the sample, partitioned according to whether firms have investment-grade bond ratings (Table 4, columns 4 through 9). Our results suggest that the significant relations between nonaudit fees and the cost of debt and the nonaudit fee ratio and the cost of debt reported in Table 4 are driven by firms with investment-grade debt. In addition, we find that the increased cost of debt is driven by nonaudit rather than audit fees. We find no evidence of a significant relation between auditor fee variables and the cost of debt for the non-investment-grade sample.

We draw two inferences from the results presented in Table 4. First, audit fees have little relation to the cost of debt. Second, nonaudit fees appear to have an insignificant role in determining the cost of debt for the non-investment-grade sample. One explanation for the insignificant effect of auditor fees in this group is that financial statement quality is less important when investors already face a substantially risky investment. Nonaudit fee measures, however, have a strongly positive association with the cost of capital for investment-grade firms, and this is consistent with the assertion that nonaudit fees paid to auditors increase firms’ cost of capital.

4.3 Indirect Effect of Auditor Fees on Bondholder Perceptions of Financial Statement Reliability

In Table 5, we estimate eq. (2), which includes auditor fee measures interacted with accounting variables. The interactions test the indirect effect of auditor fees on the relation between accounting variables and the cost of debt.

We estimate the regression for the full sample and separately for firms with and without an investment-grade rating. For the full sample, the main effect of FEERATZO (column 3) is significantly positively related to the cost of debt (coeff. = 162.96, t = 2.39). The coefficient on SCL-NAF is also weakly

7. Results are robust to using an indicator variable equal to one if the debt is investment grade and zero otherwise in place of RATING.



TA

BL

E 5

The

Eff

ect

of A

udito

r F

ees

on t

he A

ssoc

iati

on b

etw

een

the

Cos

t of

Deb

t an

d A

ccou

ntin

g In

form

atio

n fo

r a

Sam

ple

of 5

60 B

ond

Issu

es fr

om 2

001

thro

ugh

2003

Dep

ende

nt V

aria

ble =

TSP

RE

AD

All

fm

s

Inve

stm

ent g

rade (

N =

343

) N

on-in

vest

men

t gra

de (

N =

217

)

SCL-

TF

SCL-

AF

SCL-

NA

F

FE

ER

ATI

O

RO

A

RO

A*T

F

RO

A*A

F

RO

A*N

AF

RO

A*F

EE

RA

TIO

LEV

LEV

*TF

LE

VA

F

LEV

*NA

F

LE

PF

EE

RA

TIO

Indu

stry

con

trol

s

R2

194.

71

(0.7

4)

-240

.56

(- 1

.95)

24

17.1

8 (1

.75)

29.0

9 (0

.62)

-4

02.6

3 (-

0.63

)

0.70

9

- 14

34.7

6 (-

1.55

) 57

9.57

( 1

.68)

-406

.72

(-2.

74)

1398

9.00

(2

.42)

-8

5.65

6 (0

.05)

-16.

25

(-0.

31)

2903

.84

(1.4

4)

-1 1

97.7

3 (-

1.3

3)

0.71

0

162.

96

(2.3

9)

(-0.

70)

-149

.15

115.

40

(0.3

0)

160.

91

(1.9

6)

-296

.78

(-2.

02)

0.70

7

34.5

1 (0

.17)

-175

.45

(- 1

.45)

-6

25.4

3 (-

0.65

)

-40.

37

(-0.

87)

617.

14

(1.1

1)

0.44

2

600.

03

(0.7

5)

-7.9

5 (-

0.03

) 71

.80

(1.1

8)

-378

.70

144.

5 1

(-2.

45)

(0.7

6)

1085

2.00

(2

.01)

-1

701.

53

(- 1

.45)

-7

35.2

8

14.7

1 (0

.26)

-293

5.41

(-

1.26

) 91

0.27

(1

.34)

Incl

uded

0.44

9

-2.1

7)

60.2

4 -0

.68)

85.4

0 (0

.58)

0.44

9

-129

.58

(-0.

