Financial versus operating liability leverage and audit fees

• Author: Md. Safayat Hossain,Dasaratha V. Rama,Abhijit Barua
• DOI: http://doi.org/10.1111/ijau.12157
• Date: 01 July 2019
• Published date: 01 July 2019

ORIGINAL ARTICLE

Financial versus operating liability leverage and audit fees

Abhijit Barua

1

|Md. Safayat Hossain

2

|Dasaratha V. Rama

1

1

School of Accounting, Florida International

University, Miami, Florida

2

Peter T. Paul College of Business and

Economics, University of New Hampshire,

New Hampshire

Correspondence

Abhijit Barua, School of Accounting, Florida

International University, 11200 SW 8 Street,

MANGO 342, Miami, FL 33199.

Email: baruaa@fiu.edu

We argue that different types of leverage have different implications for audit risk

and audit fees, and hence need to be separately examined. Using data from the years

2004 to 2016, we find that operating liability leverage is positively associated with

audit fees and that financing leverage is negatively related to audit fees. The results

suggest that the benefits from monitoring effects of financial leverage outweigh the

costs associated with the risk of financial distress and financial misreporting. We also

find that estimated operating liability leverage has a bigger effect on audit fees than

contractual operating liability leverage, consistent with suggestions that auditors are

more conservative in the presence of higher estimation risk. Thus, our findings high-

light the importance of recognizing sources of leverage in audit risk in general and

audit fee models in particular.

KEYWORDS

audit fees, audit risk,financing leverage, operating liability leverage

1|INTRODUCTION

Leverage can originate from both financing activities and operating

activities.

1

Many prior studies have shown that leverage arising from

operating activities and financing activities has differential effects on

firm profitability and firm value (Nissim & Penman, 2003), transaction

costs (Ferris, 1981), and informational role and monitoring costs (Biais

& Gollier, 1997; Mian & Smith, 1992; Petersen & Rajan, 1997; Smith,

1987). Operating liability leverage constitutes almost one‐third of the

total assets reported in the balance sheets by publicly traded firms in

the USA (Welch, 2011). In this paper, we hypothesize that operating

and financial liability leverages have different effects on auditors'

assessment of audit risk and, hence, audit fees. We then show, using

audit fee data for 38,118 observations over the period 2004–2016,

that financial liability leverage has a negative association with audit

fees whereas operating liability leverage has a significant positive

association with audit fees.

Since Simunic's (1980) seminal paper on audit pricing, researchers

have used a variety of variables proxying for client size, financial con-

dition and performance, complexity, auditor, and audit opinion type to

explain audit fees. Many of the audit fee studies include leverage as a

control variable, but there are two different countervailing effects that

can arise from the two components of leverage: operating liability

leverage and financing leverage. For example, financing leverage is

traded in a well‐functioning capital market, whereas operating liability

leverage is traded in “less than perfect”input and output markets

(Nissim & Penman, 2003). Moreover, operating liabilities also include

some accrual components that are susceptible to opportunistic mana-

gerial behavior,

2

whereas financial liabilities are contractual obligations

that are measurable with higher degree of reliability (Richardson,

Sloan, Soliman, & Tuna, 2005). Thus, our first hypothesis relates to

the differential effects of operating liability leverage and financing

leverage on audit fees.

We then examine different components of operating liability lever-

age. Prior studies suggest some operating liability items (e.g., accounts

payable, tax payable) are contractual and hence can be measured with

greater degree of accuracy, whereas others (e.g., deferred revenue, pen-

sion obligation) are susceptible to measurement errors or managerial

discretion (Nissim & Penman, 2003; Richardson et al., 2005). Lennox

and Kausar (2017) showed that, as estimation risk increases, auditors

become more conservative. Accordingly, we examine whether audit

fees are differentially associated with the two types of operating liability

leverage by decomposing operating liability leverage into contractual

versus estimated operating liability leverage. Our second hypothesis is

that estimated operating liability leverage will have a larger effect on

audit fees than on contractual operating liability leverage.

Received: 28 August 2018 Revised: 2 January 2019 Accepted: 10 March 2019

DOI: 10.1111/ijau.12157

Int J Audit. 2019;23:231–244. © 2019 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/ijau 231