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Journal of Accounting and Economics 24 (1998) 219—237

A test of the free cash flow and debt monitoring
hypotheses:
Evidence from audit pricing
Ferdinand A. Gul, Judy S. L. Tsui*
Department of Accountancy, City University of Hong Kong, 83 Tat Chee Avenue, Kowloon, Hong Kong
(Received June 1996; final version received January 1998)

Abstract
This study examines the association between free cash flow (FCF) and audit fees. The
association is expected given Jensen’s argument that managers of low growth/high FCF
firms engage in non-value-maximizing activities. These activities increase auditors’ assessments of inherent risk and, in turn, audit effort and fees. Jensen also argues debt
mitigates the non-value-maximizing activities. Thus, the positive FCF/audit fees association is expected to be weaker for low growth firms with high debt than for similar firms
with low debt. Regression results for a sample of low growth Hong Kong firms support
these hypotheses. ( 1998 Elsevier Science B.V. All rights reserved.
JEL classification: L84; M40
Keywords: Free cash flow; Debt monitoring; Growth opportunities; Audit pricing

1. Introduction
A major strand of audit research focuses on the choice of auditors (Francis
and Wilson, 1988) and the determinants of audit fees (Simunic, 1980; Francis
and Simon, 1987; Craswell et al., 1995; Simunic and Stein, 1996). An underlying
hypothesis in these studies is that agency costs drive the demand for qualitydifferentiated audits in terms of the Big 6 vs. Non-Big 6 audit firms (previously

* Corresponding author. Tel.: (#852) 2788 7923; fax: (#852) 2788 7002; e-mail: acjt@
cityu.edu.hk.
0165-4101/98/$19.00 ( 1998 Elsevier Science B.V. All rights reserved.
PII S 0 1 6 5 - 4 1 0 1 ( 9 8 ) 0 0 0 0 6 - 8

Jensen (1986. 1986). prior studies using agency cost proxies such as leverage and management ownership of shares have not been very useful in explaining auditor choice. we examine the association between free cash flow (FCF). 1986. we explore a supply-side argument for the association between agency costs and audit fees. The demand for audit services and for quality-differentiated auditing is seen to be the efficient resolution of costly contracting problems (Watts and Zimmerman. Simunic and Stein. Recently. using two FCF proxies suggested by Lang et al. More specifically. 319). J. Prior empirical evidence on the relation between agency cost variables and the demand for audit quality is not strong (Palmrose. To examine the relation between FCF and audit fees. and audit fees. Two multiple regression models of audit fees are run for low growth firms audited by the Big 6.220 F. FCF is defined as the cash flow in excess of that required to fund positive-net-present-value projects that is not paid out in dividends. The results of Craswell et al. data is collected for publicly listed Hong Kong companies for 1993. We expect managers of these firms to mask non-optimal expenditures by accounting manipulation. Firms with higher agency costs are expected to hire higher quality. .L. auditors of high FCF/high debt firms are likely to assess a lower risk of material misstatements. Gul. We also expect auditors to respond to the higher probability of accounting misstatements or irregularities by exerting greater audit effort and charging higher audit fees. 1987. Francis and Wilson. Defond. Craswell et al. (1991. Tsui / Journal of Accounting and Economics 24 (1998) 219—237 Big 8).1 more costly auditors in order to help mitigate agency costs. For example.A.S. 1988. In this study. p. identified by Jensen (1986) as a source of agency problems for low growth firms. This could be due to leverage and management ownership of shares serving as poor proxies for agency costs or to the omission of other factors that cause cross-sectional variations in agency costs and auditing demand. managers of low growth/high FCF firms are involved in non-value-maximizing activities. Each of the two models includes 1 Audit quality is defined as the joint probability of detecting and reporting material financial statement errors (DeAngelo. 1981). 1992). are consistent with the hypothesis that firms in certain industries demand higher quality audits provided by auditors with specialization in those industries and that this translates into higher audit fees. This suggests the FCF/audit fees association depends on the debt level. According to Jensen (1986. 1989) also argues that some low growth/high FCF firms issue debt to mitigate the FCF agency problems. (1995) point to industry specialist auditors and argue that a combination of firm-specific and industry-wide factors generate cross-sectional variations in the demand for monitoring and in audit fees. provide lower audit effort and charge lower audit fees than auditors of high FCF/low debt firms. 1989).