17)

-717

.72

(-2.

61)

9788

.22

(2.0

2)

-44.

08

(-0.

48)

363.

37

(0.2

3)

0.40

6

- 15

48.5

0 (-

0.79

) 69

7.94

(0.60)

-688

.64

(-2.

45)

-164

3.25

(-

0.13

) 17

896.

00

(2.1

0)

-60.

65

(-0.

62)

3063

.35

(0.7

3)

- 14

97.9

8 (-

0.58

)

0.40

7

45.5

4 (0

.33)

-8

69.0

9 (-

2.18

)

1253

.78

( 1.6

9)

-24.

76

(-0.

17)

-49.

32

(-0.

17)

0.40

2

Not

e: t

-sta

tistic

s in

pare

nthe

ses.

All

vari

able

s are

def

ined

in T

able

2 (i

nter

cept

and

oth

er e

xpla

nato

ry v

aria

bles

sup

pres

sed)

.




significantly positive. When firms are partitioned based on whether or not they have an investment-grade rating, the main effect of audit and nonaudit fees is insignificant for all measures.

The coefficient on the interaction between SCL-AF and ROA is positive and significant in the full sample, and this suggests that the association between ROA and a firm’s cost of debt is less negative for firms with higher audit fees, which is consistent with the argument that lenders rely less on the financial statements of firms with higher audit fees.8 Similarly, the interaction between LEV and FEERATIO is negative and significant in the full sample (column 3).

When the regression is estimated separately for the investment- and non- investment-grade samples, important differences arise. In addition to a positive and significant coefficient for the interaction between SCL-AF and ROA for the investment-grade sample (column 5) , we find a negative and significant coefficient on the interaction between FEERATIO and ROA (column 6) . This result suggests that nonaudit fees strengthen the negative association between ROA and the cost of debt, consistent with the negative association between fees and abnormal accruals documented in Larcker and Richardson (2004).

For non-investment-grade firms, we find a positive and significant coefficient for the interaction between ROA and scaled nonaudit fees (SCL-NAF) in column 8 and a positive and marginally significant coefficient on the interaction between FEERATIO and ROA in column 9. The effect of nonaudit fees on the relation between ROA and TSPREAD contrasts with that found for the investment- grade sample. Even so, this is consistent with the argument that nonaudit fees reduce the extent to which investors rely on financial statements. Auditor fees do not appear to influence the association between leverage and cost of debt capital.

Broadly, our results suggest that audit and nonaudit fees have implications for firms’ cost of debt. Specifically, the cost of debt is increasing in nonaudit fees for firms with investment-grade debt ratings. We also find evidence that audit and nonaudit fees appear to influence the association between financial statement information and the cost of debt. For firms with below-investment- grade debt, nonaudit fees appear to weaken the relation between ROA and the cost of debt, which is consistent with the argument that nonaudit fees reduce the perceived reliability of financial statements. However, for firms with investment- grade debt ratings, a different picture emerges. Specifically, audit fees appear to weaken the association between ROA and the cost of debt, which is consistent with investors perceiving that higher fees create an economic bond between the auditor and client and thus impair auditor independence. This pattern is not sys- tematic, because some results also suggest that nonaudit fees actually strengthen the association between ROA and the cost of debt. One interpretation is that nonaudit fees improve the reliability of financial statements. Alternatively, it could

8. Alternatively, the results could be interpreted as lenders perceiving ROA to be positively biased or noisier for these firms.




be that firms with higher nonaudit fees have understated earnings, a finding that is consistent with results documented in Larcker and Richardson (2004). Although we cannot reject the validity of these interpretations, we cannot reconcile the finding with extant theory. A possible explanation could be that specific nonaudit services improve the quality of the financial reporting system, an issue which is beyond the scope of this paper.

