Does Auditors’ Reputation ‘Discourage’ Related-Party Transactions The French Case

Electronic copy available at: http://ssrn.com/abstract=1823464

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Does Auditors’ Reputation ‘Discourage’

Related-Party Transactions? The French Case

Moez Bennouri, Mehdi Nekhili and Philippe Touron *

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 auditor’s reputation is a surrogate for the quality

of audit reports, and test the extent to which it may reduce the number of related-

party transactions initiated by clients. We use a unique data set with a sample of 85

French firms over the period 2002–2008. 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 variables

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.

_________________________________________________________________ * 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 Maître de conférences (associate professor) at Université PARIS 1 – Panthéon-

Sorbonne. Contact author: [email protected].


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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 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 2 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.

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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. 4 See Francis et al. (2009) for a very interesting and concise description of the functioning of joint auditing in

France. 5 Following Francis et al. (2009), we consider that the international Big 4 are also the French Big 4: KPMG,

Ernst & Young, Deloitte, and PricewaterhouseCoopers.

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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.

SETTING AND INSTITUTIONAL BACKGROUND OF THE

RESEARCH

The objective of this paper is to study the relationship between the frequency of RPTs and

the quality of external auditors. The French setting offers an interesting laboratory in which to

undertake this analysis, thanks to several of its legal and institutional features. First, the

existing regulation on the disclosure of abnormal RPTs in France implicates the auditors in a

formal way. Unlike in the U.S. (McDermott et al. 2006) or in Hong Kong (Cheung et al.

2006), where the managers report directly, in France the auditors’ role in the process of

reporting these transactions is very important. Indeed, since 1967, auditors have to publish

within the annual report a special report containing all “abnormal” RPTs. This allows access

to all these transactions in a separate document for each firm. Second, French firms are

characterized by concentrated ownership, and by the prevalence of pyramidal structures

(Boubaker and Labégorre 2008). This reinforces the conflicts of interest between significant

and minority shareholders, and consequently increases the propensity to instigate abnormal

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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 firm’s report and share the legal 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 réglementées” (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 shareholders’ 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

6 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. 7 R 233-38, Commercial Code.

8 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.

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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 disclosure 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.

LITERATURE REVIEW AND HYPOTHESIS

Our study is linked to two different strands of the literature: related-party transactions and

audit quality. We briefly summarize the literature about RPTs and auditing; then we derive

our empirical hypothesis in the remainder of this section.

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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 window-

dressing. 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 shareholder’s

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 auditor’s 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 post-

contractual 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 firm’s value. Barton (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 auditor’s 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 auditor’s 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 management’s 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 auditor’s 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 high-

quality 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

firm’s 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.

DATA AND METHODOLOGY

Data Selection

Our sample contains data about companies in the French SBF 120 index,9 from which we

exclude financials (six companies). We manually collected data from the companies’ annual

reports for the period from 2002 to 2008. With respect to the adoption of the IFRS standards

(in particular IAS 24) our sample period covers three years before the adoption of this major

change in regulation, the year of its adoption (2005) and three years after it. Collection of

information about ownership structure is tedious, and annual reports do not necessarily

disclose appropriate information. Some companies were excluded from our final sample

because of missing or inconsistent data. The final sample consists of 85 companies, totalling

562 observations.10

There are several challenges in connection with RPT data collection. It is generally

difficult to identify, examine and disclose these transactions. In France, special reports

published by auditors contain information about abnormal RPTs as defined by French

legislation. It is important to mention here that for each transaction in the special report we

can find information about the counter-parties in the transaction, and a brief description of the

conditions of the transaction. However, we are not always able to distinguish the amount of

each transaction, nor the nature of the relationship between the firm and the related party in

question. Indeed, we find in the report only the names of the entities involved in the

transaction with the firm. When this entity is a person, we verify whether they have any

relationship with the directors, the managers or the principal shareholder of the firm. When it

is a company, we begin by setting out its flow chart and its ownership structure, and

investigate all potential relationships between the two companies. We can have different

combinations of potential relationships between the parties to abnormal RPTs.

