national accountants conference 2002 do external auditors perform a corporate governance role in...

National Accountants Conference 2002

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

Professor T.J. WongDirector of Center for Corporate GovernanceHong Kong University of Science and Technology


Background

Asian Financial Crisis exposed that corporate governance is weak and corporate transparency is lowOne key problem – ownership structure of firms


Ownership Concentrated in Hands of Family

0

10

20

30

40

50

60

70

80

Percentage of firms controlled by families

HKIndonesiaS. KoreaMalaysiaSingaporeTaiwanThailandEast Asia


Separation of Ownership and Control of Large Shareholders

Control (voting rights) > Ownership (cash flow rights)Main method of separating cash flow and voting rights

Stock pyramids


Stock pyramid

X X

V=50%Y

V=20%Z

V=C=10%Z

V=C=50%Y

V = 20%, weakest link in the chain,C = 10%. Pyramid structure allows leveraging up in control


Ultimate Voting and Cash Flow Rights of Largest Shareholders (Source: Claessens et al., 2000)

0

5

10

15

20

25

30

35

Voting rights Cash flow rights

HKIndonesiaS. KoreaMalaysiaPhilippinesSingaporeTaiwanThailand


Ratio of Cash Flow to Voting Rights(Source: Claessens et al., 2000)

0

1020

3040

5060

7080

90100

Cash flow over voting rights

HKIndonesiaS. KoreaMalaysiaPhilippinesSingaporeTaiwanThailand


Measuring Agency Problem

Conflicts of interests between majority shareholder (family) and minority shareholdersExpropriation of minority shareholders by majority shareholders

Effective control gives powerSeparation of cash and voting rights gives more incentives


Corporate Ownership and Transparency

Fan and Wong (forthcoming in JAE) find thatIn East Asia (excluding Japan), effective control and large separation of cash and voting rights, measuring agency problem, are associated with low earnings informativeness.

High agency cost and low credibility.Tight owner control, political rent seeking and low transparency.


Broad Research Question

Do auditors play a governance role by assuring the quality of accounting information in East Asia?


Monitoring and Bonding

Jensen and Meckling (1976) suggest that good firms will employ monitoring and bonding mechanisms to mitigate their agency costs


Governance role of auditors in Asia

Hiring independent external auditors is a potentially important governance mechanism in East Asia, because

boards of directors and takeover markets are weak to contain agency problemsweak laws and institutions to protect investors

U.S. and U.K. where laws are better enforced and alternative governance mechanisms are more abundant


Are Asian Auditors Monitors?

Positive viewExternal auditors can serve a monitoring role when conventional corporate control systems are weakThey provide credible quality assurance or make efforts to ensure financial reporting quality (Titman and Trueman, 1986)



Negative view- demand side arguments:

No demand from majority owners (relationship based transactions, culture and rent seeking)No good audit committeesWeak legal system, audit opinions have no consequences



Negative view - supply side arguments:

Lack of expertise and experienced professionalsConsulting business may create conflicts of interest (not unique to Asia)Weak disciplinary mechanism for audit profession


Number of CPAs as Percentage of Population

0.00%

0.05%

0.10%

0.15%

0.20%

0.25%

0.30%

Economies

USCanadaHong KongSingaporeKoreaIndonesiaMalaysiaPhilippinesThailand


The effects of agency problem on audit fee and opinion

Are auditors doing their job?If auditors serve as monitors and provide more assurance of quality through their superior reputation or exert efforts to mitigate agency conflicts, it would be reflected in the audit fee (Bell et al. 2001; Lyon and Maher, 2002)Likewise, if auditors monitor, poor earnings would more likely trigger a qualified opinion for clients subject to high agency problems


Data8 economies: HK, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand. All financial data, auditor names and opinions are from Worldscope 1996 Ownership data from Claessens et al., 2000.Sample period from 1994-19963,119 firm year observationsRepresenting 28% of the population of listed firms in East Asia


Three Hypotheses

Firms with ultimate owners that have gained effective control and/or have large separation of cash and voting rights

are more likely to hire B5are more likely to pay a higher audit feetheir poor earnings will more likely trigger a qualified opinion


Measuring Effective Control and Separation of Rights

Effective control DEV = 1 if voting rights – country median > 0; 0 otherwise

Separation of cash flow and voting rights

CV = cash flow rights/voting rightsCV 1 = no separation; CV 0 = large separation


Table 5 Logit Regression Results for Auditor Choice

AUDITORit = a0 + a1 log(SIZEit) + a2 LEVit + a3 GROUPi + a4 PYRAMIDi + a5 DEVi + a6 CVi + a7 DEVi*CVi + a8 fixed effects + uit