Second.. 1991). 1989) argues there is a conflict of interest between managers and shareholders of firms with high FCF and low growth opportunities. It is possible that FCF is a better proxy for agency costs than other variables. Audit risk is the likelihood of material errors in the client’s financial statements (Accounting Standards Board. It is the product of the likelihood that environmental factors. 2. Results indicate firms with high FCF and low growth opportunities are associated with higher audit fees than firms with low FCF and low growth opportunities. Lang et al.A.. 47). The results obtained here suggest prior studies that examine debt’s role in audit pricing have an omitted variables problem when they do not control for FCF and growth opportunities. such as management ownership or leverage. J. debt has a significant impact on audit fees but the direction and extent of the effect is dependent on the firm’s growth opportunities and FCF.L Tsui / Journal of Accounting and Economics 24 (1998) 219—237 221 an interaction term for the FCF proxy and debt. they proceed to invest in negative NPV projects instead of paying dividends (Rubin.S. No. This is then followed by sections on the research method. 1986. 1989).F. it provides evidence of an association between agency costs (proxied by FCF) and Big 6 audit fees not previously recognized in the literature. before considering the quality of internal controls. the likelihood the internal controls system will not prevent or detect a material error (‘control risk’) and the likelihood the audit procedures . Managers of these firms are expected to increase their compensation and perquisites consumption at the expense of the shareholders. 1989). Third. Statement on Auditing Standards. First. Christie and Zimmerman (1994) suggest these non-value-maximizing managers are more likely to mask non-optimal expenditures by accounting manipulation. The next section of the paper provides a brief discussion of the theoretical background of the study. 1993). the positive association between FCF and audit fees progressively decreases. and engage in other activities associated with management entrenchment (Shleifer and Vishny. Once managers have exhausted positive NPV projects. Theoretical background Jensen (1986. More importantly. will produce a material error (‘inherent risk’). the interaction between FCF and debt is significant and in the predicted direction. This paper contributes to auditing literature in several ways. Gul. 1990. unlike prior studies. the paper provides a supply-side explanation for the association between FCF and audit fees. The negative interaction suggests at incrementally higher levels of debt. results and discussion. Managers of these firms act opportunistically and are involved in ‘value destroying activities’ and tend to ‘overinvest and misuse the funds’ (Jensen. Auditors design audits to reduce audit risk below a given level (see Lemon et al. previously examined by other researchers. and conclusion of the study.

1986. 3. however. 1990.S. To summarize. so the net effect of higher leverage on inherent risk is ambiguous. additional leverage can motivate misstatements by management (e. The debt market also provides management discipline (Rubin. to avoid accounting-based debt covenant violations). The greater the inherent risk. 1989. the former (cash discipline) effects to dominate for high FCF/low growth firms. higher leverage) is likely to reduce agency costs associated with FCF.3 A total of 449 firm observations are available. . Stulz.222 F. it is likely that the relation between FCF and audit fees depends on debt levels.1. Data collection We use data collected on Hong Kong publicly listed companies for 19932 from Wardley Data Services Limited. 3 Wardley Data Services Limited is a securities company that maintains a database on all Hong Kong publicly listed companies. Gul. 1993).. ceteris paribus. J.g. Auditors are likely to assess firms with high FCF and ‘non-value-maximizing managers’ as having high levels of inherent risk. Research method 3.. This reasoning leads to the following hypothesis: Audit fees for low growth firms with high FCF and low levels of debt will be higher than for similar firms with high FCF and high levels of debt.L. they are likely to devote more resources to those firms’ audits and charge those firms higher fees. ceteris paribus. Issuance of debt without retention of the proceeds (i.e. The required payments under debt contracts reduce the cash flows management have available for non-valuemaximizing behavior and so restrict that behavior (Jensen. We expect..A. 1990). On the other hand. we argue that auditors charge higher fees in response to the higher inherent risk associated with the non-value-maximizing activities of managers of low growth firms with high FCF. ceteris paribus. 2 The market and regulatory environments in Hong Kong are similar to those of the US and Australia. Maloney et al. Hence. Since debt can mitigate the agency problems of FCF by requiring payments and providing a monitoring mechanism through the debt market. These effects reduce inherent risk and in turn mitigate the audit fees of high FCF firms. the more resources the auditor will have to devote to the audit to reduce detection risk to achieve a given level of audit risk. Tsui / Journal of Accounting and Economics 24 (1998) 219—237 will fail to detect a material error not detected by the control system (‘detection risk’).

