THE EFFECT OF ETHNICITY ON AUDIT PRICING by
Ayoib Che Ahmad School of Accounting Universiti Utara Malaysia. E-mail:
[email protected] and
Keith A. Houghton Department of Accounting The University of Melbourne E-mail:
[email protected]
April 2001
The financial support of the Universiti Utara Malaysia is gratefully acknowledged. We would also like to thank Don Stokes, Philip Brown, Christine Jubb and participants in seminars at the University of Melbourne, the University of Technology Sydney, and the University of Western Australia and attendees at the American Accounting Association MidYear Audit Section Meeting Conference and the Accounting Association of Australia and New Zealand Conference for their helpful comments and suggestions.
THE EFFECT OF ETHNICITY ON AUDIT PRICING
ABSTRACT Ethnicity and its effects on business and the management of companies and organizations have been addressed in the literature by a number of scholars in several different ways. By contrast the influences and effects of ethnicity in the audit of companies and within the suppliers of those audit services (audit firms), is almost non-existent. This paper hypothesizes that ethnicity will have an effect on the price paid by companies for audit services within Malaysia. Results show that Chinese controlled and/or owned companies pay less for audits and foreign owned companies pay the most. On the other hand, Chinese auditors with the Big Six auditors charge a significant fee premium for Chinese clients – suggesting that it is this group of auditors that have invested in a specialist tendency to audit this group of companies. Interestingly, matching of ethnic auditors and auditees does not result in a fee discount as might be expected. Results are not sensitive to alternative measures of ethnicity or for certain other explanations, such as an industry effect.
Key Words: Audit Pricing, Ethnicity, Malaysia. Data Availability: The data used is from public sources identified in the manuscript.
AUDIT MARKETS: THE EFFECT OF ETHNICITY ON PRICING
1.0 INTRODUCTION
In a recent paper DeFond, Francis and Wong (2000) note that while international first tier audit firms (which are industry specialists) earn a premium fee, a specialist local (Hong Kong) firm did not.
While the difference could be attributed to the fact that the
specialization premium may come from the intervention of Big 5 and audit industry specialization, another potentially more interesting explanation is that the fee differential was based, at least in part, on the differing ethnicity of the partners’ audit firms. While a significant portion of audit partners in the specialist Big 5 auditors identified in DeFond et al (2000) were, at the time the data was collected, expatriate Westerners (including English, Australian and American partners), the local firm was entirely made up of ethnic Chinese partners. The next year (after data was collected), the firm merged with Deloitte Touche. Indeed, all firms in that Asian city have undergone significant change in recent years. The objective of this study is to examine the effect of ethnicity on audit fees, such as those depicted in DeFond et al (2000).
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1.1
Background to the Audit Markets in Malaysia
The regulation of company affairs in Malaysia is similar to the British system especially with respect to the provision of financial information. Corporate annual reports (especially for publicly-held companies) are publicly available and audit fees are required to be disclosed. However, the country’s political and socio-economic structures are unlike those in much of the former British Empire. For example, the political administration is controlled by ethnic Malays (referred to as Bumiputras) while the economic sphere has been heavily influenced by ethnic Chinese. Although there are other ethnic groups (such as the Indians), the distinction between the two main groups (i.e. the Chinese and Bumiputras) dominates much of the socio-economic and political policy making.
There are many scholarly studies that examine why the Chinese community is so successful in business compared to other ethnic groups in Malaysia and other East Asian countries (see, for example, Weidenbaum and Hughes, 1996; Whitley, 1992; Redding, 1991; Hamilton, 1991; Jesudason, 1990; Limlingan 1986). Most of the researchers conclude that Chinese business practices and networking1 are responsible for the high profile ethnic Chinese have within business.
Intervention by the Malaysian government in providing some redress to the racial imbalance (through various economic policies) has changed the Malaysian economy over the past two decades with clear divisions along ethnic lines (Jesudason, 1990). Although it is acknowledged as important in influencing the Malaysian audit market by Simon et al
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(1992) and Eichenseher (1995), the effect of ethnicity on this market is unresearched. This study addresses this important social issue.
2.0 OBJECTIVES OF THE STUDY
This study investigates the extent to which ethnicity influences the market for audit services. Specifically, the study:
(1) examines the role of ethnic association (i.e. Bumiputra and Chinese ownership) and national (i.e. the presence of foreign corporations) issues in explaining the level of audit fees paid by a company (to external auditors); and
(2) investigates the role of auditor ethnicity (Chinese/Bumiputra) in explaining the level of audit fees charged by external auditors to companies.
The study utilizes well-established models of audit pricing and applies them to the Malaysian setting (with reference to Kuala Lumpur Stock Exchange [KLSE] listed companies). The results provide market wide empirical evidence as to the existence of Chinese business practices in Malaysia and contributes significantly to both auditing and sociology (ethnicity) literature.
