Voluntary Demand for Internal and External Auditing by Family Businesses. Peter Carey, Roger Simnett, and George Tanewski

AUDITING: A Journal of Practice & Theory Vol. 19, Supplement 2000 Voluntary Demand for Internal and External Auditing by Family Businesses Peter Carey, Roger Simnett, and George Tanewski SUMMARY This study investigates voluntary demand for auditing by family businesses, a significant but relatively unexplored segment of the economy. The paper considers demand for both internal and external auditing by using survey data to investigate the impact of firm characteristics linked to the cost vs. benefit of engaging an auditor. Variables examined are firm size, debt, and two agency proxies that measure separation of ownership and control, namely, the proportion of nonfamily management in the firm, and the proportion of nonfamily representation on the board of directors. The paper also considers the association between internal and external auditing. Descriptive results on voluntary demand for auditing 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 logistic regression analyses provide support for the hypothesized impact of the two agency proxies and firm debt on demand for external audit, but do not explain the demand for internal audit. For firms that voluntarily engaged an auditor (internal and/or external audit), the negative and significant correlation between internal and external audit suggest that in the family business environment they are more commonly viewed as substitute rather than complementary responses. INTRODUCTION Family businesses, in this study defined as firms that exhibit majority family ownership, accounts for a large proportion of all economic activity. Research suggests that 80 percent of all businesses in the United States are family owned (Daily and Dollinger 1992) and family businesses contribute between 50 percent and 60 percent of U.S. gross domestic product (Francis 1993; Upton 1991). Similar findings have been reported in the UK (Stoy Hayward & The London Business School 1989, 1990), Western Europe (Lank 1995), and Australia (Smyrnios and Romano 1994; Smyrnios et al. 1997). Providing further evidence of the contribution of family business to the economy, La Porta et al. (1999) and Schleifer and Vishny (1986) find that the ownership structure of even large public companies is characterized by controlling stockholders who are more often families, usually the founder or their descendants. Despite the significance of family business to the economy there are few empirical studies of this sector in general (Brockhaus 1994; Wortman 1994), Peter Carey is a Senior Lecturer and George Tanewski is a Research Fellow, both at Monash University, and Roger Simnett is a Professor at the University of New South Wales. We gratefully acknowledge the AXA Australia Family Business Research Unit for providing access to their database. The comments of participants at the 2000 Midyear Meeting of the Auditing Section of the American Accounting Association; Accounting Association of Australian and New Zealand 1998 Annual Conference; The Tenth Annual Conference of Accounting Academics; Hong Kong 1998; The Second Asian-Network Symposium on Accounting Issues Melbourne, Australia 1998; and The 2000 International Symposium for Audit Research were most appreciated. In particular, we wish to thank Rashad Abdel-khalik and Mark DeFond for their comments.

2 Auditing, Supplement 2000 Q#8 and in particular in the audit area. The family-business environment provides an opportunity to further test theory concerning demand for auditing. Derived from prior empirical research and agency theory, predictions of voluntary demand for internal and external auditing are tested using survey data from family businesses. Family businesses in Australia at the time of this study largely operated in an environment where neither external nor internal auditing was a statutory requirement, 1 and the setting offered an opportunity to observe voluntary demand for auditing. Investigating voluntary demand has the advantage of eliminating the confounding effect of regulation. Few studies have investigated voluntary demand for auditing (see Chow 1982; Abdel-khalik 1993; Blackwell et al. 1998) and the present study accordingly adds to this literature. The study incorporates the traditional characteristics of firm size and firm debt, which are expected to increase the likelihood of a family business engaging the services of an auditor. Given the nature of family businesses, unique measures consistent with the suggestion of agency theory are developed to capture variations in demand for auditing among firms. The measures are: (1) the proportion of nonfamily management in the firm, and (2) the proportion of nonfamily representation on the board of directors. For both measures it is predicted that agency costs will increase through greater separation of ownership and control. In addition, the present study argues that both (or either) internal audit and external audit can serve as a monitoring response in family businesses, and an additional contribution of this research is to examine the relationship between these monitoring mechanisms. The study analyses survey data drawn from a database of Australian family companies compiled by the AXA Australia Family Business Research Unit. Internal auditing (Yes/No) and external auditing (Yes/No) are the dependent variables examined in separate logistic regression analyses. The hypothesized independent variables are firm characteristics associated with demand for auditing, namely firm size, firm debt, the proportion of nonfamily management in the firm, and the proportion of nonfamily representation on the board of directors. THEORY AND LITERATURE REVIEW There are a number of complementary explanations as to sources of demand for auditing (see, for example, Chow et al. 1988). Business is accountable to a range of parties and the diversity of organizations causes a myriad of potential accountability relationships, making it difficult to identify a single explanatory cause. Contracting or agency theory has provided a resilient and popular framework for explaining the demand for external auditing and suggests a monitoring role for both internal and external audit. The provision of audited financial statements is normally regarded as a cost-effective contractual response to agency costs (DeAngelo 1981; Watts and Zimmerman 1976). Similarly, internal auditing may also serve as a monitoring response to agency costs (Anderson et al. 1993; DeFond 1992). Though the agency literature is suggestive of potential conflict in family businesses (Fama and Jensen 1983), empirical research investigating the monitoring response in this important business segment is limited. This limitation is perhaps not surprising as the image of a family business is one characterized by a close alignment of ownership and control (Daily and Dollinger 1992). Notwithstanding the likelihood that family businesses may exhibit a lower level of agency costs compared with listed companies, the present study argues that conflict consistent with suggestions of agency 1 The family business database used in the present study was compiled from a survey mailed in February 1997. At this time, external audit was not a requirement for private family businesses, unless directed to do so by stockholders who had at least 5 percent of the vote. From July 1998, the Australian Corporations Law was amended requiring, for the first time, private companies to engage the services of an external auditor to audit their annual financial statements if any two of the following three criteria were met: sales > $10 million; assets > $5 million; employees > 50.

