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03/13/2012

Research Proposal - Internal and External Auditing on UK’s Family Businesses


RESEARCH PROPOSAL

 

Internal and External Auditing on UK’s Family Businesses

 

 

INTRODUCTION

This paper discusses in detail the research proposal on the auditing practices within family businesses in the United Kingdom. Specifically, the research will focus on the voluntary demands for internal and external auditing in family businesses. In this research proposal, the background, context and theme of the study are presented; the objectives of the study and the research statements are formulated. Here, vital concepts, questions and assumptions are stated. Finally, the scope and limitation of the study, methodology to be used and the significance of the research are discussed.

In this study, family businesses is defined as firms that exhibit majority family ownership, accounts for a large proportion of all economic activity. Research suggests that 80 percent of all businesses in the United States are family owned (Daily and Dollinger 1992). Similar findings have been reported in the UK (Stoy Hayward and The London Business School 1989, 1990), Western Europe (Lank 1995), and Australia (Smyrnios and Romano 1994; Smyrnios et al. 1997). Providing further evidence of the contribution of family business to the economy, La Porta et al. (1999) and Schleifer and Vishny (1986) find that the ownership structure of even large public companies is characterized by controlling stockholders who are more often families, usually the founder or their descendants.

Despite the significance of family business to the economy there are few empirical studies of this sector in general (Brockhaus 1994; Wortman 1994), and in particular in the audit area. The family-business environment provides an opportunity to further test theory concerning demand for auditing. Derived from prior empirical research and agency theory, predictions of voluntary demand for internal and external auditing are tested.

Generally, the purpose of the research is to conduct a descriptive study on the internal and external auditing demands for family businesses in the UK. The study will also furnish discussions made by other authors regarding internal and external auditing in family businesses.  

The study incorporates the traditional characteristics of firm size and firm debt, which are expected to increase the likelihood of a family business engaging the services of an auditor. Given the nature of family businesses, unique measures consistent with the suggestion of agency theory are developed to capture variations in demand for auditing among firms. The measures are: (1) the proportion of nonfamily management in the firm, and (2) the proportion of nonfamily representation on the board of directors. For both measures it is predicted that agency costs will increase through greater separation of ownership and control. In addition, the study argues that both (or either) internal audit and external audit can serve as a monitoring response in family businesses, and an additional contribution of this research is to examine the relationship between these monitoring mechanisms.

Undertaking the analysis of demand for auditing in a family-business environment permitted the development of two measures of the separation of ownership and control. These measures were the proportion of nonfamily management in the firm and the proportion of nonfamily representation on the board of directors. First, a greater proportion of nonfamily management is expected to result in greater separation of ownership and managerial control. A positive correlation between the proportion of nonfamily management and demand for auditing is predicted. Second, higher nonfamily membership on the board of directors that represents nonfamily ownership creates an incentive for the family to divert resources for their personal use. The representatives of nonfamily interests on the board will demand greater monitoring. A positive correlation between the proportion of nonfamily representation on the board of directors and demand for auditing is predicted. 

Empirical research has identified a correlation between firm size and demand for both external auditing and internal auditing. The literature suggests a number of theoretical explanations. First, as the total amount of potential wealth transfers increases with firm size, the related benefits from undertaking monitoring increase (Chow 1982). Second, with increased size it becomes more difficult for the owners of private companies to oversee and be cognizant of the enterprise. Hence, there is a greater demand for auditing to compensate for the loss of control (Abdel-khalik 1993). Third, on the cost side, the marginal cost of providing an external audit decreases with firm size (Chow 1982). Similarly, larger firms have opportunities to take advantage of economies of scale from investing in the fixed costs of internal auditing, which include staff training and establishing geographically dispersed offices (Anderson et al. 1993).

Theoretical discussions as to the association between debt and demand for auditing tend to support a positive association between level of debt and demand for external auditing. It is argued that as the proportion of debt in a firm's capital structure increases, shareholders have greater incentives to transfer wealth from the bondholder and this increases the likelihood that the organization will demand an audit. Abdel-khalik (1993) adapted this argument in suggesting that owners demand an external audit in order to comply with constraints placed on an organization by creditors. Blackwell et al. (1998) found evidence that demand for external auditing is derived from the economic benefit of a lower interest rate. There is, however, no theoretical or empirical literature linking firm debt with the existence of internal audit. In this absence the hypothesis is limited to external auditing.

