FOREIGN OWNERSHIP AND CORPORATE GOVERNANCE PATTERNS: THE BOARD-AUDITOR RELATIONSHIP IN JAPAN

Kurt A. Desender Department of Business Economics Universidad Carlos III Calle de Madrid, 123, 28903. Getafe (Madrid). Spain. Email: kdesende@emp.uc3m.es; Ruth V. Aguilera Department of Business Administration College of Business, 306 Wohlers Hall 1206 S. Sixth Street, Champaign, IL 61820; and ESADE Business School Avda. Pedralbes 60-62 Barcelona, SPAIN Email: ruth-agu@uiuc.edu; Rafel Crespi Departament dEconomia de lEmpresa. Universitat de les Illes Balears. Campus Cra. Valldemossa Km7. Spain Email: rafel.crespi@uib.es Monica Lopez-Puertas Lamy Department of Business Economics Universidad Carlos III Calle de Madrid, 123, 28903. Getafe (Madrid). Spain. Email: monica.lopezpuertas@unibo.it

THIS VERSION: APRIL 2013 ABSTRACT Auditing is an important piece of the corporate governance puzzle because it is an instrument enhancing the protection of investors rights. We draw on a contingency approach which conceptualizes corporate governance as a system of interrelated elements having strategic or institutional complementarities and claims that particular governance practices will only be effective in certain combinations which may lead to different corporate governance patterns. We claim that the relationship between boards and auditors is contingent on the ownership of the firm, and in particular on the degree of foreign ownership. To test this logic, we focus on the relationship between board characteristics and audit fees in Japanan institutional setting which differs substantially from the U.S., and which has witnessed a high increase in AngloAmerican institutional investors. Our results show that board independence, as well as board of corporate auditors independence and the external auditor become complementary when foreign ownership is high, while such relation is absent when foreign ownership is low. Our findings highlight the possibility of different patterns of corporate governance within one country, shaped by the weight of foreign owners. Keywords: Board of directors, Board of auditors, Ownership structure, Audit fees, Japan

INTRODUCTION

One of the sharpest distinctions among corporate governance (CG) systems is between the market or shareholder economies of the Anglo-American countries and the stakeholder economies typified by Germany and Japan (Hall and Soskice 2001; Streeck, 2001). Unlike the Anglo-American system, the stakeholder system features debt financing, concentrated shareholders, and tightly interconnected networks among firms, their trading partners, and financial institutions. Elements common in Anglo-American CG systems often remain weak in other countries, where alternative CG mechanisms may effectively substitute and display different sets of complementarities (Aguilera et al., 2008). Japan is a particularly suitable setting for research on the confrontation between these two stylized systems, because (1) the Japanese system contrasts sharply with the Anglo-American system, and (2) the influence of foreign investors (typically Anglo-American institutional investors) increased dramatically since the 1990s. Corporate governance is an institutional element of a nations business system and hence reflects economic and social structures and norms of key stakeholders in a society (Fiss and Zajac, 2004; Guillen, 2000; Whitley, 1992). The Japanese CG system has long been characterized by large shareholdings with domestic affiliated interests, including corporate owners and financial institutions that hold various stakes in ongoing business relationships with the firms in which they invest (Clark, 1979; Gerlach, 1992). In response to the pressure of increased globalization of financial markets and entry of foreign capital, Japanese regulators aimed to replace elements of the existing system with distinctively AngloAmerican practicesindependent board members, enhanced disclosure and transparency, and greater attention to shareholder value (Ahmadjian and Song, 2004)1. The growing

In particular, in 2002 Japan introduced reforms in its corporate governance system, seeking to change from the traditional Japanese board structure which encompasses a separate board of auditors, instead of the typical audit committee within the board. Beginning in 2003, Japanese companies had the option to continue with the traditional statutory separation between the board of directors and the board of auditors, or to change to the

presence of more market-oriented shareholders, especially foreign portfolio investors, may give rise to hybrid forms of CG (Aguilera and Jackson, 2003). Ahmadjian and Robbins (2005) argue that to assess the influence of these new actors it is necessary to look not only at their direct effect, but also at how they are embedded in the existing system. The general outline of our argument is as follows. The interests of shareholders vary across business systems. In stakeholder systems such as Japan, shareholders tend to have other interests above and beyond their equity investment, such as maintaining on-going business relationships. In shareholder systems, shareholders care primarily about the return on their investment. When investors from a shareholder system invest in a stakeholder system, we argue that their interests clash with the stakeholder logic. To protect their investment, they influence the firms monitoring behavior, within the existing CG context, to implement monitoring dynamics common in the Anglo-American context. We argue that Japanese converge towards a more Anglo-American CG approach, is likely to be strongest where the proportion of foreign (Anglo-American) investors is large. To test this rationale, we examine differences in board practices rather than solely differences in board structural characteristics, given that changes in governance features may turn out to be cosmetic, symbolic, or camouflaged with the underlying practices left unchanged (Fiss and Zajac, 2004; Buck and Shahrim 2005). Specifically, we focus on the relationship between board practices and external audit fees. We claim that the relationships between boards and external auditors will be contingent on the degree of foreign ownership. Our results in Japanese listed firms show that board independence and intense external auditing becomes complementary when foreign ownership is high, while such relationship remains absent when foreign ownership is low.
Anglo-American board style which includes an audit committee. In total, only 51 out of about 2300 publicly traded Japanese companies chose to adopt the Anglo-American board structure by 2010 (TSE, 2011), a proportion which remains constant by the end of 2012. Gilson and Milhaupt (2005) argue that the 2002 Japanese governance reform is an interesting illustration of formal, but not functional, convergence. We would add that this reform is mostly symbolic.

In the context of Japanese CG, factors explaining change or continuity in CG systems include ownership structure (Yoshikawa and Gedajlovic, 2002), corporate restructuring (Ahmadjian and Robbins, 2005), external directors (Yoshikawa and Phan, 2003), and the degree of shareholder activism (Seki, 2005). Regardless of the importance of foreign

ownership in CG, there is a lack of work focusing comprehensively on the influence of foreign ownership on changes in CG patterns, including in Japan. To address this issue, we develop a contingency approach which builds on the notion that CG is a system of interrelated practices having strategic or institutional complementarities (Aguilera et al., 2008; Adams and Ferreira, 2007). We explicitly argue how heterogeneity in shareholders objectives and the span of control over governance practices is important to understand the influence of foreign ownership over existing governance arrangements, as well as the emergence of hybrid bundles of governance practices. We sustain that the substitute/complementary association between governance practices is likely to depend on the composition of shareholders as well as the heterogeneity of the shareholders objectives and influence over governance practices. Therefore, rather than assuming that one universal set of governance relationships guarantees effective governance for all shareholders, this study explores how CG practices interact by substituting or complementing each other, when foreign owners with distinct objectives and preferred governance interact with existing shareholders who rely on informal governance. This logic allows us to sidestep problems related to identifying individual elements which are universally associated with good governance. This research design also fulfills our focus on the influence of foreign ownership on board practices rather than on any specific board characteristic. External auditors are an important piece of the CG puzzle for two reasons. First, they are an instrument to enhance the protection of investors rights. Second, they interact with