This study has policy implications for the Malaysian accounting profession, the business community and Malaysian regulators with regard to the understanding of audit fee setting.
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For example, the recent controversy concerning the standard minimum audit fee schedule proposed2 by the Malaysian Institute of Accountants (MIA) (Che-Ahmad and Derashid, 1996) might have been avoided if all parties had better understood the pricing mechanism.
3.0 THE REGULATORY BACKGROUND
All companies in Malaysia are governed by the Companies Act, 1965 modeled on the UK Companies Act 1948 and the Australian Uniform Companies Act 1961 (Craig and Diga, 1996). Sections 167-171 of the Malaysian Companies Act embody much of the legislation concerning the preparation and contents of published accounts. The Act obligates companies to disclose all interests of directors. A similar requirement is also provided for the disclosure of interests of substantial shareholders (i.e. shareholders, individual or institutional, who have an interest in five percent or more of the voting shares).
Listed companies face additional requirements set out by both the Kuala Lumpur Stock Exchange (KLSE) and the Securities Commission. The requirements overseeing the continuing obligations of listed companies are embodied in the two Listing Manuals, one for the Main Board and the other for the Second Board.3 Apart from various listing rules, companies are required to prepare annual audited accounts in accordance with the Accounting Standards and pronouncements of the Malaysian Institute of Accountants (MIA).
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Until the currency crisis that started in mid-1997, the KLSE listed companies had enjoyed phenomenal growth. The KLSE was ranked the third largest emerging market in the world in terms of business turnover after Taiwan and South Korea (International Finance Corporation, 1990). In 1996, the total market capitalization of its listed companies was RM787 billion making it the largest market in South East Asia. However, the recent Asian currency crisis during the late 1990s has wiped out more than 40% of its value.
4.0 LITERATURE REVIEW
Audit fees have been extensively researched especially in a number of developed English speaking countries such as United States (including Simunic, 1980; Palmrose, 1986; Francis and Simon, 1987;
Simon and Francis, 1988;
and Turpen, 1990), United
Kingdom (including Taffler and Ramalinggam, 1982; Chan, et al, 1993; Pong and Whittington, 1994; and Gregory and Collier, 1996), Australia (including Francis, 1984; Francis and Stokes, 1986; Butterworth and Houghton, 1995 and Craswell et al, 1995), Canada (including Andersen and Zeghal, 1994; Chung and Lindsay, 1988) and New Zealand (including Firth, 1985 and 1993; and Johnson et al, 1995). These studies have investigated audit fees by regressing them on a set of explanatory variables including variables representing auditee characteristics (size, complexity, and risk), auditor attributes (auditor size, industry specialist) and other factors (see for example, Simunic, 1980; Simon and Francis, 1988; Butterworth and Houghton, 1995; and Craswell, Francis
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and Taylor, 1995), however, none of these other contextual factors deals with ethnicity or the ethnic background of either the auditor or auditee.
4.1 Other Audit Pricing Studies
Prior research has also investigated audit pricing in a number of non-western countries, including India (Simon, et al, 1986), South Africa (Simon, 1995), the Netherlands (Langendijk, 1997), Pakistan (Simon and Taylor, 1997), Bangladesh (Karim and Moizer, 1996), Japan (Taylor, 1997), Hong Kong (Simon et al, 1992; and Ho and Ng, 1996), Singapore (Low et al, 1990 and Simon et al, 1992) and Malaysia (Simon et al, 1992; Eichenseher, 1995; and Che-Ahmad and Derashid, 1996). Consistent with results in English speaking countries; client size, complexity and risk appear to be the major fee determinants and between them typically explain about half of the variance in audit fees. Table 1 below presents a summary of these studies including results for contextual variables that might explain audit fee variability.
PLACE TABLE 1 HERE
Of all the studies known to the present authors only Eichenseher (1995) examines either directly or indirectly the role of ethnicity. That study included a measure for the ethnicity of directors of the auditee. Yet as suggested above, ethnicity has the potential to play an important role in some audit markets.
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4.2 Audit Market Research in Malaysia
To date, only three published empirical studies of the audit services market in Malaysia exist: Simon et al, (1992); Eichenseher, (1995) and Che-Ahmad and Derashid (1996). These studies investigate audit fee determinants and provide some conflicting results, especially with regard to price premiums to brand name auditors. Eichenseher (1995) classified brand name auditors by dividing all multinational (including the non-Big Six international firms) and local firms (including the Big Six affiliated firms) into different categories. Despite this being inconsistent with the existing literature (and theory), no explanation was offered regarding the rationale for this classification. Similarly, the author used an unconventional measure to indicate a specialized auditor. Using regression analysis, he found evidence of significant fee premiums accruing to the entire group of multinational firms but the variable denoting a specialized auditor was insignificant. Typically, Big Six firms are involved with audits of foreign owned companies more so than other audit firms. In a subsequent ANOVA analysis of individual firms, Eichenseher showed that Price Waterhouse was the primary earner of premiums. Other multinational firms and two leading local firms (Hanafiah Raslan and Mohamad; and Kassim, Chan) emerged as a category of moderate earners and all other local firms appeared to earn no fee premium. Note that these two moderate earners are affiliated to Arthur Andersen and Deloitte Touche respectively (i.e. two of the international Big Six firms).
