Types of guarantees and their relation to external auditing：Evidence from the Chinese bond market

Abstract

Guarantee conditions and external auditing are both key parts of debt contracts. Understanding the relationship between guarantee conditions and external auditing is crucial for the improvement of debt contract efficiency and maximization of enterprise value. With non-listed enterprises in the Chinese bond market from 2008 to 2013 as the study sample, this paper investigates the relationship between different types of guarantee and external auditing. The empirical result indicates that: a related-party guarantee is significantly positively correlated with high-quality external auditing, while a local-government guarantee (in which the guarantor and bond issuer belong to the same local government) is significantly negatively correlated with high-quality external auditing. The research also shows that high-quality external auditing is significantly negatively related to bond issuance cost only if companies use a related-party guarantee. The reason is that a local-government guarantee implies the credit and security of local government, which reduces debt agency conflict and the demand for high-quality external auditing, while a related-party guarantee does not reduce information asymmetry, but increases the credit risk of bonds. This risk can be recognized by investors in the Chinese bond market which is dominated by institutional investors, thus causing stronger demand for high-quality external auditing. The result shows that a guarantee substitutes for external auditing when the guarantee is positive, otherwise external auditing is a supplement to a guarantee.