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«John Christian Langli and Tobias Svanström © John Christian Langli and Tobias Svanström 2013. All rights reserved. Short sections of text, not to ...»

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Audits of private firms

Working Paper

No. 1/2013

January 2013

John Christian Langli and Tobias Svanström

© John Christian Langli and Tobias Svanström 2013. All rights reserved. Short sections of text, not to

exceed two paragraphs, may be quoted without explicit permission, provided that full credit, including ©

notice, is given to the source. This paper can be downloaded without charge from the CCGR website

http://www.bi.edu/ccgr

Audits of private firms

by

John Christian Langli (BI Norwegian Business School)* Tobias Svanström (BI Norwegian Business School)

14. January, 2013 Abstract: Private and public firms differ across a number of important dimensions. Public firms are under scrutiny by stock exchanges, regulators, and market participants and they share the feature of separation of ownership and control. Private firms, in contrast, are much less regulated, the nature of their agency problems is different, they are less exposed to market forces, litigation and publicity, and they operate in a much more opaque information environment. The greater heterogeneity among private firms makes the role of auditing less obvious, which is reflected by auditing being made statutory in some countries while being voluntary in others. In this paper we highlight the differences between audits of private and public firms and review and synthesize the empirical evidence, which is sparse in comparison to what is available for public firms.

* Corresponding author: john.c.langli@bi.no

INTRODUCTION

Regulators around the world have agreed that public firms must disclose audited financial statements.1 One reason is the positive welfare effect of reliable information of high quality. Audited financial statements are intended to lubricate capital markets by providing relevant and reliable firmspecific information that enables more precise forecasts of future cash flows and reduced uncertainty, which ease access to finance and foster investment and growth. The improvement in the allocation of capital that is presumed to results from the proliferation of high quality financial information has led regulators to conclude that the benefits of statutory audits outweigh the cost for public firms.

There is no consensus among regulators regarding the need for statutory audits of private firms. Part of the explanation is different stances on the role played by financial statements. In some countries, such as the US and Japan, private firms operate without any requirements by law to disclose financial statements (Arrunada 2011). In other countries, among those all countries in the European Union (EU), private firms must prepare financial statements and make them publically available.2 As financial statements are a prerequisite for statutory audits, differences in accounting regulation are important for understanding differences in the auditing regulation.

Even if regulators agree that financial statements are important and thus mandatory for private firms, they may disagree about statutory audits. In the EU, Article 51(1) in the fourth directive requires mandatory auditing for all firms (European Commission 1978). However, member states may exempt the smallest firms from this audit obligation (Article 51(2)). Figure 13, adapted from Collis (2010), clearly illustrates that regulators disagree about the need for statutory audits for the smallest firms.

In 2005, all firms in Denmark, Sweden and Malta, even those with no sales, were required to prepare audited financial statements. At the same time, four countries (Cyprus, the Netherlands, Germany and the UK) mandated auditing only for firms with sales exceeding 7 million euro.

Auditing in private firms is an important topic. One reason is that research focusing on public firms may not be generalizable to private firms since they differ from private firms along a number of important dimensions. In addition the suppliers of audit services have different incentives and competences (we elaborate these below). Thus, it is not clear to what extent theory and empirical findings based on public firms can provide insight and guidance to regulators, standard setters, researchers and users of (audited) financial statements when it comes to auditing in the private firm segment of the economy.

A second reason for focusing on private firms is their economic importance. Some examples: Private firms represent more than 99 per cent of all firms in the US and these firms account for more than 50 per cent of the private sector GDP (Minnis 2011). Belgium has more than 250 000 firms and only 150 are listed (Bauwede and Willekens 2004). More than 90 per cent of all registered companies in UK are private (Chaney, Jeter and Shivakumar 2004), and private firms account for 99.6 per cent of all businesses in Australia (Australia Bureau of Statistics 2001). One type of private firm (SMEs) accounted for 67 per cent of total employment and 58 per cent of gross value added in the EU in 2012 (Wymenga, Spanikova, Barker, Konings, and Canton 2012). Thus, it is apparent that understanding governance, growth and performance of the private firm is important for economic growth and prosperity for society at large; and auditors may play a key role as a provider or verifier of financial information and as an advisor to decision makers.

A third reason to focus on private firms is that they give new opportunities for the development and testing of theories and also for conducting more robust tests of existing theories. Our review shows that researchers into private firms typically have chosen topics and questions that previously have been analyzed for public companies. However, it is possible to ask questions that are directly relevant for private firms and also to conduct tests that are not feasible in a public firm setting. These opportunities occur because of the differences between public and private firms. Besides, the variation in tests and control variables is generally larger in the private firm segment, which enables more robust tests than is possible by focusing on public firms only. Also, a lower level of concentration of the big audit firms and lower litigation risks provide other incentives for auditors;





and different market conditions and risk exposure are important in order to understand auditor behavior. Thus, the private firm segment is an arena for advancing theories and tests that should be utilized to a much greater extent than currently seen. One major challenge when studying private firms is of course the difficulties with access to data, but some data are available that have yet to be utilized.4 In addition the possibility of conducting field research in cooperation with audit firms may be better in the private firm segment, as the possibility of maintaining anonymity for both clients and audit firms is much greater due to the sheer number of clients and audit firms.

In this paper we review the literature on audits of private firms, which is sparse compared to public

firms. Francis, Khurana, Martin, and Pereira (2011: 489) describe the state of affairs quite accurately:

“Despite the importance of smaller entities to the economy and capital markets, surprisingly little is known about these firms with respect to their accounting and auditing choices or the economic consequence of these choices.” The structure of the paper is as follows. We start by highlighting the differences between private and public firms and proceed by providing an overview of existing research. We divide the overview into four broad categories; i) ability to detect misstatements, ii) ability to report on misstatements, iii) audit quality differences between audit firms, and iv) auditor choice and client firm characteristics.

