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Family entrenchment and internal control: evidence from S&P 1500 firms

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Abstract

\We examine whether family owners exploit internal control weaknesses for entrenchment purposes and whether the public disclosure requirement under SOX 404 helps alleviate this entrenchment. We find supportive evidence for both questions. In the initial years of SOX 404 implementation (2004 and 2005), ineffective internal control in family CEO firms is more conducive to entrenchment – measured by the occurrence of misstatements, frauds, and related party transactions – than ineffective internal control in nonfamily firms is. With the public disclosure requirement of SOX 404 in place, family CEO firms are more likely to remediate internal control weaknesses, and the resulting improvement in internal control in family CEO firms has significantly reduced family entrenchment. Our findings provide new evidence on the dynamics of family entrenchment in the U.S. and shed light on a key benefit of public disclosure of internal control quality.

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Notes

  1. 1.

    Entrenchment activities extract private benefits for family owners at the expense of firm value and minority shareholders (e.g., Anderson et al. 2009).

  2. 2.

    Please see Section 2.3 for more detailed discussions on how effective internal control can reduce family entrenchment.

  3. 3.

    For example, Chen et al. (2013) find that family owners’ power and control help protect poorly performing family CEOs from being fired.

  4. 4.

    While nonfamily firms also have incentives to remediate internal control problems once the problems are revealed (e.g., Li et al. 2010), family owners likely have stronger incentives to correct internal control problems, since family owners directly bear the cost of price protection by minority shareholders.

  5. 5.

    Accelerated filers are first required to file Section 404 internal control reports for the fiscal year ending on or after November 15, 2004. Thus, the first internal control disclosure year is either 2004 or 2005, depending on companies’ fiscal year end month.

  6. 6.

    These statistics are comparable to studies that also use S&P 1500 firms (e.g., Chen et al. 2008, 2013). The percentage of family firms is higher than in studies that examine only S&P 500 or Fortune 500 firms (e.g., Ali et al. 2007; Wang 2006) because the proportion of family firms is greater among S&P 400 firms and S&P 600 firms than among S&P 500 firms.

  7. 7.

    Compared to other shareholders with concentrated holdings (such as institutional investors), founding families are likely more influential within the firm because they are represented on boards of directors and usually hold top management positions (Anderson and Reeb 2003). Their influence is further enhanced because family owners are closely tied to the firm through their long-term investment and less diversified portfolios.

  8. 8.

    A material weakness exists if it is “reasonably possible that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis” (PCAOB 2007, p. 434).

  9. 9.

    Employees who assist in entrenchment and violate internal control bear the costs related to any wrongdoings, potentially losing their jobs, harming their reputations, and even suffering legal consequences.

  10. 10.

    For example, for WorldCom, the whistleblower Cynthia Cooper, VP of internal audit, and her team brought the wrongdoings of the company’s founder and CEO to light. The team decided to investigate the anomalies in the company’s accounting. They met behind closed doors for many hours, gathered evidence, and worked their way up the chain of command. This example suggests that whistle-blowing is possible even in cases of powerful family CEOs.

  11. 11.

    Our discussions related to auditors are based on interviews with three audit partners from two Big 4 audit firms and one large national non-Big 4 audit firm.

  12. 12.

    Prior studies have shown that the PCAOB’s inspection and potential sanctions provide audit firms with strong incentives to improve audit quality, including the quality of the internal control audit (Abbott et al. 2013; Nagy 2014; DeFond and Lennox 2017). Litigation and reputation concerns further ensure that auditors follow professional standards and maintain objectivity when assessing companies’ internal control quality.

  13. 13.

    As discussed earlier, internal control procedures and mechanisms are the safeguards that limit improper transactions and reporting on an ongoing basis. In contrast, directors are not directly involved in day-to-day operations of the company and thus may not be able to monitor managers closely.

  14. 14.

    There are several well-known cases where family owners took advantage of poor internal control to entrench. John Rigas, the founder and CEO of Adelphia Corp., together with other family members, misappropriated company funds for purchases of personal properties; these inappropriate transactions were not approved, checked, or recorded. Hollinger Inc. made unjustified business payments to entities controlled by Conrad Black, its founder and CEO; these payments to related entities were not properly approved and recorded. Calisto Tanzi, the founder and CEO of the Italian food corporation Parmalat, was convicted of fraud for activities that included reporting nonexistent bank accounts. There were egregious failings of internal control in this case; for instance, cash reporting was not checked or reviewed by different employees. Other examples of family members engaging in aggressive earnings management when there was weak internal control include AIG (recorded sham transactions and hid control of subsidiaries to avoid consolidation), NCO Group (engaged in aggressive revenue recognition), and OM Group (used fraudulent entries to manage earnings and meet targets).

  15. 15.

    Family members’ strong influence arises from a combination of factors, including concentrated holdings, top executive and director positions, long involvement with the firm, and superior voting rights (Anderson et al. 2009).

  16. 16.

    One can argue that family control power may be influenced by family entrenchment; more entrenched families may have more members involved as managers or directors. Under this argument, our prediction still holds. When interpreting the results, one should keep in mind that family control power can be a manifestation of family entrenchment, instead of a determinant of family entrenchment.

  17. 17.

    Before firms publicly disclose the internal control effectiveness, investors likely also price protect themselves. However, without public disclosure, it is difficult for investors to distinguish between family firms with and without effective internal control, and hence the price protection is shared by all family firms. Even if family firms with effective internal control want to communicate their internal control effectiveness to investors before the disclosure requirement, they may not be able to do so credibly, because doing so can be very costly, because there are no protocols to follow, and because auditors may be reluctant to provide a full internal control certification given the potential litigation risk. The disclosure requirement thus helps move a pooling equilibrium to a separating equilibrium.

