Does Auditor Quality and Tenure Matter To Investors? Evidence From The Bond Market

Journal of Accounting Research
Vol. 42 No. 4 September 2004

Printed in U.S.A.
Does Auditor Quality and Tenure

Matter to Investors? Evidence
from the Bond Market
S A T T A R A . M A N S I , ∗ W I L L I A M F. M A X W E L L , †
A N D D A R I U S P. M I L L E R ‡
Received 22 April 2003; accepted 7 April 2004
ABSTRACT
We examine the relation between auditor characteristics (quality and

tenure) and the cost of debt financing. Consistent with the hypothesis that
audit characteristics are important to the capital markets, we find that (1)
auditor quality and tenure are negatively and significantly related to the cost
of debt financing, (2) the relation between auditor characteristics and the cost
of debt is most pronounced in firms with debt that is noninvestment grade,
and (3) both the insurance and information role of audits are economically
significant to the cost of debt. Overall, our results suggest that, through their
dual roles of providing information and insurance, auditor quality and tenure
matter to capital market participants.
∗ Virginia Tech; †University of Arizona; ‡Indiana University. We thank Abbie Smith (the ed-
itor) and an anonymous referee for detailed comments and suggestions. We also thank Ashiq
Ali, Daniel Beneish, Bill Baber, Mark DeFond, Dan Dhaliwal, Jerome Fons, Aloke Ghosh, Cristi
Gleason, Roberto Gutierrez, Lillian Mills, Linda Myers, Kaye Newberry, David Reeb, William
Waller, and seminar participants at the University of Arizona and Arizona State University for
suggestions that have improved the quality of the paper. Special thanks to Mark Lang, Russell
Lundholm, and Linda Myers for providing their Association of Investment Management and
Research (AIMR) disclosure data and Lehman Brothers for providing bond data. Miller ac-
knowledges financial support from a DaimlerChrysler Faculty Fellowship. Mansi acknowledges
receipt of partial funding from Virginia Tech’s summer support. All remaining errors are the
responsibility of the authors.
755
Copyright
C , University of Chicago on behalf of the Institute of Professional Accounting, 2004
756 S. A. MANSI, W. F. MAXWELL, AND D. P. MILLER
1. Introduction
The potential conflicts of interests among owners, managers, and other
security holders create an environment in which an outside auditor may
contribute significant value to investors. In fact, recent high-profile mis-
statements and fraud by large corporations have brought increased scrutiny
of the role that public firm auditors play in financial markets.1 In this article
we investigate the economic impact of auditor choice and tenure on bond
investors’ required rate of return. We provide evidence on the following
questions: Do auditor characteristics, proxied by the use of a Big 6 auditor
or the length of the auditor-client relationship, affect the price investors are
willing to pay for a firm’s debt securities? Are the economic consequences of
audits different for riskier firms? The answers to these questions present new
insights into the value investors place on audit characteristics and provide
a market-based assessment of the potential impact of mandatory auditor
rotation.
The literature on auditor characteristics suggests that auditors provide
two valuable roles to capital market participants: an information role and
an insurance role. Auditors provide independent verification of manager-
prepared financial statements and can discover and report breaches in
a client’s accounting system (Watts and Zimmerman [1981], DeAngelo
[1981]). As such, audit quality contributes to the credibility of financial
disclosure, and to the extent contracting with the firm is made less costly,
it reduces the cost of capital (Jensen and Meckling [1976], Watts and
Zimmerman [1986], Ball [2001]). In addition, because investors often use
audited financial statements as the basis for asset-allocation decisions, se-
curities laws provide recourse for the investor against the auditor. In this
way, auditors provide investors with a means to indemnify losses (Kellogg
[1984], Wallace [1987], Chow, Kramer, and Wallace [1988], Stice [1991],
Dye [1993]). Consistent with this role, recent trends indicate a marked in-
crease in securities litigation against auditors (Palmrose [1991]). Taken to-
gether, the auditors’ dual characterization, as both insurance provider and
information intermediary, suggests that audits provide value to the capital
markets.
However, the empirical evidence that links audits to investors is limited
and mixed. For example, the insurance role of audits has proven notoriously
difficult to separate from their information role, with the evidence concen-
trated in the case study of the Laventhol and Horwath (LH) bankruptcy
(Menon and Williams [1994], Baber, Kumar, and Verghese [1995]) and
the initial public offering (IPO) sample of Willenborg [1999]. Menon and
Williams [1994] find that the market does not react significantly to audi-
tor reappointments after the LH bankruptcy, which is consistent with an
1 For example, the Sarbanes-Oxley Bill, passed in July 2002, limits the consulting services
provided by audit firms and requires those having primary responsibility for the audit within an
audit firm to be rotated every five years. It also directs the General Accounting Office (GAO)
to study the potential effects of requiring mandatory rotation of audit firms.
AUDITOR QUALITY AND TENURE 757
insurance effect. In contrast, Baber, Kumar, and Verghese [1994] state in

their study of the LH bankruptcy that “we cannot discriminate between
them,” referring to the insurance and information effects. For start-up IPOs,
Willenborg [1999] finds that auditor size is negatively related to underpric-
ing, evidence that is consistent with an insurance effect for these firms,
assuming that in start-up IPOs the information component of audit quality
is not important.
Furthermore, research that suggests the information role of audits mat-
ters to investors remains scarce. For example, studies that examine the in-
formation role of audits (proxied by market reaction to auditor switches)
find little evidence that changing auditors affects stock prices (Nichols and
Smith [1983], Johnson and Lys [1990], Klock [1994]). In addition, studies
of audit qualifications are mixed on whether audits provide new information
to investors (Dodd et al. [1984], Dodd, Holthausen, and Leftwich [1986],
Dopuch, Holthausen, and Leftwich [1987], McKeown and Willenborg,
[2000], Weber and Willenborg [2003]).2 Prior research that finds the in-
formation role of audits matters to investors is generally limited to samples
of IPO firms and to studies of earnings response coefficients. The theoretical
analysis of Titman and Trueman [1986] and Datar, Feltham, and Hughes
[1991] argues a link between audits and IPO underpricing. Empirically,
Balvers, McDonald, and Miller [1988] and Beatty [1989] show that em-
ploying a large auditor lowers IPO underpricing, whereas Teoh and Wong
[1993] find that the earnings response coefficient is larger for firms with Big
8 auditors. However, because the IPO market is relatively stylized in the com-
position of firms, the number of (initial) investors, the process with which
firms enter the market, and the nature of the information uncertainty, it re-
mains an open question how audit characteristics affect investors outside of
the first-day returns to IPOs.3 In sum, the evidence linking audits to security
prices is largely limited to IPO underpricing studies and case-level analyses.
As noted in Healy and Palepu [2001], there is a “paucity of evidence on the
value of auditor opinions to investors.”
2 Alternatively, studies on auditor resignations, which typically occur for firms that are in
poor financial health, show that resignations have a negative impact on stock prices (e.g., see
Beneish, Hopkins, and Jansen [2001], Shu [2000], DeFond, Ettredge, and Smith [1997], Wells
and Loudder [1997]).
3 The IPO literature suggests that the process of going public and the associated under-
pricing phenomenon are fairly stylized events. For example, IPO firms are typically younger
and smaller than the majority of publicly traded firms. In addition, IPOs can be relatively rare
events or can occur in large waves that are concentrated in a particular industry. Moreover, IPO
pricing can often represent the pricing of a relatively limited set of investors in that the initial
allocation is channeled to a select group from the underwriter’s client list. Perhaps the most
unique aspect of the IPO market is the large average underpricing, which has proven difficult
to explain empirically using either asymmetric information or legal liability arguments. Fur-
thermore, the information component of the first-day return is likely different in the primary
market (i.e., business model viability, entrance strategy decision) than in the secondary market
(i.e., earnings ability of the continued firm operation). For more information on these issues,
see the survey by Ritter and Welch [2002] and citations contained within.
We examine the role of auditors from an alternative perspective, namely,

that of bondholders. The public bond market has several key features that
provide a natural setting to examine the economic impact of auditing. First,
public debt securities represent a significant portion of the typical corpo-
ration’s value, and the public debt market represents one of the largest
securities markets in the world. Nevertheless, existing research largely ig-
nores how audits affect the pricing of public corporate bonds. For revolving
bank loans of privately held companies, Blackwell, Noland, and Winters
[1998] show that firms who purchase audits pay lower rates than those that
do not. For firms in their early public years, Pittman and Fortin [2004] in
a contemporaneous paper examine how auditor choice affects debt financ-
ing and find, similar to our results, that the use of a large auditor lowers
a firm’s interest cost. However, their paper focuses only on aggregate an-
nual interest expense rather than market bond prices to approximate debt
financing and it leaves open the question of whether the results are due to
the information or insurance role of auditor size.4 In contrast, our analysis
focuses directly on bond yields for a broad universe of firms with public
corporate debt to examine the impact of audit quality (tenure in addition
to size) on the cost of debt capital. By controlling for the role of other infor-
mation providers in the debt capital markets, we are also able to distinguish
between the information and insurance effects of auditor choice.
Second, the pricing of bonds is relatively well defined as compared with
equity pricing (bonds, in general, have precise payouts and they are less sub-
ject to criticism that the results might be driven by misspecification of the
equilibrium asset pricing model). In contrast, given the imprecision of pric-
ing stocks, research examining auditor quality in the public equity market
is generally forced to focus on stock returns around auditor changes. Audi-
tor changes are, however, often associated with other confounding events
that can influence stock prices, which can make clean inferences difficult.
Third, the information environment in the bond market is characterized
by numerous information intermediaries (such as credit ratings agencies
and bank relationships) who have access to insider information when per-
forming their independent appraisals. The information contained in these
competing sources of independent information is likely to contain or sub-
sume the information contained in the audit report. Therefore, controlling
for information intermediaries such as credit ratings, bank relationships,
and analyst following allows us to isolate the impact of the insurance effect.
Furthermore, orthogonalizing these controls with respect to auditor size
and tenure also allows us to measure the total (insurance plus information)
4 Pittman and Fortin’s [2004] coefficient estimates for auditor size are approximately two to
three times larger than the estimates in this article. This may in part be due to the difference in
the choice of the dependent variable. Pittman and Fortin use interest expense divided by the
average short- and long-term debt during the year, which is a historical measurement indicating
the cost of debt at issuance and does not necessarily reflect the firm’s current cost of debt. It
also does not account for the dynamic nature of debt financing as both the amount and type
of financing can fluctuate over the year.
impact of audits on investors. For these reasons, the bond market provides
a unique laboratory to examine the impact of auditor characteristics on the
cost of capital and to potentially differentiate and measure the insurance
and information effects of audits separately.
To address these questions, we focus on auditor quality (size) and auditor
tenure. Both the size of the audit firm and the length of the audit-client
relationship are linked to the information and insurance roles of audits.
For example, Watts and Zimmerman [1981] predict that large audit firms
supply a higher quality audit because of greater monitoring ability, whereas
DeAngelo [1981] argues that larger audit firms provide higher quality audits
because they have “more to lose” if they fail to report breaches in a client’s
records. Furthermore, recent studies suggest that the length of the auditor-
client relationship provides information on the quality of the audit (the au-
ditor expertise hypothesis). For example, longer auditor tenure may lessen
the information asymmetry between the auditor and the client, which in
turn could lead to better audit quality (Solomon, Shields, and Whittington
[1999]). Similarly, Geiger and Raghunandan [2002] argue that auditor-
client information asymmetry is high in the earlier years of auditor tenure.
Ghosh and Moon [2002] and Myers, Myers, and Omer [2003] find that
earnings management through discretionary accruals and special items de-
creases as audit tenure increases. Therefore, both the size of the audit firm
and the length of the audit-client relationship are related to the quality of
the audit, and hence these variables should proxy for the information con-
tent of the audit. Furthermore, large audit firms have deep pockets and
therefore provide investors with greater insurance in the event of securities
litigation (Dye [1993]). Similarly, audit tenure and legal liability are linked
to the extent that greater temporal exposure may strengthen the assump-
tion that the auditor is complicit in some way. Therefore, auditor size and
tenure are also related to the insurance characterization of audits because
bondholders have similar recourse to litigation as equity investors.5
Next, we test whether the economic consequences of audits are larger for
riskier firms. Prior research shows that firm risk influences firm, auditor, and
investor behavior. Poorly performing firms are more likely to make more ag-
gressive reporting choices than better performing firms (Christensen, Hoyt,
and Paterson [1999], Beneish [1997], Sweeney [1994], Petroni [1992]). Shu
[2000] and Carcello and Palmrose [1994] find that the probability of auditor
litigation increases with firm risk. In addition, studies suggest that investors
demand a premium for bearing risk when there is an information asym-
metry between managers and outside investors (Barry and Brown [1985],
Merton [1987]). Therefore, we expect the value of a high-quality auditor
with deep pockets to increase with firm risk.
Using a sample of 8,529 firm-year observations from 1974 to 1998, we
find a negative and significant relation between auditor quality and tenure,
and the return investors require on corporate bonds. Segmenting the data
5 See Davidson et al. [1987].

