Saibal Ghosh, Department of Economic Analysis and Policy, Reserve Bank of India, Central Office Building, Fort, Mumbai 400001, India. Email: email@example.com. The views expressed and the approach pursued reflect the personal opinion of the author.
This article examines how external auditing and managerial ownership relate to firm valuation. It is argued that both external auditors (which serve as an external monitoring function) and managerial ownership (which serves as an internal monitoring function) affect firm value, while internal monitoring by managers and external monitoring by auditors were viewed as substitutes or complements. After controlling for the effect of exogenous variables, the results reveal the existence of a substitution monitoring effect between auditors and the managerial group. Additionally, firm valuation is found to be a significant determinant of managerial ownership. A disaggregated analysis of firms according to size and leverage suggests the existence of a complementary monitoring effect between auditors and managers, especially for low-leveraged firms.
The importance of external auditing as a mechanism for corporate governance has attracted considerable attention of late. Academics and policy makers in both developed and emerging markets are increasingly grappling with this issue as they seek to reform their governance mechanisms. At the same time, the empirical literature also suggests that internal monitoring by managers plays an influential role in affecting firm valuation. Combining these findings, it seems that internal managerial monitoring, external auditing and firm valuation are jointly determined, with each tending to reinforce the other. Towards this end, this article explores the joint determinants of internal and external monitoring and its interrelationship with firm valuation. It is argued that both internal monitoring by managers and external monitoring by auditors play a vital role in affecting firm value, even though these two kinds of monitoring are either substitutes or complements in terms of monitoring. Accordingly, the study employs a cross-section of listed manufacturing firms for the year 2005, accounting for over 60% of the market capitalization on the stock exchange. Using a simultaneous equation framework, the findings reveal that internal monitoring is significantlynonlinearly related to external monitoring, as proxied by the number of auditors. Additionally, the results suggest that managerial ownership is a nonlinear function of firm value. The results emanating from the analysis yield a number of interesting conclusions. First, managerial ownership is found to be a significant and negative determinant of the number of firm auditors, while the number of auditors is also a significant and negative determinant of managerial ownership. Hence, internal monitoring and external monitoring are both interdependently and inversely related. Second, the number of auditor relationships and firm performance are positively related, suggesting that external monitoring enhances performance, although the converse is not necessarily valid. And third, firm valuation is a significant and positive determinant of managerial ownership, while, at the same time, managerial ownership is also a statistically significant determinant of firm value, after controlling for external monitoring.
The importance of external auditing as a mechanism for corporate governance has attracted considerable attention of late. Academics and policy makers in both developed and emerging markets are increasingly grappling with this issue as they seek to reform their governance mechanisms, particularly in the wake of the East Asian financial crises and recent accounting irregularities in the US and elsewhere. This article examines this issue in the Indian context, drawing upon the available theoretical and empirical literature. More specifically, the study investigates the joint determinants of external auditing, internal managerial monitoring and firm value. It is argued that both internal monitoring by managers and external monitoring by auditors play a vital role in affecting firm value, even though these two kinds of monitoring are either substitutes or complements in terms of monitoring.
There are three main reasons for the choice of India in this study. First, India is one of the largest and fastest growing emerging economies with a long history of auditing practice. Second, over the last decade and a half, India has introduced an extensive set of reforms in the financial sector, thereby providing an enabling environment for corporations to determine their capital structure. And finally, the firm-level database employed for the purpose provides an ideal vehicle to clearly discern the interlinkage among the different kinds of monitoring and firm valuation. The findings so obtained may be representative of the role of auditors in ensuring corporate governance in other emerging markets.
The dataset includes information on non-financial firms for the year 2005. The variables include measures of firm characteristics, ownership type and performance. The data are matched to information on the identities of auditors with which these firms have relationships. Where a firm has multiple auditor relationships, the data also provides the names of these auditors listed in order of priority (main auditor, second auditor, etc.).
The empirical literature on auditing has been confined largely to the US (Francis & Wilson, 1988; DeFond, 1992) and other developed economies such as the UK (Chan et al., 1993), Australia (Francis, 1984), New Zealand (Firth, 1985) and Canada (Chung & Lindsay, 1988) and to a lesser extent, for East Asian economies (Simon et al., 1992; DeFond et al., 2000) for two main reasons. First, until recently, corporate balance sheets were exceedingly opaque with limited disaggregated information being provided on the documentation by auditors. Second and more importantly, the accounting irregularities in the US and elsewhere have heightened the awareness about the relevance of proper accounting standards to ameliorate the agency problems between management and stakeholders. These developments have, as a consequence, prompted the need for greater transparency in the annual accounts of corporate entities.
Notwithstanding the emerging literature on this aspect for developed economies, limited research has been forthcoming in this area for developing countries. First, until recently, the corporate sector in many developing markets encountered several constraints in accessing equity and debt markets. As a consequence, any research on the interface between capital structure and corporate governance features of firms could have been largely constraint-driven and hence, less illuminating. Second, several developing countries, even until the late 1980s, suffered from ‘financial repression’, with negative real rates of interest as well as high levels of statutory pre-emptions. This could have meant restricted play of competitive forces in resource allocation.
