The separation of ownership and management in modern corporations encourages management to undertake opportunistic behaviour and hence increase the cost of agency problems that may be ultimately borne by management (Jensen and Meckling, 1976). The separation of ownership and management is not the only source of agency conflict. Since various interested parties are associated with business organisations, there have been different types of principal-agent relationship (e.g., between controlling shareholders and minority shareholders, creditors and owners/management). Therefore, CG’s main objective is to monitor the behaviours of different interested parties and ultimately to reduce the agency costs raised by different principal-agent relationships (Karpoff et al., 1996; Singh and Davidson, 2003; Lashgari, 2004; Maniam et al., 2006). Thus, CG is a set of external and internal rules, regulations, procedures and measures to govern the behaviours of different interested parties within a firm to maximise its value (Denis and McConnell, 2003; Lin and Liu, 2009). Previous studies have revealed the positive impact of CG on firms’ operating efficiency and effectiveness (e.g., Bushman and Smith, 2001; La Porta et al., 2002; Anderson et al. 2004). Other studies have found that sound CG mechanisms have a greater information content (Gompers et al., 2003; Lemmon and Lins, 2003; Bai et al., 2004; Steen, 2005. Ntim, 2015). Regulators, researchers and practitioners in developed and developing countries have devoted much effort in CG studies and proposed various procedures to raise the standards of CG over recent years, especially after the corporate scandals of the early 2000s, such as Enron and WorldCom (Denis and McConnell, 2003; Bai et al., 2004; Jiraporn et al., 2005).
Agency conflicts also lead to a demand for the services of independent auditors to ensure the fairness of financial reports prepared by management for shareholders, and to detect material deviations from generally accepted accounting principles (GAAP) (Francis and Wilson, 1988; Dye, 1993; Imhoff, 2003). Therefore, firms may voluntarily hire high-quality auditors to improve the credibility of their financial disclosure and thereby mitigate agency problems (Willenborg, 1999; Anderson et al., 2004; Wei et al., 2014; Asthana et al., 2015). Past studies have reported that firms facing serious agency conflicts are more likely to hire high-quality auditors to improve their CG and mitigate the probable conflicts (Hay and Davis, 2004; Fan and Wong, 2005; Srinidhi et al., 2014), while poor-quality auditors may be unable to exercise appropriate monitoring of the client’s financial reports (Claessens et al., 2002; Mayhew et al., 2003). For example, Wei et al. (2014) document that firms with a sufficiently high proportion of sophisticated investors are more likely to choose high-
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quality auditors. Also, Luypaert and Van Caneghem (2013) have evidence supporting that appointing one of the Big 6/5/4 auditors mitigates information asymmetry in mergers and acquisitions; contingent payments are less common when the target is audited by these auditors, after controlling for several other characteristics of the deal and firm. Furthermore, they report that the incentive to use stock payments in periods of stock market overvaluation is lower for acquirers with Big 6/5/4 auditors, and target shareholders are more likely to accept a contingent offer if the acquirer’s financial statements are certified by them. Likewise, firms with higher information asymmetry problems benefit more from Big 6/5/4 auditors in terms of lower cost of debt (Gul et al., 2013). Srinidhi et al. (2014) agree that strongly governed firms are more likely to choose better-quality (specialist) auditors and to exhibit higher earnings quality than other firms. This means that reputable auditors may be considered as a CG device to monitor a firm’s financial reporting process (Cohen et al., 2002; Ashbaugh and Warfield, 2003; Fan and Wong, 2005; Lin and Liu, 2009, 2010; Asthana et al., 2015). Firm-specific CG may also affect a firm’s choice of audit/auditor quality. In general, firms adopting sound CG mechanisms have a better control over operating activities and management performance. Thus the firm’s management or its controlling shareholders are not totally free in the choice of auditor. On the other hand, in weak governed firms, the management or controlling shareholders have a better opportunity to direct the auditor-hiring decision towards their own interests (Lin and Liu, 2009, 2010). This increases the risk of aggressive earning management or tunnelling behaviours, and thereby the credibility of financial statements may decrease.
