|Perceived value of mandatory audits of small companies | |
|Author(s): |Shifei Chung, (Assistant Professor, Department of Accounting & Finance, Rowan University, Glassboro, New |
| |Jersey, USA), Ramesh Narasimhan, (Associate Professor, Department of Accounting, Law & Taxation, Montclair |
| |State University, Montclair, New Jersey, USA) |
|Citation: |Shifei Chung, Ramesh Narasimhan, (2001) “Perceived value of mandatory audits of small companies”, Managerial |
| |Auditing Journal, Vol. 16 Iss: 3, pp.120 – 123 |
|Keywords: |Accounting standards, External audit, Hong Kong, Small firms |
|Article type: |Research paper |
|DOI: |10.1108/02686900110385551 (Permanent URL) |
|Publisher: |MCB UP Ltd |
|Abstract: |As a territory of the UK (until 1 July 1997), Hong Kong followed the UK accounting and auditing standards quite|
| |closely, in most cases mirroring the requirements. However, there was a departure regarding the elimination of |
The Term Paper on Cash Out Accounting Small Business
Acct. Term Paper "Cash Out" In an October 1998 issue of "Fortune Magazine" in the finance section, an article entitled "Cash Out on Your Own Terms" speaks about a relatively old concept refined for a new market. In the centuries past, wealthy landowners would allow working farmers to live and work on their land and tend the crops and cattle for a portion of the goods and maybe a portion of the ...
| |the statutory audit of small private companies in the UK in 1994, but this was not followed in Hong Kong. An |
| |audit is not required for small private companies in the USA either. This study evaluates the perceived value |
| |of the small companies’ audit in the opinion of two interest groups that are most affected by this requirement:|
| |small private limited companies and small audit firms. Results indicate that both groups of respondents |
| |consider the audit to be a valuable experience. While this result is not unexpected from the |
| |partners/proprietors of small audit firms, who benefit most from the mandatory audit requirement, it is a |
| |surprise from the small companies’ perspective. |
By Simnett, Roger
Publication: Auditing: A Journal of Practice & Theory
Date: Friday, December 22 2000
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Introduction
Family businesses, in this study defined as firms that exhibit majority family ownership, accounts for a large proportion of all economic activity. Research suggests that 80 percent of all businesses in the United States are family owned (Daily and Dollinger 1992) and family businesses contribute between 50 percent and 60 percent of U.S. gross domestic product (Francis 1993; Upton 1991).
Similar findings have been reported in the UK (Stoy Hayward and The London Business School 1989, 1990), Western Europe (Lank 1995), and Australia (Smyrnios and Romano 1994; Smyrnios et al. 1997).
Providing further evidence of the contribution of family business to the economy, La Porta et al. (1999) and Schleifer and Vishny (1986) find that the ownership structure of even large public companies is characterized by controlling stockholders who are more often families, usually the founder or their descendants. Despite the significance of family business to the economy there are few empirical studies of this sector in general (Brockhaus 1994; Wortman 1994), and in particular in the audit area. The family-business environment provides an opportunity to further test theory concerning demand for auditing. Derived from prior empirical research and agency theory, predictions of voluntary demand for internal and external auditing are tested using survey data from family businesses.
The Essay on Family Business
According to a study of European Commission, family business, which covers in different sectors with different sizes, makes up more than 60 percent of all European companies. In recent years, the number of family business is glooming all over the world. However, not many of them are successful in transferring into the third generation. There are many reasons leading to this situation. One of them ...
Family businesses in Australia at the time of this study largely operated in an environment where neither external nor internal auditing was a statutory requirement,(1) and the setting offered an opportunity to observe voluntary demand for auditing. Investigating voluntary demand has the advantage of eliminating the confounding effect of regulation. Few studies have investigated voluntary demand for auditing (see Chow 1982; Abdel-khalik 1993; Blackwell et al. 1998) and the present study accordingly adds to this literature.
The study incorporates the traditional characteristics of firm size and firm debt, which are expected to increase the likelihood of a family business engaging the services of an auditor. Given the nature of family businesses, unique measures consistent with the suggestion of agency theory are developed to capture variations in demand for auditing among firms. The measures are: (1) the proportion of nonfamily management in the firm, and (2) the proportion of nonfamily representation on the board of directors. For both measures it is predicted that agency costs will increase through greater separation of ownership and control. In addition, the present study argues that both (or either) internal audit and external audit can serve as a monitoring response in family businesses, and an additional contribution of this research is to examine the relationship between these monitoring mechanisms.
Family Business Plan
Besides that, Ming Yi Feeds is operated in the category of control and management of family member. All the important thing and decision is making by themselves but not the outsider. The business is the first generation and established for 8 years. The founder of Ming Yi Feeds Sdn Bhd is not currently planning his retirement and is not deciding to pass the ownership of the company to anyone since ...
The study analyzes survey data drawn from a database of Australian family companies compiled by the AXA Australia Family Business Research Unit. Internal auditing (Yes/No) and external auditing (Yes/No) are the dependent variables examined in separate logistic regression analyses. The hypothesized independent variables are firm characteristics associated with demand for auditing, namely firm size, firm debt, the proportion of nonfamily management in the firm, and the proportion of nonfamily representation on the board of directors.
