Review Jurnal Internasional : Audit

Title                 : Audit Quality and Cost of Equity Capital: Evidence of Iran

Author             : Zohreh Hajihan

  Neda Sobhani

Year                : 2012

INTRODUCTION

Today, transparency and quality of financial information, which are the base of the economical decision-making of investors, creditors, and other users, are very crucial (Alavi Tabari et al, 2009). Auditing reduces information asymmetries that exist between managers and firm stakeholders by allowing outsiders to verify the validity of financial statements (Becker et al, 1998). Therefore,  by growth of competition in audit profession, audit firms have understood necessity of quality of their services in capital market. In this line, audit quality is one of the most significant topics in the auditing profession. A higher audit quality is reliant, as part of its mandate, on an ability to reduce existing anomalies and failures. Prior studies show that “audit with higher quality” improves accuracy of information  and  makes  opportunity  for  users  and  investors  to  analyze  performance  of  company (Peecher et al, 2007). Audit quality depends on auditor’s technical capabilities and independence (De Angelo, 1981;Vanstraelen,2000; Mostafa Mohamed, 2010). Without auditing, outsiders would be skeptical of the information provided by managers and would therefore either refuse to invest capital or demand an extremely high rate of return to compensate them for the risk of potential expropriation of their capital by managers (Ahmed et al (2008)). Many researchers including Fernando (2007), Ahmed et al (2008), Li et al (2009) and Fernando et al (2010) suggested that high audit quality decreased cost of capital of client firms. Chen et al. (2010), state that if high audit quality reduces information risk, which is invisible, it should translate to a tangible benefit in the form of lower cost of equity capital. In this study,  investigate the effect of audit quality on the firm’s cost of equity capital.

PREVIOUS RESEARCH

The accounting literature has firmly established that auditor quality is very important (fallatah, 2006). The demand for auditing in capital market can be analyzed from three different perspectives (i.e. auditing roles); a monitoring role, an information role and an insurance role (Wallace 1980). Fernando (2007), shows that the monitoring role of the audit is effective in mitigating the agency problem arising out  of  the  separation  of  ownership  and  control  of  the  firm.  The  perceived  effectiveness  of  the monitoring role of auditing would be reflected in the client’s cost of capital. Leuz and Verrecchia (2005) shows that better information will lead to lower cost of capital due to alignment between the firm’s investment opportunities and its investment choices. The insurance role indicates that the more financial resources the auditor has, the lower the cost of capital of the client firm the three roles of auditing specified by Wallace(1980) would all have a role in reducing the cost of capital of firms(Fernando,2007).           

In this research, study the effect of three measures of audit firm size, auditor industry specialization, and audit tenure on cost of equity capital. Therefore will investigate the importance of each measure and develop research hypotheses.

HYPOTHESES DEVELOPMENT

Hypothesis 1   : Audit firm size has a significant relationship with cost of equity capital.

Hypothesis 2  : Auditor industry specialization has a significant relationship with cost of equity capital.

Hypothesis 3   : Audit tenure has a significant relationship with cost of equity capital.

SAMPLE SELECTIION

The  statistical  population  of  this  research  is  91 manufacturing  companies  listed  in  Tehran  Stock Exchange. A systematic random sampling was used. Time period of this research is 7 years since 2004 to 2010.

REGRESSION MODEL

Use regression model (2) to examine Hypotheses 1, 2 and 3.

IndEPj,t=β0+β1Growthj,t+β2Leveragej,t+β3Betaj,t+β4Sizej,t+β5EQj,t+β6AQIRj,t+εj,t                 (2)

An industry- adjusted earning-price ratio (IndEP) as the cost of equity capital measure. IndEP equal to firm j’s earnings-to-price ratio less the median earnings-to-price ratio of its industry classified. Independent variables consist of audit firm sizem auditor industry specialization and audit tenure. The model includes controls for Growth, Leverage, Beta, and Size Consistent with Francis et al. (2005), Li et al. (2009). Also EQ is control variable in this model.

RESULT OF HYPOTHESES TESTING

The result of test of hypothesis 1 showed that there was a reverse and significant relationship between audit firm size and cost of equity capital. This means that companies which use large an audit firm (in case of Iran, Audit Organization), have lower cost of equity capital than those which do not, because larger audit firms desire to get more fame in the market. These firms offer their services well because of having access to more sources and facilities to train their auditors and do tests. This result complies with those of Khurana & Raman (2004), Mansi et al (2004), and Pittman & Fortin (2004), Fernando et al (2010), but does  not  comply  with  those  of  Azinfar  &  Hassas  Yeganeh  (2010)  as  prior  research  in  audit environment of Iran.

The results of test of hypothesis 2 showed that there was a reverse and significant relationship between auditor industry specialization and cost of equity capital. This means that companies which use expert industry auditors have lower cost of equity capital than those which do not. Auditor with industry expertise are viewed to provide better quality audits because they have better knowledge of the industry and could also audit more efficiently through specialization to develop economies of scales. In addition, the more the audit firm is expert in a special industry, the more desire it has to offer higher quality services. This result also complies with those of Li et al (2009), Ahmed et al (2008) and Fernando et al (2010) in international results.

The result of test of hypothesis 3 indicated that there was a positive significant relationship between auditor tenure and cost of equity capital. This means that auditor tenure promote audit quality in Iran. Thus, companies that maintain their relation with an audit firm for 4 sequential years, have less cost of equity capital. This result complies with those of Lim & Tan (2009), Fernando et al (2010), Mostafa Mohamed (2010), and does not comply with those of Jackson et al (2007), and Cameran et al (2005). Generally, the results of the research hypotheses show that cost of equity capital of companies listed in Tehran Stock Exchange will decrease by increment of audit quality, as Li et al (2009) obtained the same result by other proxies for audit quality (city level industry specialist auditor and unexpected audit fees). Fernando et al (2010), show that Auditor size, industry specialization, tenure are negatively related to the cost of capital. These finding indicate that higher audit quality reduce information asymmetries between investors and managers and so leads to lower client’s cost of equity capital.