Business Group Affiliation, Board Quality and Audit Pricing Behavior: Evidence from Indian Companies

• Author: Mohammad Muttakin,Arifur Khan,Nava Subramaniam,Shireenjit K. Johl
• DOI: http://doi.org/10.1111/ijau.12061
• Date: 01 July 2016
• Published date: 01 July 2016

Business Group Affiliation, Board Quality and Audit Pricing Behavior: Evidence

from Indian Companies

Shireenjit K. Johl,

1

Arifur Khan,

1

Nava Subramaniam

2

and Mohammad Muttakin

1

1

Department of Accounting, Deakin Business School, Deakin University

2

School of Accounting, College of Business, RMITUniversity

This study examines the relationships among business group affiliation, board quality and audit fees in an emerging

market setting. Using data from Indian firms listed on the Bombay Stock Exchange (BSE) over a nine-year period

(2004–2012), our results indicate that firms affiliated with a business group pay higher audit fees than those without

such affiliations. We also find that group-affiliated firms with higher-quality boards pay relatively higher audit fees

compared to other counterparts. Further, our findings suggest that group-affiliated firms pay lower fee premiums

when an audit is undertaken by a Big 4 firm or its affiliates, which implies that economies of scale may be a potential

competitiveadvantage held by larger auditors.The results of the study have implications for the managementof audit

fees by group-affiliated firms through board structure and processes.

Key words: Business groups, board quality, audit fee pricing, Indian audit market

1. INTRODUCTION

Business groups form a significant share of the private

sector in emerging economies (La P orta, Lopez-de-Silanes

& Shleifer, 1999). Typically, a business group is controlled

by one or more families or individuals with social ties

within all affiliated firms, either directly and/or through

cross-holdings (Khanna & Rivkin, 2001).

1

Leff’s (1976,

1978) early studies propose that business groups play a

critical role in emerging capital markets as a means to

address institutional voids and market imperfections.

Empirical evidence, on one hand, suggests that group

affiliationcan lead to positive firmoutcomes such as higher

operating efficiency (Hamelin, 2011), greater knowledge

spillovers (Hsieh, Yeh & Chen, 2010), wider business risk

sharing and diversification (Khanna & Yafeh, 2005), and

greater access to larger market networks and investment

funds (Gopalan, Nanda & Seru, 2007; Shi, 2015). On the

other hand, group affiliation may be beneficial only for

those in large, diversified groups (Chu, 2004), and such

affiliation may also entail negative consequences, for

example, poor profit redistribution among group

members, high levels of corporate control at the expense

of minority shareholders (George & Kabir, 2008), and

tunneling behavior by more dominant owners within a

group (Chang & Hong, 2000; Bertrand, Mehta &

Mullainathan, 2002). The findings from these studies

suggest that business complexity and risks may

significantlyvary between group-affiliatedand standalone

firms, and therefore further research in this area allows us

to gain additional insights into the systematic differences,

if any, in the costsof firm-level governance mechanisms.

In this study, we focus on the costs of one such

governance mechanism, namely, the audit fees of firms.

Our literature review indicates that despite the

development of a vast body of research (Hay, Knechel &

Wong, 2006; Hay, 2013) that identifies a string of variables

connected with client firm features –for example, size,

complexity, profitability, industry and risk profiles –as

determinants of audit fees, there is negligible evidence on

the association between business group affiliation and

audit fees. Such evidence is particularly critical in an

emerging economy context, where business groups are

widespread and institutional voids are prevalent (Khanna

& Yafeh, 2005). Moreover, the development of the

accountingand auditing professionin emerging economies

has also been slow (Chamisa, 2000; Desai et al., 2012), and

evidence on audit firm behavior, such as audit pricing, in

such economies remains scant (Hay, 2013). Nevertheless,

the general lack of regulatory oversight in developing

markets makesit important to have a more comprehensive

understanding of the cost impacts of related governance

mechanisms such as board quality on audit fees, which

have consequences for firm monitoring and governance

outcomes (Ahmed & Goyal, 2005).