THEORY AND LITERATURE REVIEW
There are a number of complementary explanations as to sources of demand for auditing (see, for example, Chow et al. 1988).
Business is accountable to a range of parties and the diversity of organizations causes a myriad of potential accountability relationships, making it difficult to identify a single explanatory cause. Contracting or agency theory has provided a resilient and popular framework for explaining the demand for external auditing and suggests a monitoring role for both internal and external audit. The provision of audited financial statements is normally regarded as a cost-effective contractual response to agency costs (DeAngelo 1981; Watts and Zimmerman 1976).
Similarly, internal auditing may also serve as a monitoring response to agency costs (Anderson et al. 1993; DeFond 1992).
Though the agency literature is suggestive of potential conflict in family businesses (Fama and Jensen 1983), empirical research investigating the monitoring response in this important business segment is limited. This limitation is perhaps not surprising as the image of a family business is one characterized by a close alignment of ownership and control (Daily and Dollinger 1992).
Notwithstanding the likelihood that family businesses may exhibit a lower level of agency costs compared with listed companies, the present study argues that conflict consistent with suggestions of agency theory can still arise in family businesses. There are two characteristics of family businesses giving rise to a demand for audit that can be directly measured. These are: (1) the proportion of nonfamily management, and (2) the proportion of nonfamily representation on the board of directors.
The Essay on Family Business Case 5 Vega food Company
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The first of these characteristics relates to the introduction of nonfamily operational management. Depending on the circumstances of the entity,(2) family owners might delegate some level of management responsibilities to nonfamily members. This will increase the demand for auditing for reasons of higher agency costs, and a greater loss of control by the owners. DeFond (1992, 21) explains the implication of separation of ownership and control as “(1) the divergence in preferences of the manager and owner with respect to the manager’s actions, and (2) the imperfect observability of the manager’s actions by the owner.” As the proportion of nonfamily management increases, owners (family and nonfamily) will exhibit greater demand for monitoring to reduce management shirking due to information asymmetry between nonfamily management and owners.
A second characteristic that increases the demand for auditing in family businesses is where the family raises capital from outside investors (nonfamily members).
Increasing diversity of ownership creates agency conflict because the majority owners (by definition, the family) have incentive to divert resources for their personal use. Such a diversion will have the effect of restricting resource flow to nonfamily owners. Benston (1985) argued this point with regard to owner-managed enterprises where there are outside investors. The capacity and incentive for nonfamily owners to initiate monitoring will depend on their level of ownership, and their representation on the board of directors. As the proportion of nonfamily ownership and director representation rises, a greater demand for monitoring will be exhibited.(3)
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Introduction
Family businesses, in this study defined as firms that exhibit majority family ownership, accounts for a large proportion of all economic activity. Research suggests that 80 percent of all businesses in the United States are family owned (Daily and Dollinger 1992) and family businesses contribute between 50 percent and 60 percent of U.S. gross domestic product (Francis 1993; Upton 1991).
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Similar findings have been reported in the UK (Stoy Hayward and The London Business School 1989, 1990), Western Europe (Lank 1995), and Australia (Smyrnios and Romano 1994; Smyrnios et al. 1997).
Providing further evidence of the contribution of family business to the economy, La Porta et al. (1999) and Schleifer and Vishny (1986) find that the ownership structure of even large public companies is characterized by controlling stockholders who are more often families, usually the founder or their descendants. Despite the significance of family business to the economy there are few empirical studies of this sector in general (Brockhaus 1994; Wortman 1994), and in particular in the audit area. The family-business environment provides an opportunity to further test theory concerning demand for auditing. Derived from prior empirical research and agency theory, predictions of voluntary demand for internal and external auditing are tested using survey data from family businesses.
Family businesses in Australia at the time of this study largely operated in an environment where neither external nor internal auditing was a statutory requirement,(1) and the setting offered an opportunity to observe voluntary demand for auditing. Investigating voluntary demand has the advantage of eliminating the confounding effect of regulation. Few studies have investigated voluntary demand for auditing (see Chow 1982; Abdel-khalik 1993; Blackwell et al. 1998) and the present study accordingly adds to this literature.
The study incorporates the traditional characteristics of firm size and firm debt, which are expected to increase the likelihood of a family business engaging the services of an auditor. Given the nature of family businesses, unique measures consistent with the suggestion of agency theory are developed to capture variations in demand for auditing among firms. The measures are: (1) the proportion of nonfamily management in the firm, and (2) the proportion of nonfamily representation on the board of directors. For both measures it is predicted that agency costs will increase through greater separation of ownership and control. In addition, the present study argues that both (or either) internal audit and external audit can serve as a monitoring response in family businesses, and an additional contribution of this research is to examine the relationship between these monitoring mechanisms.
The Essay on The Audit Report and Internal Control Evaluation
Team D Auditing has been evaluating the evidence presented by Apollo Shoes. The audit team has developed an audit report in response to the audit and has also provided a description of the evidence, a description of the account sampling and testing procedures used, and has also given a brief description of the value of an audit report. This report is only to reflect Team D’s opinion regarding ...