Table 1 Summary of the sample selection process Sampling frame Requirements Firm observation for 1993 is available from Wardley Data Services Limited Firm is incorporated in Hong Kong Firm has shares that are publicly traded in Hong Kong Number of firms qualifying"449 Screen for growth opportunitiesa Requirements Firm has non-missing values for three proxies of growth (MKTBKEQ. After screening for low growth firms based on a composite measure of growth. financial institutions are excluded due to their unique characteristics. Table 2 lists the number of companies for each industry group.L Tsui / Journal of Accounting and Economics 24 (1998) 219—237 223 Data on auditor identity and audit fees are obtained from an inspection of annual reports.S.4 Table 3 classifies the sample according to whether the companies are audited by Big 6 or Non-Big 6 audit firms. Table 1 presents a summary of the sample selection process. MKTBKASS and PPE) Number of sampling frame firms qualifying"418 Screen for low growth firmsb Requirements Firm has a composite factor score in the bottom quartile Number of sampling frame firms qualifying"105 Screen for hypothesis subsample Requirements Firm has non-missing values for all the variables Firm is audited by Big 6 audit firms Number of firms qualifying for testing hypothesis"46 !Growth is the composite factor score obtained from common factor analysis using the following three proxies: (i) MKTBKEQ"total market value of shares outstanding divided by total book value of common equity. and (iii) PPE"gross plant. MKTBKASS and PPE. Gul. . 4 Following the reasoning of Francis and Stokes (1986). property and equipment divided by market value of the firm. J. No financial institutions are included. (ii) MKTBKASS"(total assets!total common equity#total value of shares outstanding) divided by total assets.F. "Low growth firms are those in the bottom quartile calculated on the basis of composite factor score obtained from common factor analysis using MKTBKEQ. 46 firms audited by Big 6 audit firms are available for testing the hypothesis.A.

2. " Consolidated enterprises include companies with principal activities in a combination of industry groups such as retail. Table 3 Distribution of 1993 sample firms! audited by Big 6 and Non-Big 6 and by industry Industry Utilities Properties Consolidated enterprises Industrials Hotels Others Missing information Total Total sample Hypothesis sample Big 6 Non-Big 6 Big 6 10 52 119 134 13 6 334 0 334 1 29 26 23 2 3 84 31 115 0 17 17 7 4 1 46 0 46 449 46 !Following Francis and Stokes (1986). 3.S. Gul. 1980. as in prior studies. data for financial institutions are dropped from the analysis. 1984.A. In this model. while long-term and short-term capital structure is represented by the debt to total . manufacturing and properties. Craswell et al. Tsui / Journal of Accounting and Economics 24 (1998) 219—237 Table 2 Distribution of 1993 sample firms by industry Total sample Growth sampling frame Sampling frame for hypothesis 11 84 157 172 15 10 11 82 143 159 15 8 0 17 17 7 4 1 449 418 46 Industry! Utilities Properties Consolidated enterprises" Industrials# Hotels Others !Following Francis and Stokes (1986). J. a number of control variables that are normally included in audit fee models are used (Simunic.L. 1995).224 F.. data for financial institutions are dropped from the analysis. Research design An OLS regression model is estimated to test the hypothesis. Francis. #Industrials include manufacturing or textile companies. Auditee size is measured by the natural log of total assets (SIZE).

