We are interested in understanding how agency conflicts in private firms arise through ownership structures and family relationships. Specifically, we analyze auditors’ increase of effort and firms’ choice of auditors in situations with higher level of agency conflicts. For a large sample of private firms, we use unique and confidential data (obtained through special permission by the government) to measure direct and ultimate ownership for each shareholder as well as extended family relationships (based on marriage and blood lines, going back four generations and extending out to fourth cousin) among all shareholders, board members, and CEOs. We first find that audit fees, our proxy for audit effort, vary as hypothesized with firm-level characteristics related to ownership structures and family relationships. Second, we find evidence that firms in higher agency cost settings respond by having their financial statements audited by a higher-quality auditor (i.e., a Big 4 firm). However, for CEO family-related settings (i.e., where the CEO is related to the major shareholder or as the number of board members related to the CEO increases), we find no evidence of a greater demand for a Big 4 auditor.
In this study, we seek to understand how ownership structures and family relationships influence agency costs in private firms. We do this by observing two aspects related to auditing. First, in higher agency cost settings, auditors are more likely to supply greater effort to prevent misstatement associated with moral hazard and adverse selection problems. We examine how auditors adjust their level of effort when auditing financial accounting information. Second, a subset of firms in higher agency cost settings likely have a greater demand to choose a higher-quality auditor to provide a credible signal of their commitment to higher-quality reporting. To test this, we examine the extent to which firms with various characteristics hire a Big 4 auditor.
Our examinations draw on very detailed data on ultimate ownership and extended family relationships provided by the Norwegian government. We find that audit fees (i.e., our proxy for auditor effort) increase with expected agency costs.1 Audit fees relate negatively to ownership concentration and to the extent of ownership by the second-largest shareholder. Concentrated ownership increases the likelihood that a large shareholder closely monitors managerial actions, and an influential second shareholder monitors potential expropriation by the largest shareholder. Audit fees also relate negatively to the portion of shares held by the CEO, consistent with ownership aligning the incentives of the CEO and other stakeholders. Audit fees are positively associated with family relationships between the CEO and the major shareholder (consistent with these family relationships indicating reduced monitoring).
With respect to board independence, we find that audit fees decline as the number of board members related to the largest shareholder increases, consistent with fewer agency conflicts between owners and the board. In contrast, as the number of board members related to the CEO increases, audit fees increase, suggesting less board independence and more agency conflicts.
For our tests of demand for Big 4 auditor, we report two interesting sets of results. First, for agency settings that are not CEO family-related, we observe results consistent with those obtained for our auditor effort tests. Specifically, the propensity to hire a Big 4 auditor increases as ownership concentration decreases, ownership of the second largest owner decreases, and the major shareholder’s family influence on the board decreases. These results are consistent with the demand for a Big 4 auditor being greater in higher agency cost settings. In these settings, a higher-quality auditor plays a stronger role in reducing agency costs by sending a more credible signal of managers’ commitment to higher-quality reporting. We do not find significant evidence of a relation between hiring a Big 4 auditor and the fraction of shares owned by the CEO for our main tests, but we do in sensitivity tests.
We find no association between the choice to hire a Big 4 auditor and CEO family-related agency variables. Specifically, we find no significant evidence that the demand for a Big 4 auditor is affected when a family relationship exists between the CEO and the major shareholder or as the number of board members related to the CEO increases. One explanation for the lack of significance could be that while some CEOs in family-related agency settings may wish to signal more credible reporting by hiring a Big 4 auditor, other CEOs in these settings may feel a Big 4 auditor is either unnecessary given close family ties or unwanted because of the gains from extracting private benefits which could be reduced by a Big 4 audit.2
Our research is motivated by the need to understand agency conflicts facing private firms. Private firms make up a significant portion of the economic activity in Norway and nearly all other countries, yet prior research focuses primarily on public firms. Given the sometimes vast differences between public and private firms (e.g., Ball and Shivakumar, 2005, Beatty et al., 2002 and Chaney et al., 2004), it is not apparent without testing that results for public firms will generalize to private firms. Thus, private firms offer an economically important sample worth testing. While the benefits to understanding agency conflicts accrue directly to the firm’s investors, they will also be important to many other stakeholders (e.g., creditors, employees, suppliers, and customers), regulatory bodies supervising auditors and firms’ financial reporting, and society in general.
A sample of private (as opposed to public) firms may also offer a stronger test of agency conflicts related to ownership structure and family relationships. As we discuss in more detail in Hypotheses, prior research sometimes provides conflicting evidence or conflicting predictions for the impact of ownership structures and family relationships on agency conflicts. Our study provides a potentially strong setting for testing agency conflicts because private firms exhibit heterogeneous ownership characteristics and family relationships. Public firms are more homogeneous, including wide-spread ownership, relatively low CEO ownership, and fewer family ties between managers and shareholders and between managers and board members. Private firms offer interesting ownership structures that potentially increase our understanding of the relation between agency conflicts and the supply of auditor effort. For example, private firms show considerable variation in ownership percentages by second largest shareholders. This allows us to provide a meaningful test of the impact of agency conflicts among shareholders (i.e., monitoring of largest shareholders by second largest shareholders). Private firms also show greater variation in their choice of auditor (only 18.1% choose a Big 4 auditor). Nearly all public firms opt for a Big 4 auditor, limiting the ability to empirically test signaling through demand for a high-quality auditor.
