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Market for corporate control and demand for auditing: evidence from international M&A laws

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Abstract

We investigate whether and how the market for corporate control affects the demand for audit service in a cross-country setting. In so doing, we exploit the staggered enactments of merger and acquisition (M&A) laws as an exogenous shock that substantially increases takeover pressure. We find that firms are more likely to choose Big 4 auditors in the period after the enactment of M&A laws, suggesting that the takeover pressure heightened by the passage of M&A laws increases the demand for audit verification and assurance by high-quality auditors. We also find that the enactment of M&A laws leads to greater demand for Big 4 auditors through two channels: managerial commitment to curtailing agency problems and the enhancement of board monitoring. We further show that improved auditor quality facilitates creditors’ and investors’ reliance on accounting information, as reflected in greater use of accounting-based debt covenants and enhanced earnings informativeness, respectively, in the post-enactment period. Overall our results suggest that auditors play a key role in strengthening corporate governance after the enactment of M&A laws.

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Notes

  1. For example, India eliminated several takeover defenses and unequal treatment of target shareholders regarding offer prices, and New Zealand allowed acquirers to squeeze out minority shareholders to promote M&A transactions.

  2. Out of 32 countries, 16 treatment countries passed M&A laws during the sample period, and 16 control countries had never passed M&A laws before or during the sample period. Throughout the paper, we use the term “Big 4 auditors” to denote both current Big 4 auditors and former Big 5, 6, or 8 auditors.

  3. Cross-country studies show that Big 4 auditors provide higher-quality audit services than non-Big 4 auditors because Big 4 auditors have international reputations and bear higher legal liability costs (e.g., Fan and Wong 2005; Choi et al. 2008). Moreover, the size difference between Big 4 and non-Big 4 firms is more substantial outside the United States, which prevents non-Big 4 firms from achieving the economy of scale in terms of the investment in audit quality (Choi et al. 2008). In contrast, studies on the US audit market provide mixed evidence on the difference in audit quality between Big 4 and non-Big 4 firms. Chaney et al. (2004) and Lawrence et al. (2011) find no significant difference between Big 4 and non-Big 4 firms in terms of audit fee premiums and audit quality, respectively, when they control for the endogeneity of auditor selection. On the other hand, Jiang et al. (2019) find that audit quality improves when clients change their auditors from non-Big 4 to Big 4 firms, due to M&A of audit firms, consistent with higher audit quality for Big 4 firms.

  4. We regard firms with more business segments as having greater agency conflicts because corporate outsiders face greater difficulty in monitoring such firms’ managerial activities and evaluating their performance (Berger and Hann 2003). In addition, we regard the increase (decrease) in leverage (investment) as an indication of managerial efforts to address severe agency problems (Khurana and Wang 2019) because managers under takeover pressure can increase financial leverage and reduce investment to credibly constrain their ability to divert corporate resources for private gains (Jensen 1988; Berger et al. 1997; Safieddine and Titman 1999; Servaes and Tamayo 2014). See Section 5.2 for more details.

  5. Several studies examine the relationship between external governance mechanisms and the provision of audit services but provide mixed evidence. For example, Kim et al. (2019b) show that foreign institutional ownership relates positively to the probability of appointing a Big 4 auditor. Hope et al. (2017) and Wang and Chui (2015) find that short-seller monitoring and product market competition are positively associated with audit fees, whereas Gotti et al. (2012) conclude that analyst-following is negatively associated with audit fees.

  6. Manne (1965, p. 113) describes the possible governance function of the takeover market as follows: “The lower the stock price, relative to what it could be with more efficient management, the more attractive the takeover becomes to those who believe that they can manage the company more efficiently.” Similarly, Brealey and Myers (2000, p. 945) contend: “There are always firms with unexploited opportunities to cut costs and increase sales and earnings. Such firms are natural candidates for acquisition by other firms with better management.”.

  7. Studies examining the effects of anti-takeover provisions also provide evidence consistent with the disciplinary effect of takeovers by showing that takeover defenses make management more entrenched and impair firm performance (e.g., Gompers et al. 2003). This evidence is consistent with shareholder activists’ calls for reducing takeover protection (McGurn 2002).

  8. Other internal governance mechanisms include managerial incentive plans and the internal labor market; other external governance mechanisms include outside shareholder or debtholder monitoring, product market competition, the external managerial labor market, and securities laws (Bushman and Smith 2001).

