Auditors' Governance Functions and Legal Environments: An International Investigation

Abstract

This paper uses a set of firm-level data across 39 countries to study whether national legal environments increase or decrease auditors' governance functions in serving the bonding and signaling role. On the one hand, Big Five auditors may play a stronger governance role in weaker legal environments because they are good substitutes for legal protection of outside investors and risky firms find Big Five auditors more affordable due to lower litigation costs. On the other hand, a country's poor legal environment may significantly weaken the demand and supply of quality audits, lessening their role as a bonding mechanism and a credible signal. Our empirical results provide support to the former view that Big Five auditors fulfill a stronger governance function in weaker legal environments.

Keywords: Auditor choice, corporate governance, legal environments, litigation costs

JEL Classification: G34, K22, M47, M49