The Effect of Independent Directors’ Reputation Incentives on Auditor Choice

• In Event: Engagement of Audit Firms

Abstract

We examine whether independent directors’ reputation incentives have an impact on the firm’s auditor choice. We find that firms with a higher proportion of independent directors with low reputation incentives are more likely to hire Big 4 auditors or auditors with industry expertise. Such evidence is consistent with higher agency conflicts increasing the demand for greater third-party assurance: as directors allocate less time and energy to firms of low reputational value, the agency conflicts of these firms increase, which in turn increases the demand for high-quality audit. We further show that the relation between independent directors’ reputation incentives and a firm’s demand for high-quality audit weakens with firms with strong governance mechanisms, but strengthens when firm issue large amount of equities. In addition, we document that high-quality auditors play a more important role in increasing the financial reporting quality for firms with concerns of weak independent directors’ reputation incentives.

Authors

• So Yean Kwack, City University of Hong Kong

• Jong-Hag Choi, Seoul National University

• Yuyan Guan, City University of Hong Kong

• Hua FENG, Xi'an Jiao tong University