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Publications of the University of Eastern Finland Dissertations in Social Sciences and Business Studies No 29

Publications of the University of Eastern Finland Dissertations in Social Sciences and Business Studies

ISBN 978-952-61-0551-2 ISSN 1798-5749

Jukka Karjalainen

Audit Quality and

Private Finnish Firms

Using the research setting of private Finnish firms, the purpose of this dissertation is to enhance our understanding of the relevance of audit quality in private firms. The dissertation provides evidence of the demand for differential audit quality by lenders and different types of private firm owners, as well as evidence of audit partner industry specialization as a source for audit quality differentiation in the audit market of private firms.

d is se rt at io n s

| No 29 | Jukka karjalainen | Audit Quality and Private Finnish Firms

Jukka Karjalainen

Audit Quality and

Private Finnish Firms

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Audit Quality and

Private Finnish Firms

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Dissertations in Social Sciences and Business Studies No 29

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JUKKA KARJALAINEN

Audit Quality and Private Finnish Firms

Publications of the University of Eastern Finland Dissertations in Social Sciences and Business Studies

No 29 Itä-Suomen yliopisto

Yhteiskuntatieteiden ja kauppatieteiden tiedekunta Kuopio

2011

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Kopijyvä Oy Joensuu, 2011

Sarjan toimittaja: Eija Fabritius Myynti: Itä-Suomen yliopiston kirjasto

ISBN (nid): 978-952-61-0551-2 ISSN (nid): 1798-5749

ISSN-L: 1798-5749 ISBN (PDF): 978-952-61-0552-9

ISSN (PDF): 1798-5757

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Karjalainen, Jukka

Audit Quality and Private Finnish Firms, 113 s.

University of Eastern Finland

Faculty of Social Sciences and Business Studies, 2011 Publications of the University of Eastern Finland,

Dissertations in Social Sciences and Business Studies, no 29 ISBN (nid): 978-952-61-0551-2

ISSN (nid): 1798-5749 ISSN-L: 1798-5749

ISBN (PDF): 978-952-61-0552-9 ISSN (PDF): 1798-5757

Dissertation

ABSTRACT

Despite the economic importance of private firms, most of the auditing literature fo- cuses on public firms, primarily in the common law environments. The literature on audit quality is largely limited to an environment where the demand for accounting quality is high and auditors have strong incentives to maintain their independence.

Therefore, the existing evidence on audit quality may not be directly applicable in environments where the demand for accounting quality is lower and auditors face lower litigation and reputation risks.

Using the research setting of private Finnish firms, the purpose of this disserta- tion is to address this limitation and enhance our understanding of the relevance of audit quality in private firms through four related articles. The dissertation provides evidence of the demand for audit quality by lenders and different types of private firm owners, as well as evidence of audit partner industry specialization as a source for audit quality differentiation in the audit market of private firms.

For private firms, practical implications emerging from the results relate to choice of a credible auditor for fulfilling monitoring needs of various stakeholders and re- sulting benefits in terms of lower cost of capital. In addition, the results provide in- sight into the current regulatory debate on the requirement to disclose audit partner identity. The results suggest that in the presence of lower litigation and reputation risks this requirement can provide auditors an additional incentive to contribute to audit quality.

Keywords: audit quality, private firms

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Karjalainen, Jukka

Tilintarkastuksen laatu ja yksityiset suomalaiset yritykset, 113 s.

Itä-Suomen yliopisto

Yhteiskuntatieteiden ja kauppatieteiden tiedekunta, 2011 Publications of the University of Eastern Finland,

Dissertations in Social Sciences and Business Studies, no 29 ISBN (nid): 978-952-61-0551-2

ISSN (nid): 1798-5749 ISSN-L: 1798-5749

ISBN (PDF): 978-952-61-0552-9 ISSN (PDF): 1798-5757

Väitöskirja

ABSTRAKTI

Yksityisten yritysten taloudellisesta merkityksestä huolimatta tilintarkastuksen tutkimuskirjallisuus keskittyy listattuihin yrityksiin, pääasiassa tapaoikeudellisiin juridisiin järjestelmiin perustuvissa ympäristöissä. Tutkimuskirjallisuus on siten pääasiassa rajoittunut ympäristöön, jossa tilinpäätösinformaation laadun kysyntä on korkea ja tilintarkastajilla on vahvat kannustimet säilyttää riippumattomuutensa.

Siksi olemassa oleva tutkimustieto tilintarkastuksen laadusta ei ole välttämättä so- vellettavissa ympäristöihin, joissa tilinpäätösinformaation laadun kysyntä on alhai- sempi ja tilintarkastajat kohtaavat pienemmät oikeudenkäyntiin ja uskottavuuden menettämiseen liittyvät riskit.

Hyödyntäen suomalaisten yksityisten yritysten tutkimusympäristöä tämän väitöskirjan tavoitteena on neljän toisiinsa liittyvän osatutkimuksen kautta pyrkiä täyttämään edellä kuvattua tutkimusaukkoa ja tuottamaan uutta tietoa tilintarkas- tuksen laadun merkityksestä yksityisissä yrityksissä. Väitöstutkimuksen tulokset viittaavat siihen, että tilintarkastuspalvelun laadulle on kysyntää yksityisten yri- tysten luotonantajien ja eri omistajaryhmien taholta. Lisäksi väitöstutkimus viittaa siihen, että yksittäisen tilintarkastajan toimialaerikoistumiseen perustuva toimialan erityisosaaminen selittää eroja tilintarkastuspalvelun laadussa yksityisten yritysten tilintarkastusmarkkinoilla.

