The Risk of Fraud in Family Firms: Assessments of External Auditors

47 Pages Posted: 14 Sep 2017 Last revised: 19 Oct 2022

Date Written: August 22, 2017

Abstract

There is a dearth of business ethics research on family firms, despite the importance of such firms to the U.S. economy (Vazquez 2016). We answer Vazquez’s (2016) call to examine the intersection of family firms research and business ethics, by investigating whether external auditors assess higher risk of fraud in family firms. We test the contradictory predictions of two dominant theoretical perspectives in family-firm research — entrenchment theory and alignment theory. We conduct an experiment with highly experienced external audit professionals, who assess the risk of fraud and make client acceptance decisions for family firms versus non-family firms with different strength of corporate governance: strong versus weak audit committees (AC). We find that auditors assess the risk of fraud as higher for family firms than for non-family firms, consistent with the predictions of entrenchment theory. Auditors are also less likely to make client acceptance recommendations for family firms. The strength of the AC moderates the family-firm effect, whereby auditors assess family firms with weak ACs to have the highest fraud risk, and to be the least desirable audit clients. 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.

Keywords: Family firms, Fraud risk, External auditors, Corporate governance

JEL Classification: M42

Suggested Citation

Krishnan, Gopal and Peytcheva, Marietta, The Risk of Fraud in Family Firms: Assessments of External Auditors (August 22, 2017). Available at SSRN: https://ssrn.com/abstract=3035851 or http://dx.doi.org/10.2139/ssrn.3035851

Gopal Krishnan

Bentley University ( email )

175 Forest Street
Waltham, MA 02452
United States
781-891-2477 (Phone)

Marietta Peytcheva (Contact Author)

Lehigh University ( email )

621 Taylor Street
Bethlehem, PA 18015
United States
610 758 2818 (Phone)
610 758 5992 (Fax)

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