3. property and equipment can also characterize assets-in-place. 1995) and are robust across different samples. The higher the ratio. the lower the ratio of assets-in-place to the firm value and the greater the value of growth opportunities.3. Growth opportunities There is no consensus on the most reliable proxy for growth. Gaver and Gaver.1. 1991. In order to control for possible client industry effects.. Asset mix is measured by the ratio of current assets to total assets (CURRENT).. J. property and equipment to the market value of the firm (PPE) Skinner (1993) suggests that past investments in gross plant. 3. the greater the value of growth opportunities. and the dependent variable is the natural log of total audit fees. The ratio of the market value of equity to the book value of equity (MKTBKEQ) This proxy is used because the difference between the market value and the book value of equity incorporates the value of the firm’s future investment opportunities. Three widely used proxies are employed in this study (Chung and Charoenwong. time periods and countries. The higher the ratio. Variable measurement The experimental variables of interest are FCF and FCF/debt interaction. To control off-peak pricing of audit services. 1993. 3. indicator variables for different industries are also included. the higher the assets-in-place and the lower the growth opportunities. and organizational complexity is measured in terms of the number of directly owned subsidiaries (SUB) and the percentage of subsidiaries incorporated outside Hong Kong (FOREIGN). Finally. 2.A.g. . The ratio of the market value of assets to the book value of assets (MKTBKASS) The higher the ratio. Factor analysis is conducted on the three proxies to arrive at a composite factor score (see Gaver and Gaver (1993) for an example of this procedure). an indicator variable (YE) is used (1 for non-December 31 year end and 0 otherwise). These variables have good explanatory power in the models (e. Gul. The hypothesis is tested by including an interaction term for FCF and debt in the model. a composite growth opportunities factor score is calculated and used to identify these firms. The ratio of gross plant. audit risk is measured in terms of the return on assets (ROA). Craswell et al.F.3.L Tsui / Journal of Accounting and Economics 24 (1998) 219—237 225 assets ratio (DE) and the quick ratio (QUICK) respectively. The three proxies are: 1. Skinner.S. 1993). Since the hypothesis is tested with low growth firms.

we also classify low growth firms on the basis of the individual measures.061 Panel B: Eigenvalues of the reduced correlation matrix of three growth measures MKTBKEQ" MKTBKASS PPE 1. To Table 4 Statistics related to common factor analysis of three measures of growth opportunities for 418 firms for 1993 Panel A: Estimated communalities of three growth measures! MKTBKEQ MKTBKASS 0.L. Common factor analysis for growth The results of the factor analysis are presented in Table 4. !Growth is the composite factor score obtained from common factor analysis using the following three proxies: (i) MKTBKEQ"total market value of shares outstanding divided by total book value of common equity.2.S. 5 Communalities are squared multiple correlations obtained from regressing each of the growth proxies on the other three measures. 1993).251*** ***"p(0. (1991). the literature provides little or no guidance on the measures for FCF as defined by Jensen (1986).6 3. this one common factor explains the intercorrelations among the individual measures.3. i. J.740 PPE 0. Gaver and Gaver.5 Panel B presents the eigenvalues of the reduced correlation matrix of the three growth measures.3. Tsui / Journal of Accounting and Economics 24 (1998) 219—237 3. Due to missing values of either one or more of the growth proxies from the sampling frame of 449 firm observations. Panel A shows the estimated communalities for each of the three growth measures. which have been used extensively as proxies for growth (Smith and Watts. 6 Since the estimated communality for PPE is rather low. and run separate regressions for each proxy to determine if the results are different. 1992. and (iii) PPE"gross plant.658 0.e. The common factor with an eigenvalue of 1. Free cash flow Unfortunately.970*** 0. as pointed out by Lang et al. only 418 are included for factor analysis.658 is significantly positively correlated with MKTBKEQ and MKTBKASS and negatively correlated with PPE.022 !0.A. . property and equipment divided by market value of the firm.001. and Panel C presents the correlations between the common factor and the three measures of growth.748 0. MKTBKEQ and MKTBKASS. Gul.957*** !0. (ii) MKTBKASS"(total assets!total common equity#total value of shares outstanding) divided by total assets.3.226 F.130 Panel C: Correlations between the common factor and three growth measures MKTBKEQ MKTBKASS PPE 0. " Harman (1976) and Cattrell (1966) suggest that if the first eigenvalue alone exceeds the sum of the three communalities.

