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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 auditors reputation is a surrogate for the quality of audit reports, and test the extent to which it may reduce the number of relatedparty transactions initiated by clients. We use a unique data set with a sample of 85 French firms over the period 20022008. 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 var iables 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.
JEL classification: G34; G38; K33; M42 Keywords: Related-party transaction; Audit; Reputation; Corporate governance; Ownership structure.
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* Moez Bennouri is professor at Rouen Business School, France. Mehdi Nekhili is professor at University of Reims in Champagne-Ardenne and Rouen Business School. Philippe Touron is Matre de confrences (associate professor) at Universit PARIS 1 PanthonSorbonne. Contact author: philippe.touron@univ-paris1.fr. 1
INTRODUCTION
elated-party transactions (RPTs hereafter) are commonly defined as transactions
conducted between a firm and its own managers, directors, principal shareholders or affiliated firms and subsidiaries. Both direct and indirect transactions (through firms
affiliated to officers and principal shareholders, or their family members) are considered RPTs. Recent corporate scandals around the world, in the US (Enron, Adelphia), in Europe (Schneider Rundfunwerke, Parmalat, Bremer Vulkan) and in Asia (Kangsai group, Baan Company) have brought RPTs under the spotlight. Although such transactions may sometimes be initiated for genuine business purposes, they are generally viewed as instruments for financial frauds and shareholder expropriation (Jones 2011). Regulators and standard setters reacted to increasing concern about the existence of these transactions by toughening the rules about their use and disclosure. In the U.S., the Sarbane-Oxley Act prohibited some of these transactions (McDermott et al. 2006). Several new rules were implemented in other countries to restrain their use and enhance public reporting procedures. Recently, the IFAC published a standard, the ISA 550, which provides guidance for the audit of RPTs (IFAC June 2009). In Europe, IFRS standards have been adopted since 2005 and a revised version of IAS 24 was enforced in January 2005, promoting greater transparency in the disclosure environment for RPTs. Since the paper by Gordon et al. (2004), a growing academic literature has paid more attention to RPTs. Several papers have analyzed the links between the presence of RPTs and fraudulent behavior by managers (Gordon et al. 2006; Henry et al. 2012). This negative perception of RPTs drives negative reactions to their reporting (Kohlbeck and Mayhew 2010; Cheung et al. 2006; Ge et al. 2010). Another strand of the literature studies the determinants of RPT proliferation. Since RPTs are seen as a way to expropriate minority shareholders, the methods identified to monitor their occurrence are generally based on corporate governance mechanisms. Djankov et al. (2008) focus on the way in which the legal system affects the occurrence of RPTs. Ownership concentration (Cheung et al. 2006) and the independence of directors and of the audit committee (Gordon et al. 2006; Lo et al. 2010) are examples of corporate mechanisms on which minority shareholders can rely to reduce the prevalence of RPTs. In this paper, we analyze the efficacy of the quality of external auditing, as another corporate governance device, to reduce the occurrence of RPTs. As argued by Gordon et al. (2006), internal corporate governance mechanisms generally fail to control RPTs, and
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external auditing may be considered a better alternative. External auditors indeed play a disciplinary role regarding managers (Francis and Wang 2008) and enhance investor protection (Newman et al. 2005). The reactions of regulators and standard setters to recent scandals represent another motivation for our analysis. Indeed, new rules clearly point out the importance of the role of the audit in informing outsiders fairly about RPTs. 1 However, audit quality is not directly observable. Users of financial reports therefore rely on ambiguous signals stemming from practices, achievements and all publicly available information about audit firms. These firms then engage in reputation building with the objective of sending out signals about the high quality of their audit reports. Economists model this type of building process by assuming that reputation is an asset in which (audit) firms invest by making trade-offs between short-term pay-offs and long-term benefits (Wilson 1985; Mailath and Samuelson 2001). In line with this literature, we argue that audit firms with a high reputation will deter their clients management from using RPTs because these transactions reduce the value of the audit firms reputational assets. We use data from French firms to study the links between auditor quality and the frequency of RPTs. There are five reasons for this choice. First, the ownership structure of firms in France is characterized by ownership, and by a well-documented separation between ownership and control (Faccio and Lang 2002). Second, the French legal system is perceived as offering lower protection to minority shareholders compared to other jurisdictions (La Porta et al. 1998 and 1999). These features increase the propensity to use RPTs, and they strengthen the importance of external auditors role in monitoring managers actions. Third, in the French system, auditors play a pivotal role in the disclosure of abnormal transactions. Indeed, since 1967, the auditors must publish a special report (in the annual report) containing all abnormal RPTs.2 This special report is then presented to the shareholders annual meeting for approval. Interestingly, under French regulation, external auditors are not required to make extensive investigation of RPTs, and only need to disclose those transactions communicated and so considered as abnormal by the managers and the board of directors. Therefore, external auditors do not need to employ substantial resources, or to have special competencies that can identify and examine undisclosed abnormal RPTs. This legal environment means that reputation is the main factor in the analysis of the potential correlation between the frequency
1 2
In the US, a recent survey by the Center for Audit Quality (CAQ 2010) argues that auditors are still perceived as the best instrument for investors protection. The European Commission also recognizes the The French rules on reporting, and the definition of abnormal RPTs, have evolved since 1967. A brief review of the main changes is presented in the following section. This presentation will focus mainly on those transactions which are, self-evidently, detrimental to minority shareholders.
of abnormal RPTs and the quality of the auditor. Furthermore, in the period of our study (2002 to 2008) we are able to analyze the impact of the nature of different disclosure environments, since in 2005 an important change was introduced. Forth, auditors in France are not legally responsible for potential frauds related to RPT reporting. With regard to their audit aims, it is very difficult to define their responsibilities because they should respect the non-interference principle.3 The motivation of external auditors to provide high-quality reports is thus an interesting case to study. Finally, French public firms are compelled to undergo a joint auditing process. Annual reports must be approved by two independent audit firms, and this gives rise to interesting strategic behavior, as argued by Francis et al. (2009). 4 As in the French case, where litigation plays a different role from in the U.S., Skinner and Srinivasan (2011) and Weber et al. (2008) find that auditors reputation is a driver of audit quality in the Japanese and German contexts, respectively. These authors use membership of the Big N group of audit firms as a proxy for audit reputation. Because of their international activities, and to preserve their reputation as an intangible asset, the Big 4 auditors5 will pay more attention to the frequency of RPTs, unlike the second-tier firms (non-Big N firms), which have fewer international activities and, consequently, fewer incentives to pay close attention to RPTs. Managers are aware of the importance of this reputational asset, and they may choose their external auditors in order to signal to the market their lower use of RPTs. Therefore, the choice of auditors is a strategic decision by the managers and has consequences for the behavior of both the firm and the auditors. We run a Heckman two-step model to control for the bias related to the selection of auditors. In the first step, we explain how firms choose their auditors. The explanatory variables are related to the board of directors, the ownership structure, the environment of regulatory disclosure (IFRS or not) and other control variables. The second step of our model explains the number of abnormal RPTs. This includes, besides several control variables, two binary variables explaining the choice of one Big auditor (1BIG) and two Big (2BIG) auditors. We also introduce a dummy variable capturing the introduction of the IFRS standards and in particular the IAS 24 dealing with the reporting of RPTs. Note that the dependent variable is the number of abnormal RPTs, which is by definition non-negative, and contains only integer values. As the econometric literature
3
See Art L 823-10 of the French Code of Commerce. See Francis et al. (2009) for a very interesting and concise description of the functioning of joint auditing in France. Following Francis et al. (2009), we consider that the international Big 4 are also the French Big 4: KPMG, Ernst & Young, Deloitte, and PricewaterhouseCoopers.
suggests, we use count-data regressions rather than simple linear regressions to avoid biased and inconsistent coefficients (Rock et al. 2000). Consistent with our argument about reputation, we find that the existence of one Big 4 auditor reduces the number of abnormal RPTs. However, hiring a second Big 4 auditor has a much more important (economically and statistically) negative effect on the frequency of abnormal RPTs. Interestingly, the reputation of auditors is more important than the usual corporate governance tools in explaining the frequency of RPTs (even after controlling for selection bias). We find also that the adoption of more transparent reporting standards with respect to RPTs decreases the role of external auditors in deterring managers from using RPTs. With a more transparent environment, auditors do not need to signal their quality in terms of detecting RPTs, since bringing RPTs into the open makes it harder for managers to use them to expropriate minority shareholders (so correcting the information asymmetry effect). The remainder of this paper is organized in six additional sections. The second section describes the French environment, and the third section presents a review of the literature and our testable hypothesis. The fourth section then describes the sample, and the way different variables are constructed. The fifth section presents the descriptive statistics, as an introduction to the multivariate model presented in the sixth section. Finally, the seventh section concludes. All tables and figures are in the appendix.
