CORPORATE GOVERNANCE, AUDIT QUALITY AND THE COST OF DEBT FINANCING OF FRENCH LISTED COMPANIES

Phyan - C.Piot & Missonier-Piera

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English

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CORPORATE GOVERNANCE, AUDIT QUALITY
AND THE COST OF DEBT FINANCING OF
FRENCH LISTED COMPANIES

Charles Piot
Associate Professor, GSCM - Montpellier Business School
2300 avenue des Moulins
34185 Montpellier Cedex 4, France
cpiot@supco-montpellier.fr
Tel. +33 (0)4 67 10 28 02; Fax + 33 (0)4 67 45 13 56

Franck Missonier-Piera
Associate Professor, ESSEC Business School
Ave Bernard Hirsch, BP 50105
95021 Cergy-Pontoise Cedex, France
missonier@essec.fr
Tel. +33 (0)1 34 43 28 59

Abstract. This paper investigates the effect of both Résumé. Nous examinons l’effet de la qualité des
corporate governance and audit quality on the cost systèmes de gouvernance et d’audit sur le coût de
of debt incurred by large French listed companies. l’endettement des sociétés françaises cotées. Bien
Although France has a debt-oriented financing que le capitalisme français soit largement axé sur
system, banks and other financial institutions have l’endettement, les institutions financières sont
little direct implications in corporate governance relativement peu impliquées dans les organes de
structures (such as boards of directors for example). gouvernance (conseil d’administration notamment).
Thus, those external capital providers (i.e., En conséquence, ces créanciers financiers sont
debtholders) might pay attention to the overall susceptibles d’accorder de l’importance à la qualité
quality of monitoring devices set up within des structures de surveillance déployées, et du
companies, as well as to the quality of financial reporting financier. Nous anticipons donc une
reporting. Hence, we may expect an inverse relation relation inverse entre le coût de la dette et la qualité
between the cost of debt and the quality of des organes d’audit et de gouvernance. À partir
governance and auditing structure of public d’un échantillon de grandes firmes cotées
companies. Using a pooled sample of large, non- (SBF 120) sur la période 1999-2001, nos résultats
financial listed French companies over the years empiriques suggèrent que la qualité du système de
1999 to 2001, the empirical findings reveal that gouvernance permet de réduire le coût de la dette,
corporate governance quality has a significant mais que cela n’est pas le cas pour l’audit financier.
reducing effect on the cost of debt, whereas audit En particulier, les analyses multivariées montrent
quality does not. Specifically, multivariate analyses une relation négative entre le coût de la dette
document an inverse relation between the ex post ex post et (1) la proportion d’administrateurs
cost of debt and (1) the proportion of independent indépendants au conseil, (2) la présence d’un
directors on the board, (2) the existence of a comité de rémunération exempt de cadres
compensation committee composed of non- dirigeants, et (3) la présence significative (plus de
executive directors, and (3) the presence of 5%) d’investisseurs institutionnels dans le capital.
institutional shareholders with more than 5% of
ownership. Mots clés. Qualité de l’audit, gouvernance,
surveillance, coût de la dette, sociétés cotées
Key Words. Audit quality, Corporate governance, françaises.
Monitoring, Cost of debt, French listed companies 1. INTRODUCTION
The quality of corporate governance is supposed to contribute to the overall value creation
process (Schleifer and Vishny, 1997). One direction to value creation is a reduction in the cost
of capital raised by companies. Several studies have addressed the effect of information
disclosure and/or corporate governance mechanisms on the cost of equity capital (e.g., Hail,
2002). Few studies have focussed on borrowed funds, specifically in Continental European
countries where debt financing is culturally more prevalent in the satisfaction of corporate
needs.
In this paper we investigate the effect of corporate governance and audit quality surrogates on
the cost of debt incurred by large French listed companies. The question is of importance
given that in France, as in other debt-oriented financing systems, corporate private loans have
long been the major source of financing available to companies wanting to develop. However,
contrary to the German system, for instance, banks and other financial institutions have little
direct implications in corporate governance structures such as boards of directors, suggesting
that these capital providers might pay attention to the overall quality of monitoring devices set