  9. Khurana and Wang (2019) find that the increase in accounting conservatism after the enactment of M&A laws is driven by intensified board monitoring in the international setting, consistent with the complementary relation between external governance and accounting conservatism. In contrast, Jayaraman and Shivakumar (2013) and Callen et al. (2014) find that accounting conservatism increases after the passage of antitakeover laws in the United States that reduced takeover pressure, suggesting increased demand for accounting conservatism as a substitute for the weakened governance from the corporate control market.

  10. Khurana and Wang (2019) show that board monitoring has contributed to increasing accounting conservatism, an attribute of reporting quality, after the enactment of M&A laws.

  11. We include the enactment year of M&A laws in the post-law period (POST = 1). Untabulated analyses yield virtually identical results when we classify the enactment year in the pre-law period (POST = 0) or when we exclude observations for the enactment year.

  12. Six out of seven country-level variables in Eq. (1) represent time-varying country characteristics that might influence the temporal change in auditor selection. We control for the time-varying country factors rather than country fixed effects because the latter only control for time-invariant country characteristics, whereas we test for the temporal change in the demand for Big 4 auditors following the enactment of M&A laws. When we alternatively include country fixed effects, our results are qualitatively unchanged.

  13. Following La Porta et al. (1997), we classify sample countries into five legal-origin groups: English, French, Scandinavian, German, and others, including China and Poland.

  14. Logistic regressions with fixed effects may suffer from incidental parameters problems (Greene 2012, Chapter 17). To check the sensitivity of our results, we apply the ordinary least squares (OLS) estimation to regressions with binary dependent variables. The results are consistent with those reported in this manuscript and available in the online appendix.

  15. Worldscope provides auditor identification for each client firm only for the most recent year. Thus we use data from Capital IQ for auditor identification. If auditor details are missing from Capital IQ, they are supplemented by details from Compustat Global for observations before 2004 and Worldscope otherwise. We use Compustat Global for years before 2004 because Compustat Global provides time-varying auditor identification in this period. However, Compustat Global is known to have an auditor miscoding problem for firms in Japan, South Korea, India, and Pakistan after 2004, where Big 4 firms operate under the names of local affiliates (Francis and Wang 2008; Francis et al. 2013). Thus we supplement auditor identification using Worldscope for observations after 2004. Our results are robust to using alternative sources for auditor identification data.

  16. The number of sample countries used in this study is smaller than the numbers of Lel and Miller (2015) and Khurana and Wang (2019). Mainly due to a lack of auditor data, our sample excludes Colombia, the Czech Republic, Hungary, Luxembourg, Sri Lanka, Venezuela, and Zimbabwe, which are used in those studies. In contrast, our sample includes Italy, South Africa, Spain, and Sweden, which are excluded by the two previous studies.

  17. We have checked whether any of the 16 control-group countries have enacted new M&A laws since Lel and Miller’s (2015) sample period from 1992 to 2003. Following Lel and Miller’s methodology, we have confirmed that none of the control countries enacted such laws until the end of our sample period.

  18. In Table 2, the number of observations for variables used in the debt covenant analysis (9,201 observations) is much smaller than those of other variables because we require each observation in the analysis to have either loan data from Dealscan or bond data from Thomson One. The number of observations for the audit fee variable (AUDFEE) is also small because many observations have a missing value for audit fees in Worldscope. (See Section 7.2 for more details.).

  19. An untabulated analysis shows that the Pearson correlation coefficient between BIG4 and POST × TREAT is 0.20, and it is significant at the 1% level.

  20. We estimate the effect of M&A law enactment on the probability of hiring a Big 4 auditor using the following procedures. From the logistic regression model in Column (1) of Table 3, we first calculate a log odds ratio (X) by multiplying the mean value of each variable by its coefficient and adding them up. Then we convert the log odds ratio into a predicted probability using exp(X) / (1 + exp(X)). According to this formula, the predicted probability of hiring a Big 4 auditor is 54.9% (49.3%) when POST × TREAT equals 1 (0) in treatment countries (TREAT = 1).

  21. The results for firm-level control variables are generally consistent with our predictions and the literature. The demand for Big 4 auditors is positively associated with firm size (SIZE), profitability (ROA), market-to-book ratio (MB), the number of business segments (NBS), external financing (ISSUE), asset turnover ratio (ATURN), and the cross-listing indicator (CRLST); it is negatively associated with leverage (LEV), the level of inventories and receivables (INVREC), and current ratio (CURR). The results for country-level control variables show that the demand for Big 4 auditors relates positively to regulatory quality (REGQUAL), changes in the financial reform index (CH_FR), the passage of corporate-governance reforms (CGRI), the anti-self-dealing index (ASD), and the strength of enforcement actions (ACCENF); it relates negatively to gross domestic product per capita (GDP).

