Cash Flow PDF

Journal of Accounting and Economics 24 (1998) 219237
A test of the free cash flow and debt monitoring

hypotheses:
Evidence from audit pricing
Ferdinand A. Gul, Judy S. L. Tsui*
Department of Accountancy, City University of Hong Kong, 83 Tat Chee Avenue, Kowloon, Hong Kong
(Received June 1996; final version received January 1998)
Abstract
This study examines the association between free cash flow (FCF) and audit fees. The
association is expected given Jensens argument that managers of low growth/high FCF
firms engage in non-value-maximizing activities. These activities increase auditors assessments of inherent risk and, in turn, audit effort and fees. Jensen also argues debt
mitigates the non-value-maximizing activities. Thus, the positive FCF/audit fees association is expected to be weaker for low growth firms with high debt than for similar firms
with low debt. Regression results for a sample of low growth Hong Kong firms support
these hypotheses. ( 1998 Elsevier Science B.V. All rights reserved.
JEL classification: L84; M40
Keywords: Free cash flow; Debt monitoring; Growth opportunities; Audit pricing
1. Introduction
A major strand of audit research focuses on the choice of auditors (Francis
and Wilson, 1988) and the determinants of audit fees (Simunic, 1980; Francis
and Simon, 1987; Craswell et al., 1995; Simunic and Stein, 1996). An underlying
hypothesis in these studies is that agency costs drive the demand for qualitydifferentiated audits in terms of the Big 6 vs. Non-Big 6 audit firms (previously
* Corresponding author. Tel.: (#852) 2788 7923; fax: (#852) 2788 7002; e-mail: acjt@
cityu.edu.hk.
0165-4101/98/$19.00 ( 1998 Elsevier Science B.V. All rights reserved.
PII S 0 1 6 5 - 4 1 0 1 ( 9 8 ) 0 0 0 0 6 - 8
220
F.A. Gul, J.S.L. Tsui / Journal of Accounting and Economics 24 (1998) 219237
Big 8). Firms with higher agency costs are expected to hire higher quality,1 more
costly auditors in order to help mitigate agency costs. The demand for audit
services and for quality-differentiated auditing is seen to be the efficient resolution of costly contracting problems (Watts and Zimmerman, 1986).
Prior empirical evidence on the relation between agency cost variables and
the demand for audit quality is not strong (Palmrose, 1986; Simunic and Stein,
1987; Francis and Wilson, 1988; Defond, 1992). For example, prior studies using
agency cost proxies such as leverage and management ownership of shares have
not been very useful in explaining auditor choice. This could be due to leverage
and management ownership of shares serving as poor proxies for agency costs
or to the omission of other factors that cause cross-sectional variations in
agency costs and auditing demand. Recently, Craswell et al. (1995) point to
industry specialist auditors and argue that a combination of firm-specific and
industry-wide factors generate cross-sectional variations in the demand for
monitoring and in audit fees. The results of Craswell et al. are consistent with the
hypothesis that firms in certain industries demand higher quality audits provided by auditors with specialization in those industries and that this translates
into higher audit fees.
In this study, we explore a supply-side argument for the association between
agency costs and audit fees. More specifically, we examine the association
between free cash flow (FCF), identified by Jensen (1986) as a source of agency
problems for low growth firms, and audit fees. FCF is defined as the cash flow in
excess of that required to fund positive-net-present-value projects that is not
paid out in dividends. According to Jensen (1986, 1989), managers of low
growth/high FCF firms are involved in non-value-maximizing activities. We
expect managers of these firms to mask non-optimal expenditures by accounting
manipulation. We also expect auditors to respond to the higher probability of
accounting misstatements or irregularities by exerting greater audit effort and
charging higher audit fees. Jensen (1986, 1989) also argues that some low
growth/high FCF firms issue debt to mitigate the FCF agency problems. This
suggests the FCF/audit fees association depends on the debt level; auditors of
high FCF/high debt firms are likely to assess a lower risk of material misstatements, provide lower audit effort and charge lower audit fees than auditors of
high FCF/low debt firms.
To examine the relation between FCF and audit fees, data is collected for