Questions regarding the interface between corporate governance and firm valuation have, however, gained prominence in recent years, especially in the context of the fast changing institutional framework in these countries. Several developing countries have introduced market-oriented reforms in the financial sector. More importantly, the institutional set-up within which corporate houses operated in the regulated era has undergone substantial transformation since the 1990s. The move towards market-driven allocation of resources, coupled with the widening and deepening of financial markets, including the capital market, and the stringent disclosure and transparency practices consequent upon initial public offerings have provided greater scope for corporations to determine their capital structure. This, in turn, has provided greater impetus for analysing the interrelationships among auditor relationships, managerial ownership and firm valuation.
This article makes several contributions. First, this is the first study on an emerging economy that explores how the interplay of external auditing and internal managerial monitoring affects firm valuation. Second, the paper contributes to the corporate governance literature by linking monitoring with firm value. The number of auditor firm relationships and the shareholding of the promoters in a company provide good quantifiable measures of the quality of this corporate governance mechanism. Third, from the policy perspective, the study identifies a ‘threshold’ shareholding level which prompts managers to increase internal monitoring.
The reminder of the article is structured as follows. Section 2 provides an overview of the relevant literature. The institutional considerations that affect Indian firms are highlighted in Section 3. The database and econometric methodology are presented in Section 4. Section 5 discusses the empirical results, followed by the policy conclusions.
2. RELATED LITERATURE
Jensen and Meckling (1976) contended that managerial ownership serves to align the interests of managers and outside equity holders such that a positive relationship is expected between managerial ownership and firm valuation. Stulz (1988) developed a model of firm valuation in which the entrenchment effect results in a negative relationship between managerial ownership and firm valuation at relatively high levels of managerial ownership. Other studies have also investigated the relationship between managerial ownership and firm value. For example, Morck et al. (1988) and McConnell and Servaes (1990) found that their empirical results supported both the positive alignment effect and the negative entrenchment effect.
The empirical models, however, do not account for the monitoring effects associated with external auditing. Studies for the US (Palmrose, 1988; Francis & Wilson, 1988; DeFond, 1992) document a lack of convincing evidence linking management ownership and leverage relevant in auditor choice. These results might stem from the fact that, given the wide spectrum of governance mechanisms available to alleviate agency conflicts, the relative importance of external auditors is quite limited. However, in emerging economies such as India, where conventional corporate control systems have begun to gain prominence only recently (Ghosh, 2006a), it seems likely that independent external auditors could potentially act as important monitors of controlling shareholders. More specifically, external monitoring such as those by auditors can serve to reduce the moral hazard problem associated with high managerial ownership. If this is true, then the major benefits derived from external auditing activity should be reflected in the higher capitalized value of the ownership claims on the corporation. Recent empirical evidence for East Asian economies (Fan & Wong, 2005) highlights the fact that external auditors played a monitoring and bonding role in order to mitigate the agency conflicts between controlling owners and outside investors.
Recent studies have attempted to construct a corporate governance index to evaluate its impact on firm performance. Using data on over 1500 large firms during the 1990s, Gompers et al. (2003) establish a strong relationship between corporate governance and firm performance. Following from this approach, Bauer et al. (2004) construct ‘good governance portfolios’ (or top 20% of the companies with highest corporate governance ratings) and ‘bad governance portfolios’ (or bottom 20% of the companies with lowest corporate governance ratings) using the Deminor corporate governance ratings for companies included in the FTSE Eurotop 300 index. The study uncovers a positive correlation between firm valuation (measured by Tobin's Q) and corporate governance scores.
Central to these studies has been to employ an index of governance, where auditing enters as one of the variables in the construction of the governance index. Explicitly exploring the impact of auditing on firm valuation or, for that matter, its interlinkage with managerial ownership is an aspect not adequately accounted for by any of the studies and this becomes a major concern of the article.
In order to formulate a coherent empirical framework, it is argued that external auditing, managerial ownership and Tobin's Q are jointly determined and, accordingly, is modelled within a three-equation system of equations. Chung and Jo (1996), for instance, find empirical support in favour of a two-way relationship between Tobin's Q and analyst coverage. Moyer et al. (1989), on the other hand, find analyst coverage to be negatively impacted by the percentage of insider ownership. Borrowing from these findings, it seems likely that external auditing, managerial ownership and firm valuation are simultaneously determined. The argument is represented in Figure 1. Judged thus, the present study expands on the extant literature by investigating the interaction among alternative monitoring agents and among monitoring agents and firm valuation.
3. THE INDIAN EXPERIENCE
3.1 Governance aspects
Governance issues were not an important consideration until the adoption of the economic reforms programme in India in 1991. With gradual integration with global markets and an increasing number of Indian corporations accessing global markets and being listed on overseas exchanges, public concerns have become more focused on the effective protection of investors' interests, the promotion of transparency of operations and the need to move towards international standards in terms of disclosure by the corporate sector.