As discussed above, the transactions disclosed in the special report include all those where

the managers, the directors or the significant shareholders are direct or indirect counter-parties

(through firms affiliated to them) because these are considered in the legislation as non-

9 Created in 1993, this index contains the 120 largest companies in the French market.

10 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 year-

companies were inconsistent and missing.

14

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 conditions 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 firm’s 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 company’s 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.

15

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 firm’s 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.

16

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 Labégorre (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 firm’s 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).

17

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

18

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.

19


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.


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 double-

selection 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

20

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.


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.


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

21

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 auditor’s 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; O’Sullivan 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.

22

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 = α0 + α00 + α1 VOTE + α2 SEP + α3 BOARDSIZE + α4 INDBOARD + α5 INDAUDC

+ α6 CROSS + α7 DEBT + α8 MTB + α9 ROA + α10 R&D + α11 SIZE + α12 IFRS+ ε

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 = ß0 + ß1 1BIG + ß2 2BIG + ß3 VOTE + ß4 SEP + ß5 BOARDSIZE + ß6 INDBOARD

+ ß7 INDAUDC + ß8 CROSS + ß9 DEBT + ß10 DIV + ß11 SIZE + ß12 Lambda1

+ ß13 Lambda2 + ε

Our dependent variable is the number of abnormal RPTs, which is by definition non-

negative and contains only integer values. The econometric literature suggests using count-

data 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

23

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.


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 O’Sullivan (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 Labégorre (2008) (in a corporate governance analysis) for more

details about the rationale behind the use of count data models.

24

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.


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

25

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

26

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

27

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 related-

party 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

28

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.

29

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

30

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 their 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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Table 1: Definition of different variables

Variable Definition Measure

BIG Audit performed by one the four biggest

auditing companies (KPMG, Ernst &

Young, Deloitte and PricewaterhouseCoopers)

A cardinal variable equal to 0 if no “Big” is auditing

the company, 1 if only one of the two auditors is

“Big” and 2 if both auditors are “Big”

Related-party transactions

RPT Transactions with related parties Number of related-party transactions available in

the special report provided by auditors

RRPT Renewed related-party transactions Number of transactions that were renewed from the

year before

NRPT New related-party transactions The number of new transactions with respect to the

year before

TMDS Transactions with the managers, the

directors or the significant shareholders or with firms linked to them

The number of transactions between the firm and its

managers, directors or significant shareholders and their relatives

TSAF Transactions with subsidiaries or affiliated firms

The number of transactions between the firm and its subsidiaries or affiliated firms

Governance and shareholding variables

VOTE Voting rights of the significant shareholder Percentage of voting rights detained by the principal

shareholder (by considering the percentage detained in other subsidiaries in the case of holdings)

SEP Separation between ownership and control Ratio of the voting rights over the cash-flow rights of the significant shareholder

BOARDSIZE Size of the board of directors Number of directors

INDBOARD Degree of independence of the board 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

AUDC Existence of audit committee A dummy variable equal to 1 if an audit committee

exists and 0 otherwise

INDCAUD Degree of independence of the audit

committee

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

CROSS Cross-listing in U.S. markets 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

DEBT Debt ratio Ratio of total financial debt to the total value of

assets

Other control variables

MTB Market-to-book Ratio of market value to book value of equity

ROA Return on assets Ratio of EBITDA to total value of equity

R&D Intensity of investment in R&D Ratio of investments in R&D and total sales

DIV Dividend yield Ratio of dividends to share price

SIZE Size of the firm Logarithm of the total value of equity

IFRS Mandatory adoption of the IFRS standards

by French public firms

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.