publicly listed Hong Kong companies for 1993. Two multiple regression models
of audit fees are run for low growth firms audited by the Big 6, using two FCF
proxies suggested by Lang et al. (1991, p. 319). Each of the two models includes
1 Audit quality is defined as the joint probability of detecting and reporting material financial
statement errors (DeAngelo, 1981).
F.A. Gul, J.S.L Tsui / Journal of Accounting and Economics 24 (1998) 219237
221
an interaction term for the FCF proxy and debt. Results indicate firms with high
FCF and low growth opportunities are associated with higher audit fees than
firms with low FCF and low growth opportunities. More importantly, the
interaction between FCF and debt is significant and in the predicted direction.
The negative interaction suggests at incrementally higher levels of debt, the
positive association between FCF and audit fees progressively decreases.
This paper contributes to auditing literature in several ways. First, it provides
evidence of an association between agency costs (proxied by FCF) and Big
6 audit fees not previously recognized in the literature. It is possible that FCF is
a better proxy for agency costs than other variables, such as management
ownership or leverage, previously examined by other researchers. Second, the
paper provides a supply-side explanation for the association between FCF and
audit fees. Third, unlike prior studies, debt has a significant impact on audit fees
but the direction and extent of the effect is dependent on the firms growth
opportunities and FCF. The results obtained here suggest prior studies that
examine debts role in audit pricing have an omitted variables problem when
they do not control for FCF and growth opportunities.
The next section of the paper provides a brief discussion of the theoretical
background of the study. This is then followed by sections on the research
method, results and discussion, and conclusion of the study.
2. Theoretical background
Jensen (1986, 1989) argues there is a conflict of interest between managers and
shareholders of firms with high FCF and low growth opportunities. Managers
of these firms act opportunistically and are involved in value destroying
activities and tend to overinvest and misuse the funds (Jensen, 1986, 1989).
Once managers have exhausted positive NPV projects, they proceed to invest in
negative NPV projects instead of paying dividends (Rubin, 1990; Lang et al.,
1991). Managers of these firms are expected to increase their compensation and
perquisites consumption at the expense of the shareholders, and engage in other
activities associated with management entrenchment (Shleifer and Vishny,
1989). Christie and Zimmerman (1994) suggest these non-value-maximizing
managers are more likely to mask non-optimal expenditures by accounting
manipulation.
Auditors design audits to reduce audit risk below a given level (see Lemon et
al., 1993). Audit risk is the likelihood of material errors in the clients financial
statements (Accounting Standards Board, Statement on Auditing Standards,
No. 47). It is the product of the likelihood that environmental factors, before
considering the quality of internal controls, will produce a material error
(inherent risk), the likelihood the internal controls system will not prevent or
detect a material error (control risk) and the likelihood the audit procedures
222
will fail to detect a material error not detected by the control system (detection
risk). The greater the inherent risk, ceteris paribus, the more resources the
auditor will have to devote to the audit to reduce detection risk to achieve
a given level of audit risk. Auditors are likely to assess firms with high FCF and
non-value-maximizing managers as having high levels of inherent risk. Hence,
ceteris paribus, they are likely to devote more resources to those firms audits
and charge those firms higher fees.
Issuance of debt without retention of the proceeds (i.e., higher leverage) is
likely to reduce agency costs associated with FCF. The required payments under
debt contracts reduce the cash flows management have available for non-valuemaximizing behavior and so restrict that behavior (Jensen, 1986, 1989; Stulz,
1990; Maloney et al., 1993). The debt market also provides management discipline (Rubin, 1990). These effects reduce inherent risk and in turn mitigate the
