Shareholder Governance and Crowding‐Out of External Auditing: Evidence From China

ABSTRACT This paper examines the relationship between shareholder governance and auditor choice. By exploiting a setting where non‐state‐owned shareholders are allowed to purchase shares and have delegates in the management team and the board of directors and supervisors of state‐owned enterprises (SOEs) in China, we find that non‐state‐owned shareholder ownership and engagement in firm operations significantly reduce the propensity of SOEs to hire a Big 4 external auditor. This relation is further found to be more pronounced for firms with stronger alternative governance mechanisms and for firms with higher agency costs. Overall, our findings support the notion that non‐state‐owned shareholder governance partially substitutes external auditing.