1. Auditor Selection and Corporate Social Responsibility July 2012 1

2. INTRODUCTION  Financial reporting quality has been a major concern of investors, regulators and legislators, especially after the Enron accounting scandal and the recent global financial crisis.  The credibility of financial statements is directly affected by audit quality which is positively associated with auditor industry specialization (e.g., Jenkins, Kane, and Velury 2006).  Corporate Social Responsibility (CSR) is increasingly important among managers of global organizations and scholars (Snider, Hill, and Martin 2003). Companies with better CSR ratings are believed to have a stronger incentive to demand superior financial reporting quality. 2

3. RESEARCH QUESTIONS  1. Whether CSR has a positive effect in improving firms’ financial reporting quality.  2.The relation between CSR performance and the selection of specialist auditors in each subsample: (1) firms in controversial industries (i.e., alcohol, tobacco gambling, military, and nuclear power) (2) firms in non-controversial industries Because different viewpoints and behavior are found in the controversial industries (Palazzo and Richter 2005; Byrne 2010; Kim and Venkatachalam 2011; Cai, Jo, and Pan 2012). 3

4. LITERATURE REVIEW  Industry specialized auditors provide differentiated and high quality services to their clients including,  monitoring financial reporting process more effectively,  detecting extra errors within auditors’ industry specialization,  reporting better earnings quality,  maintaining higher level of assurance,  having greater compliance with auditing standards (e.g., O’Keefe, King, and Gaver 1994; Solomon, Shields, and Whittington 1999; Owhoso, Messier, and Lynch 2002; Craswell, Francis and Taylor 1995; Balsam, Krishnan, and Yang 2003).  To guarantee high quality financial reporting, corporate management may choose to engage industry specialized auditors. 4

5. LITERATURE REVIEW  Companies and their management have an incentive to conduct business operations ethically and honestly (Garriga and Melé 2004; Kim et al. 2012).  Ethical theories  Political theories  Integrative theories  In light of stakeholders’ perspective, the major objective of CSR management is firm value maximization and wealth creation for all stakeholders including investors, customers, suppliers, and other participants (Kim, Nofsinger, and Mohr 2010). 5

6. LITERATURE REVIEW  Firms with better CSR performance have  better financial performance  better earnings quality,  reduced cost of equity capital,  lower audit fees,  less litigation risk,  lower propensity to receive a going concern audit opinion  lower CEO compensation  lower analyst forecast error (e.g., Cai, Jo, and Pan 2011; Dhaliwal, Li, Tsang, and Yang 2011; Dhaliwal, Radhakrishnan, Tsang, and Yang 2012; Kim, Park and Wier 2012; Chen, Srinidhi, Tsang, and Yu 2012).  Companies domiciled in more stakeholder-orientated countries demand high quality auditor for higher credibility of financial reports.  A stakeholder-orientated culture refers to the culture that firms are viewed as instruments to create of stakeholder value (Simnett, Vanstraelen, and Chua 2009). 6

7. Hypothesis Development  The Relation between Industry Specialized Auditors and CSR:  (1) From the audit demand side: (client perspective)  Top management of CSR firms acts more ethically or takes more social responsibility (Simnett et al. 2009);  Strive for better audit quality in order to enhance firm reputation, and to reduce litigation risk resulting from financial misstatements;  Lower audit cost than non-CSR firms (Chen et al. 2012);  Pursue for brand differentiation (Hay and Jeter 2011);  Demand more law compliance audit services. 7

8. Hypothesis Development  The Relation between Industry Specialized Auditors and CSR:  (2) From the audit supply side: (auditor perspective)  Auditors accept clients with higher CSR ratings since they are less likely to have fraudulent reporting, restatements or become targets of SEC AAERs (Kim et al. 2012);  CSR firms bring more favorable media exposure and better treatment by legislators and regulators, which may mitigate the incumbent auditors’ potential litigation threat (Brown, Helland, and Smith 2006)  Specialized auditors may engage CSR firms for reputation purpose at both individual auditor level and audit firm level. 8

9. Hypothesis Development  Two different viewpoints for controversial industries (such as alcohol, tobacco, gambling, military, or nuclear power):  (1) Controversial industries are perceived to be unethical because of a deep suspect related to poisonous substances in their products and the disputed behavior of these firms in the society (Palazzo and Richter 2005; Byrne 2010).  (2) Firms with better CSR in controversial industries still have a positive effect on firm value even though their products have unfavorable impacts on the general public and environment. They also point out that top management of controversial firms gradually recognizes the importance of CSR (Cai, Jo, and Pan 2012).  Deegan and Gordon (1996) find that CSR disclosure behavior may be influenced by firm-specific characteristics as management decision horizons, systematic risk, and social constrains. 9

10. Hypothesis Development  H 1 : Firms with better CSR ratings are more likely to hire industry specialized auditors.  H 2 : The CSR effect on specialized auditor selection is different between firms in controversial industries and firms in non-controversial industries. 10

11. Hypothesis Development CSR Auditor Selection 1.National-level leader 2.City-level leader 3.Joint national-city level leader Controversial industry H1H1 H2H2 11

12. Empirical Model 12

13. Empirical Model 13

14. Sample Selection 14

15. Descriptive Statistics 15

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20. CONCLUSIONS  1. Firms with better CSR ratings (in non-controversial industries) are significantly associated with higher likelihood of selecting industry specialist auditors, being either national-level industry leaders or joint city-national industry leaders.  2. Controversial firms may over-invest in CSR activities associated with environment and product issues, such as the avoidance of environmental fines, and boost the quality of manufactured goods and services, to disguise the sin nature of their products. Conversely, they engage low quality auditors perhaps to affect financial disclosure of potential environmental and legal liabilities. 20

21. ROBUSTNESS TESTS  Effect of Audit Committee and Board of Directors  Firm Size Effect  Self-Selection in the Choice of Industry Specialist Auditor  Following Lawrence et al. (2011), we estimate the probability of employing an industry specialist auditor by using propensity-score matching models because matched two groups with similar characteristics, firms selecting an industry specialist auditor and firms choosing a non-specialist auditor, can reduce selection bias. 21

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25. CONTRIBUTIONS  Higher CSR expectations may drive the management to hire specialist auditors and pursue high financial reporting quality.  CSR has an additionally positive effect to traditional corporate governance mechanisms on auditor selection.   The disclosure of CSR ratings may signal investors about not only firms’ behaviors but also firms’ audit and financial reporting quality.  Our findings may provide regulators and policy makers with useful information concerning whether CSR disclosure should be mandatory for non-controversial firms, and whether some CSR investments are “at the expense of shareholders” for controversial firms (Moser and Martin 2012). 25

26. Thank you so much! 26