the board of directors and share the objective of identifying and rectifying reporting errors made by managers to promote shareholders interests. While most studies predict that

outside directors are likely to demand a more extensive audit to increase the financial reporting reliability, counter arguments suggest that a board filled with outside directors should improve internal controls over financial reporting, which in turn should reduce the auditors risk assessment and the audit fees (Carcello et al., 2002; Abbott et al., 2003). Hay, Knechel and Wong (2006) reveal in their meta-analysis of audit research over the last 25 years that the vast majority of studies focus on Anglo-American firms. They call for future research to study how different forms of firm ownership and local institutional environments might affect audit fees across companies. Our proposed conceptual model is illustrated in Figure 1. --------------------------------Insert Figure 1 about here ---------------------------------Our contributions are both theoretical and empirical. From a theoretical viewpoint, we offer greater insight into the influence of foreign ownership on CG practices and contribute to debates on globalization and convergence of CG systems, by investigating how foreign capital affects strategic board practices. In addition, Aguilera and Jackson (2003) argue that firms, regardless of their legal family constraints, their labor and product markets, and the development of the financial markets from which they can draw, have some agency to choose the degree to which they adopt a given CG practice. Our study builds on these arguments and suggests that firms governance patterns must also be examined in relation to the presence of foreign ownership. Our findings demonstrate that, for Japanese listed firms, patterns of CG are contingent on the level of foreign ownership and that the convergence/divergence towards the Anglo-American system is unlikely to be uniform across

all firms, uncovering hybrid systems. Furthermore, we expand the concept of bundles of CG from a single decision-makers perspective to a setting where multiple stakeholders, with different objectives and risk profiles, influence a (partial) set of practices given the choices made by other stakeholders. This perspective sheds new light on the

substitute/complementary nature of CG practices. From an empirical viewpoint, by studying Japanese firms, we offer insights into the external validity of CG studies conducted in the Anglo-American context. Moreover, our results add to the comparative CG literature by showing the relevance of understanding the institutional context to explain cross-national differences in governance practices. Although our research is set in Japan, it has implications for a broader understanding of institutional change. Whereas researchers have emphasized distinctions between governance systems and the patterns through which these systems evolve, there is less evidence on the mechanisms by which systems change. Further development of theory on governance systems requires attention to potential mechanisms of change as well as inertial points of continuity. By investigating how global capital affects strategic board behavior, this article contributes to debates on globalization and convergence of CG systems. In the next sections, we first provide an overview of the Japanese CG context. Next, we discuss the external validity of the agency arguments developed in previous research by testing the relationship between board characteristics and the degree of audit fees in a nonAnglo-American context. Here we bring in our contingency framework. The data and

methods section specifies the model to estimate and describes the variables. The results detail the findings of the tested models which allow us to inform how foreign investors may influence board practices towards more or less auditing.

JAPANESE CORPORATE GOVERNANCE CONTEXT

Japan is usually categorized as a network-oriented country, where firms have maintained a strong stakeholder orientation. The Japanese system is characterized by tight networks of vertical and horizontal groupings known for their cross-shareholdings and financial, human, and transactional ties (Lincoln and Gerlach, 2004). Instead of owning stocks primarily as portfolio investments or for financial purposes, domestic investors are often business partners or commercial banks, both of which hold shares for the implicit purpose of business goodwill, information exchange and mutual monitoring. Crossshareholdings are also motivated to ensure stability in earnings and sales and, therefore, to protect the benefits of their business partners (Caves and Uekusa, 1976; Gedajlovic and Shapiro, 2002). They are similar to what Aguilera and Jackson (2003) categorize as investors that have strategic interests as opposed to financial interests. In addition, in the Japanese system, employees have been identified as one of the key stakeholders of a firm (Yoshimori, 1995; Colpan et al, 2011). With stakeholders concerned about long-term relationships, firms develop and implement strategy based on long-term goals, seeking to maximize market share and growth rather than profits or share price (Abegglen and Stalk 1985). In this respect, Deakin (2010) argues that most large Japanese firms are run on a variant of the community firm system in which executives see themselves as having a commitment to maintain the company as an entity in its own right, and view their obligations to customers and employees as taking priority over those owed to shareholders. While shareholders can replace the directors with a majority vote and can initiate litigation against directors, in practice, however, Japanese shareholders rarely exercise these rights. Table 1 provides a brief comparison of the Anglo-Saxon and Japanese governance context. --------------------------------Insert Table 1 about here ----------------------------------

The Japanese board of directors, like its U.S. counterpart, is vested with authority to make strategic decisions and monitor corporate activity. However, Japanese boards have not traditionally emphasized their monitoring role (Gilson and Milhaupt, 2005; Aoki, Jackson and Miyajima, 2007). Until recently, they were comprised almost exclusively of senior managers who have served the corporation throughout their careers (Cheffins and Black, 2006). While the lifetime employment system generated a great deal of loyalty to the employer, with a high level of integrity and a low level of fraud and betrayal, it also tended to make Japanese companies unwilling to appoint more outsiders in key roles such as members of the board of directors2. Deakin, (2010/2011) compare UK with Japanese boards and claim that, in Japan, there is a recognition that a lack of a deep knowledge of the companys business makes it inappropriate for outside directors to make informed decisions concerning corporate strategy, and that this in turn limits their monitoring role. Therefore, outside directors are mostly seen as advisers and not as monitors. Currently, a Japanese joint stock corporation with corporate auditors, i.e., the traditional Japanese governance system, is not required to have any outside directors on its board of directors. An outside director is defined as a director of the company who does not engage or has not engaged in the execution of business of the company or its subsidiaries as a director of any of these corporations, and who does not serve or has not served as an executive officer, manager or in any other capacity as an employee of the company or its subsidiaries. Over the past decade, however, outside directors have become more common in Japanese boardrooms. The limited presence of outside directors, however, does not mean that monitoring is non-existent. Kaplan and Minton (1994) find that top executive turnover increases

As stated by Masayasu Uno, who is a member of the board of corporate auditors of Daito Construction and Trust and a member of the Professional Accountants in Business (PAIB) Committee of the Japanese Institute of Certified Public Accountants (JICPA). http://www.ifac.org/sites/default/files/publications/files/1.4-unobridging-east-west-final.pdf (accessed 2 April, 2013).

substantially in years of outside director appointments, previously employed by banks or by other nonfinancial firms, to Japanese boards. They argue that their results are consistent with an important monitoring and disciplining role for banks, corporate shareholders, and corporate groups in Japan. In addition to monitoring by relational shareholders, there is strong peer-based monitoring, with senior executives, in effect, monitoring each other throughout their careers. Retired executives also play a significant role in monitoring, often through informal channels (Deakin, 2010/2011). Japanese law (the 2002 Commercial Code and Securities Exchange Law) requires two types of auditors, in the traditional board system. The first type is known as corporate (or statutory) auditors (kansayaku) and they are internal to the company. The corporate auditors sit on a board of auditors, separate from the board of directors. The Board of corporate auditors is a weaker version of the German supervisory board, as the Japanese corporate auditor lacks the power to appoint or remove directors (Chizema and Shinozawa, 2011). Its members are nominated by the board of directors and appointed at the general shareholders meeting. The Board of corporate auditors is responsible for establishing a CG system that will ensure the sound and continuous growth of the company and accommodate societys trust by auditing the directors performance of their duties as an independent organization entrusted by the shareholders (JCAA, art.2; 2008). Corporate auditors attend board meetings and are authorized to speak against or in favor of all corporate matters and business conduct. In case a corporate auditor suspects that a board member is engaged in misconduct or is in conflict with applicable laws and regulations, it is the duty of the corporate auditor to report it to the board of directors. The second type is the external auditor (kaikeikansinin), and is equivalent to external auditors elsewhere. The auditors role is to act as moderators of the information asymmetry between shareholders and management by validating managerial financial disclosure.

