Paul Pronobis and Jonas Schaeuble analyse why the interconnected nature of global finance affects the auditing of EU-listed firms and their wider governance
The free flow of capital across the globe is financing an increasing number of EU firms – and with geographically distant ownership come issues of control. So to improve management monitoring, foreign owners tend to resort to auditing, and in the process, shape the governance of the companies they invest in. To shed light on these mechanisms, we recently undertook a study of audit fees across Western Europe with a view to how they impact corporate governance in the EU.
From wealthy Chinese purchasing French vineyards, to Silicon Valley tech giants installing data centres in Ireland, or US hedge funds taking a stake in German company Deutsche Boerse, examples of foreign investment in Europe are prevalent. Indeed, despite the growing importance of emerging economies as hosts to foreign-owned firms, the EU is the largest recipient of foreign capital worldwide. To give an order of magnitude, according to the European Commission foreign direct investment stocks held by third-country investors in the EU amounted to €7.138bn at the end of 2019.
Due primarily to the liberalisation of many capital markets, foreign ownership has therefore become an increasingly important source of financing for EU companies. Nevertheless, its implications for the audit market are still largely unexplored. This led us to carry out our new research published in The European Accounting Review, which reveals this phenomenon has direct implications for the audit market, specifically, for audit fees. This in turn offers insights into the mechanisms that lead to changes in corporate governance across the world. The link between foreign ownership and auditing may not be instantly obvious, but it is explained by the agency problems that come with foreign ownership.
Auditing to improve control of assets
According to Agency Theory, potential opportunistic behaviour by a firm’s management is a main concern of the firm’s owners. Here, an external auditor serves as an appropriate instrument to mitigate such information asymmetries and the corresponding agency problems. Although the threat of opportunistic behaviour by the management and the related need for effective control of it by the owner is innate to all firms, both aspects are likely more pronounced in foreign-owned firms. While the geographical (and cultural) distance between say, the Silicon Valley and the suburbs of Dublin, is not comparable to that between London and 19th-century trading outposts along the Congo River for example, it does represent a disadvantage for foreign owners: they are hindered in terms of information gathering and management monitoring compared to their domestic peers. So it can be expected that they will be particularly reliant on auditing in order to increase the reliability of the firm’s financial numbers.
High-quality auditing more likely with foreign ownership
We explored the relationship between foreign ownership and auditing through empirical tests based on an international sample of more than 1,700 listed firms and corresponding financial, audit and ownership information from twelve Western European countries between 2005 and 2016 (for a total of 17,727 firm-year observations). We indeed found that foreign ownership is significantly correlated with audit fees. Why examine fees? The objective of foreign owners is to reduce the (heightened) information asymmetry through higher audit quality. The auditor needs to understand the business, have relevant work experience (e.g., be authorities in their field/industry), have international presence, among other things, hence will command higher audit fees. This also explains another one of our findings, namely that foreign owners are more likely to employ the best-known international auditing firms, professional services networks (they also offer assurance, taxation, management consulting, actuarial, corporate finance, and legal services) collectively known as the BIG4: KPMG, PwC, Deloitte and Ernst & Young. Based on their reputation for quality work, these auditors tend to charge high fees.
Premium auditing as an investor protection mechanism
In our paper, we also predict – and confirm – a greater willingness of foreign owners to pay higher audit fees for the statutory audit if the foreign owner is located in a country with a high quality of governance and investor protection. We define foreign investors from countries with a high quality of governance and investor protection as those for which the average of the four indicators – rule of law, control of corruption, government effectiveness, and regulatory quality – from the Worldwide Governance Indicators (WGI) is above the median for their home country. The origin of the foreign owners does play an important role with respect to the demand for audit services, as foreign owners from countries with strong investor protection internalise and promote the importance of auditing as an effective control mechanism from their “home-country”. As foreign investors need to protect their home-country investors, they encourage the firms that they invest in to implement the same corporate governance practices that they themselves are subject to in their home country. In other words, auditor selection and thus audit pricing are a mechanism through which foreign investors shape the firm’s governance.
In addition, we found that auditor selection is a mechanism through which foreign investors shape financial reporting comparability. As large audit firms use a highly-standardised audit model to ensure audit quality, foreign investors try to induce their target firms to switch to BIG4 auditors. These highly-standardised auditing models ensure audit quality through extensive auditing procedures and generally increase the cost of an audit.
Concentrated ownership behind increased demand for audit services
Our third finding concerns the reinforcing effect of higher levels of foreign ownership. When the percentage of ownership held by the foreign investor increases, and thus becomes more highly concentrated, the ability of the foreign investor to influence corporate governance decisions, such as the firm’s demand for audit services, increases. In contrast, when ownership becomes more highly dispersed, it is more difficult for the foreign investor to constrain managerial actions that are inconsistent with her interest. Accordingly, we found that the price of an audit increases with the percentage of foreign ownership.
In conclusion, these results shed light on the underlying mechanisms through which foreign ownership influences investee firms’ governance, particularly audit contracting decisions. While previous studies had documented that international portfolio investment encouraged effective monitoring practices around the world, this new study extends these findings by showing that those practices also require more extensive auditing procedures. It also establishes the quality of governance and investor protection of the foreign investor’s home country as an important factor to affect the design and effectiveness of the firm’s implemented governance system. These findings also suggest that corporate governance practices, in terms of auditing, travel around the world through foreign owners’ cross-border portfolio of investments.
About the authors
Professor Paul Pronobis (left) works at ESCP Business School, while professor Jonas Schaeuble works at Hochschule Magdeburg-Stendal in Germany.