To Centralize or Not: Control Right Allocation and Auditor Incentives

Abstract

We use the audit industry in China as a laboratory to examine the role of control right allocation on individual auditors’ incentives when balancing coordination and local information acquisition. Relying on proprietary information of internal control right allocations, our tests reveal that local engagement auditors of more centralized audit firms provide more effort than their decentralized peers. Auditors in centralized firms are also more likely to adjust reported earnings downward and produce better-quality audited financial statements than in decentralized firms. These effects attenuate in headquarters where the tension between coordination and local information acquisition is absent. We use Confucian culture and rice farming regions as instrumental variables of preference for centralization and find consistent results. Tests based on changes in centralization due to audit firm mergers also yield similar inferences. Further analyses show that the beneficial effects of centralization are more pronounced when central authority has lower information acquisition costs but are weaker when local clients are complex. Our findings directly inform the classic debate on coordinated versus spontaneous adaptation (Williamson, 1996; Hayek, 1945).

Keywords: Centralization, Decentralization, Control Rights, Coordination, Local information, Auditor

JEL Classification: D23, L23, G3