However, in Japan, external auditors have often been regarded as accommodating management interests (Numato and Takeda, 2010). External auditors are appointed at the general shareholders meeting, subject to the agreement of the board of corporate auditors. A series of reforms that were instituted in the early 2000s intended to transform the Japanese CG from its traditional role supportive of management to a monitoring function, more in line with Anglo-American countries. It became required for external auditors to declare whether a client faces a serious risk of going bankrupt within a year, and more importantly, auditors could be sued if found to have misled shareholders. Furthermore, the revised Japanese Companies Act of 2005, requires the board of corporate auditors to have at least three statutory auditors of which at least half must be outsiders, i.e., someone who has never been a director, accounting counselor, executive officer, manager or in any other capacity as an employee of the company or any of its subsidiaries. In addition, the board of corporate auditors must be a separate body from the board of directors, and its members may not serve concurrently on the board of directors. The Japanese system of CG, in its emphasis on a range of internal and external modes of monitoring with varying degrees of formality, contrasts strongly with the exclusive focus on formal, external monitoring that has come to characterize Anglo-American CG practice (Deakin, 2010/2011).

THEORETICAL FRAMEWORK AND HYPOTHESES External auditors are a key instrument for enhancing the protection of investors rights. Auditors attest that all shareholders are treated equally and that financial statements are in conformity with contractual commitments. The auditor considers the board as its client, since it is the board who reviews the overall planned audit scope and the audit fee (Carcello et al., 2002). An extensive body of literature discusses the level and nature of external audit fees. This research relies mostly on a theoretical model which explains audit

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fees as a function of the number of audit hours and the price per hour (Simunic, 1980), illustrating that the amount of audit fees is related to the size and complexity of the firm, as well as the risk faced by the auditor. Prior research has generally argued that there should be a trade-off between sources of control (i.e., more of one CG practice leads to less of another CG practice), implying that alternative sources of control may have a negative relationship with external assurance. This viewpoint is implicitly based on a single decision-maker scenario, e.g., one authority that optimally allocates control resources. Hay et al., (2006) suggest there may be a complementary relationship among many controls due to the multiple stakeholders in the process and the externalities of costs and benefits of their individual decisions. In this sense, Deutsch, Keil and Laamanen (2010) argue that outside directors should be understood as agents in their own right. They are powerful individuals, present or former CEOs, representatives of institutional blockholders, or top professionals that have their own individual motives as members of the board. Therefore, recognizing the presence of multiple agencies is important to understand the relationships between governance practices. For instance, a company whose shareholders wish to improve its control and governance might start by appointing more outside directors. While these directors will help to look after the interests of shareholders, they also have an interest in protecting their own reputations, and therefore have incentives/interests in demanding more extensive external auditing, beyond what might be optimal for shareholders. Over the past decade, outside directors have become more common in Japanese boards of directors, enhancing their monitoring role. While less than a third of all listed firms had at least one outside director in 2004, by 2010 almost half of all listed firms have at least one outsider on their board of directors (TSE, 2011). We focus our analysis primarily on the board of directors, given their importance in Japanese CG and the increased pressure to enhance board independence. In addition, we

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extend our analysis to the board of auditors, which function is most similar to that of an audit committee in a U.S. firm, i.e., to monitor the performance of the directors, and review and express
an opinion on the method of auditing by the company's accounting audit firm and on such accounting audit firm's audit reports, for the protection of the company's shareholders3.

Agency theory argues that an impartial assessment of managers will occur more readily if directors are independent from management. Since executive directors report to the CEO, they will be less likely to perform a monitoring role. Moreover, as outside directors are not part of the organizations management team, they are less subject to the same potential conflicts of interest which are likely to affect the judgments of executive directors (Kosnik, 1987). Following this logic, agency theorists suggest that outside directors bring objectivity to the boards monitoring role (Johnson et al., 1996; Sundaramurthy and Lewis, 2003). One important mechanism to complement outside directors monitor task, over which the board of directors has substantial influence, is their reliance on external auditors. There are two competing arguments regarding the relationship between board independence and external audit. A first line of reasoning, which is generally supported by empirical evidence, proposes that board independence may have a positive association with audit fees, because outside directors may demand more auditing in order to fulfill their responsibilities and protect their reputation against questionable financial reporting decisions made by management (Carcello et al., 2002; Abbott et al., 2003). Not only is the interaction with the external auditor considered to be an important function of the board (JCAA, 2008), but board members have incentives to ensure a high quality audit in order to reduce their own risk of litigation and the loss of their reputation in the event of fraudulent financial reporting. In addition, outside directors may collaborate with the external auditor in identifying important
3 As described by Honda, Konami, Kyocera and NTT DOMOCO, among others, who explain the differences between the corporate governance practices followed by their company and those by U.S. listed companies under Section 303A of the NYSE Listed Company Manual.

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weaknesses in the internal control practices that could compromise the reliability of the financial statements, or they could insist on a broader audit scope to enhance the quality of the audit (Desender et al., 2012). A further reason for a positive relation between board independence and audit fees is that outside directors could decrease the threat of auditor dismissal and therefore could strengthen the auditors bargaining position during fee negotiations (Abbott et al., 2003). Finally, outsiders benefit from audit services without bearing the costs by transferring some of their responsibilities to external parties (Carcello et al., 2002). Empirical research has shown support for the complementary relationship

between board independence, as well as audit committee, and audit fees in the U.K. (OSullivan, 2000), U.S. (Carcello et al., 2002; Abbott et al., 2003), Belgium (Knechel and Willekens, 2006) and New Zealand (Hay, Knechel and Ling, 2008), France and Spain (Desender et al., 2012). A second line of thought argues in favor of substitution of monitoring between boards and external auditors, as the boards effort in strengthening internal controls may lead the external auditor to reduce the assessed level of internal control risk. As a consequence, the external auditors reliance on internal controls could result in less substantive testing and hence a lower audit fee (Collier and Gregory, 1996; Goodwin-Stewart and Kent, 2006). In this scenario, there would be substitution effects between board independence and the external auditing services (Hay et al., 2006). Previous research has identified three key elements to explain the complementary relationship between board independence and audit fees that could be different in the Japanese context: directors reputation, directors legal liability and the existence of multiple stakeholders with different risk preferences and spans of control. First, while the commercial codes recommendation on the appointment of outside directors rules out former executives and employees of the firm, the independence of outside directors is not guaranteed. Outside