  22. We perform the following additional tests and confirm that our results are robust to using (1) alternative data sources for auditor identification, such as Compustat Global and Worldscope; (2) alternative sample selection procedures, such as excluding observations with M&A transactions or observations during the Asian financial crisis, requiring nonmissing observations for all years from t − 5 to t + 5 surrounding the M&A law enactment year t, and using matched samples; (3) alternative model specifications, such as weighted least squares regressions, country or firm fixed effects regressions, country or industry clustering adjustment, and regressions with a treatment-specific time trend; and (4) auditor changes analyses. The results are available in the online appendix.

  23. We do not include the standalone variables YEAR(t−1), YEAR(t), and YEAR(t+1) because they are redundant, due to the inclusion of their interaction terms with TREAT. This specification resembles Eq. (1), which excludes the standalone variable POST.

  24. For brevity, we suppress the coefficients on the control variables in Tables 4, 5, 6 and 10. The full results are available in the online appendix.

  25. Specifically, our results for the effects of M&A laws might be biased due to the influence of already treated countries on the analysis of later-treated countries. For example, South Africa, Spain, and Sweden passed M&A laws in 1991, the first enactment year in our sample. Italy, which passed M&A laws in 1992, is compared with not only countries that have not passed M&A laws by 1992 but also the three treatment countries that already enacted M&A laws in 1991. Therefore the inclusion of already treated countries (e.g., South Africa, Spain, and Sweden) in the analysis of later treated countries (e.g., Italy) might yield biased results.

  26. Our results are robust to using the stacked regression as an alternative method of an event-study DiD estimation (Baker et al. 2022). The results are available in the online appendix.

  27. We require each deal to have a public acquirer, a public target, and a deal amount above US$1 million. Due to missing deal data, the sample used in this analysis is smaller than the sample in Table 3.

  28. The results are robust to using two alternative proxies for the intensity of M&A: (1) the country-level takeover index (Nenova 2006) and (2) the firm-level probability of being a takeover target. We estimate the probability of being targeted using our firm-level data and the regression model in Table 5 of Lel and Miller (2015).

  29. The country-level subsample analyses in Tables 5 and 6 may not be independent because the subsamples partitioned by country-level variables (NDEALS, $DEALS, ANTIDIR, ASD, and AUDLIAB) may overlap, due to the correlations among the variables. We find that the correlation coefficients between the country-level variables are less than 0.5, except those for three variables (ANTIDIR, ASD, and AUDLIAB) reflecting similar constructs, and that some of the variables are even negatively correlated. The results suggest that the lack of independence across the subsample analyses cannot fully explain our findings in Tables 5 and 6.

  30. To examine the board monitoring channel, Khurana and Wang (2019) use not only country-level investor protection but also firm-level pay-performance sensitivity as cross-sectional partitioning variables. However, we cannot use the latter variable because the pay-performance sensitivity variable (estimated from the BoardEx database) has all missing values for the pre-law period of treatment countries in our sample. Our results are robust to using alternative proxies for country-level investor protection, such as the private enforcement index (La Porta et al. 2006) or government effectiveness (Kaufman et al. 2009).

  31. We confirm the positive effect of takeover pressure on financial reporting quality for our sample. Untabulated results show that the enactment of M&A laws leads to a significant decrease in three inverse measures of financial reporting quality: (1) the absolute value of discretionary accruals; (2) the incidence of reporting small earnings-per-share (EPS); and (3) the incidence of reporting small increases in EPS.

  32. The results are robust to using the numbers of accounting covenants and non-accounting covenants, respectively, rather than the corresponding indicator variables.

  33. To match between Dealscan and our dataset, we first use the Dealscan-Compustat link file provided by Chava and Roberts (2008), supplement the matching with available company identifiers (i.e., tickers), and check the matched dataset manually by company name and country. To match between Thomson One and our dataset, we first use all available company identifiers (i.e., ISIN, SEDOL, and ticker) and supplement the results by manual matching. We do not use the Mergent FISD database because this database mainly covers publicly offered bonds in the United States, whereas our sample does not include US firms.

  34. When debt covenant data fields are blank and there are valid data for debt issuance date, debt amount, and debt maturity, we treat these cases as debt contracts with no covenants.

