Does Shareholders Ratification Enhance Auditor Independence?

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Does shareholders ratification of auditor selection enhance
auditor independence?

Sear Amiri

894560
Accounting
Supervisor : S.N.M. Van den Bogaerde

-2012-

Abstract: The U.S. Department of the Treasury's Advisory Committee on the Auditing Profession (ACAP) recommends that all public companies must have an annual shareholders ratification of external auditor selection. An important aim of their recommendation was to enhance auditor independence. However the ACAP did not provide empirical support for their recommendation. Using data of 80 companies I find that cost of capital (measure of auditor independence) is higher in firms with shareholders ratification of auditor independence than in firms without shareholders ratification of auditor selection. Using the data of 40 firms with a negative restatement, I also find that after announcement of restatement the increase cost of capital is higher in firms without shareholders ratification of auditor selection than in firms with shareholders ratification of auditor selection. My results indicates that shareholders ratification of auditor selection enhance external auditor independence. I.

Introduction

The objective of this study is to examine whether shareholders ratification of external auditor selection enhance external auditor independence. The motivation for this study comes from the U.S. Department of the Treasury's Advisory Committee on the Auditing Profession (ACAP), which recommended that all public companies must have an annual shareholders ratification of external auditor selection. This recommendation is based on belief that, such an arrangement would make the auditor more a direct agent of the shareholder than of the board of directors and/or management.

Firms are separated by separation of ownership and management. Because the manager owns no more than a small portion of his firm's equity shares, he has incentives to allocate the firm's resources in ways that are not consistent with the interests of shareholders. According Section 301 of SOX serves management as an intermediary between the company and its auditors. It recommends the auditing firm to the audit committee and it negotiates audit fees and guides the audit.

Firms have sufficient incentives and opportunities to manage earnings. The value of auditing arises in part because it reduces managerial opportunistic discretion in financial statements. Auditing is a monitoring mechanism designed to improve and/or control information about the firm’s performance. This in turn, reduces information asymmetry between the firm and its investors. Auditing reduces information risk faced by investors because it allows them to verify the validity of financial statement. The stronger the effect of audit quality on constraining earnings management, the stronger the effect of audit quality on reducing 2

information risk faced by investors. In return investors will lower their required rate of return on investment. Hence, cost of capital is inversely related to the degree of reliability in reported financial (Nikolayev and Van Lent 2005). Therefore, I use cost of capital as a measure for auditor quality independence.

I expect when shareholders are allowed to ratify the selection of auditor, they also assign high degree of certainty on information in the financial statement monitored by the ratified auditor. In this view, when shareholders are ratifying auditor selection, the investors become monitors of the auditor’s work. This arrangement makes the auditor more a direct agent of the shareholder than of the board of directors and/or management (Raghunandan et al. 2012). Shareholder voting can be viewed as aligning the auditor’s incentives more with shareholders than in cases where the audit committee or management makes the auditor hiring decision without shareholder approval. Therefore I expect that shareholders ratification of auditor independence enhance auditor external auditor independence. My...
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