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The impact of voluntary audit reviews on corporate credit

ratings: Evidence from Canada

Vazir Azimli (s2819236)

University of Groningen M.Sc. Business Administration Organizational and Management control

August 2017

Supervisor: Vlad-Andrei Porumb

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Abstract

In this thesis, I analyse whether the voluntary purchase of an audit review is positively associated with firms’ credit rating. The information provided by the audit review of quarterly reports is not public and represents a tool through which boards monitor the actions of management. The audit review facilitates the detection of potential financial reporting misstatements in a timely manner, increasing the quality of disclosure and decreasing information asymmetry. Credit rating agencies, due to their ability to access private firm information, are able to access the audit review information. I therefore expect that the purchase of an audit review is associated with higher credit ratings. I draw on a sample of 4,873 firm-year observations from 1,057 non-financial Canadian firms in the 2004-2015 period to test my contentions. The results suggest that firms with an audit review have a higher credit rating relative to firms with no-audit review. This thesis is the first to analyse the role of the voluntary audit reviews for credit ratings.

1. Introduction

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and Simunic 1982; Watts and Zimmerman1986) and improve the quality of information that investors have (Ronnen 1996). Accordingly, auditing is insightful for debt holders under both mandatory and voluntary forms (Minnis, 2011). In this paper, I focus on the voluntary audit review of quarterly reports (review) and analyse if it is associated with a lower cost of debt in the form of higher corporate credit ratings.

Nonetheless, not all financial statements are subject to a statutory audit obligation and sometimes companies disclose relevant information voluntarily before the scheduled audit review, as national regulations regarding interim reviews vary. While voluntary reviews are mandatory for all public companies in some jurisdictions, such as Australia, France, United States, it is not practised in countries like Canada, United Kingdom, and Spain. Such diversity in especially mature markets suggests that there is no consensus that the benefits of this type of regulation exceed its cost and that the debate on this issue is ongoing (Bedard and Courteau, 2015). The decision whether to have a review is made by both the decision of the client and auditor (Krishnan and Zhang 2004).1

On the one hand, the client may desire a review in order to decrease information risk for potential investors, but the auditor could recommend the client not to include the review during a quarter by pointing out the threat of higher fees for client . On the other hand, the client may not want to have a review in order to prevent incurring costs or to avoid questions about discretionary accruals. Thus, a review would be performed when the benefits to the auditor and to the client exceed the costs to both parties (Boritz and Liu. 2006)

In this paper, I try to contribute to the literature by using data from publicly held companies in Canada, where firms can voluntarily choose whether to purchase a review. In doing so, I use a homogeneous group of sample, as listed firms are obliged to audit their annual financial statements and to comply with standardized financial statement disclosure requirements. According to Canadian law, the auditing requirements do not extend over the review of quarterly financial statements (Ontario Securities Commission (OSC) (2000) and this enables me to assess the debt market benefits, represented by corporate credit ratings, of the voluntary purchase of the review.

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Bedard and Courteau (2015) argue that the review has the purpose of improving the quality of financial information provided in quarterly financial statements. The review provides owners of the information with a monitoring tool that enables both boards and audit committees to control the activity of the management on a continuing basis. If quarterly reports are reviewed, auditors can locate and signal in a timely manner potential financial reporting misstatements to the management and audit committees to remedy (Ettredge et al. 1994). In Canada, the public disclosure of the review’s outcome is prohibited by regulations, so its content cannot be accessed by external users of financial information (CICA, section 7050.08). As a consequence, the parties which are able to benefit from this information are the ones with access to private firm information.

There is evidence in extant literature about corporate credit ratings and voluntary audit. The evidence is especially palpable in the absence of regulation. In 1994, UK followed the EU Fourth Directive, which allows Member States to exempt small companies from audit, allowing very small private companies to opt out of audit for the first time (Collis et al. 2004). Investigating the consequences of this exemption, Iwasaki (2008) concluded that credit rating agencies suffered a decline in their ability to generate reliable credit ratings, because of the relaxation of the audit requirement, an opinion that was already expressed in earlier consultations. The CRAs indicated that the diminished assurance provided by unaudited accounts could lead to reduced credit scores. Interestingly, and contrary to the finteres of earlier research (e.g. Berry et al. 1987) banks felt that their ability to evaluate loan creditworthiness was not negatively affected by the audit exemptions, as they had their own sources of information (e.g. bank records, relationships with clients). However, banks acknowledged that there may be an impact on external credit ratings which is one of the information sources that banks use. Both banks and credit rating agencies raised concern that small-sized companies may not recognize the negative impact of not having any independent assessment on the credibility of their financial statement disclosures. Their concerns was also shared by later research which suggests that decision makers in small firms are actually unaware of the potential consequences of opting out of audit (Collis 2010).

2. Institutional background and literature review The characteristics of the review in Canada

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reporting and auditing practices in this setting reliable. First of all, in Canada the purchase of review of quarterly reports is voluntary. This presents a different setting from other countries where companies are required to have a review. The main reason behind this difference is an ongoing debate regarding the asymmetry between the additional costs incurred through the purchase of a review and the benefits that such a verification would bring (OSC, 2000; TSX Venture Exchange 2002). On the one hand, the review creates additional work for auditors and increases total audit fees (Bedard and Courteau, 2015).

Moreover, critics of the review argue that making it obligatory would create unfavourable circumstances especially for small firms, since they will suffer the additional costs and not benefit from the additional verification. The discussion culminated in 2014, when AASBC considered the potential of modification of the current standard on Auditor Review and Interim Financial Statements and making the review mandatory. But the discussion did not lead to modification of the previous requirements, as the debate on costs and benefits of review did not produce definitive conclusions (AASBC, 2014). As a result, Canadian firms maintained the right to voluntarily purchase the review, even when they are listed in the US, due to the exemption granted for foreign private issuers (SEC, 1999a).