Väitöstutkimuksen tulosten pohjalta nousevat käytännön implikaatiot yksityisil- le yrityksille liittyvät uskottavan tilintarkastajan valintaan eri sidosryhmien valvon- tatarpeiden täyttämiseksi ja tätä kautta alentuneiden rahoituskustannusten muodos- sa koituviin taloudellisiin hyötyihin. Lisäksi väitöstutkimus tuo uutta näkemystä vallitsevaan sääntelykeskusteluun, joka liittyy vaatimukseen tilintarkastajan iden- titeetin julkistamisesta. Väitöstutkimus viittaa siihen, että tilintarkastajan kohtaa- mien oikeudenkäyntiin ja uskottavuuden menettämiseen liittyvien riskien ollessa pienemmät tämä vaatimus voisi toimia tilintarkastuspalvelun laatuun myötävaikut- tavana kannustimena.

Asiasanat: tilintarkastuksen laatu, yksityiset yritykset

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Acknowledgements

This dissertation was written at the University of Eastern Finland under the supervi- sion of Professor Jyrki Niskanen and Professor Mervi Niskanen. To them I owe my gratitude for their valuable help and advice. I am also grateful to the official disserta- tion pre-examiners, Professor Lasse Niemi and Professor Teija Laitinen.

I also want to thank Professor Juha-Pekka Kallunki, Professor Petri Sahlström, Professor Timo Salmi, Professor Markku Vieru, and Dr. Mikko Zerni for their com- ments and suggestions during the dissertation project. I appreciate the comments received from Professor Ann Gaeremynck (discussant), Professor Donald Stokes (dis- cussant), Professor Jan Mouritsen, and Professor Wim A Van der Stede. I would also like to thank the participants at the European Accounting Association (EAA) 26th Doctoral Colloquium in Accounting in Istanbul Turkey (2010) for their comments. I gratefully acknowledge the financial support for this doctoral research provided by the Graduate School of Accounting (GSA), the Foundation for Economic Education, the Finnish Cultural Foundation, the Nordea Bank Foundation, and the Research Foundation of the OP Group.

Warm thanks go to my parents and brother Jussi who have supported me. Finally, the deepest and most sincere thanks go to Anne for always encouraging me and hav- ing patience during my dissertation project.

Kuopio, October 2011 Jukka Karjalainen

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Sisällys

ACKNOWLEDGEMENTS ...7

1 INTRODUCTION ...11

1.1 Background and research environment ... 11

1.2 Purpose of the dissertation ...13

1.3 Theoretical foundation ...14

1.3.1 Demand for differential audit quality ...14

1.3.2 Audit quality differentiation ...16

1.4 Contribution of the dissertation ...18

2 SUMMARY OF THE ARTICLES ...21

2.1 Article 1: Demand for audit quality in private firms: Evidence on ownership effects ...21

2.2 Article 2: The role of auditing in small, private family firms: Is it about quality and credibility? ...21

2.3 Article 3: Audit quality and the cost of debt capital for private firms: Evidence from Finland ...22

2.4 Article 4: Audit partner industry specialization and earnings quality of privately held firms ...22

REFERENCES ...24

ARTICLES ... 28

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1 Introduction

1.1 BACKGROUND AND RESEARCH ENVIRONMENT

Financial audits serve the fundamental economic purpose of reinforcing trust and confidence of different constituencies in firms’ financial statements. Privately held firms constitute the majority of the European Union’s (EU) economy and of the EU audit services market (Van Tendeloo & Vanstraelen, 2008). Despite the economic im- portance of private firms, most of the extant research literature on auditing focuses on publicly traded firms primarily in the common law environments. Less is known about auditing of private firms in non-common law context. Therefore, research on the role of audits in mitigating information asymmetries between private firms and their various outside stakeholders (e.g., investors, suppliers, employees, and the gov- ernment) appears warranted.

A principal-agent relationship (or an agency relationship), as described by agency theory, is useful in understanding the role of an audit as a monitoring mechanism. A principal-agent relationship arises as a contract, under which one party––the princi- pal––engages another party––the agent––to perform a service on its behalf (Jensen &

Meckling, 1976). In this agency relationship, the agent has an information advantage over the principal (information asymmetry), and a tendency to act in self-interest (moral hazard). This implies that the principal lacks trust in the agent. The principal needs to establish some interest alignment and/or monitoring mechanisms to ensure that the agent acts in the principal’s best interest. In the corporate context, a share- holder-manager agency relationship arises as a result of separation of ownership and control. Another agency relationship can emerge between controlling shareholders (agent) and minority shareholders (principal) as a result of ownership concentra- tion. Yet another agency relationship arises between the shareholder (agent) and the debtholder (principal) when a firm uses debt capital. In these agency relationships, a cost-effective solution for resolving information asymmetries and conflicts of interest is typically provided by audited financial statements. Independent audits provide principals reasonable assurance that manager-prepared financial statements are free from material misstatements, and enhance contracting efficiency by minimizing con- tracting and agency costs (Jensen & Meckling, 1976; Watts & Zimmerman, 1986).