audit fees of high FCF firms. On the other hand, additional leverage can
motivate misstatements by management (e.g., to avoid accounting-based debt
covenant violations), so the net effect of higher leverage on inherent risk is
ambiguous. We expect, however, the former (cash discipline) effects to dominate
for high FCF/low growth firms.
To summarize, we argue that auditors charge higher fees in response to the
higher inherent risk associated with the non-value-maximizing activities of
managers of low growth firms with high FCF. Since debt can mitigate the
agency problems of FCF by requiring payments and providing a monitoring
mechanism through the debt market, it is likely that the relation between FCF
and audit fees depends on debt levels. This reasoning leads to the following
hypothesis:
Audit fees for low growth firms with high FCF and low levels of debt will be
higher than for similar firms with high FCF and high levels of debt, ceteris
paribus.
3. Research method
3.1. Data collection
We use data collected on Hong Kong publicly listed companies for 19932 from
Wardley Data Services Limited.3 A total of 449 firm observations are available.
2 The market and regulatory environments in Hong Kong are similar to those of the US and
Australia.
3 Wardley Data Services Limited is a securities company that maintains a database on all Hong
Kong publicly listed companies.
223
Data on auditor identity and audit fees are obtained from an inspection of
annual reports. After screening for low growth firms based on a composite
measure of growth, 46 firms audited by Big 6 audit firms are available for testing
the hypothesis. Table 1 presents a summary of the sample selection process.
Table 2 lists the number of companies for each industry group. No financial
institutions are included.4 Table 3 classifies the sample according to whether the
companies are audited by Big 6 or Non-Big 6 audit firms.
Table 1
Summary of the sample selection process
Sampling frame
Requirements
Firm observation for 1993 is available from Wardley Data Services Limited
Firm is incorporated in Hong Kong
Firm has shares that are publicly traded in Hong Kong
Number of firms qualifying"449
Screen for growth opportunitiesa
Requirements
Firm has non-missing values for three proxies of growth
(MKTBKEQ, MKTBKASS and PPE)
Number of sampling frame firms qualifying"418
Screen for low growth firmsb
Requirements
Firm has a composite factor score in the bottom quartile
Number of sampling frame firms qualifying"105
Screen for hypothesis subsample
Requirements
Firm has non-missing values for all the variables
Firm is audited by Big 6 audit firms
Number of firms qualifying for testing hypothesis"46
!Growth is the composite factor score obtained from common factor analysis using the following
three proxies: (i) MKTBKEQ"total market value of shares outstanding divided by total book
value of common equity; (ii) MKTBKASS"(total assets!total common equity#total value of
shares outstanding) divided by total assets; and (iii) PPE"gross plant, property and equipment
divided by market value of the firm.
"Low growth firms are those in the bottom quartile calculated on the basis of composite factor score
obtained from common factor analysis using MKTBKEQ, MKTBKASS and PPE.
4 Following the reasoning of Francis and Stokes (1986), financial institutions are excluded due to
their unique characteristics.
224
Table 2
Distribution of 1993 sample firms by industry
Total sample
Growth sampling
frame
Sampling frame
for hypothesis
11
84
157
172
15
10
11
82
143
159
15
8
0
17
17
7
4
1
449
418
46
Industry!
Utilities
Properties
Consolidated enterprises"
Industrials#
Hotels
Others
!Following Francis and Stokes (1986), data for financial institutions are dropped from the analysis.
" Consolidated enterprises include companies with principal activities in a combination of industry
groups such as retail, manufacturing and properties.
#Industrials include manufacturing or textile companies.
Table 3
Distribution of 1993 sample firms! audited by Big 6 and Non-Big 6 and by industry
Industry
Utilities
Properties
Consolidated enterprises
Industrials
Hotels
Others
Missing information
Total
Total sample
Hypothesis sample
Big 6
Non-Big 6
Big 6
10
52
119
134
13
6
334
0
334
1
29
26
23
2
3
84
31
115
0
17
17
7
4
1
46
0
46
449
46
!Following Francis and Stokes (1986), data for financial institutions are dropped from the analysis.
3.2. Research design