There are presently three distinct, though mutually reinforcing, avenues through which the active (‘voice’) and passive (‘exit’) options of outside debt holders and equity holders in corporate governance are sought to be ensured. These include the Companies Act 1956, the Securities and Exchange Board of India Act 1992 and a market for corporate control.
The activities of Indian companies are regulated through the Companies Act 1956. Through the consolidation of several successive amendments, the Act has sought to ensure that the interests of shareholders and creditors are protected and that shareholder voice is adequately represented in the management of companies. The Act also lays down provisions for the constitution of boards of directors, their appointment, remuneration, frequency of board meetings as well as powers and restrictions of the board. Several amendments in the Act have occurred in the 1990s, with the most recent one coming through the Companies (Amendment) Act 2001.
Central to these amendments has been the move to revamp the Board of Directors to make them more responsive to the interests of shareholders, since the board is the focal point of the decision-making process. In India, company boards are typically single-tiered, comprising a Chairman and Managing Director (one person can hold both posts) and other board members, in either executive or non-executive capacity. Previously, there was no specification regarding the proportion of executive to non-executive members. The Companies Act simply provided broad guidelines on how the board should function.
A need was increasingly felt that some statutory governance codes be instituted in view of several malpractices (like insider trading) that inflicted losses on small investors and undermined investor interests in capital markets. Accordingly, several committees were appointed by the Securities and Exchange Board of India (SEBI) to examine this aspect in its totality. Following the recommendations of these committees, SEBImade certain mandatory provisions for listed companies through a listing agreement from 2002. Accordingly, it was stipulated that a half of board members should be non-executive directors. The Board of a company should set up a qualified and independent Audit Committee with a minimum of three non-executive Directors, with the majority being independent. It was also stipulated that at least one Director needed to be well-versed in financial and accounting knowledge.1 In addition, companies were directed to constitute different sub-committees like audit and remuneration committees and report the remuneration of the CEO as part of their corporate governance report.
The activities of the stock market are regulated by the Securities and Exchange Board of India (SEBI), whose functions are similar in scope to the Securities Exchange Commission in the US. The SEBI Act 1992 imparted SEBI with statutory powers to protect the interests of investors in securities and to promote the development of, and regulate, the securities market. Before the Act, all issues of capital by Indian companies were controlled by a government agency, the Controller of Capital Issues, which regulated both the terms as well as the pricing of the issue. Under the SEBI Act, companies have been given the freedom, subject to stringent disclosure requirements, to price their issues and raise funds to meet various types of business requirements. In order to ensure that promoters' interests are closely integrated with those of minority shareholders, SEBI guidelines also contain a stipulation as to minimum promoters' contribution and lock-in period.
The market for corporate control has been rather inactive in India. The first attempts at regulating takeovers were made by incorporating a clause (namely, Clause 40) to the listing agreement that provided for making a public offer to the shareholders of a company by any person who sought to acquire 25% or more of the voting rights of the company. Current regulations, by making the disclosure of substantial acquisitions mandatory, have sought to ensure that the equity of a firm does not covertly change hands between the acquirer and the promoters. At present, the acquisition of 15% of shares/voting rights triggers a minimum public offer of 20%. Further, promoter groups holding a stake not less than 10% are allowed to consolidate their position through the provision of ‘creeping’ takeover up to 5% of shares, without attracting the mandatory public offer requirement. However, takeover defence mechanisms as poison pills for incumbent management as prevalent in the US and UK are not permitted under current regulations.
While the alignment of managerial and shareholder interests is possible through higher shareholding by corporate insiders, expropriation of minority shareholders becomes an issue in cases where the control rights of insiders, particularly those of company promoters, are disproportionately more than their cash flow rights. This is an important feature of corporate ownership structure in India, as it is in many other countries, where family-owned business groups are prevalent (Claessens et al., 2000).
3.2 Accounting aspects
The enactment of the Indian Companies Act in 1857 for the first time introduced the concept of preparing company balance sheets on a voluntary basis. Following Independence in 1947, an Expert Committee was constituted to examine the scheme of an autonomous association of accountants in India, which led to the enactment of the Chartered Accountants Act (1949) and the establishment of the Institute of Chartered Accountants of India (ICAI) in the same year. The Chartered Accountants Act governs the accountancy profession in India. A broad revision of the legislative framework relating to the accountancy profession has been underway over the last couple of years, primarily in the wake of the accounting irregularities in the US. Towards this end, the Chartered Accountants (Amendment) Bill 2003 has been prepared which seeks to reconfigure the current regulatory regime and the disciplinary arrangements in relation to the accounting profession.2
The Companies Act 1956 governs the form and contents of balance sheet and profit and loss accounts of limited liability companies. The Act requires the preparation, presentation, publication and disclosure of financial statements; and an audit of all companies by a member-in-practice certified by the ICAI. Schedule VI of the Act prescribes the form, content and minimum disclosure requirements of financial statements. The Act has been amended several times, most recently in 1999. The amendment requires all companies to comply with (Indian) accounting standards, disclose any deviation, provide reasons for such deviation and state the impact of the deviation on the financial statements. Subsequent amendments, mostnotably in 2001 and 2002 included, among others, incorporation of directors' responsibility statements in the board's report to highlight the accountability of directors in good corporate governance, prescribe voting through postal ballot and delimiting the number of companies in which a person can hold directorship to ten from more than 20 previously.