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Simon, et al (1992) completed a comparative study of audit fees in three countries in the Pacific Rim and found Big Eight premiums existed in Hong Kong and Singapore, but not in Malaysia although the statistical coefficient was in the expected direction.
However, their model was limited in scope and comprised only four independent variables. Simon et al (1992) cited the Malaysian regulations on foreign ownership and a significant number of (Chinese) family-controlled companies as possible explanations for insignificant results for the existence of brand name premiums in the Malaysian model. Che-Ahmad and Derashid (1996) incorporated eleven potential determinants of audit fees based on prior studies and included all KLSE (main board) listed companies (in 1991) in their sample. Analysis showed that the Big Six commanded a significant price premium only in the industrial sector (about 56 per cent of the sample), a sector dominated by foreign-controlled companies and having the least involvement by the Chinese business community (Jesudason, 1990). Although no direct test is applied, this result implies that the ownership structure and the nature (ethnicity) of the shareholder are possible explanators of the fee premium. It is possible that the dominance of Chinese business enterprises in the sample explains why audit fee premiums to the Big Six were not significant in Che-Ahmad and Derashid (1996) and Simon et al, (1992). The Chinese business community is known to have a different set of business practices from others that may result in different preferences in auditing. It is contended that the presence of a clearly identifiable capital segment based on the nature (ethnicity) of the owners needs to be controlled in the audit fee model in order for a meaningful analysis of product differentiated auditing.
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As mentioned earlier, the empirical studies with respect to audit fee premiums in Malaysia reveal that there are important differences between the audit services market in Malaysia and elsewhere. Further, the findings suggest the importance of including contextual variables in audit fee models applicable to this country. In particular, while suffering from serious methodological issues, Eichenseher's (1995) study argued that a distinctive ethnic domination of clients’ boards of directors significantly influences the audit market. Two dummy variables were used by Eichenseher (1995) to capture the effect of ethnic factors (due to the differences in risk preferences and/or monitoring mechanisms) on audit fees. The first is related to Malay domination of the boards of directors and the second to the presence of a foreign majority on the board. Both were significant and positive in the regression analysis implying that non-Chinese run firms systematically pay higher audit fees. Note that the variables did not directly test the effect of overall ethnic factors on the audit fee. The model assumed that audit service provision is driven by demand and differences in three groups of buyers of audit services, namely Chinese, Malay and foreign ownership but no theoretical attempt was made to explain why this may be so.4 It is however, an interesting empirical result that warrants further investigation.
Eichenseher (1995) posited that the division of the Malaysian market along ethnic lines results in the aforementioned differential demand for audit quality based simply on an agency theory perspective argument. However, it can be argued that the Malaysian segmented market and the state interventionist policies should be analyzed more carefully
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and from a more complex and considered perspective than has been the case so far. This is because the issue is about not only the principal-agent relationship but it also involves different cultural, political and business practices that influence market behaviour (see for example, Jesudason, 1990; Redding, 1991 and Hamilton, 1991). This behaviour has characterized business success/failure in the country (Jesudason, 1990 and Limlingan, 1986) and is argued to influence both the supply and the demand sides of the audit market. Differences in risk preferences and monitoring mechanisms and the presence of ethnic connection in the business environment may well affect the behaviour of both the client companies and auditors. Audit market research in Malaysia, therefore, needs to consider this sociological perspective.
5.0 THEORY AND HYPOTHESES DEVELOPMENT
Sociologists have long studied ethnicity and its relation to other factors such as culture and economic inequality. In East Asia, ethnicity is often associated with business systems and economic developments (Whitley, 1992). In particular, researchers have studied various forms of business organizations including industrially specialized corporations (kaisha) in Japan, large conglomerates (chaeboo) in South Korea and Chinese companies in Hong Kong, Taiwan and South East Asian countries (see Whitley, 1992; Redding, 1991; Hamilton, 1991; and Dore, 1993). As Whitley (1992), Redding (1991) and others have emphasized, there are considerable differences between Asian and Western business organizations in terms of both their internal structures and external organized markets.
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For example, Asian companies tend to rely more on networks of alliances to manage risk and uncertainty (Whitley, 1992, p. 25).