Carey, Simnett, and Tanewski 3 theory can still arise in family businesses. There are two characteristics of family businesses giving rise to a demand for audit that can be directly measured. These are: (1) the proportion of nonfamily management, and (2) the proportion of nonfamily representation on the board of directors. The first of these characteristics relates to the introduction of nonfamily operational management. Depending on the circumstances of the entity, 2 family owners might delegate some level of management responsibilities to nonfamily members. This will increase the demand for auditing for reasons of higher agency costs, and a greater loss of control by the owners. DeFond (1992, 21) explains the implication of separation of ownership and control as (1) the divergence in preferences of the manager and owner with respect to the manager s actions, and (2) the imperfect observability of the manager s actions by the owner. As the proportion of nonfamily management increases, owners (family and nonfamily) will exhibit greater demand for monitoring to reduce management shirking due to information asymmetry between nonfamily management and owners. A second characteristic that increases the demand for auditing in family businesses is where the family raises capital from outside investors (nonfamily members). Increasing diversity of ownership creates agency conflict because the majority owners (by definition, the family) have incentive to divert resources for their personal use. Such a diversion will have the effect of restricting resource flow to nonfamily owners. Benston (1985) argued this point with regard to owner-managed enterprises where there are outside investors. The capacity and incentive for nonfamily owners to initiate monitoring will depend on their level of ownership, and their representation on the board of directors. As the proportion of nonfamily ownership and director representation rises, a greater demand for monitoring will be exhibited. 3 Research has investigated factors associated with voluntary demand for external auditing. Chow (1982) used an agency framework to investigate the impact of agency costs (proxied by management share ownership), firm size, and debt. He found support for the effects of leverage and accounting-based debt covenants, and moderate support for the predicted role of size on voluntary demand for auditing. Abdel-khalik (1993) used a structure of organization approach to investigate the impact of the level of hierarchy (firm size) and debt. He found a correlation between voluntary demand for auditing and the extent of hierarchy (a measure of firm size), and only weak support for the impact of debt. Blackwell et al. (1998) found that small private firms derived an economic benefit from auditing through a significantly lower interest rate than that paid by nonaudited firms; thus the level of debt was a major factor in determining the level of benefit gained. Other research has investigated quality-differentiated audits. These studies, investigating firms with a statutory audit requirement, traditionally use a binary categorization of audit firm quality to capture the impact of variations in agency conflict among firms (see, for example DeFond 1992; Johnson and Lys 1990; Francis and Wilson 1988; Simunic and Stein 1987; Palmrose 1984). This literature argues that larger firms provide a higher quality service (DeAngelo 1981) and are more likely to be employed to undertake the audit of companies facing a higher level of agency conflict. Using management share ownership to proxy agency costs, some researchers have found the expected negative association between management share ownership and auditor brand-name/quality (DeFond 1992; Simunic and Stein 1987), others have found no effect (Palmrose 1984; Francis and Wilson 1988), and still others have unexpectedly found a positive association (Eichenseher and Shields 1989). 2 Circumstances likely to influence the degree of delegation to nonfamily management include the size of the business and the motivation and expertise of family members. 3 The present study uses board of director representation to measure ownership. Board of director representation in Australian family business is closely aligned with ownership (Smyrnios et al. 1997) and is expected to represent a more direct effect on demand for audit services because the decision to appoint an auditor is normally made by the board. It is noteworthy that in the present study the proportion of nonfamily board of director representation was significantly and positively correlated with the proportion of nonfamily ownership (rho =.43, p <.0005).