An OLS regression model is estimated to test the hypothesis. In this model, as
in prior studies, a number of control variables that are normally included in
audit fee models are used (Simunic, 1980; Francis, 1984; Craswell et al., 1995).
Auditee size is measured by the natural log of total assets (SIZE), while
long-term and short-term capital structure is represented by the debt to total
225
assets ratio (DE) and the quick ratio (QUICK) respectively. Asset mix is
measured by the ratio of current assets to total assets (CURRENT), and
organizational complexity is measured in terms of the number of directly owned
subsidiaries (SUB) and the percentage of subsidiaries incorporated outside
Hong Kong (FOREIGN). To control off-peak pricing of audit services, an
indicator variable (YE) is used (1 for non-December 31 year end and 0 otherwise). Finally, audit risk is measured in terms of the return on assets (ROA).
These variables have good explanatory power in the models (e.g., Craswell et al.,
1995) and are robust across different samples, time periods and countries. In
order to control for possible client industry effects, indicator variables for
different industries are also included. The hypothesis is tested by including an
interaction term for FCF and debt in the model.
3.3. Variable measurement
The experimental variables of interest are FCF and FCF/debt interaction,
and the dependent variable is the natural log of total audit fees. Since the
hypothesis is tested with low growth firms, a composite growth opportunities
factor score is calculated and used to identify these firms.
3.3.1. Growth opportunities
There is no consensus on the most reliable proxy for growth. Three widely
used proxies are employed in this study (Chung and Charoenwong, 1991; Gaver
and Gaver, 1993; Skinner, 1993). Factor analysis is conducted on the three
proxies to arrive at a composite factor score (see Gaver and Gaver (1993) for an
example of this procedure).
The three proxies are:
1. The ratio of the market value of equity to the book value of equity
(MKTBKEQ)
This proxy is used because the difference between the market value and the
book value of equity incorporates the value of the firms future investment
opportunities. The higher the ratio, the greater the value of growth opportunities.
2. The ratio of the market value of assets to the book value of assets
(MKTBKASS)
The higher the ratio, the lower the ratio of assets-in-place to the firm value
and the greater the value of growth opportunities.
3. The ratio of gross plant, property and equipment to the market value of the
firm (PPE)
Skinner (1993) suggests that past investments in gross plant, property and
equipment can also characterize assets-in-place. The higher the ratio, the
higher the assets-in-place and the lower the growth opportunities.
226
3.3.2. Common factor analysis for growth

