Ownership structure and audit quality: the mediating effect of board independence

• DOI: https://doi.org/10.1108/CG-12-2019-0369
• Published date: 12 February 2021
• Date: 12 February 2021
• Pages: 754-774
• Subject Matter: Strategy,Corporate governance
• Author: Moncef Guizani,Gaafar Abdalkrim

Ownership structure and audit quality: the

mediating effect of board independence

Moncef Guizani and Gaafar Abdalkrim

Abstract

Purpose –This study aims to examine the mediating effectof board independence on the relationship

betweenownership structure and audit quality.

Design/methodology/approach –The research uses generalized methods of moments regression to

test the relationship between ownership structure and audit quality. The sample consists of 162 non-

financial firmslisted on the Gulf Cooperation Council stock marketsbetween the years of 2009 and 2016.

To test the significanceof the mediating effect, this paperuses the Sobel test.

Findings –Empirical findings show that companies with higher family ownership are less likely to

demand extensiveaudit services and, as a result, pay lower audit fees.Conversely, this study finds that

companies with higher active and passiveinstitutional ownership are more likely to engage high-quality

auditors and pay larger audit fees. As for government ownership, it has no significant impact on audit

fees. The results also revealthat the negative (positive) effect of family (institutional)ownership on audit

quality followsthe path through reducing (enhancing)board independence. Further tests are conducted

and supportthe main findings.

Practical implications –This study has important implications for policymakers and regulators to

address the conflict between controlling shareholdersand minorities by promoting higher standards of

audit quality. The study findings may be useful to investors, assisting them in making better-informed

decisions and aids other interested parties in gaining a better understanding of the role played by

ownership structure in audit quality. The study also contributes to the strategic board behavior by

bringing a new perspectiveon how boards engage in monitoring by requestingexternal audit services.

This behavioris likely to be influenced by the type of controllingshareholder.

Originality/value –The main contributionof the present paper is to examine the board compositionas a

potential mediating variable between ownership structure and audit quality. Moreover, it highlights the

issue ofimproving governance mechanisms.

Keywords Ownership structure, Audit fees, Audit quality, Independent directors

Paper type Research paper

1. Introduction

The issue of improving corporate governance has become an important way of aiming to

limit the self-serving actionsof top management and thus protecting stockholders’ interests.

There is extensive literaturethat identifies how firms use monitors and bonding mechanisms

to ensure that management will act in the best interest of the owner, which includes the

external monitoring carriedout by independent auditors. Jensen and Meckling (1976) argue

that because agents act toward maximizing their own benefits even at the expense of

principals, external auditors helps reduce the agency problems that stem from the

principal-agent relationship. Many further studies have shown support toward the crucial

role of audit quality in resolving problems generated by conflicts of interests between firms

and their shareholders (Mitra et al.,2007;AlQadasi and Abidin, 2018;Schauble, 2018).

However, this kind of agency problem tends to occur in firms with dispersed ownership

structures where the ownership is diffused among a large number of small shareholders

Moncef Guizani is based at

the Department of

Accounting and Finance,

High Institute of Computer

Science and Management

in Kairouan, University of

Kairouan, Tunisia.

Gaafar Abdalkrim is based

at the Department of

Business Administration,

College of Sciences and

Humanities, Prince Sattam

Bin Abdulaziz Univerisity,

Slayal, Saudi Arabia.

Received 3 December 2019

Revised 31 March 2020

7 July 2020

2 October 2020

23 December 2020

Accepted 31 December 2020

PAGE 754 jCORPORATE GOVERNANCE jVOL. 21 NO. 5 2021, pp. 754-774, ©Emerald Publishing Limited, ISSN 1472-0701 DOI 10.1108/CG-12-2019-0369

and the corporate control is concentrated in the hands of managers, typically in developed

markets (e.g. the USA and UK). In fact, there is substantial cross-country evidence that

ownership structures of publicly listed firms in emerging markets are highly concentrated

(Shleifer and Vishny, 1997;La Porta et al., 1999;Shehata, 2015). It is also observed that

companies with concentrated ownership are run by the major shareholders who play a

significant role in their decision-making processes (Hay et al.,2008;AlQadasi and Abidin,

2018). This indeed leads to greater monitoring and supervision, and thus results in lower

agent-principal conflicts. On the other hand, controlling shareholders can enjoy the private

benefits of control by extracting value from the firm to the detriment of minority

shareholders, due to the absence of efficient monitoring on them (Shleifer and Vishny,

1997). According to Al-Rassas and Kamardin(2016), in most high ownership concentration,

the firm’s managers are either members of the controlling shareholders or they have close

personal relations. This close relationship may direct managers to manage earnings toward

the interest of the majority at the expense of the wealth of minority shareholders. Thus, the

expropriation concern of large shareholders begs the question of their role in corporate

governance, particularlyin demanding audit quality.

There is extensive research in the corporate governance literature that has focused on the

direct relationship between large shareholders and audit quality. However, the findings of

these studies are rather mixedand inconclusive. Some studies suggest a favorable effect of

large shareholders on audit quality (Hay et al.,2008). By contrast, other studies support a

negative effect (e.g. Alfraih, 2016;AlQadasi and Abidin, 2018).

The underlying reason for such findings may be attributed to the fact that large

shareholders have sufficient power to influence the activities of management by taking part

in the corporate board. More specifically, large shareholders exercise their voting right to

shape and reshape the structure of the corporate board to make sure that the board directs

the organizational activitiesin favor of their interests (Rashid, 2020).

There is a large literature that identifies the influence of large shareholders on board

structure. Beginning with Hermalin and Weisbach (1988), this literature considers board

structure as the outcome of a bargaining process within the firm. The composition of the

board is the result of, rather than a solution to, existing agency problems. According to

Torchia and Calarbo (2016), boards controlled by the major shareholder may result in

practices of collusion, among them, the expropriation of minorities’ wealth. Controlling

shareholders are more likely to be motivated to strengthen their control rights to facilitate

their pursuit of private benefits. Moreover, the type of shareholders maybe a relevant issue

when deciding board independence, as different types of owners might pursue different

strategic objectives and opt for different organizational designs (Desender et al.,2013).

According to Anderson and Reeb (2004), family firms are reluctant to appoint independent

directors and generally prefer to establish boards that do not try to alleviate their discretion

over decision-making. In contrast, this behavior is reduced when large external

shareholders such as institutional investors, are directly represented by an outside board

member. Institutional investorshave a number of incentives that would lead them to appoint

independent directors to reduce the possibility of negative outcomes due to managerial

fraud or negligence (Gillan and Starks,2000).

In sum, as argued by AlQadasi and Abidin (2018) and Desender (2013), the ownership

structure should be considered in studying the effectiveness of corporate governance

mechanisms. In concentrated ownership settings, large shareholders play a major role in

the composition of the board of directors which may be reflected in the quality of selected

external auditors. Accordingly, it can be held that the relationship between large

shareholders and audit quality is more complicated than the results of many prior studies

suggest. Opposing and mixed findings in prior studies may be traced back to the fact that

this relationship is not only a direct relationship. Rather, this relationship can be mediated

by other contextual variables such as board characteristics, an issue that has received less

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