into investment-grade and noninvestment-grade debt firms, we find that

the preceding relation holds in both samples although it is more economi-
cally significant for noninvestment-grade firms (the coefficients for auditor
characteristics are approximately twice as large for non-investment-grade as
for investment-grade firms). When we control for the information effects
of audits, we find that, in general, the coefficient on auditor size is lower
but remains statistically and economically significant for investment and
noninvestment-grade firms. The effect of auditor tenure, after controlling
for the information effect, also decreases and remains significant for non-
investment-grade firms. Therefore, our results suggest that investors value
the insurance role of auditors in addition to their information role. Further-
more, the finding that investors require lower rates of return as the length
of tenure increases provides direct evidence on the value investors attach to
audit tenure and suggest that mandatory auditor rotation may not be uni-
formly beneficial and could be viewed negatively by the capital market for
riskier firms. We confirm our results using several tests for serial correlation,
potential endogeneity, and correlated omitted variables. Overall, the results
are consistent with Dye’s [1993] dual characterization that audits provide
both an insurance role and an information role, and that they add value to
capital market participants.
The remainder of the paper is organized as follows. Section 2 describes
the data and provides sample statistics. Section 3 assesses the impact of au-
ditor quality and tenure on the investors’ required rate of return. Section 4
provides a comprehensive multivariate analysis on the relation between au-
ditor choice (proxied by quality and tenure) and investors’ required rate of
return. Section 5 concludes the paper.
2. Data Description
2.1 SAMPLE
We compile financial and auditor information from the Compustat In-
dustrial database for firms with a fiscal year ending between January 1974
and March 1998. To be included in the sample the firm must have auditor
choice information, audited financial statements, Compustat financial data,
and Center for Research in Security Prices (CRSP) financial information.6
We classify auditors as Big 6 and non–Big 6 firms (Compustat item 149).
Because of mergers during our sample period, the data begin with eight
large auditors, which is reduced to six at the end of our sample period.
These include: (1) Arthur Andersen; (2) Arthur Young (merged with Ernst
& Whinney); (3) Coopers & Lybrand; (4) Ernst & Young; (5) Deloitte &
Touche; (6) KPMG Peat, Marwick, Main; (7) PriceWaterhouse; (8) Touche
Ross; and all merged entities. These are the largest firms and, as such, consti-
tute a proxy for audit quality (e.g., DeAngelo [1981]). All other accounting
6 We include Firm Age as a variable, which requires CRSP data. This reduces the sample size
from a prior version of the paper, but it has no effect on the overall empirical findings.
firms are considered small firms (we refer to Big 6 and non–Big 6 auditors
as large and small auditors, respectively).
We measure auditor quality using a binary variable that assumes a value
of 1 when the firm has a small auditor, and 0 otherwise. Auditor tenure is
measured as the length of the auditor-client relationship. Because the choice
of auditing firm is unavailable before the firm enters Compustat (e.g., pre-
IPO), tenure is set to one year the first time financial information becomes
available. Information regarding a firm’s auditor begins in Compustat in
1974 (or when the firms enters Compustat), though financial information
is usually backfilled for several years when a firm is added to Compustat
(Banz and Breen [1986]). Therefore, any measure of tenure that relies on
Compustat is potentially downward biased. However, because a firm typically
issues public debt later in its life cycle, our sample is likely less affected by
this potential bias. For example, we find the mean (median) time from the
IPO to the when the firm first enters our database of publicly traded debt
is 16.22 (10.43) years. Furthermore, we find the mean (median) tenure of
a firm when it first enters our sample is 5.05 (3.00) years. Although this
suggests that our sample may suffer from less bias than a study that starts
tracking from the IPO date, we perform an additional robustness test in
section 4.7 by restricting the sample to firms that have at least five years of
tenure data to be included in the sample.
We collect bond-pricing information from the Lehman Brothers Bond
Database (LBBD). The LBBD provides month-end, security-specific infor-
mation on publicly traded corporate debt including bid price, accrued inter-
est, yield to maturity, S&P and Moody’s credit rating, call and put provisions,
and maturity for both investment-grade and noninvestment-grade debt. The
LBBD reports institutional pricing for Treasury debt and corporate bonds
from January 1973 through March 1998. Warga and Welch [1993] find that
the LBBD provides more accurate information than exchange pricing. Al-
though the difficulty with finding accurate bond data is well known, Elton
et al. [2001] analyze the corporate bond pricing in the LBBD and conclude
that it is comparable in accuracy to the CRSP database.7
To analyze the proxies for auditor quality on the rate of return investors re-
quire, we use the dependent variable, Credit Spread, defined as the difference
between the firm’s bond yield to maturity and a matched Treasury security’s
yield to maturity. The firm’s corporate bonds are matched to the closest ac-
tively traded Treasury security based on duration.8 Therefore, Credit Spread
represents the risk premium that investors require to hold the firm’s debt.
We focus on credit spreads rather than yield to maturity to mitigate concerns
about serial correlation and nonstationarity in the sample.
7 The LBBD is used extensively in previous research (e.g, see Blume, Lim, and MacKinlay
[1998], Elton et al. [2001], Anderson, Mansi, and Reeb [2003], Maxwell and Stephens [2003],
Maxwell and Rao [2003]).
8 Similar to Elton et al. [2001], we require Treasury securities to be included in Lehman
Brothers Treasury Indices. Securities in the indices are considered to be the most accurately
priced.
The majority of firms in the sample (54.7%) have a single bond outstand-
ing, and the remaining (45.3%) firms have multiple bonds. To estimate
credit spreads for firms with multiple bonds, the credit spread for each
bond is calculated and then the firm’s credit spread is computed as the
weighted average (based on market values) of the multiple bonds’ credit
spreads.9 Hence, the weighted average firm credit spread (Credit Spread) for
firm k is

J
Credit Spread k = Credit Spread i wi , (1)
i=1
where J is the number of bonds outstanding for firm k and w is the rela-
tive market value weight of bond i to the total market value of bonds out-
standing for firm k. An advantage of this approach is that it mitigates any
model misspecification as multiple observations are taken from the same
firm.
2.2 SAMPLE CHARACTERISTICS

Table 1 provides sample characteristics. The final sample includes 1,305
firms, in which 75 of the firms (6%) have a small auditor at one time
(panel A). Panel B provides firm-year observations over time and by risk cat-
egory (investment-grade and noninvestment-grade debt). The total sample
of firm-year observations is 8,529, with a total of 255 firm-year observations
with small auditors (3%). Using firm-year observations, 64% are investment
grade (of which 2% use small auditors) and 36% are noninvestment grade
(of which 5% use small auditors). The number of firms using small auditors
in our sample has decreased over the years (5%, 4%, and 1% for the 1970s,
1980s, and 1990s, respectively), which is consistent with the findings of Shu
[2000].
Panel C of table 1 provides the number of changes in auditor size by invest-
ment type (full sample, investment grade, and noninvestment grade). There
are 46 auditor size changes, 39 of which are upgrades and 7 of which are
downgrades. Most of the auditor size changes occur in noninvestment-grade
firms. For example, of the upgrades, 28 are for noninvestment-grade firms
and the remaining 11 are for investment-grade firms. There are 7 quality
downgrades (going from a large to a small auditor), 1 for investment grade
and 6 for noninvestment grade. We also find 203 auditor switches within the
Big 6, with the majority (121) in non-investment-grade firms.
Panel D of table 1 provides information regarding the dispersion
across the 12 Fama and French industry categories. These are defined as:
9 We also used a single representative bond for each firm. Elton and Green [1998] find that
the most recently issued bond is the most actively traded and therefore the most liquid of a
firm’s bonds. Thus, if the firm has multiple bond issues, we selected the most recently issued
bond as the representative issue and used this as the firm’s credit spread. We find similar results
using this method to calculate credit spreads.
TABLE 1
Distribution of the Sample (by Type and Industry) over Time
Panel A: Firm-year observations over time
Number of Firms with Percentage of Firms with
Firms in Small Auditor for at Small Auditor for at
Full Sample Least One Year Least One Year
Full sample 1,305 75 5.75%
Panel B: Firm-year observations over time and by risk

Percentage of Firm-
Firm-Year Number of Firm-Years Years with Small
Observations with Small Auditor Auditor
1970s 1,350 70 5.19%
1980s 3,286 146 4.44%
1990s 3,893 39 1.00%
Investment 5,442 92 1.69%
Noninvestment 3,087 163 5.28%
All firms 8,529 255 2.99%
Panel C: Number of changes in auditor quality

Change Full Sample Investment Grade Noninvestment Grade
Upgrade auditor 39 11 28
Downgrade auditor 7 1 6
Switching Big 6 auditors 203 82 121
Panel D: Dispersion of sample among Fama and French 12 industry categories

Sample FF1 FF2 FF3 FF4 FF5 FF6 FF7 FF8 FF9 FF10 FF11 FF12
All firms 10.0% 4.9% 22.6% 6.6% 6.3% 5.3% 5.6% 6.8% 12.4% 4.0% 5.1% 10.6%
Big 6 auditor firms include Arthur Andersen; Arthur Young; Coopers & Lybrand; Ernst & Young;
Deloitte & Touche; KPMG Peat, Marwick, Main; PriceWaterhouse; Touche Ross; and all merged entities.
Investment grade is for S&P ratings of BBB– or greater and Moody’s ratings of Baa3 or greater. “Upgrade
auditor” is defined as those switching from a small to a Big 6 auditor, and “downgrade auditor” is
defined as those switching from a Big 6 to a small auditor. Industry types are identified using Fama and
French classifications (i.e., http://mba.tuck.dartmouth.edu/pages/faculty/ken.french): (1) consumer
nondurables—food, tobacco, textiles, apparel, leather, toys; (2) consumer durables—cars, TVs, furniture,
household appliances; (3) manufacturing—machinery, trucks, planes, office furniture, paper, commercial
printing; (4) energy, oil, gas, and coal extraction and products; (5) chemicals and allied products; (6)
business equipment—computers, software, and electronic equipment; (7) telephone and television
transmission; (8) utilities; (9) shops—wholesale, retail, and some services (laundries, repair shops); (10)
healthcare, medical equipment, and drugs; (11) money and finance; (12) other—everything else.
(1) consumer nondurables, (2) consumer durables, (3) manufacturing, (4)

energy, (5) chemicals and allied products, (6) business equipment, (7) tele-
phone and television transmission, (8) utilities, (9) shops, (10) healthcare,
(11) money and finance, and (12) other. The sample is dispersed across all
industries, with small auditors present in all categories.
Table 2 provides descriptive statistics for the full sample (panel A) and for
firms with small auditors (panel B). For the full sample, the mean spread is
about 247 basis points, with a median of about 153 basis points and a stan-
dard deviation of about 250 basis points. The average firm in the sample
has a BBB credit rating, a leverage ratio of 30%, and a coverage ratio of
7.3 times, and about 63% of the sample has bank debt. The firms are prof-
itable, with a profitability ratio of about 13%, and large, with the median
TABLE 2
Descriptive Statistics
Standard
Variable Mean Median Deviation
Panel A: Full sample (n = 8,529)
Firm Credit Spread 2.47 1.53 2.50
Tenure 8.82 7.00 6.21
Firm Age 26.81 23.10 20.75
Rating 9.52 8.50 4.91
O-Score −0.21 −0.40 2.48
Profitability 0.13 0.14 0.09
Leverage 0.30 0.26 0.20
Coverage 7.31 4.49 37.37
Total Assets ($ millions) 4776.25 1340.92 14904.62
Firm-Level Duration 6.16 6.11 2.12
Percent with Bank Debt 0.63 1.00 0.48
Analysts Following Stock 10.30 8.00 10.00
Panel B: Firms with small auditors (n = 255)
Firm Credit Spread 4.01 3.65 3.09
Tenure 4.96 4.00 3.13
Firm Age 16.57 10.56 17.49
Rating 12.08 14.00 4.94
O-Score 0.21 0.07 2.20
Profitability 0.12 0.12 0.09
Leverage 0.35 0.32 0.20
Coverage 5.04 2.59 11.25
Total Assets ($ millions) 926.69 264.57 1846.55
Firm-Level Duration 5.78 5.75 2.06
Percent with Bank Debt 0.62 1.00 0.49
Analysts Following Stock 4.08 1.00 6.96
The data cover from 1974 through 1998. Credit Spread is calculated as the difference between the
corporate bond yield and its duration-equivalent Treasury yield. For firms with multiple bonds issues, Credit
Spread is calculated as a weighted average of all yields based on each bond’s market value. Tenure is the
number of years of the auditor-client relationship. Firm Age is the natural log of the time from the firm’s
initial public offering (IPO) to the observation date as identified by the Center for Research in Security
Prices (CRSP). Rating is the average of Moody’s and S&P ratings, calculated using a numerical conversion
process (1 if the firm is rated AAA, and as the bond rating declines the numerical rating increases by 1).
O-Score is the Ohlson [1980] measure of default risk. Profitability is earnings before interest and taxes (EBIT)
(Compustat item 13 minus item 14) divided by total assets (Compustat item 6). Leverage is long-term debt
(Compustat item 9) divided by total assets (Compustat item 6). Coverage is EBIT (Compustat item 13 minus
item 14) divided by interest payments (Compustat item 15). Duration is the weighted duration of the
firm’s bonds or the duration of the representative bond for the firm’s credit spread model. Bank Debt is an
indicator variable that indicates whether the firm has notes payable or bank debt. Analyst is the natural log
of the number of analysts following the stock taken from the IBES database.
total assets of about $1.3 billion. The average tenure for our sample period is
8.82 years.
The subsample of small auditor firms has larger spreads to Treasury (about
401 basis points compared with 247 basis points for the full sample), lower
average credit rating quality (BB), lower profitability and coverage ratios,
higher leverage ratios, and fewer assets (a median size of $264 million for
firms with small auditors compared with $1.3 billion for the full sample).
The portion of the firms with bank debt is about 62%, which is similar in
size to the full sample.
3. Impact of Auditor Quality and Tenure on the Bond Market