Our study addressesthe following key research issuesin

the contextof India: ‘whether affiliationto a business group

is significantlyassociated with audit fees’and ‘whether the

governing board features of the client firm and size of the

audit firm have any impactson such an association’.There

are severalmotivations for our study.Business groups form

a major part of the Indian corporate landscape, one of the

largest economies in the world, where the top ten groups

alone account for approximately 32 percent and all groups

together account for approximately 67 percent of the total

Bombay Stock Exchange(BSE) market capitalization (Basu

& Sen, 2015). Moreover, although a concentrated body of

researchon Indian business groups hasdeveloped in recent

years (Khanna & Palepu, 2000; Khanna & Rivkin, 2001;

Gopalan et al., 2007; Manos, Murinde & Green, 2007;

Chakrabarti, Megginson & Yadav, 2008), the link between

group affiliation and audit fees remains largely

unexplored.

2

While thereis some evidence based on Indian

firm data that more independent and diligent governing

boards are associated with lower earnings management

(Sarkar, Sarkar & Sen, 2008) and that external monitoring

has a positive impact on firm value (Ghosh, 2007),

empirical evidence regarding the effects of corporate

governance quality on audit pricing behavior, particularly

from a business group perspective, is negligible.

We utilize 15,412 firm-year observations of Indian firms

listed on the BSE over a nine-year period (2004–2012) and

find that firms affiliated to a business group pay higher

audit fees than those with no such affiliations. This is

consistent with the notion that the more complex nature

Correspondenceto: Shireenjit K. Johl, Department of Accounting, Deakin

Business School, Deakin University, 70 Elgar Road, Burwood, Victoria

3125, Australia.Email: shireenjit.johl@deakin.edu.au

International Journal of Auditing doi: 10.1111/ijau.12061

Int. J. Audit. 20:133–148 (2016)

©2016 John Wiley& Sons Ltd ISSN 1090-6738

and the higher business risks associated with business

groups (e.g., tunneling behaviors) may elevate audit risks,

as reflected through relatively higher fee premiums for

affiliated clients. We also document that group-affiliated

firms with higher-quality boards incur significantly higher

audit fees compared to those without such features,

signaling that better quality boards may demand their

auditors undertake more rigorous audit work due to

complexities and risks involved in group-affiliated firms.

Finally, our investigation of the effects of Big 4 firms and

their affiliates on the association between group-affiliated

client firmsand audit fees reveals that the useof Big 4 firms

and their affiliates results in lower audit fee premiums.

3

One explanation for this finding is that Big 4 audit firms

are connected with the support structure offered by the

global audit firm network and thus are likely to be better

placed to serve audit clients with complex arrangements

more cost efficiently (Desai et al., 2012). In particular, as

the audit professionis still maturing in developing nations,

smaller local firms may not be in the same position as the

Big 4 to reap the benefits of economies of scale.

The findings of our study contribute to the literature in

several ways. We add to an expanding body of literature

on the governance of business groups in India indicating

that business affiliation comes with higher monitoring

costs, i.e., audit fees (Khanna & Palepu, 2000; Gopalan

et al., 2007; Manos et al., 2007; Lamin, 2013). This finding

provides a morerefined understandingof the audit pricing

of group-affiliated firms in India and adds to Ghosh’s

(2011) study, which does not take into consideration the

effects of audit firm sizeon the group affiliation–audit fees

nexus. In doing so, this study also responds to the calls for

better understanding of audit pricing behaviors in

emerging economies (Hay, 2013). Prior studies argue that

country-specific, idiosyncratic factors such as the

regulatory environment, regional politics, economic

development, etc., can have a significant impact on audit

fees (see, e.g., Karim & Moizer, 1996; Gul, 1999; DeFond,

Francis & Wong, 2000; Johl, Subramaniam & Zain, 2012;

Liu & Subramaniam, 2013). Our findings reveal that in

India, affiliation to a business group has significant

associations with audit pricing.