Related to tests of the supply of auditor effort, a single-country setting (Norway) controls for cross-country variation in audit practices and fees and the strength of legal institutions. Cross-country differences could easily confound inferences. Norway also offers an environment where the impact of litigation on audit fees is relatively limited (Hope & Langli, 2010). This increases our ability to make more reliable inferences from using audit fees to measure auditor effort, and adds to calls for research to better understand the role of firm governance in explaining audit fees (Hay, Knechel, & Wong, 2006).
Finally, given the unique data we use in this study, we are able to measure attributes of ownership structure and family relationships that have been difficult to measure in the past. Specifically, for all private limited liability firms we have detailed information available to compute both direct and ultimate ownership for each owner, board member, and CEO.3 In addition, we have detailed data on family relationships among all owners, board members, board chairs, and CEOs (based on both marriage and blood lines, going back four generations and extending out to fourth cousin). To our knowledge, no prior study has been able to test the effects of family relationship using such detailed data. These data, based on merging databases using social security numbers, are obtained through special permission from the Norwegian government. Having these data allows us to simultaneously test multiple sources of agency conflicts in a single test. In contrast, prior studies, because of data limitations, have been able to focus only on a particular test variable (and thus leave out potentially important ownership and family details). The full model better controls for multiple agency settings. We show that the ability to simultaneously test the association of these variables on auditor effort and firms’ selection of the auditor can affect conclusions in some cases.
We next briefly discuss the importance of accounting and auditing, the role of auditing in private firms, and the importance of auditing in the private firm market. Hypotheses provides hypotheses of the expected impact that agency conflicts have on the supply of auditor effort and the demand for a Big 4 auditor. Research design introduces our research design. Data on ownership and family relationships provides details on the data underlying our study. We present empirical results in Sample and results, and Concluding remarks concludes.
This study provides empirical evidence of agency conflicts associated with ownership characteristics and family relationships for private firms in the Norwegian market. Using a detailed data set obtained by special permission from the government, we are able to measure ultimate ownership concentration, ultimate ownership of the second largest shareholder and of the CEO, and family relationships among owners, board members, and CEOs for all Norwegian private limited liability firms. These data allow us to simultaneously test multiple sources of agency conflicts.
We first test for the extent of agency conflicts using audit fees. Controlling for a large number of client-firm and audit-firm characteristics, we predict and find that ownership characteristics and family relationships explain audit fees. Specifically, we find that audit fees decrease (i.e., audit effort decreases) as ownership concentration increases and as the proportion of shares held by the second largest shareholder increases. The first result is consistent with greater ownership concentration alleviating agency costs between shareholders and the managers (i.e., vertical agency costs). Larger shareholders can more efficiently monitor managers. The second result is consistent with reduced agency costs between controlling shareholders and minority shareholders (i.e., horizontal agency costs). A second large shareholder serves as a monitor of a controlling shareholder who potentially has the ability to extract private benefits from minority shareholders.
Related to the CEO, we find that as CEO ownership increases, audit fees decrease. This is consistent with increased ownership aligning the incentives of the CEO with those of the firms’ other stakeholders. In contrast, holding CEO ownership constant, we find that when the CEO is a member of the largest owning family, audit fees increase (i.e., auditor effort increases). This finding suggests that shareholders are less likely to act as independent monitors of the CEO when a family relationship exists, increasing the probability of misappropriation by the CEO or extraction of private benefits by controlling owners.
For board independence, we find that audit fees decrease as the proportion of board members from the largest owning family increases. This finding reflects the likelihood that those inside the firm (board members) are more likely to act as effective monitors on behalf of those outside the firm (controlling owners) when a family relation exists. We also find that boards seem to lose their independence as the proportion of board members from the CEO’s family increases. This result follows from the natural expectation that family relationships with the CEO impair the oversight responsibility of the board.
As our second test, we consider each of our agency settings and the firm’s demand for a Big 4 auditor. Consistent with results found for the auditor effort tests, the demand for a Big 4 auditor decreases with ownership concentration, level of ownership by the second largest owner, and family relationships between the board and the largest owner. We find no relation between demand for a Big 4 auditor and CEO ownership for our main tests but we do in sensitivity tests. Finally, for our two CEO family-related agency cost settings, we observe no impact on the demand for a Big 4 auditor when the CEO is related to the major shareholder or as the number of board members related to the CEO increases. These insignificant relations likely reflect a 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.
Our research makes a contribution by providing a detailed investigation of the agency settings for private firms. Several differences exist between private and public firms, and results for one group are not necessarily expected to be the same as those for the other. In addition, in aggregate private firms provide the majority of economic activity throughout the world. We obtain a unique database for private firms in Norway to provide tests of the impact of ownership characteristics and family relationships on agency conflicts. This database entails combining ownership characteristics and family relationships using social security numbers, available only through special permission from the government.
There is ample opportunity for future research to further explore the issues we examine in this study. Perhaps the most obvious suggestion would be to test for economic consequences of variations in the agency conflicts and/or audit variables that we consider. Another possibility is to make further use of the register data available through linking databases using social security numbers. For example, auditor independence issues could be examined by considering auditors’ personal income and wealth. Other research could make use of interesting aspects of alternative institutional environments, or use research methods other than archival data to explore agency conflicts in private firms.