Even though companies retain discretion in deciding whether review should be bought, Canadian regulations are relatively rigid and have clear requirements regarding the way in which firms should disclose the purchase of the review to its stakeholders. According to the National Instrument 51-102 “Continuous Disclosure Obligations”, firms are obliged to disclose in their financial reports if their interim reports have not been reviewed by an auditor (OSC, 2004). Furthermore, firms are not allowed to disclose the outcome of the review to external parties. The use of the review is intended solely for internal use and it acts as a monitoring tool for potential accounting distortions in the quarterly financial statements. Though the review is not obligatory, Canadian Securities Administrators (CSA) highly recommends purchase of the review, as it enables firms to detect potential accounting misstatements in annual reports in a timely manner (OSC, 2004).

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6 Literature review

The fundamental role of audit is to assure the user that the reported results are reliable (Ball, 2001). Maines and Wahlen (2006) suggest that the "usefulness of accounting information depends on the degree to which it provides a reliable representation of the relevant economic constructs" (p. 404). Moreover, conducting audit ensures that the financial statement information is compiled and presented according to accounting regulations and standards. A third party, in this case an auditor, with both the sufficient expertise in the generally accepted rules of conveying financial information and the independence to objectively assess the informational input, may add value by ensuring that the financial statements are prepared in the form that is useful to the users. In essence, theory suggests that verification provides financial statement information with sufficient transparency and assurance, making it more useful to decision-makers.

Consistent with the findings of prior literature, I argue that the need for voluntary audit may stem from two distinct sources. While the majority of prior studies examine the role of information asymmetry between firms and their outside stakeholders (e.g., Jensen & Meckling, 1976; Chow, 1982; Fama & Jensen, 1983; Watts & Zimmerman, 1986), other studies consider the needs of the firms and the entrepreneurs themselves (Abdel-Khalik, 1993; Seow, 2001; Rennie et al., 2003; Niskanen et al., 2011; Collis, 2012).

Voluntary audit review and cost of debt

Previous research reports that firms which voluntarily review their quarterly reports suffer significant costs in the form of higher audit fees (Bedard and Courteau, 2015). Proponents of this view argues that implementing voluntary audit review without considering firm-specific aspects imposes a disproportionate cost burden on very small companies. Another issue for concern is that in small companies, the closer and longer-standing auditor/client relationship, combined with the fact that the auditor is often auditing accounts he or she has actually prepared, reduces any assurance benefits (Seow 2001). The considerable increase in cost – for something of limited benefit – lent strength to the case for exempting smaller firms from audit (Keasey et al. 1988).

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On the other hand, research also documents benefits related to the voluntary review. Past experience suggests that even if related regulations is absent, many organisations will still voluntarily subject their accounts to external inspection. For example, Collis and Jarvis (2000) surveyed 385 small companies and found that significant majority of directors predicted they would purchase an audit voluntarily even if they were granted exemption. The main determinant of this decision was the directors’ belief that the audit improved the quality of this information.2

According to previous studies, the review is associated with fewer fourth quarter adjustments (Ettredge et al. 2000), enhances the association between returns and earnings (Manry, Tiras, and Wheatley, 2003) and it reduces abnormal accruals in the fourth quarter (Bedard and Courteau, 2015). Theory posits that an independent audit reduces adverse selection and moral hazard issues between preparers and users of financial statements. Thus, audit may reduce informational problems ex ante. Apart from having ex ante influence, audits may also have an ex post role. Townsend (1979) investigates the audit as an ex post verification tool in the situation of default and finds that this costly state verification results in an efficient debt contract. Hence, both ex ante and ex post roles of an audit suggest that verification of financial statements should result in a reduction in the cost of capital.

Apart from aforementioned benefits of purchasing a review, there is also significant body of literature that examines auditing's effect on a firm's cost of capital. Dedman and Kausar (2012) argue that in the absence or relaxation of audit regulation especially for smaller companies enables them to effectively self-select into voluntary audit such that those which would benefit from the audit will purchase it. One such benefit would be access to finance at competitive rates. For example, Blackwell et al. (1998) argues that debt pricing is more affordable for private companies whose financial statements are voluntarily audited rather than unaudited. He suggests that borrowers’ financial statement audits reduce the cost of information collection for creditors, and result in reduced interest rates on loans. Furthermore, Kim, Simunic, Stein and Yi (2011) and Lennox and Pittman (2011) argue that firms with voluntary audits are considered as less risky and are consequently compensated by banks with lower interest rates. Moreover, there is evidence that private companies have their financial statements audited in order to acquire advantages

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in taking loans (Allee and Yohn 2009). Kim et al. (2011) also contributes to the discussion by examining the interest rates applied to a large sample of private companies in Korea, where he finds that firms which undergo voluntary audit benefit from interest cost savings. Furthermore, Booth (1992) finds that external monitoring reduces lending costs, which are passed on to the borrower in the form of lower interest rates.

Apart from having found evidence that verification influences lenders' debt pricing decisions, extant literature also examines a mechanism underlying why this influence manifests: the ability of the financial statements to predict future cash flows. In assessing the quality of a loan applicant, lenders assess the ability of the potential borrower to generate sufficient future cash flows to repay the debt (Libby, 1979), (Sinkey, 2002). Minnis (2011) finds that audited financial statements are better predictors of future cash flows. He also concludes that “lenders' pricing decisions are sensitive to financial statement variables commonly used in credit analysis (interest coverage, current ratio, and asset tangibility) when they have been verified”. Consequently, having a more reliable prediction tool enables companies to have a higher credit ranking. His second finding is that information from audited financial statements is more highly associated with interest rates, suggesting that lenders use this information more intensively in the debt pricing process.

