Afro-Asian J. Finance and Accounting, Vol. 4, No.

2, 2014 95

Audit quality and cost of equity capital

Rohaida Basiruddin*
International Business School (UTM IBS),
Universiti Teknologi Malaysia,
Level 10, Menara Razak, Jalan Semarak,
54100 Kuala Lumpur, Malaysia
E-mail: rohaida@ic.utm.my
*Corresponding author

Prawat Benyasrisawat
School of Accounting,
Bangkok University,
40/4 Rama 4 Road, Klongtoey,
Bangkok, 10110, Thailand
E-mail: prawat.b@bu.ac.th

Siti Zaleha Abdul Rasid

International Business School (UTM IBS),
Universiti Teknologi Malaysia,
Level 10, Menara Razak, Jalan Semarak,
54100 Kuala Lumpur, Malaysia
E-mail: szaleha@ibs.utm.my

Abstract: The purpose of this research is to examine the relationship between

audit quality and cost of equity capital. This research argues that the higher the
levels of audit quality, the lower the rate of return required by the investor. The
cost of equity capital is measured by the price-earnings growth (PEG) model.
Audit quality is measured by proxies, including audit fees, non-audit fees,
industry specialist auditors and earnings management. Based on 226 largest
companies listed on the London Stock Exchange (FTSE 350) during
2005–2008, findings report a significant relationship between earnings
management and the cost of equity capital. The research does not find a
relationship between the other three audit quality proxies. The results suggest
that among larger firms, earnings management is a major issue. Auditors are
mainly expected to deal with earnings management. It is more likely that
investors perceive auditing as an important mechanism to detect earnings
management in large firms, enhancing the value of financial information.

Keywords: audit quality; audit fees; non-audit fees; industry specialist auditor;
earnings management; cost of equity capital.

Reference to this paper should be made as follows: Basiruddin, R.,

Benyasrisawat, P. and Rasid, S.Z.A. (2014) ‘Audit quality and cost of equity
capital’, Afro-Asian J. Finance and Accounting, Vol. 4, No. 2, pp.95–111.

Copyright © 2014 Inderscience Enterprises Ltd.

96 R. Basiruddin et al.

Biographical notes: Rohaida Basiruddin is a Senior Lecturer at International

Business School, UTM. She has a PhD in Accounting and Finance from
Durham University, UK. Currently, she teaches management accounting and
financial analysis for MBA and MSc in Engineering Business Management
programmes. Her research interests are corporate governance, audit quality,
disclosure quality and creative accounting.

Prawat Benyasrisawat is an Assistant Professor in Accounting at School of

Accounting, Bangkok University, Thailand. He is currently an Associate Dean
of Academic Affairs and Research in School of Accounting. His research
interests are focused on financial accounting, auditing and corporate
governance. He is an active member in the Subcommittee of Accounting
Education and Technology in Federation of Accounting Professions Under The
Royal Patronage of His Majesty The King, Thailand.

Siti Zaleha Abdul Rasid is a Senior Lecturer at International Business School,

UTM. She has a PhD in Accounting from International Islamic University
Malaysia and currently teaches accounting subjects for MBA programmes. Her
research interests are management accounting, risk management and corporate
governance.

This paper is a revised and expanded version of a paper entitled ‘The

relationship between audit quality and cost of capital’, Doctoral Colloquium,
British Accounting Association (BAA), Cardiff City Hall, 29–30 March, 2010
and ‘Audit quality and cost of equity capital: UK evidence’, The 3rd Global
Accounting and Organisational Change Conference (GAOC 2012), Petaling
Jaya, 14–17 July 2012.

1 Introduction

The issue of audit quality has received considerable attention in recent years, especially
after the collapse of high-profile companies such as Enron, Worldcom and Tyco. The
credibility of the auditor has been questioned by the public, particularly potential
investors. The main concerns are the external auditor’s independence and the quality of
audit work delivered to their clients and public (Karjalainen, 2011). The lack of investor
confidence in audit quality can seriously undermine the financial market since investors
are a major group of users that provide capital support to the economic system. Audit
quality is defined as the likelihood that an auditor will both detect and report a breach,
material error, or omission in the client’s accounting system (DeAngelo, 1981). This
implies that fundamental audit quality depends on the technical capabilities of the audit
team to detect misstatements and the auditor’s independence to report such misstatements
(Wooten, 2003; Niemi, 2004; Baker and Al-Thuneibat, 2011). In relation to the cost of
equity capital, if the investor perceives that audited financial information contains low
quality audit, they would raise concerns in respect of the quality and credibility of a
firms’ financial information. As a consequence, investors may refuse to invest their
capital or may demand a higher rate of return to compensate them for the potential risk
attached to the lower levels of audit quality (Chou and Chang, 2011).
The objective of this research is to shed light on the relationship between audit quality
and the cost of equity capital, particularly in large UK firms. Four proxies of audit quality
are examined in this study, namely, audit fees, non-audit fees, industry specialist auditor
 Audit quality and cost of equity capital 97

and earnings management. Using the FTSE 350, during fiscal year 2005–2008, our
findings suggest that among large firms, earnings management is a major issue for audit
quality. The investor perceives that auditing procedures are mechanisms to detect
earnings management in large and complex firms. The lower the level of earnings
management perceived by the investors, the lower would be the information risk,
enhancing information value of earnings. Once the investor perceives that information,
firms are more likely to enjoy the lower ex ante cost of equity capital.
The remainder of this article is as follows. The next section discusses prior literature
and hypothesis development. Section 3 elaborates the research methodology. The
subsequent sections discuss the main results and additional tests. The final section is the
conclusion of the study.

