Organizational Complexity and Auditor Quality

• Author: Shu‐Miao Lai,Chih‐Liang Liu
• Published date: 01 July 2012
• DOI: http://doi.org/10.1111/j.1467-8683.2012.00914.x
• Date: 01 July 2012

Organizational Complexity and Auditor Quality

Chih-Liang Liu and Shu-Miao Lai*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study investigates two questions: (1) What is the relationship between organizational

complexity and auditor choice, and (2) Does auditor choice inf‌luence the relationship between organizational complexity

and f‌irm value?

Research Findings/Insights: Examination of a sample of large public US companies reveals a positive association between

auditor qualityand various proxies for organizationalcomplexity. Wealso f‌ind a positive association between organizational

complexity and f‌irm value when the complex f‌irm hires Big N auditors. The results are robust to alternative measures of

auditor quality and f‌irm value and to controls for the regulatory environment.

Theoretical/Academic Implications: The results extend the agency theory argument that agency costs resulting from

information asymmetry between managersand investors affect the demand for external monitoring by auditors, specif‌ically

the demand by organizationally complex f‌irms for higher quality audits. We also shed light on how the value enhancement

of a complex organization depends on auditor quality.

Practitioner/Policy Implications: Our f‌indings offer new perspectives for managers of complex f‌irms that are industrially

or geographically diversif‌ied. They can use the retention of a larger auditor as a credible signal that their consolidated

reports are more informative about their f‌inancial performance. Further, the f‌indings provide new insight into the value that

investors place on auditor quality when they assess the value of f‌irms with complex organizational structures.

Keywords: Corporate Governance, Auditor Quality, Information Asymmetry, Organizational Complexity

INTRODUCTION

US f‌irms have substantially expanded operations in the

past decade, whether across industries (industrial

diversif‌ication), across different geographic areas (geo-

graphical diversif‌ication), or both. Montgomery (1994)

reports that in 1992 two-thirds of Fortune 500 US public

companies were involved in more than one industry. These

organizationally complex f‌irms accounted for nearly 50

percent of US employment and represented about 60

percent of the total assets of publicly traded companies

(Martin & Sayrak, 2003).

Organizational complexity limits transparency of a f‌irm’s

operations and information to investors, which leads to sub-

stantial information asymmetries between complex f‌irms

and outside investors. For example, industrially diversif‌ied

f‌irms are required to report only limited accounting infor-

mation for their business segments. Investors can observe

the aggregate cash f‌lows of the diversif‌ied f‌irms but not the

individual divisional cash f‌lows (Gilson, Healy, Noe, &

Palepu, 2001; Krishnaswami & Subramaniam, 1999). Alter-

natively, information complexities arise due to geographic

dispersion, high auditing costs, differing legal systems, and

cultural and languagedifferences (Bushman, Chen, Engel, &

Smith, 2004; Denis, Denis, & Yost, 2002; Duru & Reeb, 2002).

Thus, diversif‌ied f‌irms have lower analysts’ forecast accu-

racy (Duru & Reeb, 2002; Gilson et al., 2001) and poorer

earnings quality (Demirkan, Radhakrishnan, & Urcan, 2011),

and trade at a discount value (e.g., Berger & Ofek, 1995; Lang

& Stulz, 1994).

Agency theory indicates a link between audit quality

and information asymmetry reduction (for a review, see

Dechow, Ge, & Schrand, 2010). Empirical studies also

suggest that auditing can play a role in mitigating informa-

tion asymmetry by improving the qualityof f‌inancial report-

ing so far (Datar, Feltham, & Hughes, 1991; DeFond, 1992;

Firth & Smith, 1992; Francis & Wilson, 1988; Titman &

Trueman, 1986). However, we have limited evidence on the

association between organizational complexity and auditor

quality and how auditor quality moderates the association

between organizational complexity and f‌irm value. Our

work attempts to f‌ill this gap.

*Address for correspondence: Shu-Miao Lai, Department ofAccounting, Kainan Uni-

versity,no. 1, Kainan Road, Luzhu Shiang, Taoyuan 33857, Taiwan.Tel: 886-3-341-2500

Ext. 6214; E-mail: emilylai@mail.knu.edu.tw

352

Corporate Governance: An International Review, 2012, 20(4): 352–368

© 2012 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2012.00914.x

We f‌irst ask whether organizational complexity increases

the demand for better quality auditing services. DeAngelo

(1981) argues that larger auditors supply high quality audits

because they have more to lose if they fail to report weakness

in a client’s records. Larger auditors also have more and

better resources and structure for training auditors and con-

ducting tests than smaller auditors (e.g., Craswell, Francis, &

Taylor, 1995). Thus, high quality auditors are more likely to

supply higher quality audits. Several studies (e.g., Datar

et al., 1991; Titman & Trueman, 1986) further suggest that

auditor qualityprovides one means of signaling the credibil-

ity of f‌inancial statements. Organizationally complex f‌irms

with limited transparency are characterized by substantial

information asymmetries between managers and investors

and this will lead to a demand for high quality auditors. We

conjecture accordingly that organizationally complex f‌irms

are more likely to hire high quality auditors in order to

reduce information asymmetry costs through improving

credibility of f‌inancial statements. We thus expect organiza-

tional complexity to be positively associated with auditor

quality.

