Demand for Audit Quality in Private Firms: Evidence on Ownership Effects

Abstract

This study investigates whether managerial ownership related agency costs are associated with the demand for audit quality in a sample of small private firms. The literature on audit quality suggests that firms with high agency costs are more likely to demand audit quality. Our database enables us to compare the demand for audit quality with three different measures: demand for Big 4 auditors and two types of certified auditors with strict professional requirements. The results show that an increase in managerial ownership decreases the likelihood that the firm will engage a Big 4 auditor or a KHT certified auditor but it does not have an impact on the demand for lower level certified auditors. Our findings also support previous studies that suggest a nonlinear connection between managerial ownership and the demand for audit quality in terms of Big 4 audits. This suggests that higher quality audits by Big 4 audit firms are used to overcome agency costs induced by information asymmetries between shareholders and managers. An increase in leverage, on the other hand, increases the likelihood that the firm will engage a lower level certified auditor as opposed to a non-certified auditor. SUMMARYThe role of audit firm selection costs has been a much revisited topic in recent literature. It has been suggested in the literature that managers voluntarily increase the observability of their actions by hiring independent auditors to monitor their behavior.The purpose of this study is to investigate the association between managerial ownership and the demand for audit quality particularly in the context of private firms. These firms can be characterized as having severe information asymmetries between firm insiders and other stakeholders. Information asymmetry in particular is expected to increase the probability of agency conflicts between management and outside stakeholders, such as shareholders and creditors, as the possibility to utilize private information gives management incentives to act in self-interest instead of in the interests of other stakeholders.Our database enables us to investigate the choice between four different types of auditors: Big 4, KHT certified, HTM certified, and non-certified auditors. Finland has a two-tier system of auditor qualifications. The lower level qualified auditors are called HTM auditors (auditors and audit firms authorized by a local Chamber of Commerce) and higher level qualified auditors KHT auditors (auditors and audit firms authorized by the Central Chamber of Commerce). Also, during the sample period (2000)(2001)(2002)(2003)(2004)(2005)(2006) all Finnish firms were required to have a financial audit regardless of firm size.The main conclusion of this study is that managerial ownership has an important impact on the demand for audit quality in our sample of small private firms. We find evidence that the demand for audit quality increases as managerial ownership decreases. Specifically, we observe CEO's ownership to be inversely associated with the likelihood that private firms ...

The demand for auditor services in wholly family-owned private firms: the moderating role of generation

“…Concerning the control variables, we find, consistent with several other studies (Piot 2001, Broye and Weill 2008, Knechel et al 2008, Francis et al 2009, Niskanen et al 2011, that the variable SIZE has a strongly significant positive coefficient in our logit and ordered logit models, denoting that there is a higher demand for both auditor engagement and assurance within larger firms. SIZE also has a significant positive coefficient in the multinomial logistic regression results for reviews and audits but not for compilations.…”

“…LEVERAGE, defined as total debt to total assets, is included to test the second agency cost hypothesis, which is in accordance with several other studies as well (Francis and Wilson 1988, Reed et al 2000, Piot 2001, Hay and Davis 2004, Francis et al 2009, Niskanen et al 2010, 2011.…”

The influence of the CEO's value perception towards auditing on audit demand in private firms

“…As the quality of an audit is not directly observable, audit quality demand is generally measured by whether the firm appoints a higher reputation audit firm or not (Lennox, 2005;Niskanen et al, 2011) and/or by the amount of audit effort demanded (e.g. As the quality of an audit is not directly observable, audit quality demand is generally measured by whether the firm appoints a higher reputation audit firm or not (Lennox, 2005;Niskanen et al, 2011) and/or by the amount of audit effort demanded (e.g.…”

“…DeFond, 1992;Firth and Smith, 1992;Francis et al, 2009;Hope et al, 2012), these studies generally focus on listed companies. Recent studies (Carey and Guest, 2000;Niskanen et al, 2011;Dedman et al, 2014), however, show that external auditing is also highly valuable for private firms because agency conflicts may be omnipresent within those firms as well. Recent studies (Carey and Guest, 2000;Niskanen et al, 2011;Dedman et al, 2014), however, show that external auditing is also highly valuable for private firms because agency conflicts may be omnipresent within those firms as well.…”

“…Several studies also support this view by examining the demand for external auditing in private firms (e.g. Niskanen et al, 2011) were examined, dependent on whether the sample firms had a statutory audit requirement or not. Dedman et al, 2014) and the demand for audit quality (e.g.…”