An Analysis of Auditorss Risk Assessment and Client Acceptance Decisions in Family Firms

Abstract

Very little is known about how auditors assess risks in publicly-traded family firms, despite the importance of these firms to the U.S. economy. Our study experimentally examines auditors’ assessments of control risk and fraud risk, as well as auditors’ client acceptance decisions for family firms vs. non-family firms with varying levels of audit committee (AC) strength. In the experiment, 60 audit partners and managers from the Big 4 audit firms and another large international audit firm examine a case describing a hypothetical company, and evaluate that company as a potential new audit client. We find that auditors assess both control risk and fraud risk to be higher for family firms than for non-family firms, and they are less likely to make client acceptance decisions for family firms. Moreover, auditors assess risks to be greatest, and audit client desirability to be the lowest, for family firms with weak ACs. Auditors’ assessment of control risk mediates the effect of the family firm structure on auditors’ willingness to pursue the firm as an audit client. Our findings suggest that auditors perceive more severe agency conflicts to be present in family firms than in non-family firms, consistent with entrenchment theory, according to which family members may behave opportunistically to extract rents and potentially expropriate the firm’s resources at the expense of minority shareholders.