The cost of debt and the characteristics of audit firms

Abstract

Purpose Audit firm bankruptcy can have significant negative impacts on the stock prices of client firms. The purpose of this paper is to identify determinants of audit firm bankruptcy risk as measured by costs of debt. Design/methodology/approach Using audit firm data publicly available in Korea, this study empirically examines whether client portfolio, financial, and organizational characteristics are associated with the weighted average interest rates assumed by auditors. Findings The authors find empirical evidence that audit firms’ client portfolio characteristics, including the incidence (or number) of lawsuits against the auditor, the proportion of audit clients under surveillance, the proportion of initial audit engagements, and the proportion of listed companies of audit clients, are positively associated with the cost of debt. The authors also find several financial and organizational characteristics associated with the cost of debt. Practical implications The findings of this study suggest that client portfolio characteristics as well as financial and organizational characteristics are important determinants of the cost of debt in audit firms, and that these characteristics are different from those of firms in other industries. Identifying the determinants of audit firms’ cost of debt provides insight to regulators, client firms, and capital market participants. Originality/value This study examines the default risk of audit firms that play an important monitoring role in capital markets. By utilizing unique data about audit firms available in Korea, this study is the first study to empirically examine the effect of detailed audit firm characteristics on audit firm’s default risk.