The nature of the assurance produced by audits is characterized by epistemologi- cal obscurity (Power, 1997, p. 28). That is, the level of assurance, or audit quality, is empirically unspecified and cannot be objectively assessed. In addition to an audited financial statement, the only observable outcome of an audit is an audit report. Given that audit reports follow a generic template and most reports are standard clean opin- ions, the reported auditor’s opinion does not provide much information about audit quality (Francis, 2004). Audit quality obscurity implies that audit quality in fact (i.e., actual audit quality) can be quite different from audit quality in appearance (i.e., per- ceived audit quality). The users of audited financial statements must therefore assess

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audit quality based on indirect indicators, such as the reputation and other character- istics of an auditor. In order for users to place value on the monitoring role of an audit, they need to be convinced that there is a nonzero joint probability that an auditor will both discover and report breaches in the client’s accounting system (DeAngelo, 1981).

The probability of discovering a breach depends on the auditor’s competence and the quantity of audit inputs, whereas the probability of reporting the breach depends on the auditor’s independence from the client (Watts & Zimmerman, 1986).

The auditing literature identifies the auditor’s expected reputation and litigation costs as important constraints for auditor independence impairment (DeAngelo, 1981;

Simunic, 1984; Chung & Kallapur, 2003). In particular, the incentives for auditors to compromise their independence are expected to decrease when expected costs of the independence impairment increase in relation to benefits––auditors consider not only the benefits of higher expected fees when compromising their objectivity (i.e., refuse to enforce generally accepted accounting principles or to issue a qualified or modified audit opinion when appropriate) in order to maintain a client, but also the expected costs related to the detection of an audit failure (Hope & Langli, 2010). These costs include the loss of client fees as a result of the loss of reputation (i.e., reputation costs), as well as litigation costs as a result of a successful lawsuit against an auditor after an audit failure becomes known. Consistent with this view, cross-country evidence shows that firms’ ownership concentration is lower in countries with strong laws en- forcing auditor liability, which suggests that auditors are more effective in resolving agency problems between controlling shareholders and minority shareholders when they face a higher threat of legal liability (Guedhami & Pittman, 2006).

This dissertation utilizes the research setting of private Finnish firms. This setting is characterized by low litigation risk and low reputation risk for auditors, implying that the legal and reputational incentives for auditors to maintain independence and supply a high audit quality are relatively low. First, Finland belongs to a group of Scandinavian code law countries, with weaker investor protections and less ability to sue auditors for negligence and misconduct in comparison to common law countries such as the US and UK (Francis, 2004; Hope & Langli, 2010). In addition, the specific characteristics of the Finnish legal system imply that auditors’ expected litigation costs are relatively low (Knechel et al., 2008). Second, because the financial statements of private firms are not as widely distributed and as scrutinized by capital markets as those of public firms, the probability of discovering an audit failure and the risk of litigation is much lower in private firms (Van Tendeloo & Vanstraelen, 2008; Vander Bauwhede & Willekens, 2004). Finally, the consequences of audit failure detection in terms of litigation costs and loss of reputation are expected to be less important in the case of private client firms than in the case of public client firms (Chaney et al., 2004; Cano-Rodríguez, 2010).

Despite the low litigation and reputation risks, the Finnish setting is characterized by institutional features that can represent forces working in the opposite direction by increasing auditor’s incentive to maintain independence and supply a high audit quality. First, auditors in Finland are required to personally sign the audit report.

This requirement can reinforce the auditors’ sense of accountability to financial state- ment users (ACAP Report, October 6, 2008, at VII: 19). Second, the Finnish accounting environment is characterized by high tax alignment; that is, the audited financial

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13 statements are taken as a basis for taxation. Previous research suggests that financial statements are more scrutinized by tax authorities in high tax alignment countries compared to low tax alignment countries. Scrutiny by tax authorities increases the probability of audit failure detection, which implies that for protecting their reputa- tion auditors have stronger incentives to supply a high audit quality to their private clients in these countries (Van Tendeloo & Vanstraelen, 2008; Ditilleux & Willekens, 2009; Cano-Rodríguez, 2010). However, some studies do not provide support for audit quality differentiation in high tax alignment countries (Vander Bauwhede &

Willekens, 2004; Jeong & Rho, 2004).

As far as the demand for differential audit quality is concerned, arguments can be found for and against the demand for high-quality audit services by different stake- holders of private Finnish firms for resolving information asymmetries and agency conflicts. Previous studies suggest that the demand for high-quality accounting infor- mation is lower in code law than in common law environments. Specifically, financial reporting is found to be of lower quality in code law than in common law countries (Ball et al., 2000). This suggests that, compared to the common-law ‘shareholder’ model of corporate governance, under the code law ‘stakeholder’ model of corporate govern- ance information asymmetries are more effectively resolved by private communication with the major stakeholders rather than by public disclosure of high-quality financial information (Ball et al., 2000). In addition, private firms are observed to have lower- quality earnings than public firms, which suggests that the same idea can be extended to comparison of private and public firms, and that private firms are likely to substitute private communication for financial reporting to reduce information asymmetries (Ball

& Shivakumar, 2005). Private communication implies that audited financial informa- tion and audit quality is less important for stakeholders of private Finnish firms.