Credit ratings and voluntary audit review

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discussion, as focus of this paper is partly on firm’s cost of debt which is dependent on its credit rating—debt becomes more expensive as credit ratings decreases.

Sufi (2009) argues that without this evaluation and following certification investors would be reluctant to lend money to the firm. Credit ratings also could contain information on firms’ credit quality beyond other publicly available information. For instance, firms could be reluctant to release strategic private information to the market in particular with regard to competitors. However, credit ratings allow them to incorporate private information without disclosing specific details to the public. Moreover, credit rating agencies are specialized financial intermediaries in the information gathering and evaluation processes and thereby could provide more reliable measures of a firm’s credit worthiness (Tang, 2009).

Voluntary audit review, CRAs, and public information

Extant literature examines the relationship between voluntary audit and corporate credit ratings. For example, Marriott et al. (2006) report case-study evidence that companies consider their credit rating when deciding whether they need an audit and find that there appeared to be an implication for a company’s credit ratings, as business would benefit from a better credit rating if audited accounts were filed. Similarly, Collis (2003) reports that credit ratings are considered as important factor in decisions about filing full accounts, in his later study he also provides evidence on audit’s positive effect on credit ratings (Collis, 2010).

Though credit score is not a perfect measure of cost of capital, there are advantages to using credit scores as cost of capital measure, supplementing the interest expense evidence presented in previous literature (e.g. Kim et al. 2011). As loans are not necessarily renegotiated on year basis, and some enterprises do not require loans at all, using interest expense rates as a cost of debt measure might lead to some inadequate results. In contrast, credit rating agencies do review and update their ratings regularly, providing a timely and less noisy information. For example, Berwart et al. (2014) provided evidence that issuer-paid CRAs have become more responsive over time due to regulatory changes and increased investor scrutiny. Another advantage is that credit ratings are available for firms which do not have debt or seek further debt (Dedman and Kausar, 2012).

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reliable, increasing the predictive ability of them (Minnis, 2011). As credit agencies are not able to do the auditor’s job, CRAs rely on the company’s external auditors for assurance that its financial statements are reliable and conform to Generally Accepted Accounting Principles (GAAP). In contrast to external auditors, a CRA is not supposed to determine whether an entity’s financial statements accurately present its financial position and results of operations in conformance with GAAP. The CRA relies on the outside auditor to make this determination, and does not have adequate resources, such as time, access to necessary information and expertise to do so itself (Frost, 2007).

Voluntary audit review, CRAs, and private information

Apart from enhancing the quality of publicly available information, there is a second channel through which voluntary audit can improve disclosure quality to the market, as credit ratings may provide information about the quality of a firm beyond other publicly available information. In Canada, the public disclosure of the review’s outcome is prohibited, so its content cannot be accessed by external users of financial information (CICA, section 7050.08).As a result, the parties which are able to benefit from this information are the ones with access to private firm information. This would be the case for CRAs, as there is sufficient evidence in the related literature that ratings agencies, as well as banks involved in private lending contracts, receive more information than what is publicly disclosed information (Jorion et al. 2005; Bushman et al. 2010). Here rather than increasing the quality of information, as it is the case in publicly available information, voluntary audit review acts as (private) information itself.

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Investigating US market after Regulation FD, Jorion et al. (2005) argues that investors perceive that rating agencies had more private information relative to other market participants. Just as positive disclosures would benefit managers in the form of higher stock prices, positive communications to the ratings agencies would also benefit managers in the form of higher credit ratings (Asquith et al. 2005). Another incentive for managers to provide positive information to CRAs privately, instead of public disclosure is the threat of competition, or proprietary costs. Managers may be reluctant to publicly disclose positive information if the revelation of that information would generate more competitive pressure (Verrecchia 1983). On the other hand, these managers would be willing to privately disclose the information to a credit rating agency or private lender such that the firm would still get the benefit of the higher credit rating or lower spread without suffering the competitive cost of revealing the detailed proprietary information (Plumlee et al., 2014).

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The aforementioned relationship can be further investigated by evaluating present literature on negative effects of not having voluntary audit on credit ratings. For example, Dedman and Kausar (2012) find that both banks and CRAs (credit-rating agencies) asserted their concern that small enterprises may not be aware of the negative influence of not having any external verification on the credibility of their financial statements and thus, on cost of debt. Especially, CRAs felt their ability to generate reliable credit ratings was deteriorated by the relaxation of the audit requirement. Iwasaki (2008) finds similar results, indicating that the diminished assurance provided by unaudited accounts might lead to reduced credit scores. Furthermore, audit firms and ACCA have argued that a consequence of widespread audit absence could be a decrease in the quality of financial reporting, a factor highly related to credit ratings, via increased risk of fraud and error and potential damage to confidence.3There is another line of research, which argues that CRAs facilitate firm access to credit markets (Faulkender and Petersen, 2006; Sufi, 2009; Tang, 2009). It is logical to argue that as long as CRAs act as honest evaluation intermediaries, one would expect borrowers with confirmed ratings to be able to raise more long-term debt financing as they would have better access to debt capital from less informed investors. In a recent research Driss et al. (2016) build on this rationale and investigate whether rated firms are able to raise additional debt capital under better terms and find that whether cost of debt capital decreases in an economically meaningful manner subsequent to CRA certification. Furthermore, Graham and Harvey (2001) found that credit ratings are one of the most influential factors in financing decisions, indicating that firms are concerned about their credit ratings. Tang (2009) finds that rated enterprises with more financial constraints and high information asymmetry act differently from other rated firms only in the post-watch period. He argues that the former group experiences a greater increase in their long-term debt financing, which leads to a considerable reduction in their cost of debt capital. Kisgen (2006) provided evidence that firms adjust their capital structure to maintain a particular bond rating, providing evidence that credit ratings can influence capital structure decisions. The effect of credit ratings on capital structure is further investigated by Graham and Harvey (2001) who find that credit ratings are one of the most important factors for CFOs when determining capital structure. As capital structure is crucial to determine an optimal level of leverage for the firm and by doing so reducing cost of debt4, the relationship between credit ratings and cost of capital can also be seen under this line of research (Leland, 1994).

