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The Risk of Fraud in Family Firms: Assessments of External Auditors

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Abstract

There is a dearth of business ethics research on family firms, despite the importance of such firms to the US economy (Vazquez in J Bus Ethics, 2016. doi:10.1007/s10551-016-3171-1). We answer Vazquez’s (2016) call to examine the intersection of family-firm research and business ethics, by investigating whether external auditors assess higher risk of fraud in family firms. We test the contradictory predictions of two dominant theoretical perspectives in family-firm research—entrenchment theory and alignment theory. We conduct an experiment with highly experienced external audit professionals, who assess the risk of fraud and make client acceptance decisions for family firms versus non-family firms with different strength of corporate governance: strong versus weak audit committees (ACs). We find that auditors assess the risk of fraud as higher for family firms than for non-family firms, consistent with the predictions of entrenchment theory. Auditors are also less likely to make client acceptance recommendations for family firms. The strength of the AC moderates the family-firm effect, whereby auditors assess family firms with weak ACs to have the highest fraud risk and to be the least desirable audit clients. Our findings suggest that auditors perceive more severe agency conflicts to be present in family firms than in non-family firms, consistent with entrenchment theory, according to which family members may behave opportunistically to extract rents and potentially expropriate the firm’s resources at the expense of minority shareholders.

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Notes

  1. In such firms, the founding family not only owns a controlling interest, but is also usually involved in the board of directors and the executive management of the firm (Anderson and Reeb 2003). Seventy-five percent of the family firms in the S&P 500 have a family member in a top executive position (Bardhan, Lin, and Wu 2015). Srinidhi, He, and Firth (2014) report that family members participate in senior management in 82% of family firms in their study.

  2. The audit risk model (ARM) helps auditors assess audit risk (AICPA 1983; Cushing et al. 1995). It decomposes audit risk into three components: control risk and inherent risk (which together constitute the risk of material misstatement, or RMM), and detection risk. Given a certain RMM, indicated by the client’s control risk and inherent risk, the auditor sets detection risk to achieve the desired audit risk.

  3. Ghosh and Tang (2015) find that family firms pay lower audit fees than non-family firms, and interpret this as evidence of higher financial reporting quality of family firms. In contrast, Srinidhi et al. (2014) find that strongly governed family firms pay the same audit fees as non-family firms, while weakly governed family firms pay lower audit fees than non-family firms. Further discussion is provided in section “Auditors’ Ex Ante Assessments of the Risk of Fraud in Family Firms”.

  4. Ghosh and Tang (2015) and Srinidhi et al. (2014) examine 2003–2010, the period before regulators proposed this new standard in 2012.

  5. The Big 4 accounting firms are Deloitte, EY, KPMG, and PwC.

  6. Anderson et al.’s (2015) results relate to founder-led firms and not descendant-led firms, suggesting that founders may engage in financial misconduct due to hubris or empire-building ambitions. However, research also finds that family firms in general—founder-led and descendant-led—are more likely to engage in related party transactions than non-family firms (e.g., Kohlbeck et al. 2017).

  7. None of these studies discusses the SEW perspective (Gómez-Mejía et al. 2007).

  8. Archival research also does not distinguish the initial year in which the auditor accepts the firm as an audit client from subsequent years, when the audit fee can be adjusted for various reasons. For example, Ghosh and Tang (2015) examine 9191 firm-year observations from 1782 unique firms (i.e., a firm appears, on average, five times in their sample) and allow firms to drop in and out of their sample through the years. In contrast, we examine the initial client acceptance decision for new audit clients.

  9. Some participants noted in the instruments that they do not disclose their gender, as per their firms’ policy.

  10. Due to the high amounts of investor capital held by publicly traded family firms and their importance to the US and global economy, the family firm in our experimental case is a publicly traded firm. This also increases the internal validity of our experiment, since we compare auditors’ views of two public companies and avoid potential confounds associated with additional features of privately held firms.