The study analyzes survey data drawn from a database of Australian family companies compiled by the AXA Australia Family Business Research Unit. Internal auditing (Yes/No) and external auditing (Yes/No) are the dependent variables examined in separate logistic regression analyses. The hypothesized independent variables are firm characteristics associated with demand for auditing, namely firm size, firm debt, the proportion of nonfamily management in the firm, and the proportion of nonfamily representation on the board of directors.
THEORY AND LITERATURE REVIEW
There are a number of complementary explanations as to sources of demand for auditing (see, for example, Chow et al. 1988).
Business is accountable to a range of parties and the diversity of organizations causes a myriad of potential accountability relationships, making it difficult to identify a single explanatory cause. Contracting or agency theory has provided a resilient and popular framework for explaining the demand for external auditing and suggests a monitoring role for both internal and external audit. The provision of audited financial statements is normally regarded as a cost-effective contractual response to agency costs (DeAngelo 1981; Watts and Zimmerman 1976).
Similarly, internal auditing may also serve as a monitoring response to agency costs (Anderson et al. 1993; DeFond 1992).
Though the agency literature is suggestive of potential conflict in family businesses (Fama and Jensen 1983), empirical research investigating the monitoring response in this important business segment is limited. This limitation is perhaps not surprising as the image of a family business is one characterized by a close alignment of ownership and control (Daily and Dollinger 1992).
Notwithstanding the likelihood that family businesses may exhibit a lower level of agency costs compared with listed companies, the present study argues that conflict consistent with suggestions of agency theory can still arise in family businesses. There are two characteristics of family businesses giving rise to a demand for audit that can be directly measured. These are: (1) the proportion of nonfamily management, and (2) the proportion of nonfamily representation on the board of directors.
The first of these characteristics relates to the introduction of nonfamily operational management. Depending on the circumstances of the entity,(2) family owners might delegate some level of management responsibilities to nonfamily members. This will increase the demand for auditing for reasons of higher agency costs, and a greater loss of control by the owners. DeFond (1992, 21) explains the implication of separation of ownership and control as “(1) the divergence in preferences of the manager and owner with respect to the manager’s actions, and (2) the imperfect observability of the manager’s actions by the owner.” As the proportion of nonfamily management increases, owners (family and nonfamily) will exhibit greater demand for monitoring to reduce management shirking due to information asymmetry between nonfamily management and owners.
A second characteristic that increases the demand for auditing in family businesses is where the family raises capital from outside investors (nonfamily members).
Increasing diversity of ownership creates agency conflict because the majority owners (by definition, the family) have incentive to divert resources for their personal use. Such a diversion will have the effect of restricting resource flow to nonfamily owners. Benston (1985) argued this point with regard to owner-managed enterprises where there are outside investors. The capacity and incentive for nonfamily owners to initiate monitoring will depend on their level of ownership, and their representation on the board of directors. As the proportion of nonfamily ownership and director representation rises, a greater demand for monitoring will be exhibited.(3)
Research has investigated factors associated with “voluntary” demand for external auditing. Chow (1982) used an agency framework to investigate the impact of agency costs (proxied by management share ownership), firm size, and debt. He found support for the effects of leverage and accounting-based debt covenants, and moderate support for the predicted role of size on voluntary demand for auditing. Abdel-khalik (1993) used a “structure of organization approach” to investigate the impact of the level of hierarchy (firm size) and debt. He found a correlation between voluntary demand for auditing and the extent of hierarchy (a measure of firm size), and only weak support for the impact of debt. Blackwell et al. (1998) found that small private firms derived an economic benefit from auditing through a significantly lower interest rate than that paid by nonaudited firms; thus the level of debt was a major factor in determining the level of benefit gained.
Other research has investigated quality-differentiated audits. These studies, investigating firms with a statutory audit requirement, traditionally use a binary categorization of audit firm quality to capture the impact of variations in agency conflict among firms (see, for example DeFond 1992; Johnson and Lys 1990; Francis and Wilson 1988; Simunic and Stein 1987; Palmrose 1984).
This literature argues that larger firms provide a higher quality service (DeAngelo 1981) and are more likely to be employed to undertake the audit of companies facing a higher level of agency conflict. Using management share ownership to proxy agency costs, some researchers have found the expected negative association between management share ownership and auditor brand-name/quality (DeFond 1992; Simunic and Stein 1987), others have found no effect (Palmrose 1984; Francis and Wilson 1988), and still others have unexpectedly found a positive association (Eichenseher and Shields 1989).
The above research establishes a link between demand for external auditing and firm size, debt, the proportion of nonfamily management, and the proportion of nonfamily representation on the board of directors. Although much of the audit-demand research has addressed external auditing, a number of authors (for example, Anderson et al. 1993; DeFond 1992) have argued that internal audit is a potential alternative monitoring mechanism. In this paper, we argue that external and internal audit might both serve as a monitoring response to variations in agency conflict in an environment where auditing is voluntary and costs and benefits of different approaches can be considered.