3 ICAEW Slams Threshold Rise’, Accountancy magazine online, 19 November 2003. 4

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3. Hypothesis development

After thoroughly investigating the relationship between voluntary audit review and cost of debt, in this case credit ratings, in the literature development section, I, therefore, formulate the following hypothesis:

H1: Credit ratings are higher for review firms relative to no-review firms.

A significant shortcoming of numerous related empirical studies is the failure to address the endogenous nature of disclosure and financial reporting quality. If researchers do not control for the determinants of disclosure and financial reporting quality, their inferences regarding the economic consequences of disclosure quality may be doubtful (Fields et al., 2001) Therefore, below I incorporate two important factors that affect the value of having review into this discussion.

In recent work, Easley and O’Hara (2004) demonstrate a link between information structure (private versus public information) and the cost of capital. They argue that firms can influence their cost of capital through the precision and quantity of the information they provide to investors.

Review, firm size, and debt financing

Previous literature concludes that due to a disproportionate distribution of costs and benefits of the purchasing review voluntarily between large and small firms, the latter would be mostly interested in purchasing the additional assurance of their quarterly financial statements. The voluntary nature of the decision to purchase a review would thus result in a non-random selection of the review and no-review samples, based on size (Ettredge et al., 1994; Bedard and Courteau, 2015). While this notion is acknowledged by regulators (OSC, 2002; Crawford Committee, 2003) and causes considerable debate regarding the desirability of voluntary review, this paper focuses only on determining whether -and to what extent- firm size has an impact on the relationship between the purchase of the review and its effect on the cost of debt. In this context, the impact of firm size depends on how credit rating agencies distinguish the value of external monitoring provided by the review for larger firms relative to

that a firm will tend to move back toward its optimal leverage to the extent that it departs from its optimum (see e.g., Fama

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smaller firms. The extent to which the review information results in reduced financial misstatements for borrowers translates into lower financing costs provided by financial intermediaries (Minnis, 2011). Given this, two rather conflicting approaches are prevalent in the literature about the impact of firm size. On the one hand, larger organizations have more incentives to manipulate the financial information in their quarterly financial statements, as compared to annual financial reports, quarterly financial statements provide reduced benefits for managers to use discretion in reporting. Especially, the only major motivation for manipulating financial statements is to reach financial analysts’ targets (Manry et al., 2003). Small firms, on the other hand, are followed by fewer analysts and they consequently would not benefit from manipulating their quarterly reports. In contrast, the previous literature provides evidence on that large firms are monitored by a greater number of financial analysts and they face increased pressure from capital markets to meet analysts’ expectations (Hong et al., 2000; Richardson et al., 2002). The rationale here is that as the incentive, and therefore likelihood, to manipulate quarterly financial numbers increases with larger firm size, the value of assurance brought by the review increases too. Thus, larger firms are more likely to benefit from the review through reduced financial misstatements, firm will enjoy reduced cost of debt financing.

Moreover, as indicated by Crawford Committee (2003), large companies are likely to suffer from difficulties in preparing financial statements, since they have relatively complex international operations. As a consequence of this complexity and of the time pressure for reporting, their quarterly financial statements are likely to contain more misstatements relative to smaller firms. Thus, the purchase of the review by larger firms would diminish negative effects of this type of bias and would likely be rewarded by financial intermediaries through reduced cost of capital.

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would be rewarded with a lower cost of debt for the additional verification provided by the purchase of the review.

Apart from having relationship with the quality (value) of financial systems, firm size influences credit rating too. For instance, Bouzouita and Young (1998) suggest that company size is likely to be positively correlated with assigned credit ratings because, amongst other things, larger entities enjoys a relatively wide pool of managerial expertise and are likely to realise economies of scale in their operations. Furthermore, Kaplan and Urwitz (1979) investigate a sample of bonds with unchanged Moody’s ratings and find that firm size is an important factor that affect credit ratings.

I, therefore, formulate the following hypothesis:

H2: Credit ratings are higher for large review firms relative to small review firms.