RPTs. Third, as argued in the literature (see for example La Porta et al. 1998), the French legal system, based on civil law, offers weak protection to minority shareholders, and the enforcement system under the existing rules is inefficient. The civil-law system imposes heavier formulation than the common-law system and implicitly limits the auditors third party liability (Piot and Janin 2007; Stolowy 2005). This affects both the way in which minority shareholders perceive the role of external auditors, and the frequency of abnormal RPTs. For insiders, the permissiveness of the civil-law system may stimulate the proliferation of abnormal RPTs. For minority shareholders, the role of the reputation of external auditors becomes very important, as part of the mechanism monitoring the managers and the controlling shareholders. Finally, French regulation evolved over the last few years by toughening the conditions for reporting and defining both normal and abnormal RPTs. It is interesting to analyze the way both the auditors and the companies practices adjusted to the new regulatory environment. Another interesting feature of the French accounting system is the obligation to employ joint auditing (which is different from dual auditing). In a joint audit, two different auditors produce the firms report and share the le gal responsibility (Francis et al. 2009). Originally, the idea of having two auditors was related to the requirement for financial institutions (receiving public savings) to use two different auditors. The practice was then extended and legally enforced in 1966. Using French data, Francis et al. (2009) find that joint auditing reduces uncertainty about the quality of reported earnings. Besides this effect on the quality of audit reports, we argue that joint auditing may create several forms of strategic behavior by auditors. We think this represents another interesting feature of the analysis of the French case, which may contribute to the debate about the effectiveness of joint auditing, at least from the perspective of reporting RPTs. In addition to prohibiting certain transactions, the French Commercial Code defines two categories of RPTs: routine transactions and regulated transactions. The first category covers all transactions that take place between the firm and its related parties and are concluded under normal conditions. These transactions are not subject to public reporting procedure but should be revealed to the members of the board and to the auditors. Since 2005, with the enforcement of the IAS 24 rules by the French legal system, these transactions must be reported in the consolidated financial statement of the firm. The second category of RPTs, called conventions rglementes (regulated agreements and commitments), are non -routine or abnormal transactions between the firm and its related parties. They are abnormal because they are executed under conditions different from the normal market conditions. These
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transactions are considered likely to have been set up to expropriate the minority shareholders. Such transactions are subject to a well-framed communication and reporting procedure. As clearly mentioned in the French Commercial Code, regulated agreements are every agreement involving directly, or through an intermediary, the company and its CEO, one of its directors, one of its shareholders holding a fraction of the voting rights above 10% (5% between 2001 and 2003)6, or, in case of corporate shareholder, the company controlling as defined in article R 233-3, shall be subject to prior approval of the Board of Directors.7 The managers and the chairman of the board are required to inform the auditors about these transactions. The auditors must establish a special report, distinct from the audit report, listing all these abnormal transactions.8 This special report is submitted to the shareholder s General Assembly for approval. It is important to note that the auditors are not required to evaluate or provide their judgment about the adequacy and usefulness of these transactions. Also, auditors are not supposed to make any systematic search for hidden RPTs (those with the highest probability of being fraudulent), but to limit their reporting to only those transactions approved and revealed by the board of directors. The content of the special report depends on the temporal nature of the agreement. However, new agreements and commitments are subject to extensive disclosure. Each of these agreements contains the names of the related parties, the nature and objective of the agreement, the terms/modalities as mentioned in the Commercial Code, and the amounts paid or received during the year. The information in the special report is generally less precise, as we mention below. For renewed agreements, the auditor only notes the nature and the importance of the services and goods delivered, and the amounts paid or received during the year. Therefore, the only agreements published in the special report are those that have been, or should have been, ratified by the board. Nevertheless, the managers have an obligation to provide information about routine agreements which are not necessarily under the umbrella of
7
8
The increase, from 5% to 10% of voting rights as the threshold defining significant shareholders, is one of the consequences of the application of the Financial Security Act of 2003, in place of the 2001 NER ( New Economic Regulations). Besides this change, the new 2003 rules broaden the scope of related-party transactions, so that more types of financial transactions between a company and its executive officers, directors, large shareholders and their immediate family members became subject to disclosure. R 233-38, Commercial Code. Note here that since the auditors receive information concerning both routine and abnormal transactions, they would be able (given their knowledge of the activities of the company) to classify as abnormal a transaction that was communicated by the managers and the chairman as routine transaction. The abnormal transaction will in this case be disclosed in the special report even though the board members and the managers do not agree with this classification. The disagreement about the classification of these transactions should also be mentioned.
the ratification process. This should allow the auditor to detect possible prevarications. However, to be legally covered, the auditors generally remind the readers of special reports about their limited liability. A classic disclaimer in the beginning of special reports is the following: Our responsibility does not include identifying any non disclosed agreements or commitments. We are required to report to shareholders based on the information provided, about the main terms and conditions of the agreements and commitments that have been disclosed to us, without commenting on their relevance or substance. Under the provision of the article R. 225-31 of the Commercial Code, it is the responsibility of shareholders to determine whether the agreements and commitments are appropriate and should be approved (Bouygues Annual Report 2009-257). During the period of our study, the rules about the definition and disclosure of RPTs evolved in a manner that should affect the behavior of auditors and companies. First, in 2005, the Act 2005-842 (July 26, 2005) requires companies to add to the list of abnormal transactions included in the special report all golden parachutes and supplementary retirement plans for managers. Second, in the same year, all French companies were obliged to adopt the IFRS standards. IAS 24 deals with the obligation for auditors to disclose all RPTs (both routine and abnormal) in the consolidated financial statement. This change clearly enhances the transparency of the disclosure environment in France. Even if the scope of RPTs is not the same in IAS 24 and the French regulation concerning the special report, there is an overlap that should formalize the auditors approach. This change in the di sclosure environment may have two effects. First, it extends the category of RPTs for auditors setting out the special report. Second, it should lead managers to class RPTs as abnormal more readily, because the price of a mistake is much less than if they wrongly class them as normal. In case of litigation, the manager will be blamed and the auditors reputation tainted if they class an abnormal transaction as a current one. Both these effects should increase the number of abnormal transactions disclosed in special reports, since the auditor no longer depends on the managers classification.
RPTs as an Expropriation Mechanism Since the seminal paper by Johnson et al. (2000), several studies have addressed the question of tunneling related to RPTs. The literature has concentrated on the nature of these transactions, their effect on firms performances and behaviors, and their determinants. For the first strand, Johnson et al. (2000) analyze the links between legal systems and the occurrence of RPTs, and find that courts in civil-law countries allow more tunnelling than courts in common-law countries. Using a questionnaire addressed to lawyers at an international law company, Djankov et al. (2008) construct anti-self-dealing indices for 72 countries, to measure how different countries deal with RPTs. Atanasov et al. (2008) provide a typology of RPTs, and their potential impact on firms. There is a consensus that outsiders usually perceive RPTs as an unfair mechanism used by significant shareholders and managers to manage earnings, and to hide the true financial conditions of the company (Henry et al. 2012). Beasley et al. (2001) point out that RPTs are among the top ten prevaricators. Several corporate scandals have been associated with such transactions. Using data from Hong Kong, Cheung et al. (2009) show that RPTs are associated with unfavorable prices, compared to similar arms length deals. Indeed, firms acquire assets from related parties at higher prices, and sell them to related parties at lower prices, than in similar arms length deals. This suggests that RPTs allow resources to be transferred away from minority shareholders, to significant shareholders and those officers who appear to benefit directly from these deals. Several studies show that the occurrence of RPTs lowers the valuation of public firms (Cheung et al. 2006; Kohlbeck and Mayhew 2010; Nekhili and Cheffi 2011). It is also argued that RPTs are generally associated with windowdressing. The case of the Italian company PARMALAT is an example of such manipulations (Enriques and Volpin 2007). The use of RPTs by major shareholders and managers was also detected to have been initiated for other purposes, like managing earnings (Chen et al. 2011) and reducing tax liabilities (Lo et al. 2010). A common question in the literature studying the determinants of RPTs is: which corporate governance mechanisms could decrease the propensity of officers and major shareholders to initiate RPTs? Lo et al. (2010) use data from Chinese firms to study the impact of governance structure on related-party transactions. They show that the presence of independent directors, and of financial experts on the audit committee, decreases the use of RPTs as a mechanism to manage earnings. Using international data for 22 countries, Dahya et al. (2008) examine the occurrence of RPTs, and show that having a higher proportion of independent directors is associated with a lower propensity to use such transactions. These results suggest that insiders