IAS24 Mandatory adoption of the IAS 24 rule A dummy variable equal to 1 after the adoption of the IAS 24 rule in 2005 and 0 otherwise

38

Table 2: Descriptive statistics: distribution of classes of RPTs in special reports

This table reports descriptive statistics about the distribution of different classes of RPTs, disclosed in special reports by 85 large French companies between 2002 and 2008. The column Reports displays information about the distribution of the

number of RPTs in special reports and the other columns display information about RPTs. NRPT is the number of newly

announced related-party transactions. RRPT is the number of renewed related-party transactions. TMDS is the number of

transactions between the firm and its managers, directors and significant shareholders. TSAF is the number of RPTs between the firm and its affiliated firms and subsidiaries.

Number of RPTs

per special report Total RPT First classification level Second classification level

Reports RPTs NRPT RRPT TMDS TSAF

Number Prop Number Prop. Number Prop. Number Prop. Number Prop. Number Prop.

0 1

2

3

4 5

6

7

8 9

10 Total

85 97

72

88

44 36

36

22

24 19

39

562

15.12 17.26

12.81

15.66

7.83 6.41

6.41

3.91

4.27 3.38

6.94

100

0 97

144

264

176 180

216

154

192 171

663

2257

0 4.30

6.38

11.70

7.80 7.97

9.57

6.82

8.51 7.58

29.37

100

0 51

68

102

77 53

120

79

93 71

321

1035

0 4.93

6.57

9.86

7.44 5.12

11.59

7.63

8.99 6.86

31.01

100

0 46

76

162

99 127

96

75

99 100

342

1222

0 3.76

6.22

13.26

8.10 10.39

7.86

6.14

8.10 8.18

27.99

100

0 63

61

100

76 69

108

51

95 73

217

913

0 6.90

6.68

10.95

8.32 7.56

11.83

5.59

10.41 7.99

23.77

100

0 34

83

164

100 111

108

103

97 98

446

1344

0 2.53

6.18

12.20

7.44 8.26

8.04

7.66

7.22 7.29

33.18

100

39

Table 3: Descriptive statistics of RPTs as a function of the selection of auditors

This table reports descriptive statistics about RPTs, disclosed in special reports by 85 large French companies between 2002

and 2008, as a function of the number of Big auditors. Big auditors are KPMG, Ernst & Young, Deloitte and PricewaterhouseCoopers. TMDS is the number of transactions between the firm and its managers, directors or significant

shareholders. TSAF is the number of RPTs between the firm and its affiliated firms and subsidiaries. BIG is the exact number

of Big auditors for each year-firm. t-statistics are related to two-tailed equality of means tests. *, ** and *** indicate

significance at 10%, 5% and 1% levels, respectively.