2 Prior literature and hypothesis development

Generally speaking, the credibility and quality of information derived from auditing
processes are relevant for investment decisions. This research examines the relationship
between audit quality and cost of equity capital. The findings of this issue are
inconclusive. Khurana and Raman (2004) found that large auditing firms are associated
with lower ex ante cost of equity capital in US firms but this finding does not apply to
firms in Australia, Canada and the UK. However, Li and Stokes (2008) found a
significant and negative relationship between the large auditors and the ex ante cost of
equity capital. Boone et al. (2009) found that the big-4 and mid-tier auditors appear to
have similar audit quality in terms of lower levels of accrual-based earnings management.
However, the audit clients of big-4 and mid-tier auditors show the opposite finding. The
client firms of big-4 auditors are more likely to enjoy lower ex ante costs of equity capital
relative to the clients of mid-tier and smaller auditors.
Khurana and Raman (2006) and Hope et al. (2009) suggest that audit and non-audit
fees deter the quality of audited financial statements because of the financial bonding
between the client and auditor, thereby increasing the ex ante cost of equity capital of the
client firm. The existing research indicates that firms that engage large auditors and
industry specialist auditors are likely to have a lower ex ante cost of equity capital
(Ahmed et al., 2008; Fernando et al., 2006; Li et al., 2009). According to one study
(Fernando et al., 2006), firms that have longer tenure with an auditor are likely to have a
lower ex ante cost of equity capital. But according to another study (Boone et al., 2008),
the ex ante cost of equity capital starts to increase with the additional years of audit
tenure because the higher tenure could possibly impair the auditors judgement, increasing
the information risk. Hribar and Jenkins (2004) employ the accounting restatement as a
proxy of audit quality. They found that the restatement initiates the uncertainty of
information provided by the management, resulting in a larger increase in the ex ante cost
of equity capital, particularly when the restatement is set out by the auditor. Overall, the
existing study suggests that audit quality is related to the ex ante cost of equity capital.
Based on the existing studies, we develop our hypotheses as follows.

2.1 Industry specialist auditor and the ex ante cost of equity capital
Prior studies suggest that the auditor industry specialist improves the auditor’ judgements
(Taylor, 2000), enhances the auditors’ skills in detecting errors (Bedard and Biggs, 1991;
98 R. Basiruddin et al.

Wright and Wright, 1997) and frauds (Johnson et al., 1991; Carcello and Nagy, 2004),
facilitates a higher disclosure quality (Dunn and Mayhew, 2004) and a higher compliance
with auditing standards (O’Keefe et al., 1994). Li and Strokes (2008) and Chou and
Chang (2011) suggest that the firm hiring the industry specialist auditor is more likely to
receive a lower ex ante cost of equity capital due to the higher competence and skill of
such auditors. Therefore, we hypothesise in terms of an alternative form as follows:
H1 There is a negative relationship between industry specialist auditors and the ex ante
cost of equity capital.

2.2 Earnings management and cost of equity capital

Anderson et al. (2001) posit that when the manager has a higher incentive to manage
earnings, the auditor perceives the manager is more aggressive, having a greater desire to
ensure that their financial statements ‘look good’ with the expectation that the auditor
will agree with their financial statements. When the client manager is expected to
manipulate financial statements, the auditor is more likely to limit earnings management
by reducing the flexibility of accounting choices inducing the client firm’s opportunistic
behaviour of earnings management (Becker et al., 1998). Thus, this research argues that
higher audit quality is associated with lower earnings management. If the investor
perceives that the auditor is more likely to be flexible in permitting earnings management
or opportunistic behaviour of management, it might increase the information risk and
reduce the information value of earnings, resulting in a higher ex ante cost of equity
capital. We hypothesise in terms of an alternative form as follows:
H2 There is a positive relationship between earnings management and the ex ante cost of
equity capital.

2.3 Audit fees and cost of equity capital

Prior literature suggests that higher audit fees are associated with higher audit quality in
order to compensate for the high-priced reputation, the auditors’ industry specialisation,
and the increase in audit effort (Simunic, 1980; Palmrose, 1986; Craswell et al., 1995;
Karim and Hasan, 2012). The development of an auditor’s reputation, brand name and
industry specialisation incur a higher cost, resulting in a higher audit fee (Craswell et al.,
1995). The client firm is willing to pay a fee premium for the auditor’s reputation and to
receive a higher quality audit. Brand name auditors convey a higher quality
differentiation compared to non-brand name auditors (Simunic, 1980; Palmrose, 1986). If
the investor perceives that the higher audit fee compensates for the extensive audit effort,
skill and competence as well as implicit guarantee, these would enhance the credibility of
audited financial statements, resulting in a lower ex ante cost of equity capital. On the
other hand, the higher audit fee could impair auditor independence and make the auditor
financially dependent on their clients. The impairment of auditor independence might
influence the auditor’s judgment because the auditor is concerned with the possibility of
losing those clients. These reduce the investor’s confidence on the credibility of the
audited financial statement, thus increasing the ex ante cost of equity capital. We
hypothesise in terms of an alternative form as follows:
H3 There is a relationship between audit fees and the ex ante cost of equity capital.
 Audit quality and cost of equity capital 99

2.4 Non-audit fees (NAS) and cost of equity capital

The central argument of NAS is generally focused on auditors’ independence - whether
the joint provision of audit fees and NAS enhances or reduces the auditors’
independence. Some suggest that the provision of NAS increases the auditor’s
independence, broadens the auditor’s knowledge and improves their judgments, resulting
in a higher audit quality (Simunic, 1984; Beck et al., 1988; Arruñada, 1999a, 1999b,
2000; Wallman, 1996; Goldman and Barlev, 1974). An alternative view suggests that the
provision of NAS compromises the auditors’ independence due to the nature of NAS
itself. A higher level of non-audit fees makes the auditor financially dependent on their
clients, making the auditor less likely to resist the client’s pressure. This lessens the
auditor’s objectivity, resulting in lower audit quality (Simunic, 1984; Beck et al., 1988;
Beattie and Fearnley, 2002; Ahadiat, 2011). In relation to the cost of equity capital, if the
investor perceives that the provision of NAS is able to enhance the auditor’s overall
competency and knowledge, it would reduce the uncertainty and information risk
contained in the audited financial statements. The economic power that the auditor gains
through NAS might provide them with a greater incentive to resist the client’s pressure.
Assurances and the auditors’ economic power may reflect a lower ex ante cost of equity
capital due to the increased level of confidence concerning the credibility of the audited
financial statements. Alternatively, if the investor perceives that the provision of NAS
and the higher level of non-audit fees compromise the auditor’s independence, these
should reduce the audit quality, resulting in a larger increase in the ex ante cost of the
equity capital of the client firm. We hypothesise in terms of an alternative form as
follows:
H4 There is a relationship between non-audit fees and the ex ante cost of equity capital.