The current nature of the relationship between internal and external auditing is unclear. One view of internal auditing, as, for example, reflected in auditing standards (International Auditing Standard ISA610, International Auditing Practices Committee 1994), is that the means for internal and external audit to achieve respective objectives are often similar, which suggests internal audit may serve as a complement to external audit. Among listed public companies, evidence of a reduction in external audit cost due to reliance on the work of internal audit suggests a complementary relationship (see Felix etAn alternative view of the relationship between internal and external auditing is that, in a voluntary setting, internal audit can serve as a substitute in one or both of two ways. First, it can be a straight substitute when internal audit performs financial statement audit work that could similarly be provided by external audit. The second substitution would be when the family business chooses an audit service other than that provided by a financial statement audit as an appropriate monitoring response. A number of authors (see, for example, Elliott 1994) have predicted an increased demand for a broader range of assurance services and a corresponding decline in the relevance of the financial statements and the related external audit service.
It may also be that relations between internal and external audit are evolving and are very dynamic. While the role of internal audit is traditionally viewed as assisting management in safeguarding assets and monitoring control systems (for example, Ratliff et al. 1996), there is evidence of internal audit changing in response to changing business needs. The emphasis in many internal audit departments is on adding value to the entity, and includes services ranging from advice on business planning and risk management to information systems evaluation (Birkett et al. 1999).
Where the emphasis of external audits was on financial statement risk, and internal auditors were seen to be control-risk focused, it was likely that in a voluntary setting internal audit was complementary to external audit. If internal audit adopts a more value-added approach, rather than a control-risk approach, it is more likely that complementarity between internal audit and external audit will diminish, and internal auditors may be viewed as substitutes to external auditors as providers of expert advice. Discussions with representatives from the Big 5 accounting firms confirm that in today’s environment, when they are approached by family companies requesting audit services in a voluntary environment, an assessment of client needs often means that they recommend the provision of internal audit services rather than the traditional external audit.
HYPOTHESES
Demand for Auditing Arising from Separation of Ownership and Control
As outlined in the previous section, undertaking the analysis of demand for auditing in a family-business environment permitted the development of two measures of the separation of ownership and control. These measures were the proportion of nonfamily management in the firm and the proportion of nonfamily representation on the board of directors. First, a greater proportion of nonfamily management is expected to result in greater separation of ownership and managerial control. A positive correlation between the proportion of nonfamily management and demand for auditing is predicted. Second, higher nonfamily membership on the board of directors that represents nonfamily ownership creates an incentive for the family to divert resources for their personal use. The representatives of nonfamily interests on the board will demand greater monitoring. A positive correlation between the proportion of nonfamily representation on the board of directors and demand for auditing is predicted.
al. 1998; Wallace 1984).(4)
With greater separation of ownership and control, the benefits from an audit, either internal or external, are more likely to exceed the cost. The preceding arguments are summarized in the following hypotheses:
H1a: In an unregulated family business environment, demand for auditing will be positively correlated with the proportion of nonfamily management.
H1b: In an unregulated family business environment, demand for auditing will be positively correlated with the proportion of nonfamily board of director representation.
Size
As previously discussed, empirical research has identified a correlation between firm size and demand for both external auditing and internal auditing. The literature suggests a number of theoretical explanations. First, as the total amount of potential wealth transfers increases with firm size, the related benefits from undertaking monitoring increase (Chow 1982).
Second, with increased size it becomes more difficult for the owners of private companies to oversee and be cognizant of the enterprise. Hence, there is a greater demand for auditing to compensate for the loss of control (Abdel-khalik 1993).
Third, on the cost side, the marginal cost of providing an external audit decreases with firm size (Chow 1982).
Similarly, larger firms have opportunities to take advantage of economies of scale from investing in the fixed costs of internal auditing, which include staff training and establishing geographically dispersed offices (Anderson et al. 1993).
The preceding arguments can be summarized in the following hypothesis:
H2: In an unregulated family business environment, voluntary demand for auditing will be positively correlated with a firm’s size.
Debt
Theoretical discussions as to the association between debt and demand for auditing tend to support a positive association between level of debt and demand for external auditing (see Chow 1982).
It is argued that as the proportion of debt in a firm’s capital structure increases, shareholders have greater incentives to transfer wealth from the bondholder(5) and this increases the likelihood that the organization will demand an audit. Abdel-khalik (1993) adapted this argument in suggesting that owners demand an external audit in order to comply with constraints placed on an organization by creditors. Blackwell et al. (1998) found evidence that demand for external auditing is derived from the economic benefit of a lower interest rate. There is, however, no theoretical or empirical literature linking firm debt with the existence of internal audit. In this absence the hypothesis is limited to external auditing.
The preceding arguments can be summarized in the following hypothesis:
H3: In an unregulated family-business environment, demand for external auditi
The preceding arguments can be summarized in the following hypothesis:
H3: In an unregulated family-business environment, demand for external auditing will be positively correlated with the level of debt in a firm’s capital structure.
