Do audits serve as an external risk oversight tool to boost firm performance?

Abstract

This study explores the relationship between audits, concentrated managerial power, and firm performance in the Chinese manufacturing industry. Analyzing 1,264 publicly listed manufacturing firms over the five-year period (2017–2021), this study provides evidence that heavily concentrated management control hurts firm performance. The finding that heavily concentrated management control hurts firm performance is consistent with existing research on emerging markets (Debnath et al., 2021). Furthermore, consistent with existing research on audits protecting shareholder interest (Beneish, 1999) and improving firm earnings (Baxter & Cotter, 2009), the results of this study demonstrate that audits have the potential to operate as a risk oversight mechanism, reducing the likelihood of concentrated management control and therefore improving firm performance overall. This role of audits in corporate governance may be especially important in China, where the protection of minority shareholder interests may be more crucial (Chen et al., 2013), and in fact, the current study shows that audits mitigate the negative effects of concentrated management control on firm performance. However, the current research also demonstrates that the effects of audits on firm performance depend critically on how audits are identified. While longer-term, more stable auditing relationships decrease the likelihood of concentrated management power and mitigate the negative impact of concentrated power on firm performance, higher auditing fees, on the contrary, are associated with more concentrated management power, exacerbating the damage concentrated power does to firm performance. The empirical results are robust when replicated using propensity score matching (PSM) and entropy balancing techniques. Overall, the results demonstrate the effectiveness of audits as a tool in corporate governance but suggest the existence of conflicts of interest in fee-based auditing, which exacerbate agency costs.