However, it is also argued that the monitoring value of auditing may be even higher in private firms than in public firms. Specifically, investors in private firms face greater information asymmetries because of private firms’ lack of stock market data and non-accounting information. These investors have greater demand for credible accounting information than investors in public firms (Lennox, 2005).

1.2 PURPOSE OF THE DISSERTATION

Using the research setting of private Finnish firms, this dissertation will examine the relevance of audit quality in private firms using four separate articles. The research questions addressed in the articles are:

(1) Does managerial ownership affect the demand for audit quality in private firms?

(2) Does family ownership and control affect the demand for audit quality in private firms?

(3) Does (perceived) audit quality and the audit outcomes––audit opinion and accruals quality––affect the cost of debt capital for private firms?

(4) Does audit partner industry specialization affect the earnings quality of private firms?

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The relevance of audit quality is examined from the demand and supply perspec- tives. The first, second, and third research questions address the relevance of audit quality from the demand-side perspective, while the fourth research question ad- dresses the issue from the supply-side point of view.

The rest of the dissertation is organized as follows: The next section presents the relevant theoretical background for the articles included in the dissertation. Section 1.4 outlines the contribution of the dissertation to the auditing literature and the prac- tical implications emerging from the results. Section 2 briefly reviews the individual articles. Finally, the original articles are presented at the end of the dissertation.

1.3 THEORETICAL FOUNDATION 1.3.1 Demand for differential audit quality

Agency theory predicts that the demand for high-quality audit services increases when needs for monitoring due to agency problems are higher (Watts & Zimmerman, 1983). Potential sources of agency problems and demand for audit quality include the separation of ownership and control, ownership concentration, and the use of debt financing.

Traditional agency theory suggests that firms that operate under a single own- er-manager can typically be considered as examples of zero shareholder-manager agency costs (Fama & Jensen, 1983; Jensen & Meckling, 1976; Ang et al., 2000). Finance literature identifies two agency problems between managers and outside sharehold- ers that result from the separation of ownership and control. A divergence of interest problem arises when managers own less than one hundred per cent of the equity, and therefore have weaker incentives to act in outside shareholders’ interest. This agency problem is expected to decrease with increases in managerial ownership (Jensen &

Meckling, 1976). However, an opposing managerial entrenchment problem arises at higher levels of managerial ownership. With higher ownership stakes and more con- trol over the firm, the manager has more ability to act in his or her own interest. These opposing effects may lead to nonlinearities in the relationship between managerial ownership and shareholder-manager agency costs. Consistent with this, Morck et al.

(1988) find a U-shaped association between managerial ownership and shareholder- manager agency costs for public US firms.

By ignoring the entrenchment effect, previous studies provide some support for the hypothesis that the divergence of interests effect results in an inverse relation between managerial ownership and demand for audit quality within public firms (Francis & Wilson, 1988; DeFond, 1992). By examining UK private firms and con- sidering both a divergence of interests effect and a managerial entrenchment effect, Lennox (2005) shows evidence suggesting that a divergence of interests effect within low and high levels of managerial ownership is related to demand for audit quality, whereas within intermediate levels of ownership the relationship is unobservable because of the offsetting entrenchment effect.

While ownership concentration can reduce agency problems between sharehold- ers and managers, it can give rise to agency problems between controlling sharehold- ers and minority shareholders. Previous studies suggest that family ownership differs

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15 from the ownership of other types of block holders, mainly because family governance is distinguished by the unification of ownership and control (Carney, 2005). However, when outside stakeholders are considered, opposing predictions on the influence of the family ownership on agency costs can be made. On the one hand, the family’s interest in the long-term survival and reputation of the firm (and the family) can lead to the development of informed long-term relationships with external stakeholders such as lenders, which implies that agency costs and the demand for audit quality are lower in family firms compared with nonfamily firms (Anderson et al., 2003; Chrisman et al., 2004). On the other hand, the general concern that management acts for the controlling family at the cost of other stakeholders (the entrenchment effect of family ownership) implies that agency cost––and demand for audit quality––can be even higher in fam- ily firms compared with nonfamily firms (Morck & Yeung, 2003; Steijvers et al., 2010).

One further line of research suggests that private family firms could be more vulnerable to agency problems than large, public family firms (Schulze et al., 2003;

Steijvers et al., 2010). Private family firms are more likely to employ family members, even if the members lack competence to sustain the wealth creation potential of the firm (familial altruism). The replacement of inefficient family members/managers is difficult. The family involvement can lead to decreasing economic performance, which in turn may have adverse consequences for the lenders and nonfamily share- holders (Steijvers et al., 2010). Previous related evidence from Australia implies that in the absence of a statutory audit requirement, demand for voluntary audits within private family firm increases with the agency cost related to use of debt and the sepa- ration of ownership and control (Carey et al., 2000).

Audits can improve the debt contracting efficiency of financial statements, and affect debt pricing in the following ways. First, audits and audit quality enhance the credibility of financial statements. The availability of credible accounting information decreases the lenders’ need to engage in their own costly information production and monitoring activities, thereby decreasing debt-monitoring costs (Jensen & Meckling, 1976; Watts & Zimmerman, 1986). Second, the auditor’s opinion can convey addi- tional timely information for the debt market. Finally, given that reported accounting choices are the joint outcome of the management’s and the auditor’s preferences (Dye, 1991; Antle & Nalebuff, 1991), audits can improve the quality of accruals (Becker et al., 1998; Van Tendeloo & Vanstraelen, 2008; Francis et al., 1999). Higher accrual quality in turn implies higher earnings informativeness and lower lender information risk (Francis et al., 2005).

