Audit partner busyness and cost of equity capital

• Author: Ahsan Habib,Xuan (Sean) Sun,Md. Borhan Uddin Bhuiyan
• DOI: http://doi.org/10.1111/ijau.12144
• Published date: 01 March 2019
• Date: 01 March 2019

ORIGINAL ARTICLE

Audit partner busyness and cost of equity capital

Ahsan Habib |Md. Borhan Uddin Bhuiyan |Xuan (Sean) Sun

School of Accountancy, Massey University,

Auckland, New Zealand

Correspondence

Ahsan Habib, School of Accountancy, Massey

University, Private Bag 102904, Auckland,

New Zealand.

Email: a.habib@massey.ac.nz

This paper examines the effects of audit partner busyness on the cost of equity

capital. We argue that audit partner busyness affects auditors' work processing

accuracy negatively and reduces professional skepticism, thus resulting in higher

information risk and, hence, an increased cost of equity capital. Using data from

Australian listed companies, we find that the cost of equity capital is indeed higher

for firms audited by busy audit partners. However, an additional test documents

that this effect is primarily driven by non‐Big 4 observations. Our mediation test

results indicate that this positive association is mediated through poor quality finan-

cial reporting but is driven by non‐Big 4 observations. Our results are robust to

endogeneity concerns emanating from firms' deliberate decisions to choose audit

partners. Our study contributes to both the auditing and to the cost of capital

literature.

KEYWORDS

audit partner busyness, Australia, cost of equity capital, discretionary accruals

1|INTRODUCTION

This research examines the impact of audit partner busyness, defined

as the number of clients being audited by an individual partner, on the

cost of equity capital in Australia. Auditors play a vital role in providing

credible financial statements and in mitigating the agency problem

between management and investors (Dopuch & Simunic, 1982; Mansi,

Maxwell, & Miller, 2004). Audit quality is thus an area of extensive

academic research. Prior research takes either an audit‐firm‐level per-

spective (Becker, DeFond, Jiambalvo, & Subramanyam, 1998; Behn,

Choi, & Kang, 2008; Francis, Maydew, & Sparks, 1999; Palmrose,

1988; Teoh & Wong, 1993) or an office‐level perspective (Choi, Kim,

Kim, & Zang, 2010; Francis & Michas, 2012; Francis, Michas, &

Seavey, 2013; Francis & Yu, 2009; Krishnan, 2005; Li, 2009; Reynolds

& Francis, 2000) in investigating the relationship between auditor

attributes and audit quality. These studies implicitly assume that,

through standardized firm‐wide quality control and knowledge shar-

ing, audit quality within an audit firm or a practice office remains uni-

form (Zerni, 2012). However, an individual auditor performs a variety

of audit tasks to form an overall assurance or attestation opinion

and, hence, disclosing the identity of audit individuals likely provides

useful information to market participants for gauging audit efficiency.

James Doty, the Chairman of the Public Company Accounting

Oversight Board (PCAOB), mentions the following:

Auditing is a profession built on reputation, and one

important way investors can assess the quality of an

audit is to know who conducted that audit …By

knowing who the engagement partner is, investors

would be able to track certain aspects of the individual

engagement partner's history, including his or her

industry expertise, restatement history, and involvement

in disciplinary proceedings or other litigation. All of

these factors provide valuable information for an

investor to fully understand the riskiness of an audit.

And it sharpens the mind.

1

Such information also allows investors to infer the audit partner's

client portfolio and, hence, the extent of that partner's work stress.

Prior research provides generally consistent evidence that audit part-

ner busyness reduces audit quality, probably because busy audit part-

ners can allocate fewer resources and audit hours to each client

(Caramanis & Lennox, 2008). Lai, Sasmita, Gul, Foo, and Hutchinson

(2018) and Gul, Ma, and Lai (2017) found that busy audit partners

are associated with high earnings manipulation. Sundgren and

Received: 7 February 2018 Revised: 13 August 2018 Accepted: 3 September 2018

DOI: 10.1111/ijau.12144

Int J Audit. 2019;23:57–72. © 2018 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/ijau 57

Svanström (2014) evidenced that an auditor‐in‐charge (e.g., audit part-

ner) who audits too many clients is less likely to issue a going‐concern

opinion to firms facing potential bankruptcy risk in Sweden.

However, Goodwin and Wu (2016) found no association between

audit partner busyness and audit quality using data from Australia.

They argue that preserving reputational capital plays a vital role in

making the trade‐offs between holding too many or too few clients.

Reputational capital is a key factor when performing effective audit

work (Carcello & Li, 2013; Watts & Zimmerman, 1983), and hence

audit partners must consider the potential loss of reputational capital

before engaging in an extra audit assignment. Profit maximization the-

ory might suggest that audit firms could maximize their revenues by

increasing the number of clients in their portfolios (Burrows & Black,

1998; Coram & Robinson, 2017). However, audit firms use a variety

of metrics to measure professionalism (e.g., results of internal and

external reviews, risk management and independence monitoring,

technical excellence, and compliance with policies and procedures).