The results of the factor analysis are presented in Table 4.
Due to missing values of either one or more of the growth proxies from the
sampling frame of 449 firm observations, only 418 are included for factor
analysis. Panel A shows the estimated communalities for each of the three
growth measures.5 Panel B presents the eigenvalues of the reduced correlation
matrix of the three growth measures, and Panel C presents the correlations
between the common factor and the three measures of growth. The common
factor with an eigenvalue of 1.658 is significantly positively correlated with
MKTBKEQ and MKTBKASS and negatively correlated with PPE.6
3.3.3. Free cash flow
Unfortunately, as pointed out by Lang et al. (1991), the literature provides
little or no guidance on the measures for FCF as defined by Jensen (1986). To
Table 4
Statistics related to common factor analysis of three measures of growth opportunities for 418 firms
for 1993
Panel A: Estimated communalities of three growth measures!
MKTBKEQ
MKTBKASS
0.748
0.740
PPE
0.061
Panel B: Eigenvalues of the reduced correlation matrix of three growth measures

MKTBKEQ"
MKTBKASS
PPE
1.658
0.022
!0.130
Panel C: Correlations between the common factor and three growth measures
MKTBKEQ
MKTBKASS
PPE
0.970***
0.957***
!0.251***
***"p(0.001.
!Growth is the composite factor score obtained from common factor analysis using the following
three proxies: (i) MKTBKEQ"total market value of shares outstanding divided by total book
value of common equity; (ii) MKTBKASS"(total assets!total common equity#total value of
shares outstanding) divided by total assets; and (iii) PPE"gross plant, property and equipment
divided by market value of the firm.
" Harman (1976) and Cattrell (1966) suggest that if the first eigenvalue alone exceeds the sum of the
three communalities, this one common factor explains the intercorrelations among the individual
measures.
5 Communalities are squared multiple correlations obtained from regressing each of the growth
proxies on the other three measures.
6 Since the estimated communality for PPE is rather low, we also classify low growth firms on the
basis of the individual measures, i.e. MKTBKEQ and MKTBKASS, which have been used
extensively as proxies for growth (Smith and Watts, 1992; Gaver and Gaver, 1993), and run separate
regressions for each proxy to determine if the results are different.
227
date, several proxies have appeared in finance literature and we adopt two of the
most widely used free cash flow definitions, those used by Lehn and Poulsen
(1989) and Lang et al. (1991). Lehn and Poulsen (1989) define FCF as the
operating income before depreciation minus taxes, interest expenses, preferred
dividends, and ordinary dividends. Such free cash flow definition is normalized
by either the total book value of equity or total assets in the previous year. It
should be noted that these measures of FCF by themselves do not provide
a measure of the availability of positive NPV projects. However, in combination
with low growth, they suggest the existence of cash flow in excess of that
required to fund positive NPV projects.
The two measures of free cash flow used are defined as follows:
FCFBEQ"(INC!TAX!INTEXP!PREDIV!ORDIV)/BEQ,
FCFBA"(INC!TAX!INTEXP!PREDIV!ORDIV)/BA,
where, INC is the operating income before depreciation; TAX is the total taxes;
INTEXP is the gross interest expenses on short- and long-term debt; PREDIV
is the total dividend on preferred shares; ORDIV is the total dividend on
ordinary shares; BEQ is the total book value of equity in previous year and BA
is the total assets in previous year.
3.4. Descriptive statistics
Table 5 presents descriptive statistics for the experimental, control and dependent variables in this study. The total audit fees and total assets in millions of
Hong Kong dollars are also given in Table 5 (see page 228).
3.5. Model specification
To test the hypothesis, firms with bottom quartile of growth factor scores are
analyzed using the following OLS regression model:
LAF"b #b SIZE#b DE#b CURRENT#b QUICK
0
1
2
3
4
#b YE#b SUB#b FOREIGN#b ROA
5
6
7
8
#b PROP#b CONSOL#b INDUS
9
10
11
#b HOTEL#b FCF#b FCF*DE
12
13
14
where LAF is the natural log of total audit fees.
Control variables
SIZE
DE
" natural log of total assets

" book value of long-term debt divided by total assets
228
Table 5
Descriptive statistics of all variables for 1993 sample used to test the hypothesis (N"46)
Variable
Mean
Std Dev
LAF
AF (HK$M)
SIZE
TA (HK$M)
DE
CURRENT
QUICK
YE"1
SUB
FOREIGN
ROA
FCFBEQ
FCFBA
GROWTH
MKTBKEQ
MKTBKASS
PPE
0.389
2.005
7.934
6754
0.135
0.366
1.380
71.7%
5.901
0.408
15.79
0.257
0.116
!0.710
0.615
0.664
1.784
0.716
2.370
1.338
11412
0.113
0.218
1.055
2.113
0.216
18.60
0.576
0.165
0.118
0.166
0.281
1.540
Range
!0.949
0.387
4.718
112
0.00008
0.066
0.150
2.646
0.039
2.217
!0.012
!0.010
!1.111
0.146
!0.897
0.055
2.766
15.900
10.990
59475
0.515
0.914
5.500
11.958
0.840
100
2.744
0.756
!0.547
0.866
0.963
8.170
LAF"natural log of total audit fees