While Western companies are largely autonomous from and competitive with other companies, Asian companies tend to be interlinked and interconnected to one another through various business networks (Hamilton, 1996, p. 2). Even among Asian business organizations, there seems to be differential patterns of business practice due to varying cultural and regulatory environments (Chen and Hamilton, 1991). For example, interfirm linkages in Chinese companies are based upon family and regional affiliations whereas business networks in Japanese firms tend to be long term inter-corporate ties. On the other hand, large business groups in South Korea are owned by elite families that have strong state support. According to Hamilton (1996, p. 9), the social networks created by Chinese society worldwide are similar in structure, mode of operation and shape to create “...the way Chinese do business in all settings.”
5.1 Audit Fees and Auditee Ethnicity
In Malaysia, the Chinese business community also practices this form of business ethics (that is embedded in its culture), in order to conduct business, especially given the perceived threats from the government and other ethnic groups (Sieh, 1992). A unique institutional characteristic of Chinese companies (including those in Malaysia) is the widespread involvement of the owners in the management of companies (Weidenbaum and Hughes, 1996). In many cases, the relatives of the owners are members of the board
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of directors and some are appointed as key management executives even after companies go public (Cheong, 1990; Sieh, 1992; and Heng, 1992). As ownership blends with control, agency theory predicts the need for a less extensive (lower quality), and therefore less costly, audit.5 Whilst the practice of utilizing family members in management might limit the pool of talent, Limlingan (1986, p. 274) argues this obstacle can be overcome by adopting several strategies. Trusted family members are placed in custodial functions while professional jobs may be left to non-family members. In Malaysia, these professional functions are also likely to be filled by ethnic Chinese managers.6
Another factor which might mitigate agency costs is the relatively greater stress on individual manager reputation in Chinese companies compared to Bumiputra or foreign companies (Eichenseher, 1995). Chinese entrepreneurs rely on trust and loyalty for management control (Barton, 1983; Kao, 1991; and Wong, 1991). These values are derived from the Confucian philosophy that stresses group harmony (collectivism) and submissiveness to authority (Limlingan, 1986; and Redding, 1991). The trust rests upon familial or semi-familial relationships that contribute to the strength of Chinese businesses. This “ethic of trustworthiness” provides discipline and moral justification for the (control) system (Redding, 199 1, p. 46). In the case of the Malaysian Chinese, the familial relationship is expected to be broader (and include ethnic bonds as well) due to perceived economic threats from other ethnic groups. The reliance on trust among Chinese business persons; also enables them “to avoid business relationships dictated by legality” (Ch’ng, 1993, p. 9) and this is likely to reduce transaction costs also.
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In Malaysia, Chinese business structure and related business practice are argued to be different from those of Bumiputra (i.e. Malay and other indigenous groups) and foreign controlled companies. The preference for family members in the management of the companies and the utilization of ethnic ties in the recruitment of employees and other business relationships are argued to result in lower agency and transaction costs as well as low operational risks associated with Chinese controlled companies. As a result, Chinese firms are likely to require a lower level of monitoring. In other words, Chinese companies have incentives to purchase less audit services (lower quantity audits) or less quality differentiated audits. Either case will eventually be reflected in lower levels of audit fees.7 Hence it is hypothesized (in null form) that, controlling for other explanations:
H1: There is no significant difference between audit fees paid by Chinese controlled companies and non-Chinese controlled companies, irrespective of ethnicity of auditor.
The arguments above do not take into account the nature and background of the suppliers of audit services.8 The Chinese controlled companies are argued to result in lower-priced audits irrespective of the ethnicity of auditor compared to non-Chinese controlled companies.
Non-Chinese companies, especially foreign controlled companies, are likely to pay higher audit fees for several reasons. Local foreign controlled companies tend to be subsidiaries of multinational companies that have headquarters in North America, Europe, Japan and
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other foreign countries. They are likely to have the same structure and employ similar managerial control as their overseas or associated parent companies. The fact that the locations of parent companies are far away may necessitate a higher level of management monitoring. This provides foreign controlled companies with the incentives to demand quality differentiated audit services to mitigate this problem. For these reasons, foreign controlled companies are all expected to give rise to higher priced audits. Based on this reasoning, it is hypothesized (in the null form) that, controlling for other explanations:
H2: There is no significant difference between audit fees paid by foreign controlled companies and non-foreign (Malaysian) controlled companies, irrespective of auditor.