1994-1996 1994 1995 1996

Intercept -0.11 -0.12 0.02 0.58 (-0.21) (-0.12) (0.03) (0.65)

SIZE 0.10*** 0.06 0.07 0.14*** (3.44) (0.98) (1.53) (2.86)

LEV -0.05 -0.06 -0.18 0.02 (-0.18) (-0.11) (-0.34) (0.03)

GROUP 0.07 -0.02 0.07 0.08 (0.68) (-0.12) (0.42) (0.45)

PYRAMID -0.24* -0.11 -0.13 -0.48** (-1.81) (-0.40) (-0.58) (-2.10)

DEV 1.18*** 1.39* 1.40** 0.71 (2.77) (1.67) (2.00) (0.96)

CV -0.12 0.44 0.23 -1.01* (-0.37) (0.70) (0.41) (-1.70)

DEV*CV -1.26*** -1.73* -1.47* -0.68 (-2.67) (-1.85) (-1.91) (-0.84)

Pseudo R2 0.06 0.12 0.06 0.07 Observations 3119 760 1108 1251


Table 7 Logit Regression Results of Auditor Choice by Economy

AUDITORit = a0 + a1 log(SIZEit) + a2 LEVit + a3 GROUPi + a4 PYRAMIDi + a5 DEVi + a6 CVi + a7 DEVi*CVi + a8 fixed effects + uit

Hong Kong

Indonesia Korea (South)

Malaysia The Philippines

Singapore Taiwan Thailand

DEV 2.86*** -1.78 -1.01 7.77*** 10.24** 1.17 -4.09 0.73

(3.11) (-1.24) (-0.90) (2.77) (2.12) (0.70) (-1.60) (0.39)

CV -0.54 -1.45 -3.65*** 0.32 2.50** 2.40*** -0.77 0.95 (-0.46) (-1.03) (-3.74) (0.36) (2.00) (2.39) (-0.63) (0.73)

DEV*CV -3.34*** 2.15 1.52 -8.04*** -9.78** -2.36 3.73 -1.03 (-3.27) (1.28) (1.20) (-2.75) (-1.96) (-1.18) (1.34) (-0.53)

Pseudo R2 0.08 0.08 0.13 0.09 0.32 0.10 0.12 0.08 Observations 651 309 591 411 204 410 223 320


Table 8 Ordinary Least Squares Regression Results of Audit Fee

LAFit = b0 + b1 log(SIZEit) + b2 ROAit + b3 LEVit + b4 CACLit + b5 ARit + b6 INVit + b7 GROUP + b8 PYRAMID + b9 DEVi + b10 CVi + b11 DEVi*CVi + b12 fixed effects + uit

Pooled sample

Hong Kong Malaysia Singapore Firms hiring big-five auditors

Firms hiring local

auditors

DEV 0.30** 0.47* -1.02*** 0.91*** 0.40** -0.17

(1.96) (1.82) (-2.76) (2.71) (2.11) (-0.39)

CV 0.21 0.12 0.17 0.28 0.18 0.18 (1.48) (0.36) (0.58) (1.42) (0.96) (0.57)

DEV*CV -0.31* -0.47* 1.14*** -1.06*** -0.40* 0.14 (-1.78) (-1.69) (2.71) (-2.63) (-1.85) (0.29)

adjusted R2 0.68 0.54 0.64 0.56 0.67 0.74 Observations 1304 534 369 401 889 179


Table 10 Logit Regression Results of Audit Opinion

OPINIONit = b0 + b1log(SIZEit) + b2ROAit + b3LEVit + b4CACLit + b5ARit + b6INVit +b7 GROUP + b8 PYRAMID + b9 DCVi

+ b10 DCVi *ROAit + fixed effects + uit

Pooled sample Firms hiring big-five auditors

Firms hiring local auditors

Intercept -5.35*** -4.52* -5.72

(-2.68) (-1.73) (-0.67)

SIZE 0.08 0.01 -0.59 (0.56) (0.06) (-1.16)

ROA -6.73*** -6.26*** -19.98** (-4.96) (-3.50) (-2.02)

DCV -0.69 0.42 -8.63 (-1.02) (0.54) (-0.17)

DCV*ROA -9.86*** -9.68*** 0.63 (-2.76) (-2.69) (0.00)

Pseudo R2 0.07 0.06 0.14 Observations 2335 1758 577 Chi-square 173.55 115.39 96.43


SummaryEast Asian firms with concentrated control and large separation in control and ownership will more likely hire Big 5 auditors

Big 5 auditors charge fee premium for agency cost imbedded in ownership structure

Big 5 auditors set lower qualification threshold for poorly performing firms with high agency cost than low agency cost

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