Ultimately, the debt pricing implications of audits depend on the extent to which lenders rely on audited financial information when monitoring debt contracts. Public financial information could be more important for bondholders contracting at arm’s length than for banks which can more effectively resolve information asymmetries through access to inside information on an “as needed” basis (Fama, 1985; Chu et al., 2009). Bank loan agreements exhibit more recontracting flexibility than do bonds;

therefore, bond pricing could be more sensitive to the quality and credibility of ac- counting information (Bharath et al., 2006). Also, given that auditors are expected to have weaker incentives to maintain their independence, choosing a reputable auditor can provide a less-credible signal of audit quality to the debt market in the code law private firm context. However, the lack of alternative publicly available information

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on these firms could imply that audited financial statements are indeed an important source of information in debt contracting (Cano-Rodríguez et al., 2008).

Ongoing research provides evidence suggesting that private firms’ choice of a vol- untary audit––and, in particular, choice of a reputable auditor––is valued by banks in non-common law low-litigation settings (Kim et al., 2007; Cano-Rodríguez et al., 2008).

However, the evidence on whether the auditor’s opinion in audit reports is of infor- mation value to lenders of private firms remains mixed. Evidence from Spain suggests that the auditor’s opinion does not matter in terms of debt pricing (Cano-Rodríguez et al., 2008), whereas evidence from Finland suggest the opposite (Hyytinen & Pajarinen, 2007). In addition, the evidence from Finland regarding the debt pricing effects of auditor certification is inconclusive. Hyytinen and Väänänen (2004) report that pri- vate Finnish firms, audited by certified auditors, have higher credit ratings and lower borrowing costs compared with those audited by non-certified auditors. However, the findings of Hyytinen and Pajarinen (2007) imply that auditor certification is irrel- evant in pricing of debt for private Finnish firms. Regarding the debt pricing effects of accruals quality, ongoing research shows evidence from Spain that accruals quality is inversely related to borrowing costs only for private firms audited by a reputable Big 4 audit firms. This suggests that audit quality increases the information value of accruals to lenders of private firms (Gill-de-Albornoz & Illueca Muñoz, 2006).

Evidence from Finland suggests that the demand for higher quality auditor in private firms follows a dynamic pattern. Specifically, the evidence suggests that this demand is first driven by firm complexity and as the firm grows complexity is sup- plemented by the need for external debt and public equity financing (Knechel et al., 2008). This result implies that in smaller private firms the benefits of appointing a higher quality auditor can relate to obtaining access to expert advice and improving internal operations. While the Finnish evidence is consistent with the idea that in larger private firms the demand for audit quality increases with the extent of share- holder-debtholder agency costs as proxied by financial leverage (Knechel et al., 2008), a cross-country study report an inverse relation between leverage and the likelihood to appoint a Big Five audit firm for a sample of small and medium-sized Finnish firms (Broye & Weill, 2008).

1.3.2 Audit quality differentiation

DeAngelo (1981) shows analytically that auditor independence is a function of audit firm size. The basic idea behind this framework is that larger audit firms have strong- er incentives to report an independent opinion because no single client is important for a large firm and the auditor has a greater reputation to lose if they misreport.

It is also argued that an establishment of a brand name reputation can serve as an incentive to provide high-quality audits (Simunic & Stein, 1987; Francis & Wilson, 1988). Consistent with these arguments, the bulk of empirical studies have applied a dichotomous Big 8/6/5/4 vs. non-Big 8/6/5/4 indicator as a proxy for audit quality. In ad- dition, the existing research evidence supports the validity of this proxy for differen- tial audit quality in the audit markets of both public and private firms (e.g., Palmrose 1988; Becker et al., 1998; Van Tendeloo & Vanstraelen, 2008; Cano-Rodríguez, 2010).

Industry specialist auditors are expected to have deeper knowledge (i.e., compe- tence) than non-specialists due to greater experience in the industry. This experience

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17 enables industry specialists to make more accurate audit judgments (Francis, 2004;

Solomon et al., 1999). This implies that a higher market share in the industry enables audit firms to develop deep industry knowledge (Francis, 2004). Using an overall audit firm as the unit of analysis, previous studies imply that auditor industry spe- cialization is a source for audit quality differentiation in audit markets of public firms.

Specifically, evidence shows that clients’ earnings are of higher quality (Krishnan, 2003; Balsam et al., 2003; Krishnan, 2005), and that audit fees are higher when an au- ditor is an industry specialist (e.g., Craswell et al., 1995; DeFond et al., 2000). When it comes to the audit market of private firms, evidence from Belgium shows that besides the general Big 4 fee premium, an industry specialization premium is earned by the Big 4 auditors as well as by the non-Big 4 auditors (Dutillieux & Willekens, 2009).

These studies assume that industry expertise is completely transferable within an audit firm through different knowledge sharing practices (e.g., internal benchmark- ing of best practices), and, therefore, is an audit firm-specific phenomenon. However, because audit engagements are typically locally administered by an office-based engagement partner, industry expertise can be partly office-specific and is not com- pletely transferable within an audit firm (Francis, 2004). Supporting this view, studies using the audit firm office level as the unit of analysis show that auditor industry specialization is partly priced at the office level (Ferguson et al., 2003; Francis et al., 2005; Basioudis & Francis, 2007).

