Does Auditors’ Reputation ‘Discourage’ Related Party Transactions? The French Case

Abstract

Regulators, standard setters and market participants consider related-party transactions a major issue in financial markets because they can be used to expropriate minority shareholders. External auditing is considered an important governance mechanism that can control the propensity of insiders to use these transactions. We consider that an auditor’s reputation is a surrogate for the quality of audit reports, and test the extent to which it may reduce the number of related-party transactions initiated by clients. We use a unique data set with a sample of 85 French firms over the period 2002–2008. The period under study includes the change in regulatory environment in Europe in 2005 with the compulsory adoption of IFRS standards. The French legal system allows us to discern how the reputation of audit firms is a consideration that may make insiders less likely to initiate related-party transactions. The results show that related-party transactions occur less frequently when external auditors have a notably high reputation. Interestingly, auditors’ reputation seems to substitute for the usual corporate governance variables to decrease the frequency of “abnormal” related-party transactions. The effect of reputation is, however, less important in a more transparent environment like the one implemented with the adoption of the IFRS standards. These results are obtained after controlling for the selection bias related to the choice of external auditors, using a two-step Heckman procedure.