Internal Controls in Family-Owned Firms

Abstract

This study investigates the relationship between family ownership and material weaknesses in internal controls over financial reporting. Recent Sarbanes-Oxley (SOX) regulation and mandatory disclosure of family relations among block shareholders and directors in Israel offer an ultimate setting for exploring this relationship. The findings reveal that (i) family ownership is significantly associated with less material weaknesses in internal controls, (ii) material weaknesses in internal controls are associated with lower earnings quality in family-owned firms than in non-family-owned firms, and (iii) investors find weaknesses in internal controls to be more serious in their potential to lessen future performance in family-owned firms than in non-family-owned firms. The contribution of the study is threefold. First, the findings expand our understanding of how ownership structure influences financial reporting procedures. Second, they suggest that family-owned firms use internal controls as a mechanism to enhance earnings quality. Third, they extend the literature on the implications of the SOX legislation by highlighting the joint effect of family ownership and effective internal controls in achieving high-quality financial reports.

View correction statement:

Correction to European Accounting Review 23(3) (2014), Special Issue on ‘Accounting and Reporting in Family Firms’

Acknowledgement

The author is grateful for valuable comments and constructive suggestions from Eli Amir, Avraham Beja, Michael Maher, Sabine Rau, two anonymous referees, and the editors, Sasson Bar Yosef, Annalisa Prencipe, and Laurence van Lent. Comments from the participants of the European Accounting Review Symposium in Bocconi University and the IFERA Conference in St. Gallen University are highly appreciated.

Notes

¹The SOX legislation in the USA was followed by similar laws in Canada, France, Germany, Italy, India, Japan, South Africa, Australia, and Israel.

²In contrast, the reliability of the methods used in prior studies on US firms to identify the family relations in family-owned firms has never been tested. These studies are generally based on information collected by performing textual searches for family relations in proxies filed with the SEC, on corporate history collected from the Lexis–Nexis and the Hoovers databases and from firms' websites, as well as on additional voluntary information sources.

³Internal control over financial reporting includes those policies and procedures that: (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company's assets that could have a material effect on the financial statements. (PCAOB, 2004)

⁴Prior to the disclosure of material weaknesses in internal controls required by the SOX Act, a number of studies opted to provide indirect evidence on internal controls. Kinney and McDaniel (1989) examine characteristics of firms that correct previously reported quarterly earnings. McMullen et al. (1996) use both SEC enforcement actions and corrections of previously reported earnings as proxies for internal control problems. Krishnan (2005) examines 128 internal control deficiencies reported from 1994 to 2000 in the 8-Ks of firms that changed auditors. She reports a positive association between audit committee quality and internal control quality. Ashbaugh-Skaife et al. (2007) find that firms making early disclosures of internal control deficiencies typically have more complex operations, recent changes in organisation structure, more accounting risk exposure, and fewer resources to invest in internal control (relative to firms not disclosing deficiencies).

⁵For example, putting less productive family members on the payroll or giving generous compensation to family members employed by the firm.

⁶While the entrenchment effect is likely to be, on average, weaker than the alignment effect for family-owned firms, this is unlikely to be true in all cases.

⁷See also Jiraporn and Dadalt (2009) and Zhao and Millet-Reyes (2007).

⁸Firms with cross-listed shares on the Tel Aviv Stock Exchange and on Nasdaq were required to comply with the SOX Act requirements before 2010.

⁹In contrast, public firms in the USA are frequently controlled by families through holdings of shares with special rights (i.e. rights to nominate board members) in a dual-class share system. Public firms with shares traded on the Tel Aviv Stock Exchange have a single class of shares.

¹⁰One possible reason for having a greater ratio of independent board members to the total number of board members lies in the size of the respective boards. On average, there are 6.5 members on the boards of family-owned firms, whereas other firms have 8.1 members on their boards.

¹¹In their regression model, Doyle et al. (2007a) used supplementary variables, such as proxies of governance, bankruptcy risk, and restructuring charges as independent variables with limited data availability. Similar data limitations preclude the inclusion of these variables in this study.

¹²Although the sample is too small to draw inferences based on categories of material weaknesses, the results seem to follow the argument that if the family-owned firm has a weakness, it will be used to expropriate wealth from minority shareholders. Company internal control weaknesses, such as overriding by senior executives, seem more likely to allow wealth expropriation than account-specific weaknesses.

¹³Dechow and Dichev (2002) model accruals as a function of past, present, and future cash flows, given their purpose to alter the timing of cash flow recognition in earnings (ΔWC = a + b ₁CFO _{t -1} + b ₂CFO _t  + b ₃CFO _{t +1} + ϵ_t). Absolute ϵt proxies for accrual quality as an unsigned measure of extent of accrual ‘errors’. See Equation (5) in Dechow and Dichev (2002).

¹⁴Wang (2006) reports a nonlinear relationship between family ownership and earnings quality.