3 Research methodology

3.1 Data collection

The initial sample population for this study includes the largest 350 companies listed on
the London Stock Exchange (FTSE 350) for fiscal year 2005 to 2008. An important
justification for choosing these companies is that they cover a broad range of industrial
and commercial activities and account for a significant portion of the UK economic
output. We employ the dataset from 2005 to reduce the effect of the change in the
accounting system on our analysis because the group financial statements of the UK
listed companies must comply with the International Financial Reporting Standards
(IFRS) beginning on or after 1 January 2005. Companies operating in the financial sector
are excluded from the study. Financial data are collected from DATASTREAM and
FAME. Earnings forecast data and analysis are gathered from the I/B/E/S database.
Deleting firms with missing variables leaves us with a final sample of 226 firms, which
are all audited by the big-4 auditors.

3.2 Research design

To examine the relationship between audit quality and the ex-ante cost of equity capital,
we use the following main regression model:
100 R. Basiruddin et al.

re = f ( IND _ SPEC , DACC , LNAF , LNNAF , BETA, LNSIZE ,VAR, GROWTH ) (1)

where
• Dependent variable:
re client-specific ex ante cost of equity capital estimated by the price-earnings
growth (PEG) model
• Test variables:
IND_SPEC the industry specialist auditor;
DACC the discretionary accrual
LNAF the natural log of audit fee;
LNNAF the natural log of non-audit fee;
• Control variables:
BETA beta calculated over 36 months to the fiscal year-end
LNSIZE the natural log of market value of common equity at the end of fiscal
year
VAR the standard deviation of analysts’ earnings at the end of fiscal year
GROWTH forecasted long-term earnings growth at the end of fiscal year.
We estimated the cost of equity capital by using the ex ante returns since the evidence
from prior literature suggests that the ex ante returns are a more precise measure relative
to ex post returns (Fama and French, 1997; Elton, 1999). In this study, we employ the
PEG model to estimate the client-specific ex ante cost of equity capital because it
provides a more stable and meaningful estimation compared to alternative approaches
(Botosan and Plumlee, 2005). The client-specific ex ante cost of equity capital is
estimated as follows:

eps2 − eps1
re = (2)
p0

where
re the client-specific ex ante cost of equity capital
eps1 the one-year ahead mean analysts’ earnings forecast per share
eps2 the two-year ahead mean analysts’ earnings forecast per share
p0 the share price at the end of fiscal year.
Audit quality is measured by industry specialist auditors (IND_SPEC), discretionary
accruals (DACC), audit fees (LNA) and non-audit fees (LNNAF). We define an industry
specialist auditor as the auditor’s market share, in percentage terms, of audit fees for each
industry (Ferguson et al., 2003; Chen et al., 2005). Firms that employ an industry
specialist auditor are expected to have a lower ex ante cost of equity capital than firms
that engage a non-specialist auditor. Consistent with Becker et al. (1998), we use the
absolute value of discretionary accruals to measure the level of opportunistic earnings
management activities and extreme reporting decisions exercised by the manager. The
 Audit quality and cost of equity capital 101

absolute value of discretionary accruals is defined as the degree of freedom given by the
auditor in allowing their clients to have flexibility in accounting choices. A high audit
quality is associated with a lower level of absolute value of discretionary accruals,
consistent with the lower flexibility of accounting choices given by the auditor. We
expect firms that have a lower level of absolute value of discretionary accruals to have a
lower ex ante cost of equity capital. We measure discretionary accruals by employing a
longitudinal variation of the modified Jones model.1 We transform audit fees and non-
audit fees to a natural logarithm to achieve a normality of data. Since the arguments
concerning the relationship between audit fees and non-audit fees with the ex ante cost of
equity capital are inconsistent, we do not have predictions for both variables.
The control variables include BETA, LNSIZE, LNB/V and GROWTH. BETA is a
measure of the systematic risk calculated from the firm specific-capital asset pricing
model (CAPM) using 36 rolling returns. The CAPM suggests that systematic risk has a
positive relationship with the cost of equity capital (Sharpe, 1964; Lintner 1965; Botosan
and Plumlee, 2005). Thus, we expect BETA to have a positive sign.
LNSIZE is a proxy for firm size and is measured by the natural log of market value of
shares at the end of fiscal year. Berk (1995) suggests that market value is inversely
related to the expected return, thus LNSIZE is expected to have a negative relationship
with the ex ante cost of equity capital (Khurana and Raman, 2004; Botosan and
Plumlee, 2005).
VAR is a proxy for earnings variability measured by the standard deviation of
forecasted earnings. Earnings variability is perceived as a source of risk for firm
valuation (Gebhardt et al., 2001; Gode and Mohanram, 2003). The higher the variability
of reported earnings the greater the perceived risk in the company, resulting in the higher
cost of equity capital. Consistent with this, we expect VAR to have a positive sign.
GROWTH is expected to have a positive sign. According to Beaver et al. (1970) the
abnormal earnings which arise from growth opportunities are more risky than normal
earnings. Such evidence has been outlined by La Porta (1996), suggesting that the high
expected-growth shares are more likely to have higher standard deviations of returns and
higher market beta as compared to the low expected-growth shares. Therefore, we expect
to have a positive relationship between GROWTH and the ex ante cost of equity capital
(Khurana and Raman, 2004; Botosan and Plumlee, 2005).

