Agency problems & audit pricing; a test of the free cash flow hypothesis: US evidence

Abstract

This study tests the hypothesis that firms with high free cash flow (FCF) and low growth opportunities have higher audit fees than other firms. This hypothesis is expected, given Jensen’s (1986) FCF theory that managers of high FCF/low growth firms are more likely to engage in non-value-maximizing activities. These activities increase auditors’ assessments of inherent or control risk and, in turn, increase audit effort and fees. Jensen (1986, 1989) also argues that debt could mitigate the agency problem of FCF, therefore it is expected that low growth firms with high FCF and high levels of debt will have lower audit fees than similar firms with high FCF and low levels of debt. ANCOVA analyses of 19,787 US company-year observations from 2000 to 2005 are utilized to test these two hypotheses. Results partially support the FCF hypothesis, however no support is found for the debt-monitoring hypothesis.