Based on the idea that industry expertise may be partly seen as the tacit knowl- edge of individual audit engagement partners (which is not completely transferable even within an office), recent studies have taken the analysis one step further and examined the pricing of auditor industry specialization at the audit partner level (Bond et al., 2004; Taylor, 2004; Kend, 2006; Zerni, 2009; Ittonen et al., 2010). These studies document somewhat mixed evidence regarding the effect of audit partner industry specialization on audit fees. In addition, based on samples of public firms, recent studies document a negative association between client earnings quality and individual audit partner industry specialization, which implies that audit partner industry specialization is a source for variation in audit quality in the audit markets of public firms (Kallunki et al., 2009; Duh et al., 2009; Ittonen et al., 2010).

Evidence from Finland suggests that perceived and/or actual audit quality can depend on the individual auditor’s certification status. Sundgren (1998) found that, between certified (HTM or KHT) auditors and non-certified auditors, the latter are less likely to issue modified audit reports whereas no difference is observed in the propensity to modify audit report between “first tier” KHT and “second tier” HTM auditors. This implies that audits by certified auditors are of higher actual quality than those of non-certified auditors on average. Additionally, Niemi (2004) reports that hourly billing rates are higher for KHT auditors compared with HTM auditors which in turn implies that there can be difference in perceived or actual audit quality also between HTM and KHT auditors.

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1.4 CONTRIBUTION OF THE DISSERTATION

The dissertation contributes to the audit literature by examining four related articles.

The first and second articles contribute to previous studies examining determinants of private firms’ choice of auditor (Lennox, 2005; Knechel et al., 2008; Broye & Weill, 2008). Drawing on a sample of private UK firms, previous evidence suggests that managerial ownership-induced agency problems are related to private firms’ demand for audit quality as proxied by audit firm size consistent with agency theoretical pre- dictions (Lennox, 2005). The first article extends this line of research to a previously unexamined code law context, where the monitoring role of an audit can be different than in a common law context (Ball et al., 2000). The second article extends previous studies by examining the role of family ownership/control as a determinant of a firm’s auditor choice. The use of private firm data in the first and second articles provides a methodogical advantage. In particular, study of private firm data permits more powerful tests of ownership effects, because there is more variation in ownership among private firms compared with public firms (Lennox, 2005).

Previous research present convincing evidence that auditing per se (Blackwell et al., 1998; Kim et al., 2007) and (perceived) audit quality as proxied by audit firm size decreases cost of private debt capital for private firms (Fortin & Pittman, 2007; Cano- Rodríguez et al., 2008; Kim et al., 2007). However, studies considering the impact of an auditor’s opinion and certification on debt pricing for private firms provide less conclusive results (Hyytinen & Väänänen, 2004; Hyytinen & Pajarinen, 2007; Cano- Rodríguez et al., 2008). Evidence from Spain suggests that accruals quality is inversely related to the cost of debt for private firms audited by a reputable audit firm (Gill-de- Albornoz & Illueca Muñoz, 2006). The third article extends debt-pricing literature by examining the debt pricing implications of both perceived audit quality and the audit outcomes; that is, audit opinion and accruals quality.

Finally, the fourth article contributes to the literature examining determinants of audit quality differentiation in the audit market of private firms (Van Tendeloo

& Vanstraelen, 2008; Ditilleux & Willekens, 2009; Cano-Rodríguez, 2010). Ongoing research suggests that audit partner industry specialization is a source of variation in audit quality in the context of public firms (Kallunki et al., 2009; Duh et al., 2009;

Ittonen et al., 2010). In addition, evidence from Belgium shows that auditor industry specialization, as measured at the audit firm level, leads to higher audit fees in the au- dit market of private firms (Dutillieux & Willekens, 2009). The fourth article extends this line of research by examining the effect of audit partner industry specialization on the earnings quality of private firms.

The Finnish institutional environment is useful to this dissertation in several ways. The first, second, and third articles use data covering the period 1999-2006, when there were different groups of auditors operating in the Finnish audit market.

Specifically, while the larger firms were required to use authorized KHT (“first tier”

certification authorized by the Auditing Board of the Central Chamber of Commerce) or HTM (“second tier” certification authorized by the Auditing Committee of a local Chamber of Commerce) auditors, the smallest firms were allowed to use auditors without any professional certifications. Given that information on individual audit partners, their professional certifications, and audit firms they represent is readily

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19 available in audit reports, the Finnish setting enables us to investigate the demand for audit quality in terms of a choice between Big 4, non-Big 4 KHT, non-Big 4 HTM, and non-certified auditors.

Finnish firms can voluntarily appoint more than one engagement partner––who can each represent the same or different audit firms––to be responsible for an audit engagement and for signing an audit report. Considering that audit credibility could increase when there is more than one engagement partner involved, an indicator of voluntary audits involving multiple engagement partners can be applied as an alter- native proxy for perceived audit quality. Finally, during the study period of 1999-2006, virtually all firms operating in Finland, regardless of size, were required by law to prepare public financial statements subject to a full audit. This makes it possible in the first, second, and third articles to examine the relevance of audit quality from the demand point of view in the overall size population of private firms. Regarding the fourth study, the requirement of the engagement partner’s signature in the auditor’s report makes it possible to identify client portfolios at the partner level and to proxy audit partner industry specialization as an industry market share in the audit market of private and public Finnish firms.

