The Role of External Auditors in Business Group Governance: Evidence from the Number of Audit Firms Selected in Taiwanese Groups

Business groups are currently one of the most crucial organizational forms worldwide. However, unlike stand-alone companies, related companies in business groups experience the agency problem of tunneling. We investigate the association between the agency problem of tunneling and the concentration of audit firm selections in business groups. On the basis of Taiwanese business groups from 1999 to 2007, we use the divergence between voting rights and cash flow rights to measure the agency problem of tunneling. Our results show that higher group divergence decreases the number of audit firm selections in business groups. In addition, auditors who audit more related companies in business groups weaken the negative association between divergence and earnings quality as proxied by discretionary accruals, financial restatements, and value-relevance of earnings. Overall, controlling shareholders with higher divergence concentrate on audit firm selections in their business groups to enhance earnings quality, consistent with the agency hypothesis of the demand for audit quality.