The case for Bumiputra controlled companies is less clear. Bumiputra companies are generally owned by individuals or trust agencies that are arguably less sophisticated than the foreign investors (Horii, 1991). For example, Bumiputras own more non-industrial stocks than industrial stocks due to the low industrial technology level and insufficient managerial knowledge and experience (Horii, 1991).9 However, most Bumiputra individuals are likely to be well connected to the government10 and many of them are direct beneficiaries of the government privatization programme the objectives of which include a target of Bumiputra equity and employment shares (Horii, 1991). The privatization policy has resulted also in key strategic companies, normally the largest in their sectors (such as national airline, automobile manufacturers and telecommunication companies), being controlled by the Bumiputras. These companies (by virtue of their
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importance to the national economy) are claimed to be monitored closely by the government and are likely to receive assistance from the government in the event of financial difficulties.11 Hence, the risk of not being a going concern is likely to be lower in Bumiputra companies than in other companies.
The other form of Bumiputra shareholding is through trust agencies and other state enterprises. These agencies invest in blue chip companies on behalf of Bumiputra investors. Many listed companies (such as the Malaysia Mining Company and Malayan Banking Corporation) are substantially controlled by trust agencies through this sort of arrangement. These listed companies are normally managed by government appointed directors. They tend to be from the elite group (including influential politicians, ex-army or ex-police high-ranking officers, members of royalty and government bureaucrats) and comprise more than half of the available Bumiputra directors (Horii, 1991). Some of these directors, arguably, lack management know-how but they have the backing of government. While opportunistic behaviour in Bumiputra companies is likely to increase business risk, it is argued that the ultimate risk of business failure is covered by the state. For these reasons, there may be less of a perceived need for high quality auditing in Bumiputra companies compared with foreign controlled companies. Based on this reasoning, it is hypothesized (in the null) that, other things being equal:
H2a There is no significant difference between audit fees paid by Bumiputra controlled companies and foreign controlled companies, irrespective of auditor.
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The following table summarizes the expected relationship between the ethnicity basis of companies and levels of agency risks, audit risk and audit fees associated with those companies.
PLACE TABLE 2 HERE
Table 2 above shows categories of companies in Malaysia and the expected effect of differences in monitoring mechanisms and expected auditors’ risk assessments on audit fees. Foreign owned companies are said to pay the highest audit fees, other things being equal, due to strong demand for audit with international reputation (or higher quality). Bumiputra companies, on the other hand, have strong support from the government and are argued to demand less quality-differentiated audit. It is contended that for these types of companies (Chinese, Bumiputra and foreign), the agency and other transaction costs associated with Chinese companies will be the lowest due to the existence of Chinese business practices of the type suggested by Limlingan (1986) and others.
5.2 Audit Fees and Auditor Ethnicity
The characteristics of client companies along ethnic divisions are also likely to feature among audit firm personnel. Chinese auditors can be argued to be more cost efficient than non-Chinese auditors due to the Chinese business practices discussed earlier. Chinese audit partners are argued to place greater emphasis on individual audit managers’
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performance and rely upon family members and other ethnic-Chinese employees to reduce business costs (Limlingan, 1986; and Kao, 1991). Chinese business practices and strategy are argued to result in lower-cost audits associated with Chinese auditors.
Interestingly, Bumiputras have been less successful in the accounting profession as compared with other professional sectors such as engineering and architectural sectors, even with government support (Horii, 1991). Partly, this could be due to the protective nature of Chinese auditors over the sector in which they have had a virtual monopoly.12 They may also have a competitive edge due to the superiority of the Chinese business network. In a way, the Chinese monopoly and network may exist as barriers to the entry of newcomers from other ethnic backgrounds in the accounting profession (Lim, 1983).13 Based on this line of reasoning, the prices of audit charged by Chinese auditors may be held substantially above competitive levels due to monopolistic behaviour by Chinese auditors. Further, Chinese auditors are relatively more experienced than non-Chinese auditors due to their long involvement in the accounting profession and this is likely to result in economic rents accruing to them. Chinese auditors have incentive to charge higher prices to reflect their greater expertise. Note that both lines of argument (i.e. cost efficiency vs. product differentiation) eventually promote barriers to free entry (Yardley et al, 1992).14 This reasoning leads to the following null hypothesis, controlling for other explanations:
H3: There is no significant difference between audit fees charged by Chinese auditors and non-Chinese auditors, irrespective of auditee.
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Further, it is argued that Chinese auditors (as a group charge fees differently from nonChinese auditors due to their unique behavioural characteristics. Evidence of the presence of a significant audit fee premium accruing to Chinese auditors would provide support for Chinese auditors’ greater audit expertise and/or monopolistic position. The rejection of the null hypothesis in the negative direction would provide evidence of Chinese auditors’ operating efficiency. It could then be concluded that Chinese auditors are more cost efficient than non-Chinese auditors due to Chinese business
practices.
Non-Chinese
auditors (Bumiputra, Indian and other non-Chinese Malaysians) are argued to be less cost efficient compared to Chinese auditors.