4 Auditing, Supplement 2000 The above research establishes a link between demand for external auditing and firm size, debt, the proportion of nonfamily management, and the proportion of nonfamily representation on the board of directors. Although much of the audit-demand research has addressed external auditing, a number of authors (for example, Anderson et al. 1993; DeFond 1992) have argued that internal audit is a potential alternative monitoring mechanism. In this paper, we argue that external and internal audit might both serve as a monitoring response to variations in agency conflict in an environment where auditing is voluntary and costs and benefits of different approaches can be considered. The current nature of the relationship between internal and external auditing is unclear. One view of internal auditing, as, for example, reflected in auditing standards (International Auditing Standard ISA610, International Auditing Practices Committee 1994), is that the means for internal and external audit to achieve respective objectives are often similar, which suggests internal audit may serve as a complement to external audit. Among listed public companies, evidence of a reduction in external audit cost due to reliance on the work of internal audit suggests a complementary relationship (see Felix et al. 1998; Wallace 1984). 4 An alternative view of the relationship between internal and external auditing is that, in a voluntary setting, internal audit can serve as a substitute in one or both of two ways. First, it can be a straight substitute when internal audit performs financial statement audit work that could similarly be provided by external audit. The second substitution would be when the family business chooses an audit service other than that provided by a financial statement audit as an appropriate monitoring response. A number of authors (see, for example, Elliott 1994) have predicted an increased demand for a broader range of assurance services and a corresponding decline in the relevance of the financial statements and the related external audit service. It may also be that relations between internal and external audit are evolving and are very dynamic. While the role of internal audit is traditionally viewed as assisting management in safeguarding assets and monitoring control systems (for example, Ratliff et al. 1996), there is evidence of internal audit changing in response to changing business needs. The emphasis in many internal audit departments is on adding value to the entity, and includes services ranging from advice on business planning and risk management to information systems evaluation (Birkett et al. 1999). Where the emphasis of external audits was on financial statement risk, and internal auditors were seen to be control-risk focused, it was likely that in a voluntary setting internal audit was complementary to external audit. If internal audit adopts a more value-added approach, rather than a control-risk approach, it is more likely that complementarity between internal audit and external audit will diminish, and internal auditors may be viewed as substitutes to external auditors as providers of expert advice. Discussions with representatives from the Big 5 accounting firms confirm that in today s environment, when they are approached by family companies requesting audit services in a voluntary environment, an assessment of client needs often means that they recommend the provision of internal audit services rather than the traditional external audit. HYPOTHESES Demand for Auditing Arising from Separation of Ownership and Control As outlined in the previous section, undertaking the analysis of demand for auditing in a familybusiness environment permitted the development of two measures of the separation of ownership and control. These measures were the proportion of nonfamily management in the firm and the proportion of nonfamily representation on the board of directors. First, a greater proportion of nonfamily management is expected to result in greater separation of ownership and managerial 4 Research findings are not conclusive. For example, Stein et al. (1994) found that reliance by external audit on the work of internal audit resulted in fewer external audit staff hours, however more higher-level hours were utilized, with no effect on the overall external audit fee.

Carey, Simnett, and Tanewski 5 control. A positive correlation between the proportion of nonfamily management and demand for auditing is predicted. Second, higher nonfamily membership on the board of directors that represents nonfamily ownership creates an incentive for the family to divert resources for their personal use. The representatives of nonfamily interests on the board will demand greater monitoring. A positive correlation between the proportion of nonfamily representation on the board of directors and demand for auditing is predicted. With greater separation of ownership and control, the benefits from an audit, either internal or external, are more likely to exceed the cost. The preceding arguments are summarized in the following hypotheses: H1a: In an unregulated family business environment, demand for auditing will be positively correlated with the proportion of nonfamily management. H1b: In an unregulated family business environment, demand for auditing will be positively correlated with the proportion of nonfamily board of director representation. Size As previously discussed, empirical research has identified a correlation between firm size and demand for both external auditing and internal auditing. The literature suggests a number of theoretical explanations. First, as the total amount of potential wealth transfers increases with firm size, the related benefits from undertaking monitoring increase (Chow 1982). Second, with increased size it becomes more difficult for the owners of private companies to oversee and be cognizant of the enterprise. Hence, there is a greater demand for auditing to compensate for the loss of control (Abdel-khalik 1993). Third, on the cost side, the marginal cost of providing an external audit decreases with firm size (Chow 1982). Similarly, larger firms have opportunities to take advantage of economies of scale from investing in the fixed costs of internal auditing, which include staff training and establishing geographically dispersed offices (Anderson et al. 1993). The preceding arguments can be summarized in the following hypothesis: H2: In an unregulated family business environment, voluntary demand for auditing will be positively correlated with a firm s size. Debt Theoretical discussions as to the association between debt and demand for auditing tend to support a positive association between level of debt and demand for external auditing (see Chow 1982). It is argued that as the proportion of debt in a firm s capital structure increases, shareholders have greater incentives to transfer wealth from the bondholder 5 and this increases the likelihood that the organization will demand an audit. Abdel-khalik (1993) adapted this argument in suggesting that owners demand an external audit in order to comply with constraints placed on an organization by creditors. Blackwell et al. (1998) found evidence that demand for external auditing is derived from the economic benefit of a lower interest rate. There is, however, no theoretical or empirical literature linking firm debt with the existence of internal audit. In this absence the hypothesis is limited to external auditing. The preceding arguments can be summarized in the following hypothesis: H3: In an unregulated family-business environment, demand for external auditing will be positively correlated with the level of debt in a firm s capital structure. 5 The wealth-transfer mechanisms include paying liquidation dividends, changing the firm s variance of return, and diluting coverage on existing debt by issuing new debt.