Smaller firms dominate the Indian auditing marketplace, even though the Indian affiliates of large international firm networks audit approximately 47% of the top 100 listed companies.3 The ICAI reports that about 53,000 audit firms operate in India, including members/affiliates of most of the international networks of accounting firms. About 1,000 firms audit at least one economically significant enterprise; and about 15 of the largest firms audit more than 70% of the top 100 listed companies. Government-owned companies and unlisted companies are generally audited by small- and medium-sized firms apparently because of the unremunerative fee scales prescribed for these engagements.
In most cases, the regulator or the Office of the Comptroller and Auditor General of India (CAG) mandates joint auditors for state-owned enterprises. A panel of firms qualified to undertake audits of state-owned enterprises is updated annually. Allocation of audit work among these audit firms is based on a points system that gives credit based on information self-disclosed by the audit firms,4 which includes the number of partners in the firm, number of employees and trainees, experience of the firm and the term of association of the partners with the firm. The Board of Directors of state-owned enterprises determines the professional fee of the auditor on the basis of guidelines issued by CAG and subsequently approved by the shareholders of the company. The CAG conducts a supplementary/test audit of all such companies on a regular basis. The state-owned enterprises that are incorporated under specific acts have associated rules with respect to auditing. Depending upon the audit arrangements, as specified by these rules, the audit may be performed either by a state-appointed auditor (which may include the office of the CAG or its appointee) or a private sector auditor or a combination of both state and private auditors.
The members of the ICAI are required to follow a detailed code of ethics as prescribed under the Chartered Accountants Act. The ICAI council is entrusted with disciplinary powers that are exercised through its disciplinary committee. Some of the salient legal restrictions on auditors include: the name of any firm that intends to register for ICAI membership must have a combination of the names of the partners of a name in being (that is, a name in use before this rule was introduced);5 after 1995, the display of any association with any firm, domestic or international, was banned; the number of partners in an audit firm is limited to a maximum of 20; the Companies Act prohibits indebtedness of audit partner to audit clients in excess of Rs.1000 (≈US$22) which includes any arm's length transactions (for example, a credit card with a banking client); and, advertising and publicity is prohibited.
Mandatory audit firm rotation, after serving as auditor for four to five years, exists for government-owned companies. Audit partner rotation has never been mandatory, and hence is not widely followed across the profession. In considering auditor independence, the Government-appointed Committee (see note 2) recommended adoption of audit partner rotation. The ICAI has recently put forward a resolution that will make mandatory audit firm rotations and joint audits for all listed companies. A final decision on this aspect, which has been referred to a high-level committee for further deliberation, is awaited.
As regards ensuring compliance with auditing standards, the Department of Company Affairs, a wing of the Government under the Ministry of Industry, enforces regulatory norms and acts decisively against any non-compliance. The two primary stock exchanges, the Bombay and National Stock Exchanges, rely on external auditors to monitor compliance with the accounting and disclosure requirements. The corporate relations department of the stock exchanges pursues any qualification by the auditors with the company and requires corrections by the following year-end.
The ICAI has made a beginning as a self-regulator by introducing peer-review of audit firms. As part of the process, an 11-member Peer Review Board was established in March 2002.6 The Board provides guidance to enhance the quality of services provided by ICAI members.
In the light of these developments, the present study seeks to formulate a coherent empirical model to explore the association among external auditing, managerial monitoring and firm valuation. It is argued that external auditing, managerial ownership and firm valuation are jointly determined and, therefore, should be modelled within a three-equation system of equations. The results demonstrate the existence of a substitution monitoring effect between auditors and the managerial group. Additionally, the results indicate that the number of auditor relationships and firm performance are positively related, suggesting that external monitoring enhances firm performance.
4. DATA AND RESEARCH DESIGN
4.1 The database
The data employed for the study is cross-sectional information for the year 2005, extracted from the Prowess database (Release 2.4), generated and maintained by the Centre for Monitoring the Indian Economy (CMIE), a leading private think-tank in India.7 This database is broadly similar to the Compustat database of US firms and is increasingly employed in the literature for firm-level analysis of Indian industry for issues such as the effect of foreign ownership on the performance of Indian firms (Chibber & Majumdar, 1999) and the performance of firms affiliated to diversified business groups (Khanna & Palepu, 2000), the linkage between monetary policy and corporate governance (Ghosh & Sensarma, 2004) and the role of financial liberalization in alleviating financing constraints for firms (Ghosh, 2006b).
