National Accountants Conference 2002 Do External Auditors Perform A Corporate Governance Role in Emerging Markets? Evidence from East Asia Professor T.J. Wong Director of Center for Corporate Governance Hong Kong University of Science and Technology

National Accountants Conference 2002 Background Asian Financial Crisis exposed that corporate governance is weak and corporate transparency is low One key problem – ownership structure of firms

National Accountants Conference 2002 Ownership Concentrated in Hands of Family

National Accountants Conference 2002 Separation of Ownership and Control of Large Shareholders Control (voting rights) > Ownership (cash flow rights) Main method of separating cash flow and voting rights Stock pyramids

National Accountants Conference 2002 Stock pyramid X X V=50% Y V=20% Z V=C=10% Z V=C=50% Y V = 20%, weakest link in the chain, C = 10%. Pyramid structure allows leveraging up in control

National Accountants Conference 2002 Ultimate Voting and Cash Flow Rights of Largest Shareholders (Source: Claessens et al., 2000)

National Accountants Conference 2002 Ratio of Cash Flow to Voting Rights (Source: Claessens et al., 2000)

National Accountants Conference 2002 Measuring Agency Problem Conflicts of interests between majority shareholder (family) and minority shareholders Expropriation of minority shareholders by majority shareholders Effective control gives power Separation of cash and voting rights gives more incentives

National Accountants Conference 2002 Corporate Ownership and Transparency Fan and Wong (forthcoming in JAE) find that In East Asia (excluding Japan), effective control and large separation of cash and voting rights, measuring agency problem, are associated with low earnings informativeness. High agency cost and low credibility. Tight owner control, political rent seeking and low transparency.

National Accountants Conference 2002 Broad Research Question Do auditors play a governance role by assuring the quality of accounting information in East Asia?

National Accountants Conference 2002 Monitoring and Bonding Jensen and Meckling (1976) suggest that good firms will employ monitoring and bonding mechanisms to mitigate their agency costs

National Accountants Conference 2002 Governance role of auditors in Asia Hiring independent external auditors is a potentially important governance mechanism in East Asia, because boards of directors and takeover markets are weak to contain agency problems weak laws and institutions to protect investors U.S. and U.K. where laws are better enforced and alternative governance mechanisms are more abundant

National Accountants Conference 2002 Are Asian Auditors Monitors? Positive view External auditors can serve a monitoring role when conventional corporate control systems are weak They provide credible quality assurance or make efforts to ensure financial reporting quality (Titman and Trueman, 1986)

National Accountants Conference 2002 Are Asian Auditors Monitors? Negative view- demand side arguments: No demand from majority owners (relationship based transactions, culture and rent seeking) No good audit committees Weak legal system, audit opinions have no consequences

National Accountants Conference 2002 Are Asian Auditors Monitors? Negative view - supply side arguments: Lack of expertise and experienced professionals Consulting business may create conflicts of interest (not unique to Asia) Weak disciplinary mechanism for audit profession

National Accountants Conference 2002 Number of CPAs as Percentage of Population

National Accountants Conference 2002 The effects of agency problem on audit fee and opinion Are auditors doing their job? If auditors serve as monitors and provide more assurance of quality through their superior reputation or exert efforts to mitigate agency conflicts, it would be reflected in the audit fee (Bell et al. 2001; Lyon and Maher, 2002) Likewise, if auditors monitor, poor earnings would more likely trigger a qualified opinion for clients subject to high agency problems

National Accountants Conference 2002 Data 8 economies: HK, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand. All financial data, auditor names and opinions are from Worldscope 1996 Ownership data from Claessens et al., Sample period from ,119 firm year observations Representing 28% of the population of listed firms in East Asia

National Accountants Conference 2002 Three Hypotheses Firms with ultimate owners that have gained effective control and/or have large separation of cash and voting rights are more likely to hire B5 are more likely to pay a higher audit fee their poor earnings will more likely trigger a qualified opinion

National Accountants Conference 2002 Measuring Effective Control and Separation of Rights Effective control DEV = 1 if voting rights – country median > 0; 0 otherwise Separation of cash flow and voting rights CV = cash flow rights/voting rights CV  1 = no separation; CV  0 = large separation

National Accountants Conference 2002

Summary East Asian firms with concentrated control and large separation in control and ownership will more likely hire Big 5 auditors Big 5 auditors charge fee premium for agency cost imbedded in ownership structure Big 5 auditors set lower qualification threshold for poorly performing firms with high agency cost than low agency cost