Spend Money to Make Money? Voluntary Audit Reviews and Firms’ Cost of Debt

An audit review (AR) is a mechanism used by boards to assess the quality of interim financial reports on a timely basis. In Canada, the AR is voluntary, with listed firms mandated to disclose when they choose not to purchase additional audit verification. Given the relatively low cost of an AR, opting out of it can be regarded as a negative signal, especially in the context of lenders’ sensitivity to downside risk. Using a sample of 7,236 firm-year observations from 1,571 public firms in Canada over the period 2004-2015, we document that firms without a voluntary AR have a higher cost of debt than firms with an AR, particularly for public bonds. Furthermore, we investigate firms that stop subscribing to the AR on their interim financial statements and find that after the “negative switching,” the increase of the cost of debt is accompanied by a rise in discretionary abnormal accruals and distress risk. Therefore, earnings management can be a reason why managers forfeit the benefits brought by the AR. Besides, the threat of earnings management on financial statement quality warrants taking the absence of the AR into the debt contracting. Our study is the first to document that listed borrowers that opt out of an AR have a higher cost of debt financing, yet they are concurrently able to engage in more earnings management.