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Audit Quality, Accounting Attributes and the Cost of Equity Capital

We argue that audit quality has direct and indirect effects on the cost of equity capital. Direct effects are consistent with auditor reputation effects reflecting insurance and/or assurance roles. However, if audit quality is at least in part a reflection of expected assurance levels, then we also expect recognized indicators of audit quality to have an indirect mitigating effect on the relation between the cost of equity capital and what would otherwise be viewed as aggressive accounting. That is, we expect that in addition to any insurance role, there is at least one component of an auditor’s assurance role that is valued for the mitigation of aggressive accounting. Our results support this prediction using two audit quality dimensions based on a measure of auditor industry specialization and a measure of unexpected audit fees. We find that in addition to higher audit quality being associated with a direct reduction in the cost of equity capital, for the unexpected audit fee-based measure of audit quality, there is also a significant mitigation of the positive impact of high accruals on the cost of equity capital. Additional analysis of instances of switching to higher quality auditors and audit qualifications provides further evidence of auditor reputation playing a mitigating role on the effect of aggressive accounting on the cost of equity capital. We therefore conclude that markets recognize the importance of both the insurance and assurance dimensions of audit quality.