The heterogeneous demands for independent audit services and different levels of audit quality to serve as a monitoring function depend on various levels of agency conflict among different firms (Lin and Liu, 2009; Luypaert and Van Caneghem, 2013; Srinidhi et al., 2014). Audit quality refers to the ability to detect misstatements, and the willingness to report misstatements uncovered in an audit process (DeAngelo, 1981; Copley and Douthett, 2002; Lee et al., 2003; Mohamed and Habib, 2013). That is, audit quality depends on the auditor’s ability to discover and report inaccuracies in the financial statements provided by management. The auditor’s technical capabilities and competence determine his/her ability to discover a breach in the client’s accounting system. However, the probability of reporting the misstatements is a function of the auditor’s independence (De Angelo, 1981; Deis and Giroux, 1992; Vanstraelen, 2000). Audit quality is difficult to observe directly, so several observable attributes are used to proxy for it, including the size of the audit firm (DeAngelo, 1981; Palmrose, 1988; Eshleman and Guo, 2014), tenure on audit engagement (Simunic and Stein, 1987), audit structure (Knapp, 1991), auditors’ industrial expertise composition (Schauer, 2002), audit fees (Beck et al., 2013; Chen et al., 2016) and litigation or stock market actions against listed firms and their auditors (Allen et al., 2005). Lin and Liu (2009, 2010) argue that the main attributes
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of a high-quality auditor are independence (relationship based), sufficient expertise (technique based) and high integrity (honesty and forthrightness).
DeAngelo (1981) argues that the quality of an audit process is a function of the size of the audit firm, or its market share. Large audit firms are more likely to provide higher quality audit to sustain their reputation and avoid litigation costs (Francis and Krishnan, 1999; Eshleman and Guo, 2014). Despite the case of Arthur Andersen, the audit literature provides much evidence confirming that large audit firms are positively associated with providing higher-quality services and a better monitoring role (e.g., Wolson and Grimlund, 1990; Willenborg, 1999; Bandyopadhyay and Kao, 2001; Ireland and Lennox, 2002; Lee et al., 2003; Francis, 2004; Watkins et al., 2004; Farbar, 2005; Lennox, 2005; Lin and Liu, 2009; Eshleman and Guo, 2014). This is because they usually have better training programmes, and a higher degree of independence and industrial expertise, which qualify them to detect and report irregularities in the financial statements provided by management (DeFond, 1992; Lennox, 1999; Reed et al., 2000; Mansi et al., 2004; Eshleman and Guo, 2014). A number of previous studies have provided empirical evidence suggesting that high-quality auditors (Big 6/5) can effectively detect earnings management and thus eventually improve the truthfulness and usefulness of accounting information (Francis and Krishnan, 1999; Balsam et al., 2003; Watkins et al., 2004). On the other hand, because of the relatively limited industrial knowledge and resources available to small audit firms, these are more likely to provide low-quality audit services (Teoh and Wong, 1993; Becker et al., 1998; Krishnan, 2003; Ghosh and Moon, 2005). Furthermore, some empirical studies have revealed that accounting numbers (e.g., earnings and book values) reported by the clients of large audit firms have greater information content for the market (Krishnan, 2003; Francis, 2004; Watkins et al., 2004; Lennox, 2005; Knechel et al., 2007). Similarly, higher audit fees may reflect audit quality and auditor effort (Beck et al., 2013), and thus may increase the credibility of corporate reporting and thereby accelerate the incorporation of future earnings information into current stock prices (Chen et al., 2016).
Managers and controlling shareholders may gain self-benefits by manipulating accounting numbers or transferring resources through tunnelling behaviour (DeFond and Subramanyam, 1998), and they may take these self-benefits into consideration when hiring external auditors (Johnson et al., 2000; La Porta et al., 2002). Firms hiring a more reputable auditor signal to the market that their financial reports are more reliable. This helps in reducing information asymmetry (Beatty, 1989; Willenborg, 1999), as well as mitigating agency costs and allowing firms to obtain finance (debt/equity) at lower costs (Beatty, 1989; Ang et al., 2000; Lin and Liu, 2009, 2010). Firms also seek to obtain high-quality audit to improve the credibility and reliability of their accounting information. Reliable accounting information, along with market measures, helps in evaluating and
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compensating management (Antle, 1982; Watts and Zimmerman, 1986; Blackwell et al., 1994). Firms not only demand the better-quality audit services provided by large audit firms but they also believe that large audit firms can provide superior tax expertise or advisory services among the other non-audit services provided (Chaney et al., 2004).