Variable Total

sample

BIG=0 BIG=1 BIG=2 t-statistic

BIG=0 /

BIG=1

t-statistic

BIG=2 /

BIG=0

t-statistic

BIG=2 /

BIG=1 Number of observations 562 33 281 248

RPT Mean 3.966 4.303 4.295 3.540 0.010 1.059 2.174 **

Stand-dev 4.074 4.902 4.230 3.734

Minimum 0 0 0 0

Maximum 25 23 21 25

Frequency 2257 142 1237 878

Fir

st c

lass

ific

atio

n l

evel

NRPT Mean 1.818 2.606 2.038 1.460 1.055 2.541 *** 2.899 ***

Stand-dev 2.544 4.930 2.612 1.883

Minimum 0 0 0 0

Maximum 22 22 16 11

Frequency 1035 86 587 362

RRPT Mean 2.147 1.697 2.257 2.081 - 1.239 - 0.733 0.765

Stand-dev 2.609 1.531 2.541 2.794

Minimum 0 0 0 0

Maximum 17 5 14 17

Frequency 1222 56 650 516

Sec

ond

cla

ssif

icat

ion

lev

el

TMDS Mean 1.604 0.545 1.681 1.657 - 2.602 *** - 3.272 *** 0.121

Stand-dev 2.193 1.121 2.474 1.907

Minimum 0 0 0 0

Maximum 16 4 16 9

Frequency 913 18 484 411

TSAF Mean 2.362 3.758 2.615 1.883 1.759 * 3.170 *** 2.676 ***

Stand-dev 3.306 4.861 3.355 2.906

Minimum 0 0 0 0

Maximum 25 23 15 25

Frequency 1344 124 753 467

40

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 Total

sample


BIG=0 /

BIG=1

t-statistic

BIG=2 /

BIG=0

t-statistic

BIG=2 /

BIG=1 Nb of observations 562 33 281 248

VOTE Mean 0.3694 0.4432 0.3532 0.3788 1.843 * 1.302 - 1.103

Stand-dev 0.2650 0.2213 0.2660 0.2680

Minimum 0.0070 0.0048 0.0070 0.0080

Maximum 1.0000 0.8785 0.9825 1.0000

SEP Mean 1.1608 1.1370 1.1795 1.1421 - 0.833 - 0.108 1.607

Stand-dev 0.2658 0.2169 0.2793 0.2546

Minimum 0.3476 0.7107 0.3476 0.6939

Maximum 2.0099 1.4487 2.0099 1.9067

BOARDSIZE Mean 11 6.2813 10.7014 11.9518 - 6.103 *** - 9.780 *** - 4.077 ***

Stand-dev 3.7660 3.4663 3.9298 3.0370

Minimum 3 3 3 4

Maximum 21 18 21 21

INDBOARD Mean 0.4778 0.2505 0.4823 0.5018 - 5.675 *** - 6.820 *** - 1.122

Stand-dev 0.2128 0.6666 0.2143 0.1856

Minimum 0.0000 0.0000 0.0000 0.0000

Maximum 1.0000 0.8571 1.0000 1.0000

INDAUDC Mean 0.6202 0.1438 0.6104 0.6929 - 7.126 *** - 9.026 *** - 2.786 ***

Stand-dev 0.3614 0.3084 0.3557 0.3259

Minimum 0.0000 0.0000 0.0000 0.0000

Maximum 1.0000 1.0000 1.0000 1.0000

DEBT Mean 0.2279 0.1942 0.2499 0.2073 2.161 *** - 0.517 3.513 ***

Stand-dev 0.1433 0.1507 0.1432 0.1390

Minimum 0.0000 0.0031 0.0002 0.0000

Maximum 0.6847 0.4263 0.6847 0.5666

MTB Mean 2.0789 2.3057 1.9215 2.2310 1.607 0.244 - 2.498 ***

Stand-dev 1.4384 1.5025 1.2362 1.6199

Minimum - 7.3112 0.0010 -7.3112 0.0001

Maximum 12.9763 6.8762 6.7738 12.9763

ROA Mean 0.0359 0.0554 0.0284 0.0422 2.061 ** 1.128 - 2.324 **

Stand-dev 0.0680 0.0414 0.0727 0.0642

Minimum - 0.6057 0.0001 -0.6057 - 0.2599

Maximum 0.4231 0.1721 0.3065 0.4231

R&D Mean 0.0267 0.0117 0.0228 0.0327 - 0.774 - 1.488 - 2.353 **

Stand-dev 0.0477 0.0214 0.0390 0.0577

Minimum 0.0000 0.0000 0.0000 0.0000

Maximum 0.2860 0.0560 0.2381 0.2860

DIV Mean 0.0271 0.0202 0.0284 0.0267 - 0.888 - 0.865 0.410

Stand-dev 0.0454 0.0408 0.0502 0.0402

Minimum 0.0000 0.0000 0.0000 0.0000

Maximum 0.5955 0.2284 0.5947 0.5655

SIZE Mean 12.3655 9.1012 12.286 12.8768 - 4.041 *** - 5.110 *** - 1.637

Stand-dev 4.2087 3.3848 4.3114 3.9977

Minimum 5.3517 5.3517 5.6855 6.7747

Maximum 21.5843 14.983 21.584 19.3224

41

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.

