Exploring the Relationship Between Audit Quality and the Cost of Capital for Public Companies

Posted: May 18, 2022

• Fiona Myers
• Austin Rhodes
• Evie Martinez

Abstract

The relationship between audit quality and the cost of capital represents a fundamental question in accounting and finance research with significant implications for corporate governance, market efficiency, and regulatory policy. Traditional approaches to this relationship have largely relied on simplified proxies for both constructs, typically employing Big N audit firm membership as the primary indicator of audit quality and using standard capital asset pricing model derivations for cost of capital measurements. While these approaches have yielded valuable insights, they fail to capture the multidimensional nature of both audit quality and capital costs, potentially obscuring important nuances in their relationship. This research introduces a novel framework that reconceptualizes both audit quality and cost of capital as complex, multi-dimensional constructs. We challenge the prevailing assumption of a simple linear relationship and instead propose a contingent model that accounts for industry characteristics, firm life cycle stages, market conditions, and the interactive effects of various audit quality dimensions.