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use RPTs as a mechanism to divert corporate resources. However, these transactions may reduce the value of the firm and so may also affect the value of a major shareholders portfolio. If the gains from RPTs are less than the amount they detract from the value of the firm, major shareholders may prefer to signal to the market that they will refrain from diverting resources, and instead establish strong corporate governance standards, such as introducing independent directors, an independent audit committee and expert members on the audit committee. Nowadays, the detection and disclosure of RPTs accounts for a large part of the auditing of financial statements (Beasley et al. 2001; Gordon et al. 2007). Louwers et al. (2008) suggest that the non-detection of RPTs is not the result of deficiencies in auditing standards but more a question of skepticism (professional skepticism and due professional care). Thus, the quality of auditors may be seen as a mechanism that increases the efficiency of the detection and the reporting of RPTs. The compulsory adoption of IAS 24 allows the enhancement of the disclosure requirements about RPTs (Enriques and Volpin 2007; McCahery and Vermeulen 2006). With the new regulation, the external audit process is considered a natural solution to monitor the occurrence and reporting of RPTs (Gordon et al. 2006). Audit Reputation and Audit Quality Many studies argue that a Big auditors opinion is a more effective label of quality than that of a second-tier firm (non-Big). This link between audit firm size and audit quality is generally related to two distinct hypotheses. The first hypothesis, the so-called deep pocket/insurance hypothesis, links audit quality to the insurance coverage offered by the auditors in case of litigation (Simunic 1980; Dye 1993). Wealthier audit firms have incentives to be diligent, as their greater wealth may result in a riskier lawsuit. The second hypothesis, the reputation hypothesis, holds that audit firms provide high quality because they then earn substantial quasi-rents that discourage them from the temptation to cheat by lowering quality (De Angelo 1981; Watkins et al. 2004). As argued by Dellarocas (2006-633), The primary objective of reputation mechanisms is to enable efficient transactions in communities where cooperation is compromised by postcontractual opportunism (moral hazard) or information asymmetries (adverse selection). In an audit market characterized by information asymmetries about the quality of firms, the literature studying the quality bias related to reputation focused mainly on three indirect measures: audit fees, initial public offering (IPO) underpricing and the reactions to failures of audit firms. Studies using audit fees generally endeavor to show the existence of an audit fee
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premium for Big N firms, reflecting a high audit quality (see, for example, Ireland and Lennox 2002). The impact of external audit quality during IPO has been extensively studied, in an environment featuring a high degree of asymmetric information. Empirically, mixed results were found regarding the link between the riskiness of IPO firms and the quality of their auditors (Firth and Smith 1995). Managers choice of external auditors reflects their understanding of the importance of their choice for their firms value. Bart on (2005) tests if the timing of client defections and the choice of a new auditor are consistent with managers incentives to mitigate costly agency problems. By analyzing the defection timing of firms after the collapse of Arthur Andersen, he finds that firms with higher visibility in financial markets, i.e. with higher coverage by press and analysts, defected sooner and hired highly reputable auditors. Using the same Enron-related defection case, Krishnamurthy et al. (2006) study the significance of auditors reputation by examining how the stock prices of former Andersen clients reacted to the replacement of their external auditor after its failure. They find a negative relationship between the new external auditors quality and firms returns, and argue that this was mainly linked to reputational concerns. In Japan, a low-litigation country in which the insurance hypothesis does not matter, Numata and Takeda (2010) test the impact of the loss of an auditors reputation, and find that the announcements of poor audit quality by ChuoAoyama (affiliated to PwC) have significantly decreased the stock prices of its clients. All these results underline how important it is for firms to build and preserve their own reputation for credible financial reporting. The auditors choice and acceptance of an audit mission follows a double -selection process that is driven by strategic considerations. Managers choose their external auditors in order to signal the quality of their reported results to the market, and to mitigate information asymmetries. On the other hand, auditors exercise a disciplinary role over managers (Francis and Wang 2008), and they may constrain the managements choice of accounting procedures. The effectiveness of this mission depends on the audit quality (Becker et al. 1998; Francis et al. 1999; Krishnan 2003). In the French context, Piot and Janin (2007) find that the presence of a Big auditor does not affect the magnitude of abnormal earnings. They argue that auditors in France are less exposed to auditing: the deep pocket hypothesis. This suggests that the insurance hypothesis is less likely because the auditors third -party liability is limited, compared to the U.S. legal system. In this context, reputation becomes the only disciplinary mechanism that guarantees the quality of the external audit report. As for RPTs, their negative impact on firm valuation underlines the importance of their treatment by auditors. The main question in this paper is: How should audit quality affect the
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frequency of RPTs? The answer is not straightforward and must surely depend on audit market features as well as on the regulatory environment. In a relatively opaque environment regarding the reporting of RPTs, and in a low-litigation jurisdiction, we argue that highquality audit firms would report fewer RPTs. This would be because they accept audit missions only from clients using RPTs less heavily or because they constrain managers to use or report fewer RPTs. Since managers are aware of the negative impact of RPTs on their firms value and of the positive signals sent by hiring audit firms with high reputation, they would prefer to hire these auditors. Following the existing literature, we proxy reputation and quality by membership of Big 4 audit firms. Our first hypothesis is: Hypothesis 1: Hiring a Big 4 firm as an external auditor decreases the frequency of RPTs. The French context is characterised by joint auditing. In France, all publicly listed firms consolidated financial statements are jointly signed by two independent auditors. Joint audits may be associated with an increase in the quality of the audit, and may be an efficient way of detecting accounting malpractices. Francis et al. (2009) find that companies with one or two Big auditors are less likely to have income-increasing abnormal accruals than other firms. Furthermore, if two Big auditors certify the financial statements, then firms are even less likely to have income-increasing accruals, compared to firms audited by only one Big auditor. In line with these results, we argue that the presence of two Big 4 auditors will even decrease the frequency of RPTs, compared to the case where only one Big 4 auditor is hired. Hypothesis 2: Firms hiring two Big 4 auditors report fewer RPTs than firms with only one Big 4 auditor. The relationship between audit quality and the occurrence of RPTs depends on the structure of the regulation about reporting RPTs. We argue that audit quality decreases the frequency of RPTs only if the legal environment is characterized by poor transparency, so that the signalling effect of reporting fewer RPTs stands out and is therefore more valuable for both firms and auditors. During our study period, the regulatory environment became more transparent in relation to the reporting of RPTs, thanks to the adoption of the IFRS standards and more particularly the IAS 24 standard for public firms on the reporting of RPTs. This change in the legal environment allows us to test the following hypothesis: Hypothesis 3: The effect of hiring one or two Big 4 auditors on the frequency of RPTs was more important before the adoption of the IAS 24 standard.
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We test these hypotheses by controlling for the effect of selecting various audit firms. Technically this should help to distinguish the criteria for selecting external auditors from the impact of the auditors reputation on the frequency of RPTs.
Created in 1993, this index contains the 120 largest companies in the French market.
For our data collection strategy, we follow companies in the SBF120 at the beginning of 2002 over the whole period. We do not consider the variations in the composition of the index during the sample period. Data about RPTs for some yearcompanies were inconsistent and missing.
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routine transactions. However, for transactions with subsidiaries and firms affiliated to the company, the 2003 FSL (Financial Security Law) requires that only non-routine transactions with conditions different from normal market conditio ns should be disclosed in the special report. This reduces the number of RPTs, and also the quality of the information disclosed in the special report. Finally, it is important to mention that special reports do not have a predefined format, and transactions are not necessarily presented in a comprehensive way. This makes the information collection process tedious, and means we have to go through the whole report to collect all existing information. Related-party Transaction Classification In our analysis, we explore different types of transactions deemed to be abnormal RPTs. Generally these transactions, which include non-routine transactions and some compensation schemes for managers, lead to a wealth transfer between the firms shareholders and the beneficiaries of the transactions. Such a transfer can profit the managers, the directors or the large shareholders.11 However, some of these RPTs are not necessarily intended to expropriate minority shareholders. Indeed, they can be seen as a way to remunerate managers, to help a subsidiary financially and operationally or, more generally, as a strategic move aimed at profiting the firm and its shareholders (Kohlbeck and Mayhew 2010). To control for this diversity, we classify related-party transactions into different categories. We define two levels of classification. On the first level we base the classification on the time persistence of the transactions. Here we divide our sample of transactions into two classes. The first class contains renewed transactions, i.e. those announced the year before (RRPT hereafter). The second class contains only newly announced transactions (NRPT hereafter). We argue that transactions of the second type would be less desirable to the market because they may signal a higher degree of permissiveness on the part of the auditors. On the second level, we base our classification on the identity of the counter-parties to the transaction. This allows us to see the importance of different types of RPTs from the point of view of the auditor. We distinguish between transactions executed with the subsidiaries or the affiliated firms (TSAF hereafter), and those with all other related parties, i.e., the managers, the directors and the significant shareholders (TMDS hereafter). These latter transactions include those most likely to sensitize the markets to potential misbehavior, capable of diverting the companys cash flow or assets to the profit of related parties. However, it is
11
As mentioned above, the legal threshold defining large shareholders increased from 5% to 10% in the 2003 FSL. Since this change occurs within our sample period, we controlled for the total number of RPTs each year. This change does not significantly affect the frequency of reported RPTs.
