Management Ownership and Audit Firm Size

Abstract

The finance literature identifies two agency problems between managers and outside shareholders. First, there is a divergence-of-interests problem as management ownership falls. Second, there is an offsetting entrenchment problem when management ownership increases within intermediate regions of ownership. Agency problems are mitigated through contracting, but contracts are often based upon accounting numbers prepared by management. Since accounting numbers must be reliable for contracts to be enforced, agency theory predicts a demand for higher quality auditors when agency problems are more severe. However, extant studies find no significant or robust relation between management ownership and audit firm size (Francis and Wilson, 1988; DeFond, 1992). In contrast to extant research, this study samples unlisted companies rather than listed companies for two reasons. First, the monitoring value of auditing may be greater in unlisted companies because they are less vulnerable to takeover and they are required to disclose much less non-accounting information to shareholders. Second, unlisted companies have much greater variation in management ownership and this permits more powerful tests of the demand for auditing as ownership varies between 0% and 100%. Consistent with a divergence-of-interests effect, the association between management ownership and audit firm size is found to be significantly negative within low and high regions of management ownership. The association is flatter and slightly positive within intermediate regions of management ownership, suggesting the existence of an opposite entrenchment effect. The negative association and the non-linearity is consistent with the finance literature and with the predictions of agency theory.

Keywords: Management Ownership, Audit Firm Size, Agency Theory

JEL Classification: D82, G34, K22, M49