Drivers of voluntary audit in Finland: to be or not to be audited?

Abstract

This paper examines factors affecting the owner-manager's voluntary decision to hire an auditor in small firms. Using a random sample of 412 small private companies in Finland responding to an Internet survey, we first probe the institutional boundaries of a prior UK study [Collis, J., Jarvis, R., and Skerratt, L., 2004. The demand for the audit in small companies in the UK. Accounting and business research, 34 (2), 87–100] and conclude that its main findings can be generalised to a different regulatory setting (Finland) typical of many Continental European countries. Second, we broaden the prior research by testing new hypotheses regarding the drivers of an audit among small companies. We hypothesise and find evidence that outsourcing of critical accounting functions creates information asymmetry between the owner-manager and the external accountant, which may arouse the need for monitoring the external accountant through a voluntary audit. In addition, we find, as hypothesised, that tax advisory services provided by the external accountant reduce the likelihood of a voluntary audit. Moreover, we hypothesise that receiving a qualified opinion from the auditor reduces the likelihood of hiring an auditor voluntarily, whereas firms experiencing financial distress would be more willing to have their financial statements audited. We find evidence consistent with these hypotheses.

Keywords:

• agency theory
• alignment of financial and tax accounting
• information asymmetry
• moral hazard
• small companies
• voluntary audit

Acknowledgements

We thank the Editor, two anonymous reviewers, Jill Collis, Mara Cameran, Robin Jarvis, Don Stokes, and the participants of the Aalto University School of Economic's accounting research workshop, the 5th Annual Workshop on Accounting in Europe, hosted by the University of Catania, Italy (2009), the 5th EARNet Symposium on auditing research, hosted by the University of Valencia, Spain (2009), and European Accounting Association 33rd Annual Congress held in Istanbul (2010), for their constructive and insightful comments on earlier versions of this paper. We are most grateful to Juha Ahvenniemi and Sirpa Airola from The Association of Finnish Accounting Firms for providing access to proprietary case materials. We gratefully acknowledge the financial support of the Paulo Foundation, Helsinki School of Economics Foundation and Foundation for Economic Education.

Notes

According to the European Commission definition (2003/361), small (medium sized) enterprises are those businesses which employ no more than 50 (250) persons and which have an annual turnover not exceeding 10 (50) million EUR, and/or total assets not exceeding 10 (43) million EUR.

By an (independent) auditor, we mean a person or a firm which conducts the statutory financial statement audit. By an external accountant, we mean a provider of accounting services (such as bookkeeping, accounting for payroll, and preparation of financial statements), and tax services for the client firm. Both the accountant and the auditor may provide financial and tax advice services, thereby competing for the same work. However, due to independence requirements stipulated in the Finnish auditing law, the preparer of financial statements cannot audit them, i.e. be selected as an (independent) auditor of the firm. Thus, from the client's perspective, the auditor and the external accountant are separate actors in the Finnish regulatory setting.

A new Auditing Act (459/2007) that came into effect in 2007 changed two features of the Finnish audit market. (1) The new Auditing Act does not recognise non-certified auditors. They were, however, allowed to continue to audit their clients until the end of the transition period in 2011. (2) Small companies with annual turnover not exceeding 200,000 EUR, total assets not exceeding 100,000 EUR, and/or the number of employees not exceeding three persons are exempt from having a statutory financial statement audit. As noted by Collis et al. (2004, p. 87), the respective thresholds in the UK in 2002 were: turnover £4.8m (approximately 7.5 million EUR), total assets £2.4m (3.7 million EUR), and employees 50. In addition, in the UK, companies must meet both financial thresholds to qualify for audit exemption, which is more stringent than the EU size tests including Finland.

In a recent study, Niskanen et al. (2011) document that managerial ownership-related agency costs are positively related to the demand for audit quality in small Finnish firms. Unlike this study, however, the setting examined by Niskanen et al. (2011) represents the traditional view of agency relationship between the firm owners and its management.

For general information on The Association of Finnish Accounting Firms, see the web page at http://www.taloushallintoliitto.fi/taloushallintoliitto/association_of_finnish_accountin/. In addition to being an umbrella organisation for Finnish accounting firms providing information and education services to its members, the Association also plays an important role as a ‘court of appeal’ for clients who have encountered problems with their external accountants. In that capacity, the Association processes complaints filed by the customers of its member accounting firms. To give an idea of the scale of customer complaints related to overall activity, the Association received about 40 complaints during the period of 2005–2010, while the number of its member accounting firms amounted to about 800. Member companies must fulfil strict membership requirements and meet high professional standards and ethical code of conduct. It is noteworthy that the majority of accounting firms in Finland are not, however, members of the Association.

