title: Supplier-major customer relationship: the effect of common auditor on the cost of equity capital and cost of bank debt
Creators: name: Kokkinos, Sotirios
Publisher: name: University of Glasgow
Year: 2022

description: This thesis consists of two main empirical chapters that investigate the effect of common auditors within a capital market context. Specifically, it examines whether capital market participants perceive that a common auditor between supplier firms and their major customers contributes to the information and estimation risk they are facing and, as a result, whether such a relationship contributes to economically significant implications on the cost of capital of the supplier firms. Extant research within the customer concentration literature suggests that supplier firms that rely on a considerable portion of their revenues from a few major customers face increased liquidity problems and cash flow risks, if their major customers become bankrupt, decide to develop products internally or switch to another supplier. Prior literature also shows that this risk is priced into the supplier’s cost of equity and debt capital. Consequently, any factor that could either mitigate or exacerbate such concerns/risks should be important for investors and creditors’ information and estimation risks. This thesis posits that common auditors constitute such a factor. However, there is conflicting evidence regarding the role of common auditors on the quality of audits of interrelated firms, and thus the impact of the common auditor on supplier’s external financing is not clear ex ante. On the one hand, audit firms can develop enhanced supply chain knowledge and better understanding of a supplier’s business inherent risks when they also audit its major customer. In that sense, supplier’s risks due to customer concentration should be better integrated into estimates when producing supplier’s financial statements. Therefore, investors and creditors should be faced with lower information and estimation risk. On the other hand, audit firms have higher motives to act opportunistically and decrease their standards of auditing when operating within common audit settings. Lower audit quality can result in less accurate and credible estimates on suppliers’ financial statements. Therefore, investors and creditors should be faced with higher information and estimation risks. The first empirical chapter focuses on the equity market context and investigates investors’ perceptions on suppliers’ cost of equity for firms sharing a common auditor with their major customers. Using a sample of 7,773 U.S. supplier-year observations over the period 1983-2016, this study finds that the existence of a common auditor is priced into the supplier’s implied cost of equity capital. These findings indicate that supplier firms having a common auditor with their major customers experience higher equity-financing compared to those firms that do not have a common auditor with their major business partners, thus supporting the notion that investors negatively perceive the existence of common auditors among such relationships. Importantly, the findings are robust in a series of sensitivity tests that control for the noise of analyst forecasts, omitted variable bias, alternative measures of the implied cost of equity and common auditor variables, propensity score matching and common auditor switch status analysis. Additional tests indicate that these results are more pronounced for supplier firms with higher customer concentration base and supplier firms with a greater number of major customers. The second empirical chapter focuses on the private debt market context and explores the effect of a common auditor on the cost of bank debt and other bank loan contracting features of the supplier firms. Employing a sample of 5,382 U.S. supplier-year-loan observations over the period 1988-2016, the study documents evidence that supplier firms that have at least one common auditor with their major customers are facing a higher cost of bank debt and more restrictive non-price loan terms. This evidence is, generally, supported by a series of robustness tests (e.g., alternative measures to capture the common auditor presence, firm-level analysis, propensity score matching, control for financial reporting effect and common auditor switch status analysis). With respect to the cost of bank debt, additional tests suggest that the results are more pronounced for supplier firms with higher customer concentration and supplier firms with a greater number of major customers. In terms of non-price terms, the results, mainly, hold irrespective of whether firms belong to any of these two sub-samples. In summary, the main findings of this thesis suggest that the existence of a common auditor between the supplier firm and its major customers has an adverse impact on supplier’s equity- and debt-financing. These findings make important contributions as they extend and advance at least three strands of the literature. First, the thesis adds to the growing literature that examines the common-audit effects. Second, with the focus being within the supply chain setting, the thesis contributes to the emerging literature which explores the economic consequences of characteristics among supply chain partners within a capital market context. Third, it complements the broader literature around capital market effects, by adding a new parameter that affects the equity- and debt-financing of the firms. Beyond the academic contributions, the findings of the current thesis could provide useful insights for regulators and accounting standard setters since they document evidence for two of the most important groups of users of audited financial statements. Further, the findings of this thesis could also have corporate policy implications. Given the importance of raising external capital, supplier firms might need to consider the trade-offs between having a common auditor with their major customers and the cost of equity and debt capital.