AF"total audit fees (HK$M)
SIZE"natural log of total assets
TA"total assets (HK$M)
DE"book value of long-term debt divided by total assets
CURRENT"ratio of current assets to total assets
QUICK"ratio of current assets less inventory to current liabilities
YE"dummy variable, 0"31/12 fiscal year end, 1"non-31/12 fiscal year end
SUB"square root of number of directly owned subsidiaries
FOREIGN"percentage of subsidiaries incorporated in countries other than Hong Kong
ROA"profit before interest and tax divided by total assets
FCFBEQ"(INC!TAX!INTEXP!PREDIV!ORDIV)/BEQ
FCFBA"(INC!TAX!INTEXP!PREDIV!ORDIV)/BA
where,
INC"operating income before depreciation
TAX"total taxes
INTEXP"gross interest expenses on short- and long-term debt
PREDIV"total dividend on preferred shares
ORDIV"total dividend on ordinary shares
BEQ"total book value of equity in previous year
BA"total assets in previous year
GROWTH"composite factor score obtained from common factor analysis using the following
three proxies;
MKTBKEQ"total market value of shares outstanding divided by total book value of common
equity
MKTBKASS"(total assets!total common equity#total value of shares outstanding) divided
by total assets
PPE"gross plant, property and equipment divided by market value of the firm.
229
CURRENT " ratio of current assets to total assets

QUICK
" ratio of current assets less inventory to current liabilities
YE
" dummy variable, 0"31/12 fiscal year end, 1"non-31/12
fiscal year end
SUB
" square root of number of directly owned subsidiaries
FOREIGN " percentage of subsidiaries incorporated in countries other than
Hong Kong
ROA
" profit before interest and tax divided by total assets
PROP
" dummy variable, 1"properties, 0"others
CONSOL " dummy variable, 1"consolidated enterprises, 0"others
INDUS
" dummy variable, 1"industrials, 0"others
HOTEL
" dummy variable, 1"hotels, 0"others
Experimenqtal variables
FCF is the two measures of free cash flow.
FCFBEQ"(INC!TAX!INTEXP!PREDIV!ORDIV)/BEQ,
FCFBA"(INC!TAX!INTEXP!PREDIV!ORDIV)/BA,
where, INC is the operating income before depreciation; TAX is the total taxes;
INTEXP is the gross interest expenses on short- and long-term debt; PREDIV
is the total dividend on preferred shares; ORDIV is the total dividend on
ordinary shares; BEQ is the total book value of equity in previous year; BA is
the total assets in previous year.
FCF*DE is the interaction between FCF and DE.
Indicator variables for industries are introduced to control for inter-industry
effects.7A significant interaction term (FCF*DE) is interpreted to mean that the
effect of FCF on the dependent variable depends on debt. A negative interaction
coefficient is predicted since the positive association between FCF and audit fees
is expected to decrease at higher levels of debt. As a control sample, a similar
regression is run for the high growth subsample (N"46)8 selected on the basis
of the top quartile of growth factor scores.
4. Results and discussion
The results reported in Panel A of Table 6 show the association between FCF
and audit fees is positive, significant, and in the predicted direction using either
7 Due to the small sample size, it is not possible to restrict the study to a single industry to
eliminate possible inter-industry effects.
8 After deleting for missing observations from the top quartile subsample (N"105), there are 46
firms audited by Big 6 and 10 audited by Non-Big 6 audit firms.
230
Table 6
Regression results for low growth (bottom quartile) firms for 1993 (N"46) (figures in parentheses
represent t-values)
Variables
Predicted
sign
Panel A: Full model with industry control

