Do Family Firms Purchase More Nonaudit Services than Non‐Family Firms?

• Published date: 01 July 2017
• Date: 01 July 2017
• Author: Fei Kang
• DOI: http://doi.org/10.1111/ijau.12090

Do Family Firms Purchase More Nonaudit Services than Non-Family Firms?

Fei Kang

California StatePolytechnic University

This study investigates the association between familyownership and the relative levelof nonaudit service (NAS) fees

paid to the incumbent auditors by public companies. Using data from S&P 1500 firms during the post-SOX period

2002–2010, the study shows that the NAS feeratio (the NAS fees relative to the totalof audit and NAS fees) is higher

for family firmsthan non-family firms. The resultssuggest that family owners’closemonitoring of their firms reduces

the information asymmetry and agency problems between shareholders and managers, and as a result family firms

tend to purchase more NAS from their auditors to appreciate the potential benefits of the auditors’knowledge

spillovers. Additional analysis demonstrates that the positive association between family ownership and the NAS

fee ratio is particularly pronounced for family firms without dual-class shares and for those with non-family-

member CEOs.

Key words: Agency problems, family firms, family ownership, nonaudit services (NAS) fees

INTRODUCTION

This study investigates the association between family

ownership and the relative level of nonaudit services

(NAS) fees paid to the incumbent auditors by public

companies. As documented by prior studies (Shanker &

Astrachan, 1996; La Porta, Lopez-de-Silanes & Shleifer,

1999), family ownership is highly prevalent in both

developing and developed countries. La Porta et al. (1999)

report that on average, more than 30 percent of the large

publicly traded firms around the world are family-owned;

even in the publicsector of the US economy,a large number

of firms are actually controlled by families, either through

direct control of shares or through indirect control

mechanisms like cross-holding or pyramid structures.

Specifically, Anderson and Reeb (2003) and Ali, Chen and

Radhakrishnan (2007) document that about one-third of

the S&P 500 are family-controlled companies in which the

founding families on average own 11 percent of the cash

flow rights and 18 percent of the voting rights.

Family firms are characterized by founding families’

concentrated ownership and family members’active

involvement in the firms’management. Family controls

are highly prevalent in both listed and non-listed firms,

and in both developed and developing countries. Due to

distinct legal environments across countries and different

types of agency problems across firms, the classification

of family firms varies across studies. A most widely

accepted classification of family-controlled public-listed

firms in the US defines them as those in which members

of the founding families continue to h old positions in top

management, sit on the board, or are blockholders of their

firms (Wang, 2006; Ali et al., 2007; Chen, Chen & Cheng,

2008, 2014; Ho & Kang, 2013). This study follows this line

of researchand focuses on US public-listedfirms controlled

by founding families. Compared to other shareholders,

family owners have a longer investment horizon, closer

monitoring of management, better access to information,

and a larger undiversified equity position in their firms

(Anderson & Reeb,2003; Ho & Kang, 2013), which provide

them substantial incentives to intervene in managerial

decision-making with respect to audit and financial

reporting processes. The distinctive ownership structure

of family firms and the relatively strict regulatory

environmentin the US provide a special setting to examine

the association between firms’agency problems and NAS

purchases.

The provision of NAS to audit clients has caused

significant regulatory concerns in recent years, because

the relative high NAS purchases have the potential to

impair auditor independence by increasing the economic

bond between auditors and clients. To address potential

threats to auditor independence, the Sarbanes-Oxley Act

(SOX) of 2002 bans the provision of most auditor-provided

NAS and requires pre-approval of NAS purchased from

the auditor by the audit committee. In spite of the

regulatory concerns, the large majority of the studies that

employ audit quality proxies capturing actual audit

outputs (i.e., restatements, GC opinions, and earnings

quality) find limited evidence that NAS is associated with

impaired audit quality (DeFond & Zhang, 2014). Using

data from Australia, prior studies document mixed

findings on the association b etween audit quality and the

provision of NAS (Barkess & Simnett, 1994; Wines, 1994;

Craswell, 1999; Hossain, 2013). However, research that

examines investors’perceptions of audit quality tends to

find that NAS is perceived to impair audit quality (e.g.,

Raghunandan, 2003; Krishnan, 2005; Francis & Ke, 2006;

Khurana & Raman, 2006). The seemingly conflicting

findingsare due to investors’concernthat companies using

NAS are subject to greater regulatory scrutiny and

increased litigation risk, even if the NAS purchase per se

does not impair actual audit quality (DeFond & Zhang,

2014).

As suggested by prior research, the NAS purchase

decision of a firm seems to be complexin nature and prior

research examining the explicit relation between agency

conflict variables and the NAS fee ratiois relatively limited

(Abbott, Parker & Peters, 2011). While NAS may impair

auditor independence, this may be offset by its

improvement to the auditor’scompetencyinproviding

high audit quality. Specifically, NAS may provide auditors

with a deeper knowledgeof the client, thereby resulting in

knowledge spillovers that enhance audit quality and

efficiency (Simunic, 1984). Parkash and Venable (1993)

argue that client firmsmanage the level of NAS purchased

from the incumbent auditor in response to agency costs

Correspondenceto: Fei Kang,Assistant Professorin Accounting, California

State Polytechnic University, 3801 W. Temple Ave, Pomona, CA 91768,

USA. Email: kang@cpp.edu

International Journal of Auditing doi: 10.1111/ijau.12090

Int. J. Audit. 21:212–221 (2017)

©2017 John Wiley& Sons Ltd ISSN 1090-6738