up within companies, as well as to the quality of financial reporting by these companies. In
such context, empirical investigations have shown that leverage proxies may, in some
circumstances, influence the choice of high-profile auditors (Piot, 2001) or the setting up of
a priori effective audit committees (Piot, 2004). Hence, in a cost-benefit reasoning – and
assuming that investments in governance and audit quality are costly –, there should exist an
inverse relation between the cost of debt capital and the quality of corporate governance and
auditing structure of public companies.
The remainder of the paper is organised as follows. Section 2 hereafter develops the
theoretical framework and hypotheses of the study. Section 3 addresses methodological issues
related to the sampling procedure and variables description. Section 4 presents the empirical
results, and a final fifth section summarizes our main findings and concludes.
2. THEORETICAL FRAMEWORK AND HYPOTHESES
To date, very few empirical research have investigated the relation between the cost of debt
and governance or audit quality attributes. Using a sample of S&P 500 firms over the period
1993-1998, Anderson et al. (2004) find that the cost of debt financing is inversely related to
board independence, board size, as well as to audit committee independence, size and meeting
frequency. Their study focuses on bondholders’ situation and thus on the accounting-based
debt covenant interpretation. Specifically, they conclude that bondholders consider the board
and audit committee’s monitoring effectiveness as a source of greater assurance with respect
to the integrity of accounting numbers. Henceforth, these creditors allow a reduction in their
risk premium.
Pittman and Fortin (2004) consider a sample of US companies that went public during 1977-
1988, and test for auditor reputation effects on their ex post cost of debt over the nine-year
period following their SEC registration. They find that the companies having retained a
Big Six auditor exhibit a lower averaged cost of debt capital. Again, this finding suggest that
1 debtholders are sensitive to auditor reputation attributes – a proxy for audit quality –, and thus
to the quality of financial statements published by newly public firms.
Overall, these US studies strongly emphasise the financial reporting interpretation, which is
consistent with the context of an extensive use of debt covenants. In France, as in other
Continental European countries, the use of debt covenants may concern bond offerings,
especially the Euro-bond market; but this monitoring device is not common in bank loans
agreements. Hence, we propose a more comprehensive framework arguing that debtholders’
risk does not only relate to financial reporting quality and earnings management; it is also
associated with the extent of expropriation strategies that managers or shareholders are likely
to use at the expense of debtholders’ claims.
2.1 Debtholders’ risk and the pricing of debt capital
The major difference between debt and equity capital is the contractual arrangement that
debtholders have no effective control on the use of the funds they provide. These funds can
then be diverted from their initial goal by corporate managers acting opportunistically in their
self-interest, or in shareholders’ ones. The use of debt covenants has culturally been important
in Anglo-Saxon contexts to prevent such behaviours, but remains marginal in France where
debtholders’ protection is largely achieved with securities and warranties mechanisms taken
on the firm’s assets in place. As a result, one can consider that debtholders’ risk stems from
two origins:
(1) The extent of agency conflicts with managers or shareholders, which are to be
circumvented by the quality of the corporate governance system;
(2) The quality of financial reporting, as long as the nature and value of assets in place in
taken into consideration to appreciate the warranties of the debt contract.
Then, as a whole, one could argue that the quality of corporate governance devices on the one
hand, and the quality of the audit process on the other hand, are likely to mitigate debtholders’
risk and therefore the cost of debt capital.
2.2 Corporate governance quality and the prevention of debtholders’ agency risk
In the disciplinary framework of corporate governance, we consider that the monitoring
effectiveness of managers’ actions stems from the board of directors on the one hand, and
from active institutional investors on the other hand. Enhanced monitoring exerted by these
governance devices is likely to r