Do External Auditors Perform a Corporate Governance Role in Emerging Markets? Evidence from East Asia

Abstract

In emerging markets, the concentration of corporate ownership has created agency conflicts between controlling owners and minority shareholders. Conventional corporate control mechanisms such as boards of directors and takeovers are typically weak in containing the agency problem. This study examines whether external independent auditors could be employed as monitors and as bonding mechanisms to alleviate the agency conflict. Using a broad sample of firms from eight East Asian economies, we document that firms are more likely to employ Big Five auditors when they are more subject to the agency problem imbedded in their ultimate ownership structure. One possible reason that this documented relation between auditor choice and the agency problem is more evident than the inconsistent results using U.S. and U.K. data is that alternative governance mechanisms are limited in East Asia. In addition, among East Asian auditees subject to the agency problem, Big Five auditors charge a higher fee and set a lower audit modification threshold while non-Big Five auditors do not. Taken together, the evidence suggests that Big Five auditors in emerging markets do have a corporate governance role.

Auditors' Governance Functions and Legal Environments: An International Investigation*

“…Endnotes 1. Fan and Wong (2005) find that in East Asia, where the legal institutions are less developed, auditors do play a significant governance role as evidenced by the positive relation between agency problems and Big 5 auditor choice. However, it is an empirical issue to study whether the governance role of auditors increases or decreases with the quality of the legal institutions in a country.…”

“…Second, we include the ownership structure of the listed firms as an additional control variable in our regression analyses (firm-year observations ϭ 42,041). 32 A firm's ownership structure is an important factor associated with its agency problems and, thus, could have significant influence on auditor choice (Fan and Wong 2005). We include the immediate ownership percentage of the largest shareholder (OWN) and LAW ϫ OWN as additional control variables.…”

Audit Pricing, Legal Liability Regimes, and Big 4 Premiums: Theory and Cross‐country Evidence*

“…Recently several studies have begun to investigate auditing-related issues in crosscountry contexts. For example, Fan and Wong (2005) examine the association between corporate transparency and auditor choices in East-Asian countries. Using a sample of firms from 39 countries, Choi and Wong (2007) investigate the association between auditor choices and countries' legal environments and find that national legal environments influence the demand for audit services.…”

Auditor Quality and Debt Covenants

“…However, as discussed earlier, the majority of prior studies suggest that the factors alleviating information or agency risks act as substitutes for debt covenants. The auditing literature indicates that high-quality auditors decrease information risks (e.g., Becker et al 1998;Dunn and Mayhew 2004) and act as independent monitors in reducing agency costs, restraining malfeasance by managers, and deterring expropriation (e.g., Francis and Wilson 1988;Fan and Wong 2005). This naturally suggests that high-quality auditors, who reduce information and agency risks for lenders, could decrease lenders' demand for intensive or stringent covenants.…”