3. However. ORDIV is the total dividend on ordinary shares. TAX is the total taxes. in combination with low growth. Model specification To test the hypothesis. INC is the operating income before depreciation.S. It should be noted that these measures of FCF by themselves do not provide a measure of the availability of positive NPV projects. 3.5. Control variables SIZE DE " natural log of total assets " book value of long-term debt divided by total assets . where. Such free cash flow definition is normalized by either the total book value of equity or total assets in the previous year. Gul.L Tsui / Journal of Accounting and Economics 24 (1998) 219—237 227 date. (1991). BEQ is the total book value of equity in previous year and BA is the total assets in previous year. several proxies have appeared in finance literature and we adopt two of the most widely used free cash flow definitions. PREDIV is the total dividend on preferred shares. J. Descriptive statistics Table 5 presents descriptive statistics for the experimental. preferred dividends. Lehn and Poulsen (1989) define FCF as the operating income before depreciation minus taxes. those used by Lehn and Poulsen (1989) and Lang et al.and long-term debt. they suggest the existence of cash flow in excess of that required to fund positive NPV projects. FCFBA"(INC!TAX!INTEXP!PREDIV!ORDIV)/BA. The total audit fees and total assets in millions of Hong Kong dollars are also given in Table 5 (see page 228). interest expenses. INTEXP is the gross interest expenses on short.F. The two measures of free cash flow used are defined as follows: FCFBEQ"(INC!TAX!INTEXP!PREDIV!ORDIV)/BEQ. and ordinary dividends. control and dependent variables in this study.4.A. firms with bottom quartile of growth factor scores are analyzed using the following OLS regression model: LAF"b #b SIZE#b DE#b CURRENT#b QUICK 0 1 2 3 4 #b YE#b SUB#b FOREIGN#b ROA 5 6 7 8 #b PROP#b CONSOL#b INDUS 9 10 11 #b HOTEL#b FCF#b FCF*DE 12 13 14 where LAF is the natural log of total audit fees.

J.408 15.370 1.113 0. INC"operating income before depreciation TAX"total taxes INTEXP"gross interest expenses on short. 0"31/12 fiscal year end.257 0. Gul.840 100 2.055 2.718 112 0.866 0.217 !0.958 0.901 0.963 8.387 4.039 2.710 0.540 Range !0.L.166 0.and long-term debt PREDIV"total dividend on preferred shares ORDIV"total dividend on ordinary shares BEQ"total book value of equity in previous year BA"total assets in previous year GROWTH"composite factor score obtained from common factor analysis using the following three proxies.990 59475 0.066 0.S. 1"non-31/12 fiscal year end SUB"square root of number of directly owned subsidiaries FOREIGN"percentage of subsidiaries incorporated in countries other than Hong Kong ROA"profit before interest and tax divided by total assets FCFBEQ"(INC!TAX!INTEXP!PREDIV!ORDIV)/BEQ FCFBA"(INC!TAX!INTEXP!PREDIV!ORDIV)/BA where.281 1.615 0.228 F.113 0.784 0.389 2.756 !0.934 6754 0.005 7.766 15.744 0.116 !0.716 2.010 !1.60 0.A.012 !0. .664 1.165 0.366 1.646 0.547 0.111 0.218 1.79 0.338 11412 0.150 2.914 5. property and equipment divided by market value of the firm.7% 5.118 0.576 0. Tsui / Journal of Accounting and Economics 24 (1998) 219—237 Table 5 Descriptive statistics of all variables for 1993 sample used to test the hypothesis (N"46) Variable Mean Std Dev LAF AF (HK$M) SIZE TA (HK$M) DE CURRENT QUICK YE"1 SUB FOREIGN ROA FCFBEQ FCFBA GROWTH MKTBKEQ MKTBKASS PPE 0.135 0.146 !0.515 0.949 0.216 18. MKTBKEQ"total market value of shares outstanding divided by total book value of common equity MKTBKASS"(total assets!total common equity#total value of shares outstanding) divided by total assets PPE"gross plant.380 71.055 2.500 11.170 LAF"natural log of total audit fees AF"total audit fees (HK$M) SIZE"natural log of total assets TA"total assets (HK$M) DE"book value of long-term debt divided by total assets CURRENT"ratio of current assets to total assets QUICK"ratio of current assets less inventory to current liabilities YE"dummy variable.897 0.00008 0.900 10.

