ATJ Asian Tax Journal

Asian Tax Journal

Print ISSN 1738-3323 Online ISSN 2733-9270

The Effect of External Auditing on the Cost of Debt －Focused on Privately Held Firms－

  • Kwak， SuKeun Seoul National University
  • Jong-Il Park Chungbuk National University

Asian Tax Journal Vol. 12 No. 4 (2011), pp. 365-394

Abstract

This paper investigates the effect of external audits on the cost of debt using privately held firms. Private companies provide an opportune setting for analyzing the assurance and signaling benefits of auditing, given that their information structure is typically poor relative to public companies. For private companies, the demand for external audits arises mainly from the need for debt contracting with banks and other private lenders and associated interest expenses. A significant body of literature examines auditing’s effect on a firm’s cost of capital. Theory posits that an independent audit reduces adverse selection and moral hazard issues between preparers and users of financial statements. Hence, audits may reduce informational problems ex ante. Audits may also play an ex post role. Thus, both ex ante and ex post roles of an audit suggest that verification of financial statements and the increased credibility of accounting information should results in a reduction in the cost of capital. The Korean environment provides a useful setting in which to examine the economic value of an external auditing. In Korea, the no-audit base case is available for privately held companies. Currently, private Korean companies with total assets of less than 10 billion South Korean won are not required to have their financial statements audited by independent auditors. As a result, we observe two distinct groups of privately held companies: small companies with no audit and audited by auditors. Using this unique setting, we aim to provide systematic evidence on the value of an external audit per se in pricing of private debt. Our primary objective is to investigate whether external audits by independent auditors are associated with a reduction in the interest rate or yield spread on the company’s debt. To do this, we construct a sample of private companies over the 5 year period of 2005-2009, of which 5,614 have no audit and 39,733 have audits. We measure cost of debt (COD) as borrowing interest rate or yield spread (Fortin and Pittman 2007), and use fractional ranks variable of COD (Francis et al. 2004). The cost of debt information comes from KIS - VALUE database. And we use indicator variables for external audit, other control variables are adopted in the determinants of cost of debt capital model based on prior studies. Also different time period is considered in the model by using t+1 in the dependent variable and t in the independent variables (Ge and Kim 2010 ; Jiang 2008). Our findings are follow. We find that private companies with external audits pay significantly lower interest rate or yield spread on their debt than do private companies with no audit. These results are still hold even after appling OLS estimation, and also t-statistics from Newey and West (1987) and Clustering test are significant, suggesting that our results are robust. In conclusion, our results show that an external audit is information value in the pricing of private debt, such as banks and other private lenders place more weigh on audited financial information in setting the interest rate. Therefore, we provide novel evidence that audited financial statements are more informative and that this significantly influences lenders’ decisions. Thus, these findings of this paper are very useful and provide a lot of important implications to regulators, investors and creditors that are interested in cost of debt. Academics can also apply the discussion in this paper for related researches.

Keywords

  • privately held firms
  • external audit
  • unaudited firms
  • audited firms
  • cost of debt
  • debt market's assessment

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