Audit quality and owner-manager agency costs: evidence from China

Abstract

Agency theory suggests that conflict interests between managers and owners cause management shirking and associated agency costs. An audit is a monitoring mechanism that provides an independent check on accounting information and reduces agency costs (Jensen and Meckling, 1976). Therefore, given severe owner-manager agency problems, higher audit quality should be associated with lower client company owner-manager agency costs. The purpose of this study is to empirically test this relation. In China, owner-manager agency problems are severe given extremely low or no management ownership. Moreover, there is a lack of variations in management holdings across Chinese public companies. Such an environment allows us to examine the role of audits in reducing owner-manager agency costs. Using a sample of Chinese listed companies, we find that observations with higher quality audits show lower owner-manger agency costs. Such a result suggests that in an emerging market, higher quality audits more effectively reduce agency costs.