Institutional Monitoring, Political Connections and Audit Fees: Evidence from Malaysian Firms

• Author: Ferdinand A. Gul,Yee‐Boon Foo,Chwee Ming Tee,Chee Ghee Teh
• Date: 01 July 2017
• Published date: 01 July 2017
• DOI: http://doi.org/10.1111/ijau.12086

Institutional Monitoring, Political Connections and Audit Fees: Evidence from

Malaysian Firms

Chwee Ming Tee,

1

Ferdinand A. Gul,

2

Yee-Boon Foo

1

and Chee Ghee Teh

1

1

School of Business, Monash University Malaysia

2

School of Business,Deakin University, Australia

This study employs data on Malaysian firms from 2003 to 2011 to show that ownership by institutional investors is

positively associated with audit fees, and this positive association is stronger for firms that are politically connected

to the Malaysian government. The results of this study are aligned with the theories that institutional investors

can play an effective monitoring role by demanding higher audit quality, particularly if their investee firms are

politically connected. Additional tests reveal that the main results are largely driven by foreign institutional

investors, while it is insignificant for local institutional investors. Therefore, our evidence suggests that institutional

investors, particularly foreign institutions, demand increased audit effort (proxied by audit fees) as a method to

monitor politically connected firms.

Key words: Institutional ownership, institutional domiciles, political connections, audit fees

1. INTRODUCTION

In recent years, institutional investors throughout the

world play an increasingly important role in the corporate

sector.The growing importance of institutionalinvestors is

reflectedin the fact that they now control a largeproportion

of global equity, particularly in emerging markets

(Khorana, Servaes & Tufano, 2005; Ferreira & Matos,

2008). The increase in institutional ownership in global

equity markets has been accompanied by a change in the

role of institutional investors from passive investors to

active investors (Gillan & Starks, 2000). As passive

investors, institutional investors adopt an exit policy

whenever a disagreement occurs with the management.

However, as active investors, institutional investors

actively engage in corporate management and influence

long-term policies of firms. In other words, institutional

investors play an important monitoring role. Prior studies

have reported that firms with a high percentage of

institutionalownership are associatedwith higher financial

reporting quality because institutional investors increase

the level of monitoring and scrutiny of firms’financial

reporting processes (Balsam, Bartov & Marquardt, 2002;

Chung, Firth & Kim,2002; Velury & Jenkins,2006; Cornett,

Marcus & Tehranian, 2008; Burns, Kedia & Lipson, 2010).

In this study, we examine the role of institutional

investors in the audit process in Malaysia, which is an

emerging economy.More specifically, we examine whether

institutional investors of Malaysian firms demand

increased audit efforts from auditors. As a result of this

increased demand, we expect a positive association

between institutional ownership and audit fees. We draw

on prior evidence which shows that strong corporate

boards, due to their monitoring activities, demand higher

audit effort to ensure thattheir clients’firms are less likely

to misreport financial information (Carcello et al.,2002;

Chung et al., 2002; Chung & Zhang, 2011). Similarly, we

argue that this additional monitoring by institutional

investorsincludes a demand for higher auditing effortfrom

the auditors to improve the quality of financial reporting.

In addition, given the strong institutional features

prevalent in Malaysia such as the existence of politically

connected firms, we also examine whether institutional

investors are likely to demand even higher audit effort for

firms that are politically connected. This is because the

political economy literature suggests that these connected

firms are associated with severe agency problems and

rent-seeking activities, which result in lower firm

performance and inefficient investments in comparison

with non-politically connected firms (Gul, 2006; Bliss, Gul

& Majid, 2011; Chenet al., 2011; Bliss & Gul, 2012). Finally,

becauseinstitutional investorscan either be local or foreign,

we explore whether the association between institutional

ownership, politically connectedfirms and audit fees differ

according to the domicile of the institutional investor.

We are motivated to examine the role of institutional

investors and political connections in Malaysia for the

following reasons. First, the capital markets in emerging

economies have experienced a drastic increase in

institutional ownership. This growth in institutional

ownership has provoked regulators to call upon

institutional investors to play an active monitoring role,

particularly after the sub-prime mortgage crisis in 2008

and 2009 (OECD, 2009).This initiative is even more crucial

for emergingmarkets which have weak legal protectionfor

shareholders. In countries with weak legal protection,

institutionalinvestors play an important role in improving

firm governanceand enhancing monitoring (Khoranaet al.,

2005). In particular, the Securities Commissionof Malaysia

has introduced the Malays ian Code of Governance for

Institutional Investors in 2011, which exhorts institutional

investors to ensure good corporate governance structure

and sustainabilityof the companies they invest in (MSWG,

2011). This code has been welcomed by certain

international institutional investors. For example, Saker

Nusseibeh, Chief Executive Officer of Hermes Fund

Managers, stated: “The Code of Governance for

Institutional Investors represents a milestone in the

evolution of corporate governance in Malaysia. Investors

continue to turn to emerging markets in their pursuit of

returns and by recognizing the leadership role played by

institutional investors in promoting good governance

practices in companies, Malaysia’s new code will ensure

Correspondence to: Chwee Ming Tee, School of Business, Monash

University Malaysia, Jalan Lagoon Selatan, 47500 Bandar Sunway,

Selangor, Malaysia. Email:tee.chwee.ming@monash.edu

International Journal of Auditing doi: 10.1111/ijau.12086

Int. J. Audit. 21:164–176 (2017)

©2017 John Wiley& Sons Ltd ISSN 1090-6738