it is not possible to restrict the study to a single industry to eliminate possible inter-industry effects. PREDIV is the total dividend on preferred shares. 0"31/12 fiscal year end. INC is the operating income before depreciation. Indicator variables for industries are introduced to control for inter-industry effects. where. INTEXP is the gross interest expenses on short. Results and discussion The results reported in Panel A of Table 6 show the association between FCF and audit fees is positive. significant. BEQ is the total book value of equity in previous year. As a control sample.and long-term debt.7A significant interaction term (FCF*DE) is interpreted to mean that the effect of FCF on the dependent variable depends on debt. J.F. . FCF*DE is the interaction between FCF and DE. 0"others HOTEL " dummy variable. 4. TAX is the total taxes. a similar regression is run for the high growth subsample (N"46)8 selected on the basis of the top quartile of growth factor scores. ORDIV is the total dividend on ordinary shares. BA is the total assets in previous year. 1"properties.A. FCFBEQ"(INC!TAX!INTEXP!PREDIV!ORDIV)/BEQ. 8 After deleting for missing observations from the top quartile subsample (N"105). and in the predicted direction using either 7 Due to the small sample size. 0"others CONSOL " dummy variable. 1"non-31/12 fiscal year end SUB " square root of number of directly owned subsidiaries FOREIGN " percentage of subsidiaries incorporated in countries other than Hong Kong ROA " profit before interest and tax divided by total assets PROP " dummy variable. 1"consolidated enterprises. 1"industrials.S. 1"hotels. FCFBA"(INC!TAX!INTEXP!PREDIV!ORDIV)/BA. Gul. A negative interaction coefficient is predicted since the positive association between FCF and audit fees is expected to decrease at higher levels of debt.L Tsui / Journal of Accounting and Economics 24 (1998) 219—237 229 CURRENT " ratio of current assets to total assets QUICK " ratio of current assets less inventory to current liabilities YE " dummy variable. there are 46 firms audited by Big 6 and 10 audited by Non-Big 6 audit firms. 0"others INDUS " dummy variable. 0"others Experimenqtal variables FCF is the two measures of free cash flow.

340 (0.691** (2.A.614) 8.199) 0.025) !0.108) !0.519) 0. J.L.703) 1.01 2.071 (0.412*** 79.05 Model 1 Model 2 !4.171) !0.230 F.101*** 80.113*** (2.10 **p(0.504) !0.445* (!1.478*** (6.211 (0.457) 0.071*** (2.780) 0.181) 0.406) !24.003 (!0.144) 9.347*** (!5.095** (2.320) !0. Tsui / Journal of Accounting and Economics 24 (1998) 219—237 Table 6 Regression results for low growth (bottom quartile) firms for 1993 (N"46) (figures in parentheses represent t-values) Variables Predicted sign Panel A: Full model with industry control INTERCEPT Control variables SIZE # DE # CURRENT # QUICK ! YE ! SUB # FOREIGN # ROA ! PROP ? CONSOL ? INDUS ? HOTEL ? Experimental variables FCFBEQ # FCFBEQ*DE ! FCFBA # FCFBA*DE ! F value R2 *p(0.012*** (!3.326 (0.43% .038 (!0.097 (0.028 (0.027 (0.16% ***p(0.641 (1.092** (2.088 (!0.083) 1.413 (0.062) 0.561) 0.535) 0.187 (0.534) 0.364) !0.477*** (6.226) 0.425*** (!6.003 (!0.687) !0.421) 0.098 (1.818) 0.S.739) !8.156*** (2. Gul.024 (!0.761) 0.054) 0.700) 0.469*** (!2.909) !4.492 (!1.150) 1.