In an environment where demand for auditing is voluntary, family businesses can respond to pressure for monitoring by choosing between internal audit and external audit. It is unclear if internal and external audit are primarily viewed as complementary responses, or as substitute monitoring mechanisms. The existence of internal auditing being positively correlated with the existence of external auditing will be evidence of their complementary nature, while a negative correlation will suggest that they may serve as substitute monitoring mechanisms. The analysis will include only firms that undertake some form of audit service. This approach is consistent with the definition in economics of a complementary good or service, as one that is used in conjunction with another good or service. Including firms that do not engage either internal or external audit introduces unwanted variability into the analysis; firms that do not engage either audit service are neither demonstrating a complementary nor substitute association.

LITERATURE REVIEW  

There are a number of complementary explanations as to sources of demand for auditing. Business is accountable to a range of parties and the diversity of organizations causes a myriad of potential accountability relationships, making it difficult to identify a single explanatory cause. Contracting or agency theory has provided a resilient and popular framework for explaining the demand for external auditing and suggests a monitoring role for both internal and external audit. The provision of audited financial statements is normally regarded as a cost-effective contractual response to agency costs (DeAngelo 1981; Watts and Zimmerman 1976). Similarly, internal auditing may also serve as a monitoring response to agency costs (Anderson et al. 1993; DeFond 1992).  

Though the agency literature is suggestive of potential conflict in family businesses (Fama and Jensen 1983), empirical research investigating the monitoring response in this important business segment is limited. This limitation is perhaps not surprising as the image of a family business is one characterized by a close alignment of ownership and control (Daily and Dollinger 1992). Notwithstanding the likelihood that family businesses may exhibit a lower level of agency costs compared with listed companies, the present study argues that conflict consistent with suggestions of agency theory can still arise in family businesses. There are two characteristics of family businesses giving rise to a demand for audit that can be directly measured. These are: (1) the proportion of nonfamily management, and (2) the proportion of nonfamily representation on the board of directors.

The first of these characteristics relates to the introduction of nonfamily operational management. Depending on the circumstances of the entity,(2) family owners might delegate some level of management responsibilities to nonfamily members. This will increase the demand for auditing for reasons of higher agency costs, and a greater loss of control by the owners. DeFond (1992, 21) explains the implication of separation of ownership and control as "(1) the divergence in preferences of the manager and owner with respect to the manager's actions, and (2) the imperfect observability of the manager's actions by the owner." As the proportion of nonfamily management increases, owners (family and nonfamily) will exhibit greater demand for monitoring to reduce management shirking due to information asymmetry between nonfamily management and owners.

A second characteristic that increases the demand for auditing in family businesses is where the family raises capital from outside investors (nonfamily members). Increasing diversity of ownership creates agency conflict because the majority owners (by definition, the family) have incentive to divert resources for their personal use. Such a diversion will have the effect of restricting resource flow to nonfamily owners. Benston (1985) argued this point with regard to owner-managed enterprises where there are outside investors. The capacity and incentive for nonfamily owners to initiate monitoring will depend on their level of ownership, and their representation on the board of directors. As the proportion of nonfamily ownership and director representation rises, a greater demand for monitoring will be exhibited.(3)

Research has investigated factors associated with "voluntary" demand for external auditing. Chow (1982) used an agency framework to investigate the impact of agency costs (proxied by management share ownership), firm size, and debt. He found support for the effects of leverage and accounting-based debt covenants, and moderate support for the predicted role of size on voluntary demand for auditing. Abdel-khalik (1993) used a "structure of organization approach" to investigate the impact of the level of hierarchy (firm size) and debt. He found a correlation between voluntary demand for auditing and the extent of hierarchy (a measure of firm size), and only weak support for the impact of debt. Blackwell et al. (1998) found that small private firms derived an economic benefit from auditing through a significantly lower interest rate than that paid by nonaudited firms; thus the level of debt was a major factor in determining the level of benefit gained.

Other research has investigated quality-differentiated audits. These studies, investigating firms with a statutory audit requirement, traditionally use a binary categorization of audit firm quality to capture the impact of variations in agency conflict among firms (see, for example DeFond 1992; Johnson and Lys 1990; Francis and Wilson 1988; Simunic and Stein 1987; Palmrose 1984). This literature argues that larger firms provide a higher quality service (DeAngelo 1981) and are more likely to be employed to undertake the audit of companies facing a higher level of agency conflict. Using management share ownership to proxy agency costs, some researchers have found the expected negative association between management share ownership and auditor brand-name/quality (DeFond 1992; Simunic and Stein 1987), others have found no effect (Palmrose 1984; Francis and Wilson 1988), and still others have unexpectedly found a positive association (Eichenseher and Shields 1989).  

