Auditors’ assessment of the capital market liability of foreignness

Abstract

Purpose This paper aims to apply the Capital Market Liability of Foreignness (CMLOF) framework to the audit fees of a sample of foreign firms listed on US exchanges to examine whether American auditors price foreignness. Design/methodology/approach The four components of the CMLOF are institutional distance (civil versus common law system and enforcement), information asymmetry (disclosures and mandatory IFRS adoption), unfamiliarity (exports, English language and geographical distance) and cultural difference [Hofstede (1980) dimensions of culture]. These variables are examined in a regression model that explains audit fees to determine the auditor perception of risk associated with the CMLOF. Findings Examining the factors that mitigate perceived agency costs, this investigation determines that auditors price risk according to each component of the liability of foreignness. Audit fees are higher for shareholders of firms headquartered in countries exhibiting greater institutional distance, unfamiliarity and cultural distance. Audit fees are higher for firms when their home country requires additional disclosures or the adoption of IFRS to reduce information asymmetry. Practical implications CMLOF is costly for capital market participants and has implications for auditors, shareholders of foreign firms and managers considering listing in the US Auditors, and investors should carefully assess this risk for pricing and valuation, and managers should take action, to the extent possible, to reduce the firm-specific level of unfamiliarity and increase transparency. Originality/value This paper is the first to apply the CMLOF to examine whether auditors price aspects of foreignness of their non-US-headquartered clients.

How Are Foreign Firms Valued in U.S. Markets? Evidence from Firm and Country Characteristics

“…Bell, Filatotchev, and Rasheed (2012) mention that foreign firms "could potentially pay higher underwriting fees, higher professional fees, or higher initial listing fees than local firms… resulting in lower trading volume and therefore reduced liquidity" (page 111). Supporting this statement, Smith, Gleason, Wiggenhorn, and Kannan (2018) provide evidence that foreign cross-listing firms are charged with higher auditing fees, compared with the auditing fees for U.S. domestic firms.…”

Equal opportunity market

“…They find that over time, CMLOF diminishes and foreignness can actually become an advantage for these firms. Smith et al (2018) extend CMLOF research to an accounting context by examining whether audit fees are related to the four components of CMLOF. They find that audit fees are higher for firms from countries exhibiting greater institutional distance, unfamiliarity and cultural distance.…”

“…Accounting research commonly examines capital market reactions to accounting events, such as earnings and restatement announcements, offering opportunities to study CMLOF. Despite this, we are only aware of one paper that studies CMLOF in an accounting setting (Smith et al, 2018). Further, Smith et al (2018) examine audit fees, not market reactions to accounting events.…”

“…Despite this, we are only aware of one paper that studies CMLOF in an accounting setting (Smith et al, 2018). Further, Smith et al (2018) examine audit fees, not market reactions to accounting events. Our paper, on the other hand, will extend the investigation of CMLOF to an accounting setting by examining market reactions to restatement announcements.…”