Joint audit, political connections and cost of debt capital

• DOI: http://doi.org/10.1111/ijau.12092
• Author: Khamis Al‐Yahyaee,Ahsan Habib,Baban Eulaiwi,Ahmed Al‐Hadi
• Date: 01 November 2017
• Published date: 01 November 2017

ORIGINAL ARTICLE

Joint audit, political connections and cost of debt capital

Ahmed Al‐Hadi

1,2

|Ahsan Habib

3

|Khamis Al‐Yahyaee

1

|Baban Eulaiwi

2

1

Sultan Qaboos University, Muscat, Sultanate

of Oman

2

Curtin University, Perth, Australia

3

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

We investigate the association between joint audit and cost of debt for a sample of non‐financial,

publicly listed firms from the Gulf Cooperation Council (GCC) countries. Although the conven-

tional wisdom suggests that “two heads are better than one”, empirical evidence on the beneficial

impact of joint audit has not been convincingly documented. We attempt to shed further insights

into this debate, using data from the GCC countries. We document a significantly negative effect

of joint audit on cost of debt in the GCC countries. This effect is more pronounced in cases where

at least one of the joint audit firms is a Big 4 auditor. We then investigate whether political con-

nections with royal families moderate the association between joint audit and cost of debt. Our

results suggest that the beneficial effects of joint audits, in terms of a lower cost of debt, are

greater in firms with such political connections.

KEYWORDS

Gulf CooperationCouncil, joint audit, cost of debt,royal family, Big 4 auditor

1|INTRODUCTION

We investigate the effects of joint audit on the firm‐level cost of debt

in the Gulf Cooperation Council (GCC) countries. Joint audit is an audit

practice whereby two independent audit firms audit the financial

statements, with a shared audit effort, but a single report signed by

both audit firms is produced (Lesage, Ratzinger‐Sakel, & Kettunen,

2012; Ratzinger‐Sakel, Audousset‐Coulier, Kettunen, & Lesage,

2015). Unlike single audit, which is the norm in most countries around

the world, some countries require, while others permit, financial state-

ments to be audited by more than one audit firm. Despite the common

understanding that joint audit should improve audit quality because of

shared audit efforts, empirical evidence has so far proved inconclusive

(Ratzinger‐Sakel et al., 2015). We attempt to extend this stream of

research by examining the effects of joint audit on the cost of debt

in the GCC region.

Whether the provision of joint audit improves or deteriorates

audit outcome has been debated. Conventional wisdom suggests that

two heads are better than one, yet we see the prevalence of single

audit around the world. Deng, Lu, Simunic, and Ye (2014) demonstrate

analytically that if two audit firms involved in joint audit have compa-

rable technological efficiency, then the audit quality under a joint audit

regime is equivalent to that of a single audit. However, adding a firm

with lower technological efficiency to form a joint audit will reduce

the overall audit quality. Prior research on joint audit generally finds

that: (i) earnings management is lower in firms audited by Big 4 audi-

tors than in firms audited by non‐Big 4 auditors (Francis, Richard, &

Vanstraelen, 2009), although Bédard, Piot, and Schatt (2012) find evi-

dence of less earnings management in joint audits involving two Big

4 auditors than in firms using one Big and one small auditor; (ii) there

is lower reporting quality in joint audits involving two Big audit firms

than in the audits of firms using one Big and one small audit firm

(Marmousez, 2009); (iii) there are no discernible effects on financial

reporting quality between joint and single audits (Lesage et al., 2012);

and, finally, (iv) there is wide variation in audit fees overall (André,

Broye, Pong, & Schatt, 2016; Audousset‐Coulier, 2015; Holm &

Thinggaard, 2016; Zerni, Haapama, Jarvinen, & Niemi, 2012).

Although the role of external auditing has been investigated in the

GCC countries (Al‐Hadi, Taylor, & Hossain, 2015; Al‐Shammari, Brown,

& Tarca, 2008), there is a paucity of research on the effectiveness of

joint audit in these countries. While joint audit is a requirement in

many jurisdictions, such as France, Finland, and Hong Kong, joint audit

is voluntary for non‐financial firms in the GCC countries, except for

Kuwait, where joint audit is mandatory.

1

This unique setting allows

us to explore the use of joint audit in a number of politically and eco-

nomically important developing countries that have similar characteris-

tics in terms of business environment, but significant cultural

differences compared with many Western countries.

Unlike prior studies that investigate the effects of joint audit on

financial reporting quality and audit fees (e.g., Audousset‐Coulier,

2015; Francis et al., 2009; Marmousez, 2009; Zerni et al., 2012), we

choose cost of debt, an outcome of direct economic consequence for

organizations.

2

We argue that the provision of joint audit enhances

the reliability of financial statements, reduces information asymmetry

Received: 26 May 2016 Revised: 31 December 2016 Accepted: 18 January 2017

DOI: 10.1111/ijau.12092

Int J Audit. 2017;21:249–270. © 2017 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/ijau 249

and, consequently, cost of capital, including cost of debt. If creditors

perceive financial statements of firms being audited by joint auditors

as being superior to single audits, then we should expect a reduction

in cost of debt. However, the composition of the audit pair will play

a dominant role in the relationship. Cost of debt might vary depending

on whether the joint audit has been performed by both Big 4 audit

firms, or by one Big and one small audit firm.