3.1 EMPIRICAL METHODOLOGY
In examining the relation between audits and corporate bond pricing, we
note that audit characteristics can affect credit spreads either (1) through
their impact on credit ratings or (2) through their marginal impact on in-
vestors’ valuation. We first examine the effect of audit characteristics on
credit ratings. Credit ratings agencies, as information intermediaries, pro-
vide independent assessments of the credit quality of the firm, and because
ratings agencies have access to insider information and knowledge of the
audit characteristics, credit ratings agencies should incorporate the infor-
mation content of audit characteristics in the bond rating. If the information
content of audits is incorporated in credit ratings, we expect auditor size and
tenure to be significantly related to credit ratings. To test this hypothesis,
we estimate the following model:
Rating = α0 + α1 Auditor + α2 Tenure + β1,...,n Firm Risk Factors
+ γ1,...,n Security Risk Factors + δ1,...,n Common Risk Factors + ε. (2)
Next, we examine the relation between auditor choice and credit spreads,
controlling for credit ratings as well as other factors that are known to in-
fluence credit spreads (i.e., firm-level, security-level, and macroeconomic
control variables (i.e., common risk factors)). The primary specification
model is:
Credit Spread = α0 + α1 Auditor + α2 Tenure + β1,...,n Firm Risk Factors
+ γ1,...,n Security Risk Factors
+ δ1,...,n Common Risk Factors + ε. (3)
Because variables from other information providers (credit ratings and
banking relations) are included in the firm risk factors, the information
effect of the auditor characteristics should be subsumed or at least signifi-
cantly mitigated in this setting.10 Therefore, this specification allows us to
examine the insurance aspect of auditor characteristics to capital market
participants. If the insurance effect of audits is valued by investors, we ex-
pect small audit firms and short-tenure firms to have higher cost of debt
(i.e., a positive coefficient on α 1 and a negative coefficient on α 2 ).
10 This assumes that the insurance aspect of auditor characteristics is not factored into the
bond rating. Given that a bond rating primarily reflects the default probability of the credit
issue, any expected recovery rate differences due to audits characteristics play a limited role
at best in the assignment of the credit rating by the rating agencies. “Moody’s ratings on in-
dustrial and financial companies have primarily reflected relative default probability.” Moody’s
does note an increasing emphasis on expected loss in bond ratings. “However, because bond
investors’ continuing aversion to default risk, irrespective of severity, default probability and
transition risk will continue to receive greater weight, particularly in the investment grade sec-
tor, than a pure expected loss methodology would suggest.” See Moody’s Investor’s Services Global
Credit Research, August 1999.
Finally, to measure the total effect (information plus insurance) of au-

ditor characteristics on credit spreads, we purge the information of audit
characteristics from the other control variables and estimate the primary
model again. Because both the information effect and the insurance effect
have predictions in the same direction, we expect the coefficients on our
audit variables to increase if the information effect of audits is important
to investors. Then, by comparing these results from the information plus
insurance effects with the previous model’s finding (insurance only), we
can provide evidence on the information effect of audit characteristics on
corporate bond investors. As such, we orthogonalize audit characteristics
to the other control variables. Specifically, Orthrat is the residual from the
regression of auditor size, tenure, and control variables on credit ratings.
That is,
Orthrat = Rating − (α0 + α1 Auditor + α2 Tenure + β1,...,n Firm Risk Factors

+ γ1,...,n Security Risk Factors + δ1,...,n Common Risk Factors), (4)
and we then reestimate equation (3) by replacing Rating with Orthrat.

For our multivariate tests, we estimate pooled cross-sectional models con-
trolling for industry and year fixed effects. To correct for serial correlation
between multiple observations of the same firm in the sample and for het-
eroskedasticity, we calculate t-statistics using Newey and West [1987] cor-
rected standard errors. As a further control for serial correlation, we reesti-
mate our models using the Fama and MacBeth [1973] procedure corrected
for serial correlation (Abarbanell and Bernard [2000]). This approach es-
timates the main model in the cross-section for each period using ordinary
least squares (OLS) and then computes a time-series average and statistical
significance (based on the estimated coefficients) using each period as an
independent observation. The standard errors are then computed using the
time-series variation with a correction for the autocorrelation between the
coefficient estimates over time.
We also perform additional robustness tests in section 4 that examine the
potential effects of endogeneity in the auditor choice decision, correlated
omitted variables, and outliers. To analyze whether the potential endogene-
ity in the decision to employ a large audit firm is biasing our results, we
employ a treatment effects model in which the auditor choice decision is
modeled in conjunction with the credit spread models. We further exam-
ine various alternative default risk, market risk, and information asymmetry
proxies. Specifically, we use both the firm credit spread and the auditor
choice as the dependent variable in our tests. To investigate whether infor-
mation asymmetry is a potentially correlated omitted variable, we include
analyst coverage in the model. To ensure the definition of tenure is robust,
we also estimate the model requiring that a firm has five years of financial
data. Finally, to examine the impact of outliers on the results, we estimate the
models using median regressions with bootstrapped t-statistics to correct for
serial correlation and heteroskedasticity, and delete observations with the
dependent variable, Credit Spread, at 2 standard deviations from the mean.

Overall, our results are robust to all of these alternative specifications.
3.2 CONTROL VARIABLES
To control for the risk of the firm’s debt, we use various proxies. First,
we include credit ratings from S&P to control for variations attributed to
default risk in the sample (credit ratings, in this case, are not historical
rating at issuance but are updated as the bond seasons). To convert default
ratings into a control variable, we map the firm’s senior bond rating into a
numerical variable. We assign Rating a value of 1 if the firm is rated AAA
and increment the rating by 1 as the bond rating declines by one notch
(i.e., AA+ equals 2, AA equals 3, etc.). Finally, Morgan [2002] finds that
a difference in the bond rating assigned by Moody’s and S&P can signal
information problems between the firm and investors. Hence, we include
an indicator variable, Split, to denote a difference in Moody’s and S&P’s
credit rating variable.11
For firms with multiple bonds, there can be variation in ratings by the same
agency for the firm. The difference in bond rating within a firm is a function
of the seniority and securitization of the individual bond issue. Bond ratings
agencies first rate the most senior bonds of the firm and then notch bonds
with significantly lower levels of investor protection downward. The notch-
ing is typically one minor rating category (A to A−) for investment-grade
bonds and two minor rating categories (BB+ to BB−) for noninvestment-
grade bonds. For the reported results, we use the most senior rating for
firms with multiple bond issues. Though not tabulated, we find similar re-
sults using either a weighted average of a firm’s individual bond ratings or
indicator variables.12 Finally, to control for the jump in the credit spreads of
the noninvestment-grade bonds (Mansi and Reeb [2002]), we include an
indicator variable for noninvestment-grade bonds.
Although credit ratings agencies provide valuable information to the mar-
kets, they are not perfect control variables for firm risk. This is apparent in
the standard deviation of yields within rating categories even after control-
ling for duration differences (Elton et al. [2001]). The dispersion of yields
within rating categories stems from divergences in investors’ and rating
agencies’ views of the riskiness of the firm (Ederington, Yawitz, and Roberts
[1987]). Bond ratings can also lag investors’ assessment of firm risk (Hand,
Holthausen, and Leftwich [1992]). Therefore, as a further control, we use
Ohlson’s [1980] bankruptcy model, referred to as the O-score, as an addi-
tional control for default risk.13 Begley, Ming, and Watts [1996] find that
the O-score original coefficient estimates are as effective as estimates using
more recent data in predicting bankruptcies. Thus, we compute the O-score
11 If the firm is rated by only one agency, that agency’s rating is the sole designation.
12 The results are available by request for any robustness tests reported but not tabulated.
13 We also estimate the models using Altman’s [1969] z-score model of default and find similar
results.
using the original coefficients.14 We include additional financial variables to

control for risk that may not be accounted for in bond ratings or the O-score.
These variables include measures of size, leverage, profitability, and cover-
age of the firm.15 In the following, we report how each variable is calculated
as well as the Compustat item number in parenthesis.
We measure firm size as the natural log of the total assets of the firm. That
is,
Size = ln(Total Assets(#6)), (5)
where total assets is the book value of the firm’s assets. Given the period
covered in the study, we adjust total assets for inflation using 1997 as the
base year. Firm leverage is the ratio of long-term debt to total capital. That
is,
Long -Term Debt(#9)
Leverage = . (6)
Total Assets(#6)
Profitability and coverage are measured using the ratio of operating in-
come before interest and tax divided by total assets, and operating income
before interest and tax divided by interest expense. That is,
Operating Income After Depreciation(#178)
Profitability = , (7)
Total Assets(#6)
Operating Income After Depreciation(#178)

Coverage = . (8)
Interest Expense(#15)
We also include firm age, as it is shown to be correlated with auditor tenure
(Myers, Myers, and Omer [2003]). Firm age is measured as the natural
log of number of years since the firm was publicly traded, computed as
the difference in years between the bond quote date and the initial equity
trading date for the firm.
Next, to control for term-structure effects in bond yields, we include du-
ration to control for differences in maturity, coupon, and the initial level of
interest rates. Typically, firms with greater risk issue shorter maturity bonds
with higher coupons. Hence, we expect a negative relation between dura-
tion and credit spreads. Duration (or Macaulay’s duration) is the effective
maturity of the bond and is computed as the weighted average of the matu-
rity of each cash payment using the percentage of the present value of the
bond attributable to each payment. That is,
K
t × C Ft
DUR = , (9)
t=1
P (1 + Y )t
14 Two common adjustments are made from the original Ohlson [1980] model. Gross do-
mestic product is substituted for gross national product and pretax income plus depreciation
is substituted for funds from operations.
15 Though not tabulated, we also include the standard deviation of profitability over the prior
four years. However, we find it has no explanatory power.

where CF t is the security cash flows at time t, t is the number of periods until
the cash flow, P is the bid price of the security, Y is the yield to maturity, and
K is the number of cash flows. For firms with multiple debt issues, duration
is computed as a weighted average of the durations of each bond, with the
weight being the fraction of the bond’s amount outstanding divided by total
outstanding debt.16
Banks, as senior debt claimants, can also serve as a third party certification
of the firm and provide a monitoring function as senior debtholders (e.g.,
Diamond [1984], Fama [1985]). For example, Datta, Iskandar-Datta, and
Patel [1999] find that bondholders in firms with bank debt have a lower cost
of debt financing. Therefore, we control for the information and monitoring
effects for firms with bank loans using an indicator variable for firms with
notes payable in their financial statements.
To control for macroeconomic factors that may influence the cost of debt,
we include the spread between the Baa index and the Aaa index (Chen, Roll,
and Ross [1986]), referred to as the Quality Spread. This is similar to the
variable Fama and French [1993] use to explain corporate bond returns
(the spread of long-term corporate debt minus the return on long-term
government debt). We use Quality Spread because it is relative to two rat-
ing categories, which helps control for changes in rating requirements over
time.17 We expect this variable to be positively related to credit spreads,
as the spread increases during economic downturns. In addition, Elton et
al. [2001] find that the Fama and French risk factors are priced in the
corporate bond markets. Hence, we also include RMRF t , the CRSP value-
weighted market index return minus the one-month Treasury-bill return;
SMB t , the return on a portfolio of small stocks minus the return on a port-
folio of large stocks; and HML t , the return on a portfolio of stocks with high
book-to-market ratios minus the return on a portfolio of stocks with low
book-to-market ratios.18 Finally, we include industry and year indicator vari-
ables to control for industry and time fixed effects. For industry categories,
we include indicator variables for the Fama and French 12 industry cate-
gories, as found in section 2.2. The year indicator variables control for any
time-specific effects or regime shifts.
Table 3 reports the correlation table of our various control variables and
the proxies for auditor quality. We find, as expected, credit spreads are
negatively related to auditor tenure, firm age, bank debt, and duration, and
are positively related to small auditors and bond ratings. The O-score is
highly correlated with bond ratings and positively related to credit spreads.
16 We also examined liquidity in bond prices using the age of the firm’s debt, or the difference
between the quote date and the issue date (e.g., Beim [1992]), and found age to be insignificant.
17 Blume, Lim, and MacKinlay [1998] find that credit ratings have become more stringent
in the 1990s as compared with those in the 1980s.

