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Proceeds from sale of shares De Franco et al. (2011) analyze how audit choices impact share prices of private firms by testing if owners who sell all shares or firm’s assets obtain higher proceeds if they hired a Big N auditor. For public firms, research has documented that Big N auditors are perceived to provide higher audit quality than non-Big N, which for example explains why private firms that undergo an initial public offering (IPO) obtain higher IPO prices (see De Franco et al. (2011) for references). However, IPO firms are not comparable to those studied by De Franco et al. (2011) since only IPO firms can be expected to make heavy investments in governance systems prior to the IPO. Contrary to IPO firms, the firms analyzed by De Franco et al. (2011) provide no offer documents to investors, analysts, media or the SEC. Thus, to reduce information risk, the owners of the selling firms have incentives to hire high quality auditors. De Franco et al. (2011) document substantial decreases in enterprise value by not hiring Big N auditor. Different techniques give different estimates, but the drop in enterprise value varies from $1.9 million to $5.2 million in stock-purchased private firms, which is significant given that the median enterprise value ranged from $14 million to $18 million. The net benefit of hiring a Big N auditor is not analyzed, but since not all owners of private firms engage a Big N auditor prior to a sale the costs are likely to be substantial.
Internal value of audits An audit may benefit the auditee because it may contribute to reduced internal agency problems or the auditor may e.g. suggest improvements in process efficiency and assist in regulatory compliance (Knechel et al. 2008). However, the potential internal benefits are likely to be highly individual and have not been given much attention in empirical audit research.
Abdel-Khalik (1993: 35) argues that, while “fully private companies do not have the risk of moral hazard emanating from separation of ownership and control, they are subject to the problems of moral hazard “internal” to the operation of the firm.” When firms grow larger and delegation of responsibilities is necessary, direct supervision is no longer effective. Instead internal control systems serve as a way to control subordinates’ behaviors, and the audit may (via the feedback given to management) directly or indirectly enhance the quality and effectiveness of such systems. In essence, an audit can (partly) compensate for organizational loss of control in hierarchical organizations. The role of auditing for management control in more complex organizations is supported in Hay and Davis (2004). The fact that the firm hires an auditor is likely to reduce the risk that individuals take self-maximizing actions that are detrimental to the firm.
Collis, Jarvis and Skerratt (2004) found a positive association between demand for auditing in the UK and the degree to which management perceived the audit as i) improving the quality of financial statements, and ii) a control of internal books and records. These relationships are also confirmed in Niemi et al. (2012), using private company data from Finland. Audit serving as a remedy for weaknesses of internal controls may especially be the case in SMEs, where systems, controls, routines and policies are less formal and less developed. Based on the outcome of the audit procedures, management may receive suggestions about how to improve internal controls and administrative routines.
By hiring an auditor, the firm gains access to expertise. The possibility to ask the auditor for technical assistance and advice may be especially valuable for managers in SMEs which often lack competence in e.g. accounting and taxation. Svanström and Sundgren (2012) show that small private firms frequently use the incumbent auditor for different types of non-audit services, while services provided by other audit firms are purchased only by a small proportion of firms. They find that the length of the auditor-client relationship and good experiences of the quality of audit work are positively related to the purchase of non-audit services from the incumbent auditor, but negatively associated with the use of consulting services from other audit firms. The role of the auditor goes beyond just providing assurance in many SMEs, but the NAS primarily lies within auditor’s core competence such as accounting, taxes and some legal issues, and only rarely includes more strategic support services such as budgeting and investments.
Auditor choice and client firm characteristics The reasons why companies voluntarily engage an auditor, or choose a specific auditor in a statutory auditing regime, are complex and likely to vary across companies and countries. As for public firms there are certain characteristics related to size, complexity and risk that partly explain why firms choose a high quality auditor over a low quality auditor in a statutory auditing regime. The same variables are also important drivers of why firms voluntarily engage auditors when auditing is voluntarily. The variables capturing these characteristics are commonly incorporated as control variables in audit choice tests, and we do not discuss these variables here.
As for public firms, private firm research documents positive associations between voluntarily hiring an auditor or a high quality auditor and agency conflicts measured as e.g. the degree of separation between ownership and management or level of (unsecured) debt (Carey et al. 2000; Chaney et al 2004; Clatworthy et al. 2009; Collis et al. 2004; Hope et al. 20012; Knechel et al. 2008; Niemi et al.
2012). However, the private firm setting has enabled researchers to advance our understanding of agency conflicts beyond what is possible when using public firms due to greater variation in the data.
Lennox (2005) hypothesized that there is a non-linear relationship between managerial ownership (which varies between 0 and 100 per cent for private firms) and demand for high quality auditors measured by Big N auditors: “First, there is a divergence-of-interests effect, such that managers with smaller shareholdings have weaker incentives to act in outside shareholders' interests. Second, there is an entrenchment effect, such that managers with larger shareholdings have greater control over
the company and therefore greater scope for acting in their own private interests” (Lennox 2005:
207). Thus, the demand for high quality auditors is predicted to be higher at the low and at the high region of managerial ownership. Using a sample of large UK private firms, the hypothesis is supported.
The importance of agency conflicts are also documented by Hope et al. (2012) who use a sample of predominantly small and medium sized private firms. They document that the likelihood of choosing a Big N auditor “decreases with ownership concentration, level of ownership by the second largest owner, and family relationships between the board and the largest owner” (p. 513). However, no relationship is found between the choice of a Big N auditor and CEO ownership in the main tests.