Then we discuss directions for future research before a short summary concludes the paper.

WHAT IS SPECIAL ABOUT PRIVATE FIRMS AND THEIR AUDIT?

Private firms are different from public firms. Whether these differences increase or decrease the demand for auditing or make audits more or less important, is not clear a priori. Nor is it apparent without testing that results for public firms can be generalized to private firms (Hope, Thomas and Langli 2012). We highlight the major differences between private and public firm in this section.

One important difference between public and private firms is that the nature of the agency conflicts is different. Compared to public firms, private firms have much more concentrated ownership, especially greater ownership by managers, “major capital providers often have insider access to corporate information and capital providers may take a more active role in management (van Tendeloo and Vanstraelen 2008: 449). Besides, family ties between CEOs and shareholders and between CEOs and board members are much more common (Hope et al. 2012). Furthermore, private firms operate in a substantially poorer information environment, disclose less non-financial information, their financial statements are less scrutinized by market participants, they have little capital-market pressure to hire high-quality auditors, and their financial statements may be more influenced by taxation, dividend and other political issues such as the intention to transfer the firm to the next generation (Chaney et al. 2004; De Franco, Gavious, Jin and Richardson 2011; Ball and Shivakumar 2005; Hope et al. 2012; Sharma and Carney 2012). Thus there are weaker incentives for private firms to produce high quality financial statements and there is less agency conflict between shareholders and managers, but potentially more agency conflict between majority owners and minority owners (whether being members of the same family or not) and/or between owners and creditors and tax authorities. Thus the monitoring role of auditing may be more important in private firms (Lennox, 2005), but there are also arguments related to how private firms may solve moral hazard and asymmetric information problems that may make auditing less valuable in private firms (Cano Rodriguez and Alegria 2012).

A second reason for focusing on private firms is that they may demand auditing for reasons not related to agency costs. We know that signaling that financial statements are free from material errors and that managers refrain from extraction of benefits on behalf of other stakeholders are important reasons why firms voluntarily hire an auditor when audit is not statutory, or voluntarily hire a high quality auditor when audit is statutory. In the private firm segment the demand for auditing may also reflect other reasons. For instance may a firm demand an external auditor to compensate for the loss of control that is inherent in hierarchical organizations as a longer chain of command reduces the top manager’s ability to observe subordinates’ actions (Abdel-Khalik 1993), to improve “operational efficiency and effectiveness due to auditor evaluation of internal processes, deterrence of management malfeasance, increased compliance with legal and regulatory constraints, and market permission to undertake certain activities (e.g., participate in public capital markets)” (Knechel, Niemi, and Sundgren 2008: 66), and to get access to competences not available in-house as private firms may not be able to afford employees with expertise in accounting, taxation and other business issues (Svanström and Sundgren 2012). “Consequently, the choice of auditor in any given setting may be due to more complex factors than simply the reduction of external agency costs, especially for firms that are small or not publicly traded” (Knechel et al. 2008: 69). Thus there is much greater heterogeneity in the reasons why private firms hire auditors than for public firms.

Not only are there important differences on the demand side of the audit market, substantial differences also exist on the supply side. Among listed firms, the market may be characterized as an oligopoly as the large international audit firms, currently Ernst & Young, KPMG, Deloitte and PwC (henceforth Big N) dominate.5 Their market share is over 90 per cent of public firms in most EU member states (ESCP Europe 2011), 72 per cent in Spain (Cano Rodriguez and Alegria 2012), 97.4 per cent among FTSE 350 firms in 2005 (Oxera 2006) and 52.3 [80] per cent in the Australian sample used in Goodwin (2011) [Salman and Carson 2009]. The United States Government Accountability Office (GAO 2008) reports that the four largest accounting firms audit 98 per cent of the more than 1,500 largest public US companies whereas mid-size and smaller audit firms audited almost 80 per cent of the more than 3,600 smallest companies.

The Big N market share among private firm is more difficult to estimate as the data covering all private firms within a country is not easily accessible. However, there is no doubt that the Big N market share among private firm is substantially lower than for public firms, with large variations across countries: 28 per cent in Spain (Cano Rodriguez and Alegria 2012), 18.1 per cent in Norway (Hope et al. 2012), 34 per cent in Korea (Kim, Simunic, Stein and Yi 2011), 8.3 [6] {50} per cent in the UK samples used by Clatworthy, Makepeace, and Peel (2009) [Pittman and Lennox 2011] {Chaney et al. 2004}, while Van Tendeloo and Vanstaelen (2008) reports Big N market shares of 37.6 in Belgium,

90.2 per cent in Finland, 14.4 per cent in France, 84.9 per cent in the Netherlands, 27.7 per cent in Spain and 45.6 per cent in the UK. When public and private firms are viewed as a whole, the market share of Big N firms is less than 26 per cent in 19 EU member states and between 35 and 44 per cent in Denmark, Luxembourg, Sweden and the UK (ESCP Europe 2011). Taken together, the figures indicate that the audit market both among private and public firms is segmented with a large Big N dominance among the largest firms.

The dominance of Big N, particularly among listed firms, has led regulators to worry about market concentration and how this may affect audit quality. Among EU regulators the concern is that the concentration gives large firms too few suppliers to choose from and that “concentration might entail an accumulation of systemic risk.. ” that could, if one of the Big N firm collapses, “disrupt the whole market” (European Commission 2011). In the private firm segment the audit firms are mostly small with a local anchor, and the market concentration is of less concern. However, a large number of suppliers of auditing services of which most are small create other threats to audit quality.



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