The data set contains financial information on around 8,000 companies, which are either listed on the stock exchanges as well as major unlisted public limited companies having sales exceeding Rs.200 million (≈US$4.2 million). Accordingly, the firms in the sample generally do not include the smallest firms due to the requirements for firms to be included in Prowess. Thus, in effect, the sample is skewed towards larger Indian firms. There is detailed information on the financial performance of these companies culled from their profit and loss accounts, balance sheets and stock price data. The database also includes information on the ownership type of the firm as well as the number of auditors with which a firm maintains relationships.8 Additionally, the database contains detailed information on the financial performance of these companies also culled from their profit and loss accounts and balance sheets.
The selection of the sample was guided by the availability of data. We proceeded in several stages for the selection of sample firms. In step one, we extracted information on all manufacturing firms for the year 2005 that are listed on the National Stock Exchange.9 This, in effect, provided us with aggregate information on 753 firms. We subsequently deleted a number of firms from the sample. First, we excluded firms which did not report any auditor relationship, reducing the sample to 719 firms. In stage two, we deleted 30 firms which did not provide information on their share prices. And finally, we deleted 12 firms which did not report their CEO ownership. The final sample, therefore, consisted of 677 manufacturing firms for the year 2005. Taken together, these firms accounted for nearly 65% of the market capitalization of all firms listed on the National Stock Exchange.
Table 1 provides a description of the relevant variables along with their mean and standard deviation. The percentage of managerial ownership in the sample firms averaged 46%. In other words, the level of CEO ownership was high among the listed companies as a whole, and thus, ownership and control rights were close among the companies. The average firm size was 2.56 and the average firm age was 1.41. These figures reveal that the firms are in operation for a certain period of time and a significant scale of operations had already been reached. The average number of auditor relationships was 1.11, suggesting that listed corporations tend to maintain multiple auditor relationships. Access to a wider choice of sources of finance for corporations, such as capital markets and external financing, creates a tendency for a transaction-based banker–customer relationship, which could impinge on the access to the information required by the bankers for financial assessment, and also on the ability of corporations to get an assured and appropriately priced financial package (Reddy, 2005). This might be an important factor behind the multiple auditor certification by corporations. The leverage ratio of corporations stood at 38%. The average adjusted Q for the full sample was 1.18, which indicatedthat most of the firms exhibited high growth opportunities. The return on assets was positive on average, with low variability, signifying that profitability levels were fairly synchronous for listed companies. The sample firms had a high proportion of tangible assets, and were therefore informationally less opaque. Finally, the average level of R&D was quite low, compared to an average of around 2–3% for developed countries, suggesting that R&D investment across listed companies is still quite limited.
Table 1. Firm-specific variables – description and summary statistics
Number of shares held by the Board of Directors/Total shares outstanding
Number of auditor firm relationships
Market value of equity plus book value of debt/Total asset
Natural logarithm of equity value, where equity value is measured as the stock price times the shares outstanding
Natural logarithm of total assets
Natural logarithm of number of years since the incorporation of the firm
Total debts/Total assets
Tangible assets (= Plant, property and equipment)/Total assets
Operating profit/Total assets
Expenditure on research and development/Total sales
Dividend payment/Net operating income
Numerical value equal to the number of subsidiaries
Current assets/Total assets
Dummy variable = 1, if a firm belongs to a business group, else zero
Dummy variable = 1, if a firm is Indian private-owned, else zero
Dummy variable = 1, if a firm is foreign-owned, else zero
Dummy variable = 1, if a firm is state-owned, else zero
4.2 Research Design
Following from the earlier discussion, the empirical framework comprises estimating the following simultaneous equation system:
We include dummies for firm ownership (OD) and industry groups (ID) in all equations, but do not report them in the regressions.10
In the first equation, termed the external monitoring equation, higher managerial ownership (internal monitoring) might necessitate higher or lower external auditing (external monitoring), the sign of which is left to be determined econometrically. On the other hand, following Bhattacharya and Chisea (1995), it is likely that firms with higher valuation will tend to maintain fewer auditor relationships in order to prevent information leakage, so that NA is likely to be negatively related to adjusted Q. Likewise, in (2), greater external monitoring (the number of auditors a firm has, NA) would influence internal monitoring, the sign of which is not clear a priori. Additionally, adjusted Q is also included as a determinant of managerial ownership: higher quality firms (proxied by higher adjusted Q) will inspire higher percentages of managerial ownership. Finally, in (3), higher managerial ownership is expected to impact firm valuation in a way consistent with the alignment and entrenchment effect of Jensen and Meckling (1976). In addition, we expect the number of external auditors to positively affect Q consistent with the argument that outside monitoring reduces agency costs. A tabular representation of the expected relationships among the endogenous variables is presented in Table 2.
