Signing auditors' experience gap and the cost of capital: Evidence from China

• Published date: 01 January 2024
• Author: Huifeng Xu,Xin Yang,Jun Liu
• Date: 01 January 2024
• DOI: http://doi.org/10.1111/ijau.12316

ORIGINAL ARTICLE

Signing auditors' experience gap and the cost of capital:

Evidence from China

Huifeng Xu

1

| Xin Yang

2

| Jun Liu

1

1

School of Accounting, Guangdong University

of Finance and Economics, Guangzhou, China

2

School of Business, Hohai University, Nanjing,

China

Correspondence

Xin Yang, School of Business, Hohai

University, Nanjing, Jiangsu Province, China.

Email: x.yang@hhu.edu.cn

Funding information

High-level Personnel Project of Jiangsu

Province, Grant/Award Number:

JSSCBS20210259; National Natural Science

Foundation of China, Grant/Award Number:

71702199

We investigate whether the experience gap between signing auditors affects inves-

tors' and creditors' perceptions of risk assessment, as measured by the cost of capital.

Our argument is that the experience gap between signing auditors could lower the

information risk and improve audit quality, leading to a decreased cost of capital.

Using unique data from China, where the information of the signing auditors can be

obtained from audit reports, we find that a higher experience gap between signing

auditors is linked to a lower cost of capital. Further analysis reveals that the effect is

stronger for firms with higher information asymmetry, lower audit quality and weaker

financial environments. Our results suggest that the higher experience gap between

signing auditors can reduce information asymmetry by enhancing audit quality, and

external investors incorporate this factor into pricing strategy, thereby, resulting in a

lower cost of capital.

KEYWORDS

cost of capital, experience gap, signing auditors

1|INTRODUCTION

In China, audit reports are required to list the signatures of two sign-

ing auditors

1

at the end of the report: the engagement auditor, who

leads the fieldwork, and the review auditor, who performs a final

review (Ministry of Finance of the People's Republic of China [MOF],

2001). Rather than examining the audit outcome of various charac-

teristics of one single auditor like prior literature (e.g., Carey &

Simnett, 2006; Chen et al., 2010; Zerni, 2012), we employ the unique

data in China to investigate the effect of two signing auditors' experi-

ence gap on audit outcomes to see how the signing auditors interact

with each other, as these auditors play the most critical role in deter-

mining the outcome of the audit. By examining their interaction, this

study seeks to shed light on how the audit team functions as a

whole.

The recent trend in auditing has been to examine the impact of

auditor characteristics on audit outcomes (Lennox & Wu, 2018).

Although previous studies have explored the effects of individual

auditor factors such as tenure, rotation and industry specialization

(e.g., Carey & Simnett, 2006; Chen et al., 2010; Zerni, 2012), little is

known about the impact of auditor interaction on audit outcomes.

This study aims to fill this gap by examining the effect of the experi-

ence gap between the engagement auditor and the review auditor on

audit outcomes, capturing the interaction between auditors in their

performance of audit tasks.

The audit team plays a crucial role in ensuring credible

financial statements and reducing the agency problem between

management and investors (Mansi et al., 2004). Therefore, it is

important to understand the relationship between the structure of

the audit team and investors' risk assessments, specifically, the cost

of capital. This study investigates whether and how the cost of

capital varies as the experience gap between the signing auditors

expands.

Existing research has shown that auditor experience can influence

audit outcomes in both positive and negative ways. Some studies

have found a positive association between auditor experience and

audit quality (Chi et al., 2017; Sonu et al., 2019), whereas others have

reported a decline in audit quality with increased auditor experience

(Frederick & Libby, 1986; Haynes et al., 1998; Koch et al., 2012;

Sundgren & Svanström, 2014).

The inconsistent conclusions of previous studies may be due to

the use of data from different countries with varying institutional

Received: 26 March 2022 Revised: 4 April 2023 Accepted: 21 April 2023

DOI: 10.1111/ijau.12316

62 © 2023 John Wiley & Sons Ltd. Int J Audit. 2024;28:62–82.wileyonlinelibrary.com/journal/ijau

environments (e.g., Norway in Sundgren & Svanström, 2014; Taiwan

in Chi et al., 2017; Korea in Sonu et al., 2019) and differing methods

of measuring experience (e.g., the number of engagements in

Sundgren & Svanström, 2014; pre-client and client-specific experi-

ence in Chi et al., 2017; length of time as a certified public accountant

[CPA] in Sonu et al., 2019).