6 Auditing, Supplement 2000 The Relationship between Internal and External Auditing In an environment where demand for auditing is voluntary, family businesses can respond to pressure for monitoring by choosing between internal audit and external audit. It is unclear if internal and external audit are primarily viewed as complementary responses, or as substitute monitoring mechanisms. The existence of internal auditing being positively correlated with the existence of external auditing will be evidence of their complementary nature, 6 while a negative correlation will suggest that they may serve as substitute monitoring mechanisms. The analysis will include only firms that undertake some form of audit service. This approach is consistent with the definition in economics of a complementary good or service, as one that is used in conjunction with another good or service (for example, Jackson et al. 1998). Including firms that do not engage either internal or external audit introduces unwanted variability into the analysis; firms that do not engage either audit service are neither demonstrating a complementary nor substitute association. Because of the exploratory nature of this section of the study, the following hypothesis is expressed in the null form: H4: In an unregulated family-business environment, and for businesses that engage an audit service, there will be no correlation between demand for external auditing and demand for internal auditing. METHOD Data Collection Procedure and Sample The data subject to analysis comprised 186 Australian family businesses drawn from a database of 318 family businesses compiled by the AXA Australia Family Business Research Unit (AAFBRU) at Monash University. The database was compiled from a survey of 3,000 Australian businesses randomly selected from the Dun & Bradstreet list of Australian businesses. The Australian Family Business Equity Participation Questionnaire (AFBEPQ) was designed by the AAFBRU and comprised seven sections: Background of the Business, Current Ownership and Management of the Business, Succession, Planning the Growth of the Family Business, Alternate Investment, Background of the CEO, and Audit Protocol. Authors of the present study were permitted to incorporate a limited number of questions into the questionnaire that were relevant to the research issues addressed in this paper. This study reports findings drawn from three sections of the questionnaire: Background of the Business, Current Ownership and Management of the Business, and Audit Protocol. Background of the Business assesses: whether the firm was a family business; industry; age of business; number of employees; legal structure; gross sales; average rate of earnings from sales before interest and tax; and value of total assets. Current Ownership and Management gauges: proportion of family ownership; generation of ownership; number of family and nonfamily directors; and proportion of family management. Audit Protocol measures whether family firms voluntarily engage both external and internal audits. Tests of responses revealed that respondent organizations were slightly larger than the population of businesses contained on the Dun & Bradstreet list. Indeed, as shown in Table 1, respondent organizations that had sales turnover exceeding $20 million were overrepresented in our sample by approximately 10 percent. A breakdown of respondents by number of employees indicates that, when compared with Dun & Bradstreet data, 7 our sample is overrepresented in the 20 49 and 50 99 categories, but underrepresented in both the less than 20 and 100+ employee categories. 8 When comparing the breakdown by number of employees with sales turnover estimates, our results appear to be more 6 The complementary nature of the existence of these monitoring mechanisms may be enhanced by a substitution effect on effort, as would be evidenced by reduced external audit work resulting from reliance on internal audit. 7 The Dun & Bradstreet data are comparable to the Australian Bureau of Statistics (ABS) figures on small- to mediumsized businesses. 8 The Australian Bureau of Statistics (ABS 1998) defines small businesses for statistical purposes as nonmanufacturing firms with less than 20 employees, and manufacturing firms with less than 100 employees.

