Assessing Financial Reporting Quality of Family Firms: The Auditors’ Perspective

Abstract

Prior studies provide conflicting evidence on the reporting/disclosure quality of family firms. We provide unique insights by analyzing the pricing of audit engagements. Because financial reporting quality affects audit risk, which determines how auditors price engagements, we analyze audit fees to extract auditor’s professional assessment of family firms’ reporting quality. Relative to non-family firms, we find that audit fees are significantly lower for family firms, which suggests that auditors view family firms as having superior financial reporting quality (i.e. audit risk is low). Because a fee discount might also be attributable to lower litigation risk, we analyze litigation data and find no reliable difference in auditor lawsuits between family and non-family firms. Finally, we provide corroborating evidence on the financial reporting quality of family firms based on three audit risk tests. First, using a financial reporting metric for audit risk, we show that audit risk is lower for family firms. Second, we show that the fee discount is lower for family firms with high audit risk. Third, using audit report lag as a proxy for audit effort, we show that family firm auditors work less to provide the desired level of assurance. Our findings provide compelling evidence in favor of the explanation that auditors charge less from family firms because of superior reporting quality, which lowers audit risk and, therefore, the need for greater audit investments.

Keywords: family firms, audit risk, financial reporting quality, audit fees, audit report lag

JEL Classification: M40, M41