In particular, Bumiputra auditors are relative newcomers to the profession and hence, they may lack experience and industry expertise. The presence of foreign accountants is negligible due to strict residential requirements under Malaysian law. Additionally, the admission to the Malaysian Institute of Accountants (MIA) is mandatory for those intending to work in Malaysia under the Accountant Act, 1967. For this reason, auditors in Malaysia are partitioned into two categories only, namely Chinese and non-Chinese auditors.
To rule out the influence of Chinese (or non-Chinese) companies on audit fee, the following sub-hypotheses are investigated, other things being equal:
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H3a:
There is no significant difference between audit fees charged by Chinese auditors and non-Chinese auditors, where the auditee is a Chinese controlled company.
H3b:
There is no significant difference between audit fees charged by Chinese auditors and non-Chinese auditors, where the auditee is a non-Chinese controlled company.
The sub-hypotheses (H3a and H3b) are designed to provide further but different evidence of the effects of Chinese business practices on audit fees. Rejection of the null hypotheses would support the notion that Chinese auditors (alone) give rise to a different level of audit fees, irrespective of the nature of the auditee. Further, Chinese auditors are contended to charge fees differently from non-Chinese auditors even in the absence of an ethnic match between auditor/auditee (H3b).
6.0 RESEARCH DESIGN
6.1 Sample and Data
Data for the study is drawn from annual reports of all Kuala Lumpur Stock Exchange (KLSE) listed companies for both the Main and the Second Board in the period 19931995.15 The process of data collection involved registering the data of each company for the period 1993-1995 from company records and verifying the data with KLSE annual
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handbooks [volumes 21 (1-4) and 22 (1-4)].16 The three-year period used in the study (1993-1995) represents the early years of post-New Economic Policy (NEP).17 The period was characterized by high economic growth and low unemployment rates. The data was deflated based on the Consumer Price Index (CPI) to avoid effects of inflation (if any) on audit fee and other financial data. In addition to economic solidity, the three-year period was a period of high political stability.
The selection of KLSE companies offers several advantages over non-listed companies. Firstly, annual financial reports are publicly available. All listed companies must submit their annual reports to the KLSE within a stipulated period. Further, they are required by the Companies Act, 1965 to file annual reports to the Registrar of Companies. Secondly, it enables direct comparison with previous studies in Malaysia and explanation of any possible inconsistencies in results. Thirdly, the effects of foreign investment are observable in this market. Fourthly, the selection of companies represents the population of KLSE listed companies. Finally, the data which are extracted from annual reports can be verified using various volumes of KLSE annual handbooks.
The utilization of pooled cross-sectional and time series data (sometimes known as longitudinal or panel data)18 provides several advantages over cross-sectional data or time series data.19 In particular, it allows for more efficient estimation of the parameters given a richer source of variation (Baltagi, 1995). As well, less restrictive assumptions are needed to test the models with panel data and this allows researchers to specify and test more sophisticated behavioural models (Baltagi, 1995 and Balestra, 1992). The data sets
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are also able to control for individual heterogeneity and may alleviate the problem of multicollinearity (Balestra, 1992). The technique can identify and estimate effects that are not detectable in pure cross-sections or pure time-series data (Baltagi, 1995). Table 3 describes companies in the data set.
PLACE TABLE 3 HERE
The sample for this study consists of all companies listed on the KLSE for the years 1993, 1994 and 1995. Newly listed companies were deleted because of unavailability of lagged data. The annual reports for these companies prior to the listing are not publicly accessible. Similarly, not all data is obtainable if the companies were quoted after their respective financial year-ends the year before (33 cases). A number of companies with annual reports that do not have all the necessary information required for the study were also eliminated. This included annual reports that did not contain the signing date (21 cases) and audit partner's name (9 cases) in the audit report. This information is crucial to determine the audit time lag and the ethnic background of the auditor. Seven cases were excluded for statistical reasons due to their undue influence on the regression equation.20
6.2 Model Specification
This study replicates earlier audit fee models (for example, Butterworth and Houghton, 1995) in order to investigate the pricing of audit fees. Since the study utilizes panel data, Generalized Least Squares (GLS) model is more appropriate than the OLS model.21 First,
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the random effects approach22 of the Error Components Model (ECM)23 is estimated using Generalized Least Squares (GLS) regression. The GLS model24 is similar to the previous model that has been used extensively in the literature25 but it now has a time dimension attached to it to cope with the panel data. Several contextual variables are incorporated in the model to accommodate the Malaysian audit services market environment as discussed elsewhere. Specifically, the model takes the following form:26
LAFEEit = 0 + 1ETHNICVARit, + 2LASSETit + 3LSUBSit + 4INVREC + 5LEVit + 6ROEit + 7LDELAYit + 8LNASit + 9BSIXit + 10SPECit + 11BOARDit + + 12FINit + 13 MINit + 14PLANTit + 15BUSYit + 16LQUALit + 17CHANGEit + i + εit
(1)
where the definition of the variables is set out below (the specification of the measures follows later in the paper) LAFEE = Log transformation of audit fee ETHNICVAR = Hypothesis variable either related to ethnically controlled companies [Chinese (CCCS) or foreign (FCCS)], Chinese auditors (CA)] LASSET = Log transformation of total assets LSUBS = Log transformation of number of subsidiaries plus one INVREC = Proportion of inventory and receivables to total assets LEV = Ratio of long term debt to total equity ROE = Return on equity LDELAY = Log transformation of audit delay LNAS = Log transformation of non-audit fee BSIX = Brand name or Big Six auditor SPEC = Specialist auditor BOARD = KLSE board membership FIN = Financial sector MIN = Mining sector PLANT = Plantation sector
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BUSY LQUAL CHANGE 0, 1, … 17 i
= = = = =
Busy season Lagged (-1) audit opinion Auditor change Constant term and regression coefficients Random disturbances related to cross-sectional, specific components (time-invariant) assumed to be normally distributed with constant variance. εit = Error term assumed to be normally distributed with constant variance (the remainder effects).