4

The results of this study

also impose some qualifications over prior research findings

on the impact of board attributes on audit costs (Cohen &

Hanno, 2000; Carcello et al., 2002) by revealing that better

quality boards in group-affiliated firms are more likely to

receive a fee discount compared to such firms with poorer

board quality. Finally, while much of the extant literature

proposes that the Big 4 tend to earn a fee premium

(Palmrose, 1986; Hay, 2013), the present study finds that

Big 4 premiums tend to be lower for business-group-

affiliated clients. Some potential explanations relate to the

presenceof informational advantages or economies of scale

benefits on which the Big 4 are able to draw, leading to

lower audit risk or efforts vis-à-vis group-affiliated clients.

This paper proceedsas follows. The next section presents

the institutional background. Section 3 discusses the prior

literature, which is followed by hypothesis development

in Section 4. Sections 5 and 6 describe the research design

and main results including the results of the robustness

tests, respectively. Section 7 concludes the paper.

2. INSTITUTIONAL BACKGROUND

The emergence of business groups in India could be

attributed to policy distortion as well as to institutional

voids that date back to the early post-independence era

(Kedia, Mukherjee & Lahiri, 2007). India gained its

independence from British rule in 1947 and subsequently

opted for a socialist governance structure with most of its

industries and enterprises controlled by the state. It

imposed severe regulatory and bureaucratic hindrances

on corporate growth, often through the creation of policy

instruments that were excessively restrictive for private

businesses. Firms had to seek a host of regulatory

clearancesbefore they could begin a new operation or even

increase production capacity (Lensink, van der Molen &

Gangopadhyay, 2003). Consequently, with a conspicuous

absence of institutions needed for the efficient functioning

of product, labor, and capital markets, many early Indian

firms were pressured to develop business networks or

groups (Singh & Gaur, 2009), which facilitated drawing on

internal markets for capital, products, and labor (Gopalan

et al., 2007). Despite the significant economic liberalization

initiatives, for example, the dis-establishment of public

monopolies and freeing of financial markets (Gautam &

Singh, 2010), resulting from the 1991 national economic

crisis and the IMF’s interventions, group networking

continues topredominate over corporate culture.

Business groups in India are typically highly diversified

collections of legally independent firms with high family

ownership and clustered in several industries. The

companies affiliated to a business group are often linked

through cross-holdings of equity and interlocking

directorates and usually emphasize a common identity.

Chakrabarti et al. (2008) argue that such group structures

are a critical concern for corporate governance in India

and notes that concentrated structures provide owners

with ‘both the temptation and the means to expl oit the

minority or non-family holders’(p. 59). Furthermore, in

family-owned firms, it is very typical for ownership and

management not to be segregated, leading to informality

in governance policies and inadequate controls (Standard

&Poor’s, 2009), which in turn increases perceived inherent

risks. However, business affiliations are still likely to be

favored in Indiafor reasons other than common ownership

through historical or family roots. Gopalan et al.’s (2007)

investigationsof the internal capital marketof firms within

Indian businessgroups reveal that solvent businessgroups

tend to support their member firms and reduce their

bankruptcy probability. The authors further argue that

such support not only provides access to capital via

internal sources but also helps acquire external capital in

an emerging market where creditor protection is poor.

The accounting and auditing profession market in India

is rather unique. The Institute of Chartered Accountantsof

India (ICAI) is the main professional accounting body in

India responsible for setting national auditing and

assurance standards. Members of the ICAI are eligible to

practice and verify accounts prepared by both private and

public limited companies. The Big 4 firms in India began

to grow in the Indian market only after 1991 (Desai et al.,

2012). For many years post-independence, multinational

accounting firms were not allowed to be registered as

auditors in India. Huber (2011), based on an international

analysis of audit firm concentration levels, reports that

the Big 4 audit firms’share in India was 41 percent

compared with that in other emerging countries such as

Brazil (79 percent), China (14 percent), and Russia (52

percent) in 2010. The audit market in India has been

serviced predominantly by local firms, but in the last

couple of decades, local audit firms have begun to partner

134 S. K. Johl et al.

©2016 John Wiley & Sons Ltd Int. J. Audit. 20:133–148 (2016)