Auditor Choice and Its Implications for Group-Affiliated Firms

47 Pages Posted: 22 Sep 2015

See all articles by Junxiong Fang

Junxiong Fang

Fudan University - School of Management

Jeffrey Pittman

Memorial University of Newfoundland (MNU) - Faculty of Business Administration

Yinqi Zhang

American University

Yuping Zhao

University of Houston

Date Written: September 21, 2015

Abstract

We examine which of two opposing financial reporting incentives that group-affiliated firms experience shapes their accounting transparency evident in auditor choice. In one direction, complex group structure and intra-group transactions enable controlling shareholders to pursue diversionary activities that they later hide by distorting reported earnings. In the other direction, as outside investors price protect against potential expropriation, controlling shareholders may be eager to improve financial reporting quality in order to alleviate agency costs. To empirically clarify whether group affiliation affects company insiders’ incentives to address minority shareholders’ concerns over agency costs, we examine auditor selection of group firms relative to stand-alone firms. In comparison to non-group firms, our evidence implies that group firms are more likely to appoint Top 10 audit firms in China, especially when their controlling shareholders have stronger incentives to improve external monitoring of the financial reporting process. After isolating group firms, we find that the presence of a Top 10 auditor translates into higher earnings and disclosure quality, higher valuation implications for related-party transactions, and cheaper equity financing, implying that these firms benefit from engaging a high-quality auditor. In additional analysis consistent with our predictions, we find that group firms that are Top 10 clients pay higher audit fees and their controlling shareholders are more constrained against meeting earnings benchmarks through intra-group transactions and siphoning corporate resources at the expense of minority investors. Collectively, our evidence supports the narrative that insiders in firms belonging to business groups weigh the costs and benefits stemming from auditor choice.

Keywords: business group, auditor selection, accounting transparency, related-party transactions

JEL Classification: G32, G34, M41, M42

Suggested Citation

Fang, Junxiong and Pittman, Jeffrey A. and Zhang, Yinqi and Zhao, Yuping, Auditor Choice and Its Implications for Group-Affiliated Firms (September 21, 2015). Contemporary Accounting Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2663358

Junxiong Fang

Fudan University - School of Management ( email )

No. 670, Guoshun Road
No.670 Guoshun Road
Shanghai, 200433
China

Jeffrey A. Pittman (Contact Author)

Memorial University of Newfoundland (MNU) - Faculty of Business Administration ( email )

St. John's, Newfoundland A1B 3X5
Canada
709-737-3100 (Phone)
709-737-7680 (Fax)

Yinqi Zhang

American University ( email )

4400 Massachusetts Ave NW
Washington, DC 20016
United States

Yuping Zhao

University of Houston ( email )

334 Melcher Hall
Houston, TX 77204
United States
713-743-2166 (Phone)
713-743-4828 (Fax)

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