Leverage, Optimum Leverage and Audit Pricing

• In Event: DSFI: Part I

Abstract

This study investigates how auditors’ perception about clients’ leverage in assessing audit risk depends on the sources of leverage and on the deviation from optimum level of leverage. Consistent with prior studies, we find a significant positive association between audit fees and total leverage in the audit fee model. However, when we replace total leverage with operating liability leverage and financing leverage, the former (later) shows strong positive (negative) association with audit fees, suggesting asymmetric effects of two sources of leverage. A negative association for financing leverage suggests that benefits from monitoring effects of debt outweigh the costs associated with the risk of financial distress and financial misreporting, and the agency cost of debt. We also investigate optimum leverage and find that sub-optimal capital structure choices are likely to affect adversely (favorably) audit fees when firms are over-levered (under-levered). Thus, our findings highlight the importance of recognizing sources and optimum-level of leverage in audit risk analyses.

Authors

• Abhijit Barua, Florida International University

• Md Safayat Hossain, Florida International University