4 Empirical findings and discussions

4.1 Descriptive statistics

Table 1 presents the descriptive statistics for 226 observations including mean, median,
standard deviation, minimum, maximum, skewness and kurtosis of the variables. The
mean and median of the ex ante cost of equity capital are 0.099 and 0.094, respectively,
which are relatively similar to those reported in Khurana and Raman (2004). For industry
specialist auditors, the mean and median are 0.348 and 0.318, respectively. The mean and
median absolute values of discretionary accruals measured by the modified Jones model
are 0.069 and 0.043, respectively. With regard to audit fees and non-audit fees, the means
for both variables are 2.943 and 2.809, respectively. The results suggest that on average,
audit fees are higher than non-audit fees.
102 R. Basiruddin et al.

Table 1 Descriptive statistics on variables used (n = 226)

Standard
Variables Mean Median Minimum Maximum Skewness Kurtosis
deviation
re 0.099 0.094 0.043 0.018 0.233 1.101 6.357
BETA 1.118 1.063 0.553 –0.024 2.562 0.651 6.079
LNSIZE 3.308 3.187 0.575 2.506 4.952 1.068 3.787
VAR 1.597 1.035 1.756 0.080 9.920 2.938 15.153
GROWTH 8.676 8.000 5.382 –3.510 27.000 1.416 12.821
IND_SPEC 0.349 0.318 0.189 0.021 0.720 0.259 2.179
DACC 0.069 0.043 0.080 0.000 0.379 2.257 8.895
LNAF 2.943 2.903 0.465 1.996 4.041 0.088 2.903
LNNAF 2.809 2.928 0.693 0.000 4.176 –1.171 6.243
Notes: re = client-specific ex ante cost of equity capital estimated by the PEG model;
BETA = share beta calculated over 36 months to the fiscal year-end;
LNSIZE = the natural log of market value of shares at the end of fiscal year;
VAR = the standard deviation of analysts’ earnings at the end of fiscal year;
GROWTH = forecasted long-term earnings growth at the end of fiscal year;
IND_SPEC = industry specialist auditor measured by the auditor’s percentage of
audit fees market share for each industry; DACC = discretionary accruals;
LNAF = the natural log of audit fees and LNNAF = the natural log of non-audit
fees.
As shown in Table 1, several variables are not normally distributed. For instance, VAR
and GROWTH are highly skewed. One possibility of violating the normality assumption
is the heteroscedasticity problem. To confirm whether or not heteroscedasticity exists, we
perform the White and the Breusch-Pagan tests with the null hypothesis that the variance
of the residuals is homogenous. The untabulated results show that the p-value and chi-
square of both tests are significant, suggesting the existence of heteroscedasticity in our
measures.2 To mitigate the heteroscedasticity problem, we use the generalised least
squares estimator (GLS) for the regression analysis to reweight the error variance and
obtain a constant variance as suggested by Adkins and Hill (2007).

4.2 Correlation matrix

Table 2 presents the correlation matrix for all variables. Overall, the variables are less
likely to be inter-correlated with one and another except for variables LNSIZE and DACC
that have a moderate correlation (0.408). The larger firm measured by market value is
more likely to have higher earnings growth (GROWTH) and higher earnings management
(DACC). The variable of interest – the ex ante cost of equity capital (re) - is positively
and significantly related to BETA, GROWTH and DACC. These coefficients are
significant with the expected signs. LNSIZE and VAR are not significantly correlated with
the ex ante cost of equity capital. Similarly, IND_SPEC, LNAF and LNNAF are
insignificant with the ex ante cost of equity capital (re). In sum, the correlation matrix
reveals no highly correlated independent variables, suggesting that multicollinearity is
not an issue. However, we further investigate multicollinearity by performing the
variance inflation factor (VIF) and tolerance value. The untabulated results indicate a VIF
value ranging from 1.0 to 1.8 and tolerance values of more than 0.50.
 Table 2

Variables re BETA LNSIZE VAR GROWTH IND_SPEC DACC LNAF LNNAF

re 1.000
BETA 0.233*** 1.000
LNSIZE –0.010 –0.155** 1.000
VAR 0.076 0.063 0.122 1.000
GROWTH 0.078*** 0.057 0.167** –0.178*** 1.000
IND_SPEC –0.076 –0.090 0.055 0.056 –0.086 1.000
Pearson correlation coefficient matrix

DACC 0.196*** –0.085 0.408*** 0.025 0.243* –0.081 1.000

Audit quality and cost of equity capital

LNAF 0.048 –0.041 –0.170*** 0.053 0.000 0.247*** –0.073 1.000

LNNAF 0.038 0.042 –0.101 0.001 0.0411 0.032 –0.030 0.609*** 1.000
Notes: re = client-specific ex ante cost of equity capital estimated by the PEG model; BETA = share beta calculated over 36 months to the fiscal
year-end; LNSIZE = the natural log of market value of shares at the end of fiscal year; VAR = the standard deviation of analysts’ earnings at
the end of fiscal year; GROWTH = forecasted long-term earnings growth at the end of fiscal year; IND_SPEC = industry specialist auditor
measured by the auditor’s percentage of audit fees market share for each industry; DACC = discretionary accruals; LNAF = the natural log of
audit fees and LNNAF = the natural log of non-audit fees.
***, **, and * are significant at the level of 1%, 5% and 10%, respectively.
103
104 R. Basiruddin et al.

