Signaling in Debt Contracting via Voluntary Verification of Timely Information

• In Event: Continental Breakfast - Research and Education Forum
  In Roundtable Session: Table 11: Audit Regulation

Abstract

The importance of timely and reliable information is increasing in the focus of lenders, especially when they make investment decisions during the financial year, far apart from the firm’s annual report. If firms want to get better financing conditions, they need to provide this information in order to fulfil the lenders’ needs. We are interested in the conditions under which firms choose to signal their private information by overpaying their annual audit fees (pure signaling) or by having their interim financial statements additionally reviewed (verified disclosure signal). In our model, we show that the costs of the pure signal via the audit fees are very high but can substantially be reduced when the signal is supported by timely verified disclosure in form of a reviewed interim financial statement. Hence, the firm would only use the pure signaling if the interim review is too costly. If the interim review effort is cheap, the auditor can earn a rent from the review even though he operates in a perfectly competitive market but the rent will never be as high as in the pure signaling. Only for very low review costs, it is beneficial for all firms to hire an auditor for the review which economically justifies a one-size-fits-all regulation for mandatory reviews. These insights are relevant for regulators in the discussion whether to adopt mandatory reviews. We also derive valuable insights for empiricists about the structure of audit fees.

Author

• Sebastian Kronenberger, University of Texas