Review, auditor quality, and debt financing

Empirical literature examines the relation between verification and the cost of capital in multiple ways. Because variation in the presence of an audit is generally unavailable, the most prominent approach is to study variation in the characteristics of the auditors. The literature on auditor characteristics suggests that auditors provide two main roles to capital market participants: an information role and an insurance role (Watts and Zimmerman, 1981; De Angelo, 1981). Given this, audit quality contributes to the credibility of financial disclosure, and to the extent contracting with the firm is made less costly, it reduces the cost of capital (Jensen and Meckling, 1976; Watts and Zimmerman, 1986)

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during 1977 – 88 and test for auditor reputation effects on their cost of debt and concludes that the companies that retained a big 6 auditor exhibit a lower average cost of debt. This finding is important, as it suggests that debtholders are sensitive to auditor reputation — a proxy for audit quality. Similarly, Kim et al. (2007) find that banks charge a significantly lower rate for borrowers with big 4 auditors than for borrowers with non – big 4 auditors. Though literature on this issue mainly focuses on cost of debt represented by bank interest rate, there is also evidence on credit ratings agencies’ reaction to auditor quality in determining ratings. For example, Mansi et al. (2004) finds that investors place a premium on the bonds of firms with large auditors, suggesting that the insurance effect of audits adds value to capital market participants. They also suggest that firms switching to a large auditor enjoys a lower required rate of return after controlling for firm, security, and macroeconomic variables. Therefore, I suggest following hypothesis.

H3: Credit ratings are higher for review firms with Big 4 auditors relative to review firms with non-Big auditors.

DATA

In Canada, the review of quarterly financial statement is done on a voluntary basis. However, starting from the fiscal years on or after January 1, 2004, listed Canadian firms are required to disclose a notice in their interim financial statements if the statements have not been reviewed by an auditor (OSC, 2004). This new regulation makes Canada an exceptional institutional setting to examine the benefit of audit review where the purchase of the review is voluntary and disclosure of a notice not having a review is mandatory. I use the SEDAR website to hand-collect the information on the purchase of the review and the name of the auditor from firms’ quarterly reports. All firm-specific controls are collected from Compustat. After discarding observations of firms with missing financial information and without available review information, I am left with a sample of 4,873 observations from 1,057 firms. Out of the 4,873 observations, 3,112 pertain to firms with voluntary reviews (review sample) and 1,762 observations pertain to firms without review (no-review sample).

4. Methodology

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negative impact on firms’ cost of debt or a positive impact on credit ratings. In Model (1) this contention is tested by using the empirical approach based on determinants of debt financing as specified by Kim et al. (2011a) and Minnis (2011). In Model (2) interaction between Review and Size is added to test the prediction of Hypothesis 2, that large review firms have an incrementally higher credit rate. In similar vein, in Model (3) interaction between Review and Big4 is added to test the prediction of Hypothesis 3, that review firms with Big4 auditors have an incrementally higher credit rate.

In order to examine the relationship between review and credit rating, I use yearly, not quarterly data, as in the sample the review information does not vary throughout the fiscal year. Thus, the use of quarterly data would result in a larger dataset which does not bring any additional information in terms of the review.

In Model (1), the main variable of interest is voluntary review (Review), which is an indicator variable that equals one if a company has a voluntary review and zero otherwise. A positive and significant coefficient is estimated for Review, providing evidence on suggestions made in the hypothesis development section.

Credit Rating= α + β1 Review + β2 Size + β3 Big4+ β4 ROA + β5 TANG + β6 CR +

β7 LEV + + β8 NegE + β9 IntCov + β10 SalGro + β11 DIFRS+ ε (1)

In Model (2), the main variable of interest is the interaction term Review*Size. I expect a positive and significant coefficient estimate for Review*Size, indicating that large review firms have an incrementally higher credit ratings relative to smaller review firms.

Credit Rating= α + β1 Review + β2 Size+ β3 Review*Size + β4 Big4 + β5 ROA + β6 TANG + β7 CR + β8 LEV + β9 NegE + β10 IntCov + β11 SalGro+ β12 DIFRS + ε (2)

In Model (3), the main variable of interest is the interaction term Review*Big4. Here I also predict a positive and significant coefficient estimate for Review*Big4, indicating that review firms with Big4 auditors have an incrementally higher credit ratings relative to review firms with non-Big4 auditors.

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In all 3 models the dependent variable is Credit Ratings. However, due to data limitation in this study obtaining credit rating scores for every firm in the study was not possible. I, therefore, estimated credit ratings for companies using Florou and Kosi (2015) and (Barth et al. 1998), where the information about credit ratings is not available. Based on the estimated coefficients, a rating is generated for all firms to simulate Standard & Poor’s credit rating equivalent on a scale of 2–27 (AAA to D):

Credit Rating = ß0 + ß1 Total Assets+ ß2 Return on Assets+ ß3 (Long term Debt/Total Assets) + ß4 (1 if a firm paid dividends in the current year) + ε.

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financial leverage a negative feature of companies’ capital structure, proposing that lower leverage results in higher grade of rating assigned to firms (Brotman, 1989; Pottier, 1998). In order to control for the risk of distress and agency costs, we use leverage (LEV) and negative equity (NegE). Kim et al. (2011) also find that firms with negative equity face higher borrowing costs so we control for this in our tests and expect a negative association between the negative equity indicator variable and credit rating. Following Kim et al. (2011), we control for growth potential using sales growth, and expect any relationship to be positive. Previous literature on cost of debt financing suggests that the cost of borrowing is expected to be negatively associated with the quantity of tangible assets, as investors are more likely to retrieve their investment back, even if the company faces financial distress, if there are more assets to liquidate. I therefore anticipate that companies with higher total assets are rated relatively high by the credit rating agency, but that tangible assets are favoured, resulting in a positive association between our tangibility (TANG) variable and credit rating (Kim et al. 2011b, and Florou and Kosi, 2015). Finally, in order to control for the negative association between IFRS and the cost of borrowing (Florou and Kosi, 2015), I include IFRS adoption dummy (DIFRS) into the model.

[INSERT TABLE 1: Variables Definition]

5.