The inconsistent conclusions may also be because previous

research did not take into account the interaction between auditors,

particularly the two signing auditors, who play the most important

role in the audit team. Single auditor experience may not determine

the audit outcome, as multiple auditors with their collective knowl-

edge, skills and experience tend to influence each other. The rela-

tionship between single auditor characteristics and audit outcomes

may be misleading if the interaction between signing auditors is not

taken into account. Hence, it is important to further investigate

how the experience structure of signing auditor teams affects audit

outcomes.

Financial reports, which are audited by teams with different

levels of experience gap, are the primary source of information for

market participants (Bradshaw et al., 2001). The financial reports

allow creditors and investors, who are the most important users, to

assess information risks and determine the cost of capital. This study

explores whether shareholders and creditors perceive a greater expe-

rience gap between signing auditors as a lower information risk,

resulting in a lower required return. To the best of our knowledge,

no previous research has explored whether shareholders and credi-

tors incorporate the audit team's experience structure into their pric-

ing decisions. This study sheds new light on the role that auditor

interaction plays in driving audit outcomes and helps firms and inves-

tors better assess the audit quality of different auditor team experi-

ence structures.

The experience gap between signing auditors may impact team

dynamics in two ways: it may result in either a complementary effect

or a friction cost effect. On one hand, auditors with different levels of

experience may provide complementary benefits and offer diverse

perspectives, leading to more effective judgments. An audit team

composed of signing auditors with varying levels of experience brings

different skills, backgrounds and resources, which can help analyse

and interpret information from different angles, thereby improving

audit quality. From this perspective, a larger experience gap may

enhance audit quality and reduce information risk, leading investors to

demand a lower risk premium.

On the other hand, auditors with varying levels of experience

may generate friction costs as they may struggle to reconcile their

differences in knowledge and perspectives, leading to compromise.

The less experienced auditors may feel pressure from the more

experienced auditors, and they may have different judgments on the

evidence gathered during the audit process. Reconciling these differ-

ences can be challenging, especially in complex situations (Simons &

Peterson, 2000; Van den Steen, 2010). Verifying their judgments

based on different perspectives can also take longer (Baranchuk &

Dybvig, 2009). In this case, a larger experience gap may not improve

or even harm audit quality, increasing the information risk and

resulting in investors demanding a higher risk premium. This study

aims to determine which effect, the complementary effect or the fric-

tion cost effect, dominates the relationship between the experience

gap of signing auditors and investors' perception of corporate infor-

mation risks.

In this study, we focus on the overall experience of signing

auditors. Specifically, we use the number of reports issued by the

auditors before the current year as a proxy for their experience

2

and measure the experience gap as the difference between the

review auditor and the engagement auditor. To mitigate the

skewed concern of experience gap data, we use the natural

logarithm of the absolute value of the difference in the number of

audit reports signed by the two signing auditors as our independent

variable.

We have documented several empirical findings. First, the two

signing auditors complement each other, meaning the complementary

effect dominates. In other words, a higher experience gap reduces

information asymmetry, leading to a decrease in the cost of capital.

Second, the effect is more pronounced for firms with higher informa-

tion asymmetry, lower audit quality and weaker financial environ-

ments. Third, audit quality partially mediates the relationship

between the experience gap and the cost of capital. This means that

the negative effect of the experience gap on the cost of capital is

partially attributed to the improved audit quality and the resulting

reduction in information asymmetry. These conclusions are consis-

tent and support the idea that the experience gap reduces the cost

of capital.

This study makes several contributions. First, it responds

to the call for further research at the individual auditor level,

complementing audit-firm-level and audit-office-level attribute stud-

ies (e.g., DeFond & Francis, 2005; Gul, Wu, & Yang, 2013; Lennox &

Wu, 2018). Second, it contributes to the literature on the determi-

nants of the cost of capital. Although prior literature has documented

a negative association between audit firm reputation (Big 4 audit firm

and/or industry-specialist auditors) and the cost of capital

(Khurana & Raman, 2004; Mansi et al., 2004), the effect of audit

team diversity on the cost of capital has not been explored. This

study fills this gap by investigating the effect of the experience gap

between signing auditors on the cost of capital. Third, this paper

enriches the relevant research on the diversification of audit teams.

Although existing literature has explored the economic consequences

of diversified audit teams in terms of age, gender, educational back-

ground and position (Bianchi, 2018; Cameran et al., 2018;He

et al., 2021; Hossain et al., 2017; Srinidhi et al., 2019), our study

expands this research area from the perspective of the diversity of

auditors' experience.

The rest of the paper is structured as follows: Section 2pro-

vides the institutional background and relevant literature and

develops the hypotheses. The research methods and sample selec-

tion are described in Section 3. Descriptive statistics and regression

results are presented in Section 4. Additional tests are conducted in

Section 5to further verify the results. The paper concludes in

Section 6.

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