Researchers find evidence of added auditor scrutiny involving credit default swaps | 4/16/2018 | Staff
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Institutions that monitor public companies include governments and regulators, financial media, analysts, shareholders, debtholders and auditors. A forthcoming paper that includes two University of Kansas School of Business professors suggests that reduced monitoring incentives among bondholders lead to increased monitoring efforts by auditors.

Adi Masli, Felix Meschke and KU graduate Lijing Du, who is now an assistant professor at Towson University, provide evidence that auditors increase their professional scrutiny of companies when it becomes easier for the debtholders of those firms to insure against loss via credit default swaps, or CDS.

Results - Substitution - Effect - Meschke - Associate

"The results suggest a substitution effect," said Meschke, associate professor of finance. "Because CDS-insured debtholders lack incentives to monitor or make concessions if firms become financially distressed, auditors seem to increase their own monitoring effort, which is reflected in higher audit fees."

The researchers find that audit fees increase between 5.4 percent and 11 percent for companies with CDS-referenced debt. Their study is forthcoming in Auditing: A Journal of Practice & Theory.

Credit - Default - Swaps - Instruments - Insure

Credit default swaps are financial instruments that insure against default of a bond. If the issuer of a bond fails to pay lenders, CDS buyers receive money from the seller of those instruments. Banks, hedge funds or large insurance companies like AIG sell credit default swaps.

In fact, many people associate credit default swaps with the 2008 financial crisis and the government bailout of AIG, Meschke said. AIG had sold a large number of credit default swaps without properly hedging their risk, and during the subprime housing crisis, AIG lacked the funds to meet its obligations. The government took over control and bailed out the insurer with $180 billion.

Research - Credit - Default - Swaps - Incentives

Previous research shows how credit default swaps can distort the incentives of creditors. Ordinarily, lenders have incentives to monitor their borrowers to ensure that the borrowing firms act prudently and return the borrowed funds....
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