Aurora Borealis
1 August 2013 CFA Institute Journal Review

Association between Big 4 Auditor Choice and Cost of Equity Capital for Multiple-Segment Firms (Digest Summary)

  1. Michal Szudejko

Choosing an auditor from what is known as the Big 4 has an impact on a company’s cost of equity. The authors analyze the relationship between audit quality and information asymmetry. They show that Big 4 auditor choice may reduce information imbalances between investors and managers, which may lead to a lower equity cost in a company. Moreover, information asymmetry and the impact of Big 4 auditor choice on the cost of equity are both stronger for multiple-segment firms.

What’s Inside?

The relationship between Big 4 auditor choice and cost of equity has more implications for multiple-segment firms than for single-segment firms. The reason seems to be related to the assumption of higher information asymmetry for multiple-segment than for single-segment entities. An audit carried out by a Big 4 auditor may reduce such an imbalance and, simultaneously, equity cost. The same effect in a single-segment firm is weaker. The findings of the paper continue the work of prior research. In part, the authors reaffirm the importance of quality audit services to the investment industry. They test the relationship in question from multiple angles to cover loopholes identified in other research.

How Is This Research Useful to Practitioners?

The authors’ research is based on prior research that showed a negative relationship between Big 4 auditor choice and cost of equity. But they are unable to determine whether the underlying mechanism is actually related to the choice of auditor or to other individual characteristics of a company.

The authors have also incorporated literature about agency conflict into their research. In particular, they assume that agency problems tend to increase with the number of segments. Diversified companies typically have several layers of management. In addition, the managerial supervision in such companies tends to be relatively superficial. As a result, information asymmetry may be higher than in comparable single-segment firms. Because of higher information asymmetry, equity investors may require an additional premium on their contribution, which the authors describe as a “diversification discount.”

The key question the authors ask is whether Big 4 auditor choice can reduce this discount. They confirm the importance of selecting a Big 4 auditor, particularly in the presence of greater information asymmetry. The results indicate both a decrease in the cost of capital and an increase in the investor confidence in the presence of a Big 4 auditor.

The authors list a few types of professionals who may be interested in the outcomes of their research, from practitioners in the investment market to academics. The quality of audits is a vital matter for regulators and auditor firms. For example, the authors’ work highlights the need for non–Big 4 auditors to exert greater effort when dealing with multiple-segment firms.

How Did the Authors Conduct this Research?

The authors test whether the decrease in the cost of equity capital when firms employ a Big 4 auditor is greater for multiple-segment firms. They proxy the cost of capital with an average of discount rate estimates derived from earlier literature.

The authors use separate multivariate regression models for multiple- and single-segment firms. To be designated a multiple-segment firm, the firm must report at least two operating segments. The model regresses the cost of equity against several variables, including a control factor for the size of the auditor, accruals estimates, size of firm and the structure of its capital, and measures of risk premiums associated with given firms and industry classification. The regression is calculated over 36 months, with the last month being the fiscal year-end. The authors use two specifications of the model and account for different firm characteristics associated with information asymmetry. They also attempt to verify the endogeneity of auditor choice as well as inspect the relationship between auditor tenure and audit quality.

The dataset consists of all the firms listed on the NYSE, Amex, and NASDAQ during 1987–2010. The sources of information are Compustat, CRSP, and Thomson I/B/E/S. The authors make several exclusions from the dataset, such as firms with missing data on segment or firm-year and firms belonging to regulated industries. The final sample includes 21,177 firm-year observations, of which 8,717 are observations from multiple-segment firms.

Abstractor’s Viewpoint

In my view, the authors present a holistic yet very systematic approach to the research subject. With a limited-step methodology, they produce a well-documented description of the relationship. The research includes certain points that could be explored in the future. In particular, a panel regression could be used to fully account for sample diversification. Next, certain quantitative measures of audit quality and effort could be used, such as audit process duration. Finally, the relationship between information asymmetry and cost of equity could be tested.

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