Accepted by Peter Clarkson. I would like to thank Peter Clarkson (associate editor) and two anonymous referees for their helpful comments and suggestions. This paper also benefited from comments by Jong-Hag Choi, Gilles Hilary, Chul Park, Don Stokes, Steve Taylor, Peter Wells, Yi Lin Wu, and workshop participants at Hong Kong University of Science and Technology, Chinese University of Hong Kong, University of Technology, Sydney, University of New South Wales, and the International Symposium of Auditing Research (2003). I gratefully acknowledge financial assistance from Hong Kong University of Science and Technology (DAG 02/03.BM06).
Management Ownership and Audit Firm Size*
Version of Record online: 15 JAN 2010
2005 Canadian Academic Accounting Association
Contemporary Accounting Research
Volume 22, Issue 1, pages 205–227, Spring 2005
How to Cite
LENNOX, C. (2005), Management Ownership and Audit Firm Size. Contemporary Accounting Research, 22: 205–227. doi: 10.1506/K2CG-U6V0-NPTC-EQBK
- Issue online: 15 JAN 2010
- Version of Record online: 15 JAN 2010
- Agency theory;
- Audit firm size;
- Management ownership
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 on accounting numbers prepared by management. Because 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. 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 higher in unlisted companies because they are less vulnerable to takeover and they are required to disclose much less nonaccounting information to shareholders. Second, unlisted companies have greater variation in management ownership, which permits more powerful tests of the demand for auditing as ownership varies between 0 percent and 100 percent. 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 nonlinearity is consistent with the finance literature and with the predictions of agency theory.