The above research establishes a link between demand for external auditing and firm size, debt, the proportion of nonfamily management, and the proportion of nonfamily representation on the board of directors. Although much of the audit-demand research has addressed external auditing, a number of authors (for example, Anderson et al. 1993; DeFond 1992) have argued that internal audit is a potential alternative monitoring mechanism. In this paper, we argue that external and internal audit might both serve as a monitoring response to variations in agency conflict in an environment where auditing is voluntary and costs and benefits of different approaches can be considered.

The current nature of the relationship between internal and external auditing is unclear. One view of internal auditing, as, for example, reflected in auditing standards (International Auditing Standard ISA610, International Auditing Practices Committee 1994), is that the means for internal and external audit to achieve respective objectives are often similar, which suggests internal audit may serve as a complement to external audit. Among listed public companies, evidence of a reduction in external audit cost due to reliance on the work of internal audit suggests a complementary relationship.

An alternative view of the relationship between internal and external auditing is that, in a voluntary setting, internal audit can serve as a substitute in one or both of two ways. First, it can be a straight substitute when internal audit performs financial statement audit work that could similarly be provided by external audit. The second substitution would be when the family business chooses an audit service other than that provided by a financial statement audit as an appropriate monitoring response. A number of authors (see, for example, Elliott 1994) have predicted an increased demand for a broader range of assurance services and a corresponding decline in the relevance of the financial statements and the related external audit service.

It may also be that relations between internal and external audit are evolving and are very dynamic. While the role of internal audit is traditionally viewed as assisting management in safeguarding assets and monitoring control systems (for example, Ratliff et al. 1996), there is evidence of internal audit changing in response to changing business needs. The emphasis in many internal audit departments is on adding value to the entity, and includes services ranging from advice on business planning and risk management to information systems evaluation (Birkett et al. 1999).

Where the emphasis of external audits was on financial statement risk, and internal auditors were seen to be control-risk focused, it was likely that in a voluntary setting internal audit was complementary to external audit. If internal audit adopts a more value-added approach, rather than a control-risk approach, it is more likely that complementarity between internal audit and external audit will diminish, and internal auditors may be viewed as substitutes to external auditors as providers of expert advice.

METHODOLOGY

There are three kinds of research methods, correlational, experimental and descriptive (Walliman and Baiche, 2001).

The correlational research refers to studies in which the purpose is to discover relationship or association between variables. The correlational kind of research method is used due for ethical problems with experiments. Moreover, it is also used due to practical problems with experiments. This mode of study is widely applicable, cheap, and usually ethical. A correlational relationship between two variables is occasionally the result of an outside source, so one has to be careful and remember that correlation does not necessarily tell about cause and effect. It should, however, be pointed out that the most serious danger of this type of research is the conclusion that because two factors go together, one is the cause and the other is the effect. However, inferring causality from correlation is not actually impossible, but very difficult. Nonetheless, there exist some "third variable" issues and measurement problems.

Landman (1988) summarises experiential research when he states that it is research designed to study cause and consequence. A clear distinction between the terms experiment and experimental research should be evident. In the former there is normally no question about the interpretation of data in the discovery of new meaning. Experimental research, however, has control as fundamental characteristic. The selection of control groups, based on proportional selection, forms the basis of this type of research. Basically, experimental research is the method that can be applied in a research laboratory. The basic structure of this type of research is elementary: two situations (cause and consequence) are assessed in order to make a comparison. Following this, attempts should be made to treat the one situation (cause) from the outside (external variable) to affect change, and then to reevaluate the two situations. The perceivable changes that occurred can then be presumed as caused by external variables.

Lastly, the descriptive research method uses observation and surveys. In this method, it is possible that the study would be cheap and quick. It could also suggest unanticipated hypotheses. Nonetheless, it would be very hard to rule out alternative explanations and especially infer causations. This descriptive type of research utilised observations in this study. Descriptive research is a type of research that is primarily concerned with describing the nature or conditions and degree in detail of the present situation (Landman, 1988; Creswell, 1994). The emphasis is on describe rather than on judge or interpret. The aim of descriptive research is to verify formulated hypotheses that refer to the present situation in order to elucidate it.

According to Klopper (1990) researchers who use this method for their research usually aim at demarcating the population by means of perceiving accurately research parameters and recording in the form of a written report of that which has been perceived. The aim of the latter is, that when the total record has been compiled, revision of the documents can occur so that the perceptions derived at can be thoroughly investigated. Because the total population during a specific investigation can not be contemplated as a whole, researchers make use of the demarcation of the population or of the selection of a representative test sample. Test sampling therefore forms an integral part of descriptive research.

