Information Risk and Debtholders’ Mispricing by Considering Audit Quality

We examine how audit quality perceptions impact debt mispricing in the presence of earnings management. The Big Four auditors (BFAs) and auditor tenure are used as proxies for perceptions of higher quality audits. Debt mispricing means that debtholders charge a lower (higher) cost of debt to a firm with low (high) accrual earnings management (AEM) and high (low) real earnings management (REM). We find that debt mispricing is accentuated (attenuated) by considering the BFA and auditor tenure because debtholders fixate on quality audits curving AEM. For low AEM and REM firms, debt investors place a premium on low AEM with the BFAs/long‐tenured auditors, worsening the mispricing. For high AEM and low REM firms, debt investors impose a “smaller discount” on high AEM with the BFAs/long‐tenured auditors. This study demonstrates that the accentuation (attenuation) of debt mispricing when considering the BFA and auditor tenure occurs mainly if the firm raised only private debt rather than both private and public debt.