Hence, an argument other than audit partner busyness might explain

an adverse effect on audit quality. The limitations of performance‐

based compensation could induce audit partners to serve more clients

and to shirk on tasks that are more difficult to measure (e.g., indepen-

dence and effort). As the result of less time and effort spent on audit

assignments, audit quality may be adversely affected.

We test whether firms audited by busy audit partners incur higher

costs of equity capital. Market participants consider firm‐provided

financial statements as the primary source of information about the

business (Sloan, 2001). Financial statements allow investors to assess

the investment risks, a crucial component of the cost of sourcing

funds. The estimation and the likely determinants of the cost of equity

is of paramount importance in accounting and finance research. This is

frequently used in settings such as the estimation of equity risk pre-

miums, firm valuation, and capital budgeting, and in investment man-

agement practices such as portfolio allocation, performance

evaluation, active risk management, and attribution analysis (Câmara,

Chung, & Wang, 2009; Hou, Van Dijk, & Zhang, 2012). The cost of

equity depends on firms' economic fundamentals, including corporate

governance mechanisms among other determinants (Banz, 1981;

Fama & French, 1989; Gebhardt, Lee, & Swaminathan, 2001). We

incorporate audit quality, measured at the audit partner level, as a

likely determinant of the cost of equity capital.

Audit quality contributes to the credibility of financial disclosures

and, to the extent that more credible financial statements reduce

contracting costs, higher audit quality reduces the cost of capital

(Jensen & Meckling, 1976; Watts & Zimmerman, 1986). But audit

quality suffers when audit partners take on a large pool of clients.

Partners may suffer from ‘capacity stress’when the number of their

clients increases, with the unintended consequence of lowering audit

quality. Moreover, a heavy workload could distract an audit partner

from ensuring adequate assurance services and could motivate the

audit partners to perform shortcuts instead of gathering the audit evi-

dence required (PCAOB, 2015). Caramanis and Lennox (2008)

document that low audit effort increases aggressive earnings manage-

ment. Low audit quality introduces noise into the information signal

disseminated to the market, and thus increases information risk and

cost of equity capital (Lambert, Leuz, & Verrecchia, 2007).

Using data from Australian listed companies

2

during the 2001–

2015 sample period, we find that firms employing busy audit partners

(measured as the number of public clients) incur a higher cost of cap-

ital. The reported coefficient in the baseline models suggests that a

one standard deviation increase in the number of clients is associated

with an 86‐basis‐point increase in the cost of equity capital. However,

an additional test documents that this effect is primarily driven by

non‐Big 4 observations (coefficients on audit partner busyness are

positive and significant for the non‐Big 4 group but insignificant for

the Big 4 group). The insignificant association between audit partner

busyness and cost of equity capital may be consistent with the “equi-

librium theory,”supporting the notion that Big 4 audit firms, as they

tend to be concerned about their reputational capital, choose an opti-

mum level of audit clients to ensure the provision of high‐quality

audits. We further find that poor earnings quality mediates the posi-

tive association between audit partner busyness and the cost of equity

capital, although the direct effect of audit partner busyness on cost of

equity capital dominates the effect.

Our research responds to the call for additional research at the

audit partner level, to better understand how audit partner attributes

affect audit quality, which is incremental to audit‐firm‐level attributes

(e.g., DeFond & Francis, 2005; Lennox & Wu, 2018). Gul, Wu, and

Yang (2013) suggested that academic research should consider the

individual auditor as the unit of analysis, since audit partners supervise

the work of audit employees and subordinate auditors and are respon-

sible for the output of the audit teams. Second, we contribute to the

determinants of the cost of capital literature. Prior evidence docu-

ments a negative association between audit firm reputation (Big 4

audit firm and/or industry‐specialist auditors) and cost of capital

(Khurana & Raman, 2004; Mansi et al., 2004), but how audit quality

at the individual auditor level affects the cost of capital remains unan-

swered. We fill this void in the literature.

The remainder of the paper is organized as follows. Section 2 pre-

sents the existing literature on audit partner busyness and develops

the hypotheses. The research methods and sample selection are

described in Section 3. Descriptive statistics and test results are

reported in Section 4. Section 5 concludes the paper.

2|LITERATURE AND HYPOTHESIS

The estimation and the likely determinants of the cost of equity are

important, since these are frequently used in settings such as the esti-

mation of equity risk premiums, capital budgeting, firm valuation, port-

folio allocation, and performance evaluation (Câmara et al., 2009; Hou

et al., 2012). Easley and O'Hara (2004) stated that the quantity and

quality of information affect the cost of equity. Hence, the extant lit-

erature discusses the role of information from two related perspec-

tives: information asymmetry and information risk (e.g., Bhattacharya,

Ecker, Olsson, & Schipper, 2012; Diamond & Verrecchia, 1991; Easley

& O'Hara, 2004; Hughes, Liu, & Liu, 2007; Lambert et al., 2007). Dia-

mond and Verrecchia (1991) argued that information asymmetry

would heighten in the absence of disclosures. Since informed inves-

tors are privy to private information, they are more likely to make bet-

ter portfolio decisions than their uninformed counterparts. Thus,

58 HABIB ET AL.