INTERCEPT
Control variables
SIZE
DE
CURRENT
QUICK
YE
SUB
FOREIGN
ROA
PROP
CONSOL
INDUS
HOTEL
Experimental variables
FCFBEQ
FCFBEQ*DE
FCFBA
FCFBA*DE
F value
R2
*p(0.10
**p(0.05
Model 1
Model 2
!4.347***
(!5.909)
!4.425***
(!6.181)
0.477***
(6.519)
0.413
(0.703)
1.113***
(2.535)
0.028
(0.364)
!0.038
(!0.226)
0.092**
(2.025)
!0.445*
(!1.320)
!0.003
(!0.687)
!0.024
(!0.054)
0.326
(0.761)
0.211
(0.457)
0.097
(0.199)
0.478***
(6.780)
0.641
(1.083)
1.156***
(2.700)
0.098
(1.108)
!0.088
(!0.534)
0.095**
(2.171)
!0.492
(!1.504)
!0.003
(!0.561)
0.027
(0.062)
0.340
(0.818)
0.187
(0.421)
0.071
(0.150)
1.071***
(2.739)
!8.469***
(!2.614)
8.412***
79.16%
***p(0.01
2.691**
(2.406)
!24.012***
(!3.144)
9.101***
80.43%
232
Table 6 (continued)
where,
TAX"total taxes
FCFBEQ*DE"interaction between FCFBEQ and DE
FCFBA*DE"interaction between FCFBA and DE.
of the two FCF variables. The interaction terms comprising the first order
interaction between FCFBEQ and debt and FCFBA and debt, respectively, are
also significant and in the predicted direction. Some of the control variables are
significant and consistent with prior studies (e.g., Craswell et al., 1995). For
example, the ratios of current assets to total assets are both significant and in the
correct direction. Similar significant results are also obtained for the variables
SIZE and SUB. Except for the variables FOREIGN and QUICK, the other
control variables are all in the expected direction, but insignificant.
Panel B of Table 6 reports the results for a reduced model without the control
variables for industries, QUICK, YE, FOREIGN and ROA, and the results for
the experimental variables are similar.9 As an additional check on the use of the
growth proxy, two identical regressions are run for low growth firms, each
classified on the basis of the bottom quartile of individual growth measures
MKTBKEQ and MKTBKASS respectively.10 The results show both the main
effects of FCF and the interactions between debt and FCF are significant
(p(0.01) and also in the predicted direction. The significance levels of the other
variables are qualitatively similar to the results reported in Panel A of Table 6.
The regression results for the high growth subsample firms classified on the
basis of growth factor scores are reported in Table 7. As expected, none of the
interactions nor the main effects of FCF are significant.
9 These control variables are not significant in the regression of the full model as shown in Panel
A of Table 6.
10 These additional analyses are prompted by a query raised by the referee regarding the low
estimated communality for the PPE measure. The results show that the partition of the sample into
high and low growth opportunities is not sensitive to the exclusion of this growth proxy in the
common factor.
233
Table 7
Regression results for high growth (top quartile) firms for 1993 (N"46) (figures in parentheses
represent t-values)
Variables
Predicted
Sign
INTERCEPT
Control variables
SIZE
DE
CURRENT
QUICK
YE
SUB
FOREIGN
ROA
PROP
CONSOL
INDUS
HOTEL
Experimental variables
FCFBEQ
FCFBEQ*DE
FCFBA
FCFBA*DE
F value
R2
*p(0.10
**p(0.05
Model 1
Model 2
!1.920
(!1.680)
!2.408**
(!2.588)
0.248**
(2.220)
0.429
(0.927)
!1.248*
(!1.676)
!0.046
(!0.639)
!0.075
(!0.356)
0.098*
(1.636)
0.154
(0.281)
0.001
(0.074)
1.129*
(1.843)
0.653
(1.331)
0.531
(0.989)
0.424
(0.534)
0.287***
(2.884)
0.363
(0.696)
!0.602
(!0.948)
!0.025
(!0.341)
0.069
(0.330)
0.090*
(1.525)
0.247
(0.464)
0.015
(1.199)
0.603
(1.144)
0.302
(0.710)
0.056
(0.117)
0.258
(0.341)
0.127
(0.683)
!5.233
(!1.606)
3.781***
63.07%
***p(0.01
!1.052
(!1.290)
!7.534
(!1.025)
4.008***
64.42%
234
Table 7 (continued)
The above asterisks indicate significance levels in a one-tail or two-tail t-test (as appropriate).
SIZE"natural log of total assets
DE"book value of long-term debt divided by total assets
CURRENT"ratio of current assets to total assets
QUICK"ratio of current assets less inventory to current liabilities
YE"dummy variable, 0"31/12 fiscal year end, 1"non-31/12 fiscal year end
SUB"square root of number of directly owned subsidiaries
FOREIGN"percentage of subsidiaries incorporated in countries other than Hong Kong
ROA"profit before interest and tax divided by total assets
