The Impact of Managerial Ownership on the Likelihood of Provision of High Quality Auditing Services

Abstract

This study investigates the relation between managerial ownership and the audit quality of the firm. In modern corporations, the separation of ownership and control creates incentives for managers to maximize their own wealth at the expense of shareholders (Jensen and Meckling 1976). Manager‐owners thus have an incentive to reduce associated agency costs by providing high quality auditing. High audit quality should thus be increasing as managerial ownership decreases. A related agency problem is that of entrenchment‐ whereby managers, by virtue of their increased voting power, have increasing power to shirk and procure perquisites at shareholders' expense. The associated increasing agency risk implies that, when the risk of entrenchment decreases, the need, and thus provision, of high audit quality should also decrease. Based on these arguments, and following prior empirical research, we posit and find that at low and high levels of managerial ownership (below 5% and above 25%), where entrenchment is not increasing, audit quality is decreasing in managerial ownership. At intermediate levels, where entrenchment arguably does increase, it is unclear which effect (divergence‐of‐interests or entrenchment) dominates. For our sample, we document a negative association in this region, a result consistent with the notion that divergence‐of‐interests is the primary agency‐related determinant of audit quality at all levels.

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