Results

Descriptive statistics and univariate analysis

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[INSERT TABLE 2: Summary Statistics]

In Table 3, I present Pearson correlations. The dependent variable, Credit Rating, is significantly correlated with most of the independent variables, except Tangibility. Our variable of interest, Review, is positively correlated with Credit Rating. Furthermore, Review is significantly correlated with almost all variables, except CR, SalGro and DIFRS variables. As suggested by extant literature, Size is positively and significantly correlated with Review. This is in line with the expectation set in Section 2 and indicates that Review is determined by firm-specific factors, while firm size is a major determinant among them.

[INSERT TABLE 3: Correlation matrix]

Propensity Score Matching

Purchasing a review of quarterly financial statements is voluntary in Canada, therefore there is a potential selection bias in the review and no-review samples. Previous literature indicate that firms’ purchase of voluntary review is influenced by firms-specific determinants. Specifically, consensus is that firms are more likely to purchase a review if the induced benefit is higher than the implied cost (e.g. Bédard and Courteau, 2015; Kajüter et al. 2016). As this potential selection bias problem and the endogenous nature of the review may affect the analyses, I follow Bédard and Courteau (2015) and use a PSM approach to matching the review firms and no-review firms on firm-specific characteristics in order to address this issue. Firstly, I compute for each firm propensity scores that are based on observable firm specific variables and then I match firms from the review sample (treatment sample) with firms from the no-review sample (control sample) based on the similarity of their propensity scores.

In order to compare and match firms with review and no-review, I follow Ettredge et al. (1994), Bédard and Courteau (2015), Kajüter et al. (2016) and Minnis (2011) to generate the following audit choice model:

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Big 4 audit firms are expected to have a tendency to have comparatively timely and high quality audit and therefore firms audited and it is expected to have a positive association between Review and Big4. Ettredge et al., (1994) argue that firms’ choice of timely audit (review) is positively associated with the size, complexity and agency cost. Thus, in order to control the impact of the size, complexity and the growth opportunities I add Firm Size (Size), Tangibility (TANG) and Sales Growth (SalGro) to the Model. I expect a positive relationship between size and all of them. In order to control for agency cost and firms’ financial strength, I add Current Ratio (CR), Leverage (LEV) and Negative Equity (NegE). I expect that Review will be positively associated with CE, LEV, and NegE. Furthermore, I control for the profitability and investment tendency by using Return on Asset (ROA) and Interest Coverage (IntCov). I expect that firms with higher profitability, high ability to cover its interest cost have a propensity to have a review. Finally, I add DIFRS dummy variable to control for the principles-based accounting standards, which are highly different relative to the rules-based Canadian GAAP. It is expected that firms will have the tendency to purchase the review in order to ensure a better implementation of the standard by using more complex IFRS.

[INSERT TABLE 4: Selection of the matched sample Dependent Variable: Review]

Table 5, Model 1, presents the regression results of the effect of review on the credit rating (Hypothesis 1), estimated on the matched sample. In Model 1, in line with the predictions of Hypothesis 1, the coefficient of Review is positive and significant (β= 1.907; p<0.005), suggesting that if firms’ quarterly financial statements are reviewed by an auditor, their credit ratings are higher relative to no-review firms.

Regarding the control variables, Rating is positively and significantly associated with Size, ROA, Interest Coverage and IFRS adoption dummy, supporting my expectation that firms larger in size, performing better and having higher interest coverage ratio and adopting IFRS have higher ratings. Additionally, the negative and significant coefficient of LEV posits that firms with higher leverage have higher distress risk and agency problems and subsequently attain a lower credit rating, consistent with previous literature. In contrast to my expectations, Big4 variable, though positive, has an insignificant coefficient. Furthermore, TANG has a significant negative coefficient and the coefficient of NegE is negative, but insignificant.

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firm size on the association between voluntary review and credit rating. Contrary to my predictions of Hypothesis 2, the coefficient of Review*Size is positive, but statistically insignificant (β= 0.093; p>0.05), indicating that companies that are larger in size and have a review enjoy no significant additional benefit in terms of higher credit ratings compared to review companies of relatively smaller size.

In a similar vein, Table 5, Model 3 present the regression result of incremental effect of review on credit ratings in firms with a Big4 auditor, estimated on a matched sample (Hypothesis 3). The main variable of focus is Review*Big4 and represent the incremental effect of having Big4 auditor on the relationship between voluntary review and credit rating. No significant result is found after conducting regression analysis, resulting in rejecting Hypothesis 3.

[INSERT TABLE 5: Regression Results]

6.

Conclusion

In this study, we examine the impact of a review voluntary purchase on firms’ cost of debt. I draw on a sample of 4,873 firm-year observations from 1,073 non-financial Canadian firms in the 2004-2014 period. The results suggest that review firms have a higher credit rating relative to no-review firms. I also find that this effect is not stronger for firms audited by Big4 companies. Another major finding of the study is that contrary to previous research I find no evidence on the positive association between firm size and credit rating.

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size has a significant influence on the relationship between having a review and cost of debt. Results of my analysis shows that though firm size as an independent variable has a significant positive associations with credit ratings, it has no significant influence on the relationship between purchasing a review and credit rating, as I find that the relationship is not significantly affected as firm size increases. Moreover, in Hypothesis 1, I find that having a Big4 firm as an auditor has no benefit on credit ratings. Similarly, in Hypothesis 3, this finding is further evidenced, as I find that it does not make any significant difference for review firms having Big4 or non-Big4 firm as an auditor. Though contrary to my findings, it is in line with Fortin and Pittman (2007) who find that private firms with a Big4 auditor enjoy no cost of debt benefits in terms of yield spreads or credit ratings, compared to similar firms which do not have a Big4 auditor. Kim et al. (2011) therefore argue that it is the audit itself, not auditor quality, which enhances the reliability of financial statements to external parties

Finally, I refer to the potential limitations and suggestions for future research this study entails. The main limitation of this study is that due to data limitation in this study obtaining credit rating scores for every firm in the study was not possible. I, therefore, estimated credit ratings for companies using Florou and Kosi (2015) and (Barth et al. 1998), where the information about credit ratings was not available. This may lead to some bias in my analysis. Furthermore, my focus was on a single country, limiting the ability of this study to make some generalization across countries.

