Do credit ratings influence the demand/supply of audit effort?

• Published in: Journal of applied accounting research 2021-01, Vol.22 (1), p.72-92
• Main Authors: Lim, Hyoung Joo, Mali, Dafydd
• Format: Article
• Language: English
• Subjects: Accounting firms; Annual reports; Audit fees; Audit quality; Audit risk; Credit ratings; Default; Financial reporting; Incentives; Litigation; Rating services; Ratings & rankings
• ISSN: 0967-5426; 1758-8855
• DOI: 10.1108/JAAR-02-2020-0028

PurposeFirm management has an incentive to improve credit ratings to enjoy the reputational and financial benefits associated with higher credit ratings. In this study, the authors question whether audit effort in hours can be considered incrementally increasing with credit ratings. Based on legitimacy theory, the authors conjecture that firms with higher credit ratings will demand higher levels of audit effort to signal audit and financial quality compared to firms with higher levels of credit risk.Design/methodology/approachThe authors conduct empirical tests using a sample of Korean-listed firms using a sample period covering 2001–2015.FindingsThe results show that firms with higher credit ratings demand higher audit effort in hours compared to client firms with lower credit ratings. The authors interpret that firms with higher ratings (lower risk) demand higher levels of audit effort in hours to reduce information asymmetry and to demonstrate that financial reporting systems are robust based on audit effort signaling audit quality. The authors also interpret that firms with lower credit ratings do not have incentives to signal similar audit quality. The authors also capture the “Big4 auditor expertise” effect by demonstrating that client firms audited by nonBig4 auditors demand additional audit effort with increasing credit rating compared to Big4 clients.Research limitations/implicationsAudit effort is considered a signal of firm risk in the literature. This study’s results show evidence that audit effort is inversely related to firm risk.Practical implicationsThe results show that audit hour information is informative and likely managed by firm stakeholders. Internationally, it is not possible to capture the audit demand of clients because listing audit hours on financial statements is not a rule. Given that audit hours can be considered informative, the authors believe that legislators could consider implementing a policy to mandate that audit hours be recorded on international annual reports to enhance transparency.Originality/valueSouth Korea is one of few countries to list audit effort on annual reports. Therefore, the link between audit effort and credit ratings is unique in South Korea because it is one of few countries in which market participants likely monitor audit effort.