Carey, Simnett, and Tanewski 7 TABLE 1 Comparison of Family Business Sample with Dun & Bradstreet Dun & Bradstreet Sample (n = 186) Sales < $20 million 80% 70.4% > $20 million 20 29.6 Industry Manufacturing 15.4 17.2 Retail & Wholesale Trade 35.7 51.6 Transport & Storage 4.5 4.8 Finance, Property, & Business Services 23.1 5.4 Construction 13.0 10.2 Other 8.3 10.8 Employees < 20 39 35 20 49 12 24 50 99 10 22 100+ 39 19 Value of total assets (millions) < $1m 20 $1m $5m 37 $6m $19m 35 $20m $49m 6 $50m $99m 1 > $100m 1 underrepresentative of small-sized compared to the large-sized businesses. A further breakdown of respondents by industry demonstrates that our respondents are overrepresented in the retail and wholesale trade industry, but underrepresented in the finance, property, and business services industries. From the database of 318 family businesses, 132 businesses were deleted for the following reasons: (1) 25 responses 9 were deleted to eliminate the potentially confounding effect of regulation; (2) six responses were deleted as they failed to satisfy the family-business criteria used in this study; and (3) the remaining 101 responses were deleted due to missing values for any one of the variables in the model. To assess whether deleted respondents differed significantly from our usable response group (n = 186), they were compared on three key characteristics (i.e., number of full-time employees, gross sales in 1996, and industry). Chi-square tests indicate that there were no systematic differences between the two groups for all three characteristics: number of full-time employees (χ 2 = 5.99, df = 4, p =.2003), gross sales in 1996 (χ 2 = 8.17, df = 5, p =.1473), and industry (χ 2 = 13.38, df = 9, p =.1461). 9 Six respondents indicated they were listed public companies therefore requiring a statutory audit and 19 indicated that a major reason for engaging an external auditor was other regulatory compliance (e.g., compliance with taxation or building/construction regulations, or compliance with governmental supplier contracts).

8 Auditing, Supplement 2000 Logistic Regression Analyses Logistic regression analyses were used to predict discrete outcomes (Yes/No for Internal Audit and Yes/No for External Audit) from three continuous independent variables in the internal audit model and four continuous variables in the external audit model (refer to Exhibit 1). 10 Two logistic regression analyses were performed to assess prediction of firms voluntarily adopting an internal and an external audit on the basis of the proportion of directors that are nonfamily members (PROPDIR), proportion of nonfamily participation in the management team (PROPMAN), size of the firm (SIZEFACT), and the proportion of funding for the business provided by debt (DEBTA) (only for the prediction of voluntary external audit). 10 The measures employed in this study identify the existence rather than the nature and extent of these services. A potential limitation is that these measures do not capture variations in the nature and extent. This is more likely to be a concern for internal rather than external audit. EXHIBIT 1 Variables Used in the Models The two logistic regression equations took the following form: π log ι = log O (PROPMAN) (PROPDIR) (SIZEFACT) (DEBTA) 1 i(eayes) = α + Β1 + Β2 + Β3 + Β π 4 ι where O i(eayes) = the conditional odds of a family business adopting an external audit. log π ι = log O (PROPMAN) (PROPDIR) (SIZEFACT) 1 i(eayes) = α + Β1 + Β2 + Β π 3 ι where O i(iayes) = the conditional odds of a family business adopting an internal audit. Q#10 Dependent Variables IAYES (Internal Audit) was derived from a dichotomous measure (Yes/No) based on responses to two questions: Does your business employ permanent staff member/s to conduct internal auditing? Does your business employ an external accounting firm to conduct internal auditing? Where a respondent answered yes to either of these questions, this variable took a value of 1; otherwise it was assigned a value of 0. EAYES (External Audit) was derived from a single question: Is the business subject to an annual financial statement audit? Where a respondent answered yes, this variable took a value of 1; otherwise it was assigned a value of 0. Independent Variables PROPMAN refers to the proportion of nonfamily participation in the management team. PROPDIR refers to the proportion of directors who are family members. This variable was calculated by dividing the number of nonfamily directors into the total number of directors. SIZEFACT. To ensure size was captured in the model, a principal components analysis (PCA) with varimax rotation was performed on three size variables: (1) gross annual sales; (2) the number of people employed full time; and (3) the value of total assets. The PCA revealed a single factor solution that explained 76 percent of the variance. The Cronbach s alpha coefficient for SIZEFACT is.83. Factor loadings ranged from.865 to.874 for the three items. DEBTA. Respondents were asked to indicate the proportion of funding for the business that was provided by debt and the proportion provided by equity. DEBTA was calculated by dividing the proportion of debt into the value of total assets.

