Auditing Section Research Summaries Space

A Database of Auditing Research - Building Bridges with Practice

This is a public Custom Hive  public

research summary

    The Quality of Internal Control over Financial Reporting in...
    research summary posted July 27, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.02 Assessing Material Weaknesses, 07.03 Reporting Material Weaknesses 
    462 Views
    Title:
    The Quality of Internal Control over Financial Reporting in Family Firms.
    Practical Implications:

    Family owners are motivated to maintain weaker internal controls in order to extract private benefits. The greater likelihood of material weaknesses is driven by family firms with dual-class shares. The study increases the understanding of the association between family firm status and the quality of internal controls over financial reporting. It also contributes to the extant literature on family firms by providing further insight into the mechanisms through which family firms can exert undue influence on internal control over financial reporting.

    Citation:

    Bardhan, I., Lin, S., & Wu, S. L. 2015. The Quality of Internal Control over Financial Reporting in Family Firms. Accounting Horizons 29 (1): 41-60.

    Keywords:
    corporate governance, disclosure, dual-class shares, family firms, internal control, material weakness
    Purpose of the Study:

    Family firms represent a majority of businesses worldwide, and play a crucial role in the socio-economic development of both developed countries and emerging economies. A family firm is defined as a company where family members, either founders or descendants, continue to hold positions in top management and/or on the board, or they are the firms’ largest stockholders. Recent studies report that family firms account for the creation of 70 to 80 percent of global gross domestic product. As an important form of organization, family firms are typically characterized by lower owner- manager conflict but higher owner-owner conflicts. The interests of managers and shareholders in family firms are better aligned because of founding families’ concentrated ownership and active participation in management. However, concentrated ownership can motivate large shareholders to pursue private benefits at the expense of smaller shareholders.

    This study focuses on the relationship between family firm status and internal control over financial reporting (ICFR). Due to their unique features, such as greater concentration of ownership and reputation concerns, it is important to develop a better understanding of the organizational attributes of family firms that differentiate them from non-family firms with respect to internal control over financial reporting.

    Design/Method/ Approach:

    This study uses a sample of 446 firms from Businessweek’s 2003 analysis of Standard & Poor’s 500 firms. The authors create a logistic regression model to estimate the relationship between the characteristics of family firms and the likelihood of material weaknesses (MWs) using a dummy variable FAMILY, which equal 1 for family firms, and 0 otherwise.

    Findings:
    • The findings suggest family owners may prefer relatively weak internal controls in order to maintain private benefits of control.
    • Family firms have more internal control MWs relative to non-family firms under Section 404 of SOX.
    • The analysis suggests that family firms with dual-class share structures drive the higher incidence of MWs in family firms.
    • Among other types of family firms, there is no evidence to suggest that they have more MWs relative to non-family firms.
    • Family firms with dual-class shares exhibit a lower quality of internal control relative to nonfamily firms.
    • The dual-class share structure manifests itself as the most significant factor in affecting family firms’ internal control quality among the three control-enhancing mechanisms: dual-class shares, board representation, and family management.
    • The incentives of family members to entrench themselves and extract private benefits of control dominate their reputation concerns or their concerns for the long-term welfare of the firm.
    Category:
    Internal Control
    Sub-category:
    Assessing Material Weaknesses, Reporting Material Weaknesses