Table 3 The result of multivariate regressions estimated by GLS with random effect (n = 226)

re = f (BETA, LNSIZE, VAR, GROWTH, IND_SPEC, DACC, LNAF,LNNAF)

Prob > chi2 0.0001
2
Overall R 0.13
Independent variables Coefficient z-statistic
Intercept 0.073*** 2.63
BETA 0.018*** 3.51
LNSIZE –0.007 –1.37
VAR 0.001 0.77
GROWTH 0.001* 1.87
IND_SPEC –0.014 –0.91
DACC 0.140*** 3.73
LNAF 0.008 0.98
LNNAF –0.002 –0.48
Notes: re = client-specific ex ante cost of equity capital estimated by the PEG model;
BETA = share beta calculated over 36 months to the fiscal year-end;
LNSIZE = the natural log of market value of shares at the end of fiscal year;
VAR = the standard deviation of analysts’ earnings at the end of fiscal year;
GROWTH = forecasted long-term earnings growth at the end of fiscal year;
IND_SPEC = industry specialist auditor measured by the auditor’s percentage of
audit fees market share for each industry; DACC = discretionary accruals;
LNAF = the natural log of audit fees and LNNAF = the natural log of non-audit
fees; n = a number of observations.
***, **, and * are significant at the level of 1%, 5% and 10%, respectively.

4.3 Multivariate regressions

Table 3 reports results estimated by GLS with the random effect. We use the random
effect because of the suggestion of the Hausman test. From our results, the overall model
is significant and the explanatory power of the regression is 0.13. The coefficient of
DACC is significant and positively related to the ex ante cost of equity capital. The result
suggests that when auditors limit earnings management, information risks should decline
and information value of earnings should be enhanced. Thus, the firm is more likely to
enjoy lower ex ante cost of equity capital. The industry specialist auditors, audit fees and
non-audit fees are not significantly associated with the firm-specific ex ante cost of
equity capital. These findings are inconsistent with previous studies (Fernando et al.,
2006; Hope et al., 2009; Khurana and Raman, 2006), that largely examine the US and
Australian firms. We argue that investors do not perceive industry specialist auditors,
audit fees and non-audit fees as value added attributes and/or as a threat to auditor
independence in our large UK sample-firms. This is due to the fact that all sample firms
hire the highly reputable big-4 auditing firms. Thus, the investor is not concerned about
the services provided by the high-reputation auditing firms and their high service fees.
However, the investor is more likely to be concerned with earnings management in large
complex firms that engage a variety of different contracting parties. Our results suggest
 Audit quality and cost of equity capital 105

that investors expect auditors to detect earnings management, which implies that the
investor views audit quality as the detection of earnings management, and that an
auditing procedure is a mechanism to deal with earnings management. With regard to the
control variables, the evidence suggests that the variables BETA and GROWTH have a
significantly positive relationship with the ex ante cost of equity capital. The higher the
risk, the higher the ex ante cost of equity capital. These findings are consistent with the
existing literature (Khurana and Raman, 2004, 2006; Botosan and Plumlee, 2005; Easton,
2004). The coefficients of LNSIZE and VAR are, respectively, negative and positive but
both of them are insignificant.

5 Additional analyses

5.1 Least squares estimator with robust standard error

For the robust test, we re-estimate equation (1) using the least squares estimator with
robust standard error to correct for heteroscedasticity and autocorrelation [Adkins and
Hill, (2007), p.194]. The results are presented in Table 4. The primary findings remain
unchanged, that DACC is significantly associated with the ex ante cost of equity.
Table 4 Least squares estimator with robust standard error (n = 226)

re = f (BETA, LNSIZE, LNB/V, GROWTH, IND_SPEC, DACC, LNAF,LNNAF)

F-statistic 0.002
2
R 0.13
Independent variables Coefficient t-statistic
Intercept 0.073*** 2.68
BETA 0.018** 1.87
LNSIZE –0.007 –1.37
VAR 0.001 0.80
GROWTH 0.001* 1.97
IND_SPEC –0.014 –0.87
DACC 0.140*** 3.03
LNAF 0.008 0.94
LNNAF –0.002 –0.50
Notes: re = client-specific ex ante cost of equity capital estimated by the PEG model;
BETA = share beta calculated over 36 months to the fiscal year-end;
LNSIZE = the natural log of market value of shares at the end of fiscal year;
VAR = the standard deviation of analysts’ earnings at the end of fiscal year;
GROWTH = forecasted long-term earnings growth at the end of fiscal year;
IND_SPEC = industry specialist auditor measured by the auditor’s percentage of
audit fees market share for each industry; DACC = discretionary accruals;
LNAF = the natural log of audit fees and LNNAF = the natural log of non-audit
fees; n = a number of observations.
***, **, and * are significant at the level of 1%, 5% and 10%, respectively.
106 R. Basiruddin et al.

5.2 Different measures of audit quality

We employ different measures of audit quality3 for further testing. We estimate the
regression model by using GLS with random effect. First, we use the other four measures
for the industry specialist auditor, including

1 the continuous variable based on the percentage of client’s sales in each

industry audited by a specific audit firm (Abbott and Parker, 2000; Chen et al.,
2005)

2 the industry leader; a dichotomous variable, 1 is coded if the incumbent auditor is the
largest supplier of audit services provided in each industry; audit services are
measured by the market share of audit fees, or 0 otherwise (Ferguson et al., 2003;
Chen et al., 2005)

3 the auditor’s client sales in each industry divided by the total auditor’s client
sales

4 variable (1) multiplied by variable (3).

Unreported findings are qualitatively similar to the primary findings. Second, we use

1 Jones model

2 a performance discretionary accruals measure introduced by Kothari et al. (2005) for

estimating discretionary accruals.

Unreported results are consistent with the primary findings. Lastly, we use the ratio of
audit fees to total revenue as a proxy for audit fees (Khurana and Raman, 2006) and the
ratio of non-audit fees to total fees. Again, additional results are qualitatively similar to
the main findings.