Carey, Simnett, and Tanewski 9 RESULTS Descriptive Results Table 1 provides background information on family businesses analyzed in this study. The calculated mean number of full-time employees was 58 (11 part-time employees). The calculated mean gross sales in the previous financial year was $22 million, the calculated mean value of total assets was $9 million, and the calculated mean rate of return from sales before interest and tax was 14 percent. The legal structure of family business respondents in this study was 70 percent companies, 25 percent family trusts, 4 percent partnerships, and 1 percent other. This result is consistent with prior research into family businesses (Smyrnios et al. 1997) and research by the Australian Commonwealth Government into small- and medium-sized enterprises (SMEs) (Industry Commission and Department of Industry, Science, and Tourism 1997). Size and industry were not associated with the legal form of family businesses. 11 While the benefits of the corporate legal structure are widely known, the choice of the family trust by Australian businesses is primarily tax driven. 12 External Audit Of the 186 observations, 86 (46 percent) engaged an external auditor and 100 (54 percent) did not (refer to Table 2). A univariate comparison of organizations revealed significant differences (PROPDIR (t(184) = 4.27, p <.0005) and PROPMAN (t(184) = 4.57, p <.0005)) in the expected direction for the two measures capturing separation of ownership and control in family business (refer to Table 3). As hypothesized, the level of debt to total assets (DEBTA) was higher for businesses that indicated Yes to an external audit (X = 42.3%) compared with businesses that indicated No to an external audit (X = 33.6%). The difference was statistically significant (t(184) = 2.08, p <.05). With regard to company size (SIZEFACT), group comparisons revealed businesses that engaged the services of an external auditor were significantly larger than businesses that did not (t(184) = 3.87, p <.0005). Internal Audit Of the 186 observations, 110 (59 percent) voluntarily engaged the services of an internal auditor compared with 76 (41 percent) companies that did not (refer to Table 2). Of the 110 organizations utilizing internal audit services, 46 percent (n = 50) had the service provided solely by an external accounting firm (outsourced), 34 percent (n = 37) had the service provided solely by permanent staff members, and 20 percent (n = 23) had the service provided jointly. 13 Comparison of firms that had their internal audit service provided solely or jointly by an external accounting firm (outsourced) with those that had their service provided solely by permanent staff members indicated no statistically significant size differences. 14 It was also noteworthy that of the 110 organizations, 57 percent (n = 63) voluntarily engaged internal audit services while simultaneously engaging external audit services. Of the 86 organizations that engaged an external auditor, 77 percent (n = 63) did so while simultaneously engaging internal audit services (refer to Table 2). 11 There is no association between the legal structure of the business and the size of the family business (as measured by number of employees) (χ 2 = 5.29, df = 4, p =.259) as well as industry (χ 2 = 8.47, df = 9, p =.487). 12 Family trusts are commonly used in Australia as a means of income-splitting between family members, where the assessment of income tax is on an individual rather than a family basis. Family trusts must however distribute all profits or pay tax at the highest individual marginal tax rate. At the time of this study the corporate tax rate was 36 percent and the highest individual marginal tax rate was 48.4 percent. 13 The high rate of internal audit outsourcing is not considered unusual in view of findings that in 1994 over 50 percent of Australian listed public companies outsourced some or all of their internal audit function (Mathews et al. 1995). 14 Three contingency tables were analyzed. Results for full-time employees were (χ 2 = 5.39, df = 4, p =.250); sales turnover 1996 (χ 2 = 7.60, df = 5, p =.180); and, value of total assets 1996 (χ 2 = 8.08, df = 5, p =.152).

