Are Financially Constrained Firms Bad Audit Clients?

Audit assurance becomes more valuable for financially constrained businesses as they face operational and financial uncertainty.
Ahmet KurtFebruary 7, 2023
Are Financially Constrained Firms Bad Audit Clients?
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Not all firms have easy access to capital markets, particularly when economic conditions worsen. Whereas large and mature firms are considered relatively financially unconstrained, others typically have limited internal funds and face more friction when attempting to raise external financing. 

How do financing constraints impact firms’ financial reporting behavior? A plausible argument is that because financially constrained firms often look for ways to ease their access to financing, they may tend to window-dress their financial statements through opportunistic reporting choices such as accelerating the recognition of revenues and underestimating bad debt expenses.   

Measuring Financial Constraint

Prior studies find firms facing higher financial constraints are associated with seemingly aggressive accounting and corporate tax decisions. Yet, this stream of literature does not attribute these findings to managerial opportunism intended to mislead investors. 

Instead, evidence indicates that the managers of financially constrained firms use their financial reporting discretion to signal their firms’ favorable prospects to capital market participants and maximize firm value. 


Ahmet Kurt

Investors appear to see through managers’ motivation (e.g. trying to boost internal funds via careful tax planning) and reward financially constrained firms accordingly. For instance, constrained firms with lower effective cash tax rates have lower costs of equity

Motivated by these findings, in our recent study forthcoming in the European Accounting Review, my colleagues and I examined whether financially constrained firms are associated with positive audit signals, which may help them communicate the reliability and timeliness of their financial reports to investors. 

We focus on two audit signals: audit fees and audit report lag (i.e., the number of days between the fiscal year-end date and the audit report date minus the SEC’s annual report filing deadline). Previous research points out that higher audit fees are an indication of greater commitment to financial statement reliability, whereas longer audit lags signal potential financial reporting issues. 

To measure financial constraints, we utilize a textual measure developed by two prominent finance scholars: Gerard Hoberg and Vojislav Maksimovic. Their measure is based on firms’ disclosures in the capitalization and liquidity subsection of the MD&A section of 10-K filings and captures the extent to which the firm’s vocabulary resembles the vocabulary commonly used by constrained firms (e.g., curtail capital spending, eliminate research, scale back expansion). 

Hoberg and Maksimovic’s financial constraints database includes firms traded on U.S. stock exchanges and extends through 2015. For our analysis, we focus on the period 2004-2015 and use 26,666 firm-year observations. The average firm in our sample is 19.5 years old and has $2.36 billion in total assets. 

Signaling greater audit assurance becomes more valuable for financially constrained audit clients as executives expect higher growth from future investments.

Our findings suggest that financially constrained firms do not make bad audit clients. In the face of greater financing constraints, firms pay higher audit fees and have their audits completed sooner. In economic terms, moving from the bottom to the top decile of financial constraints is, on average, associated with a 3.4% increase in audit fees and a 24% decrease in audit lag. 

How about the role of investment opportunities? When the firm’s investment opportunities are high, the relationship between audit fees and financial constraints is stronger, with the economic significance of the documented result almost doubling (i.e., a 6.5% increase in audit fees). This is consistent with the view that signaling greater audit assurance becomes more valuable for financially constrained audit clients as executives expect higher growth from future investments.  

Positive Audit Signals 

Could these findings be due to constrained firms’ facing greater operational and financial uncertainty than their unconstrained counterparts (resulting in greater auditor effort)? The answer is no because our models already account for the observable differences in firms’ financial and operational characteristics (e.g. liabilities, return-on-assets, the number of segments, etc.), risk disclosures, and ex-ante litigation risk.  

How do short audit lags help? Having their audits completed early and filing their annual reports sooner rather than later are in the best interest of financially constrained firms as doing so gives both investment bankers and investors timely access to critical, audited financial information, enabling access to much-needed funds. It may also signal that the management was responsive to the audit team’s information requests and that the audit team did not encounter any significant issues during the audit. 

Equity-seeking-constrained firms raise more equity financing in the next year when they pay high audit fees and have short audit lags.

Our analysis reveals that the likelihood of early audit completion (i.e., at least 10 days before the SEC’s filing deadline) is 13.2% higher for firms in the top versus the bottom decile of financial constraints. And this figure rises to 22.1% when firms pay high audit fees. 

Are positive audit signals (e.g. higher audit fees and shorter audit lags) associated with greater future external financing for constrained firms? The evidence suggests so. Equity-seeking-constrained firms raise more equity financing in the next year when they pay high audit fees and have short audit lags. We do not observe a similar result in the case of debt-seeking constrained firms. 

Access to Financing

How do equity-seeking constrained firms perform after raising financing? Consistent with the positive signaling argument, high audit-fee-paying constrained firms exhibit better long-run stock performance after the follow-on offering than low audit-fee-paying constrained firms. 

CFOs are advised to be proactive and improve their firms’ credit flexibility. 

We also analyzed the ex-post litigation risk of firms facing higher financial constraints. The results show that equity-seeking-constrained firms that paid higher audit fees in the current year are less likely to get sued in the near future.  

Our findings have implications for auditors, audit committees, and CFOs. While financially constrained firms are subject to greater operational and financial uncertainty, they are not necessarily “bad” audit clients. In the face of higher financial constraints, firms pay higher audit fees and have their audits completed sooner. And financially constrained firms that pay higher audit fees exhibit better stock price performance and have lower future litigation risk.  

CFOs are advised to be proactive and improve their firms’ credit flexibility. Doing so helps ensure that enough funds are available to undertake positive NPV projects and that the firm does not experience underinvestment. 

One way to boost a firm’s access to financing is to invest in the external auditing function. Positive audit signals serve as an important mechanism to mitigate the adverse selection problem between managers and the providers of financing. Specifically, higher audit fees and shorter audit lags can facilitate access to equity financing by increasing investors’ confidence in the reported financial information. Hence, trying to cut audit expenses may not be a wise strategy for financially constrained firms. 

Ahmet Kurt is an assistant professor of accounting at Bentley University.