.

Except for the variables FOREIGN and QUICK. The results show that the partition of the sample into high and low growth opportunities is not sensitive to the exclusion of this growth proxy in the common factor.g.10 The results show both the main effects of FCF and the interactions between debt and FCF are significant (p(0. two identical regressions are run for low growth firms. 10 These additional analyses are prompted by a query raised by the referee regarding the low estimated communality for the PPE measure. As expected. Craswell et al..L. YE. the ratios of current assets to total assets are both significant and in the correct direction. but insignificant. . The interaction terms comprising the first order interaction between FCFBEQ and debt and FCFBA and debt. J. 1995).and long-term debt PREDIV"total dividend on preferred shares ORDIV"total dividend on ordinary shares BEQ"total book value of equity in previous year BA"total assets in previous year FCFBEQ*DE"interaction between FCFBEQ and DE FCFBA*DE"interaction between FCFBA and DE.S. respectively. The significance levels of the other variables are qualitatively similar to the results reported in Panel A of Table 6. are also significant and in the predicted direction. none of the interactions nor the main effects of FCF are significant.9 As an additional check on the use of the growth proxy. and the results for the experimental variables are similar. the other control variables are all in the expected direction.01) and also in the predicted direction. Some of the control variables are significant and consistent with prior studies (e. 9 These control variables are not significant in the regression of the full model as shown in Panel A of Table 6. For example.. Panel B of Table 6 reports the results for a reduced model without the control variables for industries.232 F. QUICK. The regression results for the high growth subsample firms classified on the basis of growth factor scores are reported in Table 7.A. of the two FCF variables. INC"operating income before depreciation TAX"total taxes INTEXP"gross interest expenses on short. Gul. each classified on the basis of the bottom quartile of individual growth measures MKTBKEQ and MKTBKASS respectively. FOREIGN and ROA. Tsui / Journal of Accounting and Economics 24 (1998) 219—237 Table 6 (continued) FCFBEQ"(INC!TAX!INTEXP!PREDIV!ORDIV)/BEQ FCFBA"(INC!TAX!INTEXP!PREDIV!ORDIV)/BA where. Similar significant results are also obtained for the variables SIZE and SUB.

525) 0.290) !7.247 (0.42% .408** (!2.281) 0.429 (0.220) 0.341) 0.636) 0.10 **p(0.989) 0.588) 0.330) 0. J.531 (0.07% ***p(0.639) !0.L Tsui / Journal of Accounting and Economics 24 (1998) 219—237 233 Table 7 Regression results for high growth (top quartile) firms for 1993 (N"46) (figures in parentheses represent t-values) Variables Predicted Sign INTERCEPT Control variables SIZE # DE # CURRENT # QUICK ! YE ! SUB # FOREIGN # ROA ! PROP ? CONSOL ? INDUS ? HOTEL ? Experimental variables FCFBEQ # FCFBEQ*DE ! FCFBA # FCFBA*DE ! F value R2 *p(0.680) !2.696) !0.606) 3.05 Model 1 Model 2 !1.843) 0.927) !1.01 !1.602 (!0.356) 0.683) !5.331) 0.127 (0.884) 0.710) 0.948) !0.287*** (2.248** (2.A.117) 0.302 (0.129* (1.199) 0.154 (0.S.464) 0.676) !0.075 (!0.025) 4. Gul.258 (0.056 (0.008*** 64.603 (1.015 (1.090* (1.341) 0.074) 1.046 (!0.534) 0.233 (!1.F.001 (0.069 (0.534 (!1.098* (1.248* (!1.363 (0.920 (!1.052 (!1.653 (1.781*** 63.144) 0.424 (0.025 (!0.