Table 2. Endogenous variables and expected relationships
CEO → Auditors
Higher managerial ownership might necessitate higher or lower external auditing
CEO → Adjusted Q
Managerial ownership serves to align the interests of managers and outside equity holders such that a positive relationship is expected between managerial ownership and firm valuation
Auditors → CEO
Greater external monitoring (auditing) will influence internal monitoring
Auditors → Adjusted Q
Outside monitoring is likely to reduce agency costs and therefore positively impact firm valuation
Adjusted Q → Auditors
Firms with higher valuation will tend to exhibit higher or lower external monitoring by auditors
Adjusted Q → CEO
Higher quality firms will inspire higher percentages of managerial ownership
The control variables in (1) include size (LnAsset), age (LnAge), asset tangibility (Tangible), number of subsidiaries of the firm (Subsidiaries) and current asset ratio (Current). Larger and hence more visible firms would face less informational asymmetry, making it easier for them to gain access to equity markets (Rajan & Zingales, 1995). This would presumably imply better external auditing, although its impact on the number of auditors is not evident a priori. At the same time, as Demsetz and Lehn (1985) have argued, concentration is likely to be lower in larger firms: if owners are risk-averse, then increasing percentages of wealth are required to achieve the same percentage of firm ownership. Likewise, older firms, to the extent they are better known to outside investors, might face less severe adverse selection problems, and as a result, are less likely to resort to multiple auditor relationships. Likewise, firms with higher tangible asset are expected to be less informationally opaque, implying the possibility of such firms being associated with multiple auditors. We also include the number of subsidiaries (Subsidiaries) to capture the organizational complexity of firm operations (Craswell et al., 2002). Borrowing from the literature (Craswell et al., 2002; Fan & Wong, 2005), we include the firm's current asset ratio (Current). A low current ratio, indicative of liquidity problems, might lower the likelihood for auditors to be associated with such firms.
The second equation is labelled the managerial ownership equation. The control variables in this equation include LnMVE, LnAge, leverage, R&D and tangible assets. Size is expected to negatively impact managerial ownership because wealth constraints prevent managers from obtaining a large percentage of equity as a firm grows bigger. Leverage is also expected to be a negative determinant of managerial ownership because high-leveraged firms are more intensely exposed to market monitoring. Additionally, the inclusion of a dividend variable stems from the argument forwarded by Jensen et al. (1992) that insider ownership is a function of the amount of dividend.
In the third specification, the adjusted Q equation, the control variables are those already employed by Chung and Jo (1996). Specifically, they find the natural logarithm of total assets, R&D, profitability and leverage to be significant determinants of firm valuation.
5. RESULTS AND DISCUSSION
Table 3 sets out the results of the nonlinear 3SLS estimates for the simultaneous equation model defined by equations 1–3. Under the 3SLS procedure, a structural equation is defined as one of the equations specified in the system. Dependent variables have their usual interpretation as the left-hand side variable in an equation with an associated disturbance term. All dependent variables are explicitly endogenous to the system and as such are treated as correlated with the disturbances in the system's equations. All other variables in the system are typically treated as exogenous to the system and uncorrelated with the disturbances. The exogenous variables are taken to be instruments for the endogenous variables.
Table 3. 3SLS model of external auditing, managerial ownership and adjusted Q
Auditors (Model 1)
CEO (Model 2)
Adjusted Q (Model 3)
Robust standard errors in parentheses.
***, ** and *
indicate statistical significance at 1, 5 and 10%, respectively.
Model 1 in Table 3 provides the regression estimates of the external auditing equation. The level of managerial ownership (internal monitoring) is significantly nonlinearly related to the number of auditor relationships (external monitoring). More specifically, the negative estimate on the parameter CEO reveals the existence of a substitution monitoring effect between auditors and the managerial group. This effect, however, is increasingly retarded at higher percentages of managerial ownership, as the sign of the estimated CEO squared is positive. The inflection point in the relationship is 15.2%.11 This convex quadratic relationship between auditor monitoring and managerial monitoring suggests that an increase in managerial ownership will result in a less significant auditor monitoring while the percentage of managerial ownership is below 15.2%. Beyond this threshold, however, the number of auditor relationships is accompanied by a rise in the level of managerial ownership. The interpretation of this inflection point is that once the managerial ownership exceeds this threshold, the moral hazard resulting from managerial private benefits presumably rises, so that auditors need to increase their external monitoring to counter this moral hazard behaviour that is difficult for outsiders to monitor.
It is also observed that adjusted Q has a limited impact on the number of auditor relationships. In terms of the exogenous variables, firm size (LnMVE) carries a positive and significant parameter, suggesting that larger firms need to have manifold multiple auditor relationships to maintain their larger sources of demand. Finally, higher R&D has a negative effect on the number of auditors, suggesting that auditors are less likely to be associated with riskier and hence, R&D intensive firms.
Model 2 of the equation explores the factors influencing the percentage of managerial ownership. The results indicate that the number of auditor relationships is significantly negatively related to the percentage of managerial ownership which is consistent with the discussions regarding a substitution effect: increased external monitoring by auditors being accompanied by a simultaneous decrease on the part of managers to engage in internal monitoring. The point estimate on the parameter in relation to external auditor monitoring shows that a unit increase in monitoring per auditor results in a decline of 0.86 in managerial ownership. Consistent with earlier studies, adjusted Q is a positive and significant determinant of managerial ownership, suggesting that managers guided by self-interest tend to hold higher level of ownership capital in high-quality firms.