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directors can be affiliated with a major shareholder, parent company, or another subsidiary of the parent company (commercial code, art.188). Companies that open their boards to

outsiders may therefore invite individuals who are from related companies or corporate partners, creditors, customers, or suppliers, i.e., not truly independent (Chizema and Shinozawa, 2011). Therefore, while reputation concerns may be linked to monitoring in Anglo-American firms, reputation is likely to be less linked to monitoring and more to other board functions, such as advice, in Japan. In addition, to the extent that board membership is a reward for employee loyalty and effort, reputation incentives to insist on enhancing the audit testing by the external auditor may become weak. Second, unlike in the U.S., litigation against directors is low in Japan (Numato and Takeda, 2010; Skinner and Srinivasan, 2010). This is likely to lower the incentives of outside directors to reduce their legal liability by enhancing the audit scope. Third, reliance on external auditing is likely to depend upon the set of control practices employed by different stakeholders. While in Japan, stakeholders share a common goal of stability and growth and employ more informal channels of monitoring, stakeholders in Anglo-Saxon firms may differ in their objectives and rely on formal CG arrangements for monitoring, with a special emphasis on the role of the board to protect shareholder interests. Taking these three specific characteristics into account, we expect the complementary relationship found in the AngloAmerican literature between board independence and audit fees, to be substantially weaker for Japanese firms. Taking our arguments together, we hypothesize that: H1a: The relationship between board of directors independence and external audit fees is likely to be positive. Previous literature has considered both the influence of the audit committee and the board of directors on audit fees, without providing conclusive results regarding the mechanisms underlying the relationship. On the one hand, Carcello et al. (2002) find that

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board characteristics rather than audit committee characteristics are associated with higher audit fees. Contrarily, Abbott et al. (2003) report a significant positive association between audit committee characteristics and audit fees. We expect outsiders on the board of auditors to behave similarly towards external audit services, as outside board members, as their incentives coincide. Therefore: H1b: The relationship between board of corporate auditors independence and external audit fees is likely to be positive.

Foreign Ownership, Board Behavior and External Audit Fees Our core interest is in uncovering the influence of foreign shareholders on CG relations. Previous work by Boycko et al. (1996) and Dyck (2001), among others, has argued that foreign investors are a source of change in governance practices. In this respect,

Aggarwal et al. (2011) demonstrate that changes in institutional ownership over time drive changes in firm-level governance, but that the opposite does not hold true. Thus, the

direction of the effect is from institutional ownership to subsequent changes in governance, and not from governance to institutional ownership. Furthermore, they show that

independent institutions that are unlikely to have business ties with the invested firm are the main drivers of governance reforms, rather than non-independent institutions. Translating these findings to our setting, we expect foreign investors to be a driver of governance change in Japan, rather than foreign investors seeking to invest in those firms which operate more closely to the Anglo-American governance system. Ahmadjian and Robbins (2005) argue that the rising influence of foreign investors in Japan resulted from a political process. Foreign actors, with very different interests and incentives, replaced local shareholders who were more tightly bound to the stakeholder system. This occurred as Japanese financial institutions, and, to a lesser extent, corporations,

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sold their shareholdings as a result of the financial crisis. The percentage held by foreign shareholders sharply rose in the 1990s, and foreign investors became important shareholders in Japanese firms. By the mid-1990s, U.S. and U.K. institutional investors jointly constitute around 70 percent of all foreign equity investments in Japan (Bank of Japan, 200010). For our sample of 1436 Japanese firms, foreign ownership is between zero and ten percent for more than half of all firms, especially smaller firms. One fourth of our sample has foreign ownership between ten and twenty percent, while foreign ownership is between 20 and 30 percent in 15 percent of our sample. Finally, nine percent has foreign ownership of more than 30 percent. For the Nikkei-225 firms, we find that foreign shareholdings are around 24 percent, of which 75 percent relates to Anglo-American institutional investors. Foreign equity investors tend to become outside blockholders with the ability (through voting rights) and the incentive (through cash-flow rights) to monitor incumbent management and introduce strategic changes aligned with interests of outside shareholders as a class (Shleifer and Vishny, 1997). Aggarwal et al. (2011) find that in countries with institutions granting weak shareholder protection, a key role in enhancing governance is played by foreign institutional investors, particularly those which originate from countries with strong shareholder protection. In this respect, Japan scores relatively low in terms of providing confidence to shareholder value oriented investors. For example, according to the CG ratings from the IMDs World Competitiveness Yearbook (2004), Japan ranks 38th out of 60 countries, compared to the 13th position for the U.S. We argue that foreign ownership participation may encourage the adoption of new and more generally defined practices in areas such as information disclosure, internal checks and balances, and accounting standards (OECD, 2002). Foreign shareholders use both exit and voice strategies to make their interests clear to management. As foreign portfolio investors tend to trade shares more frequently than

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domestic investors, their holdings disproportionately affect the share price of Japanese firms. Foreign shareholders accounted for more than 50 percent of trading volume in 2007 (Tokyo Stock Exchange, 2008). Therefore, even when foreign investors own a relatively small block of shares, they can significantly affect the strategic decisions in their invested firms (David et al., 2006, 2010; Nitta, 2000). In addition to this exit option, they also use voice- through direct meetings with the management to influence Japanese managers (Ahmadjian and Robbins, 2005). Hence, Japanese managers are generally keenly aware of the interests of foreign investors (Colpan et al., 2011). Past research examining the Japanese ownership structure finds that foreign owners and domestic owners have different investment objectives, which shape strategic behavior of their invested firms. For example, Nishizaki and Kurasawa (2002) show that foreign

investors, as outside monitors, are able to increase managerial discipline and improve the performance of Japanese firms. Other studies look at the influence of foreign ownership on downsizing (Ahmadjian and Robbins, 2005; Ahmadjian and Robinson, 2001), reduction of employee wages (Yoshikawa et al., 2005), R&D and capital investment (David et al., 2006), and corporate performance (Gedajlovic et al., 2005; Miyajima, 2007; Miyajima and Kuroki, 2007; Yoshikawa and Rasheed, 2010). In sum, previous research establishes that foreign and domestic ownership is a critical distinction in the Japanese context. Furthermore, foreign investors may demand additional controls over management because the conflict of interest and asymmetry of information between the management and the foreign investors may be magnified by geographical distance and cross-national differences (Buckley, 1997). Hence, foreign ownership is likely to affect external audit fees in two ways, directly and indirectly. First, heightened information asymmetry issues for foreign shareholdings are expected to increase the demand for more extensive auditing procedures and higher audit efforts which will translate into higher external audit fees (Rose,