Collectively, the empirical results of the dissertation enhance our understanding of the relevance of audit quality in a context of private firms. The first, second, and third articles explore the relevance of audit quality from the demand-side point of view specifically by considering demand for audit quality from the perspective of different groups of stakeholders (i.e., non-managerial owners, non-family owners, and lenders). Finally, the fourth study explores the relevance of audit quality from the supply-side perspective by considering the audit partner industry specialization as a source for differential (actual) audit quality.

The results of the dissertation have potential practical implications for private firms. The findings of the first and the second article imply that the controlling own- ers of private firms need to consider the monitoring needs of various groups of own- ers when setting up their ownership structure. The articles acknowledge that the dilution of ownership to less-informed outsiders increases the importance of a high- quality audit’s monitoring role. The findings imply that private firms can benefit from proactively managing perceptions of audit quality by the choice of an auditor. The re- sults of the first and the second article imply that these benefits can relate to improved availability of financing in the form of debt for smaller private firms and outside equity for larger private firms. In addition, the results of the third article suggest that larger private firms benefit from engaging in a credible audit in the form of decreased borrowing costs. However, previous studies show that quality-differentiated audits are associated with higher audit fees (e.g., Dutillieux & Willekens, 2009). Because of lack of fee data, the third article is unable to draw conclusions on the net benefits of engaging in high-quality audits. The third article suggests that, regardless of the size of a private firm and an identity of the auditor, there are benefits related to auditing.

The audit opinion and accruals quality as the outcomes of an audit appear to matter in terms of decreased cost of borrowing. With respect to Finnish private firms, the results imply that although the Auditing Act (459/2007) does not currently obligate the smallest firms (i.e., firms where not more than one of the following conditions were met in both the past completed financial year and the financial year immedi-

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ately preceding it: (1) total assets > 100 000 euros, (2) sales > 200 000 euros, (3) number of employees > 3) to carry out an audit, these firms could benefit from a clean audit opinion in terms of decreased borrowing costs.

The findings of the third and the fourth study provide insight into the current de- bate of the regulatory changes and initiatives in the European Union (EU) and the US regarding the requirement for disclosing audit partner identity. The EU’s amended Eighth Directive requires that the engagement partner sign the auditor’s report, and the Public Company Accounting Oversight Board (PCAOB) in the United States is currently considering this requirement. According to the recommendation of the U.S. Treasury’s Advisory Committee on Auditing Profession (ACAP) final report to the PCAOB, the requirement of engagement partner signature in the auditor’s report would improve audit quality by affirming accountability of the auditor to financial statement users and increasing audit transparency. Audit firms have an additional incentive to improve the quality of their overall personnel (ACAP Report, October 6, 2008, at VII: 19). Consistent with this rationale, the results of the third article suggest that the engagement partner signature requirement improves the transparency of an audit, which affects lenders’ perceptions of audit quality. Furthermore, the results of the fourth article suggest that when an auditor is faced with a relatively low litiga- tion risk, this requirement can provide an incentive to supply a high audit quality.

However, professional ethics and integrity, and/or tax-alignment cannot be ruled out as alternative sources of incentive to supply high audit quality.

This dissertation is subject to the following limitations. First, endogeneity cannot be ruled out as an alternative explanation for the results of the third and fourth arti- cle. The “good” private firms may be more likely to choose an auditor with a brand name reputation or industry specialization as well as have higher quality earnings, more often clean audit opinions, and lower costs of borrowing. This implies that the observed relations in the third and fourth article can be subject to endogeneity bias.

However, as noted by Francis and Lennox (2008) correcting endogeneity biases is es- pecially difficult in accounting research. Second, the validity of the conclusions based on the fourth article depends crucially on the ability of the applied proxy to capture partner industry specialization as well as the ability of the applied accruals quality metric to capture actual audit quality. The third concern relates to the generalization of the results. The dissertation uses data from only one country, which can be seen as a limitation. Because the demand-and-supply functions of audit quality may differ from one country to next depending on the institutional setting, the conclusions of the dissertation may not extend to other national settings.

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2 Summary of the articles

2.1 ARTICLE 1: DEMAND FOR AUDIT QUALITY IN PRIVATE FIRMS: EVIDENCE ON OWNERSHIP EFFECTS

Using a unique survey panel data set of private Finnish firms, the first article inves- tigates the effect of managerial ownership-related agency costs on the demand for audit quality in the private firm context. The data set is composed of survey data that are collected through a private survey directed to about 2,000 private firms in Eastern Finland and combined with firm-specific financial and auditing data obtained from the VOITTO database of Suomen Asiakastieto Oy. The final test sample covers the period 2000-2006 and consists of 466 individual firms and 1,740 observations. The statistical methods applied in the study are pooled logistic and multinomial logistic regression analysis.

