Information Risk and Debtholders’ Mispricing by Considering Audit Quality*

• Date: 01 June 2020
• DOI: http://doi.org/10.1111/ajfs.12298
• Published date: 01 June 2020

Information Risk and Debtholders’

Mispricing by Considering Audit Quality*

Yong-Ki Jung

College of Business Administration, Chonnam National University, Republic of Korea

Sun-Hwa Kim**

Management Research Institute, Chonnam National University, Republic of Korea

Received 1 October 2018; Received in current form (3rd revision) 23 March 2020; Accepted 23 March 2020

Abstract

We examine how audit quality perceptions impact debt mispricing in the presence of earn-

ings management. The Big Four auditors (BFAs) and auditor tenure are used as proxies for

perceptions of higher quality audits. Debt mispricing means that debtholders charge a lower

(higher) cost of debt to a firm with low (high) accrual earnings management (AEM) and

high (low) real earnings management (REM). We find that debt mispricing is accentuated

(attenuated) by considering the BFA and auditor tenure because debtholders fixate on quality

audits curving AEM. For low AEM and REM firms, debt investors place a premium on low

AEM with the BFAs/long-tenured auditors, worsening the mispricing. For high AEM and low

REM firms, debt investors impose a “smaller discount” on high AEM with the BFAs/long-

tenured auditors. This study demonstrates that the accentuation (attenuation) of debt mis-

pricing when considering the BFA and auditor tenure occurs mainly if the firm raised only

private debt rather than both private and public debt.

Keywords Debtholders; Debt mispricing; Earnings management; Audit quality

JEL Classification: G30, G34, M41,

1. Introduction

Opportunistic earnings management activities by managers increase financial infor-

mation uncertainty by increasing the difficulty in predicting future cash flows,

which increases the risk faced by financial information users. Meanwhile, the audit

role may act as a potential guarantee and some insurance to financial information

users by monitoring managers and disclosing accurate management performance

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution

and reproduction in any medium, provided the original work is properly cited.

©2020 The Authors. Asia-Pacific Journal of Financial Studies published by John Wiley & Sons Australia, Ltd on behalf

of Korean Securities Association 463

*The authors are grateful for helpful comments from the editor and two anonymous review-

ers.

**Corresponding author: Management Research Institute, Chonnam National University, 77

Yongbong-Ro, Buk-Gu, Gwangju 61186, Republic of Korea. Tel: +82-62-530-1475, email:

hskj1220@naver.com.

Asia-Pacific Journal of Financial Studies (2020) 49, 463–508 doi:10.1111/ajfs.12298

(Wallace, 1987). Hence, higher quality audit services are able to restrain earnings

management, which reduces the risk faced by information users (Song et al., 2014).

In general, audit quality is defined as the combination of the probability that an

auditor will actually find errors in the audited entity’s financial statements and hon-

estly report the errors (DeAngelo, 1981). However, estimating audit quality is com-

plicated and requires intensive analysis. Previous studies have used various

measures as alternative proxies for audit quality, including large auditors (e.g., the

BFAs) (Becker et al., 1998; Francis et al., 1999), audit tenure (Johnson et al., 2002;

Myers et al., 2003), audit fees and audit hours (Francis and Stokes, 1986; Palmrose,

1986; Choi and Paek, 1998), abnormal audit fees and abnormal hours (Caramanis

and Lennox, 2008; Park and Jeon, 2008), peer reviews (Park et al., 1999), frequency

and size of the prior period’s adjustment items (Kim and Hwang, 1998), the pres-

ence of field-specialized auditors (Na and Choi, 2005; Goh et al., 2009), and prior

audit opinions (Na and Choi, 2006).

In the case of Korean firms after the 1998 crisis, accounting transparency was

enhanced, and various efforts were made to improve audit quality. In particular,

the BFAs provided high-quality audit services by restricting AEM due to reputation

and litigation risks (Goh et al., 2009). Moreover, when auditor tenure is long, audit

quality improves due to the auditors’ experience and expertise (Lim, 2006; Kwon

et al., 2008). Hence, debtholders are inclined to believe the assurance of high audit

quality by the BFA and longer auditor tenure (Kim, 2006; Choi et al., 2010; Park

et al., 2012). It is therefore inferred that if debtholders suffer difficulty in detecting

earnings management, they can consider audit quality, and subsequently, mispricing

in the debt market accentuated (attenuated) by the BFA and auditor tenure. How-

ever, studies on this relation are scarce.

