Founding family and auditor choice: Evidence from Taiwan

• DOI: http://doi.org/10.1111/corg.12226
• Date: 01 March 2018
• Author: Che‐Hung Lin,Hwa‐Hsien Hsu,Shou‐Min Tsao
• Published date: 01 March 2018

ORIGINAL ARTICLE

Founding family and auditor choice: Evidence from Taiwan

Hwa‐Hsien Hsu

1

|Che‐Hung Lin

2

|Shou‐Min Tsao

3

1

Durham University Business School, Durham

University, Mill Hill Lane, Durham DH1 3LB,

UK

2

CTBC Business School, No. 600, Sec. 3,

Taijiang Blvd., Annan District, Tainan City 709,

Taiwan

3

National Central University, No. 300,

Zhongda Rd., Zhongli District, Taoyuan City

32001, Taiwan

Correspondence

Che‐Hung Lin, CTBC Business School, No.600,

Sec. 3, Taijiang Blvd., Annan District, Tainan

City 709, Taiwan, R.O.C.

Email: s1525103@ctbc.edu.tw

Abstract

Manuscript Type: Empirical

Research Question/Issue: From an agency perspective, we investigate whether family

ownership and control configurations are systematically associated with a firm's choice of auditor.

Our analysis focuses on three different characteristics of family ownership and control: family

ownership (cash flow rights), disparity between cash flow and voting rights held by family owners

(cash–vote divergence), and the family identities of CEOs.

Research Findings/Insights: Our findings suggest that different family ownership and con-

trol configurations lead to different agency effects. The alignment effect prevails in family firms

with greater family ownership, founder CEOs, and professional CEOs, whereas the entrenchment

effect prevails when there is greater cash–vote divergence. Despite the presence of two distinct

types of agency effects, regardless of differences in family ownership and control configurations,

none of these firms is inclined to appoint higher‐quality auditors.

Theoretical/Academic Implications: This study advances our understanding of the varied

agency effects arising from family ownership, cash–vote divergence, and the family identities of

CEOs, as well as the impact of family ownership and control features on auditor choice. Our

empirical evidence provides a unique insight, showing that higher‐quality auditors do not tend

to be appointed in firms where family alignment with outside investors is relatively strong, as this

lowers demand for such auditors. In addition, although family entrenchment may create greater

outside investor demand for higher‐quality auditors, such demand is difficult to realize.

Practitioner/Policy Implications: Auditors are an important external governance mecha-

nism. This study offers insights for policymakers, family owners, auditors, and other capital mar-

ket participants, with regard to the varied effects of different family ownership and control

features on auditor choice.

KEYWORDS

Corporate Governance, Family Firm Governance, Auditor Choice,Ownership Structure, CEO

Family Identity

1|INTRODUCTION

Family firms are a distinct type of organizational structure. Unlike non‐

family firms, they are often characterized by concentrated family own-

ership and greater involvement by family members in the management.

However, it should be noted that family firms are not a homogeneous

group. Differences in family ownership and control features create

varied incentives for family owners and consequently influence the

agency environment within the firm (e.g., Anderson & Reeb, 2003;

Chen, Cheng, & Dai, 2013b; Wang, 2006). This in turn may influence

auditor choice, which is an important company decision relating to

financial reporting. It has been suggested that monitoring by higher‐

quality auditors can reduce insiders' incentives and ability to render

financial statements less informative, thereby alleviating the problem

of agency conflict between insiders and outsiders by mitigating infor-

mation asymmetry (e.g., Becker, DeFond, & Jiambalvo, 1998). How-

ever, to date, few studies have examined auditing issues in family

firms (Ho & Kang, 2013; Trotman & Trotman, 2010). This study adds

to the existing literature by investigating whether family ownership

and control configurations are systematically associated with a firm's

Received: 6 April 2015 Revised: 31 August 2017 Accepted: 1 September 2017

DOI: 10.1111/corg.12226

118 © 2017 John Wiley & Sons Ltd Corp Govern Int Rev. 2018;26:118–142.wileyonlinelibrary.com/journal/corg

choice of auditor. Our analysis focuses on three different features of

family ownership and control: founding family ownership (cash flow

rights), disparity between cash flow and voting rights held by family

owners (cash–vote divergence), and the family identities of CEOs.

From an agency perspective, appointing higher‐quality auditors

may be a double‐edged sword when aimed at controlling family

owners. A family firm's propensity to hire a higher‐quality auditor will

depend on how family owners view the importance of credible finan-

cial reporting in relation to their own interests. The presence of a

founding family significantly influences agency conflicts within a firm

in two opposing ways, referred to in the literature as the alignment

effect and the entrenchment effect. The alignment effect predicts

that when there are stronger economic and/or emotional bonds

between family owners and their firms, the controlling family owners

may introduce monitoring mechanisms that restrict managers' ability

to expropriate firms' resources at the expense of shareholders. In this

way, the controlling owners can enhance or preserve long‐term mon-

etary and non‐monetary gain for the founding family, and in the pro-

cess, mitigate agency conflicts between managers and shareholders

(Type I agency problem) (Jensen & Meckling, 1976). If such an align-

ment effect prevails, the controlling family owners are more willing

to hire higher‐quality auditors for better monitoring. On the other

hand, the entrenchment effect prevails when family owners are

empowered by their concentrated ownership. Tight family control

as a result of the concentrated shareholdings may allow opportunistic

family owners greater power and opportunity to divert corporate

resources for personal use. This can lead to severe conflicts of inter-

est between the controlling (family) shareholders and other share-

holders (Type II agency problem). To ensure that their private

interests can be realized, the controlling owners may be reluctant to

hire higher‐quality auditors, as such auditors would conduct strict

monitoring.

