Pipo Club

Ownership structure affects CG and corporate values in different ways (Lin and Liu, 2009). Agency theory suggests that a higher extent of separation between ownership and control might increase agency costs and motivate firms to demand timely independent audits to monitor managerial performance (Abdel-khalik, 1993; Chan et al., 1993; O’Sullivan and Diacon, 2002). As ownership becomes more dispersed, direct monitoring by shareholders becomes more costly (O’Sullivan, 2000; O’Sullivan and Diacon, 2002). Therefore, Chan et al. (1993), O’Sullivan (2000) and O’Sullivan and Diacon (2002) suggest that firms with widely dispersed ownership (a lower level of block ownership) are more likely to demand higher-quality audit as a means of monitoring managerial behaviour, thus paying higher audit fees to mitigate agency conflict. Furthermore, agency costs are expected to increase in firms with dispersed ownership, because managers are more likely to pursue their own interests at owners’ expense (Jensen and Meckling, 1976; Reverte, 2009). However, managers are expected to bond by a more extensive audit, signalling their concern for shareholders’ interests (Chan et al., 1993; O’Sullivan, 2000; O’Sullivan and Diacon, 2002). O’Sullivan (2000) and O’Sullivan and Diacon (2002) argue that firms with dispersed ownership demand better-quality audit and thereby pay higher fees to minimise opportunities for managerial discretion. Therefore, firms with dispersed ownership may utilise extensive auditing to substitute for this weakness in the ownership structure, and consequently pay higher audit fees. Expected losses for audit firms arising from subsequent discovery of errors in the audit may be higher in firms with dispersed ownership than in those with more concentrated ownership (Simunic, 1980; Pratt and Stice, 1994; Simunic and Stein, 1996). These

193

possible losses increase auditors’ claimed risk premium, and thereby increase audit fees (O’Sullivan and Diacon 2002).

Similarly, firms with concentrated ownership are exposed to greater agency conflict because controlling shareholders may have a prevailing influence on most of the firm’s affairs to serve their self-interest at the expense of minority shareholders, and it is probably easier for controlling shareholders to bypass the monitoring of other stakeholders (Fama and Jensen, 1983; Johnson et al., 2000). This means that controlling shareholders may be engaged in aggressive tunnelling behaviours that ultimately expropriate the minority shareholders (La Porta et al., 1998, 1999; Fan and Wong, 2002). Therefore, firms with concentrated ownership try to avoid being monitored by high-quality (large) auditors, to maximise self-interest through earning management and tunnelling behaviours (Lin and Liu, 2009, 2010). Controlling shareholders can secure more opaqueness in firms with a concentrated ownership structure (Chau and Leung, 2006). Listed firms’ motives for issuing less transparent financial statements not only include securing private benefits but may also involve reducing political costs encountered by these firms. This means that listed firms with concentrated ownership may prefer to have a weak CG (e.g., hiring a low-quality auditor) and to issue less transparent financial reporting to prevent competition or social sanctions (Lin and Liu, 2009). High- quality auditors provide a more efficient monitoring role and thereby detect and report misstatements in financial reporting. This may lead to external intervention by minority shareholders, analysts, stock exchanges or regulators (Haw et al., 2004). Moreover, shareholders with controlling ownership can easily control and dominate the nomination and appointment of directors, senior management and auditors (Lin and Liu, 2009, 2010). Therefore, firms with more concentrated ownership may prefer to select lower-quality auditors so that they can easily obtain private benefits (Karpoff et al., 1996; Copley and Douthett, 2002; Lin and Liu, 2009, 2010).

On the other hand, and as mentioned above, large shareholders are more likely to try to maximise their own interest by benefit-transfer dealings or tunnelling behaviours, thereby expropriating other stakeholders (Claessens et al., 2002; Copley and Douthett, 2002; Fan and Wong, 2002; La Porta et al., 2002; Anderson et al., 2004; Chau and Leung, 2006). Consequently, this enrichment increases agency costs, for example by increasing the cost of issuing new shares in the market (Claessens et al., 2002; Gelb and Zarowin, 2002). Firms with concentrated ownership tend to use monitoring or bonding mechanisms to protect stakeholders’ interests and thereby reduce agency costs (Ang et al., 2000; Fan and Wong, 2005). This leads these firms to hire large auditors to signal good CG and credible financial reporting to minority shareholders and other stakeholders, to mitigate agency costs (Reed et al., 2000; Johnstone and Bedard, 2004; Fan and Wong, 2005; Lin and Liu, 2009). Similarly, in firms with more concentrated ownership, block shareholders are motivated to

194

extensively monitor managerial behaviour, given to the size of their equity holdings and the probable cost of any non-value-maximising behaviour by managers (O’Sullivan, 2000). Accordingly, block shareholders are more likely to demand more extensive auditing, paying higher audit fees.

Overall, previous studies have suggested the appointment of large audit firms and higher audit fees both in companies with widely dispersed ownership due to the effective monitoring role of auditors and the bonding motivation of managers, and in companies with large external block holders due to monitoring of block holders’ financial incentives and to obtain finance with lower costs. Generally, MENA listed firms are characterised by concentrated ownership, particularly dominated by state and family control (Fawzy, 2004; Jamali et al., 2007; Omran et al., 2008; Ararat et al., 2010; Weir, 2011; Piesse et al., 2012; Hasan et al., 2014). In other words, a MENA listed firm normally has a dominant controlling owner, either the government or a family. The controlling owner tends to interfere in many of the firm’s decisions, including the choice of audit firm (Al-Awaji, 1971; Helms, 1981; Wahdan et al., 2005a, b; Mohamed and Habib, 2013). Previous studies have suggested that the decision to hire a high-quality auditor involves a trade-off between relevant benefits (e.g., obtaining debt at a lower cost or issuing equity at higher prices) and costs (e.g., giving up opaqueness gains from earning management and tunnelling behaviour) to the controlling owner. The MENA region aims to increase foreign investments and to protect minority shareholders’ interests. Therefore, firms listed in MENA markets are motivated to raise capital with lower costs. This posits that firms with weak CG (e.g., concentrated ownership) intend to signal more concern to protect minority shareholders’ interests and thereby choose higher-quality auditors.