18 We thank Ken French for providing the industry categorization and the Fama and French
[1993] risk factors, which can be found at http://mba.tuck.dartmouth.edu/pages/faculty/

ken.french.
770
TABLE 3
Pearson Correlation Matrix for Variables
Credit Small Auditor Analyst Bank Firm Bond Baa-Aaa

Spread Auditor Tenure Following Debt Age O-Score Rating Duration Spread RMRF SMB
Small Auditor 0.11∗∗∗
Auditor Tenure −0.18∗∗∗ −0.11∗∗∗
Analyst −0.41∗∗∗ −0.10∗∗∗ 0.33∗∗∗
Bank Debt −0.22∗∗∗ −0.01 0.09∗∗∗ 0.22∗∗∗
Firm Age −0.31∗∗∗ −0.08∗∗∗ 0.35∗∗∗ 0.38∗∗∗ 0.27∗∗∗
O-Score 0.40∗∗∗ 0.04∗∗∗ −0.04∗∗∗ −0.35∗∗∗ −0.15∗∗∗ −0.26∗∗∗
Bond Rating 0.66∗∗∗ 0.09∗∗∗ −0.16∗∗∗ −0.55∗∗∗ −0.32∗∗∗ −0.43∗∗∗ 0.48∗∗∗
Duration −0.33∗∗∗ −0.02∗∗ −0.08∗∗∗ 0.14∗∗∗ 0.07∗∗∗ 0.13∗∗∗ −0.18∗∗∗ −0.31∗∗∗
Baa-Aaa Spread 0.00 0.09∗∗∗ −0.20∗∗∗ −0.02∗∗ 0.14∗∗∗ 0.08∗∗∗ −0.14∗∗∗ −0.14∗∗∗ 0.04∗∗∗
RMRF 0.02 −0.01 0.08∗∗∗ 0.07∗∗∗ −0.02∗ 0.03∗∗∗ 0.02∗∗ 0.00 −0.04∗∗∗ −0.16∗∗∗
SMB −0.05∗∗∗ 0.01 −0.03∗∗∗ −0.02∗∗ 0.01 0.00 −0.03∗∗∗ −0.02∗ 0.03∗∗∗ 0.07∗∗∗ −0.03∗∗∗
HML −0.02 0.01 −0.02∗∗ −0.06∗∗∗ −0.07∗∗∗ −0.04∗∗∗ 0.04∗∗∗ 0.07∗∗∗ −0.01 −0.07∗∗∗ −0.58∗∗∗ −0.20∗∗∗
Small Auditor is all auditor firms except Big 6 auditors, which include Arthur Andersen; Arthur Young; Coopers & Lybrand; Ernst & Young; Deloitte & Touche; KPMG Peat, Marwick,
Main; PriceWaterhouse; Touche Ross; and all merged entities. Credit Spread is calculated as the difference between the corporate bond yield and its duration-equivalent Treasury yield.
For firms with multiple bonds issues, Credit Spread is calculated as a weighted average, based on each bond’s market value. Auditor Tenure is the number of years of the auditor-client
S. A. MANSI, W. F. MAXWELL, AND D. P. MILLER
relationship. Firm Age is the natural log of the time from the firm’s initial public offering (IPO) to the observation date as identified by the Center for Research in Security Prices
(CRSP). Bond Rating is calculated using a numerical conversion process (1 if the firm is rated AAA, and as the bond rating declines the numerical rating increases by 1). O-Score is the
Ohlson [1980] measure of default risk. Duration is the weighted duration of all publicly traded bonds for the firm. Bank Debt is an indicator variable that indicates whether the firm has
notes payable or bank debt. Analyst is the natural log of the number of analysts following the stock taken from the IBES database. Baa-Aaa Spread is the spread between the Baa and Aaa
corporate bond indexes. RMRF , SMB, and HML are common risk factors (Fama and French [1993]). RMRF is the CRSP value-weighted market index return minus the one-month
Treasury-bill return, SMB t is the return on a portfolio of small stocks minus the return on a portfolio of large stocks, and HML t is the return on a portfolio of stocks with high book-to-
market ratios minus the return on a portfolio of stocks with low book-to-market ratios. ∗ , ∗∗ , and ∗∗∗ denote statistical significance at the 10%, 5%, and 1% confidence levels, respectively.
4. Empirical Findings
4.1AUDITOR CHARACTERISTICS (QUALITY AND TENURE)
AND BOND RATING
Dye [1993] shows theoretically that audits can provide both information
and insurance to the capital markets. Because the insurance and informa-
tion hypotheses give largely the same predictions in most capital market
settings, separating the effects can be difficult. The bond market provides
a natural setting to potentially disentangle the value investors place on the
insurance and information aspect of auditor choice. For example, bond-
holders are provided the same insurance associated with the auditor as the
stockholders. In addition, bond investors have access to competing sources
of independent information such as those provided by credit ratings agen-
cies and banks, which offer independent assessments of the firm to the
capital markets. Under this scenario, the information role of the auditor
should be minimized and the general model (equation (3)), should rep-
resent primarily the insurance effect (in this case the information effect
should be captured by credit ratings). Therefore, our first test examines the
impact audit characteristics have on credit ratings agencies.
To test the hypothesis that credit ratings capture the information effect
of audits, we regress Small Auditor , Tenure, and the control variables on
credit ratings using both pooled cross-sectional time series (PCSTS) with
the standard errors corrected for heteroskedasticity and serial correlation
and Fama-MacBeth (FM) regressions with the standard errors corrected
for serial correlations. Table 4 reports the results. The coefficient estimate
for Small Auditor is 1.17 (t-statistic = 4.05) and 1.00 (t-statistic = 3.55) using
PCSTS and FM regressions, respectively. These results suggest that firms with
small auditors are downgraded by approximately one minor rating category.
For example, firms with small auditors are rated BBB whereas similar firms
with large auditors are rated BBB+. Tenure is also related to bond rating with
coefficients of −0.07 (t-statistic = 5.98) and −0.06 (t-statistic = 2.90) using
PCSTS and FM regressions, respectively. This is consistent with the idea that
firms with long-tenured auditors receive a better bond rating. The other
information variable, Bank Debt, is also statistically significant and suggests
that firms with bank debt receive a more favorable bond rating. The other
control variables have their correct theoretical signs.
Our results suggest that the information variables, auditor characteristics,
and bank debt are factored into a firm’s bond rating by credit rating agen-
cies. Hence, by employing our models that include credit ratings, we control
for the information content of audits. In this way, we are able to provide
insights into the value investors place on the insurance effect of audits.
However, we also employ specifications in which credit ratings are replaced
with the residual of the regression in table 4 (referred to as the orthogonal-
ized bond rating), thus allowing us to measure the total effect (insurance
plus information) of audits. If the information content of the auditor is
extracted from credit ratings, we would expect an even larger (insurance
TABLE 4
Auditor Quality and Tenure and Bond Ratings
Dependent Variable = S&P Credit Rating
Model 1 Model 2 Model 3 Model 4

Variable PCSTS FM PCSTS FM
Constant 19.501∗∗∗ 20.452∗∗∗ 19.311∗∗∗ 19.103∗∗∗
(21.88) (14.93) (25.85) (16.71)
Small Auditor 1.166∗∗∗ 1.001∗∗∗ 0.961∗∗∗ 0.970∗∗∗
(4.05) (3.55) (3.26) (3.41)
Tenure −0.067∗∗∗ −0.059∗∗∗ −0.042∗∗∗ −0.072∗∗∗
(5.98) (2.90) (4.28) (3.71)
Bank Debt −1.558∗∗∗ −1.510∗∗∗ −1.137∗∗∗ −1.173∗∗∗
(13.18) (6.37) (10.38) (9.83)
Analyst −0.168∗∗∗ −0.163∗∗∗
(14.1) (11.08)
Firm Age −1.121∗∗∗ −0.947∗∗∗ −0.731∗∗∗ −0.494∗∗∗
(9.57) (6.86) (9.15) (6.73)
O-Score 0.705∗∗∗ 1.193∗∗∗ 0.503∗∗∗ 0.870∗∗∗
(3.67) (10.72) (3.28) (9.57)
Duration −0.527∗∗∗ −0.444∗∗∗ −0.417∗∗∗ −0.400∗∗∗
(12.50) (9.65) (12.98) (10.96)
Baa-Aaa Spread −1.294∗∗∗ −1.546 −1.080∗∗∗ −1.131
(3.52) (0.89) (2.93) (0.70)
RMRF −0.020 0.002 0.006 0.012
(0.95) (0.05) (0.33) (0.35)
SMB −0.029 −0.070 −0.033 −0.075∗
(1.05) (1.06) (1.23) (1.73)
HML 0.023 0.060 0.016 0.040
(0.65) (1.16) (0.51) (1.16)
Industry fixed effects Included Included Included Included
Year fixed effects Included Included Included Included
N 8,529 25 7,738 25
Adjusted R 2 0.442 0.539 0.519 0.597
The dependent variable is S&P Bond Rating , calculated based on a numerical conversion process
in which an AAA-rated bond is assigned a value of 1, and as the bond rating declines the numerical
rating increases by 1. Small Auditor is all auditor firms except Big 6 auditors, which include Arthur
Andersen; Arthur Young; Coopers & Lybrand; Ernst & Young; Deloitte & Touche; KPMG Peat, Marwick,
Main; PriceWaterhouse; Touche Ross; and all merged entities. Tenure is the number of years of the
auditor-client relationship. Bank Debt is an indicator variable that indicates whether the firm has notes
payable or bank debt. Analyst is the natural log of the number of analysts following the stock taken from
the IBES database. Firm Age is the natural log of the time from the firm’s initial public offering (IPO)
to the observation date as identified by the Center for Research in Security Prices (CRSP). O-Score is
the Ohlson [1980] measure of default risk. Duration is the weighted duration of all outstanding debt
for the firm. Baa-Aaa Spread is the spread between the Baa and Aaa corporate bond indexes. RMRF ,
SMB, and HML are common risk factors (Fama and French [1993]). RMRF is the CRSP value-weighted
market index return minus the one-month Treasury-bill return, SMB t is the return on a portfolio of
small stocks minus the return on a portfolio of large stocks, and HML t is the return on a portfolio of
stocks with high book-to-market ratios minus the return on a portfolio of stocks with low book-to-market
ratios. PCSTS refers to pooled cross-sectional time-series results with standard errors corrected for both
heteroskedasticity and serial correlation (at one lag) using the Newey and West [1987] specification.
Fama-MacBeth (FM) regressions are used to correct for serial correlation. N denotes the number of
firm-year observations per model. The data cover from 1974 through 1998. The t-statistics are reported
in parentheses. ∗ , ∗∗ , and ∗∗∗ denote statistical significance at the 10%, 5%, and 1% confidence levels,
respectively.
plus information) effect for our auditor test variable, as it incorporates both
factors. We can then examine the difference between the coefficients in the
two models described earlier to estimate the dual characteristics of audits.
4.2 INSURANCE ROLE OF AUDITS

Table 5 provides the results of our multivariate regression models. Our
first set of tests (models 1 and 2) measures the impact of auditor size and
tenure on credit spreads while including bond credit ratings as a control
variable. The results show that the coefficient on Small Auditor is positive
and statistically significant (PCSTS regression: 43 basis points, t-statistic =
2.81; FM regression: 45 basis points, t-statistic = 3.57). The results suggest
that even after controlling for credit ratings, investors place a premium on
the bonds of firms with large auditors. Therefore, the results are consistent
with the hypothesis that the insurance effect of audits adds value to capital
market participants. When examining the results for Tenure, we find the
variable is −0.9 basis points (t-statistic = 2.15) in the PCSTS regression but
insignificant in the FM regression.
TABLE 5
Auditor Quality and the Cost of Debt—Multivariate Regressions
Dependent Variable = Yield Spread
Bond Rating Orthogonal Bond Rating