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difficult to detect whether the former (TSAF) transactions are intended to expropriate minority shareholders, or are initiated for strategic reasons. Furthermore, we would expect the TSAFs to be more easily detectable by the auditors (in particular after the application of the IAS 24 rule) than the TMDS transactions. Details about the transactions are generally not available from the special reports published by auditors. In particular the amounts published do not generally refer to individual transactions. In our analysis we consider the number of RPTs announced in the special report. Gordon et al. (2006) find that better results can be achieved using the number of transactions rather than their amounts. They argue that the mere existence of these transactions affects the value of the firm, since financial markets react to their existence. The alternative is to consider a dummy variable that signals companies announcing RPTs, as in Cheung et al. (2006 and 2009). In our analysis, this variable would not capture our idea, since our objective is to focus on the importance of the signal that some classes of RPTs transmit concerning the quality of the audit process. Also, since we distinguish different categories of RPTs, the significant variations between categories in the number of transactions may be better explained by using the number of these transactions, rather than their mere existence. A second alternative is to consider the total value of transactions. Apart from the impossibility of having this information for all transactions in our sample, we argue that the value of transactions varied widely within our specified classes. This would create a bias for some classes, and also deviate from the purpose of our analysis, which is the study of the audit process of RPTs, independently of their values.12 Finally, using the value of a transaction may have no significance. Assume a transaction by a firm which is a purchase from an affiliated company. The potential loss related to this transaction will be difficult to detect, since we need to know the normal market conditions for this transaction. In this case the use of the number of transactions seems a better alternative. Note also that our classification of RPTs departs from the one used in Cheung et al. (2006). In that paper, the authors define RPTs in three categories: those that are a priori likely to result in expropriation, those that are likely to benefit the listed firms minority shareholders, and those that could have strategic rationales and perhaps are not intended to expropriate minority shareholders. This classification is mainly based on the type of each transaction (asset sales, asset acquisitions, cash receipts, etc). However, in our case the transaction classification is based on the identity of the counterparty in each transaction. This choice is
12
Note also that, in French legislation, RPTs are not restricted to transactions with a minimum amount.
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motivated by two main reasons. First, since we are not using the values of transactions, we consider that markets pay more attention to the identity of the counterparty involved in the transaction than to its category. Second, our sample already contains some transactions initiated at conditions different from normal market conditions. These are mainly transactions with firms affiliated to the company. This makes our classification more in line with the French definition of RPTs. Ownership Structure French companies are generally widely held (Faccio and Lang 2002; La Porta et al. 1999), which increases the likelihood of minority shareholders expropriation. Furthermore, there is in general a difference between ownership structure (cash-flow rights) and voting rights structure, and this may minimize the expropriation costs, as suggested by Fama and Jensen (1983). Faccio and Lang (2002) find a large difference between ownership and voting rights percentages for majority shareholders in French firms. As this difference increases, expropriation costs decrease and the number of RPTs increases (Claessens et al. 2006). In our analysis we consider the voting rights (VOTE) in order to estimate the occurrence of RPTs, and also a variable capturing the existence of a difference between cash-flow rights and voting rights. To measure these variables, we construct the ultimate control and ownership structure, using the methodologies suggested by Faccio and Lang (2002). This latter variable is measured by the ratio of the voting rights over the cash-flow rights of the significant shareholder (SEP), following Boubaker and Labgorre (2008). The difference between control and cash-flow rights is considered to provide information on the ability and incentives of significant shareholders to expropriate the firms resources (Claessens et al. 2002; Laeven and Levine 2008). If we find more than one significant shareholder, we calculate this variable for the shareholder with the highest proportion of voting rights. Corporate Governance Variables Empirical studies show that several corporate governance variables affect the occurrence and frequency of RPTs. The size of the governance board may increase the occurrence of RPTs, because of the higher probability of collusion (Gordon et al. 2006). Dahya et al. (2008) focus on the independence of the board of directors. Directors in our analysis are considered independent if they have no business or personal relationship with the managers or the main shareholders of the company. This classification casts into sharper focus the finding that where the board of directors is largely independent, the firm uses fewer RPTs (Gordon et al. 2006; Cheung et al. 2006).
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The audit committee plays an important role in the prevention of RPTs, since it facilitates the monitoring of information disclosure. As suggested in Klein (2002), the audit committee intermediates between the auditors and the managers. It is also intended to enhance the quality of the audit process. In the French case, several studies find a positive correlation between the independence of the audit committee and the probability of hiring a Big auditor (e.g., Francis et al. 2009). As discussed above, this is supposed to deliver a better audit report. The independence of the audit committee should reduce the number of RPTs (Cheung et al. 2009). This is either a direct effect, or due to auditors preventing the transactions. Note however that the impact of the audit committee is only post-transaction, i.e., when the transaction is already completed, contrary to the role of the governance board, which is pre-transaction. We consider the independence of the audit committee as a variable affecting RPT occurrence because, for our sample period, French law did not require the existence or independence of an audit committee (under the 2001 NER and the 2003 FSL and 2005 Act). Only in June 2008 did the European legislator oblige firms to have an audit committee with several constraints on its composition. Other Variables The existing literature proposes several other variables that may affect the occurrence of RPTs. First, cross-listing on the U.S. markets for firms originating from countries with less stringent rules about information diffusion is considered a way to enhance the quality of the published information, and so to help protect minority shareholders. Clark et al. (2007) and Klapper and Love (2004) find that foreign firms cross-listed in U.S. markets rank higher in terms of the quality of their published information. RPTs may also represent a potential additional cost for cross-listed firms, because of the possibility of being pursued legally by U.S. minority shareholders. As a matter of fact, we should expect cross-listing in U.S. markets would reduce the number of RPTs. We control for firms cross-listed in one of the U.S. stock markets by considering both direct listings and American Depository Receipt (ADR) issuances. This information is collected from the Bank of New York and JP Morgan ADR/cross-listing databases. Secondly, debt, especially bank debt, is considered a way of monitoring managers. Therefore we can argue that the existence of debt should allow for a decrease in RPTs, as suggested by Gordon et al. (2006). However, McConnell and Servaes (1995) argue that debt may be associated with minority expropriation behavior. Faccio et al. (2003) find that debt
17
contracted by controlled firms may work to the advantage of significant shareholders. In our study, we control for the impact of debt ratio on the number of RPTs. Finally, we use other control variables that are considered to affect the number of RPTs or the choice of auditors, or both. Such variables are the book-to-market ratio, the return on assets (ROA) and the intensity of investment in R&D (R&D). An increase in firms financial, economic or commercial performances can affect the decisions of directors when they choose auditors and when they initiate RPTs. R&D investment intensity is a proxy for the level of asymmetric information and potential conflicts of interest between managers and shareholders, as suggested in Francis et al. (2009). The size of the firm, measured by its market capitalization, increases the visibility of the firm and its coverage by financial analysts, which should enhance the quality of the information available to shareholders, and consequently affect the number of RPTs (Cheung et al. 2006). Firm size is also thought to affect the choice of auditors, since bigger auditors are generally associated with higher audit fees, and also because of reputational effects, as discussed above. We also consider the dividend yield as a control variable. As La Porta et al. (2000) suggest, dividend yield is positively correlated with the protection of minority shareholders, and so may affect the occurrence of RPTs. We also control in our model for the adoption of the IAS 24 rules, which are considered important in enhancing the quality of the reported information about RPTs. We introduce dummy variables equal to 1 for data after the application of this rule (2005). We also introduce a dummy variable equal to 1 for when the IFRS standards became mandatory in 2004. Table 1 defines the different variables used, and the way they are measured. [Please insert Table 1 here]
DESCRIPTIVE STATISTICS
Our sample contains 2,257 transactions that auditors have deemed RPTs in 562 published special reports. The number of RPTs in these reports lies between 0 and 25, with an average of 3.97 transactions per report. Table 2 displays the distribution of reported transactions by their occurrence in special reports. For our sample period, 84.88% of the special reports contain at least one RPT, with 6.94% containing more than ten transactions. Among the 2,257 transactions, 1,035 were new deals, while 1,222 were renewed transactions. Using the other classification levels, 1,344 of the reported transactions were made with subsidiaries or affiliated firms, while 913 were conducted with significant shareholders, managers and directors, or with firms affiliated to them.
