A test of the free cash flow and debt monitoring hypotheses:: Evidence from audit pricing

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Abstract

This study examines the association between free cash flow (FCF) and audit fees. The association is expected given Jensen's argument that managers of low growth/high FCF firms engage in non-value-maximizing activities. These activities increase auditors' assessments of inherent risk and, in turn, audit effort and fees. Jensen also argues debt mitigates the non-value-maximizing activities. Thus, the positive FCF/audit fees association is expected to be weaker for low growth firms with high debt than for similar firms with low debt. Regression results for a sample of low growth Hong Kong firms support these hypotheses.

Introduction

A major strand of audit research focuses on the choice of auditors (Francis and Wilson, 1988) and the determinants of audit fees (Simunic, 1980; Francis and Simon, 1987; Craswell et al., 1995; Simunic and Stein, 1996). An underlying hypothesis in these studies is that agency costs drive the demand for quality-differentiated audits in terms of the Big 6 vs. Non-Big 6 audit firms (previously Big 8). Firms with higher agency costs are expected to hire higher quality,1 more costly auditors in order to help mitigate agency costs. The demand for audit services and for quality-differentiated auditing is seen to be the efficient resolution of costly contracting problems (Watts and Zimmerman, 1986).

Prior empirical evidence on the relation between agency cost variables and the demand for audit quality is not strong (Palmrose, 1986; Simunic and Stein, 1987; Francis and Wilson, 1988; Defond, 1992). For example, prior studies using agency cost proxies such as leverage and management ownership of shares have not been very useful in explaining auditor choice. This could be due to leverage and management ownership of shares serving as poor proxies for agency costs or to the omission of other factors that cause cross-sectional variations in agency costs and auditing demand. Recently, Craswell et al. (1995)point to industry specialist auditors and argue that a combination of firm-specific and industry-wide factors generate cross-sectional variations in the demand for monitoring and in audit fees. The results of Craswell et al. are consistent with the hypothesis that firms in certain industries demand higher quality audits provided by auditors with specialization in those industries and that this translates into higher audit fees.

In this study, we explore a supply-side argument for the association between agency costs and audit fees. More specifically, we examine the association between free cash flow (FCF), identified by Jensen (1986)as a source of agency problems for low growth firms, and audit fees. FCF is defined as the cash flow in excess of that required to fund positive-net-present-value projects that is not paid out in dividends. According to Jensen, 1986, Jensen, 1989, managers of low growth/high FCF firms are involved in non-value-maximizing activities. We expect managers of these firms to mask non-optimal expenditures by accounting manipulation. We also expect auditors to respond to the higher probability of accounting misstatements or irregularities by exerting greater audit effort and charging higher audit fees. Jensen, 1986, Jensen, 1989also argues that some low growth/high FCF firms issue debt to mitigate the FCF agency problems. This suggests the FCF/audit fees association depends on the debt level; auditors of high FCF/high debt firms are likely to assess a lower risk of material misstatements, provide lower audit effort and charge lower audit fees than auditors of high FCF/low debt firms.

To examine the relation between FCF and audit fees, data is collected for publicly listed Hong Kong companies for 1993. Two multiple regression models of audit fees are run for low growth firms audited by the Big 6, using two FCF proxies suggested by Lang et al. (1991, p. 319). Each of the two models includes an interaction term for the FCF proxy and debt. Results indicate firms with high FCF and low growth opportunities are associated with higher audit fees than firms with low FCF and low growth opportunities. More importantly, the interaction between FCF and debt is significant and in the predicted direction. The negative interaction suggests at incrementally higher levels of debt, the positive association between FCF and audit fees progressively decreases.

This paper contributes to auditing literature in several ways. First, it provides evidence of an association between agency costs (proxied by FCF) and Big 6 audit fees not previously recognized in the literature. It is possible that FCF is a better proxy for agency costs than other variables, such as management ownership or leverage, previously examined by other researchers. Second, the paper provides a supply-side explanation for the association between FCF and audit fees. Third, unlike prior studies, debt has a significant impact on audit fees but the direction and extent of the effect is dependent on the firm's growth opportunities and FCF. The results obtained here suggest prior studies that examine debt's role in audit pricing have an omitted variables problem when they do not control for FCF and growth opportunities.

The next section of the paper provides a brief discussion of the theoretical background of the study. This is then followed by sections on the research method, results and discussion, and conclusion of the study.

Section snippets

Theoretical background

Jensen, 1986, Jensen, 1989argues there is a conflict of interest between managers and shareholders of firms with high FCF and low growth opportunities. Managers of these firms act opportunistically and are involved in `value destroying activities' and tend to `overinvest and misuse the funds' (Jensen, 1986, Jensen, 1989). Once managers have exhausted positive NPV projects, they proceed to invest in negative NPV projects instead of paying dividends (Rubin, 1990; Lang et al., 1991). Managers of

Data collection

We use data collected on Hong Kong publicly listed companies for 19932 from Wardley Data Services Limited.3 A total of 449 firm observations are available. Data on auditor identity and audit fees are obtained from an inspection of annual reports. After screening for low growth

Results and discussion

The results reported in Panel A of Table 6 show the association between FCF and audit fees is positive, significant, and in the predicted direction using either of the two FCF variables. The interaction terms comprising the first order interaction between FCFBEQ and debt and FCFBA and debt, respectively, are also significant and in the predicted direction. Some of the control variables are significant and consistent with prior studies (e.g., Craswell et al., 1995). For example, the ratios of

Conclusion

This study investigates the effect of FCF and debt on audit fees. The results show the association between FCF and audit fees is dependent on debt. The significant and positive main effects of FCF and the negative sign of the interaction terms suggest that at progressively higher levels of debt, the positive association between FCF and audit fees decreases.

Our test, however, does not unambiguously preclude other explanations such as the demand for higher quality audits to mitigate the agency

Acknowledgements

We acknowledge comments from Dan Simunic (the referee), Ross Watts (the editor), Jere Francis, Theodore Mock, Eric Noreen, Greg Whittred, the participants at the University of California, Berkeley, the Hong Kong University of Science and Technology and University of Otago workshops, the 1996 Hong Kong Academic Conference and AAANZ Conference. We also acknowledge the financial assistance provided by a Hong Kong RGC grant.

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