CEO power and audit fees: Evidence from Malaysia

• DOI: http://doi.org/10.1111/ijau.12166
• Author: Chwee Ming Tee
• Published date: 01 November 2019
• Date: 01 November 2019

ORIGINAL ARTICLE

CEO power and audit fees: Evidence from Malaysia

Chwee Ming Tee

1,2

1

Faculty of Accountancy, Finance and

Business, Tunku Abdul Rahman University

College, Penang, Malaysia

2

School of Business, Accounting and Finance,

Monash University Malaysia Jalan Lagoon

Selatan, Sunway, Selangor, Malaysia

Correspondence

Chwee Ming Tee, Faculty of Accountancy,

Finance and Business, Tunku Abdul Rahman

University College, 77, Lorong Lembah Permai

Tiga, Tanjong Bungah, 11200 Penang,

Malaysia.

Email: teecm@tarc.edu.my

This study examines the association between chief executive officer (CEO) power and

audit fees, and whether this association is influenced by family ownership and political

connections. The results show that CEO power is associated with lower audit fees, con-

sistent with alignment incentive effect. However, this relationship is attenuated by

political connections and family ownership. Whereas the overall findings suggest that

audit fees are affected by CEO power, its association is largely influenced by key insti-

tutional settings in an emerging market setting.

KEYWORDS

audit fees, CEO power, family ownership, political connection

1|INTRODUCTION

The chief executive officer (CEO) power literature has recognized the

association between CEO power and various firm outcomes from the

perspectives of the incentive alignment or entrenchment effect. The

incentive alignment effect shows that a CEO will act in the owners'

best interests, provided their interests are properly aligned (Jensen &

Meckling, 1976). Yet, the risk of expropriating shareholders' wealth

is higher in firms with powerful and entrenched CEOs (Bebchuk, Fried,

& Walker, 2004). Meanwhile, auditing literature establishes that the

demand and supply for audit quality is driven by information asymme-

try and conflict of interest between managers (i.e., CEOs) and owners

(Ghosh & Tang, 2015; Srinidhi, He, & Firth, 2014). Audit effort will

determine the auditors' costs of gathering and validating financial

information, leading to the issuance of an audit opinion (Ho & Kang,

2013). Besides ensuring that financial statements are prepared in

accordance with accepted accounting standards, auditors also con-

sider the CEO's power (Chen, Gul, Veeraraghavan, & Zolotoy, 2015).

Focusing on these issues, this study examines the relation between

CEO power and audit fees in Malaysia. Further, this study investigates

the propensity for political connections and family ownership to exacer-

bate or attenuate the association between CEO power and audit fees.

Political connections and family ownership are chosen as moderating

variables, as both represent Malaysia's distinct institutional setting.

First, crony capitalism and the political patronage system is deeply

rooted in Malaysia. This system is facilitated by weak institutional struc-

tures (i.e., the judiciary and poor legal protection for minority share-

holders), further exacerbating the impact of political connections on

various firm outcomes (Gomez, 2002; Gomez & Jomo, 1999; Gomez,

Padmanabhan, & Norfaryan, 2017).

1

For these reasons, Malaysia ranks second in the recent crony capital-

ism survey (The Economist, 2016), and was named as one of the world's

top 10 kleptocratic states in 2017 (Asia Times, 2018). Second, capital

markets in Malaysia have a large family ownership (Claessens, Djankov,

Fan, & Lang, 2002; Fan & Wong, 2005; Tee, 2018). In this study's

dataset, 43.3% (unreported) of Bursa Malaysia (Malaysian Stock

Exchange) listed firms are in the hands of family ownership. This

exceeds the percentage of family ownership in the USA (35%; Anderson

& Reeb, 2003) and is similar to Europe (44.29%; Faccio & Lang, 2002)

and East Asia (43.60%; Faccio, Lang, & Young, 2001). Furthermore, prior

literature suggests that family ownership can either influence the

appointment of managers who are aligned to shareholders' interest

(Type 1) or be a source of severe agency problem to minority share-

holders (Type 2).

The novelty of this study can be seen in two ways. Whereas audit

effort and audit risk are established in the auditing literature as two

key determinants of audit fees, the influence of the CEO's power on

audit fees should not be ignored. More so because CEO power can

affect accruals quality, firm governance, and auditor choice, which in

turn affects audit risk, audit effort, and subsequently audit fees. This

study fills the research gap by examining whether CEO power (i.e.,

shareholding, tenure, and founder of the firm) is significantly associated

with audit fees. Further, the association between CEO power and audit

fees is argued to be motivated by either alignment or entrenchment

effect. Second, it considers the nation's key institutional settings (i.e.,

PCFs) and family ownership as moderating variables. In doing so, this

Received: 26 July 2018 Revised: 23 April 2019 Accepted: 7 May 2019

DOI: 10.1111/ijau.12166

Int J Audit. 2019;23:365–386. © 2019 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/ijau 365

study investigates whether political connections and family ownership

moderate the association between CEO power and audit fees. Auditors,

therefore, gain insights into the effects of key institutional settings on

audit risk and audit effort. They can then use this information to make

course corrections, particularly as Malaysia is plagued by weak institu-

tional structures and lower protection for minority shareholders

(Gomez, 2002; Gomez & Jomo, 1999).