  11. The narrative stated that the board of directors “include the CEO and two close relatives, who are also officers of the company.” Although we did not include the specific family relationships of the officers, auditors would normally document in detail the relationships of family members. This is consistent with auditing standards documentation requirements, according to which “the auditor should include in the audit documentation the names of the identified related parties and the nature of the related party relationships” (AICPA AU-C Section 550).

  12. Similar to Agoglia et al. (2011), we describe the “weak” AC as still meeting (instead of failing) the minimal SEC requirements: In the weak AC condition, all AC members still meet the SEC threshold for independence, and the weak AC meets the SEC recommendation to have at least one member that qualifies as a financial expert. We make an experimental choice to have a weak AC that does not violate the minimum SEC conditions for public companies, in order to maintain strong external validity in the post-Sarbanes–Oxley environment.

  13. The following variables were also significantly different between the strong AC and the weak AC condition, in the expected direction: (1) Some members of the Corporation’s Audit Committee are former officers of the company (M = 3.27, SD = 2.70 vs. M = 10.10, SD = 1.52; t58 = 12.76, p < .001); (2) none of the Corporation’s Audit Committee members have disclosed any prior relationship with the company (M = 9.20, SD = 2.37 vs. M = 2.63, SD = 1.96; t58 = 11.71, p < .001); (3) the Corporation’s Audit Committee has some members who do not qualify as financial experts (M = 2.97, SD = 2.61 vs. M = 8.60, SD = 2.57; t58 = 8.43, p < .001); (4) the Corporation’s Audit Committee meets 2 times per year (M = 2.59, SD = 2.40 vs. M = 9.17, SD = 2.67; t58 = 9.96, p < .001); and (5) the Corporation’s Audit Committee meets 12 times per year (M = 9.20, SD = 2.93 vs. M = 1.70, SD = 2.29; t58 = 12.83, p < .001).

  14. Alignment theory’s predicted main effect for fraud risk is: cell A > cell B and cell C > cell D; the interaction suggests [cell C–cell D] > [cell A–cell B]; rearranging, we also obtain [cell C–cell A] > [cell D–cell B]. This suggests that cell C is the highest, cells D and A are lower, and cell B is the lowest.

  15. Alignment theory’s predicted main effect for client acceptance decisions is: cell B > cell A and cell D > cell C; the interaction suggests [cell D–cell C] > [cell B–cell A]; rearranging, we also obtain [cell D–cell B] > [cell C–cell A]. This suggests that cell C is the lowest, cells A and D are higher, and cell B is the highest.

  16. Our contrast weights best capture the pattern predicted by H1 and H2. For robustness, we also conduct tests with the orthogonal contrast weights of (−1, −1, −1, +3) for fraud risk and (1, 1, 1, −3) for client acceptance decisions, which yield similar results. The contrast for fraud risk is significant (F1,56 = 7.64, two-tailed p = 0.008), while the residual between-cells variance is not (F2,56 = 0.20, two-tailed p = 0.817). The contrast for client acceptance decisions is also significant (F1,56 = 4.55, two-tailed p = 0.037), while the residual between-cells variance is not (F2,56 = 0.62, two-tailed p = 0.546). Another choice of weights for fraud risk (−2, −1, 1, 2) and client acceptance (2, 1, −1, −2) yields similarly significant results.

  17. Eighty-three percent (85%) of participants indicate that, in the course of conducting audits, they normally assess control risk (inherent risk) on a word scale rather than a numeric or other scale.

  18. The Big 4 audit firms audit over 99% of firms on the S&P 500 list (Pakaluk 2017), and the largest ten audit firms audit over 60% of all publicly traded firms (Fritz 2016).

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Acknowledgements

We thank Sanaz Aghazadeh, Bryan Cloyd, Tamara Lambert, Andrew Trotman, Ken Trotman, participants at Villanova University and Lehigh University Singleton workshops, the 2014 ABO Conference, and the 2015 AAA Annual Meeting, for their valuable comments.