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Appendix

TABLE 1: Variable Definition

Credit Rating Score (Credit Rating)

Audit Review (Review)

Firm Size (Size)

Big-4 auditor (Big4)

Return on Asset (ROA)

Tangibility (TANG)

Current Ratio (CR) Leverage (LEV)

Interest Coverage (IntCov)

Sales Growth (SalGro)

Negative Equity (NegE)

IFRS adoption dummy (DIFRS)

Standard &Poor’s credit rating equivalent on a scale of 2–27 (AAA to D).

An indicator variable that equals 1 if a company has voluntary audit review in year t-1 and 0 otherwise. The natural log of Total Assets

An indicator variable that equals 1 if a company is audited by one of the Big 4 auditors and 0 otherwise. Net income divided by total assets

Net property, plant, and equipment divided by total assets

Current assets divided by current liabilities

Total liabilities divided by total assets in

Earnings before interest and taxes divided by interest expense

Percentage change in sales from previous year An indicator variable that equals 1 if total year-end liabilities are greater than total year-end assets; 0 otherwise.

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TABLE 2: Summary Statistics

Univariate test (t-test statistics to testmean

(A) (B) difference)

Full Sample (N=4,873) Audit Review (N=3,112) No Audit Review (N=1,761) H0 = A – B = 0

Std. Std. Std.

Variable Mean Dev. Min Max Mean Dev. Min Max Mean Dev. Min Max Difference S.E

Credit Rating 14.45 7.38 2.00 27.00 16.286 6.99 2.00 27.00 11.213 6.75 2.00 27.00 4.954 0.2201 *

Audit Review dummy (Review) 0.64 0.48 0.00 1.00

Firm Size (Size) 4.82 2.16 1.20 8.08 5.894

1.918 1.202 8.084 3.537 1.753 1.202 8.084 2.3582 0.0555 *

Big-4 auditor (Big4) 0.78 0.41 0.00 1.00 0.904 0.295 0.000 1.000 0.604 0.489 0.000 1.000 0.2997 0.0113 *

Return on Asset (ROA) -0.09 0.27 -0.77 0.13 -0.024 0.207 -0.774 0.131 -0.181 0.307 -0.774 0.131 0.1564 0.0074 *

Tangibility (TANG) 0.46 0.31 0.03 0.90 0.493 0.298 0.032 0.899 0.429 0.319 0.032 0.899 0.0638 0.0091 *

Current Ratio (CR) 1.72 1.26 0.25 4.36 1.715 1.198 0.250 4.361 1.720 1.351 0.250 4.361 -0.0405 0.0376

Leverage (LEV) 0.14 0.15 0.00 0.43 0.162 0.150 0.000 0.426 0.106 0.142 0.000 0.426 0.0567 0.0043 *

Sales Growth (SalGro) 1.71 1.45 0.00 4.67 1.791 1.392 0.000 4.667 1.577 1.537 0.000 4.667 0.0263 0.0144 * Negative Equity (NegE) 0.10 0.29 0.00 1.00 0.068 0.251 0.000 1.000 0.139 0.346 0.000 1.000 -0.0874 0.0081 *

Interest Coverage (IntCov) 4.68 7.13 0.00 22.00 5.526 7.385 0.000 22.00 3,197 6,402 0.000 22.000 2.337 0.2098 *

IFRS adoption dummy (DIFRS) 0.39 0.49 0.00 1.00 0.248 0.477 0.000 1.000 0.243 0.429 0.000 1.000 0.005 0.0129

Rating, estimated credit rating to capture Standard &Poor’s credit ratings equivalent on a scale of 2–27 (AAA to D) at the end of year t; Review, an indicator variable that equals 1 if a company has voluntary audit review in year t-1 and 0 otherwise; Size, the natural log of Total Assets; Big4, an indicator variable that equals 1 if a company is audited by one of the Big 4 auditors and 0 otherwise; ROA, net income divided by total assets; TANG, net property, plant, and equipment divided by total assets; CR, current assets divided by current liabilities; LEV, total liabilities divided by total assets; NegE, an indicator variable that equals 1 if total year-end liabilities are greater than total year-end assets or 0 otherwise;DIFRS, an indicator variable referring to firms that use IFRS reporting; SalGro, percentage

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TABLE 3: Correlation matrix (N=8,275)

Variable Rating Review Size Big4 ROA TANG CR LEV NegE SalGro IntCov DIFRS

Rating 1 1.000

Audit Review dummy (Review) 2 .332 ** 1.000

Firm Size (Size) 3 .517 ** .520 ** 1.000

Big-4 auditor (Big4) 4 .275** .357 ** .546 ** 1.000

Return on Asset (ROA) 5 .419 ** .290 ** .661 ** .377 ** 1.000

Tangibilitiy (TANG) 6 .005 .100 ** .187 ** -.008 .121 ** 1.000

Current Ratio (CR) 7 .030* -.002** .017 .107 ** .088 ** -.222 ** 1.000

Leverage (LEV) 8 .096** .212 ** .359 ** .203 ** .150 ** .023 -.116 ** 1.000

Negative Equity (NegE) 9 .180* -.388 ** -.388 ** -.218 ** -.519 ** -.218 ** -.256 ** 0.097** 1.000