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[Please insert Table 2 here] Table 3 summarizes the descriptive statistics of our sample by analyzing the relationship between the quality of auditors and the number of RPTs. More specifically, we consider the number of Big auditors as a discrimination variable. We can see that less than 10% (33/562) of firm-years in our sample have no Big auditors, 44.13% have two Big auditors and 50% have only one Big auditor. [Please insert Table 3 here] As for the distribution of RPTs, Table 3 displays the results of tests for differences of means. We can see that firms audited by two Big auditors are those with the lowest number of RPTs. This result occurs also for NRPT and TSAF. The presence of at least one Big does not necessarily decrease the number of RPTs. These results should be considered with caution since the number of year-firms having non-Big auditors is relatively low (only 33), compared to those having two Big or only one Big. The results related to the first classification level suggest Big auditors are more efficient in preventing NRPTs but not necessarily RRPTs. This may, however, reflect some doubleselection phenomena. Indeed, firms with fewer propensities to initiate new RPTs hire Big auditors, and Big auditors prefer to audit only those firms. For the second classification level, we see 913 transactions with significant shareholders, directors and managers or firms affiliated to them (TMDS), with a maximum of 16 transactions for a single special report. The largest number of transactions made with subsidiaries and affiliated companies (TSAF) is 25. The presence of two Big auditors decreases significantly the number of TSAF but not the number of TMDS. For the other variables, Table 4 and Table 5 present descriptive statistics for the different variables we use by making distinctions based on the number of Big auditors. Table 4 displays the statistics for continuous variables, and Table 5 presents the proportion statistics for dummy variables. Table 4 shows that the degree of independence of the audit committees in our sample is relatively low, with an average 62.02% of independent members per committee. The principal shareholder controls an average of 36.94% of voting rights, and the ratio of voting rights to cash-flow rights for these significant shareholders is on average equal to 1.161. Firms in our sample are also characterized by a board of directors composed of 11 members on average, with only 47.78% of members being independent. They are also characterized by: an average
19
dividend yield (DIV) equal to 2.71, a rate of return (ROA) of 3.59% and a market-to-book ratio (MTB) equal to 2.079. Finally, firms have a high debt ratio, with an average ratio equal to 22.79%. Tests for differences of means show that firms audited by two Big auditors have larger boards that are slightly more independent (50.18% against 48.23%), and are characterized by a larger degree of independence of their audit committees (69.29% against 61.04%). They also invest more intensively in R&D. Note that the size effect should be considered cautiously here, since it can be correlated with other variables. There are no significant differences for the other variables. [Please insert Table 4 here] Table 5 reports the frequencies of binary variables included in our model. We can see that 84.70% of year-firms in our sample have an audit committee. Analyzing these observations based on the number of Big auditors shows that year-firms with an audit committee do not necessarily hire more or fewer Big auditors. However, year-firms without an audit committee are less likely to hire two Big auditors. This is consistent with data about the independence of the audit committee, and suggests lower governance standards for these year-firms. Finally, 29.18% of year-firms in our sample are cross-listed in the U.S. markets. Year-firms with two Big auditors are more likely than others to be cross-listed. IFRS and IAS 24 do not significantly discriminate between one Big and two Big, showing that the use of Big auditors was not affected by the adoption of these standards. [Please insert Table 5 here] However, as for the behavior of auditors in reporting RPTs after the adoption of these rules, Figure 1 shows that the higher transparency standards associated with these rules (in particular the one related to the reporting of RPTs IAS 24) increased the number of reported RPTs. This increase mainly reflects higher numbers of TMDS. [Please insert Figure 1 here] Finally, to consider potential multi-colinearity problems, we test the Pearson correlations between different variables. Table 6 in the Appendix displays the matrix correlation of independent variables. We consider that a correlation is significantly high if it is above a critical threshold equal to 0.6. As expected, the IFRS variable is highly correlated with IAS 24. Also, there is a large correlation between the presence of an audit committee (AUDC) and
20
its degree of independence (INDCAUD). To avoid problems of endogeneity, the independent variables correlated with one another will not be introduced simultaneously in the same equation. The VIF values were also computed to check the existence of this problem. They range between 1.07 and 2.95, far below the critical value of 10.
MULTIVARIATE ANALYSIS
We argue that the existence of two Big auditors decreases the occurrence of abnormal RPTs. This is because Big auditors, compared to second-tier auditors, will take into account the negative signal of permissiveness they will convey by reporting RPTs. Their international activities and the potential scandals related to RPTs would therefore motivate them to discourage firms from initiating RPTs. On the other hand, firms also prefer dealing with Big auditors in order to signal the quality of their governance process (Newman et al. 2005). To test our hypothesis, we develop a Heckman two-step model. We chose this methodology because of an endogeneity problem in the relationship between the variables Big and RPT. Since the choice of auditors by firms is not random, in the first step we consider a selection model in which we set the determinants of firms choice between one Big (1BIG) or two Big (2BIG) auditors. Ireland and Lennox (2002) show that the auditors selection bias is important and may create significant distortions. Indeed, firms select their auditors according to their needs, sizes and characteristics. So, the decision to select (or not) one or two Big auditors may affect the decision to limit or proliferate abnormal RPTs. There is therefore a risk of co-determination, and an endogeneity between the choice of auditor and the frequency of abnormal RPTs. We control for this risk by using the two-step Heckman methodology (Heckman 1979). In the first step, we run an ordinal probit model in order to explain the choice of zero, one or two Big auditors by firms. Consistent with the literature on the determinants of auditors choice, the explanatory variables we use are related to the board of directors, the ownership structure and other control variables. Related to the board of directors composition, we consider the size of the board (Carcello et al. 2002; Lennox 2005; Goodwin-Stewart and Kent 2006) and the independence of its members (Abbott and Parker 2000; OSullivan 2000; Carcello et al. 2002).13 For ownership structure, like Fan and Wong (2005) we use the voting
13
We do not consider the existence of an audit committee in our model for two reasons. First, using French data, Francis et al. (2009) find that the existence of an audit committee and the selection of a Big auditor are not significantly related. Second, from Table 6 we can see that the variables AUDC and INDAUDC are highly correlated and consequently we should use only one of them. Running the same model by substituting AUDC for INDAUDC confirms the result of Francis et al. (2009) on the independence between the existence of an audit committee and the selection of Big auditors.
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rights of significant shareholders and the degree of separation between ownership and control. As control variables, we consider the indebtedness of firms (Pittman and Fortin 2004; Piot 2005; Francis et al. 2009), cross-listing in U.S. markets (Francis et al. 2003), the variable related to the adoption of the IFRS standards, and other variables of performance and firm characteristics as presented in the following equation: BIG = 0 + 00 + 1 VOTE + 2 SEP + 3 BOARDSIZE + 4 INDBOARD + 5 INDAUDC + 6 CROSS + 7 DEBT + 8 MTB + 9 ROA + 10 R&D + 11 SIZE + 12 IFRS+ The second step of our model is to explain the number of abnormal RPTs. This includes, besides the control variables, two binary variables explaining the choice of one Big auditor (1BIG) or two Big (2BIG) auditors, and the inverse Mills ratios ( Lambda1 and Lambda2) derived from the first equation of the model. These Mills ratios take into account the unobservable characteristics associated with the choice of the auditors. This may be, for example, the existence of informal transactions between the firm and the auditor, or between the auditors. This second equation can then adjust for the problem of self-selection of auditors, which challenges the endogeneity of the firms choice of auditors. If the coefficients for the inverse Mills ratios are significant, this signals an endogeneity of the auditor choice in the model. The fact that we have inter-temporal data for individual firms requires the use of panel data techniques to control for the fixed effect in error terms. The second equation in our model is: TPL = 0 + 1 1BIG + 2 2BIG + 3 VOTE + 4 SEP + 5 BOARDSIZE + 6 INDBOARD + 7 INDAUDC + 8 CROSS + 9 DEBT + 10 DIV + 11 SIZE + 12 Lambda1 + 13 Lambda2 + Our dependent variable is the number of abnormal RPTs, which is by definition nonnegative and contains only integer values. The econometric literature suggests using countdata regression instead of simple linear regression to avoid biased and inconsistent coefficients (Rock et al. 2000. Two alternative models are generally suggested: the negative binomial model and the Poisson model. To apply this latter model, we should first test the mean-variance assumption related to the Poisson distribution. The results of different tests
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reject the equality between the mean and the variance of the distribution of the variable RPT. This supports the use of the negative binomial model.14 Auditor Selection Table 7 presents the results of the model explaining the choice of external auditor. In the characteristics of ownership and control, the concentration of voting rights for the significant shareholder favors the selection of Big audit firms. This can be interpreted as a way to signal to minority shareholders the higher quality of the information transmitted, since Big auditors are associated with higher audit quality (Becker et al. 1998; Chang et al. 2009; Boone et al. 2010). This is consistent with the results of Fan and Wong (2005) for emerging markets. However, the degree of separation between cash-flow rights and voting rights does not influence the choice of external auditor. [Please insert Table 7 here] For corporate governance variables, all three variables (the size of the board, the independence of the board and the independence of the audit committee) significantly increase the probability of hiring Big audit firms. The impact of the size of the board is small (0.10) but significant at 1%. The impacts of the independence of the board and of the audit committee are both economically significant, with coefficients equal to 0.803 and 0.58 respectively. These results are consistent with OSullivan (2000) for British firms and with Abbott and Parker (2000) and Carcello et al. (2002) for U.S. firms. Assuming that hiring Big auditors is associated with higher audit quality, these results are also in line with the new requirements under different regulations to make the boards of directors and of the audit committee more independent. For the other variables, the intensity of investment in R&D affects the selection of Big auditors positively and significantly at 10%. Intensive investment in R&D is generally related to larger information asymmetries between the managers and the minority shareholders. The existence of a Big auditor would signal for these firms the higher quality of their accounting information. Another interpretation is that higher R&D investment is associated with more complex operations requiring more specialized auditors. Intensive R&D companies hire specialized auditors (Godfrey and Hamilton 2005) and specialized auditors are Big 4 (Ettredge et al. 2009). The debt ratio does not significantly affect the probability of hiring Big auditors, which is in line with previous findings in the French context (Piot 2005).
