The effect of audit quality on the pension risk – cost of equity relation

Abstract

PurposeThe purpose of this paper is to empirically investigate how audit quality affects the cost of equity (COE) defined benefit pension risk relation. As an antecedent to these tests, this study first uses implied COE measures and their pension intensity risk predictors to examine the relation between a defined benefit plan (DBP) firm’s implied COE and pension intensity risk. Then, using these measures, the authors provide new evidence on how audit quality affects this relation.Design/methodology/approachUsing panel data over fiscal years 1999–2014, fixed effects models regress dependent variable, implied the COE on controls and proxies that measure pension intensity risk and pension intensity risk conditional on the quality of the audit.FindingsThis study documents that audit quality attenuates the positive relation between a sponsoring firm’s COE and pension risk. The authors rationalize these findings by asserting that the positive relation between a sponsoring firm’s COE and pension intensity risk reflects increased financial risk associated with higher pension obligations but the quality of the auditor attenuates this risk. This paper further documents that these findings are robust to a sponsoring firms’ level of financial distress.Research limitations/implicationsA limitation of this research is that the sample is limited to DBPs companies only. Although results of the tests show similar results for controls that are used in other COE-related studies that include DBP and non-DBP firms, the generalizability of the findings may be limited to the extent that the financial characteristics of firms without defined contribution plans differ from the sample.Practical implicationsResults of this study suggest that while pension intensity risk has COE implications, managers may be able to mitigate these effects by managing their plans and utilizing high-quality auditors.Originality/valueUsing implied COE and pension intensity risk measures, this study provides new information on the favorable effect that high-quality audits have on the COE – pension risk relation.