Using 1,378 firm year‐observations from seven GCC stock mar-

kets, we document a 3.37 basis point decrease in cost of debt for firms

employing joint auditors. We further find that this effect is more pro-

nounced when at least one of the joint auditors is a Big 4 audit firm.

Our results are robust to potential endogeneity concerns emanating

from the auditor self‐selection problem. We then extend our analysis

to examine the moderating role of royal family ownership, a form of

political connection, on the association between joint audit and cost

of debt. Prior literature suggests that firms with political connections

are perceived as higher risk by creditors, who charge higher interest

on their loans than they charge non‐connected firms (Bliss & Gul,

2012). Houston, Jiang, Lin, and Ma (2014), on the other hand, find

the opposite. However, none of these studies examines the impact

of joint audit in moderating the association between politically con-

nected firms and cost of debt. We find that cost of debt is significantly

lower for firms with royal family connections, but only when they are

joint audited. A plausible explanation for this finding relates to the fact

that royal ownership may be conducive to expropriation, which

increases firm risk and hence cost of debt capital. A joint audit might

be more effective in constraining such opportunistic behavior through

a more extensive audit practice made possible through shared audit

efforts.

Our paper differs in some important respects from some of the

prior research on joint audit. Zerni et al. (2012) investigate the impact

of voluntary joint audit on audit quality (reporting conservatism and

abnormal accruals) for a sample of firms that include private firms in

Sweden. Although investigating the earnings quality implications of

joint audit is important, it does not address the economic consequence

aspect, which is of immense importance for debt and equity holders.

We extend Zerni et al. (2012) by incorporating both joint audit and

earnings quality effects on cost of debt. In addition, our research set-

ting—the GCC countries—differs significantly from Sweden, in that

political connections in the GCC countries play a very important role

in debt financing choices. Joint audit in such a setting could be valuable

as a mechanism for signaling the credibility of financial statements: an

important input into the lending decision. Marmousez (2009) finds that

the presence of two Big 4 audit firms is associated with lower financial

reporting quality in France. That study, like Zerni et al. (2012), did not

investigate the economic consequences of joint audit, or how the

reported association might be conditional on its unique institutional

environment: dominance of political connections. Furthermore, her

results are based on a single year of analysis, and this casts doubt on

the reliability of her empirical findings. Karjalainen (2011) finds that

joint audit reduces cost of debt for private firms in Finland. However,

the impact of joint audit in reducing information asymmetry and,

hence, cost of debt, may be less pronounced for private firms, since

the degree of information asymmetry is lower in private firms com-

pared to that in their listed counterparts (Ball & Shivakumar, 2005).

From an auditor appointment perspective, Finnish audit regulations

allow the engagement of uncertified or unprofessional auditors,

besides certified auditors, as joint auditors. Audit regulations in the

GCC countries, in contrast, require all auditors to be professionally cer-

tified and, hence, provide a minimum audit quality benchmark. Finally,

as discussed above, studying the association between joint audit and

cost of debt financing in an environment where political connections

play a dominant role, clearly differentiates our paper from Karjalainen

(2011).

We enrich the literature on the audit quality implications of joint

audit. Prior evidence, using financial reporting quality and audit fees

as the outcome variables, has provided mixed results on the benefits

of joint audits. We consider the effect of joint audit on cost of debt,

given the significance of the debt markets in the GCC. The role of

stock markets in the GCC countries’economic development is rela-

tively limited (Kern, 2012). Raising capital from the stock market

through equity financing subjects companies to stringent market regu-

lation and monitoring. Given that most companies in the GCC coun-

tries are connected to royal families, using bank loans instead of

equity financing may assist companies in a voiding the disclos ure

requirements (Al‐Hadi et al., 2015). Banks have an advantage in

collecting information, but are potentially more expensive sources

of capital than publ ic debt markets. The co sts of monitoring and

imperfect financial contracting should raise costs of deb t for firms

borrowing from banks . Whether the provision o f joint audit reduces

debt financing costs, therefore, is an important research topic. By

documenting a benefi cial effect of joint audit in terms of a reduct ion

in debt financing costs, we contribute to the joint audit and debt

financing literature.

The remainder of the paper proceeds as follows. In the next sec-

tion, we give an overview of the GCC setting for joint audit, debt

financing, and political connections. Section 3 builds on the relevant lit-

erature to develop our hypotheses. Section 4 presents variable defini-

tions, discusses sample construction, and presents descriptive

statistics. Section 5 presents our main regression results. Finally,

Section 6 concludes the paper.

2|AN OVERVIEW OF THE GCC SETTING

FOR JOINT AUDIT AND DEBT FINANCING

The GCC countries collectively constitute a rapidly growing group of

developing countries that derive a considerable amount of their

income from oil exports, hold 45% of the world oil reserves, and have

rapidly expanding equity markets (Al‐Hadi et al., 2015; Al‐Shammari

et al., 2008). Economic development in the GCC has been accompa-

nied by an increase in the number of listed firms, which grew from

473 in 2005 to 705 in 2013.

3

TheGCCcountrieshavestrong

economic and social ties and share a similar Islamic culture

(Al‐Shammari et al., 2008). Recently, the countries have witnessed

strong economic growt h with an increase in gros s domestic product

(GDP) from US$817 billion in 2006 to US$1,635 billion in 2014.

4

Similarly, the stock markets have experienced rapid growth where

market capitalization increased from US$120 billion in 2002 to US

$1,179 billion in 2014.

5

250 AL‐HADI ET AL.