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However, the correlated omitted variable problem deserves more attention in private firm research than in public firm research because the impact is likely to be more severe.13 An example is that the importance of heterogeneity in ownership and governance structures are often neglected, which raises the possibility that effects ascribed to test variables might disappear when adequate controls are included.
A substantial subset of private firms is controlled by families.14 Family firms may have fewer internal agency problems than others because kinship and marriage align goals and incentives between managers and owners, but there are other differences. In their review article, Stewart and Hitt (2012) sort the differences between family and non-family firms into eight categories: ownership, governance, returns, rewards, networks, leadership, careers and management. For instance, family firms might differ from non-family firms “in their capacity to develop and leverage intangible assets such as social capital, trust, reputation, and tacit knowledge”, and “[e]conomic and financial performance may be compromised in preference for creating and preserving types of socioemotional wealth (SMW) such as perpetuating family name, values, control, and employment, or supporting a desirable lifestyle” (Sharma and Carney 2012: 233). For such reasons, significant differences exist between family and non-family firms, and the family effect correlates with variables typically included in the tests such as size, growth and profitability, even though the results are mixed (Steward and Hitt 2012). More importantly, family variables are likely to correlate with the test variables used in audit research. For instance, the choice of a Big N auditor might correlate with family control because of less need to hire a Big N auditor due to fewer internal agency conflicts in family firms; the interest expenses might be lower in family firms because families obtain better terms due to long-lasting relationship with the bank or higher willingness to use private wealth as collateral; and family firms might exhibit higher earnings quality because family owners fear that questionable accounting choices will damage the good name of the family if revealed to the public.
Thus, there are reasons to expect systematic correlations between family variables usually not included in the tests and the variables that are of primary interest.15 The best solution to the omitted variable problem is to incorporate the relevant variables into the test or to use tests and methods that make the relevant variables redundant.16 If omitted variable problems cannot be avoided, the researchers should acknowledge the limitation and provide a caveat that makes the reader aware of this limitation and also discuss how omitted variables may impact the results.17 Access to data on private firm is an obstacle in many countries – the data is simply not available or not as easily available as the data for public firms. This calls for wider search for available data sources. For instance do banks, credit agencies, tax authorities and other governmental agencies and international organization collect data which should be utilized by researchers? Another option is to collect data through surveys (see Allee and Yohn 2009 for a good example) or field research.
Cooperation with audit firms and regulatory bodies may also give access to data. It may be easier to guarantee anonymity of audit firms and/or clients in the private firm segment compared to the public firm segment because there are many more audit firms and clients to choose from. We encourage greater ingenuity in how to obtain data.
SUMMARYIn this paper, we highlight the differences between audits of private and public firms and review and synthesize the relatively sparse empirical evidence on audits of private firms. Compared to audits of public firms, little is known about private companies in general and their auditing choices and the pros and cons of auditing of private firms in particular.
The traditional definition of audit quality is the ability to both discover and report on material misstatements. Existing evidence indicates that auditors take the potential negative effects of agency conflicts in an auditee’s ownership and governance structure into account when they plan and execute the audit program, to ensure that financial statements are free for material misstatements.
To the extent that there is a systematic relationship between provision of non-audit services and audit quality, it seems to be positive, indicating that there is a spillover from provision of non-audit services to auditing. Audit quality seems to increase with client-specific knowledge and partner tenure, but decrease when auditors approach retirement age or when they become too busy (measured by number of assignments). The detrimental effect of being busy at the partner level may not be observable at audit firm level. However, the results indicate that audit quality is more heterogeneous among the smallest audit firms and that audit firms apply different strategies to gain market shares (including meeting the demand for low quality audits in statutory audit regimes).
Contrary to the results for public firms, the apprehension that large audit firms deliver audits of higher quality than small audit firms does not receive unanimous support. Inadequate controls for auditee, audit partner/office/firm and country specific factors and different measures of audit quality may explain part of the mixed results. In short, our interpretation is that most studies indicate that Big N firms are more sophisticated, deliver audits of higher quality and charge higher fees than nonBig N firms, and that the Big N firms’ incentives to deliver audits of higher quality increase with the extent to which the auditee exposes the audit firm to risk.
The benefits of private company audits are multifaceted and vary considerably across companies.
While agency factors are important drivers of voluntary audits and the choice of high quality auditors, there are also other drivers. The evidence suggests that voluntary audit eases access to credits, reduces cost of capital and improves credit ratings and can also to some extent be of internal value to the auditee. Overall, evidence suggests that audits of private companies are valued by users of audited financial statements (among them the management of the auditee is an important user), but whether or not benefits exceed costs is firm-specific.
The private firm setting is different from the more homogeneous public firm segment. This makes it necessary to verify the generalizability of results from public firm studies. Even more importantly, the uniqueness of the private firm setting gives researchers opportunities to investigate questions that cannot be addressed using public firm data. Some of these questions may provide regulators with useful insights, for instance related to provision of non-audit services (no detrimental effect of non audit services has so far been found), the imposition of statutory auditing (which suppresses firms’ abilities to signal their type because they are denied the option of voluntarily engaging an auditor) and the costs and benefits of auditing (none of the studies document cost of debt savings that exceed the direct audit fees paid by the client, and the total costs of auditing is likely to be high).
Thus, by exploiting the particularities of the private firm segment, we believe researchers have great potential for advancing our understanding of the role of auditing.
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