Analysing the Impact of Auditing on Corporate Cost of Debt and Innovation: A comparative Study between Audited and Non-Audited Italian Companies

Abstract

The importance of auditing has significantly increased during the past three decades, as business have experienced an unprecedented growth in complexity (Schillemans and Van Twist, 2016). The role of the auditor grew with the expansion of the financial markets and the firms’ size. Essentially, audit is a third-party, impartial examination of an organization's financial statements. The objective of this activity is to allow the auditor to determine whether the financial statements were produced in compliance with the relevant financial reporting framework in all material respects. Hence, external auditors protect the public interest and for this reason, above certain conditions, are mandated by legislation as they play a pivotal role in balancing the information asymmetry between the stakeholders as whole and the management of the firm, which prepared the financial statements. When there is information asymmetry, the market fails to offer a Pareto optimum solution, a condition known as 'market failure' (Stiglitz, 2000). Audit activity is what economists refer to as signaling activity, which means that when there is an information asymmetry, an independent third party is required to signal the real quality of the products – essentially distinguishing between good and bad products, as in normal laissez faire, the good ones are likely be carried away by the 'lemons' (Akerlof, 1970). Information asymmetry can have significant implications for market structure and company decision-making in the context of financial markets. In fact, companies often borrow cash to finance initiatives that, according to their Net Present Value (NPV), should yield higher profits than the cost of the borrowed funds. This activity is extremely advantageous to the general economic prosperity of society as it creates new value through the firms’ activity. For instance, Halov and Heider (2011) discovered that US corporations often refrain from issuing debt instruments if the market has little information about them, regardless of the underlying project. Instead, Myers and Majluf (1984) claimed that firms' stock prices will eventually fall, and their cost of equity capital will rise if they elect to issue stock securities in a market with severe information asymmetry. In both circumstances, corporations will be forced to abandon initiatives that may have yielded significant profits given the existence of knowledge asymmetry. As a result, a market failure in the global financial markets system might cause a large financial loss to the society. Audit is an essential activity in fostering trust in the global financial markets as it reduces the information asymmetry between firms and private investors/lenders and improves the quality of their own disclosures (Paprocki & Stone, 2004). This leads to better resource allocation (Watts and Zimmerman, 1983; DeFond & Zhang, 2014), particularly in the debt market (Pittman & Fortin, 2004; Minnis, 2011; Causholli and Knechel, 2012; Hug et al., 2022). The purpose of this study is to determine if it is accurate to say that audit adds value to the market by examining how audit affects the firm's perceived risk and its level of innovativeness in the Italian private market. Starting with the relationship with perceived risk, the firms’ Cost of Debt (CoD) will be the dependent variable analyzed. In fact, it makes sense that if auditors truly balance the information asymmetry in the market between lenders and companies, their guarantee will enable lenders to reduce their monitoring costs—that is, the costs associated with controlling the firm's management. All other things being equal, if the auditor assurance lowers the lenders' monitoring expenditures, market competition will force financial institutions to pass these cost savings on to borrowers in the form of lower interest rates and thus lower CoD. Additionally, if it is true that Audit positively impact the firm Cost of Debt (CoD) as it signals to the market the real quality of the firms’ Financial Statements, then the extent to which the auditor's activity is viewed as high-quality by the market should likewise have an effect on CoD. De Angelo (1981) found a favorable correlation between the size of the auditing firm and audit quality, indicating that the external auditors' dimensions may be a useful proxy for assessing it. As a result, I also investigated in this study if the firms’ decision of being audited by a Big Four affects their own CoD in a sample that solely included audited businesses. Finally, the second purpose of this study is that of investigating the relationship between the degree of innovation in a corporation and the quality of its audits. Although it may appear contentious because the first is associated with the solution of a financial market’s failure, while innovation inherently belongs to the nature of the firm, the two are really more closely related than is often believed. According to the existing literature, companies who choose to pay for an audit service see a notable rise in debt and investments. This suggests that, in general, audited companies are able to secure significantly more funding for their projects than their non-audited counterparts. Therefore, because auditing promotes better financial transparency and trustworthiness (Healy & Palepu, 2001; Beyer et al., 2010), the auditee should have more access to finance, which will allow for higher investments in R&D and innovative projects.