Does audit quality affect firms' debt structure?

Using a large sample of US firms, we show that high audit quality is associated with a higher proportion of public debt and correspondingly a lower proportion of bank debt in firms’ debt financing. The findings are robust to endogeneity issues, alternative measures of audit quality, and alternative model specifications. We also find that the effect of audit quality on the debt mix is stronger in firms with high information asymmetry and poor governance. The results suggest that high audit quality improves firms’ transparency, alleviating the concerns of public lenders and thereby enabling firms to borrow more information-sensitive public debt. Particularly, the results suggest that high audit quality mitigates the post-contract moral hazard between public debtholders and managers, which in turn reduces the advantage of bank loans arising from bank monitoring. Last, we show that audit quality is incrementally effective and has a substitutive effect over accruals quality (i.e. audit quality is more effective in shifting the debt preference towards public debt when accruals quality is lower).