«Chiraz Ben Ali ESC Amiens chiraz.benali Cédric Lesage* HEC Paris lesage *: corresponding author Version –March 2010 – ...»
Ownership concentration and audit fees: do auditors matter most
when investors are protected least?
Chiraz Ben Ali
*: corresponding author
Version –March 2010 – Please do not cite without permission – Comments welcome.
Cédric Lesage acknowledges the financial support of the Fondation HEC (Project F0802) and of the INTACCT
program (European Union, Contract No. MRTN-CT-2006-035850). He is a member of GREGHEC, CNRS Unit, UMR 2959. The authors are pleased to thank W. Alissa, V. Capkun and G. Hilary for their useful comments on earlier versions of this paper.
1 Ownership concentration and audit fees: do auditors matter most when investors are protected least?
Minority expropriation could result when controlling shareholders can expropriate minority shareholders and profit from private benefits of control. This agency conflict (named Type II) has been rarely studied, as the most commonly assumed agency conflict resides between managers and shareholders (Type I). We want to study the role of the auditors in reducing the type II agency conflict. Using an audit fees model derived from Simunic (1980), we study the impact of type I and type II agency conflicts on audit fees in code law vs common law countries. We then focus two civil law countries (Germany and France) providing a lower investor protection level, and two common law countries (the USA and UK) providing a higher investor protection level (La Porta et al. 1998, 2000). Our results show 1) a negative relation between audit fees and managerial shareholding, which is stronger for common law than for civil law countries; 2) a curvilinear (concave) relation between audit fees and controlling shareholding for civil law countries; 3) no Type II conflict in the common law countries. These results illustrate the mixed effects of the legal environment and of each agency conflict on audit fees.
Keywords: audit fees, controlling shareholder, minority expropriation, agency conflict.
2 Ownership concentration and audit fees: do auditor matter most when investors are protected least? 1
1. Introduction Previous literature evidenced that civil law countries present weak investor protection compared to common law countries which gives shareholders incentives to hold large partof capital to better control managers (La Porta et al. 1999; La Porta et al. 2000). Consequently, ownership is more concentrated in civil law countries and the agency conflict between managers and shareholders (called type I agency conflict) is reduced (Shleifer and Vishny 1997; La Porta et al. 1998; La Porta et al. 1999; Denis and McConnell 2003; Gillan and Starks 2003). However, this situation gives controlling shareholders the possibility to profit from private benefits of control which raises a new agency conflict between controlling shareholders and minority shareholders (called type II agency conflict). Indeed, (La Porta et al. 2000, p. 4) assert that “Investor protection turns out to be crucial because, in many countries, expropriation of minority shareholders and creditors by the controlling shareholders is extensive”.
Corporate governance is, to a large extent, a set of mechanisms through which outside investors protect themselves against expropriation by the insiders 2. We investigate a
complementary firm-level corporate governance to better protect minority shareholders:
auditing. Auditors’ role is to increase trust on corporate information by reducing the possibility of manipulation of accounting numbers. Traditional audit fees model (Simunic
1980) explains that the amount of audit fees is a function of (1) the effort of the auditor during the engagement and (2) the risk incurred by the auditor after the disclosure of his/her audit report (risk premium). Consequently, agency conflicts should influence the risk premium (Lafond and Roychowdhury 2008) and thus the audit pricing.
Most of prior research focuses on the impact of the type I agency conflict on audit pricing because they have been mainly made in common law countries, particularly in the USA and the UK where ownership is dispersed. These studies find a negative relation between 1 This title has been inspired from Lang et al.’s (2004) title paper: Concentrated control, analyst following, and
valuation: Do analysts matter most when investors are protected least? Journal of Accounting Research 42 (3):
2 We refer to both managers and controlling shareholders as the “insiders”.
3 management ownership and audit fees and conclude that audit plays a governance role to mitigate type I agency problems (Agrawal and Jayaraman 1994; Gul and Tsui 2001; Nikkinen and Sahlstöm 2004). To our best knowledge, only one study (Fan and Wong 2005) focuses on type II agency conflict across countries while this conflict is predominant in the world (La Porta et al. 2000). Indeed, controlling shareholders have the possibility to expropriate minority shareholders and profit from private benefits of control, therefore type II agency conflict is likely to influence audit pricing.
Moreover, Niemi (2005) and Hay et al. (2006) underline that very few studies examined the relation between ownership and audit fees and these studies present mixed results about the direction and the significance of the relation between ownership concentration and fee levels.
We suggest two alternative perspectives to explain these ambiguous results.
First, previous studies define ownership concentration as the insiders’ ownership with the exception of only two studies (Peel and Clatworthy 2001; Fan and Wong 2005). Therefore, previous research does not distinguish between both types of conflicts, which could potentially lead to conflicting effects on audit fees. In this study, we examine the impact of both agency conflicts separately.
Second, based on the results of La Porta et al. (2000), we suggest that the legal system should play an important role in influencing audit fees risk premium related to agency conflicts (type I vs. type II agency conflicts). We then suggest that in weak investor protection countries, the relationship between audit fees and minority expropriation should be curvilinear (concave) while the few studies which isolate this conflict assumed its linearity. Namely, it is likely that a type II conflict first increases with the percentage of controlling shareholders ownership (entrenchment effect). Then, when controlling shareholders hold a very large part of capital, their interests could be expected to be aligned with the interests of minority shareholders, therefore mitigating type II agency problems and decreasing audit fees (alignment effect).