10 Auditing, Supplement 2000 TABLE 2 Frequency of Family Businesses Using the Services of External Audit (EAYES) and Internal Audit (IAYES) (n = 186) IAYES NO YES TOTAL EAYES NO 53 47 100 (54%) YES 23 63 86 (46%) TOTAL 76 (41%) 110 (59%) 186 TABLE 3 External Audit Yes No All Demand an Demand an Observations Audit Audit (n = 186) (n = 86) (n = 100) Variables a Mean (S.D.) Mean (S.D.) Mean (S.D.) t-value PROPDIR 18% (.29) 28% (.33) 10% (.23) 4.27 (p <.0005) PROPMAN 31% 50% 15% 4.57 (p <.0005) DEBTA 37.6% (28.8%) 42.3% (28.2%) 33.6% (28.8%) 2.08 (p <.05) SIZEFACT.008.295l.254 3.87 (p <.0005) a See Exhibit 1 for a description of the variables. A univariate comparison of organizations based on whether they engaged an internal auditor revealed significant differences in the expected direction for only one of the proxy measures capturing separation of ownership and control (PROPDIR (t(184) = 2.01, p =.046)) (refer to Table 4). While the result for PROPMAN was in the expected direction, it was not significant (t(184) = 1.30, p =.195). With regard to company size (SIZEFACT), group comparisons revealed businesses that engaged the services of an internal auditor were not significantly larger than businesses that did not engage an internal auditor (t(184) = 1.59, p =.114). It is noteworthy that group comparisons revealed nonsignificant differences in the level of debt to total assets (DEBTA) (t(184) = 0.93, p =.353). The legal structure of family businesses was not found to be significantly associated with demand for either internal or external audit. While 46 percent of family businesses demanded an external audit, this type of audit was favored by 52 percent of companies and 34 percent of family trusts. With regard to internal audit, 59.5 percent of trusts and 59.6 percent companies voluntarily engaged the services of an internal auditor. No significant differences were observed between companies and trusts on demand for external audit (χ 2 = 3.56, df = 1, p =.059) and for internal audit (χ 2 = 0.004, df = 1, p =.995). Logistic Regression Analyses EAYES and IAYES, with their respective predictors, were subjected to direct logistic regression analyses. An examination of the EAYES model indicated that the predictors, as a set, adequately

Carey, Simnett, and Tanewski 11 TABLE 4 Internal Audit Yes No All Demand Demand Observations Internal Audit Internal Audit (n = 186) (n = 110) (n = 76) Variables a Mean (S.D.) Mean (S.D.) Mean (S.D.) t-value PROPDIR 18% (.29) 22% (.31) 13% (.27) 2.01 (p <.05) PROPMAN 31% 35% 25% 1.30 (p =.195) DEBTA 37.6% (28.8%) 36.0% (28.5%) 40.0% (29.1%) 0.93 (p =.353) SIZEFACT.00.09.14 1.59 (p =.114) a See Exhibit 1 for a description of the variables. distinguished demand for external audit among family businesses (χ 2 = 36.32, df = 4, p <.0001). Overall fit of 80.8 percent for EAYES was achieved. According to the Wald criterion, PROPDIR, PROPMAN, and DEBTA significantly predicted voluntary demand for external audit (z = 6.41, p Link <.001, z = 10.40, p <.001, and z = 4.09, p <.05, respectively). In contrast, a test of the IAYES to model (χ 2 Q#1 = 5.56, df = 3, p >.05) failed to find any reliable predictors. Table 5 shows regression on coefficients and Wald statistics for each of the predictors. Table The two agency proxies measuring separation of ownership and control were positively associated with demand for external audit in family businesses. In particular, there were significant link- 6 ages between the proportion of family management (PROPMAN) and demand for external audit (EAYES) (B = 1.92, p <.0005) as well as the proportion of family directors (PROPDIR) and demand for external audit (EAYES) (B =.43, p <.0005). These relationships provide support for H1a and H1b in the predicted direction for external audit. In contrast, for PROPMAN and PROPDIR, there were no significant associations with IAYES, providing no support for H1a and H1b with regard to internal audit. The hypothesized impact of firm size on demand for audit (H2) was also not supported, for either external audit or internal audit. 15 Results confirmed the hypothesized impact of firm debt on demand for external audit (H3). Firm debt (DEBTA) was found to be significantly associated with external audit (EAYES) (B =.09, p <.05). Finally, for the reduced sample of firms that did engage an audit, a significant negative association was identified between internal and external audit (H4). After eliminating the 53 cases where IAYES and EAYES were both No, we find a significant negative correlation between IAYES and EAYES (Spearman s rho =.338, p <.0005), suggesting that in the family-business environment at the time of this study, internal and external audit are potential substitutes. With the logistic regression analysis showing that agency-related variables explain demand for external audit, but not for internal audit, the substitution effect appears to be related to factors other than those hypothesized in this study. If agency costs are high, external audit is the appropriate monitoring mechanism to reduce them. 15 Abdel-khalik (1993) found that number of employees was significantly associated with demand for external auditing by private firms. As additional analysis, number of employees was substituted in the model for SIZEFACT and was similarly found to be nonsignificant.

