The integrity of information is a key issue when companies make financing decisions. Outside investors need to trust a firm's financial accounts and when they do not, this can affect whether the firm issues equity or debt. A key factor in establishing this trust and reducing "asymmetry of information" between the firm and investors is auditor quality.

A high-quality auditor can signal to investors that the information they receive is reliable. Poor-quality auditors, on the other hand, are less likely to detect manipulation of earnings and the market is aware of this. When high earnings are reported, investors may not be able to distinguish whether this is due to true earnings or to the failure of the auditor to detect misreporting, so equity issuance can be mispriced.

Sudipto Dasgupta of HKUST and Xin Chang and Gilles Hilary set out to investigate whether auditor quality subsequently affected the equity and debt decisions of firms, and they find confirmation of this notion. Firms using the Big 6 auditors, which are generally thought to offer higher audit quality, are more likely to issue equity than those audited by smaller auditors. They also make larger equity issues and have debt ratios that are less affected by market conditions.

"Our research is based on the idea that the quality of the auditor can reduce information asymmetry about future earnings of the company," they say.

They tested their ideas on all companies listed on the Compustat Industrial Annual files from 1985-2005, with assets of more than US$10 million. Those audited by the Big 6 were 3.5 per cent more like likely to issue equity than those audited by a smaller firm. They also had less debt in their capital structure.

Market conditions can affect equity issuance incentives. Irrespective of auditor quality, companies rely more on equity issuance when the market is optimistic about their prospects, but this effect is expected to be less important for companies with Big 6 auditors.

"The equity issuance of companies audited by low-quality auditors will be more sensitive to market conditions," they say. "The mispricing they face when they report high earnings is less when market conditions are good, which allows them to finance bigger projects with equity as well."

Switching to a Big 6 auditor reduces sensitivity to market conditions by about 50 per cent. "When we look at company size, the effect is stronger for the smallest companies but insignificant for the largest ones," they say.

A reason for this may be that larger companies tend to be monitored by analysts so investors have other sources of information about the firm's financial prospects.

"Our empirical results show auditor quality is relevant for companies' financing decisions, and this is generally stronger for smaller companies. Their auditors are likely to play a key role since there are no additional outside informational intermediaries between managers and investors",the authors say.

"Prior research and our own results collectively support the idea that large auditors reduce information asymmetry through an improvement of the disclosure policy of firms, and especially their accounting reporting."