The other exogenous variables are characterized as follows. The coefficient on LnMVE is negative and statistically significant. In other words, wealth constraints prevent managers from obtaining a large percentage of equity as firm size increases. On the other hand, leverage is significantly negatively related to the percentage of managerial ownership, suggesting that firms with higher financial risk are less likely to be subject to internal monitoring than to external monitoring by auditors. Finally, the positive sign on the coefficient on age means that older firms may be regarded as having better reputations which provides managers with higher motivation to increase their ownership.
The final model explores the determinants of adjusted Q. The percentage of managerial ownership is a nonlinear function of firm value as measured by adjusted Q. The nonlinear function estimates an inflection point of 13.2%. In other words, an increase in managerial ownership will lead to higher firm performance right from the beginning (the alignment effect), but once CEO ownership exceeds the threshold level of 13.2%, the moral hazard resulting from private managerial benefits exceeds contribution of managers (the entrenchment effect), so that performance declines. The inflection point so obtained is close to that derived in the causal relationship from managerial ownership to auditor relationships.
In addition, the number of auditors is found to have a positive and significant impact on adjusted Q, after controlling for the effects of managerial ownership. This suggests that firms subject to multiple external auditing tend to exhibit higher valuation.
Among the exogenous variables, LnAsset is found to be related inversely to firm valuation, consistent with the fact that larger firms, having a more diversified asset composition, tend to retard market valuation (Lang & Stulz, 1994). Additionally, higher leverage is found to have a dampening effect on firm value, indicating that firms with higher risk tend to perform poorly. It is also observed that firms with higher tangible assets tend to exhibit higher valuation. Finally, R&D carries positive parameter estimates, consistent with earlier findings in the literature (Morck et al., 1988; McConnell & Servaes, 1990; Chung & Jo, 1996; Chen & Steiner, 2000).
5.2 Additional results
We re-estimated the equations for the sub-samples. Since the control variables are materially unaltered in sign and significance, Table 4 reports the estimated coefficients for the endogenous variables. The first two sub-samples comprise the top and bottom 25 percentile of the size distribution, respectively, where size is measured by LnAsset. The third and fourth sub-samples, on the other hand, comprise the top and bottom 25 percentile of the leverage distribution, where leverage is measured by Leverage. The findings arising from the analysis are summarized below.12
Table 4. 3SLS model of external auditing, managerial ownership and adjusted Q sub-sample results
Robust standard errors in parentheses.
***, ** and *
indicate statistical significance at 1, 5 and 10%, respectively.
At the top end of the asset distribution, the results are similar to those obtained for the entire sample: a substitution monitoring effect between CEO and auditors in the initial stages, followed by lower auditor monitoring beyond a threshold, computed to be 19.76%. The threshold level is higher than that obtained for the entire sample. In other words, the managerial stake in large firms is higher than that for the entire sample. In the third equation, increased CEO monitoring is observed to raise firm valuation, although the entrenchment effect (a negative relationship) gains prominence after a threshold. The results also indicate, after controlling for internal managerial monitoring, increased oversight by auditors has a salutary effect on firm valuation.
On the other hand, for the bottom 25% of firms by asset, the results indicate that adjusted Q has a negative impact on the number of auditors, suggesting that smaller firms with higher valuation will tend to maintain fewer auditor relationships, resulting in less external monitoring. Likewise, there is evidence of a substitution effect between external auditing and internal managerial monitoring. Finally, in the third equation, an increase in external auditing is found to improve firm performance, consistent with the argument that outside monitoring reduces agency costs.
Turning to the results by leverage, the results for the top 25% of firms are at variance with those obtained for the entire sample. More specifically, the results indicate the lack of any monitoring between auditors and managerial group. The results, in particular, suggest a two-way relationship between firm valuation and external auditors: on one hand, adjusted Q has a positive impact on the number of auditor relationships, on the other, firms with multiple auditors exhibit higher valuation.
On the other hand, for low-leveraged firms, the results are at variance with those obtained for the entire sample. More specifically, the positive and significant coefficient on the CEO parameter indicates the existence of a complementary monitoring effect between auditors and the managerial group. This effect, however, was found to decline as the percentage of CEO ownership increased, since the CEO squared term was positive. In other words, an increase in managerial ownership is accompanied by an increase in auditor relationship for a level of managerial ownership up to 4.73%. Beyond this threshold, the number of auditor relationships is accompanied by a decline in the level of managerial ownership, suggesting a lowering of moral hazard resulting from managerial private benefits beyond the threshold.