Debtholders have contractually fixed claims, such as periodic interest payments,

which lead them to consider earnings management on debt pricing. This is because

earnings management makes it difficult to predict future cash flows, which increases

the information risk that debtholders face (Grahan et al., 2008; Ahn and Choi,

2009). If credit rating agencies and lenders perceive earnings management as oppor-

tunistic behavior, earnings management should be related more positively to the

cost of debt. However, real earnings management (REM) is virtually indistinguish-

able from optimal business activities, and thus, debt mispricing occurs by charging

a lower (higher) cost of debt to a firm with low (high) AEM and high (low) REM

(Kim and Jung, 2016).

When the information asymmetry of a firm with low (high) AEM and high

(low) REM is relatively high (Kim and Jung, 2016), the BFA cannot entirely con-

strain AEM, even with their sophisticated audit abilities. Moreover, if such a firm

has high information asymmetry, auditors will find it difficult to fully detect AEM,

even with longer audit periods. Nevertheless, if debtholders have substantial diffi-

culty in detecting earnings management, they will seek to reduce the information

risk by considering audit quality. Thus, debt mispricing is accentuated (attenuated)

Y.-K. Jung and S.-H. Kim

464 ©2020 The Authors. Asia-Pacific Journal of Financial Studies published by John Wiley & Sons Australia, Ltd on behalf

of Korean Securities Association

by the BFA and auditor tenure because debtholders fixate on quality audits curving

AEM.

In the case of domestic firms, many listed companies do not issue corporate

bonds, and Korean financial institutions do not adequately reflect the information

risk inherent in discretionary accruals to the loan interest rate (Park and Yoon,

2014). Therefore, financial institutions’ incentive to consider audit quality to reduce

information risk can be larger, and accentuation (attenuation) of debt mispricing

by considering audit quality may differ between a company with only private debt

as compared to one with private and public debt.

The empirical results are summarized as follows. First, for a firm with low

(high) AEM and high (low) REM, debt mispricing when considering the BFA and

auditor tenure is accentuated (attenuated) because debtholders fixate on quality

audits curving AEM. Therefore, if low AEM and high REM firms are audited by the

BFAs/long-tenured auditors, debt investors tend to place a premium on a low

AEM, in addition to imposing “small discounts” to high AEM for high AEM and

low REM firms audited by the BFAs/long-tenured auditors. Second, we find that

the accentuation (attenuation) of debt mispricing when considering the BFA and

auditor tenure occurs mainly if the firm only has private debt.

This study differs from previous research. First, it verifies whether the accentua-

tion (attenuation) of debt mispricing occurs due to debtholders’ belief in audit

quality, in addition to their belief in foreign investors. This is based on accentuation

(attenuation) of debt mispricing occurring in the debt market due to debtholders’

belief in audit quality. Second, the results will help understand the characteristics of

debtholders by showing that there is a difference in debt mispricing between corpo-

rations that raised only private debt and those that raised private and public debt.

The remainder of this paper is structured as follows. Section 2 describes the the-

oretical background and discusses the hypotheses proposed herein. Section 3 outli-

nes the research design and sample selection. Section 4 presents empirical results,

and section 5 presents the conclusions.

2. Theoretical Background and Hypotheses

2.1. Debt Mispricing Based on Debtholders’ Perception of the BFAs

A manager’s opportunistic earnings management increases the difficulty in predict-

ing future cash flows, which increases financial information uncertainty; this

includes the possibility of information users making the wrong decision ( Becker

et al., 1998; Lee and Kim, 2011). The purpose of an external audit is to ensure the

reliability of financial information to users by monitoring managers and disclosing

accurate management performance (Wallace, 1987). Hence, higher quality audit ser-

vices can decrease earnings management, which reduces the risk to information

users.

Big Four audit firms may show a higher audit quality than non-Big Four audit

firms (Becker et al., 1998; Francis et al., 2005), which relates to audit firm

Information Risk and Debtholders’ Mispricing

©2020 The Authors. Asia-Pacific Journal of Financial Studies published by John Wiley & Sons Australia, Ltd on behalf

of Korean Securities Association 465