I opt to use this kind of research because I want to obtain first hand data from the respondents so as to formulate rational and sound conclusions and recommendations for the study. Moreover, this method allows me to utilise approaches that are more applicable in understanding a culture. The purpose of this study is to describe the demand for internal and external auditing among family businesses in the UK.

To come up with pertinent findings and to provide credible recommendations, this study utilises two sources of research: primary and secondary.  Primary research data will be obtained through this new research study. Questionnaire survey and in-depth interviews will be conducted. On the other hand, the secondary research data will be obtained from previous studies on the same topic. 

The research described in this document is based on both quantitative and qualitative research methods. According to Burns and Grove (2001) quantitative research is a formal, objective, systematic process in which numerical data are utilised to obtain information about the world. This allows investigation of important new issues and questions on Kuwaiti clothing as they arise, and allows the investigators to drop unproductive areas of research from the original research plan.

When selecting approach to a study it should be a reflection of which approach is most suitable for the topic under consideration. However it is also reasonable to suggest that it also reflects the bias of the researcher. For example, the majority of medical research is quantitative and considered to produce "hard", generalisable results, whilst much of nursing research is qualitative and considered to produce "soft" results. Qualitative approaches to research are based on a "world view" which is holistic. Under these approaches, it is believed that there is not a single reality; reality is based upon perceptions that are different for each person and change over time; and What we know has meaning only within a given situation or context.

This study will also employ qualitative research methods because I intend to find and build theories that will explain the relationship of one variable with another variable through qualitative elements in research. Through this method, qualitative elements that do not have standard measures such as behavior, attitudes, opinions, and beliefs within the UK’s family businesses will be analysed. 

Furthermore qualitative research can be multimethod in focus, involving an interpretative, naturalistic approach to its subject matter. This means that qualitative researchers study things in their natural settings, attempting to make sense of, or interpret phenomena in terms of the meanings people bring to them. Accordingly, qualitative researchers deploy a wide range of interconnected methods, hoping always to get a better fix on the subject matter at hand.

The reasoning process used in qualitative research involves perceptually putting pieces together to make wholes. From this process meaning is produced. However, because perception varies with the individual, many different meanings are possible.

            For this research design, the researcher will gather data, collate published studies from different local and foreign universities and articles from business management journals; and make a content analysis of the collected documentary and verbal material.  Afterwards, the researcher will summarise all the information, make a conclusion based on the null hypotheses posited and provided insightful recommendations.

This study will report findings drawn from three sections of the questionnaire: Background of the Business, Current Ownership and Management of the Business, and Audit Protocol. Background of the Business assesses: whether the firm was a family business; industry; age of business; number of employees; legal structure; gross sales; average rate of earnings from sales before interest and tax; and value of total assets. Current Ownership and Management gauges: proportion of family ownership; generation of ownership; number of family and nonfamily directors; and proportion of family management. Audit Protocol measures whether family firms' voluntarily engage both external and internal audits.

For validation purposes, the researcher will initially submitted a sample of the set of survey questionnaires; and after approval, the survey was initially conducted to five respondents. The respondents will be composed of my colleagues who are knowledgeable about designing questionnaires.  After the questions are answered, the researcher will ask the respondents for any suggestions or any necessary corrections to ensure further improvement and validity of the instrument. The researcher will examine the content of the interview questions to find out the reliability of the instrument. Afterwards, the researcher will exclude irrelevant questions and change words that would be deemed difficult by the respondents, to much simpler terms. The researcher will exclude the five respondents who were initially used for the validation of the instrument.  The researcher will then tally, scored and tabulated all the responses in the provided interview questions.

For the interview part, open-ended questions will be used to obtain as much information as possible about how the interviewee feels about the research topic.  The questions were based on the research questions for this project; the research supervisor will review, refine and approve the questions. The researcher also will design a semi-structured interview. Here, the researcher encouraged the interviewee to clarify vague statements and to further elaborate on brief comments. The researcher will not share personal beliefs and opinions. The results from the interview will be given in the question answer format, while the results of questionnaire survey would be presented in the tabular form with a few graphical representations. The questionnaire will be given at the appendix. Content analysis were drawn from the interviews to identify how effective is the harmonization of Kuwaiti and Western clothing styles.

Summary

As stated in this chapter, the research will undergo stages. In the research design, the researcher will collect secondary data and will formulate and develop the questionnaire and interview. In this stage, these instruments will be subjected to approval and validation. During the data collection, I will collate and summarise the data that will be obtained from the questionnaire and survey. I will then analyzed these data and from these, I will come up with findings and recommendations that shall be presented in the following chapters.

 

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