Abstract
Previous literature shows mixed evidence on the effect of discretionary accruals and auditing on the cost of debt. We hypothesize that, in the SMEs setting, auditing can act as a substitute for accruals quality, and thus audits may mitigate the effect of discretionary accruals on the cost of debt. Using a sample of Spanish SMEs, we find that auditing is negatively related with the cost of debt, while higher discretionary accruals are related with a lower cost of debt. Nonetheless, this effect is lower than that one observed for audits. When considering the combined effect of both variables, the effect of discretionary accruals is replaced by that of auditing. These results suggest that, among SMEs, discretionary accruals do not have a relevant effect on the cost of debt when companies are audited, supporting the hypothesis that there exists a substitution effect between discretionary accruals and auditing. JEL Classification: M42; G32
Highlights
Previous literature shows that there exists a theoretical discussion about the effect of accounting quality on the cost of debt, which relies on the potential association between discretionary accruals and information risk, and the empirical evidence is mixed
Most of previous literature shows that companies reporting lower discretionary accruals have lower financing costs, what is theoretically supported by the hypothesis that discretionary accruals are associated with earnings management with opportunistic purposes and the information risk is increased (Bhojraj & Swaminathan, 2009; Carmo et al, 2016; Shen & Huang, 2013; Vander Bauwhede et al, 2015)
We find that auditing is negatively related with the cost of debt; results show that, in line with Aldamen and Duncan (2013), the association between discretionary accruals and the cost of debt is negative and companies with higher discretionary accruals have a lower cost of debt
Summary
Previous literature shows that there exists a theoretical discussion about the effect of accounting quality on the cost of debt, which relies on the potential association between discretionary accruals and information risk, and the empirical evidence is mixed. Financial audits have the purpose of examining and assessing a company’s financial statements in order to guarantee that they are a fair representation of the company’s actual situation and performance. For this reason, audits are considered to improve their clients’ accounting quality, and audited financial statements are considered as more reliable and credible than the unaudited ones (Cassar, 2011). Prior literature has examined the relationship between auditing and the cost of debt, but it shows mixed evidence: while some papers find that voluntary audits help companies to get upgrades in their financial ratings (Lennox & Pittman, 2011) and to reduce their financing costs (Kim et al, 2011), other studies do not find significant differences (Cassar et al, 2015; Huguet & Gandía, 2014)
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