2

This study employs CEO shareholding, tenure of the CEO, and foun-

der CEO status as proxies for CEO power. Next, listed firms are classi-

fied as (i) connected and nonconnected to top politicians in Malaysia,

and (ii) family owned and nonfamily owned. Based on a dataset from

2002 till 2015, this study identifies two main contributions to the liter-

ature. First, it contributes to the auditing literature in the sense that it is

the first study that explores the association between CEO power and

audit fees. Besides audit risk and audit effort as two key determinants

of audit fees, evidence suggests that CEO power (i.e., shareholding,ten-

ure, and founder CEO status) does influence audit risk and audit effort,

particularly through accruals quality, firm governance, and financial per-

formance. In the accounting and finance literature, the underlying ten-

sion of CEO power can either be viewed from the lens of incentive or

entrenchment effect. The result suggests that the alignment effect of

CEOs is stronger than their entrenchment effect, leading to lower audit

fees. This is corroborated by additional tests showing that higher CEO

power is associated with higher accruals quality, stronger firm gover-

nance, and higher financial performance. Therefore, it mitigates the

concern that CEOs may self‐select non‐Big 4 audit firms due to their

lower audit quality.

3

Furthermore, this study responds to calls for more

research to improve our understanding on the relationship between

CEO characteristics (i.e., CEO power) and audit fees (Hay, 2013; Hay,

Knechel, & Ling, 2008; Hay, Knechel, & Wong, 2006). Second, specific

key institutional settings, such as political connections and family own-

ership, can increase the firm's agency problems, resulting in higher audit

risks, audit effort, and audit fees. In the case of Malaysia, political con-

nections and family ownership attenuate the incentive effect of CEO

power on audit fees. Although Lin and Liu (2013) showed that higher

managerial shareholding is associated with lower audit fees, their study

did not incorporate key institutional settings that may result in different

firm outcomes. Moreover, Fan, Wei, and Xu (2011) argued that compar-

ing firm outcomes in emerging markets with those in advanced markets

would be misleading, if these critical institutional settings are ignored.

Thus, this gap is filled in this study.

The remainder of this paper is organized as follows. Sections 2 and 3

review the institutional background and the literature and hypotheses

development. Section 4 details the research methodology. The results

are reported and discussed in Section 5, and Section 6 concludes the

findings.

2|AUDITING, POLITICAL CONNECTIONS,

AND FAMILY OWNERSHIP

From 1957 to 1970, auditors were seen as colonial agents, influencing

and providing access to the Malaysian auditing market, particularly to

fulfill the needs of foreign investments and facilitate their continued

presence in Malaysia (Ali, Haniffa, & Hudaib., 2006).

4

In view of this,

the Malaysian Association of Certified Public Accountants was

established in 1958 as a private‐sector initiative to enhance the

accounting profession.

5

This was followed by the passing of the Com-

panies Act, 1965, and the Accountants Act, 1967. The former empha-

sized the need for auditors to be independent and granted full access

to all financial information, whereas the latter heralded the emergence

of the Malaysian Institute of Accountants as a local statutory body.

The Malaysian Institute of Accountants was given the task to regulate,

determine the qualification of its members, and maintain the register

of accountants. Although auditors are required to comply with profes-

sional auditing standards, certain institutional factors may impede the

auditor's ability to reduce audit risk when assessing client‐related risks.

The two key Malaysian institutional factors for the post‐1970 period

are discussed as follows.

First, the implementation of the affirmative New Economic Policy

(NEP) in 1970 ended Malaysia's experiment with the laissez‐faire

approach, as the NEP calls for active participation by the govern-

ment in the economy and capital markets (Bliss & Gul, 2012). Its

main objective was to reduce income disparity between various eth-

nic groups in Malaysia. In order to achieve a numerical quota of 30%

equity ownership for the Malay‐majority ethnic group, foreign com-

panies such as Sime Darby, Boustead, and Harrisons and Crosfield

were taken over by the state (Gomez, 2002; Gomez & Jomo,

1999). Meanwhile in 1975, the government introduced the Industrial

Coordination Act as a means to force Malaysian Chinese‐controlled

firms to offer equity ownership to the Malays (Ali et al., 2006). By

1980, the government controlled institutional financing, as it owned

77.4% of the local banking industry (Hui, 1988). Therefore, the post‐

1970 period witnessed the expansion of government bureaucracy

and companies, resulting in excessive interference in the capital mar-

kets. Not surprisingly, the Malaysian capital markets are dominated

by large government‐linked companies (GLCs) and privately con-

trolled companies that are closely connected to top politicians (Bliss

& Gul, 2012; Gomez, 2002; Gomez et al., 2017; Gomez & Jomo,

1999).

6

Since the government is the regulator (i.e., via the Securities

Commission and Bursa Malaysia) and also happens to be a share-

holder in some connected firms, one can expect massive conflicts

of interest between PCFs and the auditor. Allowing auditors to

report accounting irregularities in PCFs would have exposed the

deficiencies of the NEP, of which its objectives have to be achieved

regardless of the cause and consequence (Ali et al., 2006). Moreover,

Gul (2006) suggested that political connections can significantly

affect audit risk, audit effort, and fees charged by auditors in Malay-

sia. For instance, during the initial phase of the Asian currency crisis,

auditors charged PCFs higher audit fees due to concerns of material

misstatements, since the government may not be able to provide

financial assistance. However, PCFs incurred lower audit fees after

the imposition of capital controls in 1998, as such policies are per-

ceived by auditors to benefit these connected firms. The recent

1MDB financial scandal, which gained worldwide attention, only

serves to highlight the precarious auditor–PCF relationship. Despite

TEE

366