From the auditors’ point of view, they aim to provide high-quality audit process to minimise their business risk by increasing the auditee’s satisfaction, avoiding litigation, and reducing damage to their reputation in the case of audit failure (Al-Ajmi, 2009; Eshleman and Guo, 2014; Kalelkar and Khan, 2016). Large audit firms also provide high-quality audit services for a number of other reasons, including availability of highly qualified and experienced staff; adequate technological resources (DeAngelo, 1981; Frantz, 1999); effective control systems (Al-Ajmi, 2009); more independence of their clients (DeAngelo, 1981); high economic costs imposed on the auditor in the event of audit failure, and the risk of losing the reputation (DeAngelo, 1981) which enables them to charge high audit fees and therefore devote more time and effort to each audit engagement (Francis, 2004; Goodwin-Stewart and Kent, 2006). A considerable number of studies have investigated whether the big audit firms may provide a superior audit quality service, with mixed results. Although extensive empirical evidence suggests that these auditors provide high-quality audits (DeAngelo 1981; Palmrose, 1988; Deis and Giroux, 1992; Mutchler et al., 1997; Krishnan and Schauer, 2000; Fuerman, 2004; Eshleman and Guo, 2014), there is also evidence which suggests that no differences in quality exist between the big and non-big auditors (Jeong and Rho 2004; Khurana and Raman, 2004).
In conclusion, the independent audit process can be considered as one of the effective CG mechanisms, where an independent and professional auditor will provide external monitoring of the financial information provided by management and thereby enhance market confidence in corporate financial reporting (Lin and Liu, 2009, 2010; Luypaert and Van Caneghem, 2013). Auditors can also improve the monitoring role of CG by examining and evaluating a firm’s internal control procedures to ensure the reliability of disclosed financial reports (Beasley et al., 2000; La Porta, 2002; Fan and Wong, 2005). The big audit firms are usually more independent and possess greater professional industrial expertise, both of which are necessary to detect and report misstatements and irregularities in financial reports and thereby better fulfil their monitoring role (Willenborg, 1999; Chaney and Philipich, 2002; Cohen et al., 2002; Ghosh and Moon, 2005; Lin and Liu, 2009; 2010). Well governed firms are more likely to hire a higher-quality auditor to ensure that financial reports are fairly presented in conformity with GAAP, eventually enhancing the credibility and usefulness of financial reports to various stakeholders (Bushman and Smith, 2001; Dewing and Russell, 2003; Fan and Wong, 2005; Maniam et al., 2006; Srinidhi et al., 2014). Therefore, sound CG mechanisms are associated with the quality and effectiveness of the auditing process (Ashbaugh and Warfield, 2003;
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Francis et al., 2005; Abbott et al., 2007). On the other hand, in firms with weak CG mechanisms, it is more likely that managers and controlling shareholders will interfere in the choice of external auditor, so that the independent audit process may not be able to fulfil its monitoring role (Rosner, 2003; Marnet, 2005; Lin and Liu, 2009, 2010).
Indeed, the impact of sound CG mechanisms on external auditing (including auditor choice and fees) is an important issue worthy of study. In particular, the auditing profession and CG practices in MENA countries differ substantially from those in developed countries (as discussed in detail in Section 2), which may have different impacts on the utility of the auditing function in the MENA context. Therefore, investigating the antecedents of auditor choice and fees from the perspective of CG context in the MENA market environment should not only promote the development of CG and independent auditing in these emerging economies, but also enrich the literature on the CG/audit quality-related issues. In particular, this study examines the impact of the CG index, board characteristics (size, diversity, independence, and non-duality of chairperson and CEO roles) and ownership structure mechanisms (government, director and block ownership) on both auditor choice and fees decisions in the MENA context.