Foreign Ownership and Audit Fees in European Listed Firms

Abstract

This paper investigates whether foreign ownership affects audit fees by analyzing shareholdings of listed firms from Western European countries. The results show that foreign ownership is an important factor that drives the demand for audit services. However, the willingness to pay higher audit fees is mainly driven by the quality of governance and investor protection of the foreign investor's home country. This is consistent with the notion that foreign investors encourage the firms that they invest in to implement the same corporate governance practices in terms of auditing that they themselves are subject to in their home country. Finally, we document that the influence of the foreign investor on audit fees is increasing in the percentage of ownership held.

KEYWORDS:

• Foreign ownership
• Audit fees
• Shareholder protection
• Governance quality

Acknowledgements

We thank Henrik Nilsson (associate editor) and two anonymous reviewers for their constructive suggestions on a previous version of this paper. The paper further benefited from insights of Jochen Bigus, Klaus Ruhnke, Reiner Quick, and workshop participants at the Freie Universität Berlin, and the 38th EAA Annual Congress at Glasgow. We thank Omer Cemal for research assistance.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 The report of the European Commission is available at: http://ec.europa.eu/economy_finance/international/globalisation/fdi/index_en.htm.

2 A recent literature review by Hay et al. (2006), which summarizes a large body of literature on audit fee determinants, corroborates the view that previous research has offered only scarce evidence of how ownership structure impacts audit fees. While several studies have conclusively demonstrated a negative association between managerial ownership and audit fees (e.g., O’Sullivan, 2000; Gul & Tsui, 2001; Peel & Clatworthy, 2001; Gul et al., 2003; Nikkinen & Sahlstrom, 2004; Niemi, 2005; Mitra et al., 2007; Ali & Lesage, 2010), the results of the few studies on the association between non-managerial ownership and audit fees are mixed and inconclusive (e.g., Chan et al., 1993; Ezzamel et al., 1996; Firth, 1997; Carcello et al., 2002; Ezzamel et al., 2002; Goddard & Masters, 2000; Whisenant et al., 2003; Khan et al., 2011; Adelopo et al., 2012; Ali & Lesage, 2013). Niemi (2005) and Nelson and Mohamed-Rusdi (2015) have investigated foreign ownership's impact on audit fees. Both studies, among others, have found that foreign ownership positively impacts audit fees. Desender et al. (2013b) investigate the association between foreign ownership and corporate governance patterns. Among others, the authors find a positive effect of foreign ownership on audit fees. More recently, Kim et al. (2019) find a positive association of foreign ownership and BIG4 auditor choice.

3 In practice, foreign investors are able to impact the audit through the audit tender process which is organized by the audit committee in order to identify and recommend the most suitable auditor to be appointed by shareholder approval during the annual general meeting. Section 2 describes this process in greater depth.

4 Alternatively, and as explained in more detail in section 2, higher audit fees might be driven by audit supply factors such as additional effort to communicate with distant investors and including a risk premium for higher litigation risk when agency conflicts increase due to greater information asymmetry associated with geographical distance.

5 A more detailed description of the measure for high quality of governance and investor protection is provided in section 3.1.

6 These findings also hold true for private firms (Guedhami et al., 2009).

7 According to Hay et al. (2006) and DeFond and Zhang (2014), audit fees is a audit contracting feature which proxies for the demand for audit assurance. Besides, audit fees are strongly related to audit effort (Gipper et al., 2020).

8 Since auditing is an important instrument of enhancing the protection of investors’ rights and represents an important aspect of corporate governance, this study adds to this stream of research.

9 To achieve this objective in publicly listed companies, the audit committee needs to make sure that the auditor understands the business, has relevant work experience (e.g., be authorities in their field/industry), has international presence, and provides ‘value for money’ (KPMG Audit Committee Institute, 2017, p. 132; Handelsblatt, 2018), among other things.

10 We have conducted several interviews with audit committee members of publicly listed firms in Germany who confirmed that these evaluation criteria play a role in the selection of an auditor and generally result in higher audit fees. Further, recent research by Gipper et al. (2020) confirms that audit effort (as proxied by audit hours) and audit fees are highly correlated.

11 Previous research has also shown that strong investor protection is associated with greater financial transparency (Bhattacharya et al., 2003; Bushman et al., 2004), less managed earnings, and more value-relevant earnings (Ball et al., 2000; Hung, 2000; Leuz et al., 2003). The above-mentioned summary of La Porta et al.'s findings is in conformity with the one of Francis et al. (2003).

12 For example, The Children's Investment Fund (TCIF) investment into Deutsche Boerse represents a high-profile case in which a foreign investor was crucial in the outcome of a takeover bid and the accompanying consequences on the firm's governance (Economist, 2008).

13 We thank an anonymous reviewer for this additional suggestion.

14 Eq. (1) – (3) are estimated using a pooled sample of 17,727 firm-year observations including industry-fixed effects in accordance with the definition of Frankel et al. (2002), year-fixed effects, and country-fixed effects to control for potential hetereogeneity effects within industry, year, and/or country. To control for heteroscedasticity the analysis further employs heteroscedasticity-adjusted robust standard errors clustered for 1,744 unique firms.

15 According to Kaufmann et al. (2009), ‘rule of law’ captures perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence; ‘control of corruption’ captures perceptions of the extent to which public power is exercised for private gain, including both petty and grand forms of corruption, as well as ‘capture’ of the state by elites and private interests; ‘government effectiveness’ captures perceptions of the quality of public services, the quality of the civil service and the degree of its independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government's commitment to such policies; and ‘regulatory quality’ captures perceptions of the ability of the government to formulate and implement sound policies and regulations that permit and promote private sector development. The WGIs are available at http://info.worldbank.org/governance/wgi/index.aspx#home.

16 The WGI project uses 35 data sources provided by 33 different organizations and reports worldwide governance indicators as aggregates of hundreds of specific and disaggregated individual variables measuring various dimensions of governance.

17 The EUR Business Research Database is available online at: http://www.eur-businessresearch.com/.

18 Amadeus is a database of Bureau van Dijk Electronic Publishing and collects information from a wide variety of sources: (1) directly from the firm's annual reports, (2) from official bodies, (3) from press releases, (4) from regulatory authorities, and (5) from the associated information provider (e.g. Verband der Vereine Creditreform for Germany).

19 This is necessary as different currencies are used in the sample countries. For example, GBP in the United Kingdom, NOK in Norway, etc. Balance sheet items are translated using spot exchange rates, while income statement items are translated using the average exchange rates over the fiscal year.

20 However, the audit fees of domestic owners in both systems of governance quality and investor protection are still generally lower than the audit fees of foreign owners.

21 A closer look to the dataset reveals that our foreign ownership variables are relatively sticky. That makes it difficult to get a sufficient number of observations for which we can identify changes in foreign ownership. For example, we only observe a total of 546 changes of largest investors from foreign to domestic or vice versa Therefore, the results provided by estimating our change model have only limited explanatory power.

22 Small (mid-sized) firms refer to observations for which assets are <25th (≥25th and <75th) percentile. Large firms refer to observations for which assets are ≥75th percentile.

23 These alternative explanations provide an interesting venue for future research.