14
See Cameron and Trivedi (1990) and Boubaker and Labgorre (2008) (in a corporate governance analysis) for more details about the rationale behind the use of count data models.
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Consistent with the findings of Piot (2005) and Francis et al. (2009), CROSS does not affect the probability of hiring Big auditors for French firms. Contrary to the existing literature, the other variables considered (MTB, ROA and SIZE) do not affect significantly the probability of hiring Big auditors. This may be explained by the fact that the effect of some of these variables is already captured by other significant variables (for example the size of the board and the size of the firm). Finally, compliance with IFRS standards increases the probability of hiring Big auditors, which is consistent with the positive correlation between the two variables found by Hodgdon et al. (2009) for an international sample. Number of RPTs and Auditor Reputation The results of the first model determine the probability of choosing one or two Big auditors. Besides the interesting results discussed above, this model allows the calculation of the inverse Mills ratios (Lambda1 and Lambda2), which will be introduced in the second model. We run the model for the total number of RPTs and for the different classes of RPTs. The results of the second equation, using a negative binomial regression model, are displayed in Table 8. Note that the coefficients for Lambda1 and Lambda2 are not significantly different from zero for almost all models. This suggests that the endogeneity problem related to the choice of auditors has been corrected for. [Please insert Table 8 here] Table 8 shows that the appointment of Big auditors decreases the number of abnormal RPTs. This impact is, however, significant only for the case of two Big auditors. At first glance, this result argues that our reputation argument applies only in cases of two Big auditors. The appointment of only one Big auditor does not seem to correlate with a reduction in the number of abnormal RPTs. Two reasons explain this result. First, the way auditors share their audit mission under the French regulation on joint auditing leaves room for some strategic behavior by Big auditors, since they can always argue that the default is originated by their joint signatory, the second-tier auditor (Francis et al. 2009). Second, our sample period covers a major change of the required rules for reporting RPTs. Although we control for this change by including the variable IAS24 in our regression models, we should control for the cross effects of this variable since it appears to increase
the number of RPTs. We analyze the regressions using this cross effect in the next subsection. The other corporate governance variables in our models do not significantly affect the number of abnormal RPTs. This result suggests that the quality of external audit substitutes
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for the other governance mechanism, as for the impact on the number of RPTs. In the French context, with the particular procedure of reporting abnormal RPTs, the reputation of auditors seems to be a predominant criterion that affects the number of reported RPTs. As for the other variables, only DEBT, SIZE and IAS24 affect significantly the number of reported RPTs. The monitoring effect related to indebtedness does not seem to decrease RPTs. This is consistent with the finding of Faccio et al. (2003), who suggest that debt increases the potential to expropriate minority shareholders for companies with significant shareholders, which is the case for our sample. We also find that larger companies are associated with a larger number of abnormal RPTs, though the result is economically insignificant (0.048). Using the first classification level, Table 8 displays the results of the negative binomial model for new and renewed transactions (models 2 and 3). The results are qualitatively identical to those of model 1 with lower significance of 2BIG for RRPTs. Note that for NRPTs, Lambda 2 (model 2) is statistically significant, which raises questions about the relevance of the endogeneity problem of auditor selection. Counter-intuitively, VOTE reduces and CROSS increases the number of RRPTs. However, the independence of the board reduces the number of RRPTs, as suggested by Cheung et al. (2006). Table 8 (models 4 and 5) displays the results of the regression, using classification based on the identity of the counterparty in the transactions. The number of transactions with the directors, the managers and the significant shareholders is less affected by the quality of the auditors. The coefficient of two Big auditors associated with TMDS is not significant and the coefficient of one Big is weakly significant and positive. Besides this major difference from the results for the whole sample, some other variables turn out to be significant. Indeed, the variable VOTE positively and significantly increases the number of TMDS, while CROSS and DIV reduce it; which is, for these last two variables, in line with the literature (Klapper and Love 2004; La Porta et al. 2000). Furthermore, where audit quality is not used as a governance mechanism, the independence of the board of directors retrieves its role of reducing the number of these abnormal transactions. For transactions with subsidiaries and affiliated firms (TSAF), hiring one Big or two Big auditors significantly reduces the number of these transactions. Therefore, hiring Big auditors helps to decrease the number of those transactions that are perceived by financial markets as prejudicial to the minority shareholders of the firm. The marginal impact of hiring the second Big is about twice that of hiring the first Big auditor. As argued in the above results, a joint audit executed by one Big and one second-tier auditor does not necessarily affect the reputation of the Big auditor, since any potential error will be attributed to the less reputable
25
auditor. However, with two Big auditors, both auditors are concerned about their reputation, and so will endeavor to pay attention to the way RPTs could harm their reputation. The results applied to the second classification level can be related to the specific features of the auditing process. Compared to the TMDS, the TSAF are more easily detectable because the auditors deal with these transactions during the audit of consolidated financial statements, allowing them to give their opinion about these transactions. Also, TSAF are supposed to have larger values and consequently their occurrence should do more to reduce expropriation. To summarize, the variables related to ownership structure do not seem to affect the number of abnormal RPTs. Both the concentration of voting rights and the separation between cash flows and voting rights are very common features for large French companies, which reduces their importance as indicators of more persistent misbehavior aimed at expropriating minority shareholders. The impact of the corporate governance variables on the number of abnormal RPTs is marginal compared to the quality of the audit firm. Therefore, at least for the occurrence of RPTs, the quality of the audit firm seems to substitute for the usual corporate governance mechanisms required by regulation. Another striking result is related to the independence of the audit committee, which does not affect the number of RPTs. In our auditor selection mechanism we find, however, that the independence of the audit committee does play a significant role. This is in line with a suggestion in a survey published by Ernst & Young in 2007, which attributes the poor governance mechanisms of the audit committees in Europe to their involvement only in the pre-transaction process. In almost all models, the variable IAS 24 affects positively and significantly the number of different classes of abnormal RPTs. With the adoption of IAS 24, the reporting environment of RPTs became much more transparent, which should increase the number of reported RPTs. Also, the definition of abnormal RPTs was broadened by integrating the golden parachutes and remuneration packages granted to managers. These two changes are assumed to increase the frequency of disclosed RPTs. To properly control for this regulation evolution, we run our model in two sub-periods: before and after the adoption of the IAS 24 standard. The Impact of the Disclosure Environment Table 9 displays the results of the regression using a sub-sample of year-firms before the implementation of the standard IAS 24. Both 1BIG and 2BIG variables reduce significantly the occurrence of abnormal RPTs. This result occurs for all classes of transactions except for the TMDS, for which the coefficients are negative but not significant. In all cases, the existence of one Big auditor reduces the number of abnormal transactions, and hiring a second
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Big auditor will confirm the propensity to decrease these transactions. All the governance variables have no impact on the number of RPTs. This suggests the predominance of audit quality, rather than the other corporate governance variables, as a way of controlling relatedparty transactions. The coefficients of DEBT and SIZE variables are still positive and significant for all classes of RPTs. Therefore, in an environment that is less transparent but still stringent on the reporting of RPTs, the presence of Big auditors reduces the occurrence of these transactions. In the French legal system specifically, we argue that this effect is mainly driven by the need for Big auditors to preserve their reputational asset. For the other control variables, VOTE and SEP increase significantly only the number of TSAF, reflecting the important perception of these transactions as a way to expropriate minority shareholders. Cross-listing in U.S. markets increases the number of RRPTs and TSAFs, which is in line with the fact that Big auditors pay more attention to these transactions and make more effort to control for their occurrence. Finally, the dividend yield does not affect the total number of RPTs. However, using the first classification level, DIV increases significantly the number of RRPTs and decreases significantly the number of NRPTs. This suggests that managers use dividend distribution strategically, at least for renewed RPTs. However, an increase in dividends can lead to less expropriation as it can be used instead of initiating new RPTs to reward shareholders. From 2005, the reporting environment for RPTs changed in two ways. First, with the mandatory implementation of the standard IAS 24, the reporting of RPTs became more transparent, since managers are now required to list all RPTs (both normal and abnormal) and these should be certified by auditors in the consolidated financial statements. Second, a new act was adopted, requiring more transactions (in particular managers golden parachutes) to be included as abnormal transactions in the special report. This new environment allows auditors and outsiders to have access to all related-party transactions. With this increased transparency, auditors are able to discern the criteria used by managers and directors to qualify some of these transactions as abnormal; and the market is better informed about these transactions, which puts more pressure on auditors to control the way firms use the transactions. For this new environment (between 2005 and 2008), the results of the models for all classes of RPTs are displayed in Table 10. The Mills ratios (Lambda1 and Lambda2) are only significant for the NRPTs. We should interpret the results of this model with care. Also, before turning to the interpretation of the results, it is important to mention that very few year-firms in the sub-sample have no Big
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auditors. We should be careful in the analysis of the results related to the variable 1BIG. 15 The quality of auditors does not affect significantly the total number of RPTs. However, the independence of the members of the board of directors significantly decreases it. This suggests that the INDBOARD variable retrieves its role as a governance mechanism in this new environment characterized by greater transparency (resulting in a lesser role for auditors). The result for INDBOARD is stable for all classes of RPTs. More strikingly, our results confirm the weak role played by the independence of the audit committee, as discussed before. The coefficients for this variable (INDCAUD) are even significantly positive for some classes of RPTs. The presence of Big auditors reduces significantly only the number of RRPTs and of TSAFs. This confirms the importance of these transactions as methods of expropriation, and also their importance for Big auditors as a quality rating, particularly in the newer, more transparent environment. However, the presence of Big auditors increases significantly the number of TMDSs. This result may be explained by the new Act implemented in France and by the adoption of IAS 24. Indeed, the new Act categorizes new transactions as RPTs by nature. These transactions are related to the remuneration packages for managers which are in our TMDS class of RPTs. Managers of firms audited by Big auditors are more likely to get these remuneration packages, which explains the positive coefficient.