Constant 0.138 −0.475 3.030∗∗∗ 2.054∗∗∗
(0.47) (0.76) (10.59) (2.98)
Small Auditor 0.431∗∗∗ 0.445∗∗∗ 0.634∗∗∗ 0.622∗∗∗
(2.81) (3.57) (4.15) (5.16)
Tenure −0.009∗∗ −0.059 −0.015∗∗∗ −0.064
(2.15) (1.14) (3.56) (1.24)
Bank Debt −0.016 −0.079 −0.256∗∗∗ −0.286∗∗∗
(0.32) (0.95) (5.15) (3.69)
Firm Age 0.036 0.045 −0.149∗∗∗ 0.113∗∗∗
(1.29) (1.23) (4.66) (3.02)
O-Score 0.099∗∗ 0.187∗∗∗ 0.207∗∗∗ 0.280∗∗∗
(2.44) (5.26) (5.60) (8.51)
S&P Rating 0.153∗∗∗ 0.133∗∗∗ 0.152∗∗∗ 0.131∗∗∗
(12.28) (7.77) (12.25) (7.65)
Split Rating 0.150∗∗∗ 0.258∗∗∗ 0.151∗∗∗ 0.258∗∗
(3.43) (2.42) (3.46) (2.43)
Noninvestment Grade 1.767∗∗∗ 1.888∗∗∗ 1.781∗∗∗ 1.908∗∗∗
(19.35) (7.22) (19.57) (7.26)
Duration −0.137∗∗∗ −0.122∗∗∗ −0.213∗∗∗ −0.188∗∗∗
(12.29) (7.42) (16.22) (9.65)
Baa-Aaa Spread 0.537∗∗∗ 1.487∗ 0.464∗∗∗ 1.410
(3.69) (1.65) (3.19) (1.57)
RMRF −0.007 −0.040 −0.009 −0.042∗
(0.70) (1.59) (1.00) (1.69)
T A B L E 5 — Continued

SMB −0.026∗∗ −0.006 −0.026∗∗ −0.007
(1.96) (0.19) (1.98) (0.22)
HML −0.028∗ −0.065∗ −0.025∗ −0.063∗
(1.91) (1.89) (1.73) (1.83)
Year fixed effects Included Included
N 8,529 25 8,529 25
R2 0.550 0.626 0.550 0.626
The dependent variable, Credit Spread, is calculated as the difference between the corporate bond yield
and its duration-equivalent Treasury yield. For firms with multiple bonds issues, Credit Spread is calculated
as a weighted average, based on each bond’s market value. Small Auditor is all auditor firms except Big 6
auditors, which include Arthur Andersen; Arthur Young; Coopers & Lybrand; Ernst & Young; Deloitte &
Touche; KPMG Peat, Marwick, Main; PriceWaterhouse; Touche Ross; and all merged entities. Tenure is the
Prices (CRSP). Bank Debt is an indicator variable that indicates whether the firm has notes payable or bank
debt. O-Score is the Ohlson [1980] measure of default risk. S&P Rating is calculated using a numerical
conversion process (1 if the firm is rated AAA, and as the bond rating declines the numerical rating inceases
by 1). In the first set of models, we use S&P Rating as calculated. In the second set of models, we use
orthogonalized credit rating. Split Rating denotes when Moody’s and S&P have different bond ratings for
the firm. Noninvestment Grade denotes whether the firm’s bonds are rated noninvestment grade. Duration
is the weighted duration of all outstanding debt for the firm. Baa-Aaa Spread is the spread between the
Baa and Aaa corporate bond indexes. RMRF , SMB, and HML are common risk factors (Fama and French
[1993]). RMRF is the CRSP value-weighted market index return minus the one-month Treasury-bill return,
SMB t is the return on a portfolio of small stocks minus the return on a portfolio of large stocks, and HML t is
the return on a portfolio of stocks with high book-to-market ratios minus the return on a portfolio of stocks
with low book-to-market ratios. PCSTS refers to pooled cross-sectional time-series results with standard
errors corrected for both heteroskedasticity and serial correlation (at one lag) using the Newey and West
[1987] specification. Fama-MacBeth (FM) regressions are used to correct for serial correlation. N denotes
the number of firm-year observations per model. The data cover from 1974 through 1998. The t-statistics
are reported in parentheses. ∗ , ∗∗ , and ∗∗∗ denote statistical significance at the 10%, 5%, and 1% confidence
levels, respectively.
4.3 INFORMATION ROLE OF AUDITS

In our next set of tests, we replace credit ratings with the residual of
regression (3) (i.e., the orthogonalized bond ratings). Models 3 and 4 of
table 5 report the results. Similar to the prior models that employ credit rat-
ings, we find the coefficient on Small Auditor to be positive and significant
in both specifications. However, both the magnitude and significance in-
creases compared with the prior specification using bond rating. The Small
Auditor coefficient is about 63 basis points (t-statistic = 4.15) for the PCSTS
regression and 62 basis points (t-statistic = 5.16) for the FM regression. The
results for Tenure is −1.5 basis points (t-statistic = 3.56) in the PCSTS re-
gression model and an insignificant −6.4 basis points in the FM model. The
insignificant results for Tenure using the FM regressions are not surprising
as there is little if any variation in Tenure in the early years of the study (e.g.,
Tenure for all firms in the sample in 1974 is 1).
When directly comparing the corresponding models, we find that the

coefficients on Small Auditor are about 20 basis points lower in the bond
rating models. Because the auditor coefficients in orthogonalized bond rat-
ing models reflect both the information effect and the insurance effect,
the results suggest that of the approximate overall effect of 63 basis points
(model 3), 43 basis points (model 1) can be attributed to the insurance
effect and the remaining 20 basis points can be attributed to the informa-
tion effect of auditor quality on firm (bond) credit spreads. To the extent
that our controls capture the information effect, the size of the coefficients
is an indication that investors put more emphasis on the insurance effect
rather than on the information effect. For Tenure, we find that the magnitude
of the coefficient increases from −0.9 basis points to 1.5 basis points. The
results are consistent with an information and insurance effect for auditor
tenure (about 1 to 2 basis points per year of tenure).
Comparing the coefficients and significance levels between the PCSTS
and FM regressions, we find that our results are largely similar using either
method. One difference is the coefficient for Tenure, a variable we examine
further in section 4.8. As we subdivide the data in the remaining sections
of the paper, the calculation of the FM regressions becomes impractical as
we lose a significant number of years or degrees of freedom, or both, when
estimating the results in a cross-section. In the remaining tables, we continue
to correct for serial correlation at the firm level using Newey-West [1987]
corrected standard errors.
4.4AUDITOR QUALITY AND THE COST OF DEBT FOR INVESTMENT-GRADE

AND NONINVESTMENT-GRADE DEBT
In this section we examine whether the economic consequences of
auditor size and tenure are larger for risky firms. To test this hypothesis, we
examine the impact of audits on the subsets of investment-grade and non-
investment-grade bonds. The results are reported in table 6. For investment-
grade firms, the coefficient on Small Auditor ranges from 18 basis points
(t-statistic = 1.63) using bond rating to 37 basis points (t-statistic = 3.33)
using the orthogonalized bond rating. For noninvestment-grade firms, the
Small Auditor coefficient is also positive and statistically significant, with a
minimum t-statistic of 2.41, and coefficients range from 55 to 74 basis points.
Similar to table 5, both coefficients and t-statistics increase when using the
orthogonalized bond ratings. Consistent with the hypothesis that auditor
choice is more significant for high-risk firms, the coefficient estimates in
the noninvestment-grade sample are more than twice the estimates in the
investment-grade sample. Therefore, our results suggest that the economic
impact of auditor choice is larger for riskier firms because both the insurance
effect and information effect of audits become larger in the noninvestment-
grade sample. The results are consistent with previous studies that suggest
that information uncertainty is higher in risky firms (Christensen, Hoyt,
and Paterson [1999], Beneish [1997], Sweeney [1994], Petroni [1992])
and that investors price this risk (Barry and Brown [1985], Merton [1987]).
TABLE 6
Results for Investment-Grade and Noninvestment-Grade Subsamples
Variable Investment Noninvestment Investment Noninvestment
Constant −0.287∗∗ 2.988∗∗∗ 2.423∗∗∗ 5.743∗∗
(2.12) (4.64) (18.84) (10.45)
Small Auditor 0.182 0.552∗∗ 0.372∗∗∗ 0.735∗∗∗
(1.63) (2.41) (3.33) (3.20)
Tenure 0.004∗ −0.019∗ −0.004∗∗ −0.027∗∗∗
(1.69) (1.85) (2.07) (2.60)
Bank Debt −0.021 −0.076 −0.247∗∗∗ −0.296∗∗∗
(0.88) (0.70) (10.54) (2.65)
Firm Age −0.033∗∗ −0.083 −0.199∗∗∗ −0.078
(2.21) (1.42) (13.15) (1.19)
O-Score 0.005 0.175∗∗∗ 0.101∗∗∗ 0.271∗∗∗
(0.46) (2.57) (10.44) (4.15)
S&P Rating 0.143∗∗∗ 0.148∗∗∗ 0.144∗∗∗ 0.143∗∗∗
(26.70) (6.42) (27.00) (6.25)
Split Rating 0.068∗∗∗ 0.352∗∗∗ 0.063∗∗∗ 0.351∗∗∗
(3.14) (3.04) (2.90) (3.02)
Duration −0.040∗∗∗ −0.414∗∗∗ −0.111∗∗∗ −0.486∗∗∗
(5.97) (9.34) (15.81) (10.85)
Baa-Aaa Spread 0.384∗∗∗ 0.805∗∗ 0.347∗∗∗ 0.766∗∗
(4.70) (2.06) (4.23) (1.96)
RMRF 0.009∗∗ −0.010 0.006 −0.013
(1.99) (0.48) (1.33) (0.65)
SMB −0.013∗∗ −0.061∗∗ −0.012∗∗ −0.060∗
(2.12) (1.97) (1.91) (1.93)
HML 0.014∗ −0.081∗∗∗ 0.017∗∗ −0.077∗∗
(1.78) (2.63) (2.17) (2.49)
N 5,442 5,442 3,087 3,087
Adjusted R 2 0.383 0.240 0.383 0.240
The dependent variable, Credit Spread, is calculated as the difference between the corporate bond yield
and its duration-equivalent Treasury yield. For firms with multiple bonds issues, Credit Spread is calculated
as a weighted average, based on each bond’s market value. Small Auditor is all auditor firms except Big 6
auditors, which include Arthur Andersen; Arthur Young; Coopers & Lybrand; Ernst & Young; Deloitte &
Touche; KPMG Peat, Marwick, Main; PriceWaterhouse; Touche Ross; and all merged entities. Tenure is the
Prices (CRSP). Bank Debt is an indicator variable that indicates whether the firm has notes payable or bank
debt. O-Score is the Ohlson [1980] measure of default risk. S&P Rating is calculated using a numerical
conversion process (1 if the firm is rated AAA, and as the bond rating declines the numerical rating
inceases by 1). In the first set of models, we use S&P Rating as calculated. In the second set of models, we
use orthogonalized credit rating. Split Rating denotes when Moody’s and S&P have different bond ratings
for the firm. Duration is the weighted duration of all outstanding debt for the firm. Baa-Aaa Spread is the
spread between the Baa and Aaa corporate bond indexes. RMRF , SMB, and HML are common risk factors
(Fama and French [1993]). RMRF is the CRSP value-weighted market index return minus the one-month
Treasury-bill return, SMB t is the return on a portfolio of small stocks minus the return on a portfolio
of large stocks, and HML t is the return on a portfolio of stocks with high book-to-market ratios minus
the return on a portfolio of stocks with low book-to-market ratios. PCSTS refers to pooled cross-sectional
time-series results with standard errors corrected for both heteroskedasticity and serial correlation (at one
lag) using the Newey and West [1987] specification. Fama-MacBeth (FM) regressions are used to correct
for serial correlation. N denotes the number of firm-year observations per model. The data cover from
1974 through 1998. The t-statistics are reported in parentheses. ∗ , ∗∗ , and ∗∗∗ denote statistical significance
at the 10%, 5%, and 1% confidence levels, respectively.
Furthermore, it is consistent with the findings of Shu [2000], who finds that
the probability of auditor litigation increases with firm risk.
When we examine auditor tenure for the investment-grade sample con-
trolling for bond ratings, we find the coefficient on Tenure is 0.4 basis points
(t-statistic = 1.69). When using orthogonalized bond rating, we find the
coefficient on Tenure is −4 basis points (t-statistic = 2.07). For the non-
investment-grade sample, the coefficients on Tenure are −2 basis points
(t-statistic = 1.85) and 3 basis points (t-statistic = 2.60) for the models with
bond and orthogonalized bond rating, respectively. When analyzing table 6
in conjunction with table 4, the results suggest that both bond rating agen-
cies and investors view auditor tenure as a significant issue, though they may
weight this issue differently given the changing sign of the investment-grade
results in table 6.
The results from table 6 suggest that the economic impact of audit charac-
teristics is largest in high-risk firms. Overall, the use of a large auditor reduces
the required rate of return for both investment-grade and noninvestment-
grade firms, but the effect is more than twice as large in noninvestment-
grade firms. The length of the auditor-client relationship on credit spreads
reduces the cost of debt in the noninvestment-grade firms but has less of an
effect on investment-grade firms. Taken together, the findings of table 6 are
consistent with the hypothesis that firm risk is an important determinant in
the value investors attach to audits.
4.5 CHANGES IN AUDITOR QUALITY AND CHANGES