Neither is any relationship found between choice of Big N and the family relationship between the CEO and the major shareholder and between the CEO and board members. Hope et al. (2012: 513) attribute the insignificant results to ”the trade-off between the benefits of more credible reporting from using a Big 4 auditor versus the potential costs of increased fees associated with a Big 4 auditor and the reduced ability of the CEO (or the CEO’s family) to extract resources from the firm.” Due to the multifaceted value of auditing, an audit may be demanded for other reasons than minimizing agency costs. The positive relationship between firm size and the voluntarily hiring of an auditor (Senkow et al. 2001, Collis et al. 2004 and Francis et al. 2011) could be caused by auditing generating more multidimensional value for larger and more complex companies (Knechel et al.
2008). Research in the UK and Ireland, summarized in Collis et al. (2004), shows that the main users of statutory audits are the directors of small companies. Further, Collis et al. (2004: 97) document that the primary determinants of auditing in small UK firms are managers’ perception “that audit improves the quality of information and/or provides a check on internal records” and the educational level of the principal director, and at these two factors are more important than firm size and agency relationships with lenders. Niemi et al. (2012), from a sample of Finnish private companies, identify a positive relationship between voluntary audits and use of an external accountant for financial accounting services, but a negative relationship between audits and use of tax advisory services from an external accountant. Taken together, audits seem to have a wider function in private companies than just working as a monitoring device for controls of agency conflicts.
UNRESOLVED ISSUES AND FUTURE RESEARCHOur knowledge about auditing of private firms is sparse compared to that of public firms. This gives ample opportunities for research that advance theory and insight about the role of auditing in general and among private firms in particular.
The role played by auditing in private firms is not clearly understood, which is probably caused by the heterogeneity of private firms (addressed above and further discussed below) and the difficulties of measuring the costs (of which the audit fee may be of minor importance) and the benefits of auditing.
Here, more research is needed. We need to address the issues with theories and tests that embrace the particularities of private companies in institutional settings and environment that differ from country to country.10 Thus, what does an audit really mean for private firms and why do private firms demand (high quality) auditors?
The available empirical evidence is dominated by researchers that more or less have asked the same questions as those that have been addressed for public companies, adjusted for particularities of the private firm setting. While this is valid and important due to the differences that exist between public and private firms (as outlined above), the strategy does not take full advantage of the unique opportunities provided by the private firm segment. Francis (2011) presents a general framework where six factors are seen as the drivers of audit quality: audit input; audit processes; accounting firms; audit industry and audit markets; institutions; and economic consequences of audit outcomes.
Each of these factors is suited for analyses, and numerous examples of unanswered questions for researchers to investigate are given in text. Numerous questions are also found in Knechel et al.
(2012) and Causholli et al. (2010). We believe these surveys will spur a researcher’s imagination and ingenuity when they are read with the following suggestions in mind: (i) Explain carefully why results for public firms may or may not generalize to private firms, i.e. why should we (not) expect something different? (ii) Develop ideas, theories, hypotheses and research designs that take advantages of the differences that exist between private and public firms, i.e. what can we learn from studying private firms that cannot be learned from analyzing public firms? (iii) Collect data from different sources using different techniques and utilize the greater variation in the data to conduct more robust tests than is possible using public firm data only.
As shown above, a number of studies have tested if (higher quality) auditing lowers cost of debt and improves credit ratings for private firms. Two of these studies, Minnis (2011) and Pittman and Lennox (2011), are noticeable examples of excellent private firm research. The reason is not how they document benefits of auditing in terms of lower interest expenses or better credit ratings, but because they add new insight about the role of auditing in general. Minnis (2011) identifies a mechanism that makes audited financial statements more useful: The accrual component of earnings, which is the soft part of earnings subject to possible earnings management, becomes a better predictor of future cash flow. Pittman and Lennox (2011) are able to isolate the signaling effect of voluntary purchase of audit from the assurance effect. Therefore, they are able to document that mandatory auditing suppresses a company’s ability to send signals beyond what is possible when auditing is voluntary, and that “it is difficult to force companies to privately contract for stringent audits if they would choose not to be audited voluntarily” (Lennox and Pittman 2011). We welcome more of these types of studies.
In auditing research, it is common to measure e.g. industry specialism by the proportion of clients’ sales or assets within a particular industry and economic bonding by a particular client’s fees relative to the total fees from all clients. When such measures are computed using data from public firms the measures do not capture that audit firms also serves private companies. The resulting measurement errors may threaten the validity of the results as the measures computed using public data only may be systematically biased. There are numerous private firms that on average are as large as listed firms, and private firms outnumber public firms. Thus, we do not know how good a proxy the measures of e.g. industry expertise or economic dependence are, and if systematic measurement errors can explain some of the mixed results that exist.11 For those analyzing private firms, it may be important to account for the effects that can occur because some auditors of private firms also audit public firms (which is an easier task that analyzing public firms and control for auditors’ private firm activities due to public data being much easier available than private firm data).
One caveat with many studies of private firms is their tendency to treat private firm as one homogeneous group.12 Lack of data that enable controls for firm heterogeneity beyond those captured by accounting numbers, industry affiliation, and auditor type is the likely cause of treating all private firms as equal. We accept that research implies making assumptions and simplifications.