12 Auditing, Supplement 2000 TABLE 5 Logistic Regression Analysis of Voluntary Audit EAYES B S.E. Wald Test (z-ratio) PROPDIR.43.17 6.41 *** PROPMAN 1.92.60 10.40 *** SIZEFACT.22.19 1.33 DEBTA.09.03 4.09 * Constant Only Model 2 Log Likelihood = 256.80 Full Model 2 Log Likelihood = 220.48 Model Chi-Square χ 2 = 36.32, df 4, p =.0001 Pseudo R 2 =.141 Q#7 IAYES B S.E. Wald Test (z-ratio) PROPDIR.90.57 2.51 PROPMAN.06.16.15 SIZEFACT.14.18.67 Constant Only Model 2 Log Likelihood = 251.60 Full Model 2 Log Likelihood = 246.05 Model Chi-Square χ 2 = 5.56, df 3, p =.135 Pseudo R 2 =.020 *, **, *** p <.05; p <.01; p <.001, respectively. DISCUSSION AND CONCLUSIONS Despite the obvious advantage of the unregulated environment for studying determinants of demand for auditing, the family-business stratum has been largely ignored in the auditing literature. The models developed and tested in this paper find empirical support for the impact of agency proxies measuring the separation of ownership and control on the use of an external auditor as a monitoring mechanism by family businesses. In an unregulated family-business environment, demand for external auditing is positively correlated with the proxies of agency conflict, the proportion of nonfamily management (PROPMAN-H1a) and the proportion of nonfamily directors (PROPDIR- H1b). However, no significant associations were observed between the proxies for agency conflict and internal auditing. The agency proxies developed in the present study appear to have successfully captured the association between the separation of ownership and control and demand for external auditing in a family business environment, but do not explain the demand for internal auditing in this environment. No support was found for H2 that in an unregulated family business environment, demand for auditing, either internal or external, is positively correlated with firm size. The result that SIZEFACT was not significantly correlated with the existence of external auditing in family businesses is not consistent with findings from prior empirical research investigating demand for auditing in an unregulated environment (see Chow 1982; Abdel-khalik 1993). This result may be explained in part by the data set that was used in this study underrepresenting small- and large-sized family businesses. Results support H3 that in an unregulated family-business environment, demand for external auditing is positively correlated with the level of firm debt. This finding is consistent with findings from prior empirical research investigating voluntary demand for auditing (see Chow 1982; Abdelkhalik 1993; Blackwell et al. 1998). Results from the present study suggest that in the late 1990s, lenders continue to rely on external auditors to serve a monitoring role.

Carey, Simnett, and Tanewski 13 Q#9 Finally, the null form of H4, for firms that have an audit there is no association between internal and external audit, is rejected, with a significant negative relationship observed. The negative correlation suggests that where family firms engage internal audit they are less likely to engage external audit, and vice versa. Results indicate that in response to pressure for monitoring mechanisms or other perceived advantages of audit, internal audit is a potential substitute for external audit for family businesses. However, our analysis shows that internal and external audit do not substitute with regard to agency costs. If agency costs are high, then external audit is the appropriate monitoring mechanism to reduce them. Moreover, internal audit is not appropriate for agency-related issues. Thus, internal audit and external audit may be substituting for services other than those related to agency issues (e.g., business or fraud risk assessment, information systems evaluation). The results of the study should be considered in light of the following limitations. First, even though the data are representative of medium-sized businesses in the manufacturing, retail, and wholesale trade industries, and transport and storage industries in Australia, caution should nonetheless be exercised in generalizing the sample to both smaller and larger sized businesses in other industries. While medium-sized family businesses were well represented in our sample, it is possible that if the sample had included more smaller (i.e., less than 20 employees) and larger (i.e., greater than 100 employees) firms, size may have been found to be significant. While this is a limitation of our study, the results are nonetheless reflective of medium-sized businesses in Australia. Second, the survey instrument collected financial data using mainly categorical measures in order to simplify the task for respondents and to minimize unintentional error. The model s explanatory power might have been improved if respondents were required to provide actual rather than categorical responses. Third, the study did not measure the impact of conflict within families a potential source of demand for auditing. Family-business research is in its infancy and future research might provide greater insight into demand for auditing by considering the impact of additional distinguishing family-business variables such as nonfamily managerial share ownership, a more sophisticated measure of the state of relationships between family members, or a more detailed description of the type and extent of work undertaken by internal audit. REFERENCES Abdel-khalik, A. R. 1993. Why do private companies demand an audit? A case for organizational loss of control. Journal of Accounting, Auditing and Finance (Winter) 8: 31 52. Anderson, D., J. R. Francis, and D. J. Stokes. 1993. Auditing, directorships and the demand for monitoring. Journal of Accounting and Public Policy 69 (12): 353 375. Australian Bureau of Statistics (ABS). 1998. Small Business in Australia 1997 (1321.0). Canberra, ACT: ABS. Benston, G. J. 1985. The market for public accounting services: Demand, supply and regulation. Journal of Accounting and Public Policy 4: 33 79. Birkett, W. P., M. R. Barbera, B. S. Leithhead, M. Lower, and P. J. Roebuck. 1999. Internal Auditing: The Global Landscape. City, FL: The Institute of Internal Auditors Research Foundation. Blackwell, D. W., T. R. Noland, and D. B. Winters. 1998. The value of auditor assurance: Evidence from loan pricing. Journal of Accounting Research 36 (1): 57 70. Brockhaus, R. H. 1994. Entrepreneurship and family business research: Comparisons, critiques, and lessons. Entrepreneurship, Theory and Practice 19 (1): 25 38. Chow, C. W. 1982. The demand for external auditing: Size, debt and ownership influences. The Accounting Review (April): 272 291., L. Kramer, and W. A. Wallace. 1988. The environment of auditing. In Research Opportunities in Auditing: The Second Decade, edited by A. R. Abdel-khalik, and I. Solomon, 155 183. Sarasota, FL: AAA. Q#2 Q#3

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