CONCLUSION
Using data from large French companies, our study shows the existence of a negative relationship between the presence of Big auditors and the number of reported abnormal RPTs. Interestingly, we find that the quality of auditors (with a proxy based on the distinction between Big and second-tier auditors) substitutes for the usual corporate governance tools to control for the occurrence of abnormal RPTs. Given the particular features of French regulation with respect to the reporting of related-party transactions, our result may be explained by the reputational cost for Big auditors when they report these transactions in their special reports. French law does not oblige auditors to make more efforts to detect and report these transactions. Misbehavior or reporting errors lead to a decrease in the auditing activities of audit firms. This negative impact is much more important in countries where minority shareholders are better protected. Big auditors pay more attention to reporting RPTs in countries perceived as less protective of minority shareholders as a way to preserve their
15
We run the same regressions by ignoring this variable, and the results remain qualitatively unchanged.
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reputation. The marginal impact of hiring a second Big auditor is more important, which confirms our argument about reputation. With only one Big auditor, the potential misreporting would be attributed to the presence of the non-Big auditor. We consider four classes of abnormal RPTs using two different dimensions of classification: time persistence and the identity of the counter-parties. For the first dimension, we distinguish new from renewed transactions. For the second dimension, we distinguish transactions with managers, directors and significant shareholders from transactions with subsidiaries and affiliated companies. The analysis of the occurrence of these different classes of RPTs shows that our results remain stable for all classes except for those executed with directors, the managers and significant shareholders. In this case, the corporate governance tools (in particular the independence of the board of directors) retrieve their role of controlling the occurrence of abnormal RPTs. This last result came about because of the time period of our analysis (2002 2008). During this period, a major change in the regulation concerning the reporting of RPTs was implemented. This change requires more transparency for the reporting of RPTs (adoption of the standard IAS 24) and a requirement to include remuneration packages for managers in the list of abnormal transactions. Our results are even more clear-cut during the period 2002 2004, during which the auditors needed to signal their quality by controlling the reporting of RPTs. Between 2005 and 2008, in a more transparent environment, the auditors no longer needed to try harder to signal their quality. Our results show indeed that for this period, corporate governance tools retrieve their role of reducing the use of abnormal RPTs and the role of Big auditors is less important or, for some classes, simply disappears. This suggests interaction between the regulatory environment and the behavior of both firms and auditors in the processes of using and reporting abnormal RPTs, other things being equal. We develop a Heckman two-step model. This procedure is intended to control for the endogenous nature of the choice of auditors. In the first step, we run a selection model in which we look for the determinants of choosing one Big (1BIG) or two Big (2BIG) auditors by firms. Firms select their auditors according to their needs, size and characteristics. Therefore, the decision to select (or not) one or two Big auditors may affect the decision to limit or proliferate RPTs. The results of this first equation are in line with the existing literature regarding the positive effect of the independence of the audit committee (Carcello et al. 2002), and the effect of the concentration of voting rights (Fan and Wong 2005). As for the occurrence of RPTs, considered as a method of expropriating minority shareholders, we show the negative impact of audit quality and the importance of the
29
regulation in this regard. We argue that this effect is channeled through a double-selection process between firms and auditors. How is this negative relationship set up? We can think of different ways to answer this question. First, it may be related to how auditors accept audit mandates. Indeed, Big auditors may study the practices of the firm on the use and reporting of RPTs and may actually accept the mandate on condition that these transactions are reduced. Second, it may be related to a Scope and Scale hypothesis. Indeed, with the ir international experience, Big auditors may qualify some transactions as normal (and so will not report them in the special report) while second-tier auditors would consider them as abnormal transactions. A third alternative would be the auditors slippery slope theory advanced by Corona and Randhawa (2010). If we assume that reputation is the sole motivation for auditors, a strategic manager can induce the auditor to misreport by reducing artificially the number of RPTs. Unfortunately, our data do not allow us to deal with this important question about the practices of auditors with respect to the reporting of RPTs. The relative effect of joint auditing by Big auditors on the number of announced RPTs should be considered with caution, for two reasons. First, in their special reports, auditors in France do not necessarily mention routine transactions between a firm and its subsidiaries that are considered normal. There is, moreover, no clear definition of the concepts of normal and routine operations. This enables managers and auditors to use open interpretations of these concepts. This in turn allows them to decide subjectively not to classify transactions as normal market conditions. It is not clear whether the concept of joint auditing tends to reduce this subjectivity, since both auditors, notably when they share the same peer group, may choose to select the same criteria to define routine transactions and normal market conditions. This, of course, creates a negative bias on the number of RPTs we consider in this paper. Second, auditors in France are not required to make further investigations to detect and highlight new transactions unless reported voluntarily by management. If, in their normal control, the auditors detect RPTs not revealed in a special report, they can only inform managers (or the board of directors) about this irregularity, without necessarily being obliged to publish another special report. This again creates a negative bias regarding the true number of RPTs realized by firms.
