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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
National Accountants Conference 2002
Background
Asian Financial Crisis exposed that corporate governance is weak and corporate transparency is lowOne key problem – ownership structure of firms
National Accountants Conference 2002
Ownership Concentrated in Hands of Family
0
10
20
30
40
50
60
70
80
Percentage of firms controlled by families
HKIndonesiaS. KoreaMalaysiaSingaporeTaiwanThailandEast Asia
National Accountants Conference 2002
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
National Accountants Conference 2002
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
National Accountants Conference 2002
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
National Accountants Conference 2002
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
National Accountants Conference 2002
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
National Accountants Conference 2002
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.
National Accountants Conference 2002
Broad Research Question
Do auditors play a governance role by assuring the quality of accounting information in East Asia?
National Accountants Conference 2002
Monitoring and Bonding
Jensen and Meckling (1976) suggest that good firms will employ monitoring and bonding mechanisms to mitigate their agency costs
National Accountants Conference 2002
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
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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)
National Accountants Conference 2002
Are Asian Auditors Monitors?
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
National Accountants Conference 2002
Are Asian Auditors Monitors?
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
National Accountants Conference 2002
Number of CPAs as Percentage of Population
0.00%
0.05%
0.10%
0.15%
0.20%
0.25%
0.30%
Economies
USCanadaHong KongSingaporeKoreaIndonesiaMalaysiaPhilippinesThailand
National Accountants Conference 2002
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
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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
National Accountants Conference 2002
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
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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
National Accountants Conference 2002
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
National Accountants Conference 2002
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
National Accountants Conference 2002
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
National Accountants Conference 2002
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
National Accountants Conference 2002
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