Our second hypothesis examines how auditor quality

moderates the association between organizational complex-

ity and f‌irm value. Prior studies suggest that higher quality

auditors reduce informationasymmetry about historical and

future earnings of f‌irms, improve investor conf‌idence, and

thereby raise the f‌irm value (e.g., Behn, Choi, & Kang, 2008;

Chang, Dasgupta, & Hilary, 2009; Datar et al., 1991). In other

words, if investors perceive large auditors as providing

higher quality auditsand more credible f‌inancial statements,

complex f‌irms audited by a large auditor are expected to

have a higher f‌irm value. Thus, we expect a positive associa-

tion between organizational complexity and f‌irm value

when the complex f‌irm hires a higher quality auditor.

Our empirical evidence yields several f‌indings. First, we

f‌ind that organizationally complex f‌irms are more likely to

employ a Big N auditor. This f‌inding suggests that organi-

zational complexity increases demands on higher quality

auditors to reduce informationasymmetry costs. Second, we

f‌ind that the interaction term between organizational com-

plexity and Big N auditor is positivelyand signif‌icantly asso-

ciated with f‌irm value. Thus, our results suggest that auditor

quality has a moderating effect on the association between

organizational complexity and f‌irm value.

The results of several sensitivity tests increase conf‌idence

in our primary empirical results. First, to provide a more

complete picture of how organizational complexity affects

auditor choice, we combine two proxies for auditor quality

(auditor size and auditor expertise) into one categorical

measure and run a multinomial logistic regression. The

empirical results are similar to the f‌irst result that organiza-

tional complexity is positively associated with auditor

quality.

We next use an alternative measure of f‌irm value based on

stock return in excess of benchmark portfolio returns. We

also perform additional analysis to validate our results of

excess value using an alternative measure of expertise for

auditor quality. These results are similar to our main result

that auditor quality has a moderating effect on the associa-

tion between organizational complexity and f‌irm value.

Finally, since segment reporting rules changed in 1997, f‌irms

have been required to report segments in a manner consis-

tent with the f‌irm’s actual organizational structure. To

examine whether our results are inf‌luenced by the adoption

of SFAS 131 (Financial Accounting Standards Board (FASB),

1997), we repeat the analysis for both pre- and post-SFAS 131

periods. We f‌ind the main results are robust to the new

disclosure standards.

Our work contributes to the literature in two important

respects. First, we add to the auditorselection literature with

new evidence on the association between auditor quality

and organizational structure. Other research has docu-

mented that engagement of a high quality auditor is associ-

ated with f‌irm characteristics such as size, f‌inancial

performance, litigation risk, agency costs, and f‌inancial risk

(Copely, Gaver, & Gaver, 1995; DeFond, 1992; Johnson & Lys,

1990; Lawrence, Minutti-Meza, & Zhang, 2011; Simunic &

Stein, 1987). Until now, there has been little research that

examines whether organizational structure affects auditor

choice. We provide new evidence that organizationally

complex f‌irms with limited information transparency are

more likely to hire high quality auditors to signal the cred-

ibility of their f‌inancial statements.

Second, we shed light on how the value enhancement of a

complex organization depends on auditor quality. Our f‌ind-

ings suggest that auditor quality has a moderating effect on

the positive association between organizational complexity

and f‌irm value. We thus extend the literature, showing that

audits of f‌inancial statements have signif‌icant economic

impacts in capital markets (Behn et al., 2008; Chang et al.,

2009; Khurana & Raman, 2004; Mansi, Maxwell, & Miller,

2004).

The paper is organized as follows. In the next section, we

develop empirically testable hypotheses. We then go on to

describe the sample and research design, which is followed

by a discussion of our results. We then present the sensitiv-

ity analysis. A f‌inal section concludes the paper.

HYPOTHESES DEVELOPMENT

Organizational Complexity and Auditor Choice

Agency theory suggests a link between auditor quality and

information asymmetry reduction (for a review, see Dechow

et al., 2010). Auditor choice studies start with the hypothesis

that the demand for high quality audit arises from informa-

tion asymmetry between managers and investors. Examples

are Datar et al. (1991), DeFond (1992), Firth and Smith (1992),

Francis and Wilson (1988), and Titman and Trueman (1986).

Our paper extends extant studies by examining whether

information asymmetry arising from organizational com-

plexity affects the demand of complex f‌irms for higher

quality auditors.

Researchers suggest that organizational complexity is

associated with greater informationasymmetry (e.g., Bens &

Monahan, 2004; Bushman et al., 2004; Demirkan et al., 2011;

Duru & Reeb, 2002; Gilson et al., 2001). Combining diverse

operations, for example, creates information aggregation

problems that can result in substantial information asymme-

tries between managers and outside investors (Gilson et al.,

2001; Krishnaswami & Subramaniam, 1999). That is, outside

investors can observe aggregate earnings but not individual

ORGANIZATIONAL COMPLEXITY AND AUDITOR QUALITY 353

Volume 20 Number 4 July 2012© 2012 Blackwell Publishing Ltd