External versus Internal Monitoring: The Importance of Multiple Large Shareholders and Families to Auditor Choice in Western European Firms

Abstract

The ownership structures of Western European firms engender agency conflicts between: (i) owners and managers (type I); and (ii) minority and controlling shareholders (type II). Prior research stresses that credible financial reporting ameliorates agency problems by identifying any diversion of corporate resources. We examine whether external monitoring by a high-quality auditor helps reduce the agency problems embedded in the ownership structures of Western European firms. In regressions that control for firm characteristics as well as country and industry fixed effects, we find that the demand for a Big Four auditor is insensitive to whether the largest shareholder’s control rights exceed her cash flow rights. Consequently, we fail to find any evidence that the agency conflict between minority and controlling shareholders affects the demand for external monitoring. In contrast, we find strong, robust evidence that firms with multiple large shareholders and family-dominated firms are associated with a lower demand for Big Four auditors. This suggests that committed internal monitoring by multiple large shareholders and families is valuable, which reduces the benefit of external monitoring by a Big Four auditor. Collectively, our research suggests that Western European firms rely more heavily on Big Four auditors when the type I agency problem stemming from the separation of ownership from management is worse. However, supplementary analysis reveals that East Asian firms that are known to suffer from poor corporate governance do not substitute between external monitoring by a high-quality auditor and internal monitoring by multiple large shareholders or families, which squares with prior research that the type II agency problem is more relevant in this region.