4.4 Robustness Tests

We test whether our results are sensitive to including utility firms in our sample or are driven by the post-Sarbanes Oxley Act (SOX) time period. We also test that our results are robust to controlling for differences in auditor quality and corporate governance. First, we partition the sample into utility and nonutility firms. Results for the utility and nonutility subsamples are qualitatively similar to those reported in Tables 4 and 5 for the full sample. We do not partition by investment grade because we have an insufficient number of utilities with non-investment-grade ratings for a meaningful test.

We also test whether our results are driven by time period. We partition the sample based on whether the bond issue date is before or after the June 25, 2002, Senate introduction of the SOX bill. We find that results generally are stronger in the post-SOX period. In the pre-SOX period, FEERATIO is not significant (coeff. =16.74; t = 0.56) and total fees and nonaudit fees are weakly significant (SCL-TF coeff. =139.27; t = 1.65; SCL-NAF coeff. = 219.95; t =

1.96). This is likely due to increased investor attention to auditor fees following the accounting scandals at Enron and Worldcom and the introduction of the SOX legislation.

Mansi, Maxwell, and Miller (2004) show that firms using larger auditing firms have a lower cost of borrowing, while firms whose auditors have been with the client for a shorter amount of time have a higher cost of borrowing. They at- tribute this effect to the importance of audit quality on information content and to the insurance role of the audit to bondholders. Although we do not have an ex ante prediction regarding the correlation between auditor fees and audit quality, we do investigate whether the results change when we control for audit quality.

To capture audit quality, Mansi, Maxwell, and Miller (2004) utilize auditor size (as measured by an indicator variable for a Big-N firm) and auditor tenure (as measured as the number of years of the auditor-client relationship). Only six observations in our sample are audited by non-Big-N firms; thus, we designate auditor tenure as a proxy for audit quality. Using Compustat data beginning in 1979, we calculate auditor tenure (TENURE) as in Mansi, Maxwell, and Miller (2004). The mean (median) length of the auditor-client relationship is 14.14 (16) years, and ranges from 1 to 24 years. Univariate correlations reveal that TEN- URE is positively and significantly correlated with the scaled fee measures and with FEERATIO. Thus, it appears that audit and nonaudit fees are greater when the length of the auditor-client relationship is longer. The positive relation




between audit and nonaudit fees, along with auditor tenure, suggests that the coefficient estimate for the effect of auditor fees on the cost of debt could be understated. In untabulated sensitivity tests, we include a control for auditor tenure in our regressions. We find that our results with respect to audit fees are qualitatively similar to those reported in the tables. Although auditor fees are related to tenure, including tenure in the analysis does not alter the inferences drawn from our analysis.

Larcker and Richardson (2004) argue that analyzing the effect of auditor- provided nonaudit services without considering the effect of corporate governance results in an incomplete analysis. Following Klock, Mansi, and Maxwell (2005), we use GINDEX as a proxy for corporate governance in our regressions. GINDEX as defined in Gompers, Ishii, and Metrick (2003) is a composite index of shareholders’ rights and is based on various anti-takeover measures of publicly traded firms provided by the Investor Responsibility Research Center (IRRC). Based on the extent to which existing governance provisions either protect or limit investors’ rights, firms are assigned a score to denote their level of corporate governance. A low (high) GINDEX is indicative of extensive (limited) pro- tection rights, implying strong (weak) governance. Klock, Mansi, and Maxwell (2005) document a significant negative relation between yield spread and GINDEX. Limited availability of GINDEX reduces the sample to 504 observations.

We find that although GZNDEX has the predicted negative relation with cost of debt in simple correlations, the coefficient on GINDEX is still negative but no longer significantly different from zero when we control for bond rating. Thus, in our sample period, bond ratings appear to subsume all the information in GINDEX.