Funding

This study was entirely funded by the university research account of the first author.

Author information

Authors and Affiliations

  1. Department of Accountancy, Adamian Academic Center, Bentley University, 175 Forest Street, Waltham, MA, 02451, USA

    Gopal Krishnan

  2. Department of Accounting, College of Business, and Economics, Lehigh University, 621 Taylor Street, Bethlehem, PA, 18015, USA

    Marietta Peytcheva

Authors
  1. Gopal Krishnan
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  2. Marietta Peytcheva
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Corresponding author

Correspondence to Marietta Peytcheva.

Ethics declarations

Conflict of interest

The first author declares that he has no conflict of interest. The second author declares that she has no conflict of interest.

Ethical Approval

All procedures performed in studies involving human participants were in accordance with the ethical standards of the institutional and/or national research committee and with the 1964 Declaration of Helsinki and its later amendments or comparable ethical standards.

Ethical Approval

This article does not contain any studies with animals performed by any of the authors.

Informed Consent

Informed consent was obtained from all individual participants included in the study.

Appendix: Experimental Manipulations

Appendix: Experimental Manipulations

Family Firm Condition

The Corporation is a family-controlled public company. The Corporation’s CEO is a direct descendant of the founding CEO. The CEO’s family controls 60% of the voting shares of the Corporation. The Corporation’s shares are traded on the NYSE, and it is an accelerated filer.

[ … ]

The Corporation has an eight-member board of directors, which meets quarterly to declare dividends, set executive compensation, and deliberate on major issues facing the Corporation. Three members (J. Ranch, H. Ranch, and G. Ranch) include the CEO and two close relatives, who are also officers of the company. The remaining five members (J. Smith, F. Jones, W. Johnson, S. Sanders, and B. Murcer) qualify as independent directors.

[ … ]

Information about the Corporation’s management is provided in the following table

Name

Title

Salary ($)

J. Rancha

Chairman, CEO

550,000

H. Rancha

Executive VP

450,000

G. Rancha

CFO

400,000

H. Clarke

VP, Marketing

350,000

S. Bahnsen

VP, Operations

350,000

B. Resnick

VP, Purchasing

350,000

  1. aAlso serves on board of directors

Non-family Firm Condition

The Corporation is a publicly traded company. There are no dominant controlling interests in the Corporation’s ownership structure. The Corporation’s shares are traded on the NYSE, and it is an accelerated filer.

[ … ]

The Corporation has an eight-member board of directors, which meets quarterly to declare dividends, set executive compensation, and deliberate on major issues facing the Corporation. Three members (J. Ranch, H. Asbury, and G. Rotz) include the CEO and two officers of the company. The remaining five members (J. Smith, F. Jones, W. Johnson, S. Sanders, and B. Murcer) qualify as independent directors.

[ … ]

Information about the Corporation’s management is provided in the following table

Name

Title

Salary ($)

J. Rancha

Chairman, CEO

550,000

H. Asburya

Executive VP

450,000

G. Rotza

CFO

400,000

H. Clarke

VP, Marketing

350,000

S. Bahnsen

VP, Operations

350,000

B. Resnick

VP, Purchasing

350,000

  1. aAlso serves on board of directors

Strong AC Condition

All three members of the Corporation’s Audit Committee qualify as independent directors. None of these members has any disclosed prior relationship with the company. All Audit Committee members qualify as financial experts as defined by the SEC. The Audit Committee meets 12 times per year.

Weak AC Condition

All three members of the Corporation’s Audit Committee qualify as independent directors. One of these members has no disclosed prior relationship with the company. However, the other two members are former officers of the company. One of the three members of the Audit Committee qualifies as a financial expert as defined by the SEC. The Audit Committee meets 2 times per year.

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Krishnan, G., Peytcheva, M. The Risk of Fraud in Family Firms: Assessments of External Auditors. J Bus Ethics 157, 261–278 (2019). https://doi.org/10.1007/s10551-017-3687-z

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