Summing up, the results obtained from the estimation of the simultaneous equation system lead to some interesting conclusions. First and more generally, external monitoring by auditors, managerial ownership and firm valuation are jointly determined, with each serving to reinforce the other. More specifically, the percentage of managerial ownership is a nonlinear determinant of the number of auditor relationships. Second, auditor monitoring is a positive determinant of managerial ownership, consistent with the existence of a substitution monitoring effect. This effect was evidenced primarily for large firms. Secondly, adjusted Q is a significant and positive determinant of managerial ownership, while managerial ownership is also a statistically significant determinant of adjusted Q, after controlling for external monitoring. Third, for low-leveraged firms, there is evidence of a complementary monitoring effect between auditors and managers.
6. CONCLUDING REMARKS
The study presents a nonlinear simultaneous equation model of external auditing, managerial oversight and firm valuation. After controlling for the effects of exogenous variables, the results reveal the existence of a substitution monitoring effect between auditors and the managerial group. In addition, the results indicate that increased external monitoring by auditors will simultaneously raise the incentive for managers to engage in internal monitoring. Also, firm valuation is found to be a significant determinant of managerial ownership.
The analysis leads to several interesting policy conclusions. First, the findings indicate that company value is low when promoters have a low stake in the company. Since control of such companies can still be in the promoters' hands because of the dispersed nature of shareholding, such companies need to be subjected to more vigilant external monitoring by auditors, for example, and to the discipline of an active market for corporate control. However, as the promoters' stake increases beyond a threshold, consistent with agency theory, there is a positive effect on company value.
Second, the analysis suggests that external monitoring can perform an important governance role. However, as has been much of the experience in Germany and Japan, external monitors in India have been perceived by and large to be extremely passive in corporate governance. With the envisaged revisions in the Companies Act, and the Chartered Accountants Act, which provide explicit emphasis on external auditing, it is expected that this aspect will become much more prominent.
There were several other recommendations made by the committees. Salient among these include: presence of the chairman of the Audit Committee at the Annual General Meeting to answer shareholder queries; the Company Secretary should act as the secretary to the Audit Committee; the Audit Committee should meet at least three times a year with a quorum of either two members or one-third of the members of the Audit Committee and granting the Audit Committee necessary powers to investigate any activity within its terms of reference, to seek information from any employee; to obtain outside legal or professional advice, and to secure attendance of outsiders if necessary. In addition, the recommendations also emphasized that the Audit Committee should discharge various roles, such as reviewing any change in accounting policies and practices; compliance with Accounting Standards; compliance with Stock Exchange and legal requirements concerning financial statements; the adequacy of internal control systems; the company's financial and risk management policies.
The Department of Company Affairs, an arm of the Government which enforces the Companies Act, appointed a Committee in August 2002 to examine issues such as auditor-firm relationship, certification of the financial statements by directors and setting up an independent regulator along the lines of the Public Company Accounting Oversight Board established under the Sarbanes-Oxley Act in the United States. The proposed Chartered Accountants (Amendment) Bill and Companies Act concept paper includes certain recommendations of the Committee.
Local affiliates of large international networks audit 11 out of the top 50 Indian companies and jointly audit six other companies in the top 50 with another medium-sized firm. They also audit 25 out of the top 51–100 companies and jointly audit five to ten other companies in that bracket with another medium-sized firm.
The audit firms have to provide the required information in a standard questionnaire, which is reviewed on a limited basis by the CAG.
Because of this 1988 regulation, two Indian affiliates of the Big 4 international network operate using their pre-1988 registered brand names. The other two did not have any firms registered with the ICAI before 1988 and hence use completely unconnected Indian member firm brand names. Also, all four firms and some of the other larger international networks have private limited companies registered in India that use the global brand and actively sell all the firms' services, other than those restricted from being provided by ICAI members. These private limited companies are not required to follow the strict code of ethics.
The Peer Review Board is made up of six ICAI members and five members from industry and government bodies and users of financial statements.
The Prowess database provides information on auditor-firm relationships only for a single point in time; it does not provide a cross-sectional and time series variation in the number of auditor-firm relationships. Updating of the information in Prowess takes the form of replacing the earlier database on the auditor-firm relationships figures with the revised information. As a consequence, the analysis is based on cross-sectional data.
Under the heading ‘Associates and subsidiary companies name’, Prowess provides information on the number of auditors with which a firm is associated listed in order of priority (primary auditor, second auditor, etc.).
The National Stock Exchange is the state-of-the-art exchange for listed corporations in India.
We consider eleven industry groups: Automobiles, Cement, Chemicals, Diversified, Electronics, Electrical Machinery and equipment, Food, Metal and metal products, Paper and plastic, Textiles and Others (which includes glass and ceramics, refined petroleum products and nuclear fuel, paper and printing, mining and quarrying, extraction of crude petroleum and natural gas, gems and jewellery, manufacture of coke and cosmetics).
The inflection point is computed as the derivative of number of auditor relationships with respect to managerial ownership. The other reported inflection points are computed in a similar manner.
Owing to missing data, the number of observations vary under each case of the sub-sample estimation.
Saibal Ghosh is working as an Officer in the Department of Economic Analysis and Policy, Reserve Bank of India, Mumbai. Prior to this, he was working with the Industrial Development Bank of India, a leading development bank in India.