PROP"dummy variable, 1"properties, 0"others
CONSOL"dummy variable, 1"consolidated enterprises, 0"others
INDUS"dummy variable, 1"industrials, 0"others
HOTEL"dummy variable, 1"hotels, 0"others
where,
TAX"total taxes
FCFBEQ*DE"interaction between FCFBEQ and DE
FCFBA*DE"interaction between FCFBA and DE
The positive coefficients for FCF in the models in both Panels A and B of
Table 6 suggest FCF is positively related to fees. The interaction parameter
reflects the extent to which fees are affected by FCF and debt. A differentiation
of the equation with respect to FCF provides b -b (Debt). This implies that
13 14
the positive relationship between FCF and audit fees progressively reduces at
higher levels of debt.11 The results are consistent with the argument that, ceteris
paribus, auditors supply12 more audit effort and charge higher audit fees in
11 Further analyses are performed to compare the mean scores of audit fees for the low and high
FCF groups with high and low debt. As expected, mean audit fees are higher for firms with high FCF
and low debt than firms with high FCF and high debt (results not reported here are available from
the authors).
12 The supply-side argument suggests that similar regression results should also be obtained for
Non-Big 6 auditees. Unfortunately, the small sample size (N"20) precludes such an analysis.
However, a full regression with all the variables including an indicator variable for Big 6 (N"46)
and Non-Big 6 (N"20) auditees yielded similar significant results for FCF and the interaction
between FCF and debt (results available from the authors).
235
response to the higher inherent risk associated with higher levels of FCF
(combined with low growth opportunities). They are also consistent with auditors of high FCF/high debt firms assessing lower levels of inherent risk and,
therefore, supplying lower levels of audit effort (and lower audit fees) than
auditors of high FCF/low debt firms.
5. Conclusion
This study investigates the effect of FCF and debt on audit fees. The results
show the association between FCF and audit fees is dependent on debt. The
significant and positive main effects of FCF and the negative sign of the
interaction terms suggest that at progressively higher levels of debt, the positive
association between FCF and audit fees decreases.
Our test, however, does not unambiguously preclude other explanations
such as the demand for higher quality audits to mitigate the agency costs
of FCF. Another possibility is that auditors charge higher fees since they are
aware that firms have the ability to pay more because of the availability of
discretionary resources as a result of high FCF and low growth opportunities. It
is also possible that firms with high FCF and low debt have entrenched
management (Shleifer and Vishny, 1989). The higher fees could represent high
perquisites such as cross-subsidization of other dealings managers have with the
auditors.13 The higher fees could also reflect a premium for higher risk of
litigation (Simunic and Stein, 1996). The above possibilities suggest room for
further research.
Acknowledgements
We acknowledge comments from Dan Simunic (the referee), Ross Watts
(the editor), Jere Francis, Theodore Mock, Eric Noreen, Greg Whittred,
the participants at the University of California, Berkeley, the Hong Kong
University of Science and Technology and University of Otago workshops,
the 1996 Hong Kong Academic Conference and AAANZ Conference. We
also acknowledge the financial assistance provided by a Hong Kong RGC
grant.
13 These could be in the form of manager-specific implicit contracts (see Shleifer and Vishny, 1989,
p.132).
236
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Journal of Accounting and Economics 24 (1998) 219237

A test of the free cash flow and debt monitoring

3.2. Research design

3.3.2. Common factor analysis for growth

Panel B: Eigenvalues of the reduced correlation matrix of three growth measures

" natural log of total assets

LAF"natural log of total audit fees

CURRENT " ratio of current assets to total assets

Panel A: Full model with industry control

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