The Relationship between Internal and External Auditing
In an environment where demand for auditing is voluntary, family businesses can respond to pressure for monitoring by choosing between internal audit and external audit. It is unclear if internal and external audit are primarily viewed as complementary responses, or as substitute monitoring mechanisms. The existence of internal auditing being positively correlated with the existence of external auditing will be evidence of their complementary nature,(6) while a negative correlation will suggest that they may serve as substitute monitoring mechanisms. The analysis will include only firms that undertake some form of audit service. This approach is consistent with the definition in economics of a complementary good or service, as one that is used in conjunction with another good or service (for example, Jackson et al. 1998).
Including firms that do not engage either internal or external audit introduces unwanted variability into the analysis; firms that do not engage either audit service are neither demonstrating a complementary nor substitute association. Because of the exploratory nature of this section of the study, the following hypothesis is expressed in the null form:
H4: In an unregulated family-business environment, and for businesses that engage an audit service, there will be no correlation between demand for external auditing and demand for internal auditing.
METHOD
Data Collection Procedure and Sample
The data subject to analysis comprised 186 Australian family businesses drawn from a database of 318 family businesses compiled by the AXA Australia Family Business Research Unit (AAFBRU) at Monash University. The database was compiled from a survey of 3,000 Australian businesses randomly selected from the Dun & Bradstreet list of Australian businesses. The Australian Family Business Equity Participation Questionnaire (AFBEPQ) was designed by the AAFBRU and comprised seven sections: Background of the Business, Current Ownership and Management of the Business, Succession, Planning the Growth of the Family Business, Alternate Investment, Background of the CEO, and Audit Protocol. Authors of the present study were permitted to incorporate a limited number of questions into the questionnaire that were relevant to the research issues addressed in this paper.
This study reports findings drawn from three sections of the questionnaire: Background of the Business, Current Ownership and Management of the Business, and Audit Protocol. Background of the Business assesses: whether the firm was a family business; industry; age of business; number of employees; legal structure; gross sales; average rate of earnings from sales before interest and tax; and value of total assets. Current Ownership and Management gauges: proportion of family ownership; generation of ownership; number of family and nonfamily directors; and proportion of family management. Audit Protocol measures whether family firms’ voluntarily engage both external and internal audits.
Tests of responses revealed that respondent organizations were slightly larger than the population of businesses contained on the Dun & Bradstreet list. Indeed, as shown in Table 1, respondent organizations that had sales turnover exceeding $20 million were overrepresented in our sample by approximately 10 percent. A breakdown of respondents by number of employees indicates that, when compared with Dun & Bradstreet data,(7) our sample is overrepresented in the 20-49 and 50-99 categories, but underrepresented in both the less than 20 and 100+ employee categories.(8) When comparing the breakdown by number of employees with sales turnover estimates, our results appear to be more underrepresentative of small-sized compared to the large-sized businesses. A further breakdown of respondents by industry demonstrates that our respondents are overrepresented in the retail and wholesale trade industry, but underrepresented in the finance, property, and business services industries.
TABLE 1
Comparison of Family Business Sample with Dun & Bradstreet
Dun & Sample
Bradstreet (n = 186)
Sales
> $20 million 20 29.6
Industry
Manufacturing 15.4 17.2
Retail & Wholesale Trade 35.7 51.6
Transport & Storage 4.5 4.8
Finance, Property, & Business Services 23.1 5.4
Construction 13.0 10.2
Other 8.3 10.8
day, December 22 2000
You are viewing page 7
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Introduction
Family businesses, in this study defined as firms that exhibit majority family ownership, accounts for a large proportion of all economic activity. Research suggests that 80 percent of all businesses in the United States are family owned (Daily and Dollinger 1992) and family businesses contribute between 50 percent and 60 percent of U.S. gross domestic product (Francis 1993; Upton 1991).
Similar findings have been reported in the UK (Stoy Hayward and The London Business School 1989, 1990), Western Europe (Lank 1995), and Australia (Smyrnios and Romano 1994; Smyrnios et al. 1997).
Providing further evidence of the contribution of family business to the economy, La Porta et al. (1999) and Schleifer and Vishny (1986) find that the ownership structure of even large public companies is characterized by controlling stockholders who are more often families, usually the founder or their descendants. Despite the significance of family business to the economy there are few empirical studies of this sector in general (Brockhaus 1994; Wortman 1994), and in particular in the audit area. The family-business environment provides an opportunity to further test theory concerning demand for auditing. Derived from prior empirical research and agency theory, predictions of voluntary demand for internal and external auditing are tested using survey data from family businesses.
Family businesses in Australia at the time of this study largely operated in an environment where neither external nor internal auditing was a statutory requirement,(1) and the setting offered an opportunity to observe voluntary demand for auditing. Investigating voluntary demand has the advantage of eliminating the confounding effect of regulation. Few studies have investigated voluntary demand for auditing (see Chow 1982; Abdel-khalik 1993; Blackwell et al. 1998) and the present study accordingly adds to this literature.