Generally, there is a dearth of studies investigating the relationship between the degree of concentration of share ownership and audit fees (Chan et al., 1993). Using data from 300 UK quoted companies in 1987, Chan et al. (1993) document a significant negative association between ownership concentration and audit fees. Additionally, O’Sullivan and Diacon’s (2002) empirical evidence based on 117 UK registered insurance companies in 1992 supports the negative relationship between concentrated ownership and audit fees. Datar et al. (1991) and Copley and Douthett (2002) document empirical evidence supporting the inverse relationship between the selection of better- quality auditors and retained ownership.

Lin and Liu (2009), using 184 IPO firms listed on the Shanghai and Shenzhen Stock Exchanges 2001-2004, find that firms with highly concentrated ownership are less likely to choose a Top 10 (high-quality) auditor in China. Furthermore, they report in a later study (Lin and Liu, 2010) that firms with a high level of controlling owners are more likely to switch to a smaller auditor than to a larger one. These results reflect the Chinese context at a specific period of time when the stock market was weak and listed firms were less enthusiastic to offer new equity securities to the public.

195

The China Securities Regulatory Commission (CSRC) even stopped the listed firms from issuing new equity securities to the public in June 2002. In such a market it is suggested that the benefits of lowering capital-raising costs are insignificant because the listed firms have little intention or possibility of offering new equity securities to the public. Therefore, the opaqueness gains from weak CG are supposed to outweigh this.

However, using data from eight East Asian economies between 1994 and 1996, Fan and Wong (2005) find empirical evidence confirming that firms with agency problems embedded in the ownership structure (highly concentrated ownership) between controlling owners and the minority shareholders, are more likely to hire Big 5 auditors and to pay higher audit fees. Likewise, using data from New Zealand listed firms in 1995 and 2005, Hay et al. (2008) document that the existence of a major outside shareholder is positively related to audit fees but only where there is sufficient variation in CG arrangements. However, the empirical results of O’Sullivan (2000), using a sample of 402 UK quoted companies in 1992, suggests no relationship between concentrated (financial institutions and non-financial institutions) ownership and audit fees. Given the inconclusive theoretical and empirical literature, the eighth hypothesis is as follows:

H8a. A firm with a high percentage of total shares held by the largest owners is more/less

likely to choose a high-quality (Big 4) auditor.

H8b. A firm with a high percentage of total shares held by the largest owners is more/less

likely to pay high audit fees.

4 Research Design

4.1 Sample Selection and Data Sources

The study’s sample covers 600 firm-year observations of 100 firms listed on five MENA countries’ stock exchanges from 2009 to 2014.17 _{Financial and utility firms are excluded from this} study because their operations and governance structures are quite different from other types of firms (Lin and Liu, 2009, 2010). Additionally, since the majority of literature examining the link between CG and audit quality emphasise non-financial institutions (O’Sullivan, 2000; Carcello et al., 2002), financial companies are excluded from this study. Therefore, the results can be discussed in the context of existing studies. The remaining companies are classified into five main industries: basic materials/oil and gas; industrial; customer goods; customer services/health care; and technology/telecommunication.

UAE. The choice of these the

and Jordan, Oman, Saudi Arabia Egypt,

are study MENA countries used in the current

17

196

In order to examine the impact of internal CG on both auditor choice and fees decision, CG variables (i.e., CG index, board characteristics and ownership structure mechanisms) were collected by hand from the sampled firms’ annual reports, their websites, capital markets websites and other websites. Financial and accounting variables were collected from the Datastream database. Country- level data, including GDP and Corruption Perception Index were collected from the website of the World Bank and Transparency International websites, respectively, while the Inflation Index came from the International Monetary Fund’s website.

With regard to audit fees, Jordan, the UAE and Omani companies are obliged to disclose the amount of the audit fees paid to their auditor in their annual financial statements. However, Egyptian companies’ audit fees were collected from general assembly meetings reported on the Egyptian stock exchange market website. Saudi Arabia listed firms do not disclose audit fees to the public, and the researcher tried to obtain this information by direct contact with companies and audit firms but unfortunately was unsuccessful in this. Therefore, the current study ends up with audit fees data for 470 firm-year observations (there are ten missing audit fees data in the UAE sampled firms). Thus, the current study only uses firm-year observations that were identified in order to test hypotheses. The final sample has satisfied two predetermined criteria. Firstly, organisation’s CG data should be available for all the six-year period from 2009 to 2014. Secondly, financial data should be accessible for sampled firms for the same time period. These criteria help us to obtain a balanced panel data analysis to increase degrees of freedom and decrease multicollinearity among examined variables (Gujarati 2003; Wooldridge 2010). This design also provides the opportunity to compare the current findings with results of previous studies (Lin and Liu, 2009, 2010; Johansen and Pettersson, 2013).

4.2 Measurement of Variables

This section illustrates dependent, independent and control variables, and models specifications of the study. The study’s variables are classified into three main categories as illustrated in Table 19.