IN THE FIRM’S COST OF DEBT
In tables 4 through 6, we conduct our tests in levels and find results
consistent with the hypothesis that auditor quality and tenure are related to
the required rate of returns on corporate bonds. For robustness, we examine
the effect of a change in auditor quality on the change in the required rate of
return. If auditor choice provides value-relevant information to investors, we
expect a reduction in the return investors require for firms switching from
a small to a large auditor. Consistent with this idea, we expect an increase
in required rates of return if the firm switches from a large to small auditor.
To test this hypothesis, we examine changes in a firm’s credit spread from
one year to the next. We begin with the original sample. We require two
years of complete financial data, which provides us with a sample of 7,241
firm-year observations. We then examine the number of changes from small
to large auditors and the alternative. We find 39 firms that switch from small
to large auditors (denoted as Auditor Upgrade); table 2 provides information
regarding the sample. We find 7 firms that switch from large to small auditors
(denoted as Auditor Downgrade). Given a sample size of 7 downgrades, we do
not draw conclusions but report results for completeness. Hence, we focus
on firms switching from a small to a large auditor. Because any change in
auditor, not just an upgrade or downgrade, may convey news to the market,
we also include the variable Big 6, which denotes a change from a Big 6
auditor to another Big 6 auditor.
We estimate a model similar to the model found in equation (1) with

the exception of focusing on changes rather than levels. The pooled cross-
sectional model is
Credit Spread = α0 + α1 Big6 + α2 Auditor Upgrade + α3 Auditor Downgrade
+ α4 Up-Bank Debt + α5 Down-Bank Debt + α6 Rating
+ α7 Leverage + α8 Coverage + α9 Profitability
+ α10 Size + α11 Duration + α12 Spread + α13 RMRF
+ α14 SMB + α15 HML + ε. (10)
The results from estimating the model found in equation 10 are provided
in table 7. We estimate the model for the full sample and for the subsam-
ple of noninvestment-grade bonds. For the full sample, the Auditor Upgrade
coefficient is a significant −94 basis points (t-statistic = 3.24) and −102
basis points (t-statistic = 3.45) using both bond rating and orthogonalized
bond rating. The Auditor Downgrade coefficient is not statistically signifi-
cant using either bond rating or orthogonalized bond rating, which is not
surprising given the small number of downgrades. Finally, we find that the
coefficient on Big 6 is also insignificant in both full samples. When examin-
ing the results for the subsample of noninvestment-grade firms, we find the
Auditor Upgrade coefficient to be 144 and 158 basis points (both significant
at the 1% level) using both bond rating and orthogonalized bond rating.
Both the Auditor Downgrade and Big 6 coefficients remain insignificant.
Overall, when examining changes in auditor quality, we find evidence con-
sistent with level models. Firms switching to a large auditor have a lower re-
quired rate of return after controlling for firm, security, and macroeconomic
variables.
4.6 INFORMATION ASYMMETRY

In this section we investigate whether information asymmetry is a
potentially important omitted variable in our analysis. Previous research
shows that the firm’s information environment can affect the at-issue cost of
debt. Therefore, to the extent that our existing controls do not capture this
effect, a potentially significant variable may be omitted from our analysis.
To proxy for the information environment of the firm, we follow Lang and
Lundholm [1996], who find that higher analyst following indicates a better
information environment.19 If analyst coverage is a proxy for information
asymmetry, the expected sign of the coefficient is negative, as increased
19 In a prior version of the paper, we examined how corporate disclosure information used
in Lang and Lundholm [1996] and Lundholm and Myers [2002] influences the findings.
However, by requiring disclosure scores, we significantly limited the sample. Hence, we now
report results using analyst coverage as the proxy for information disclosure. We thank the
anonymous referee for suggesting the use of analyst coverage in the analysis.
TABLE 7
Changes in Auditor Quality
Bond Rating Orthogonalized Bond Rating
Full Noninvestment Full Noninvestment

Constant −0.078 −0.212 −0.069 −0.215
(1.19) (1.47) (1.03) (1.44)
Big 6 0.048 −0.109 0.047 −0.088
(0.31) (0.31) (0.29) (0.24)
Auditor Upgrade −0.939∗∗∗ −1.438∗∗∗ −1.022∗∗∗ −1.580∗∗∗
(3.24) (2.66) (3.45) (2.81)
Auditor Downgrade 0.177 −0.041 0.063 −0.216
(0.26) (0.04) (0.09) (0.19)
Up-Bank Debt 0.055 0.015 0.055 0.055
(0.60) (0.07) (0.59) (0.24)
Down-Bank Debt −0.014 0.137 0.021 0.194
(0.15) (0.66) (0.23) (0.91)
S&P Rating 0.157∗∗∗ 0.127∗∗∗ 0.029∗∗ 0.020
(10.49) (4.27) (2.47) (0.86)
Leverage 0.951∗∗∗ 1.218∗∗∗ 0.938∗∗ 1.159∗∗∗
(4.47) (3.19) (4.27) (2.90)
Coverage −0.001 −0.003 −0.001 −0.002
(1.60) (0.70) (0.75) (0.49)
ROA −0.618∗ −0.355 −1.939∗∗∗ −1.564∗∗
(1.88) (0.60) (4.69) (1.96)
Size −0.093 0.149 −0.221∗∗∗ 0.033
(1.22) (0.81) (2.78) (0.17)
Duration −0.344∗∗∗ −0.981 −0.352∗∗∗ −1.004∗∗∗
(17.98) (16.61) (18.04) (16.61)
Baa-Aaa Spread 0.720∗∗∗ 0.840∗∗∗ 0.660∗∗∗ 0.727∗∗∗
(13.05) (5.37) (11.81) (4.47)
N 7,241 2,436 7,241 2,436
Adjusted R 2 0.087 0.134 0.134 0.087
This table provides data on the relation between changes in the full sample and the noninvestment-grade
sample and changes in the independent variables. Credit Spread is defined as the change in the firm’s
credit spread. Big Six is defined as an auditor change within the Big 6 auditing firms. Auditor Upgrade
(Auditor Downgrade) is defined as a switch to a Big 6 auditor (non–Big 6). Up-Bank Debt ( Down-Bank
Debt) is defined as a change in the Bank Debt indicator variable, where Bank Debt is an indicator variable if
the firm has notes payable, which is an indication of whether the firm has bank debt. S&P Rating is the
change in the credit rating, calculated using a numerical conversion process (1 if the firm is rated AAA,
and as the bond rating declines the numerical rating increases by 1). In the first set of models, we use S&P
credit rating as calculated. In the second set of models, we use orthogonalized credit rating. Leverage
is the change in leverage, or the ratio of long-tern debt (Compustat item 9) to total assets (Compustat
item 6). Coverage is the change in the coverage ratio, or the ratio of earnings before interest and tax
(EBIT) (Compustat item 13) divided by interest expense (Compustat item 15). ROA is the change in the
return on assets, or the ratio of EBIT (Compustat item 13) divided by total assets (Compustat item 6). Size
is the change in firm size, or the natural log of total assets. Duration is the change in total debt duration,
or the weighted duration of all outstanding debt for the firm. Baa-Aaa Spread is the change in the
spread between the Baa and Aaa corporate bond indexes. N denotes the number of firm-year observations
per model. The data cover from 1974 through 1998. Regressions are estimated with heteroskedastic-
consistent robust standard errors using the White [1980] specification. The t-statistics are reported in
parentheses. ∗ , ∗∗ , and ∗∗∗ denote statistical significance at the 10%, 5%, and 1% confidence levels,
respectively.
analyst coverage should reduce information asymmetry and thus reduce

the required return on bonds. We also expect the magnitude of the coeffi-
cient to be higher in the high-risk sample, that is, the non-investment-grade
firms.
The data on analyst coverage is provided from the IBES database for 1978
through 1998. Because there is some ambiguity on how to code a firm with no
analyst coverage, we treat a firm with missing analyst coverage information
in two ways. In the first set of models, if a firm has no analyst information,
we assume there is no coverage and assign a 0, which is consistent with
Bushman, Piotroski, and Smith [2004]. This reduces our sample to 7,738
firm-year observations. In the second set of models, if a firm has no analyst
information, we assume the data are missing, which reduces the sample to
5,856 firm-year observations. The analyst variable is then calculated as the
natural log of the number of analysts following the stock, after adding 1. We
also estimate the results using analyst coverage as a linear variable and find
similar results.
Similar to our prior analysis, we first examine whether analyst coverage is
related to bond ratings. The results are found in table 4 (models 3 and 4).
The analyst coefficient is −0.17 (t-statistic = 14.10) and −0.16 (t-statistic =
11.08) for the PCSTS and FM regressions, respectively. This suggests that
firms with a higher degree of analyst following have a better bond rating,
which supports the findings of Healy and Palepu [2001] that analyst fore-
casts provide the capital markets with information beyond that contained
in financial statements. We save the residuals from this analysis and again
create an orthogonalized bond rating for this sample.
The results including analyst coverage are provided in table 8. To be
concise, we only report the results using the orthogonalized bond rating
variable. Our analyst variable is statistically significant at the 1% level in all of
the estimated models. The Small Auditor coefficient is positive and significant
in all of the models. For the full sample, the Small Auditor coefficients are 56
(t-statistic = 3.21) and 50 (t-statistic = 2.45) basis points. Consistent with the
prior models, the Small Auditor coefficient is larger for the noninvestment-
grade sample. The Tenure coefficient is negative and significant in all the
models, though only at the 10% level for one of the noninvestment-grade
samples. In summary, although we find analyst coverage to be a significant
variable in the analysis, it does not subsume either auditor size or tenure, as
the results are similar to the prior findings. Furthermore, to the best of our
knowledge, this is first documentation of relation between analyst coverage
and a firm’s cost of debt financing.
4.7 SELF-SELECTION
One potential concern regarding our test specifications is endogeneity.
Suppose that firms with a low cost of capital tend to use a large auditor for
reasons unrelated to their audit quality and that our controls for firm and
bond characteristics do not capture this information. Then, we might infer
a link between auditor choice and the cost of capital when none exists. For
example, suppose that
Y = βx + δC + ε, (11)
where C is the indicator variable that equals 1 if the firm uses a small auditor,
and 0 otherwise. Because firms choose an auditor based on various factors,
we can model this decision as
C ∗ = γ w + u
(12)
C =1 if C ∗ > 0, 0 otherwise.
If the typical firm selects an auditor because of some expected benefit in Y ,
OLS estimates of δ will not correctly measure the effect of auditor choice.
This problem of self-selection is often handled empirically with a treatment
effect model (e.g., see Greene [1990]).
TABLE 8
Information Asymmetry
Missing Analyst Data: Missing Analyst Data:

No Coverage No Data
Constant 3.133∗∗∗ 6.191∗∗∗ 3.375∗∗∗ 6.516∗∗∗
(10.46) (10.95) (11.66) (9.94)
Small Auditor 0.557∗∗∗ 0.725∗∗∗ 0.498∗∗ 0.831∗∗
(3.21) (3.03) (2.45) (2.46)
Tenure −0.016∗∗∗ −0.019∗ −0.016∗∗∗ −0.029∗∗
(3.68) (1.76) (3.85) (2.32)
Analyst −0.163∗∗∗ −0.269∗∗∗ −0.246∗∗∗ −0.346∗∗∗
(7.26) (4.97) (5.76) (3.57)
Bank Debt −0.212∗∗∗ −0.227∗∗ −0.177∗∗∗ −0.313∗∗
(4.10) (2.04) (3.47) (2.33)
Firm Age −0.099∗∗∗ −0.043 −0.105∗∗∗ −0.120
(3.07) (0.66) (3.35) (1.47)
O-Score 0.180∗∗∗ 0.237∗∗∗ 0.297∗∗∗ 0.499∗∗∗
(4.94) (3.72) (10.31) (8.50)
Orthogonal Bond Rating 0.138∗∗∗ 0.128∗∗∗ 0.120∗∗∗ 0.154∗∗∗
(10.88) (5.45) (9.99) (4.92)
Split Rating 0.122∗∗∗ 0.261∗∗ 0.098∗∗ 0.312∗∗
(2.63) (2.35) (2.42) (2.30)
Noninvestment Grade 1.695∗∗∗ 1.485∗∗∗
(18.27) (16.02)
Duration −0.197∗∗∗ −0.482∗∗∗ −0.156∗∗∗ −0.514∗∗∗
(15.13) (10.60) (13.22) (9.78)
Baa-Aaa Spread 0.560∗∗∗ 0.672 0.654∗∗∗ 1.215∗∗∗
(3.03) (1.62) (4.45) (2.65)
RMRF 0.005 0.018 0.014 0.029
(0.47) (0.90) (1.59) (1.22)
T A B L E 8 — Continued
Missing Analyst Data: Missing Analyst Data:
No Coverage No Data
SMB −0.018 −0.039 −0.021 −0.073∗
(1.18) (1.22) (1.50) (1.94)
HML −0.011 −0.045 0.011 −0.023
(0.73) (1.53) (0.68) (0.61)
N 7,738 2,939 5,856 1,700
Adjusted R 2 0.549 0.253 0.587 0.307
The sample is restricted to observations after 1978 through 1998, which reflects the beginning of the
analyst coverage information. We calculate the log of analyst coverage in two ways. In the first set of models,
if a firm has no analyst information, we assume there is no coverage and assign a 0. We then calculate the
natural log after adding 1. In the second set of models, if a firm has no analyst information, we assume
the data are missing. Full, investment, and noninvestment reflect the samples. The dependent variable,
Credit Spread, is calculated as the difference between the corporate bond yield and its duration-equivalent
Treasury yield. For firms with multiple bonds issues, Credit Spread is calculated as a weighted average
based on each bond’s market value. Small Auditor is all auditor firms except Big 6 auditors, which include
Arthur Andersen; Arthur Young; Coopers & Lybrand; Ernst & Young; Deloitte & Touche; KPMG Peat,
Marwick, Main; PriceWaterhouse; Touche Ross; and all merged entities. Tenure is the number of years of
the auditor-client relationship. Firm Age is the natural log of the time from the firm’s initial public offering
(IPO) to the observation date as identified by the Center for Research in Security Prices (CRSP). Bank Debt
is an indicator variable that indicates whether the firm has notes payable or bank debt. O-Score is the Ohlson
[1980] measure of default risk. Split Rating denotes when Moody’s and S&P have different bond ratings for
the firm. Noninvestment Grade denotes whether the firm’s bonds are rated noninvestment grade. Duration
is the weighted duration of all outstanding debt for the firm. Baa-Aaa Spread is the spread between the
Baa and Aaa corporate bond indexes. RMRF , SMB, and HML are common risk factors (Fama and French
[1993]). N denotes the number of firm-year observations per model. Standard errors are corrected for
both heteroskedasticity and serial correlation (at one lag) using the Newey and West [1987] specification.
The t-statistics are reported in parentheses. ∗ , ∗∗ , and ∗∗∗ denote statistical significance at the 10%, 5%, and
1% confidence levels, respectively.
To mitigate this potential endogeneity in our sample, we employ a treat-