The study incorporates the traditional characteristics of firm size and firm debt, which are expected to increase the likelihood of a family business engaging the services of an auditor. Given the nature of family businesses, unique measures consistent with the suggestion of agency theory are developed to capture variations in demand for auditing among firms. The measures are: (1) the proportion of nonfamily management in the firm, and (2) the proportion of nonfamily representation on the board of directors. For both measures it is predicted that agency costs will increase through greater separation of ownership and control. In addition, the present study argues that both (or either) internal audit and external audit can serve as a monitoring response in family businesses, and an additional contribution of this research is to examine the relationship between these monitoring mechanisms.
The study analyzes survey data drawn from a database of Australian family companies compiled by the AXA Australia Family Business Research Unit. Internal auditing (Yes/No) and external auditing (Yes/No) are the dependent variables examined in separate logistic regression analyses. The hypothesized independent variables are firm characteristics associated with demand for auditing, namely firm size, firm debt, the proportion of nonfamily management in the firm, and the proportion of nonfamily representation on the board of directors.
THEORY AND LITERATURE REVIEW
There are a number of complementary explanations as to sources of demand for auditing (see, for example, Chow et al. 1988).
Business is accountable to a range of parties and the diversity of organizations causes a myriad of potential accountability relationships, making it difficult to identify a single explanatory cause. Contracting or agency theory has provided a resilient and popular framework for explaining the demand for external auditing and suggests a monitoring role for both internal and external audit. The provision of audited financial statements is normally regarded as a cost-effective contractual response to agency costs (DeAngelo 1981; Watts and Zimmerman 1976).
Similarly, internal auditing may also serve as a monitoring response to agency costs (Anderson et al. 1993; DeFond 1992).
Though the agency literature is suggestive of potential conflict in family businesses (Fama and Jensen 1983), empirical research investigating the monitoring response in this important business segment is limited. This limitation is perhaps not surprising as the image of a family business is one characterized by a close alignment of ownership and control (Daily and Dollinger 1992).
Notwithstanding the likelihood that family businesses may exhibit a lower level of agency costs compared with listed companies, the present study argues that conflict consistent with suggestions of agency theory can still arise in family businesses. There are two characteristics of family businesses giving rise to a demand for audit that can be directly measured. These are: (1) the proportion of nonfamily management, and (2) the proportion of nonfamily representation on the board of directors.
The first of these characteristics relates to the introduction of nonfamily operational management. Depending on the circumstances of the entity,(2) family owners might delegate some level of management responsibilities to nonfamily members. This will increase the demand for auditing for reasons of higher agency costs, and a greater loss of control by the owners. DeFond (1992, 21) explains the implication of separation of ownership and control as “(1) the divergence in preferences of the manager and owner with respect to the manager’s actions, and (2) the imperfect observability of the manager’s actions by the owner.” As the proportion of nonfamily management increases, owners (family and nonfamily) will exhibit greater demand for monitoring to reduce management shirking due to information asymmetry between nonfamily management and owners.
A second characteristic that increases the demand for auditing in family businesses is where the family raises capital from outside investors (nonfamily members).
Increasing diversity of ownership creates agency conflict because the majority owners (by definition, the family) have incentive to divert resources for their personal use. Such a diversion will have the effect of restricting resource flow to nonfamily owners. Benston (1985) argued this point with regard to owner-managed enterprises where there are outside investors. The capacity and incentive for nonfamily owners to initiate monitoring will depend on their level of ownership, and their representation on the board of directors. As the proportion of nonfamily ownership and director representation rises, a greater demand for monitoring will be exhibited.(3)
Research has investigated factors associated with “voluntary” demand for external auditing. Chow (1982) used an agency framework to investigate the impact of agency costs (proxied by management share ownership), firm size, and debt. He found support for the effects of leverage and accounting-based debt covenants, and moderate support for the predicted role of size on voluntary demand for auditing. Abdel-khalik (1993) used a “structure of organization approach” to investigate the impact of the level of hierarchy (firm size) and debt. He found a correlation between voluntary demand for auditing and the extent of hierarchy (a measure of firm size), and only weak support for the impact of debt. Blackwell et al. (1998) found that small private firms derived an economic benefit from auditing through a significantly lower interest rate than that paid by nonaudited firms; thus the level of debt was a major factor in determining the level of benefit gained.
Other research has investigated quality-differentiated audits. These studies, investigating firms with a statutory audit requirement, traditionally use a binary categorization of audit firm quality to capture the impact of variations in agency conflict among firms (see, for example DeFond 1992; Johnson and Lys 1990; Francis and Wilson 1988; Simunic and Stein 1987; Palmrose 1984).
This literature argues that larger firms provide a higher quality service (DeAngelo 1981) and are more likely to be employed to undertake the audit of companies facing a higher level of agency conflict. Using management share ownership to proxy agency costs, some researchers have found the expected negative association between management share ownership and auditor brand-name/quality (DeFond 1992; Simunic and Stein 1987), others have found no effect (Palmrose 1984; Francis and Wilson 1988), and still others have unexpectedly found a positive association (Eichenseher and Shields 1989).
