Engagement Partner Quality, Costs of Capital, and Valuation

• In Event: Valuation

Abstract

Accounting theory predicts that the clients of higher quality auditors should enjoy lower costs of capital and have more predictable future cash flows, therefore, having higher values. However, empirical evidence on whether and how the audit quality at the engagement partner (EP) level influences the clients’ costs of capital and values is scarce. Therefore, employing five proxies for the EP quality (characterized by size and industry specialization), and analyzing 414-739 EPs from the United Kingdom, we examine and find, consistent with the theoretical predictions, that the clients of high-quality EPs generally enjoy lower costs of capital and have higher values. The former effect is mainly due to the markets’ perception that high-quality EPs improve their clients’ accruals quality. The effect of EP quality on clients’ value is the improvement in the prediction of future cash flows and reduction of discount factors. The results are not sensitive to controls for the industry, year, client, and audit firm fixed effects, to alternative measurements of EP quality and clients’ value, and to a median regression method. Our additional analyses on the effect of EP quality on debt covenants show that the loan contracts of clients of high quality EPs are less likely secured and have larger amount of facilities and lower loan spread over LIBOR. Our results suggest that audit quality at the EP level benefit clients.

Authors

• Kose John, New York University

• Min Liu, Brooklyn College