5.3 Endogeneity and two-stage least squares regressions

Since the prior literature recognises the various motivation of earnings management as
either beneficial information to the market (Watts and Zimmerman, 1986; Subramanyam,
1996; Sankar and Subramanyam, 2001; Arya et al., 2003) or opportunistic behaviour of
management (Healy, 1985; Gaver at al., 1995; Holthausen et al., 1995; Sweeney, 1994;
Defond and Jiambalvo, 1994; Barth et al., 1999), the earnings management variable
might suffer the endogeneity problem. We perform the Durbin-Wu-Hausman test with
the null hypothesis that the residual of DACC is jointly equal to zero. Our unreported
result shows that the F-statistic is 7.56, rejecting the null hypothesis. The rejected null
hypothesis suggests the present of endogeneity in the DACC. We further employ a
two-stage least squares regression (2SLS) to deal with the endogeneity issue. We use the
industry average value of the endogenous variable as our instrumental variable. For this
case, we use the industry average of DACC. The results are reported in Table 5.
Consistent with the primary findings, our results show the positive relationship between
the earnings management and the ex ante cost of equity capital.
 Audit quality and cost of equity capital 107

Table 5 2SLS regression (n = 226)

re = f (BETA, LNSIZE, LNB/V, GROWTH, IND_SPEC, DACC, LNAF,LNNAF)

The instrumented variable is DACC, while the instrument variable is INDAVEDACC, measured
by the industry average of DACC.
F-statistic 0.000
2
Adjusted R 0.08
Independent variable Coefficient t-statistic
Intercept 0.081*** 2.88
BETA 0.018*** 3.52
LNSIZE –0.012** –2.05
VAR 0.001 0.77
GROWTH 0.001** 2.11
IND_SPEC –0.011 –0.71
LNAF 0.007 0.94
LNNAF –0.003 –0.51
DACC 0.207*** 4.83
Notes: re = client-specific ex ante cost of equity capital estimated by the PEG model;
BETA = share beta calculated over 36 months to the fiscal year-end;
LNSIZE = the natural log of market value of shares at the end of fiscal year;
VAR = the standard deviation of analysts’ earnings at the end of fiscal year;
GROWTH = forecasted long-term earnings growth at the end of fiscal year;
IND_SPEC = industry specialist auditor measured by the auditor’s percentage of
audit fees market share for each industry; DACC = discretionary accruals;
LNAF = the natural log of audit fees and LNNAF = the natural log of non-audit
fees; n = a number of observations.
***, **, and * are significant at the level of 1%, 5% and 10%, respectively.

6 Summary, conclusions and limitations

This study provides evidence regarding the relationship between audit quality and cost of
equity capital. Audit quality is measured by proxies including audit fees, non-audit fees,
industry specialist auditors and earnings management. The finding suggests that the
earnings management being detected by the auditor will reduce the ex ante cost of equity
capital, enhancing information value of earnings. As a result, firms are more likely to
enjoy the lower ex ante cost of equity capital. In our context, the investor does not
perceive the industry specialist auditor, audit fees and non-audit fees as value added
attributes and/or as a threat to auditor independence. This finding contributes to the extant
literature in terms of the audit quality in the UK context. An implication from our results
is that auditors are mainly expected to deal with earnings management. The auditors that
are less flexible toward the opportunistic earnings behaviours are priced by the investors.
Regardless of how much auditors charge service fees or what services they provide to
their clients, we conclude that investors perceive auditing as an important mechanism to
detect earnings management, resulting in the enhancement of the value of financial
information.
108 R. Basiruddin et al.

References
Abbott, L.J. and Parker, S. (2000) ‘Auditor selection and audit committee characteristics’,
Auditing: A Journal of Practice & Theory, Vol. 19, No. 2, pp.47–66.
Adkins, L.C. and Hill, R.C. (2007) Using Stata for Principles of Econometrics, 3rd ed., John Wiley
& Sons, Inc., New York.
Ahadiat, N. (2011) ‘Association between audit opinion and provision of non-audit services’,
International Journal of Accounting and Information Management, Vol. 19, No. 2,
pp.182–193.
Ahmed, A., Rasmussen, S. and Tse, S. (2008) Audit Quality, Alternative Monitoring Mechanisms,
and Cost of Capital: An Empirical Analysis, Working paper, Texas A&M University, College
Station, TX.
Anderson, U., Kadous, K. and Koonce, L. (2001) The Role of Reporting Incentives and
Quantification in Auditors’ Evaluations of Earnings Fluctuations [online]
http://ssrn.com/abstract=276570 (accessed 3 February 2010).
Arruñada, B. (1999a) ‘The provision of non-audit services by auditors: let the market evolve and
decide’, International Review of Law and Economics, Vol. 19, No. 4, pp.513–531.
Arruñada, B. (1999b) The Economics of Audit Quality: Private Incentives and The Regulation of
Audit and Non-Audit Services, Kluwer, Dordrecht.
Arruñada, B. (2000) ‘Audit quality: attributes, private safeguards and the role of regulation’, The
European Accounting Review, Vol. 9, No. 2, pp.205–224.
Arya, A., Jonathan, G. and Shyam, S. (2003) ‘Are unmanaged earnings always better for
shareholders?’, Accounting Horizons, Supplementary issue, Vol. 17, pp.111–116.
Baker, R.A. and Al-Thuneibat, A. (2011) ‘Audit tenure and the equity risk premium: evidence from
Jordon’, International Journal of Accounting and Information Management, Vol. 19, No. 1,
pp.5–23.
Barth, M.E., Elliott, J.A. and Finn, M.W. (1999) ‘Market rewards associated with pattern of
increasing earnings’, Journal of Accounting Research, Vol. 37, No. 2, pp.387–413.
Beattie, V. and Fearnley, S. (2002) Auditor Independence and Non-Audit Services: A Literature
Review, Institute of Chartered Accountants of England and Wales (ICAEW), London.
Beaver, W., Kettler, P. and Scholes, M. (1970) ‘The association between market determined and
accounting determined risk measures’, The Accounting Review, Vol. 45, No. 4, pp.654–681.
Beck, P., Frecka, T. and Solomon, I. (1988) ‘A model of the market of MAS and audit services:
knowledge spillovers and auditor-auditee bonding’, Journal of Accounting Literature, Vol. 7,
pp.50–64.
Becker, C.L., DeFond, M.L., Jiambalvo, J. and Subramanyam, K.R. (1998) ‘The effects of audit
quality on earnings management’, Contemporary Accounting Research, Vol. 15, No. 1,
pp.1–24.
Bedard, J.C. and Biggs, S. (1991) ‘The effect of domain-specific experience on evaluation of
management representations in analytical procedures’, Auditing: A Journal of Theory &
Practice, Supplementary issue, Vol. 10, pp.77–90.
Berk, J. (1995) ‘A critique of size-related anomalies’, Review of Financial Studies, Vol. 8, No. 2,
pp.275–286.
Boone, J.P., Khurana, I.K. and Raman, K.K. (2008) ‘Audit firm tenure and equity risk premium’,
Journal of Accounting, Auditing and Finance, Vol. 23, No. 1, pp.115–140.
Boone, J.P., Khurana, I.K. and Raman, K.K. (2009) Is audit Quality Different for Big-4 and
Mid-Tier Auditors?, Working paper, The university of Texas at San Antonio, College of
Business, Texas.
Botosan, C. and Plumlee, M. (2005) ‘Assessing alternative proxies for the expected risk premium’,
The Accounting Review, Vol. 80, No. 1, pp.21–54.
 Audit quality and cost of equity capital 109

