Voluntary Demand for Internal and External Auditing by Family Businesses

Abstract:     
This study investigates demand for auditing by family businesses, which is a significant but relatively unexplored segment of the economy. First, the study measures the impact of firm characteristics commonly linked to the cost versus benefit of engaging an auditor (proxies for the separation of ownership and control, firm size and debt). The nature of family business governance structures allows for the development of more direct measures of agency costs than the traditional proxy of management share ownership (i.e., the proportion of non-family management and the proportion of non-family directors). Second, the study investigates voluntary demand for internal and external auditing and the association between these monitoring alternatives. In particular the study examines whether internal audit remains in its traditional role as a complementary activity of strengthening internal control and potentially reducing external audit costs; or whether, in a setting where less emphasis may be placed on financial risk, internal audit acts as a substitute monitoring mechanism.

Descriptive results of voluntary demand for audit by 186 family businesses revealed that internal audit was more prevalent than external audit, and outsourcing was a common method for providing internal audit. Results from a Lisrel model supported the hypothesized impact of agency cost proxies on demand for external audit, and provided some support for the impact on demand for internal audit. The positive and significant correlation between internal and external audit provides evidence that internal audit is generally viewed as a complimentary rather than as a substitute monitoring mechanism.

JEL Classification: M40, M49, D23, D82

working papers series