In contrast to the lack of significance for bond ratings when we incorporate a measure of debt rating, the effects of the auditor fee variables are robust to including GINDEX in the regression. In untabulated tests, we find that total fees, nonaudit fees, and the fee ratio continue to be positively and significantly related to the cost of debt. Thus, better governance does not appear to mitigate the effect of auditor fees. Further, auditor fees have incremental explanatory power relative to debt ratings, while GINDEX does not contribute beyond the information captured in IGRADE.

5. Conclusion We investigate the relation between auditor fees and cost of debt capital.

Our study is motivated by the SEC’s concerns that nonaudit fees weaken investors’ perception of auditor independence, reduce financial statement reliability, and lead to a higher cost of capital. The SEC’s prohibition against providing certain nonaudit services to clients under SOX is a consequence of these public and regulatory concerns, but researchers have yet to find convincing evidence that the presence of auditor fees are associated with decreased auditor independence.




By exploiting a setting in which audited financial statements presumably are relied on to price a firms’ debt, we test whether auditor fees are systematically associated with the cost of borrowing. We also provide more direct evidence of the role played by fees in affecting how financial statement reliability is perceived. We test whether the relation between financial statement information and the cost of debt is affected by the fees paid to the auditor.

In general, our results provide support for the conjecture that nonaudit fees are positively related to firms’ cost of debt, but only for investment-grade firms. The positive relation between the cost of debt and nonaudit fees is robust to controlling for auditor tenure and firm governance characteristics. For firms with non-investment-grade debt, there is some evidence that investors appear to rely less on ROA when nonaudit fees are higher. Our results provide no support for the conjecture that higher fees have net positive effects. However, that test may not be possible in our debt setting.

REFERENCES

Abbott, Lawrence, Susan Parker, Gary Peters, and Kannan Raghunandan. 2003. “An Empirical Inves- tigation of Audit Fees, Nonaudit Fees, and Audit Committees.” Contemporary Accounting Research 20 (2): 215-234.

Anderson, Ronald, Sattar Mansi, and David Reeb. 2003. “Founding Family Ownership and the Agency Cost of Debt.” Journal of Financial Economics 68 (2): 263-285.

Antle, Rick, Elizabeth Gordon, Ganapathi Narayanamoorthy, and Ling Zhui. 2006. “The Joint Deter- mination of Audit Fees, Nonaudit Fees and Abnormal Accruals.” Review of Quantitative Finance and Accounting 27 (2): 235-266.

Ashbaugh, Hollis, Ryan LaFond, and Brian Mayhew. 2003. “Do Nonaudit Services Compromise Auditor Independence?” The Accounting Review 78 (3): 61 1-639.

Bhojraj, Sanjeev, and Partha Sengupta. 2003. “Effect of Corporate Governance on Bond Ratings and Yields: The Role of Institutional Investors and Outside Directors.” Journal of Business 76

Brandon, Duane M., Aaron D. Crabtree, and John J. Maher. 2004. “Nonaudit Fees, Auditor Inde-

Carcello, Joseph, Dana Hermanson, Terry Neal, and Richard Riley Jr. 2002. “Board Characteristics

Chung, Hyeesoo, and Sanjay Kallapur. 2003. “Client Importance, Nonaudit Services, and Abnormal

DeAngelo, Linda E. 198 la. “Auditor Independence, ‘Low Balling,’ and Disclosure Regulation.” Jour-

DeAngelo, Linda E. 1981b. “Auditor Size and Audit Quality.” Journal of Accounting and Economics

DeFond, Mark, K. Raghunandan, and K. R. Subramanyam. 2002. “Do Non-audit Service Fees Impair Auditor Independence? Evidence from Going Concern Audit Opinions.” Journal of Account- ing Research 40 (4): 1247-1274.

Firth, Michael. 1997. “The Provision of Nonaudit Services by Accounting Firms to Their Audit Cli- ents.” Contemporary Accounting Research 14 (2): 1-21.