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1999). Empirically, Niemi (2005) uncovers a positive relation between foreign holding control and audit fees for a sample of Finnish firms. Aggrawal et al. (2011), on the other hand, do not find evidence on the relation between institutional investors and firms choices of auditors for an international sample. Second, and more importantly, foreign investors may have a preference to introduce CG practices which are closer to their domestic governance logic. This would lead to hybrid forms of CG in which Japanese corporations with a high degree of foreign ownership combine elements common to both the Japanese CG context, e.g., a board of auditors (BoA), and the Anglo-American context, e.g., board monitoring. We argue that foreign ownership is likely to change board practices within a firm, and particularly, we expect the relationship between board independence and audit fees to be contingent upon the level of foreign ownership4. Two recent studies in the Japanese setting have contributed to the debate on its convergence on or persistent divergence towards the Anglo-American CG system. First, Colpan et al. (2011) analyze the effects of the changing institutional environment on strategic orientations of Japanese electronics firms during the 1990s. They argue that domestic

relational investors play a role in maintaining continuity with the local institutional arrangements. Second, Chizema and Shinozawa (2011) show that Japanese firms with high proportions of foreign ownership are more likely to adopt the (Anglo-American) board committee system, and thus move away from the traditional Board of corporate auditors structure. Furthermore, Aggarwal et al. (2011) examine whether a higher presence of

The recent Olympus scandal illustrates the confrontation between the English CEO, Michael C. Woodford, and the Japanese Chairman , Tsuyoshi Kikukawa over payouts and questionable acquisitions. Without the boards knowledge, Mr. Woodford commissioned a report by the accounting firm PricewaterhouseCoopers into the Gyrus deal, including the unusually high advisory fee and apparent lack of due diligence. Mr. Woodford was fired three days after the report was circulated to the board. In an internal e-mail, circulated to Olympus employees on Monday, Mr. Kikukawa complained that Mr. Woodford did not understand the Japanese art of nemawashi, or informal consensus building. From the NY Times: http://www.nytimes.com/2011/10/27/business/global/olympus-chairman-resigns-amid-widening-scandal.html

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institutional investors improves the board of directors ability to identify and terminate poorly performing CEOs. They find that firms with higher institutional ownership have a greater propensity to shed poorly performing CEOs. Following this line of research, we propose that foreign ownership is likely to change the CG bundle, especially when the CG context in which the firm operates is less oriented towards minority shareholder protection. Thus, we would expect foreign institutional owners to modify their bundle of corporate practices to incorporate logic which works effectively in their home country. In the case of Japan, foreign investors are mostly Anglo-American institutional investors. Compared to U.S. boards, Japanese boards of directors tend to be larger and until recently, they were comprised almost exclusively of senior managers who have served the corporation throughout their careers (Cheffins and Black, 2006). Furthermore, Japanese boards have not traditionally emphasized their monitoring role (Gilson and Milhaupt, 2005). We expect board behavior with respect to contracting audit fees to be contingent upon the degree of foreign ownership, because foreign ownership is likely to influence reputation concerns of outside directors and, more importantly, foreign owners may put emphasis on strengthening the monitoring role of the board, above other governance practices, to protect their interests. In the next paragraphs, we discuss and later we will test how our proposed hypotheses (H1a-H1b) are contingent on foreign ownership. We hypothesize that for firms with a high proportion of foreign ownership, the board of directors, and the board of auditors, will behave closer to Anglo-American boards, i.e., rely on external audit services to complement their monitoring function. First, foreign owners tend to hold, individually, a relatively small stake, which reduces their incentives of direct monitoring, but increases their reliance of internal CG practices, primarily the board

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structure5.

The divergence in objectives and risks between foreign and domestic

shareholders, combined with the traditional informal governance practices employed by the Japanese shareholders, such as banks, suppliers or clients, requires foreign investors to seek other practices to protect their interests. In this sense, strengthening the monitoring role of board of auditors is likely to be a governance mechanism, which protects foreign investors interests and lies within their span of control. Outside directors on the board of auditors are likely to feel pressure from foreign investors and may want to give a credible signal regarding their monitoring function. Thus, outside board members who are considered to be ineffective monitors may face a higher risk of replacement where foreign ownership is high, which increases their incentives for monitoring. Furthermore, audit services are likely to be favored by foreign owners, as it constitutes an important CG mechanism in the Anglo-American CG context and the recent Japanese reforms in the audit profession are in part a result of foreign investors pressure. In addition, the costs of auditing are shared between all shareholders, while the benefits in terms of reduced information asymmetries may be reaped by frequent (foreign) traders, rather than stable (domestic) owners. Intensifying the audit scope is a board action that constitutes a formal and credible signal of enhanced monitoring to foreign owners. For firms with a low degree of foreign ownership, we expect boards to rely less on external audit fees (as a formal mechanism), given that domestic shareholders employ informal channels to disciple managers, and count less on the board of auditors for monitoring. Moreover, as argued before, board members do not face the same risk of litigation or loss of reputation as U.S., board members reducing their incentives to enhance the audit scope. As a consequence, we argue that the Japanese changes in the audit laws and procedures are likely to have a weaker effect in firms without foreign ownership. A strong

One example of institutional investors focus on strengthening the board is given by ISSs International Corporate Governance Policy regarding Japan for 2012 in which voting recommendations are made to enhance board independence. For example, for 2012, ISS will give warnings to companies with all-insider boards, while engaging with market participants on this issue at every opportunity.

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reliance on the external auditor by Japanese boards represents a shift from organizational routines and may receive resistance from inside actors (Hannan and Freeman, 1984). Given these arguments, we propose that: H2a: The relationship between board of directors independence and external audit fees is strengthened with the presence of foreign ownership. H2b: The relationship between board of corporate auditors independence and external audit fees is strengthened with the presence of foreign ownership.

DATA AND METHODS Sample To test our hypotheses, we consider all listed firms in the Tokyo stock Exchange and start from an initial sample of 2151 firms. Japanese firms are only required to disclose audit fees since March 2004. Financial firms are excluded because their accounts and the audit process are significantly different. Data was collected for the 2006-2011 period and comes from several data sources. The CG and ownership structure data was manually collected from the corporate governance reports on the Tokyo Stock Exchange website. Finally, we gathered audit data as well all control variables from company financial statements and Thompson Worldscope. The audit industry in Japan is dominated by three large accounting firms which are associated with KPMG, Ernst & Young, Deloitte and PwC, which account for more than 75 percent of all audit engagements in our sample. PricewaterhouseCoopers is restructuring its operations in Japan, after the fallout of a financial reporting fraud by one of its major clients (Kanebo). A report in 2004 by the Japanese Institute of Certified Public Accountants (JICPA), which is the equivalent of the AICPA, found that the Big 4 firms audited 76 percent of all statutorily-required audits which includes both publicly-traded and large privately-held companies (JICPA, 2004). These percentages are similar to those

21

reported in the United States.