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Transactions with the managers, the directors or the significant shareholders or with firms linked to them TSAF Transactions with subsidiaries or affiliated firms Governance and shareholding variables VOTE Voting rights of the significant shareholder
Number of related-party transactions available in the special report provided by auditors Number of transactions that were renewed from the year before The number of new transactions with respect to the year before The number of transactions between the firm and its managers, directors or significant shareholders and their relatives The number of transactions between the firm and its subsidiaries or affiliated firms Percentage of voting rights detained by the principal shareholder (by considering the percentage detained in other subsidiaries in the case of holdings) Ratio of the voting rights over the cash-flow rights of the significant shareholder Number of directors Ratio of the number of non-executive independent directors to the size of the board of directors. Independence of directors is verified by looking for potential links between the director and managers or principal shareholders A dummy variable equal to 1 if an audit committee exists and 0 otherwise Ratio of the number of non-executive independent members of audit committee to the total number of the members of the audit committee. Independence of the members is defined as for all directors A dummy variable equal to 1 if the firm is listed in one of the U.S. markets (direct listing or through ADRs) and 0 otherwise Ratio of total financial debt to the total value of assets Ratio of market value to book value of equity Ratio of EBITDA to total value of equity Ratio of investments in R&D and total sales Ratio of dividends to share price Logarithm of the total value of equity A dummy variable equal to 1 one year before the compulsory adoption of the IFRS standards in 2005 and 0 otherwise. We consider such lagged codification because the majority of large French firms anticipated the new regulation and began applying the IFRS standards one year before its official implementation. A dummy variable equal to 1 after the adoption of the IAS 24 rule in 2005 and 0 otherwise
Separation between ownership and control Size of the board of directors Degree of independence of the board of directors
AUDC INDCAUD
CROSS
DEBT
Debt ratio
Other control variables MTB Market-to-book ROA Return on assets R&D Intensity of investment in R&D DIV Dividend yield SIZE Size of the firm IFRS Mandatory adoption of the IFRS standards by French public firms
IAS24
37
38
Variable Number of observations Mean RPT Stand-dev Minimum Maximum Frequency Mean NRPT Stand-dev Minimum Maximum Frequency Mean RRPT Stand-dev Minimum Maximum Frequency Mean TMDS Stand-dev Minimum Maximum Frequency Mean TSAF Stand-dev Minimum Maximum Frequency
Total sample 562 3.966 4.074 0 25 2257 1.818 2.544 0 22 1035 2.147 2.609 0 17 1222 1.604 2.193 0 16 913 2.362 3.306 0 25 1344
BIG=0 33 4.303 4.902 0 23 142 2.606 4.930 0 22 86 1.697 1.531 0 5 56 0.545 1.121 0 4 18 3.758 4.861 0 23 124
BIG=1 281 4.295 4.230 0 21 1237 2.038 2.612 0 16 587 2.257 2.541 0 14 650 1.681 2.474 0 16 484 2.615 3.355 0 15 753
BIG=2 248 3.540 3.734 0 25 878 1.460 1.883 0 11 362 2.081 2.794 0 17 516 1.657 1.907 0 9 411 1.883 2.906 0 25 467
1.055
2.541 ***
2.899 ***
- 1.239
- 0.733
0.765
- 2.602 ***
- 3.272 ***
0.121
1.759 *
3.170 ***
2.676 ***
39
Table 4: Descriptive statistics for continuous variables as functions of the audit quality
This table reports descriptive statistics for different continuous variables characterizing our sample containing 85 large French companies for the period between 2002 and 2008. These variables are displayed as a function of the number of Big auditors. Big auditors are KPMG, Ernst & Young, Deloitte and PricewaterhouseCoopers. BIG is the exact number of Big auditors for each year-firm. VOTE is the proportion of voting rights detained by the significant shareholder and SEP is the ratio of voting rights to cash-flow rights for the significant shareholder. BOARDSIZE is the number of members of the board of directors. INDBOARD is the proportion of independent directors on the board as defined by the French regulators. INDAUDC is the proportion of independent members on the audit committee. DEBT is the ratio of total debt to the total value of assets. MTB is the market-to-book ratio measured as market value to the book value of equity and ROA is the return over assets of the firm measured by the ratio of EBITDA to the total value of equity. R&D is the ratio of investments in R&D over total sales. DIV is the dividend payout ratio and SIZE is the total value of equity of the firm (in millions of euros). t-statistics are related to two-tailed equality of means tests. *, ** and *** indicate significance at 10%, 5% and 1% levels, respectively.
Variable Nb of observations Mean VOTE Stand-dev Minimum Maximum Mean SEP Stand-dev Minimum Maximum Mean BOARDSIZE Stand-dev Minimum Maximum Mean INDBOARD Stand-dev Minimum Maximum Mean INDAUDC Stand-dev Minimum Maximum Mean DEBT Stand-dev Minimum Maximum Mean MTB Stand-dev Minimum Maximum Mean ROA Stand-dev Minimum Maximum Mean R&D Stand-dev Minimum Maximum Mean DIV Stand-dev Minimum Maximum Mean SIZE Stand-dev Minimum Maximum
Total sample 562 0.3694 0.2650 0.0070 1.0000 1.1608 0.2658 0.3476 2.0099 11 3.7660 3 21 0.4778 0.2128 0.0000 1.0000 0.6202 0.3614 0.0000 1.0000 0.2279 0.1433 0.0000 0.6847 2.0789 1.4384 - 7.3112 12.9763 0.0359 0.0680 - 0.6057 0.4231 0.0267 0.0477 0.0000 0.2860 0.0271 0.0454 0.0000 0.5955 12.3655 4.2087 5.3517 21.5843
BIG=0 33 0.4432 0.2213 0.0048 0.8785 1.1370 0.2169 0.7107 1.4487 6.2813 3.4663 3 18 0.2505 0.6666 0.0000 0.8571 0.1438 0.3084 0.0000 1.0000 0.1942 0.1507 0.0031 0.4263 2.3057 1.5025 0.0010 6.8762 0.0554 0.0414 0.0001 0.1721 0.0117 0.0214 0.0000 0.0560 0.0202 0.0408 0.0000 0.2284 9.1012 3.3848 5.3517 14.983
BIG=1 281 0.3532 0.2660 0.0070 0.9825 1.1795 0.2793 0.3476 2.0099 10.7014 3.9298 3 21 0.4823 0.2143 0.0000 1.0000 0.6104 0.3557 0.0000 1.0000 0.2499 0.1432 0.0002 0.6847 1.9215 1.2362 -7.3112 6.7738 0.0284 0.0727 -0.6057 0.3065 0.0228 0.0390 0.0000 0.2381 0.0284 0.0502 0.0000 0.5947 12.286 4.3114 5.6855 21.584
BIG=2 248 0.3788 0.2680 0.0080 1.0000 1.1421 0.2546 0.6939 1.9067 11.9518 3.0370 4 21 0.5018 0.1856 0.0000 1.0000 0.6929 0.3259 0.0000 1.0000 0.2073 0.1390 0.0000 0.5666 2.2310 1.6199 0.0001 12.9763 0.0422 0.0642 - 0.2599 0.4231 0.0327 0.0577 0.0000 0.2860 0.0267 0.0402 0.0000 0.5655 12.8768 3.9977 6.7747 19.3224
- 0.833
- 0.108
1.607
- 6.103 ***
- 9.780 ***
- 4.077 ***
- 5.675 ***
- 6.820 ***
- 1.122
- 7.126 ***
- 9.026 ***
- 2.786 ***
2.161 ***
- 0.517
3.513 ***
1.607
0.244
- 2.498 ***
2.061 **
1.128
- 2.324 **
- 0.774
- 1.488
- 2.353 **
- 0.888
- 0.865
0.410
- 4.041 ***
- 5.110 ***
- 1.637
40
Table 5: Descriptive statistics for dummy variables as functions of the audit quality and tests of equality of proportions
This table reports descriptive statistics for different continuous variables characterizing our sample containing 85 large French companies for the period between 2002 and 2008. These variables are displayed as a function of the number of Big auditors. Big auditors are KPMG, Ernst & Young, Deloitte and PricewaterhouseCoopers. BIG is the exact number of Big auditors for each year-firm. AUDC is a dummy variable equal to 1 if the firm has an audit committee and 0 otherwise. CROSS identifies firms listed in U.S. stock markets directly or through ADRs. Proportions are in parentheses. IFRS is a dummy variable equalling 0 for the years 2002 to 2003 and 1 for the years 2004 to 2008. IAS24 is a dummy variable equalling 0 for the years 2002 to 2004 and 1 for the years 2005 to 2008. Chi- squares are related to two-tailed equality of proportions tests. *, ** and *** indicate significance at 10%, 5% and 1% levels, respectively.
Total sample 562 86 (15.30 %) 476 (84.70 %) 405 (72.06 %) 157 (27.94 %) 150 (26.69 %) 412 (73.31 %) 255 (45.37 %) 307 (54.63 %)
BIG=1 281 44 (7.83 %) 237 (42.17 %) 216 (38.43 %) 65 (15.57 %) 73 (12.99 %) 208 (37.01 %) 138 (22.56 %) 143 (25.44 %)
BIG=2 248 18 (3.20 %) 230 (40.93 %) 156 (27.76 %) 92 (16.37 %) 63 (11.21 %) 185 (32.92 %) 98 (17.44 %) 150 (26.69 %)
1 CROSS 0
1 IFRS 0
1 IAS24 0
41
42
43
Variables VOTE SEP BOARDSIZE INDBOARD INDAUDC DEBT CROSS MTB ROA R&D SIZE IFRS Constant 1 Constant 2 N Chi2 Prob > Chi2 Pseudo R2
Coefficient 0.480 ** 0.091 0.101 *** 0.803 *** 0.580 *** - 0.178 0.199 0.062 0.821 1.938 * 0.016 0.232 ** 0.815 * 2.938 *** 562 120.30 0.0000 12.62%
t-stat 2.22 0.44 6.24 2.75 3.42 - 0.48 1.52 1.60 1.25 1.80 1.26 2.01 1.93 6.96
44
45
46
47
Figure 1: The average number of RPTs per special report over the sample period 20022008 This figure displays the number of RPTs per special report over the period 2002 2008 for 85 French firms. RRPT is the average number of renewed RPTs. NRPT is the average number of new RPTs. TSAF is the average number of transactions with subsidiaries and affiliated firms. TMDS is the average number of transactions with the firms managers, directors and significant shareholders.
0 2002 2003 2004 RPT RRPT 2005 2006 NRPT TMDS 2007 2008
TSAF
48