Sales Growth (SalGro) 10 -.205** .035 ** .002 -.041 ** .062 ** .115 ** -.025 -.075 ** -.079** 1.000

Interest Coverage (IntCov) 11 .376** .210 ** .450 ** .270 ** .623 ** -.038 * -.070 ** .188 ** -.154 ** .044 * 1.000

IFRS adoption dummy (DIFRS) 12 .059 ** .006 ** .046 ** .042 ** -0.140* 0.083* .015 * -.002 ** -0.045** -.067 ** .007 1.000

**: Correlation is significant at the 0.01 level (2-tailed). *: Correlation is significant at the 0.05 level (2-tailed).

Rating estimated credit rating to capture Standard &Poor’s credit ratings equivalent on a scale of 2–27 (AAA to D) at the end of year t; Review, an indicator

variable that equals 1 if a company has voluntary audit review in year t-1 and 0 otherwise; Size, the natural log of Total Assets; Big4, an indicator variable that equals 1 if a company is audited by one of the Big 4 auditors and 0 otherwise; ROA, net income divided by total assets; TANG, net property, plant, and equipment divided by total assets; CR, current assets divided by current liabilities; LEV, total liabilities divided by total assets; NegE, an indicator variable that equals 1 if total year-end liabilities are greater than total year-end assets or 0 otherwise;DIFRS, an indicator variable referring to firms that use IFRS reporting; SalGro, percentage

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TABLE 4: Selection of the matched sample Dependent Variable: Audit Review

Panel A: Probit analysis of the choice of purchasing interim review

Review = α + β1 Size + β2 Big4 + β3 ROA + β4 TANG + β5 CR + β6 LEV + β7 IntCov+ β8 NegE + β9 SalGro

+ β10 DIFRS + ε

Variables Coeff. s.e.

Firm Size (Size) 0.650 *** 0.040

Big-4 auditor (Big4) 0.554 *** 0.155

Return on Asset (ROA) -1.217 *** 0.314

Tangibility (TANG) 0.201 * 0.193

Current Ratio (CR) -0.049 0.048

Leverage (LEV) 0.172 0.392

Sales Growth (SALGRO)) 0.246 * 0.148

Negative Equity (NegE) 0.010 0.235

Interest Coverage (INTCOV) 0.000 0.000

IFRS adoption dummy (DIFRS) -0.237 *** 0.121

Constant -3.042 *** 0.242

Pseudo R2 0.229

LR chi2 (p-value) 689.75 0.000

Panel B: Descriptive Statistics for the matched sample

Univariate test (A) (B) (t-test statistics to test mean difference)

Audit No Audit H0 = A – B = 0

Review Review

t-value

Stat p-value

Determinants of Audit Review

Firm Size (Size) 3.923 4.015 -1.400 0.162

Big-4 auditor (Big4) 0.731 0.715 1.270 0.205

Return on Asset (ROA) -0.138 -0.134 -0.330 0.743

Tangibility (TANG) 0.414 0.427 -0.530 0.597

Current Ratio (CR) 1.811 1.766 1.150 0.249

Leverage (LEV) 0.111 0.118 -1.620 0.106

Sales Growth (SALGRO) 1.644 1.609 0.750 0.456

Negative Equity (NegE) 0.118 0.127 -0.980 0.329

Interest Coverage (INTCOV) 0.109 0.117 -1.190 0.234

IFRS adoption dummy (DIFRS) 0.391 0.405 -0.980 0.327

Dependent Variable

Rating 16.37 14.45 -1.620 0.105

Observations 4,838

***, **,*: significant at the 1%, 5%, 10% level for a one-tailed test.

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TABLE 5: Regression results (N= 1,482)

Model 1 Model 2 Model 3

Variables Coefficients s.e. Coefficients s.e. Coefficients s.e.

Audit Review dummy (Review) 1.907 *** 0.315 1.500 *** 0.916 2.726 *** 0.714 Firm Size (Size) 1.163 *** 0.140 1.129 *** 0.157 1.157 ** 0.140

Review*Size 0.093 0.197

Review*Big4 -1.013 0.793

Big-4 auditor (Big4) 0.299 0.424 0.304 0.424 0.681 0.519 Return on Asset (ROA) 2.469 ** 0.879 2.447 *** 0.881 2.533 *** 0.881 Tangibility (TANG) -2.084 *** 0.577 -2.079 *** 0.577 -2.091 *** 0.586 Current Ratio (CR) -0.355 ** 0.146 -0.355 ** 0.146 -0.361 ** 0.148 Leverage (LEV) -1.709 ** 1.151 -1.709 *** 1.151 -1.714 *** 1.150 Sales Growth (SALGRO) -1.934 *** 0.432 -1.934 *** 0.432 -1.954 *** 0.441 Negative Equity (NegE) -0.034 0.642 -0.034 0.642 -0.032 0.642 IFRS adoption dummy (DIFRS) 1.285 *** 0.359 1.285 ** 0.359 1.275 ** 0.349 Interest Coverage (INTCOV) 0.263 *** 0.238 0.263 *** 0.238 0.262 * 0.238 Constant 7.487 *** 0.722 7.487 *** 0.722 7.269 *** 0.722

Observations 1482 1482 1482

Fixed effects (Year/Industry) Yes Yes Yes

R-squared (adjusted) 0.3564 (0.3535) 0.3147 (0.3091) 0.3153 (0.3097)

F value 123.33 56.20 56.37

Prob > F 0.000 0.000 0.000

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