Model specification The primary estimation method used to test the importance of foreign ownership for board behavior towards external audit services is Generalized Least Square (GLS) Random Effect (RE) technique following the Baltagi and Wu (1999) procedure. This technique is robust to first-order autoregressive, AR(1), disturbances (if any) within unbalanced-panels and to cross-sectional correlation and/or heteroskedasticity across panels. In the presence of unobserved firm fixed-effects, panel Fixed-Effect (FE) estimation is commonly suggested. However, such FE estimation is not suitable for our study for a number of reasons. First, FE estimation requires significant within panel variation of the variable values to produce consistent and efficient estimates. Given that our key variables, i.e., the degree of foreign ownership and board independence variables do not vary much over time, the FE estimates would be imprecise (Wooldridge 2002, p.286). Second, for large N and fixed small T, (which is the case in our study as we consider about 1500 firms over 4-5 years), FE estimation is inconsistent (Baltagi 2005, p.13). Finally, FE estimates may aggravate the problem of multicollinearity if solved with least squares dummy variables (Baltagi, 2005). Thus, an alternative to FE, i.e., GLS RE, is proposed here. The Breusch-Pagan Lagrange multiplier (LM) test rejects the null hypothesis that the variance across entities is zero, which means OLS would not be suitable. To test our hypotheses, we extend the traditional audit fee model (Simunic, 1980; Carcello et al., 2002; Abbott et al., 2003) using a number of GLS RE regression models including our variables of interest. Our dependent variable, Total Audit fee, is the natural log of audit fees, as prior studies on the relationship between CG and audit demand do (Hay et al., 2008; Carcello et al., 2002, Abbott et al., 2003). This variable includes the total fee paid for the

22

audit services to the external auditor. Independent Variables: Foreign Ownership. Foreign ownership reflects the percentage of total outstanding shares held by non-Japanese investors. The Tokyo Stock Exchange reports the degree of foreign ownership in four categories: between 0 and 10 percent; between 10 and 20 percent; between 20 and 30 percent; and more than 30 percent. We adopt this classification. Board of directors Independence (BoD Independence). We define BoD independence as the proportion of outside board members over the total board size, similar to previous studies (e.g., Carcello et al., 2002, Hay et al., 2006). Alternatively, we also use a dummy variable which adopts the value 1 if there is at least one outside director on the board, and zero otherwise. Board of Auditors Independence (BoA Independence). We define Board of corporate auditors independence as a dummy variable which adopts the value 1 if more than half of the board are outsiders and zero otherwise. By law, at least half of all members must be outsiders. Control Variables: Size. Larger companies are involved in a greater number of transactions that necessarily require longer hours for an auditor to inspect (Carcello et al., 2002; Hay et al., 2006). Firm size is measured as the natural logarithm of total assets. Receivables and Inventories. Receivables and inventories constitute risk categories because their evaluation is complex and requires more in-depth inspection. They also involve higher involvement on the part of the most experienced and expensive auditors. This variable is scaled by total assets and captures partially the complexity of the audit process (Hay et al., 2006). Big-4 auditor. Higher audit fees are expected when an auditor is recognized to be of superior

23

quality to other firms (Hay et al., 2006). This variable takes value 1 if the client firms are working with one of the big 4 auditors, i.e., AZSA & Co. (KPMG), Tohmatsu (Deloitte Touche); ShinNihon (Ernst & Young) and Aarata (PwC) and 0 otherwise. Return on Assets. Client profitability is often considered a measure of risk for the auditor because it reflects the extent to which the auditor may be exposed to loss in the event that a client is not financially viable (Simunic, 1980). Leverage. Leverage is measured as the total long-term debt divided by total assets. Firms that are highly leveraged are more likely to fail, exposing the auditor to potential litigation costs, and hence, are expected to be associated with higher fees (Simunic, 1980). Industry and year. We control for industry and year effects.

RESULTS In this section, we first provide descriptive statistics of our data and we later test our proposed hypotheses. Table 2 gives an overview of the descriptive statistics for the most important variables used in this study as well as the correlations between variables. The first column shows the mean values for the entire sample, while columns 2-4 show the standard deviation, the minimum and the maximum values for the firms in our sample. The total sample consists of 6823 firm-year observations. The average audit fee for the entire sample is 33.8 million ($0.4 million). The highest fee in the sample is 4833 million, while the smallest fee is less than 5 million. A study conducted by the JICPA found that audits in the U.S., the U.K., Germany, France, and Canada consume between 20% and 180% more auditor hours, on average, than a Japanese audit for a client of similar size in the same industry (Fuchita, 2006). In terms of board composition, 10 percent of the board members are outsiders, a finding which is substantially lower compared to Anglo-American or Continental European

24

boards. This is in line with the 13 percent reported by Saito (2009) considering Nikkei-500 firms between 1996 and 2006. In addition, we find that almost half of our firms have at least one outside board member, and that 69 percent of the firms go beyond the legal requirement that at least half of the members of the board of auditors must be outsiders. Under the conventional statutory auditor system, the Board of corporate auditors is separate from the Board of directors, unlike in the Anglo-American committee system. Additionally, foreign ownership is between zero and ten percent for more than half of all firms. One fourth of our sample has foreign ownership between ten and twenty percent, while foreign ownership is between 20 and 30 percent in 15 percent of our sample. Finally, nine percent of the sample has more than 30 percent of foreign ownership. In terms of our control variables, the average firm size in terms of total assets is 96 billion. In addition, 34 percent of the firms assets are receivables and inventory and only 10 percent of their total assets are financed through longterm debt. Furthermore, firms have an average return on investment of 6 percent and about 82 percent of all firms have a Big-4 auditor. The correlation coefficients between audit fees and the control variables show the expected sign, except for receivables and inventory. In line with previous literature, the highest correlation coefficient is found for firm size. Furthermore, foreign ownership is positive and significantly correlated with audit fees. We test for possible multicollinearity considering all independent and control variables. The Variance Inflation Factor (VIF) gives a mean value of 1.40 and a maximum value of 1.53 for firm size, indicating that there are no multicollinearity problems. -----------------------------------------Insert Table 2 about here -------------------------------------------Next, we discuss the multivariate analysis to test our hypotheses. Table 3 presents the

25

results obtained from the regression model with total audit fees as the dependent variable. Models 1 and 2 estimating specifications that include only with control variables explain a large proportion of the audit fee variance, confirming previous studies with Anglo-American samples (e.g., OSullivan, 2000; Carcello et al., 2002; Abbott et al., 2003). Firm size, leverage and the presence of Big-4 auditor are associated with higher audit fees. Receivables and inventory and ROA are not significantly related to audit fees once we include industry and year effects in model 2. We next present models 3-8, considering the influence of foreign ownership, board of directors and board of corporate auditors characteristics and the control variables on audit fees. The specification of model 3 introduces board independence and foreign ownership, showing a positive relationship in both cases. The coefficient of BoD independence (defined as the proportion of outsiders to the total board size) shows a positive significant sign, consistent with findings of most Anglo-American studies. Model 5 tests the robustness of this result by defining BoD independence as a dummy variable, taking value 1 if at least one member of the board is an outsider, and zero otherwise. Results for this alternative specification are consistent with model 1. In addition, firms with higher levels of foreign ownership tend have higher audit fees. These findings lend support to our hypotheses H1a. Overall, the models show that firms with higher levels of board independence and higher degree foreign ownership tend to have higher external audit fees, after controlling for size, receivables and inventory, the presence of a big-4 auditor, return on assets, and leverage. -------------------------------Insert Table 3 about here -------------------------------We present the results of the influence of foreign ownership on the boards actions with respect to audit fees in Table 3, models 4 and 6. Using interaction terms, we are able to test whether the relationship between Board independence and audit fees is contingent upon