Applying CEO ownership as a proxy for firm-specific agency costs related to managerial opportunism, the study shows evidence that the demand for audit qual- ity increases with these managerial ownership-related agency costs. Specifically, the results indicate that CEO ownership is inversely associated with the likelihood that private firms engage in audits by the non-Big 4 KHT and Big 4 auditors. Additional analyses imply that the demand for audit quality in addressing shareholder-manager agency costs increases with leverage and decreases with CEO duality. Within smaller firms allowed to use non-certified auditors, the demand for audit quality appears to increase with financial leverage. This suggests that for these firms the demand for audit quality is driven by shareholder-debtholder agency costs rather than conflicts of interest induced by the separation of ownership and control. The results also indicate that the demand for the two types of certified auditors in the Finnish context is by no means equal. The results support previous findings suggesting that the actual or perceived quality differs by auditor type. KHT-certified audits are used to mitigate shareholder-manager agency costs. Creditors, on the other hand, seem to require HTM-certified audits as opposed to non-certified audits as leverage increases.

2.2 ARTICLE 2: THE ROLE OF AUDITING IN SMALL, PRIVATE FAMILY FIRMS: IS IT ABOUT QUALITY AND CREDIBILITY?

The second article investigates the effects of family ownership and control on the demand for audit quality in private firms, using the same survey data set as the first article. The test sample covers the period 2000-2006 and consists of 476 individual firms and 1,781 observations. The effects of interest are examined by means of pooled logistic and multinomial logistic regression analysis. The results show that family- held or -controlled firms are less likely to use Big 4 auditors than nonfamily firms, and that an increase in family ownership decreases the likelihood of a Big 4 audit.

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This suggests that higher-quality audits are used to overcome agency costs induced by information asymmetries when ownership dispersion increases with a decrease in family ownership. When family firms are investigated separately, leverage is ob- served to have an impact on the type of audit firm that the firm uses. The results fur- ther suggest that the demand is different for Big 4 auditors and other certified auditors in family firms. The demand for Big 4 audits is driven by family ownership and/or influence, financial distress, and export activities; whereas the demand for certified audits is driven by firm size, age, legal requirements, and group membership. This implies that nonfamily owners are given extra assurance by employing more credible Big 4 auditors. Combining the results, it seems that audit quality and credibility have more value to nonfamily shareholders than to the financial institutions in our sample.

2.3 ARTICLE 3: AUDIT QUALITY AND THE COST OF DEBT CAPITAL FOR PRIVATE FIRMS: EVIDENCE FROM FINLAND Using a large panel data set of private Finnish firms, the third article examines the debt pricing effects of perceived audit quality, the auditor’s opinion, and accruals quality in the context of private firms. The data are obtained from the VOITTO da- tabase. The final sample includes 3,890 individual firms and 10,799 firm-year obser- vations from 2000 to 2006. The statistical methods applied in the study are pooled ordinary least squares (OLS) and fixed effects (within) regression analysis. The results show that private firms with Big 4 audits and those with multiple auditors have a lower cost of debt capital than other firms. Also, firms with a modified audit report have higher interest rates on their debt capital than do firms with a clean audit re- port. Finally, accruals quality is inversely associated with the cost of debt capital.

Additional analysis suggests that Big 4 audits, and audits involving multiple auditors, are more important in the pricing of debt for larger private firms. In conclusion, the results suggest that both the perceived audit quality––in terms of a Big 4 audit and an audit involving multiple auditors––and the audit outcomes––in terms of the auditor’s opinion and accruals quality––are important in debt capital pricing for private firms.

Additional analysis suggests that the outcomes of an audit appear to be relevant re- gardless of a firm’s size, whereas the relevance of the perceived audit quality, in terms of who audits, appears to increase with a firm’s size.

2.4 ARTICLE 4: AUDIT PARTNER INDUSTRY SPECIALIZA- TION AND EARNINGS QUALITY OF PRIVATELY HELD FIRMS Using a large cross-sectional data set of Finnish firms based on fiscal years 2006-2010, the fourth study examines the effect of the audit partner industry specialization on the earnings quality of private firms. The test sample is obtained from the AMADEUS database of the Bureau Van Dijk and it includes 26,775 observations. The data are analyzed using OLS regression analysis. Applying an industry market share in the audit market of private and public Finnish firms as a proxy for audit partner industry specialization, the results suggest that the audit partner industry specialization has a

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23 positive effect on the earnings quality of private firms. Specifically, the results show that the audit partner’s market share in the client’s industry is inversely related to absolute abnormal accruals reported by the client firm. This association is strongest for audit partners representing the Big 4 audit firms and for client firms reporting earnings increasing abnormal accruals. The result holds after controlling for audit firm level factors (e.g., audit firm size). The results imply that the audit partner indus- try specialization is a source for variation in audit quality in the relatively low auditor litigation setting of private firms.

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Publications of the University of Eastern Finland Dissertations in Social Sciences and Business Studies No 29

Publications of the University of Eastern Finland Dissertations in Social Sciences and Business Studies

ISBN 978-952-61-0551-2 ISSN 1798-5749

Jukka Karjalainen

Audit Quality and

Private Finnish Firms

Using the research setting of private Finnish firms, the purpose of this dissertation is to enhance our understanding of the relevance of audit quality in private firms. The dissertation provides evidence of the demand for differential audit quality by lenders and different types of private firm owners, as well as evidence of audit partner industry specialization as a source for audit quality differentiation in the audit market of private firms.

d is se rt at io n s

| No 29 | Jukka karjalainen | Audit Quality and Private Finnish Firms

Jukka Karjalainen

Audit Quality and

Private Finnish Firms

Viittaukset

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