Economic bonding, corporate governance and earnings management: Evidence from UK publicly traded family firms

• Date: 01 July 2020
• DOI: http://doi.org/10.1111/ijau.12186
• Published date: 01 July 2020

ORIGINAL ARTICLE

Economic bonding, corporate governance and earnings

management: Evidence from UK publicly traded family firms

Jihad Al-Okaily

1

| Nourhene BenYoussef

2

| Salim Chahine

1

1

American University of Beirut, Beirut,

Lebanon

2

Université de Sherbrooke, QC, Canada

Correspondence

Jihad Al Okaily, Assistant Professor in

Accounting, Olayan School of Business,

American University of Beirut, Bliss Street, PO

Box 11-0236. Beirut, Lebanon.

Email: ja84@aub.edu.lb

This study examines whether auditor–client economic bonding and corporate gover-

nance moderate the adverse effects of principal–principal agency problems on earn-

ings quality in U.K.-listed family firms. We find that although earnings management is

lower in family firms, there is a higher tendency of earnings management for those

firms with economic bonding. However, such an impact may be moderated by good

governance mechanisms where the latter may alleviate the adverse effects of the

lack of auditor independence on the association between earnings management and

family firms.

KEYWORDS

agency theory, audit committee, corporate governance, earnings management, independence,

non-audit services

1|INTRODUCTION

Despite recent corporate scandals on the quality of the financial

reporting and the independence of auditors in publicly listed firms,

family firms are viewed as being more ethical (e.g., Aronoff & Ward,

1995; O'Boyle, Rutherford, & Pollack, 2010), and having lower

principal–agent conflicts of interest (e.g., Ali, Chen, & Radhakrishnan,

2007; Cascino, Pugliese, Mussolino, & Sansone, 2010; Chi, Hung,

Cheng, & Lieu, 2015; Prencipe & Bar-Yosef, 2011) compared to

nonfamily firms. However, they may still face principal–principal prob-

lems, which reflect the divergence between large controlling family

members and small shareholders (Ali et al., 2007; Ho & Kang, 2013;

Prencipe, Bar-Yosef, & Dekker, 2014). Anecdotal scandalous affairs in

the case of Pescanova in Spain or Parmalat in Italy show that family

firms may still engage in bad accounting practices and financial fraud

to hide losses and debt. Family firms may thus opportunistically

manipulate earnings for their private rents, and this is likely to happen

if there is a lack of available and effective external audit. Similar to

nonfamily firms, they may use their close association with their exter-

nal auditors to engage in unethical behavior and manipulate their

financial reports.

Prior research has primarily examined the association between

family firms and earnings quality (e.g., Ali et al., 2007; Anderson, Mar-

tin, & Reeb, 2017; Bardhan, Lin, & Wu, 2015; Srinidhi, He, & Firth,

2014). However, researchers have devoted limited attention to the

conditions where the entrenchment effect prevails over the interest-

alignment effect in determining the earnings quality in family firms

(Salvato & Moores, 2010). To fill this gap, we argue that the auditor–

auditee economic interaction, that is, financial dependency, affects

audit quality and the content and credibility of financial reporting

(Holm & Laursen, 2007; Sahnoun & Zarai, 2009). Specifically, we

explore the extent to which auditor–client economic bonding and the

quality of corporate governance moderate the adverse effects of

principal–principal agency problems on earnings quality in U.K.-listed

family firms.

Family firms are characterized by ownership concentration, family

control of management and directors' positions (Ali et al., 2007;

Anderson & Reeb, 2003), longer executive tenure (Tsai, Hung, Kuo, &

Kuo, 2006; Zellweger, 2007), longer-term relationships with their

auditors (Khalil, Cohen, & Trompeter, 2011), and the purchase of more

nonaudit services compared to nonfamily firms (Dobler, 2014). More-

over, auditors are considered the closest and most trusted external

advisors for family firms (Dobler, 2014; Jaffe, Lane, Dashew, & Bork,

1997; Nicholson, Shepherd, & Woods, 2009). They play a crucial role

in resolving the problems of family firms, and they get involved in

many family issues such as successions, compensation and employ-

ment of family members, and other future strategic choices

1

(Jaffe

et al., 1997). As such, auditors do not just provide “traditional ‘hard’

Received: 18 September 2018 Revised: 30 December 2019 Accepted: 14 January 2020

DOI: 10.1111/ijau.12186

Int J Audit. 2020;24:185–204. wileyonlinelibrary.com/journal/ijau ©2020 John Wiley & Sons Ltd 185

advisory services such as accountancy and law, but also ‘soft’services

from psychology and counseling backgrounds such as mediation and

conflict resolution”(Nicholson et al., 2009, p. 2). These are likely to

increase the familiarity between the two parties (CEO and external

auditor) and lead to a stronger auditor–client economic bonding,

which might jeopardize auditor objectivity and probably increase the

likelihood of earnings management (Krishnan & Peytcheva, 2019).