ment effects model that corrects for this self-selection bias. We model the
auditor decision as a function of firm-specific variables that are shown to
be important factors in the auditor choice decision, including profitability,
size, and leverage. For example, Johnson and Lys [1990] show that firms
switching auditors are less profitable than those that do not switch, whereas
Eichenseher and Shields [1986] and Francis and Wilson [1988] document a
relationship between client leverage and changes to large auditors. In addi-
tion, we include bond-specific determinants of the auditor choice decision.
We include growth in total assets to control for the propensity of growth
firms to switch to less conservative auditors (DeFond and Subramanyam
[1998]). We further include an indicator variable for noninvestment-grade
bonds because firms may chose an auditor based on the risk of their securi-
ties as well as indicator variables corresponding to industry because auditor
choice may be a function of industry. Finally, we account for time trends
in the auditor choice using year indicator variables. We obtain consistent
estimates using full maximum likelihood estimation (a Heckman [1979]

two-step estimation procedure produces similar results).
Table 9 reports the treatment effects models that control for self-selection
using jointly estimated results for the PCSTS models of the full sample (com-
parable to models 1 and 3 in table 5) and when analyst coverage is included
(comparable to models 1 and 3 in table 8). The first-stage probit model
reports that larger, more profitable, better rated firms, with a longer history
are likely to use a large auditor, even after controlling for industry and timing
effects. In the jointly estimated treatment effects models, we see that the co-
efficient on Small Auditor is positive, ranging from 52 to 72 basis points, and
statistically significant, with t-statistics ranging from 2.69 to 4.00. Therefore,
after controlling for firm, security, market conditions, and self-selection, we
still find Small Auditor to be significant. We also find that for the treatment
effects models, the coefficient on Tenure is negative (ranging from −1.1 and
−2.0 basis points) and statistically significant in all of the models.
To test whether, in fact, self-selection is biasing our results, we report the
Wald test of independence. We cannot reject the hypothesis that the equa-
tions are independent (p-values range from .25 to .81 in the four models).
This finding suggests that self-selection is not biasing our results.
4.8 TENURE
We next investigate an alternative specification of auditor tenure. In our
previous analysis, the length of the auditor-client relationship started at
the beginning of sample period or when the firm enters Compustat. This
could create a bias to the extent that it systematically underestimates tenure.
Hence, we reestimate the models, requiring firms to have at least five years
of tenure data to minimize any possible bias. The requirement of five years
of data to calculate tenure before the firm enters the sample reduces the
sample to 7,053 firm-year observations. The mean (median) tenure of this
sample is 10.12 (9.00) years and the percentage of the sample with tenure
equal to 1 is 4.3%, which indicates a limited bias in the sample. As a further
check, we also assign indicator variables for this sample to indicate the upper
and lower deciles based on tenure and replace Tenure with these indicator
variables. To be concise, we only report the results using the orthogonalized
bond rating variable.
Table 10 reports the results. In model 1, we find auditor tenure is −2
basis points, which is significant at the 1% confidence level. In fact, when
comparing the coefficient and t-statistics with the unrestricted sample in
model 3 in table 5, we find an increase in both the coefficient and t-statistic.
In model 2, we find that firms with the lowest tenure (1st decile) have a
19-basis-point higher credit spread (significant at the 5% level) and firms
with the highest tenure (10th decile) have a 24-basis-point lower cost of debt
(significant at the 1% level). Overall, we find the results are not driven by the
construction of the tenure variable and are robust to alternative measures
of Tenure.
TABLE 9
784
Auditor Quality and Tenure and the Cost of Debt: Correcting for Self-Selection Bias
Missing Analyst: No Coverage Missing Analyst: No Data
Model 3 Model 4
Models 1 Model 1 Model 2
&2 Jointly Jointly Jointly Jointly
Variable Probit Estimated Estimated Probit Estimated Probit Estimated
Constant 0.640∗∗ 1.054∗∗∗ 3.923∗∗∗ 0.093 3.134∗∗∗ −0.357 3.365∗∗∗
(2.09) (3.91) (14.91) (0.16) (10.69) (0.52) (11.93)
Small Auditor 0.524∗∗∗ 0.722∗∗∗ 0.539∗∗∗ 0.617∗∗∗
(2.91) (4.00) (2.69) (2.70)
Tenure −0.011∗∗∗ −0.020∗∗∗ −0.016∗∗∗ −0.016∗∗∗
(3.01) (5.17) (4.06) (4.33)
Analyst −0.025 −0.163∗∗∗ −0.165∗∗ −0.244∗∗∗
(0.72) (8.14) (2.08) (6.44)
Firm Age −0.096∗∗∗ 0.041 −0.135∗∗∗ −0.110∗∗∗ −0.099∗∗∗ −0.107∗∗ −0.105∗∗∗
(3.10) (1.62) (4.69) (3.15) (3.41) (2.33) (3.72)
O-Score 0.098∗∗ 0.200∗∗∗ −0.180∗∗∗ −0.297∗∗∗
(2.45) (5.45) (4.97) (10.82)
Bank Debt −0.005 −0.245∗∗∗ −0.211∗∗∗ −0.177∗∗∗
(0.11) (5.42) (4.48) (3.83)
S&P Rating 0.154∗∗∗
(13.52)
Orthogonal Bond Rating 0.154∗∗∗ 0.138∗∗∗ 0.120∗∗∗
(13.46) (11.95) (11.16)
Split Rating 0.145∗∗∗ 0.143∗∗∗ 0.112∗∗∗ 0.098∗∗∗
(3.64) (3.60) (2.83) (2.58)
Noninvestment Grade 0.152∗ 1.762∗∗∗ 1.772∗∗∗ 0.128 1.695∗∗∗ 0.011 1.485∗∗∗
(1.65) (21.72) (21.56) (1.28) (20.44) (0.09) (17.92)
Duration −0.135∗∗∗ −0.210∗∗∗ −0.197∗∗∗ −0.156∗∗∗
(13.90) (18.29) (16.99) (14.82)
Baa-Aaa Spread 0.774∗∗∗ 0.731∗∗∗ 0.560∗∗∗ 0.654∗∗∗
(5.64) (5.32) (2.98) (4.33)
RMRF −0.009 −0.012 0.005 0.014
(1.00) (1.36) (0.50) (1.62)
SMB −0.030∗∗ −0.029∗∗ −0.018 −0.021
(2.29) (2.20) (1.21) (1.55)
HML −0.025∗ −0.021 −0.011 −0.011
(1.76) (1.48) (0.77) (0.71)
Leverage −0.146 −0.107 0.108
(0.87) (0.63) (0.49)
Profitability −0.346 −0.550 −1.150∗∗
(1.01) (1.57) (2.19)
Size −0.258∗∗∗ −0.239∗∗∗ −0.104∗∗
(7.97) (6.77) (2.17)
Growth 0.189∗ 0.217∗∗ 0.243∗∗
(1.77) (2.03) (1.97)
Industry fixed effects Included Included Included Included Included Included Included
Year fixed effects Included Included Included Included Included Included Included
N 8,529 8,529 8,529 7,738 7,738 5,856 5,856
Wald χ 2 1.09 1.06 0.06 1.33
(0.297) (0.304) (0.806) (0.249)
ρ −0.025 −0.025 0.005 −0.039
This table provides treatment effects models to examine whether there is a selection bias influencing the results. The treatment effects models are estimated using full maximum
likelihood. The dependent variable, Credit Spread, is calculated as the difference between the corporate bond yield and its duration-equivalent Treasury yield. For firms with multiple
bonds issues, Credit Spread is calculated as a weighted average based on each bond’s market value. Small Auditor is all auditor firms except Big 6 auditors, which include Arthur
Andersen; Arthur Young; Coopers & Lybrand; Ernst & Young; Deloitte & Touche; KPMG Peat, Marwick, Main; PriceWaterhouse; Touche Ross; and all merged entities. Tenure is the
number of years of the auditor-client relationship. Firm Age is the natural log of the time from the firm’s initial public offering (IPO) to the observation date as identified by the Center
for Research in Security Prices (CRSP). Bank Debt is an indicator variable that indicates whether the firm has notes payable or bank debt. O-Score is the Ohlson [1980] measure of
default risk. S&P Rating is calculated using a numerical conversion process (1 if the firm is rated AAA, and as the bond rating declines the numerical rating increases by 1). Split Rating
denotes when Moody’s and S&P have different bond ratings for the firm. Noninvestment Grade denotes whether the firm’s bonds are rated noninvestment grade. Duration is the weighted
duration of all outstanding debt for the firm. Baa-Aaa Spread is the spread between the Baa and Aaa corporate bond indexes. RMRF , SMB, and HML are common risk factors (Fama
and French [1993]). RMRF is the CRSP value-weighted market index return minus the one-month Treasury-bill return, SMB t is the return on a portfolio of small stocks minus the
return on a portfolio of large stocks, and HML t is the return on a portfolio of stocks with high book-to-market ratios minus the return on a portfolio of stocks with low book-to-market
AUDITOR QUALITY AND TENURE
ratios. Leverage is long-term debt (Compustat item 9) divided by total assets (Compustat item 6). Profitability is earnings before interest and taxes (EBIT) (Compustat item 13 minus
item 14) divided by total assets (Compustat item 6). Size is the natural log of total assets (MM) in 1997 dollars. Growth is the firm percentage change in sales (Compustat item 12)
from the prior year. N denotes the number of firm-year observations per model. The data cover from 1974 through 1998. Standard errors are corrected for heteroskedasticity using
the Newey and West [1987] specification. The t-statistics are reported in parentheses. ∗ , ∗∗ , and ∗∗∗ denote statistical significance at the 10%, 5%, and 1% confidence levels, respectively.
785
786
TABLE 10
Alternative Tenure Specifications (Firms Must Have Five Years of Complete Information)
Model 3 Model 5 Model 6

Model 1 Model 2 First Time Model 4 Investment Noninvest.
Alternative Alternative Firm Enters Median Median Median
Variable Tenure Tenure a Sample Regressions Regressions Regressions
Constant 3.004∗∗∗ 2.816∗∗∗ 3.887∗∗∗ 2.854∗∗∗ 2.188∗∗∗ 6.987∗∗∗
(9.72) (9.18) (9.25) (16.52) (21.26) (8.50)
Small Auditor 0.617∗∗∗ 0.621∗∗∗ 0.378∗ 0.368∗∗∗ 0.248∗∗ 0.620∗∗∗
(3.24) (3.27) (1.66) (6.75) (2.14) (4.29)
Tenure −0.021∗∗∗ −0.054∗∗∗ −0.007∗∗∗ −0.003∗ −0.027∗∗∗
(4.75) (6.13) (4.12) (1.85) (4.49)
Tenure (1st decile) 0.189∗∗
(2.10)
Tenure (10th decile) −0.244∗∗∗
(3.76)
Bank −0.215∗∗∗ −0.218∗∗∗ −0.221∗ −0.219∗∗∗ −0.221∗∗∗ −0.261∗∗∗
(3.90) (3.95) (1.86) (11.00) (11.46) (4.26)
Firm Age
−0.158∗∗∗ −0.162∗∗∗ −0.097∗ −0.136∗∗∗ −0.154∗∗∗ −0.048

