Instructional Case: Is Auditor Selection Associated with Cost of Capital?

This article examines whether auditor selection is associated with the cost of capital of a company. The choice by an entity of an audit or of a particular public accounting firm can act as a signal to the market as to the fairness of various representations made about operations and performance, as well as a commitment to provide monitoring information to those who provide funds. It is expected that an entity that had made false representations, as an example, would be hesitant to undergo an audit for fear of detection, that is, the cost of such discovery would outweigh whatever positive effects the initial auditor selection might have on potential lenders or investors. An action will only serve as an effective signal if there is a cost incurred in emitting the signal and if there are consequences to emitting a false signal. Audit-related adjustments show an overwhelmingly negative effect on preaudit net earnings and net assets. The average aggregate adjustment reduces earnings and assets by two to eight times the minimum amount that would materially misstate the financial statements.