Frankel, Richard, Marilyn. Johnson, and Karen Nelson. 2002. “The Relation between Auditor’s Fees of Nonaudit Services and Eamings Management.” The Accounting Review 77 (4): 71-105.

Gleason, Cristi, and Lillian Mills. 2006. “Do Auditor-Provided Tax Services Compromise Auditor In- dependence with Respect to Tax Expense?” Working Paper, University of Iowa.

Gompers, Paul, Joy Ishii, and Andrew Metrick. 2003. “Corporate Governance and Equity Prices.” Quarterly Journal of Economics 118 (1): 107-155.

Holthausen, Robert, and Ross Watts. 2001. “The Relevance of the Value-Relevance Literature for Fi- nancial Accounting Standard Setting.” Journal of Accounting and Economics 31 (1-3): 3-75.

(3): 455475.

pendence, and Bond Ratings.” Auditing: A Journal of Practice and Theory 23 (2): 89-103.

and Audit Fees.” Contemporary Accounting Research 19 ( 3 ) : 365-384.

Accruals.” The Accounting Review 78 (4): 931-955.

nal of Accounting and Economics 3 (2): 113-128.

3 (3): 183-200.




Kinney, William, and Robert Libby. 2002. “Discussion of The Relation between Auditor’s Fees of Nonaudit Services and Earnings Management.” The Accounting Review 77 (4): 107-1 14.

Kinney, William R. Jr., Zoe-Vonna Palmrose, and Susan Scholz. 2004. “Auditor Independence, Non- audit Services, and Restatements: Was the U.S. Government Right?” Journal of Accounting Research 42 (3): 561-588.

Klock, Mark S., Sattar Mansi, and William F. Maxwell. 2005. “Does Corporate Governance Matter to Bondholders?” Journal of Financial and Quantitative Analysis 40 (4): 693-7 19.

Larcker, David, and Scott Richardson. 2004. “Fees Paid to Audit Firms, Accrual Choices and Corpo- rate Governance” Journal of Accounting Research 42 (3): 625-658.

Magee, Robert, and Mei-Chiun Tseng. 1990. “Audit Pricing and Independence.” The Accounting Review 65 (2): 315-336.

Mansi, Sattar, William Maxwell, and Darius Miller. 2004. “Does Auditor Quality and Tenure Matter to Investors? Evidence from the Bond Market.” Journal of Accounting Research 42

Parkash, Mohinder, and Carol Venable. 1993. “Auditee Incentives for Auditor Independence: The Case of Nonaudit Services.” The Accounting Review 68 (1): 113-134.

Reeb, David, Sattar Mansi, and John Alee. 2001. “Firm Internationalization and the Cost of Debt Fi- nancing: Evidence from Non-Provisional Publicly Traded Debt.” Journal of Financial and Quantitative Analysis 36 (3): 395414.

Sengupta, Partha. 1998. “Corporate Disclosure Quality and the Cost of Debt.” The Accounting Review 73 (4): 459474.

Shiller, Robert, and Franc0 Modigliani. 1979. “Coupon and Tax Effects on New and Seasoned Bond Yields and the Measurement of the Cost of Debt Capital.” Journal of Financial Economics 7

Shi, Charles. 2003. “On the Trade-off Between the Future Benefits and Riskiness of R&D: A Bond-

Simunic, Dan. 1980. “The Pricing of Audit Services: Theory and Evidence.” Journal of Accounting

Simunic, Dan. 1984. “Auditing, Consulting, and Auditor Independence.” Journal of Accounting

(4): 755-793.

(3): 297-318.

holders’ Perspective.” Journal of Accounting and Economics 35 (2): 227-254.

Research 18 (1): 161-190.

Research 22 (2): 679-702.



Documents

Journal of Accounting, Auditing & Financeschwert.ssb.rochester.edu/heitzman/DGHM_JAAF08.pdfter monitoring. Additionally, firms pay nonaudit fees for expert advice that has the potential