  18. 18.

    Examining the change in internal control quality and the potential reduction of family entrenchment after the public disclosure of internal control quality also sheds light on the interplay between internal and external monitoring mechanisms. Rather than work independently, internal and external monitoring mechanisms can work jointly and complement each other to reduce family entrenchment. External parties such as minority shareholders cannot closely monitor the daily operation of family firms. However, once internal control quality is publicly disclosed, external monitors can pressure family owners to implement effective internal control for the purpose of curbing family entrenchment.

  19. 19.

    For example, in order to establish an internal control system, evaluate its effectiveness, and remediate the weakness in the system, firms would have needed to hire more internal auditors around 2003. However, Harrington (2004) observes that the limited labor supply made it challenging to secure new internal audit hires during that period, which could have significantly delayed the remediation process. Consistent with internal control problems taking time to be remediated, prior studies find that many ICMWs existed for several years prior to their initial disclosure (Doyle et al. 2007; Hogan and Wilkins 2008).

  20. 20.

    Following Chen et al. (2008), we also use “an alternative definition of family firms—firms where the members of the founding family have an equity ownership of 5% or higher (page 507).” We find results similar to theirs.

  21. 21.

    We only have related party transaction data in 2004. We thank Mark Kohlbeck and Brian Mayhew for sharing their related party transaction data with us.

  22. 22.

    As presented in Table 1, family CEO firms are more likely to have ICMWs than nonfamily firms in 2004 and 2005 (13.3% vs. 8.9%). In 2006, however, the incidence of ICMWs decreases significantly, and the difference between family CEO firms and nonfamily firms is no longer significant (5.8% vs. 4.2%).

  23. 23.

    We follow Johnstone et al. (2011) to categorize general vs. specific ICMWs. Johnstone et al. (2011) find that general ICMWs (those having pervasive effects on financial reporting) are more difficult to remediate than specific ICMWs (those at the account or transaction level).

  24. 24.

    In contrast to the results in Table 2 and Table 3, the coefficient on FamilyCEO × Specific ICMW in Table 4 is significantly positive, while the coefficient on FamilyCEO × General ICMW is not. This suggests that, for family CEO firms, specific material weaknesses rather than general material weaknesses are associated with more related party transactions. One possible explanation is that related party transactions are of many different types, including loans, borrowings, guarantees, consulting arrangements, legal or investment services, leases, business activities, overhead reimbursements, and stock transactions. (Kohlbeck and Mayhew 2010, 2017). Some of these transactions can be facilitated by material weaknesses of particular procedures and controls (i.e., specific material weaknesses), rather than by material weaknesses at the company level (i.e., general material weaknesses).

  25. 25.

    To ensure the robustness of the results, we also employ propensity score matching. Specifically, following Anderson and Reeb (2003), we use the natural log of total assets, the square of the natural log of total assets, and monthly stock return volatility to estimate the tendency for the firm to be a family firm. We then match a family firm with a nonfamily firm based on the closest propensity score (within a distance of 0.03, with replacement matching). We are able to match 997 (347) observations from family firms with nonfamily firms, leading to 1994 (694) observations in our matched sample for misstatement and fraud (related party transaction) analyses. The results (untabulated) are similar to our main results, though slightly weaker, possibly due to reduced power.

  26. 26.

    When family owners are influential, they may select their friends and business associates as board members. Because we do not have data on the connection between family owners and other board members, we measure family power using the number of family members on the board. We acknowledge that this measure of family power is subject to measurement errors. These errors, however, are unlikely to bias in favor of our finding that ICMWs in family CEO firms are more closely associated with negative consequences when family power is higher.

  27. 27.

    For both Table 5 and Table 6 (Panel A and B), the coefficient on FamilyCEO is significantly positive for LOW_FPOWER family firms but insignificant for HIGH_FPOWER family firms, suggesting that when family CEO firms with high family power have effective internal control, they are no more likely to engage in misstatements or related party transactions than nonfamily firms with effective internal control. Note that family CEO firms with high family power are those family CEO firms where a family member serves as CEO and at least two other family firms are on the board or among top executives. These characteristics are likely to make these firms the most powerful family firms. We conjecture that the powerful family firms with effective internal control are probably the ones that care the most about family reputation; hence, they do not have material control weaknesses and are less likely to commit misstatements or to engage in related party transactions. Because our research question is about how weak internal control facilitates family entrenchment, we leave exploring this unique group of family firms to future research.

  28. 28.

    Further analyses show that, relative to nonfamily firms, family CEO firms are not significantly associated with the incidence of ICMWs in 2007–2009.

  29. 29.

    We only examine the change in misstatements because our sample firms have very few frauds (only 3) in 2006, and we do not have related party transaction data for 2006.

  30. 30.

    We rely on the SEC’s decisions, because while the SEC likely decides whom to sue based on wrongdoings, shareholders may pay more attention to recouping losses and thus are more likely to sue parties with deep pockets. To the extent that family CEOs are wealthier than other CEOs, using litigation data such as class action lawsuits will bias toward finding that family CEOs are more likely to be sued than other CEOs.

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Correspondence to Xia Chen.

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Chen, X., Feng, M. & Li, C. Family entrenchment and internal control: evidence from S&P 1500 firms. Rev Account Stud (2020) doi:10.1007/s11142-019-09527-7

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Keywords

  • Family firms
  • Internal control weakness
  • Family entrenchment

JEL classification

  • G32
  • M40