These cases are analogous to cost escalation and service debasement risks attributable to the so-called client lock-in scenario in the context of outsourcing information technology of a firm (see Bahli and Rivard, 2003).

The word ‘important’ in the hypothesis (H1) refers to the perceived significance of the services provided by the external accountant to the firm. It is also consistent with our questionnaire data used in the empirical tests.

External accountants and auditors are not obliged to be (but usually are) members of a professional body in Finland. In the UK, however, while a person can call himself/herself an accountant and provide accountancy services without being a member of a professional body, this is not the case with auditors. (The authors are grateful to an anonymous reviewer for pointing this out.)

Similarly, for example, Alford et al. (1993, p. 190) and Ali and Hwang (2000, p. 7) suggest that in the UK the alignment between financial and tax reporting of public firms is lower than in many Continental European countries.

Laki elinkeinotulon verottamisesta, EVL 54§ (Company Tax Law in Finland, Paragraph 54).

For the use of the word ‘important’, please see Note 7.

Beattie et al. (2000, p. 181) define ‘discussion’ and ‘negotiation’ as follows. In ‘discussion’, matters are raised by one side or the other (or both) and are considered in speech or writing. ‘Negotiation’ is the process of reconciling conflicting views advanced in discussion, by concessions on one or both sides. ‘Conflict’ can be defined as interaction of interdependent people who perceive the opposition of goals, aims, and/or values, and who see the other party as potentially interfering with the realisation of these goals (aims, or values) (see Beattie et al. 2004, p. 3).

By self-selection bias, we mean the possibility that small firms with having experience from voluntary audit are more likely to respond to the survey.

At the time the survey was conducted, all companies had to have a financial statement audit, but small companies were allowed to hire a non-certified auditor. Although the new Auditing Act (2007) acknowledges only certified auditors, small companies that had chosen non-certified auditors were allowed to retain them during a transition period to the end of 2011 (see footnote 3).

Mean score computed from the respondent's perceptions concerning the improvement of financial information quality from the view point of two user groups: (a) the owners of a firm and (b) parties doing business with each other (e.g. clients, suppliers).

In Collis et al. (2004), EDUCATN is a management-related dummy variable that takes the value of 1 if the respondent has a degree or holds a professional/vocational qualification or has studied/received training in business/management subjects. Collis et al. (p. 93) explain that EDUCATN is a proxy for the directors’ knowledge of the costs and benefits of the audit. To preserve consistency with Collis et al. (2004), we label our variable equally. However, we measure directly the directors’ knowledge of costs and benefits of the audit and code our ordinal variable EDUCATN as 1 when owner-manager awareness of the costs and benefits of the audit is lowest and 3 when awareness is highest.

The Z-score is based on the discriminant function estimated by Laitinen and Laitinen (2004) from a sample of 7076 financially distressed and 78,953 non-distressed Finnish firms during 1998–2003. The estimated discriminant function includes three key financial ratios: quick ratio (measuring firm's liquidity), earnings before depreciation and amortisation (measuring profitability), and equity ratio (measuring solvency).

In order to check for potential multicollinearity, we calculate the variance inflation factors (VIFs) for the variables in our binary logit regressions (Table 3). The highest VIFs are 1.698 and 1.725 in the benchmark and hypothesised models, respectively. As these VIFs are clearly below 10.0 (frequently regarded as the critical limit value for suspecting serious multicollinearity), it seems clear that multicollinearity is not an issue in our regressions.

In retrieving ‘population’ data, we define small companies as having sales not exceeding 10 million EUR following the definition of European Commission (cf. footnote 1). The maximum sales of 10 million EUR is also consistent with the largest firms in our sample. Similar to our sample selection criteria, we delete accounting and auditing firms from the ‘population’ of small Finnish companies. In addition, we drop from the ‘population’ firms with sales less than 15,000 EUR to be able to examine firms that are de facto active like those in our sample.

The exact points in time when respondents returned the questionnaires were recorded in the Internet survey. Descriptive statistics indicate that DAYS ELAPSED from sending the questionnaire to receiving it back from the respondents varied between 1 and 30 days, the average being 23.5 days. The indicated deadline for responses was 30 days.