The Effect of External Auditors on Managerial Slack

SYNOPSIS: We investigate the role of external auditors in constraining managerial slack. Using panel data on Chinese public firms, we find that firms hiring Big 8 auditors are associated with reduced managerial slack after controlling for the endogenous auditor choice. We also document that Big 8 auditors are more effective in mitigating slack in privately controlled firms and firms located in more developed regions. Moreover, we show that international Big 4 auditors are more effective than the domestic Big 4, and the Big 8 effect is more salient in more competitive and less regulated industries, and in industries with higher litigation risks. Finally, we document a positive relationship between managerial slack and audit fees, particularly in the presence of Big 8 auditors. Overall, our results suggest that high-quality external auditors play an important corporate governance role by serving as both bonding and controlling mechanisms to mitigate managerial exploitation of firm resources.