Carcello, J.V. and Nagy, A.L. (2004) ‘Client size, auditor specialization and fraudulent financial
reporting’, Managerial Auditing Journal, Vol. 19, No. 5, pp.651–668.
Chen, H., Zeyun, C.J., Lobo, G.J. and Yanyan, W. (2011) ‘Effects of audit quality on earnings
management and cost of equity capital: evidence from China’, Contemporary Accounting
Research, Vol. 28, No. 3, pp.892–925.
Chen, Y.M., Moroney, R. and Houghton, K. (2005) ‘Audit committee composition and the use of
an industry specialist audit firm’, Accounting and Finance, Vol. 45, No. 2, pp.217–239.
Chou, S.T. and Chang, C.H. (2011) ‘Whether an auditor imagination of industry specialist reduces
the cost of capital? Empirical from Taiwan’, Proceedings of the 2011 International
Conference on Business and Information (BAI2011), 4–6 July, Bangkok.
Craswell, A.T., Francis, J.R. and Taylor, S.L. (1995) ‘Auditor brand name reputations and industry
specializations’, Journal of Accounting and Economics, Vol. 20, No. 3, pp.297–322.
DeAngelo, L. (1981) ‘Auditor size and audit quality’, Journal of Accounting and Economics,
Vol. 3, No. 3, pp.183–199.
DeFond, M.L and Jiambalvo, J. (1994) ‘Debt covenant violation and manipulation of accruals’,
Journal of Accounting and Economics, Vol. 17, Nos. 1–2, pp.145–176.
Dunn, K.A. and Mayhew, B.W. (2004) ‘Auditor industry specialization and client disclosure
quality’, Review of Accounting Studies, Vol. 9, No. 1, pp.35–58.
Easton, P. (2004) ‘PE ratios, PEG ratios, and estimating the implied expected rate of return on
equity capital’, The Accounting Review, Vol. 79, No. 1, pp.73–96.
Elton, E.J. (1999) ‘Expected return, realized return, and asset pricing tests’, Journal of Finance,
Vol. 54, No. 4, pp.1199–1220.
Fama, E. and French, K. (1997) ‘Industry costs of equity’, Journal of Financial Economics,
Vol. 43, No. 2, pp.153–193.
Ferguson, A., Francis, J. and Stokes, D. (2003) ‘The effects of firm-wide and office-level industry
expertise on audit pricing’, The Accounting Review, Vol. 78, No. 2,pp.429–449.
Fernando, G.D., Elder, R.J. and Abdel-Meguid, A.M. (2006) Audit Firm Size, Industry
Specialization, Client Size, and Cost of Capital – Information and Monitoring Effects,
Working paper, Syracuse University, New York.
Gaver, J.J., Gaver, K.M. and Austin, J.R. (1995) ‘Additional evidence on bonus plans and income
management’, Journal of Accounting and Economics, Vol. 19, No. 1, pp.3–28.
Gebhardt, W., Lee, C. and Swaminathan, B. (2001) ‘Toward an implied cost of capital’, Journal of
Accounting Research, Vol. 39, No. 1, pp.135–176.
Gode, D. and Mohanram, P. (2003) ‘Inferring the cost of capital using the Ohlson-Juettner model’,
Review of Accounting Studies, Vol. 8, No. 4, pp.399–433.
Goldman, A. and Barlev, B. (1974) ‘The auditor-firm conflict of interests: its implications for
independence’, The Accounting Review, Vol. 49, No. 4, pp.707–718.
Healy, P.M. (1985) ‘The impact of bonus schemes on the selection of accounting principles’,
Journal of Accounting and Economics, Vol. 7, pp.85–107.
Holthausen, R.W., Larkers, D.F. and Sloan, R.G. (1995) ‘Annual bonus schemes and the
manipulation of earnings’, Journal of Accounting and Economics, Vol. 19, No. 1, pp.29–74.
Hope, O., Kang, T.T., Wayne, B. and Yoo, Y.K. (2009) ‘Impact of excess auditor remuneration on
cost of equity capital around the world’, Journal of Accounting, Auditing & Finance, Vol. 24,
No. 2, pp.177–1210.
Hribar, P. and Jenkins, N.T. (2004) ‘The effect of accounting restatements on earnings revisions
and the estimated cost of capital’, Review of Accounting Studies, Vol. 9, Nos. 2–3,
pp.337–356.
Johnson, P., Jamal, K. and Berrman, R. (1991) ‘Effects of framing on auditor decisions’,
Organization Behaviour and Human Decision Process, Vol. 50, No. 1, pp.75–105.
Jones, J. (1991) ‘Earnings management during import relief investigations’, Journal of Accounting
Research, Vol. 29, No. 2, pp.193–228.
110 R. Basiruddin et al.