26

the level of foreign ownership, testing hypotheses 2a. Model 4 presents the interaction effect of foreign ownership, on the relationship between board independence and audit fees. The analysis grants support for our hypothesis 2a, showing that the relationship between BoD independence and external audit demand is contingent on the level of foreign ownership. Specifically, for low levels of foreign ownership, there is a positive, but not significant, relationship between board independence and audit fees. This relationship becomes larger and significant as the foreign ownership level increases. For firms with relatively high proportions of foreign ownership, the relationship between Board of directors independence and audit fees is therefore complementary. Model 6 provides similar results for our

alternative specification of board independence, adding robustness to our findings. Finally, models 7 and 8 consider the influence of foreign ownership on the link between board of corporate auditors (BoA) characteristics and audit fees. Model 7 shows a positive effect of BoA independence on audit fees, i.e., firms that go beyond compliance in terms of BoA independence exhibit larger audit fees. This result is in line with our findings for the board of directors and provides support to our hypothesis 2b. Furthermore, model 8 shows a positive interaction coefficient between foreign ownership and BoA independence. For lower and medium levels of foreign ownership, there is no relationship between the BoA independence and audit fees. However, as the level of foreign ownership increases (beyond 30 percent), this relationship turns positive, indicating a complementary relationship between the BoAs independence and the external audit. Overall, our results offer support for our hypothesis 2b. Given that most studies focusing on Anglo-American firms underscore the complementary relationships between the board or audit committee and audit fees, and that foreign ownership in Japan is typically held by Anglo-American institutional investors, we believe that our results corroborate the argument that foreign owners are likely to change board strategic decisions in foreign-held firms, to resemble those of their home-based CG

27

system.

DISCUSSION This paper espouses the view that CG practices effectiveness must be examined in light of the institutional context, as well as the foreign ownership composition of the firm. In particular, we focus on the influence of board independence and foreign ownership on external audit fees considering a sample of Japanese listed firms. Auditing research (e.g., Carcello et al., 2002) has argued that the more concerned a board is with fulfilling its monitoring role, the more supportive it will be of the external audit function and hence, the higher the firms external audit fees. Following previous literature, we test whether there exist a direct relationship between board independence and foreign ownership with the level of audit fees (board practices), and whether the existing logic holds in a different institutional environment (i.e., Japan). Interestingly, our results indicate important contingencies related to foreign ownership. We find a direct positive influence of board of directors independence and board of auditors independence on the level of audit fees, and show that this relationship is strongest where foreign ownership is largest and that this relationship is insignificant for low levels of foreign ownership. We consider three competing explanations for our findings. First, that the monitoring function of the board is weaker in Japan as the relatively low proportion of nonexecutives on the board indicates. Second, one could argue that the lower risk of litigation against directors in Japan reduces the incentives of directors to complement their internal monitoring role. Our review of empirical research on how the composition of the board of directors determines its strategic behavior shows inconclusive results. One reason for the mixed empirical findings regarding the effectiveness of various governance practices may be the

28

oversight of patterned variations in CG across different organizational environments (Filatotchev, 2008, Aguilera et al., 2008). In light of this debate, Rediker and Seth (1995) and Sundaramurthy et al. (1997) point out that research on a single governance practice (e.g., board characteristics) often neglects the broader linkages to the other existing governance practices in the firm (e.g., ownership structure) and their joint impact. Building on this stream of literature, we adopt a configurational framework to explain how the ownership structure of the firm will affect the strategic action of the board towards more or less external auditing. In doing so, we advance a more comprehensive understanding of the board

monitoring function, as our study demonstrates that CG patterns are influenced by foreign ownership. In addition, our study adds to the debate on globalization and convergence of CG systems by showing where the tipping point might be and how hybrid ultimately practices become. Our findings demonstrate that board action, with respect to audit fees, is significantly different in firms with a high proportion of foreign owners compared to firms with a low proportion of foreign shareholders. Specifically, our results show that there is a

complementary relationship between the board independence and board of auditors independence, on the one hand, and audit services, on the other hand, when foreign ownership is high. However, this relationship is only significant when foreign ownership is high. Given that foreign owners in Japan are typically Anglo-American institutional

investors, our results are consistent with the idea that foreign investors are able to change the CG patterns in firms they invest, adjusting their practices to resemble foreign CG practices. In addition, our results add to the call by Aguilera et al. (2011) to shift our conceptualization of governance systems beyond the dichotomous world of common-law/outsider/shareholderoriented system vs. civil law/ insider/ stakeholder oriented system. If foreign ownership is able to shape bundles of CG, in addition to ownership concentration, it is difficult to continue

29

to equate firm nationality with governance systems. From a practical viewpoint, our results add to the comparative CG literature by illustrating how cross-national differences affect governance patterns. Our dataset considers a large set of firms from Japan, to exploit the distinctions between shareholder and stakeholder economies. The use of a comprehensive set of board and ownership measures for Japanese firms represents an empirical contribution to CG research. Moreover, few studies have investigated the influence of the board of auditors and the ownership structure on audit fees. Furthermore, compared to previous auditing research, the context in which we test the relationship between board independence and audit fees is novel, as few studies have looked at these relationships for Japanese listed firms. More importantly, we are able to speak to the external validity of CG findings conducted in the Anglo-American context and to test to what degree they are confirmed for a sample of firms from a different institutional context. The institutional context is likely to influence the effectiveness of a given bundle of CG practices (e.g., Crossland and Hambrick, 2007, 2010). While our results show that the foreign

ownership shapes CG patterns, these results need to be seen in the light of foreign institutional investors in an environment of weak investor protection. It is therefore not clear that in a context of high investor protection, similar results should be found, to the extent that legal protection of shareholders could influence the incentives of foreign investors to change the CG practices. Our research also has implications for policymakers and in particular for the CG reforms undertaken following accounting scandals. Universalistic policy prescriptions, in terms of board independence, may lead to important shortcomings and, as a result, they need to be substantially adapted to the local contexts of firms or translated across diverse national institutional settings (Filatotchev, 2008). Our findings show that regulation merely focusing

30

on board independence may not lead to a higher audit scope, or to better monitoring of management in general. We argue that CG recommendations and policy making could be more effective if they take into account the potential diversity of governance practices. We argue that theory and empirical research should progress to a more context dependent understanding of CG. This, in turn, will prove useful for practitioners and policy makers interested in applying CG in particular situations. Our study has limitations as well, as it focuses on listed companies from an institutional context of weak investor protection. Therefore, our conclusions may not be generalizable to non-listed companies or firms from a different institutional context. Furthermore, we do not distinguish between individual shareholders, at least not for the full set of firms, to explore other characteristics of foreign or domestic owners. CONCLUSIONS We build on the configurational approach to CG that proposes that effective CG depends upon the alignment of interdependent organizational and environmental characteristics, rather than on one universal set of relationships that hold across all organizations. Our study suggests that the relationship between different CG practices must also be examined in light of contingencies related to the level of foreign ownership. Our findings demonstrate that, for a large sample of listed Japanese firms, the relationship between board independence and audit services is contingent upon the degree of foreign ownership. We find that the relationship between board of directors independence and board of corporate auditors independence is positive for high levels of foreign ownership, while this relationship is not significant for lower levels of foreign ownership. These results highlight the possibility of different patterns of CG within one country, shaped by the importance of foreign owners.