The above research establishes a link between demand for external auditing and firm size, debt, the proportion of nonfamily management, and the proportion of nonfamily representation on the board of directors. Although much of the audit-demand research has addressed external auditing, a number of authors (for example, Anderson et al. 1993; DeFond 1992) have argued that internal audit is a potential alternative monitoring mechanism. In this paper, we argue that external and internal audit might both serve as a monitoring response to variations in agency conflict in an environment where auditing is voluntary and costs and benefits of different approaches can be considered.
The current nature of the relationship between internal and external auditing is unclear. One view of internal auditing, as, for example, reflected in auditing standards (International Auditing Standard ISA610, International Auditing Practices Committee 1994), is that the means for internal and external audit to achieve respective objectives are often similar, which suggests internal audit may serve as a complement to external audit. Among listed public companies, evidence of a reduction in external audit cost due to reliance on the work of internal audit suggests a complementary relationship (see Felix et al. 1998; Wallace 1984).(4)
An alternative view of the relationship between internal and external auditing is that, in a voluntary setting, internal audit can serve as a substitute in one or both of two ways. First, it can be a straight substitute when internal audit performs financial statement audit work that could similarly be provided by external audit. The second substitution would be when the family business chooses an audit service other than that provided by a financial statement audit as an appropriate monitoring response. A number of authors (see, for example, Elliott 1994) have predicted an increased demand for a broader range of assurance services and a corresponding decline in the relevance of the financial statements and the related external audit service.
It may also be that relations between internal and external audit are evolving and are very dynamic. While the role of internal audit is traditionally viewed as assisting management in safeguarding assets and monitoring control systems (for example, Ratliff et al. 1996), there is evidence of internal audit changing in response to changing business needs. The emphasis in many internal audit departments is on adding value to the entity, and includes services ranging from advice on business planning and risk management to information systems evaluation (Birkett et al. 1999).
Where the emphasis of external audits was on financial statement risk, and internal auditors were seen to be control-risk focused, it was likely that in a voluntary setting internal audit was complementary to external audit. If internal audit adopts a more value-added approach, rather than a control-risk approach, it is more likely that complementarity between internal audit and external audit will diminish, and internal auditors may be viewed as substitutes to external auditors as providers of expert advice. Discussions with representatives from the Big 5 accounting firms confirm that in today’s environment, when they are approached by family companies requesting audit services in a voluntary environment, an assessment of client needs often means that they recommend the provision of internal audit services rather than the traditional external audit.
HYPOTHESES
Demand for Auditing Arising from Separation of Ownership and Control
As outlined in the previous section, undertaking the analysis of demand for auditing in a family-business environment permitted the development of two measures of the separation of ownership and control. These measures were the proportion of nonfamily management in the firm and the proportion of nonfamily representation on the board of directors. First, a greater proportion of nonfamily management is expected to result in greater separation of ownership and managerial control. A positive correlation between the proportion of nonfamily management and demand for auditing is predicted. Second, higher nonfamily membership on the board of directors that represents nonfamily ownership creates an incentive for the family to divert resources for their personal use. The representatives of nonfamily interests on the board will demand greater monitoring. A positive correlation between the proportion of nonfamily representation on the board of directors and demand for auditing is predicted.
With greater separation of ownership and control, the benefits from an audit, either internal or external, are more likely to exceed the cost. The preceding arguments are summarized in the following hypotheses:
H1a: In an unregulated family business environment, demand for auditing will be positively correlated with the proportion of nonfamily management.
H1b: In an unregulated family business environment, demand for auditing will be positively correlated with the proportion of nonfamily board of director representation.
Size
As previously discussed, empirical research has identified a correlation between firm size and demand for both external auditing and internal auditing. The literature suggests a number of theoretical explanations. First, as the total amount of potential wealth transfers increases with firm size, the related benefits from undertaking monitoring increase (Chow 1982).
Second, with increased size it becomes more difficult for the owners of private companies to oversee and be cognizant of the enterprise. Hence, there is a greater demand for auditing to compensate for the loss of control (Abdel-khalik 1993).
Third, on the cost side, the marginal cost of providing an external audit decreases with firm size (Chow 1982).
Similarly, larger firms have opportunities to take advantage of economies of scale from investing in the fixed costs of internal auditing, which include staff training and establishing geographically dispersed offices (Anderson et al. 1993).
The preceding arguments can be summarized in the following hypothesis:
H2: In an unregulated family business environment, voluntary demand for auditing will be positively correlated with a firm’s size.
Debt
Theoretical discussions as to the association between debt and demand for auditing tend to support a positive association between level of debt and demand for external auditing (see Chow 1982).
It is argued that as the proportion of debt in a firm’s capital structure increases, shareholders have greater incentives to transfer wealth from the bondholder(5) and this increases the likelihood that the organization will demand an audit. Abdel-khalik (1993) adapted this argument in suggesting that owners demand an external audit in order to comply with constraints placed on an organization by creditors. Blackwell et al. (1998) found evidence that demand for external auditing is derived from the economic benefit of a lower interest rate. There is, however, no theoretical or empirical literature linking firm debt with the existence of internal audit. In this absence the hypothesis is limited to external auditing.
The preceding arguments can be summarized in the following hypothesis:
H3: In an unregulated family-business environment, demand for external auditing will be positively correlated with the level of debt in a firm’s capital structure.