Karim, A.W. and Hasan, T. (2012) ‘The market for audit services in Bangladesh’, Journal of
Accounting in Emerging Economies, Vol. 2, No. 1, pp.50–66.
Karjalainen, J. (2011) ‘Audit quality and cost of debt capital for private firms: evidence from
Finland’, International Journal of Auditing, Vol. 15, No. 1, pp.88–108.
Khurana, I.K. and Raman, K.K. (2004) ‘Litigation risk and the financial reporting credibility of big
4 versus non-big 4 audits: evidence from Anglo-American countries’, The Accounting Review,
Vol. 79, No. 2, pp.473–495.
Khurana, I.K. and Raman, K.K. (2006) ‘Do investors care about the auditor’s economic
dependence on the client?’, Contemporary Accounting Research, Vol. 23, No. 4,
pp.977–1016.
Kothari, S.P., Leone, A.J. and Wasley, C.E. (2005) ‘Performance matched discretionary accruals’,
Journal of Accounting and Economics, Vol. 39, No. 1, pp.163–197.
La Porta, R. (1996) ‘Expectations and the cross-section of stock returns’, Journal of Finance,
Vol. 51, No. 5, pp.1715–1742.
Li, Y. and Stokes, D. (2008) ‘Audit quality and cost of equity capital’, 2nd Workshop of Audit
Quality, EIASM.
Li, Y., Stokes, Taylor, D. and Wong, L. (2009) Audit Quality, Accounting Attributes and the Cost
of Equity Capital, unpublished paper.
Lintner, J. (1965) ‘The valuation of risk assets and the selection of risky investments in stock
portfolios and capital budgets’, Review of Economic Statistics, Vol. 47, No. 1, pp.13–25.
Niemi, L. (2004) ‘Auditor size and audit pricing: evidence from small audit firms’, The European
Accounting Review, Vol. 13, No. 3, pp.541–560.
O’Keefe, T.B., Simunic, D.A. and Stein, M.T. (1994) ‘The production of audit services: evidence
from a major public accounting firm’, Journal of Accounting Research, Vol. 32, No. 2,
pp.241–261.
Palmrose, Z-V. (1986) ‘Audit fees and auditor size: further evidence’, Journal of Accounting
Research, Vol. 24, No. 1, pp.97–110.
Sankar, M.R. and Subramanyam, K.R. (2001) ‘Reporting discretion and private information
communication through earnings’, Journal of Accounting Research, Vol. 99, No. 2,
pp.365–386.
Sharpe, W. (1964) ‘Capital asset prices: a theory of market equilibrium under conditions of risk’,
Journal of Finance, Vol. 19, No. 3, pp.425–442.
Simunic, D.A. (1980) ‘The pricing of audit services: theory and evidence’, Journal of Accounting
Research, Vol. 18, No. 1, pp.161–190.
Simunic, D.A. (1984) ‘Auditing, consulting, and auditor independence’, Journal of Accounting
Research, Vol. 22, No. 2, pp.679–702.
Subramanyam, K.R. (1996) ‘The pricing of discretionary accruals’, Journal of Accounting and
Economics, Vol. 22, Nos. 1–3, pp.249–281.
Sweeney, A. (1994) ‘Debt covenant violations and managers’ accounting responses’, Journal of
Accounting and Economics, Vol. 17, No. 3, pp.281–308.
Taylor, M.H. (2000) ‘The effects of industry specialization on auditors’ inherent risk assessments
and confidence judgments’, Contemporary Accounting Research, Vol. 17, No. 4, pp.693–712.
Wallman, S.M.H. (1996) ‘The future of accounting, Part III: reliability and auditor independence’,
Accounting Horizons, Vol. 10, No. 4, pp.76–97.
Watts, R.L. and Zimmerman, J.L. (1986) Positive Accounting Theory, Englewood Cliffs,
Prentice-Hall: NJ.
Wooten, T.C. (2003) ‘Research about audit quality’, The CPA Journal [online]
http://www.nysscpa.org/cpajournal/2003/0103/dept/d014803.htm (accessed 3 February 2010).
Wright, S. and Wright, A.M. (1997) ‘The effect of industry experience on hypothesis generation
and audit planning decision’, Behavioural Research in Accounting, Vol. 9, pp.273–294.
 Audit quality and cost of equity capital 111

Notes
1 The discretionary accruals are computed by the following regression:
⎡ Δ1 (1 TAijt −1 ) + α 2 ⎡( ΔREVijt − ΔRECijt ) TAijt −1 ) ⎤ ⎤
DACCijt = (TACCijt TAijt −1 ) − ⎢ ⎣ ⎦⎥ + e
ijt
⎢ +α 3 ( PPEijt TAijt −1 ) ⎥
⎣ ⎦
where
DACCij discretionary accruals for sample firm i in industry j for year t–1
TACCijt total accruals for sample firm i in industry j for year t
TAijt-1 total assets for sample firm i in industry j for year t–1
∆REVijt change in revenues for sample firm i in industry j for year t
∆RECijt change in account receivable for sample firm i in industry j for year t
PPEijt gross property plant and equipment for sample firm i in industry j for year t
eijt error term for sample firm i in industry j for year t.
The total accruals are computed by earnings before earnings extraordinary items and
discontinued operations less the net cash flows from operating activities. The industry j is
classified by the Industry Classification Benchmark of Dow Jones and FTSE. Each industry
group has at least six observations to ensure unbiased discretionary accruals estimation
(DeFond and Jiambalvo, 1994; Subramanyam, 1996).
2 The results are available upon request to the authors.
3 The results are available upon request to the authors.