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Table 1: A comparison of Market-oriented and Network-oriented governance systems

Countries Mainstakeholder Conceptofthefirm Boardofdirectors Ownershipconcentration Capitalmarkets Marketforcorporatecontrol Executivecompensation,performancedependent RoleofEmployees InterFirmrelationships LaborMarket Socialorder Marketoriented USA,UK,Canada,Australia Shareholders Shareholderoriented Outsiderdominated;focuson monitoring Low High Active High Low Low Open Individualism Networkoriented Japan Citybanks,otherfinancial institutions, employees,ingeneraloligarchicgroup Stakeholderoriented Insiderdominated;focusonstrategicadvice Low/Moderate High Inactive Low High High Closed Collectivism

Table 2: Descriptive statistics and Correlations (N=6823) Mean st.dev. min 1 AuditFees(Log) 3.85 0.89 0.00 2 BoDoutsiders/BoDSize 0.10 0.14 0.00 3 BoDoutsiders>0 0.47 0.50 0.00 4 BoAindependence>50% 0.69 0.46 0.00 5 ForeignOwn:0%10% 0.51 0.50 0.00 6 ForeignOwn:10%20% 0.25 0.43 0.00 7 ForeignOwn:20%30% 0.15 0.35 0.00 8 ForeignOwn>30% 0.09 0.28 0.00 9 Size 18.38 1.48 12.89 10 ReceivablesandInventory 0.34 0.17 0.00 11 Big4Auditor 0.82 0.38 0.00 12 Leverage 0.10 0.12 0.00 13 ROA 0.06 0.06 0.54

max 8.55 0.89 1.00 1.00 1.00 1.00 1.00 1.00 24.20 0.93 1.00 0.69 0.61

1 1.00 0.17 0.21 0.01 0.33 0.07 0.19 0.24 0.69 0.08 0.22 0.28 0.07

2 1.00 0.77 0.11 0.12 0.01 0.08 0.13 0.07 0.06 0.10 0.06 0.05

3 1.00 0.05 0.01 0.01 0.07 0.08 0.14 0.08 0.11 0.09 0.03

10

11

12

1.00 0.00 0.03 0.01 0.04 0.08 0.11 0.02 0.05 0.05

1.00 0.59 0.43 0.32 0.48 0.09 0.11 0.02 0.22

1.00 0.24 0.18 0.13 0.00 0.06 0.00 0.09

1.00 0.13 0.28 0.07 0.05 0.02 0.08

1.00 0.29 0.07 0.04 0.00 0.14

1.00 0.10 0.13 0.38 0.05

1.00 0.06 1.00 0.33 0.04 1.00 0.07 0.09 0.17

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Table 3: Results of Regression Analyses (GLS RE): Board of Directors Independence Dependentvariable:auditfees Model1 Model2 Model3 Model4 Model5 Model6 BoDIndependence BoDIndependence definedasthenumber definedasadummy ofoutsiderstothetotal takingvalue1ifthe boardsize numberofoutsiders>0 BoDIndependence 0.281*** 0.138 0.071*** 0.031 0.067 0.090 0.017 0.022 ForeignOwn:10%20% ForeignOwn:20%30% ForeignOwn>30% Foreign10%20%*BoDIndependence Foreign20%30%*BoDIndependence Foreign>30%*BoDIndependence Size ReceivablesandInventory Big4Audit Leverage ROA Constant Yeardummies Industrydummies Firmyearobservation groups R2within R2between R2overall 0.364*** 0.401*** 0.009 0.009 0.214*** 0.073 0.078 0.070 0.391*** 0.009 0.114* 0.070 0.290*** 0.032 0.337*** 0.095 0.183* 0.113 0.021 0.018 0.036 0.025 0.105*** 0.033 0.012 0.021 0.006 0.029 0.055 0.040 0.090 0.123 0.359*** 0.138 0.395** 0.164 0.391*** 0.009 0.114* 0.070 0.290*** 0.032 0.327*** 0.095 0.174 0.113 0.027 0.018 0.045* 0.024 0.12*** 0.032 0.387*** 0.009 0.104 0.069 0.287*** 0.032 0.331*** 0.093 0.167 0.111 0.016 0.023 0.028 0.031 0.047 0.043 0.023 0.032 0.142*** 0.040 0.144*** 0.053 0.387*** 0.009 0.105 0.069 0.286*** 0.032 0.321*** 0.093 0.154 0.111

0.341*** 0.295*** 0.035 0.032 0.531*** 0.305*** 0.106 0.093 1.326*** 0.134 0.121 0.111

3.024*** 4.321*** 0.165 0.199 No No 6823 1436 0.0252 0.6070 0.4992 Yes Yes 6823 1436 0.4437 0.6663 0.6142

4.174*** 4.167*** 4.131*** 4.107*** 0.212 0.212 0.207 0.207 Yes Yes 6823 1436 0.4386 0.6498 0.5992 Yes Yes 6823 1436 0.4388 0.6748 0.6217 Yes Yes 6823 1436 0.4433 0.6741 0.6205 Yes Yes 6823 1436 0.4436 0.6773 0.6231

37

Table 4: Results of Regression Analyses (GLS RE): Board of Auditors Independence Dependentvariable:auditfees Model7 Model8 BoardofAuditorindependence>50% 0.041** 0.024 0.017 0.022 ForeignOwn:10%20% ForeignOwn:20%30% ForeignOwn>30% Foreign10%20%*BoAindependence>50% Foreign20%30%*BoAindependence>50% Foreign>30%*BoAindependence>50% Size ReceivablesandInventory Big4Audit Leverage ROA Constant Yeardummies Industrydummies Firmyearobservation groups R2within R2between R2overall 0.380*** 0.009 0.102 0.069 0.204*** 0.032 0.335*** 0.093 0.174 0.111 4.189*** 0.210 Yes Yes 6823 1436 0.4438 0.6706 0.6176 0.026 0.018 0.043* 0.024 0.11*** 0.032 0.006 0.028 0.039 0.037 0.041 0.052 0.029 0.032 0.041 0.042 0.100** 0.046 0.391*** 0.009 0.097 0.069 0.295*** 0.032 0.332*** 0.093 0.174 0.111 4.170*** 0.211 Yes Yes 6823 1436 0.4439 0.6712 0.6180

38

Figure 1: The Relationship between Board independence, Foreign Ownership, and External Audit Services

Control Variables
Firm Size BoD Independence BoA Independence H1a H1b H2a H2b

Audit Fees

Complexity Audit risk

Foreign Ownership

39