The alignment or entrenchment effect arising from the different

family ownership and control configurations is reflected in a family

firm's financial reporting practices (Ali, Chen, & Radhakrishnan, 2007;

Wang, 2006), which will influence outside investors' perceptions

regarding the importance of higher‐quality auditors to their own inter-

ests. When outside investors perceive their interests to be closely

aligned with the controlling family owners (i.e., less severe Type I

agency problem), demand for higher‐quality auditors is lower because

the monitoring benefits of hiring these auditors become less important.

In contrast, when outside investors perceive that the family owners are

entrenched (i.e., more severe Type II agency problem), demand for

credible accounting information for management oversight will be

greater, and thus demand for higher‐quality auditors will also be

greater.

Both family owners and outside investors operationally have a

voice in relation to auditing matters (Dao, Raghunandan, & Rama,

2012; Trotman & Trotman, 2010). We argue that a family firm's auditor

choice is a consequence of a tradeoff between the family owners'

intrinsic alignment or entrenchment incentive for supplying credible

accounting information, and the outside investors' corresponding

demand for such information. Therefore, in this study we test the net

effect of this tradeoff in different family ownership and control

scenarios.

Taiwan is an ideal setting in which to study auditorchoice in family

firms, because of the predominance of family‐controlled firms with

highly concentrated family member ownership (Claessens, Djankov, &

Lang, 2000; Fan, Wei, & Xu, 2011). Family owners often possess

excessive control rights beyond cash flow rights (Yeh, 2005) and dom-

inate the top executive positions in the firms (Claessens, Djankov, Fan,

& Lang, 2002). In addition, Taiwan is also characterized by weaker pro-

tection for shareholders and inferior corporate governance mecha-

nisms (Chen, Gray, & Nowland, 2013a; Claessens et al., 2000; La

Porta, Lopez‐de‐Silanes, Shleifer, & Vishny, 2000).

1

In such an environ-

ment, with weaker shareholder protection mechanisms, the natural

effects of family ownership and control configurations are more easily

observable.

Two legal features underpin the governance role of auditors in

Taiwan. One is that audit firms are required to operate within

unlimited liability partnerships or proprietorships (Chen, Lin, & Lin,

2008).

2

The other is that governmental regulations require that the

audit reports for public companies be certified by two audit partners

from the same audit firm, and that these partners' names be disclosed

in the audit reports (Chen, Lin, & Zhou, 2005; Chi & Chin, 2011). These

requirements mean that auditors face higher legal and reputational

liability in Taiwan, which strengthens the incentive to fulfill their

professional duties. The importance of the monitoring function played

by auditors is also heightened by the absence of other effective

governance mechanisms for investor protection in Taiwan.

This study uses the Big N auditors

3

as a proxy for auditor quality.

Research to date reveals that the Big N auditors provide better audit

quality than non‐Big N auditors because of their scale, technical exper-

tise, and reputational incentives to identify and expose accounting

irregularities (e.g., Barton, 2005; Choi & Wong, 2007; Fan & Wong,

2005; Francis, 2004). Our findings suggest that different family owner-

ship and control configurations lead to different agency effects in the

firms. The alignment effect prevails in family firms with greater family

ownership, founder CEOs, and professional CEOs, whereas the

entrenchment effect prevails when there is greater cash–vote diver-

gence. Despite the occurrence of two distinct types of agency effects

in firms with different family ownership and control configurations, all

the firms have a disinclination to appoint Big N auditors. The

1

See the detailed discussion in Section 2.1.

2

Unlike in Taiwan, audit firms in other countries (e.g., the United States or the

United Kingdom) can be formed as entities with limited liability. Individual part-

ners in audit firms with unlimited liability face higher levels of potential liability

than those in firms with limited liability. Prior research has demonstrated that

audit quality is higher when auditors have unlimited liability than when they

have limited liability (Dye, 1995).

3

The “Big N auditors”refers to the Big 4 or the Big 5 auditors. Before June 1,

2003, Taiwan's top‐tier audit firms were the Big 5, namely T.N. Soong & Co.

(an affiliate of Arthur Andersen), PricewaterhouseCoopers, KPMG, Deloitte

and Touche, and Ernst & Young. Following the Enron scandal and Andersen's

consequent ceasing of operations on August 31, 2002, T.N. Soong & Co. merged

with Deloitte and Touche on June 1, 2003. The clients of T.N. Soong were also

transferred to Deloitte and Touche. Consequently, after June 1, 2003, Taiwan's

top‐tier audit firms became the Big 4, namely PricewaterhouseCoopers, KPMG,

Deloitte and Touche, and Ernst & Young. Accordingly, before 2003, our measure

of auditor quality (AUDITOR) measures top‐tier designation according to

whether the auditor belongs to one of the Big 5 audit firms. After 2003, AUDI-

TOR measures auditor quality according to whether the auditor belongs to one

of the Big 4 audit firms.

HSU ET AL.119