  35. Untabulated results show that the increased use of accounting covenants is more pronounced in countries with high auditor legal liability than those with low auditor legal liability. This result suggests that creditors rely more on accounting information when auditors have stronger incentives to provide high-quality assurance to mitigate their exposure to litigation risk.

  36. Untabulated results show that the positive effect of the enactment of M&A laws on the informativeness of accounting earnings is significantly larger in countries with higher auditor legal liability.

  37. Given prior empirical evidence of the positive association between the valuation and incentive contracting roles of accounting measures in evaluating managerial performance (Banker et al. 2009), our results are consistent with the finding of Lel and Miller (2015) that the enactment of M&A laws increases the sensitivity of CEO turnover to accounting-based performance measures. Our results, along with those of Lel and Miller (2015), suggest that the enactment of M&A laws could increase the reliance on financial statement information for contracting.

  38. Our definition of Erroneous_Opinion is consistent with the definition of incorrect audit opinions for internal control weakness of Ge et al. (2017) and Cunningham et al. (2019). We focus on the type II error because auditor litigation arises mainly from the type II error (Ge et al. 2017). In addition, our sample includes no potential case of a type I error (i.e., the client-years that fall below the 95th percentile of the predicted value of QAO but receive a qualified opinion). We set the 95th percentile as a cutoff point because only 1.3 percent of our sample observations received a qualified audit opinion. We find similar results when we use the 97th percentile of the predicted value of QAO as a cutoff to define Erroneous_Opinion.

  39. We translate audit fees in local currency to US dollars using average exchange rates for the fiscal year. We do not adjust inflation rates for the measurement of AUDFEE because foreign exchange rates already reflect different inflation rates across countries. To eliminate any residual influence of inflation on audit fees, we control for the inflation rate measured by the percentage change in average consumer prices of each country-year (INF). Our results are also robust to using inflation-adjusted audit fees as the dependent variable.

  40. The coefficient on POST × TREAT in Panel C of Table 10 captures the incremental effect of M&A law enactment on audit fees. Its negative coefficient indicates a smaller increase in audit fees rather than a decrease in audit fees because the average audit fees in treatment countries increase both in the pre- and post-law periods. Thus the enactment of M&A laws reduces the growth rate of audit fees (not the level of audit fees) in treatment countries, compared to the growth rate in control countries.

  41. Untabulated results show that the negative effect of the enactment of M&A laws on audit fees is significantly larger in countries with higher auditor legal liability. This evidence is consistent with the view that the increased takeover pressure disciplines managers and improves pre-audited reporting quality, which in turn reduces auditor litigation risk and allows auditors to charge relatively low audit fees.

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Acknowledgements

We are grateful for the helpful comments of Lakshmanan Shivakumar (editor), an anonymous reviewer, James Anderson (2021 AAA discussant), Yi-Chun Chen (2017 AAA discussant), Jong-Hag Choi, Bowe Hansen (IAS discussant), Robert Kim, Sangwan Kim, Bradley Pomery (2021 CAAA discussant), Naqi Sayed (2017 CAAA discussant), Michael Stein, Qiang Wu, Xiaolu Xu, and participants at the 2022 AAA International Accounting Section Midyear Meeting, 2017 and 2021 AAA Annual Meetings, 2017 and 2021 CAAA Annual Conferences, 2019 International Symposium on Audit Research, 2017 AAA Northeast Region Meeting, and Ph.D. seminars/workshops at City University of Hong Kong, Fudan University, Hong Kong Baptist University, Sungkyunkwan University, University of Massachusetts Lowell, University of South Florida, and University of Waterloo. We also thank Ugur Lel for his suggestions about updating the M&A law status following his data period in Lel and Miller (2015). J.-B. Kim acknowledges partial financial support from the GRF of the HK SAR Government (Grant No. 9042767: CityU11501219). Earlier versions of this paper were circulated under the title “The Impact of the Market for Corporate Control on Audit Fees: Evidence from International M&A Laws” or “Market for Corporate Control, Auditor Selection and Audit Fees: Evidence from International M&A Laws.” This paper won the outstanding paper award at the 2022 AAA International Accounting Section Midyear Meeting.

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Choi, A., Kim, JB., Lee, J.J. et al. Market for corporate control and demand for auditing: evidence from international M&A laws. Rev Account Stud (2023). https://doi.org/10.1007/s11142-023-09756-x

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