We use regression analyses on non financial listed companies over 17 countries (10 code law and 7 common law countries) on 2006-2008. We then focus on four countries (Germany and Franc for code law and UK and the USA for common law countries). First, the results of this study show a negative relation between management ownership and audit fees stronger in common law countries than in code law countries. We assume that type I agency conflict is less severe in firms where the manager hold large percentage of cash flow rights because he is more invested in the company, which leads to less effort from auditors and decreases the
Second, we find different results depending on the country investor protection level for the relation between ownership concentration and audit fees. In lower investor protection environment (civil law countries), we find a significant quadratic relation between the controlling shareholders capital rights and audit fees. Audit fees first increase with the controlling shareholders ownership: audit could be seen here as a substitution mechanism to mitigate internal corporate governance weaknesses. Then, beyond a threshold of around 20the relation becomes negative. We assert that very high ownership concentration does not harm the interests of minority shareholders: cash flows resulting from the detention of shares are superior to the private benefits of control, which contribute to align the interests of controlling shareholders with the interests of minority. These results are consistent with the Williamson’s (1983) substitution hypothesis.
In high investor protection countries (common law countries), our results show that controlling shareholding level does not influence audit fees. We therefore conclude that the type II agency conflict is non relevant in high investor protection (for instance the USA) and that auditors do not ask for a risk premium. Our results are coherent with the results of La Porta et al. (2000) on investor legal system. In common law countries, the main agency conflict is the one opposing shareholders and managers.
We contribute to the existing literature in several ways. First, this is the first study that examines the influence of agency conflicts (type I and type II) on audit pricing in relation to investor protection and legal systems. Also, Niemi (2005) and Hay et al. (2006) notice the absence in audit research of studies on ownership structure, particularly the influence of non managerial ownership concentration on audit fees. Our study aims to fulfill this need in demonstrating that the relation between ownership concentration and fee levels depend on the investor protection legal system assuming two levels of investor protection (high: common law countries, weak: civil law countries). Then, in civil law countries, the relation is likely to be curvilinear: the behavior of shareholders depends of the level of ownership concentration.
This study therefore contributes to the research on corporate governance mechanisms in putting in evidence the effect of type II agency conflict (La Porta et al. 1998).
2. Investor protection and corporate governance
2.1 Ownership concentration as a substitute governance mechanism in low investor protection countries La Porta et al. (1998) first evidenced that the investor protection regulations and its enforcement vary across countries and legal families. They show that civil laws give investors weaker legal rights than common laws, the weakest protection being given by French-civil law countries (with German-civil-law and Scandinavian countries fallen between the other two). Then they wonder whether the poor protection countries have other substitute mechanisms of corporate governance. First, they check whether the quality of law enforcement substitutes or compensates for the quality of laws. Their results reject this hypothesis: the quality of the enforcement is the highest in the Scandinavian and Germancivil-law countries, next highest in common law countries, then again the lowest in Frenchcivil-law countries. If it does not exist at the country level, a substitute mechanism of corporate governance may be set by shareholders themselves. They therefore investigate a firm-level substitution mechanism: ownership concentration. They posit two main reasons for which ownership in weaker investor protection countries should be weaker. First, “large, or even dominant shareholders who monitor the managers might need to own more capital, ceteris paribus, to exercise their control rights and thus to avoid being expropriated by the managers” (La Porta et al. 1998, p. 1145), which is especially true when legal protection is weak.. Second, small investors may not be willing to buy shares at high prices, because of the risk of expropriation: therefore, as firms are not likely to issue shares at low prices, this effect increases indirectly the ownership concentration.
La Porta et al ‘s (1998) results suggest that highly concentrated ownership may substitute at the firm level for weak investor protection stated at the country level. La Porta et al (2000) privilege the legal approach of corporate governance, which “holds that the key mechanism is the protection of outside investors (whether shareholders or creditors) through the legal
We posit that within the country level investor protection regulations, internal corporate governance mechanisms at the firm level remain pivotal to investor protection to compensate agency problems. La Porta et al (La Porta et al. 1998; La Porta et al. 2000) themselves studied the ownership concentration. In relation to this stream, we want to investigate one specific corporate governance mechanism: auditing.
2.2 Auditing: a firm level substitute for investor protection Since the role of auditing is to enforce the application of proper accounting polices (Francis and Dechun 2008, p. 157), auditing is part of the corporate governance system (Francis et al.
2003), whose cost has to be beard by the shareholders as one key component of monitoring costs (Jensen and Meckling 1976). It is therefore expected that the auditors will spend more time, relative to regular inspection of accounts, to inspect managers’ activities if the agency problem is greater, which may lead to higher audit fees.
A large body of audit research has focused on the determinants of audit fees (Hay et al. 2006) since the original seminal Simunic’s work (1980). This author has developed an audit fees model which has become a landmark in audit research. Its starting point is that auditors are jointly liable together with the managers of the financial information quality vis-à-vis the financial statement users. Consequently, Simunic (1980) develops an audit fees model that includes two components: audit effort and risk premium.
Where AUDFEE is the amount of audit fees, p: hourly pricing, q: number of auditing hours, E(L): risk premium, assessing the probability of expected losses.
The first component (p*q) represents the audit effort needed, which depends of the difficulty of the audit engagement. The determinants are mainly the size of the client and its organization complexity that is largely related to the industrial sector, internationalization degree, etc. The second element represents a premium related to the expected risk of paying post auditing losses in case of unveiled audit failure.