the small sample size (N"20) precludes such an analysis. 12 The supply-side argument suggests that similar regression results should also be obtained for Non-Big 6 auditees. a full regression with all the variables including an indicator variable for Big 6 (N"46) and Non-Big 6 (N"20) auditees yielded similar significant results for FCF and the interaction between FCF and debt (results available from the authors).A. 1"industrials. 0"others CONSOL"dummy variable. auditors supply12 more audit effort and charge higher audit fees in 11 Further analyses are performed to compare the mean scores of audit fees for the low and high FCF groups with high and low debt.and long-term debt PREDIV"total dividend on preferred shares ORDIV"total dividend on ordinary shares BEQ"total book value of equity in previous year BA"total assets in previous year FCFBEQ*DE"interaction between FCFBEQ and DE FCFBA*DE"interaction between FCFBA and DE The positive coefficients for FCF in the models in both Panels A and B of Table 6 suggest FCF is positively related to fees. J. Gul. mean audit fees are higher for firms with high FCF and low debt than firms with high FCF and high debt (results not reported here are available from the authors). . 1"properties.234 F. 0"others HOTEL"dummy variable. 1"consolidated enterprises. However. As expected. The interaction parameter reflects the extent to which fees are affected by FCF and debt. 1"hotels. 0"others FCFBEQ"(INC!TAX!INTEXP!PREDIV!ORDIV)/BEQ FCFBA"(INC!TAX!INTEXP!PREDIV!ORDIV)/BA where. This implies that 13 14 the positive relationship between FCF and audit fees progressively reduces at higher levels of debt. INC"operating income before depreciation TAX"total taxes INTEXP"gross interest expenses on short. 0"others INDUS"dummy variable.L. 0"31/12 fiscal year end. A differentiation of the equation with respect to FCF provides b -b (Debt).S.11 The results are consistent with the argument that. 1"non-31/12 fiscal year end SUB"square root of number of directly owned subsidiaries FOREIGN"percentage of subsidiaries incorporated in countries other than Hong Kong ROA"profit before interest and tax divided by total assets PROP"dummy variable. SIZE"natural log of total assets DE"book value of long-term debt divided by total assets CURRENT"ratio of current assets to total assets QUICK"ratio of current assets less inventory to current liabilities YE"dummy variable. Tsui / Journal of Accounting and Economics 24 (1998) 219—237 Table 7 (continued) The above asterisks indicate significance levels in a one-tail or two-tail t-test (as appropriate). ceteris paribus. Unfortunately.

S. J. Our test. the positive association between FCF and audit fees decreases. Greg Whittred. the Hong Kong University of Science and Technology and University of Otago workshops.13 The higher fees could also reflect a premium for higher risk of litigation (Simunic and Stein. It is also possible that firms with high FCF and low debt have entrenched management (Shleifer and Vishny.L Tsui / Journal of Accounting and Economics 24 (1998) 219—237 235 response to the higher inherent risk associated with higher levels of FCF (combined with low growth opportunities). Eric Noreen. Berkeley. therefore. Jere Francis. 5. Acknowledgements We acknowledge comments from Dan Simunic (the referee). The results show the association between FCF and audit fees is dependent on debt. p. the 1996 Hong Kong Academic Conference and AAANZ Conference. 1989).A. The significant and positive main effects of FCF and the negative sign of the interaction terms suggest that at progressively higher levels of debt. supplying lower levels of audit effort (and lower audit fees) than auditors of high FCF/low debt firms. We also acknowledge the financial assistance provided by a Hong Kong RGC grant. 1989. Gul. Conclusion This study investigates the effect of FCF and debt on audit fees. the participants at the University of California. 1996). The higher fees could represent high perquisites such as cross-subsidization of other dealings managers have with the auditors. . The above possibilities suggest room for further research. Ross Watts (the editor). Theodore Mock.132). does not unambiguously preclude other explanations such as the demand for higher quality audits to mitigate the agency costs of FCF. 13 These could be in the form of manager-specific implicit contracts (see Shleifer and Vishny.F. They are also consistent with auditors of high FCF/high debt firms assessing lower levels of inherent risk and. Another possibility is that auditors charge higher fees since they are aware that firms have the ability to pay more because of the availability of discretionary resources as a result of high FCF and low growth opportunities. however.

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