(4.31) (4.43) (1.67) (11.45) (14.17) (1.08)
O-Score 0.201∗∗∗ 0.200∗∗∗ 0.176∗∗∗ 0.169∗∗∗ 0.099∗∗∗ 0.309∗∗∗
(4.96) (4.96) (3.89) (12.77) (6.53) (10.20)
Orthogonal Bond Rating 0.151∗∗∗ 0.151∗∗∗ 0.185∗∗∗ 0.112∗∗∗ 0.116∗∗∗ 0.116∗∗∗
(10.73) (10.76) (6.84) (24.40) (26.38) (5.72)
Split 0.112∗∗ 0.115∗∗ 0.198∗ 0.030∗∗ 0.038∗∗∗ 0.006
(2.47) (2.53) (1.80) (2.37) (3.26) (0.07)
High Yield 1.778∗∗∗ 1.775∗∗∗ 1.306∗∗∗ 1.816∗∗∗ −0.059∗∗∗ −0.378∗∗∗
(17.65) (17.74) (6.09) (32.08) (17.82) (10.40)
Duration −0.200∗∗∗ −0.201∗∗∗ −0.267∗∗∗ −0.088∗∗∗ 0.535∗∗∗ 0.668∗∗
(14.71) (14.74) (8.48) (16.21) (11.10) (1.93)
Spread 0.525∗∗∗ 0.524∗∗ 0.707∗∗∗ 0.408∗∗∗ 0.000 −0.009
(2.80) (2.80) (5.47) (7.22) (0.01) (0.65)
RMRF 0.001 0.001 −0.015 −0.001 −0.005∗∗∗ −0.064∗∗∗
(0.06) (0.11) (0.72) (0.24) (1.74) (3.27)
SMB −0.011 −0.011 −0.074∗∗∗ −0.012∗∗ 0.012∗∗∗ −0.031
(0.67) (0.67) (3.43) (2.36) (2.84) (1.27)
HML −0.012 0.011 −0.019 0.008 −0.221∗∗∗ 0.157
(0.74) (0.69) (0.55) (1.19) (11.46) −0.261
Industry fixed effects Included Included Included Included Included Included
Year fixed effects Included Included Included Included Included
R 2 or pseudo R 2 0.548 0.549 0.491 0.441 0.265 0.157
N 7,053 7,053 1,305 8,529 5,442 3,087
The sample is restricted to firms that have at least five years of data to calculate Tenure. The dependent variable, Credit Spread, is calculated as the difference between the
corporate bond yield and its duration-equivalent Treasury yield. Column 1 provides regression results using alternative tenure using a full sample. Column 2 provides regression
results using alternative tenure (top and bottom quartiles). Column 3 provides regression results when firm enters the sample for the first time. Column 4 provides results when
median regressions are performed. Column 6 provides regression results with credit spreads truncated at two standard deviation. For firms with multiple bonds issues, Credit
Spread is calculated as a weighted average based on each bond’s market value. Small Auditor is all auditor firms except Big 6 auditors, which include Arthur Andersen; Arthur
Young; Coopers & Lybrand; Ernst & Young; Deloitte & Touche; KPMG Peat, Marwick, Main; PriceWaterhouse; Touche Ross; and all merged entities. Tenure is the number of
years of the auditor-client relationship. Firm Age is the natural of the time from the firm’s initial public offering (IPO) to the observation date as identified by the Center for
Research in Security Prices (CRSP). Bank Debt is an indicator variable that indicates whether the firm has notes payable or bank debt. O-Score is the Ohlson [1980] measure of
default risk. Noninvestment Grade denotes whether the firm’s bonds are rated noninvestment grade. Duration is the weighted duration of all outstanding debt for the firm. Baa-Aaa
Spread is the spread between the Baa and Aaa corporate bond indexes. RMRF , SMB, and HML are common risk factors (Fama and French [1993]). N denotes the number of
firm-year observations per model. The data cover from 1974 through 1998. Standard errors are corrected for both heteroskedasticity and serial correlation (at one lag) using
the Newey and West [1987] specification. The t-statistics are reported in parentheses. ∗ , ∗∗ , and ∗∗∗ denote statistical significance at the 10%, 5%, and 1% confidence levels, respectively.
AUDITOR QUALITY AND TENURE
787
4.9 OTHER ROBUSTNESS TESTS

In this section we outline other robustness tests and, to be concise, only
report results with the orthogonalized bond rating variable. The results are
reported in table 10. First, although we control for serial correlation in both
the FM and PCSTS regressions, we perform an additional test to ensure
that the results are not driven by a few firms that are in the sample multiple
times. In this test, we only include a firm in the analysis the first time it enters
the sample. This reduces the sample to 1,305 firms. We exclude the year
indicator variables because for many years there is only one small auditor in
the subsample. The results, found in model 3, show that the coefficients on
both Tenure and Small Auditor remain statistically significant (1% and 10%
confidence levels, respectively).
Next, we examine the impact of outliers on our results. To do this, we per-
form median regressions with the standard errors bootstrapped from the
underlying distribution to control for heteroskedasticity and serial correla-
tion. Model 4 in table 10 provides the results for the full sample. We find that
both the Small Auditor coefficient (37 basis points) and Tenure coefficient
(0.7 basis points) remain significant at the 1% confidence level. When com-
paring the median regression results with the comparable PCSTS results in
model 3 in table 5, we find that median coefficients decrease by approxi-
mately half for Small Auditor and Tenure (63 basis points and 1.5 basis points,
respectively, from table 5). Models 5 and 6 provide results of median re-
gressions on the subsample of investment and noninvestment-grade bonds,
which are comparable to the PCSTS results in models 3 and 4 in table 6. For
the investment-grade sample, we see the Small Auditor coefficient decreases
using a median regression from 37 to 25 basis points, though it remains
significant at the 5% level. The Tenure coefficient decreases slightly from 0.4
to 0.3 basis points using a median regression approach, and the significance
drops to a 10% confidence level. For the noninvestment-grade sample, the
Small Auditor coefficient decreases to 62 basis points, significant at the 1%
level, compared with 74 basis points using PCSTS. The Tenure coefficient re-
mains unchanged at 2.7 basis points and significant at the 1% level. Overall,
we conclude that although some observations may be inflating the coeffi-
cient in the PCSTS method, they are not driving the results.
4.10 ECONOMIC SIGNIFICANCE OF AUDITOR CHOICE

Our results also can provide insights on the economic trade-offs firms face
when choosing an auditor. For example, small auditor firms in our sample
have a median market value of debt of $37 million. Assuming a premium of
approximately 60 basis points (table 5), this implies an incremental interest
cost of $222,000 per year over the median duration of 5.75 years. Using
the estimates from the median regressions, the Small Auditor coefficient is
reduced to approximately 37 basis points, which implies an incremental in-
terest cost of approximately $137,000 per year. These incremental interest
costs are likely to be weighed against other demand-side effects, such as
audit fees, auditor tenure, and the transactions costs of auditor realignment
(DeAngelo [1981], Magee and Tseng [1990]). Although audit fee data do
not exist for most of our sample period, some estimates can be inferred
from previous studies. For example, Frankel, Johnson, and Nelson [2000]
find that the median audit fee for publicly traded companies is $191,000
and the average audit fee for non–Big 5 firms is approximately $127,000.
Palmrose [1986] and Francis and Simon [1987] find fees are larger for
non–Big 8 clients but that the difference is only significant for small firms.20
Given that our small auditor firms have median total assets of $264 million,
the firms employed in our sample are likely to fall in the range of firms ex-
periencing nonzero audit fee premiums in addition to any one-time fixed
switching costs. Our results also show that over our sample period, the num-
ber of firms with publicly traded debt that employ non–Big 6 auditors has
decreased, which is consistent with the hypothesis that capital market partic-
ipants deem that the benefits outweigh the costs. In addition, firms without
publicly traded debt still have a much higher incidence of use of non–Big 6
auditors. Taken together, our results suggest that capital market participants
(investors and credit rating agencies) value the information and insurance
effects of audits and that firms have rationally responded to the extent that
the benefits outweigh the costs.
5. Conclusions
In this article we examine whether auditor quality and tenure influence
capital market participants using firm-level bond price data. Because audi-
tors provide independent verification of manager-prepared financial state-
ments, auditor quality contributes to the credibility of financial disclosure.
In addition, because investors often use audited financial statements as the
basis for asset-allocation decisions, securities laws provide recourse for the
investor against the auditor. In this way, auditors provide investors with a
means to indemnify losses (Dye [1993]). Consistent with this role, recent
trends indicate a marked increase in securities litigation against auditors
(Palmrose [1991]). Taken together, the auditors’ dual characterization, as
both insurance provider and information intermediary, suggests that audits
provide value to the capital markets.
Using a sample of 8,529 firm-year observations from 1974 to 1998, we
find a negative relation between auditor quality and tenure and the return
investors require on corporate bonds. This impact is approximately twice as
large for noninvestment-grade as for investment-grade firms. Our findings
are consistent with the hypothesis that audits are valued by capital market
participants. When we control for the information effects of audits, we find
that the coefficient on auditor size is lower but remains statistically and eco-
nomically significant for investment-grade and noninvestment-grade firms.
20 Palmrose [1986, p. 109, appendix A] finds a difference in audit fees between Big 8 and
non–Big 8 of $170,000 for firms with total assets of less than $150 million.
The effect of tenure after controlling for the information effect decreases as
well and remains significant for noninvestment-grade firms. Therefore, our
results suggest that in addition to the information effect of audits, investors
value the insurance role of auditors. Furthermore, the finding that investors
require lower rates of return as the length of tenure increases provides direct
evidence regarding the value investors attach to audit tenure and suggests
that mandatory auditor rotation may not be uniformly beneficial and could
be viewed negatively by the capital market for riskier firms. Overall, we in-
terpret our results as consistent with Dye’s [1993] dual characterization of
audits providing both insurance and information that are in turn valued by
investors.
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Does Auditor Quality and Tenure Matter To Investors? Evidence From The Bond Market

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Does Auditor Quality and Tenure Matter To Investors? Evidence From The Bond Market

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Journal of Accounting Research

Vol. 42 No. 4 September 2004

Does Auditor Quality and Tenure

Received 22 April 2003; accepted 7 April 2004

We examine the relation between auditor characteristics (quality and

insurance effect. In contrast, Baber, Kumar, and Verghese [1994] state in

We examine the role of auditors from an alternative perspective, namely,

5 See Davidson et al. [1987].

into investment-grade and noninvestment-grade debt firms, we find that

2.2 SAMPLE CHARACTERISTICS

Panel B: Firm-year observations over time and by risk

Panel C: Number of changes in auditor quality

Panel D: Dispersion of sample among Fama and French 12 industry categories

(1) consumer nondurables, (2) consumer durables, (3) manufacturing, (4)

3. Impact of Auditor Quality and Tenure on the Bond Market

Finally, to measure the total effect (information plus insurance) of au-

Orthrat = Rating − (α0 + α1 Auditor + α2 Tenure + β1,...,n Firm Risk Factors

and we then reestimate equation (3) by replacing Rating with Orthrat.

dependent variable, Credit Spread, at 2 standard deviations from the mean.

using the original coefficients.14 We include additional financial variables to

Operating Income After Depreciation(#178)

four years. However, we find it has no explanatory power.

in the 1990s as compared with those in the 1980s.

[1993] risk factors, which can be found at http://mba.tuck.dartmouth.edu/pages/faculty/

Credit Small Auditor Analyst Bank Firm Bond Baa-Aaa

Dependent Variable = S&P Credit Rating

Model 1 Model 2 Model 3 Model 4

4.2 INSURANCE ROLE OF AUDITS

Dependent Variable = Yield Spread

Bond Rating Orthogonal Bond Rating

Model 1 Model 2 Model 3 Model 4

Bond Rating Orthogonal Bond Rating

Model 1 Model 2 Model 3 Model 4

4.3 INFORMATION ROLE OF AUDITS

When directly comparing the corresponding models, we find that the

4.4AUDITOR QUALITY AND THE COST OF DEBT FOR INVESTMENT-GRADE

4.5 CHANGES IN AUDITOR QUALITY AND CHANGES

We estimate a model similar to the model found in equation (1) with

4.6 INFORMATION ASYMMETRY

Dependent Variable = Yield Spread

Bond Rating Orthogonalized Bond Rating

Full Noninvestment Full Noninvestment

analyst coverage should reduce information asymmetry and thus reduce

Dependent Variable = Yield Spread

Missing Analyst Data: Missing Analyst Data:

To mitigate this potential endogeneity in our sample, we employ a treat-

estimates using full maximum likelihood estimation (a Heckman [1979]

Dependent Variable = Yield Spread

Model 3 Model 5 Model 6

−0.158∗∗∗ −0.162∗∗∗ −0.097∗ −0.136∗∗∗ −0.154∗∗∗ −0.048

4.9 OTHER ROBUSTNESS TESTS

4.10 ECONOMIC SIGNIFICANCE OF AUDITOR CHOICE

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