Prior studies show significant differences between family and

nonfamily firms across many dimensions. According to Trotman and

Trotman (2010), it is expected that these differences will result in a

range of accounting variations between family and nonfamily firms,

including financial reporting and auditing. Hence, it becomes essential

to examine the difference between family and nonfamily firms regard-

ing the association between economic bonding and earnings

management.

Using a sample of 1,765 firm-year observations for the period

2005–2013, we find evidence that although earnings management

is lower in family firms relative to nonfamily firms, it is higher in

family firms that exhibit an economic bonding, that is, use of non-

audit services (NAS), with their external auditors. Specifically, our

empirical results show that the positive effect of economic bonding

on earnings management is higher for family firms than for

nonfamily firms. Moreover, this effect becomes more significant in

weakly governed family firms than in their nonfamily counterparts.

These results suggest that the presence of good corporate gover-

nance mechanisms alleviates the negative effects of economic

bonding on earnings management.

The contributions of our study to the extant literature on family

firms are three-fold. First, this article responds to the call of Trotman

and Trotman (2010) to explore further how audit quality would differ

between family and nonfamily firms. It also provides answers to ques-

tions about the consequences of economic bonding in family firms in

a common law country (Dobler, 2014). Moreover, this study comple-

ments prior research addressing both alignment and entrenchment

perspectives (e.g., Villalonga & Amit, 2006). To the best of our knowl-

edge, this is the first study that investigates the role of economic

bonding and corporate governance in family firms. Our findings pro-

vide new evidence on the conditions under which the principal–

principal agency problems become more severe and offset the inher-

ent advantages of family firms in terms of alleviating principal–agent

agency problems.

Second, our article contributes to the current debate on audi-

tor independence within family firms (e.g., Dobler, 2014; Khalil

et al., 2011). As such, it provides a further understanding of audi-

tor's ability to resist the pressures that might be exercised by eco-

nomically influential clients and the negotiation outcome, that is,

earnings quality, of this economic relationship. We find that the

positive association between the supply of a high amount of non-

audit services, usually considered as one of the main concerns of

regulators and standard setters, and earnings management is higher

in family firms than in nonfamily firms. This also shows that an

increase in NAS threatens auditor judgment due to “increasing eco-

nomic dependence on the client; increasing familiarity and trust

with the client; creating complicated situations for self-revision”

(EU Commisison, 2000; Campa & Donnelly, 2016, p. 425).

Third, a handful of studies document the importance of corpo-

rate governance mechanisms in minimizing the economic bond

(e.g., Sharma, Sharma, & Ananthanarayanan, 2011; Wu, Hsu, &

Haslam, 2016). However, no research has examined that matter in

the family firms' context. Moreover, notwithstanding the impor-

tance of family firms worldwide and the numerous empirical stud-

ies done on family firms, very few studies were done on external

auditing issues in family firms (Carey, Simnett, & Tanewski, 2000;

Kang, 2017; Trotman & Trotman, 2010). In particular, research has

overlooked the extent and outcomes of nonaudit services in family

firms. Khalil et al. (2011) showed that family firms in the United

States have long-term relations with their auditors, signifying a fer-

tile atmosphere for both knowledge spillovers and threats to audi-

tor independence. Therefore, issues related to jointly provided

audit and nonaudit services by auditors are expected to be pre-

dominant in family businesses and are worth examining. In addi-

tion, due to confidentiality and trust concerns, family firms tend to

engage their incumbent auditors to offer nonaudit services to

restrict the number of external bodies that have access to sensitive

information (Dobler, 2014; Schaefer & Frishkoff, 1992; Strike,

2012). This implies that family firms are likely to purchase more

nonaudit services from their incumbent auditors relative to

nonfamily firms (Jaffe et al., 1997). This, in turn, could be economi-

cally beneficial to the firm but may impair auditing quality indepen-

dence and efficiency. Our study fills these gaps and shows that

corporate governance mechanisms can moderate the adverse effect

of auditor–client economic dependence in family firms, and there-

fore enhance earnings quality by reducing earnings management.

This confirms the role played by good governance in monitoring

the economic bonding through nonaudit service fees, which has

been emphasized by practitioners, researchers, and U.K. regulators

(Financial Reporting Council, 2014; PWC, 2012; Sharma et al.,

2011; Wu et al., 2016).

The rest of the article is organized as follows. Section 2 presents

our theoretical framework and discusses our hypotheses; section 3

describes data and methodology; section 4 presents the results.

Section 5 concludes the article.

2|THEORETICAL FRAMEWORK AND

HYPOTHESES DEVELOPMENT

2.1 |Agency theory: principal–principal versus

principal–agent problems

Family firms have been referred to as “high trust”organizations

(e.g., Jones, 1983) due to the informal agreements governed by these

firms (Gomez-Mejia, Nunez-Nickel, & Gutierrez, 2001). This trust is

similar to rational trust by which “emotion enters into relationship

between parties …leading to the formation of the attachments …and

entails a greater level of faith in the intentions of the other party”

186 AL-OKAILY ET AL.