The Relationship between Internal and External Auditing
In an environment where demand for auditing is voluntary, family businesses can respond to pressure for monitoring by choosing between internal audit and external audit. It is unclear if internal and external audit are primarily viewed as complementary responses, or as substitute monitoring mechanisms. The existence of internal auditing being positively correlated with the existence of external auditing will be evidence of their complementary nature,(6) while a negative correlation will suggest that they may serve as substitute monitoring mechanisms. The analysis will include only firms that undertake some form of audit service. This approach is consistent with the definition in economics of a complementary good or service, as one that is used in conjunction with another good or service (for example, Jackson et al. 1998).
Including firms that do not engage either internal or external audit introduces unwanted variability into the analysis; firms that do not engage either audit service are neither demonstrating a complementary nor substitute association. Because of the exploratory nature of this section of the study, the following hypothesis is expressed in the null form:
H4: In an unregulated family-business environment, and for businesses that engage an audit service, there will be no correlation between demand for external auditing and demand for internal auditing.
METHOD
Data Collection Procedure and Sample
The data subject to analysis comprised 186 Australian family businesses drawn from a database of 318 family businesses compiled by the AXA Australia Family Business Research Unit (AAFBRU) at Monash University. The database was compiled from a survey of 3,000 Australian businesses randomly selected from the Dun & Bradstreet list of Australian businesses. The Australian Family Business Equity Participation Questionnaire (AFBEPQ) was designed by the AAFBRU and comprised seven sections: Background of the Business, Current Ownership and Management of the Business, Succession, Planning the Growth of the Family Business, Alternate Investment, Background of the CEO, and Audit Protocol. Authors of the present study were permitted to incorporate a limited number of questions into the questionnaire that were relevant to the research issues addressed in this paper.
This study reports findings drawn from three sections of the questionnaire: Background of the Business, Current Ownership and Management of the Business, and Audit Protocol. Background of the Business assesses: whether the firm was a family business; industry; age of business; number of employees; legal structure; gross sales; average rate of earnings from sales before interest and tax; and value of total assets. Current Ownership and Management gauges: proportion of family ownership; generation of ownership; number of family and nonfamily directors; and proportion of family management. Audit Protocol measures whether family firms’ voluntarily engage both external and internal audits.
Tests of responses revealed that respondent organizations were slightly larger than the population of businesses contained on the Dun & Bradstreet list. Indeed, as shown in Table 1, respondent organizations that had sales turnover exceeding $20 million were overrepresented in our sample by approximately 10 percent. A breakdown of respondents by number of employees indicates that, when compared with Dun & Bradstreet data,(7) our sample is overrepresented in the 20-49 and 50-99 categories, but underrepresented in both the less than 20 and 100+ employee categories.(8) When comparing the breakdown by number of employees with sales turnover estimates, our results appear to be more underrepresentative of small-sized compared to the large-sized businesses. A further breakdown of respondents by industry demonstrates that our respondents are overrepresented in the retail and wholesale trade industry, but underrepresented in the finance, property, and business services industries.
TABLE 1
Comparison of Family Business Sample with Dun & Bradstreet
Dun & Sample
Bradstreet (n = 186)
Sales
> $20 million 20 29.6
Industry
Manufacturing 15.4 17.2
Retail & Wholesale Trade 35.7 51.6
Transport & Storage 4.5 4.8
Finance, Property, & Business Services 23.1 5.4
Construction 13.0 10.2
Other 8.3 10.8
Employees
20 – 49 12 24
50 – 99 10 22
100+ 39 19
Value of total assets (millions)
$1m – $5m 37
$6m – $19m 35
$20m – $49m 6
$50m – $99m 1
> $100m 1
From the database of 318 family businesses, 132 businesses were deleted for the following reasons: (1) 25 responses(9) were deleted to eliminate the potentially confounding effect of regulation; (2) six responses were deleted as they failed to satisfy the family-business criteria used in this study; and (3) the remaining 101 responses were deleted due to missing values for any one of the variables in the model. To assess whether deleted respondents differed significantly from our usable response group (n = 186), they were compared on three key characteristics (i.e., number of full-time employees, gross sales in 1996, and industry).
Chi-square tests indicate that there were no systematic differences between the two groups for all three characteristics: number of full-time employees ([chi square] = 5.99, df= 4, p = .2003), gross sales in 1996 ([chi square] = 8.17, df= 5, p = .1473), and industry ([chi square] = 13.38, df= 9, p = .1461).
Logistic Regression Analyses
Logistic regression analyses were used to predict discrete outcomes (Yes/No for Internal Audit and Yes/No for External Audit) from three continuous independent variables in the internal audit model and four continuous variables in the external audit model (refer to Exhibit 1).(10) Two logistic regression analyses were performed to assess prediction of firms’ voluntarily adopting an internal and an external audit on the basis of the proportion of directors that are nonfamily members (PROPDIR), proportion of nonfamily participation in the management team (PROPMAN), size of the firm (SIZEFACT), and the proportion of funding for the business provided by debt (DEBTA) (only for the prediction of voluntary external audit).
