Monitoring Function of the Board and Audit Fees: Contingent upon Ownership Concentration

Abstract

Board independence is considered as a key corporate governance mechanism to help preserve the necessary checks and balances between the board and executive management. Request for external audit services falls into the realm of board strategic decisions. To test the monitoring function of the board, the objective of this paper is to revisit the board independence-audit fees relationship while taking into account the ownership structure of the firm. Two effects are unfolding along the ownership concentration spectrum: separation of ownership and control (Principal-Agent problems) and separation of voting and cash flow rights (Principal-Principal problems).

The study is conducted over a seven-year period (2002-2008) using panel regressions on a sample of Canadian publicly traded companies. The results show a positive and significant relationship between board independence (BI) and audit fees (AF) when ownership is concentrated in the hands of a dominant/controlling shareholder. The highest level of separation between voting and cash flow rights is also found in controlled entities. The higher the gap between voting and cash flow rights of the ultimate owner, the stronger the relationship between BI and AF. Overall, evidence supports both the Demand Based Perspective on audit fees and the Expropriation Effect argument.