Different indicated variables for ethnically controlled companies (i.e. Chinese, Bumiputra and foreign) are used for the tests of H1 and H2. Similarly, an indicated variable for Chinese auditors (CA) is utilized to test H3, H3a and H3b.
6.3 Variable Measurements
Except for the hypothesis and year indicated variables, other variables come from the models used in previous studies (see for example Chan et al, 1993; Butterworth and Houghton, 1995; and Craswell et al, 1995). The measurement of the variables in the GLS regression model is discussed below.
6.3.1 Dependent Variable
The dependent variable for the GLS Regression Model is audit fee which is measured by the dollar value of the audit fee paid by the firm to its principal auditor. Like several British Commonwealth countries, audit fees are required by law to be disclosed in company annual reports. In Malaysia, this duty is mandated by the Companies Act,
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(1965) which has substantial penalties for non-, or inaccurate disclosure. Consistent with previous studies, logarithmic transformation is applied to audit fees since they are likely to increase at a decreasing rate with size.
6.3.2 Hypothesis Variables
Testing hypotheses H1 - H3 require data concerning whether or not a majority of the substantial shareholding is Chinese, Bumiputra or foreign. Only substantial shareholders (as defined by the law) are considered for the purpose of this classification. A shareholder (individual or institutional) who has an interest in five percent (or more) of the voting shares is classified as substantial shareholder and the disclosure of this information is required by law (see, Section 69 of the Companies Act, 1965).27
A previous study conducted by Chan, et al (1993) in the UK also used five percent of shareholding as a cut-off point for ownership control. The cut-off point is somewhat arbitrary but it is expected to represent significant influence by shareholders either through voting rights or representation on the board of directors. This is because it would be difficult for smaller shareholders (i.e. those with shareholdings of less than five percent) to organize to take action (Francis and Wilson, 1988).
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6.3.2.1 Chinese Controlled Companies (CCCS).
This is a continuous variable and defined as the percentage of Chinese substantial shareholding (i.e. the ownership of Chinese substantial shareholders as a group) to total substantial shareholding. The ethnicity of the individual shareholder is based on the name disclosed in annual reports.28 The ethnicity of the corporate shareholder is based on its ultimate owner(s).29 This variable is expected to be negatively related to audit fees due to Chinese business practices discussed earlier (hypothesis H1).
A dummy variable for Chinese controlled companies based on an ethnic Chinese/nonChinese dichotomy is also used in the further analysis described later in the paper. The company is defined as Chinese controlled if the Chinese substantial shareholders (as a group) own the majority of voting shares (coded 1 and 0 otherwise).30 This variable is used also to classify the company based on the ethnicity of its majority substantial shareholders in descriptive analysis. Further, continuous and dummy measures of Chinese controlled companies based on the percentage of Chinese directors to total directors on the board are also tested. Similarly, these measures are applied to other ethnic (Bumiputra and foreign) controlled companies for further tests.
6.3.2.2 Chinese Auditor (CA)
The auditor is defined as Chinese in operation if the engagement partner is of Chinese descent (coded 1 and 0 otherwise). The engagement partner is responsible for managing
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the audit work and other day-to-day dealings with the client-company and is assumed to negotiate the audit fee with the client.31 The name of the partner is provided at the end of the audit report in the corporate annual report. The same method as for identifying the ethnicity of substantial shareholders in section 6.2.21 (CCCS) is applied here.
