Academic journal article Auditing: A Journal of Practice & Theory

Free Cash Flow, Debt Monitoring, and Audit Pricing: Further Evidence on the Role of Director Equity Ownership

Academic journal article Auditing: A Journal of Practice & Theory

Free Cash Flow, Debt Monitoring, and Audit Pricing: Further Evidence on the Role of Director Equity Ownership

Article excerpt

Agency theory suggests that there is a conflict of interest between managers and shareholders in firms with low management ownership; this occurs because the interests of the managers and the shareholders may not be closely aligned. We expect this problem to be particularly severe when the firm also has high free cash flows (FCF), which is excess cash available (after the firm has invested in promising projects) that is not paid out in dividends. This situation of high FCF is typically associated with low growth firms. We expect managers of these firms to act against the interests of shareholders by investing in non-value maximizing projects and paying themselves higher compensation. Two factors are likely to mitigate the agency costs of FCF. First, high debt firms have a higher level of debt monitoring that we expect to reduce the agency problems of FCF. Second, we expect firms with high management ownership to reduce the agency costs of FCF.

We tested the theory by linking these expectations to audit fees charged by Big 6 CPA firms of 140 Australian firms. We expect low growth firms with high FCF to be associated with higher inherent risk and therefore higher audit effort and resulting audit fees. However, we expect this positive association to be weaker for firms with higher levels of director equity ownership. Further, we expect this relationship only for firms with low levels of debt. We also expect that high levels of debt can compensate for the high agency costs associated with low levels of management share ownership, high levels of FCF or both. The results support both expectations. These findings suggest that auditors recognize the agency risks present and adjust audit fees accordingly. Interestingly, high levels of debt may actually reduce the inherent risks associated with high FCF and low management ownership.

INTRODUCTION

Gul and Tsui (1998) provide evidence to show that there is a positive association between the agency costs of free cash flow (FCF) and audit fees charged by Big 6 auditors for low growth firms and that debt moderates this relationship. Free cash flow is defined as the excess of cash available to a firm after it has invested in all positive-net-present-value projects that is not paid out in dividends (Jensen 1986, 1989). Managers of low growth firms with high FCF are expected to be involved in non-value maximizing activities including an increase in perquisite consumption and compensation at the expense of shareholders as well as the manipulation of accounting numbers (Jensen 1989; Shleifer and Vishny 1989; Lang et al. 1991; Christie and Zimmerman 1994). Thus, auditors of low growth/high FCF firms are likely to assess higher levels of inherent risk that leads to higher audit effort and resulting higher fees than auditors of low growth/low FCF firms (Gul and Tsui 1998).(1) However, this association is expected to be weaker for firms with high debt because, as Jensen (1986) points out, debt monitoring mitigates the agency costs of FCF. An important ingredient of the FCF and debt monitoring hypotheses suggested by Jensen (1986) is the existence of the separation of ownership and control problem for firms with low levels of management ownership. Unfortunately, Gul and Tsui (1998) in their analysis did not control for management or director equity ownership.

The primary objective of this study is to extend the findings of Gul and Tsui (1998) by introducing director ownership, as a proxy for management ownership of shares, into the analyses that link FCF to higher audit fees. This is done in three ways. First, we directly test the hypothesis that the positive association between FCF and audit fees for low growth firms is dependent on director ownership. Second, we conduct a test of the debt monitoring hypothesis by running two separate OLS regressions for high and low debt firms (median split) and examine the interaction coefficient for FCF/director ownership for each of the regressions; the FCF/director ownership interaction is expected to exist for firms with low growth/low debt firms. …

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