6.3.2.3 Foreign Controlled Companies (FC)
This variable is defined as the percentage of foreign substantial shareholding (i.e. the ownership of foreign substantial shareholders as a group) to total substantial shareholding. The identification of foreign ownership is similar to that of Chinese controlled companies (see also footnotes 28 and 29).
6.3.3 Control Variables
In order to test for the effects of ethnic business practices, sixteen variables that proxy for company size (LASSET), complexity (SUBS and INVREQ, risk (LEV, ROE and LQUAL), industry (BOARD, FIN, MIN and PLANT), auditor quality attributes (BSIX and SPEC) and other factors (LNAS, BUSY and CHANGE), which affect audit fees, are controlled in the model. These variables were found to be significant explanators in most previous studies (see for e.g. Chan, et al, 1993; Butterworth and Houghton, 1995; and Craswell, et al, 1995). The measurement of these variables is described in Table 4 below.
PLACE TABLE 4 HERE
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7.0 DESCRIPTIVE AND ANALYTIC RESULTS
7.1 Descriptive Analysis
Table 5 presents the descriptive statistics for relevant variables. The amounts are in Malaysian Ringgit (RM).
PLACE TABLE 5 HERE
The audit fees for the sample population range from RM3,000 to RM2,753,000 while total assets range from RM3,951,000 to RM81,779,252,000. KLSE listed companies have an average gearing level (LEV) of about 7.9% and average ROE of 28.5 1 %. A number of variables have a standard deviation greater than the mean, such as AFEE, NASFEE, TASSET, LEV and ROE. Moreover, the distributions of some of these variables are positively skewed due to the presence of several very large companies. The distributions are similar to previous studies of the Malaysian market (see Lin and Yin, 1990; Eichenseher, 1995 and Che-Ahmad and Derashid, 1996) and comparable to the studies in the West (see for example Chan, et al, 1993). Following previous studies, a logarithmic transformation is applied to these variables in the regression model.
Similar to other business environments, Big Six (BSIX) auditors dominate the Malaysian market with 77.1% market share in terms of number of audits for the three-year period.
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About 16% of the KLSE companies hire a specialist auditor (SPEC) to do audit works. The auditor is likely to be retained by the company as indicated by low turnover rate (CHANGE = 4.7%). As expected, Chinese audit partners are the largest (61.5%) followed by Bumiputra partners (27.3%) and others (11.2%). Table 6 describes summary statistics for the companies in the sample based on ethnic backgrounds.32
PLACE TABLE 6 HERE
Audit fees produce a mean of RM140,560, RM159,840 and RM99,060 for Chinese, Bumiputra and foreign companies respectively. The average mean of total assets for Bumiputra companies is about six times greater than foreign companies and about 2.75 times greater than Chinese companies. As indicated earlier, the presence of several large companies (such as Telekom, Tenaga Nasional, Malaysian Airline System and Malaysian International Shipping Corporation) influence the means of variables for Bumiputra companies. Foreign companies have the lowest average gearing level (LEV of 2.8%) and the highest level of profitability (ROE = 44.7%). As expected, the average ratio of Bumiputra directors to total directors is highly significant in all types of companies. Similarly, Bumiputras hold a substantial average percentage of substantial shareholding in those companies. This is because of affirmative action policies adopted by the government as discussed earlier. Table 7 exhibits a matrix of correlations for the independent variables.
PLACE TABLE 7 HERE
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Pearson’s correlations are comparatively low. All have values below 0.5 except the correlation between log total asset (LTASSET) and log subsidiaries plus one (LSUBS) (r = 0.54). However, this is not expected to significantly influence the regression results (Balestra, 1992).33
7.2 Regression Analysis
Table 8 presents GLS regression results for all hypotheses for panel data (1993-1995)34 while Tables 9, 10 and 11 presents OLS regression results for all hypotheses for each year (1993, 1994 and 1995). In this first stage of the analysis each hypothesis is tested separately with each hypothesis variable being included in the GLS model one after another. Similar approach is also carried out in the OLS model. The models are all significant at p < 0.00 1.
PLACE TABLES 8, 9, 10 AND 11 HERE
Column A in each table provides the regression results for hypothesis 1 (H1). The coefficient of the variable for Chinese-controlled companies was highly significant (p < 0.01) for panel data as well as cross-sectional data (1993 p < .01; 1994 p = .05; 1995 p = .10) and in the predicted (negative) direction in all estimations. The coefficient of the variable for Chinese-controlled companies is significant and in the predicted (negative) direction for each year.35 Hypothesis H1 confirms the notion that Chinese companies pay
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significantly lower audit fees than non-Chinese controlled companies controlling for the factors outlined above.
Column B in Tables 8, 9, 10 and 11 (H2) reveals that, as predicted from theory, foreign companies pay significantly higher fees than local companies in the total sample as evidenced by significant and positive coefficient of variable FCCS (H2) (p