Variable Total

sample


BIG=0 /

BIG=1

t-statistic

BIG=2 /

BIG=0

t-statistic

BIG=2 /

BIG=1 Number of

observations

562 33 281 248

AUDC 0 86 24 44 18 61.384 *** 102.447 *** 8.471 ***

(15.30 %) (4.27 %) (7.83 %) (3.20 %) (p-value =

0.000)

(p-value =

0.000)

(p-value =

0.004)

1 476 9 237 230

(84.70 %) (1.60 %) (42.17 %) (40.93 %)

CROSS 0 405 33 216 156 10.323 *** 17.864 *** 9.568 ***

(72.06 %) (5.87 %) (38.43 %) (27.76 %) (p-value = 0.001)

(p-value = 0.000)

(p-value = 0.002)

1 157 0 65 92

(27.94 %) (0 %) (15.57 %) (16.37 %)

IFRS 0 150

(26.69 %)

14

(2.49 %)

73

(12.99 %)

63

(11.21 %)

0.552

(p-value =

0.457)

2.561

(p-value =

0.110)

2.713

(p-value =

0.100)

1 412

(73.31 %)

19

(3.38 %)

208

(37.01 %)

185

(32.92 %)

IAS24 0 255 19 138 98 4.230 1.897 3.243

(45.37 %) (3.38 %) (22.56 %) (17.44 %) (p-value =

0.629)

(p-value =

0.168)

(p-value =

0.072)

1 307 14 143 150

(54.63 %) (2.49 %) (25.44 %) (26.69 %)

42

Table 6: Pearson correlation matrix and VIF

This table reports the correlation matrix for different variables characterizing our sample containing 85 large French companies for the period between 2002 and 2008. BIG is the number of Big auditors of the firm and it

is equal to 0, 1 or 2. RPT is the number of RPTs. 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. AUDC is a dummy variable equal to 1 if the

firm has an audit committee and 0 otherwise. INDAUDC is the proportion of independent members on the audit committee. CROSS identifies firms listed in U.S. stock markets directly or through ADRs. DEBT is the

ratio of total debt to the total value of assets. MTB is the market-to-book ratio measured as the 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

total value of equity. ΔSALES is the ratio of the difference of sales between T and T-1 to the value of sales at T-1. R&D is the ratio of investments in R&D over total sales. DIV is the dividend payout ratio. SIZE is the

total value of equity of the firm (in millions of euros). IFRS is a dummy variable equal to 0 for the years 2002 to 2003 and 1 for the years 2004 to 2008. IAS24 is a dummy variable equal to 0 for the years 2002 to 2004 and 1 for the years 2005 to 2008. P-values for Pearson correlation tests are in parentheses. * indicates significance at 1% level.

BIG RPT VOTE SEP BOARDSIZE INDBOARD AUDC INDAUDC CROSS DEBT

BIG 1.000

RPT - 0.0830 * 1.000

VOTE - 0.0003 - 0.0393 1.000

SEP - 0.0383 - 0.0085 - 0.1544 * 1.000

BOARDSIZE 0.3064 * 0.1740 * - 0.1162 * 0.0223 1.000

INDBOARD 0.1925 * - 0.1153 * - 0.3105 * - 0.1461 * 0.0067 1.000

AUDC 0.3214 * 0.0343 0.1009 * - 0.1059 * 0.2295 * 0.2434 * 1.000

INDAUDC 0.2781 * - 0.0218 - 0.0217 -0.0763 0.0321 0.4645 * 0.7043 * 1.000

CROSS 0.1928 * 0.0657 - 0.2117 * -0.0544 0.2265 * 0.1653 * 0.1723 * 0.3355 * 1.000

DEBT - 0.0780 0.1701 * - 0.0363 0.0600 0.0276 - 0.0411 - 0.0846 * - 0.1267 * - 0.0790 1.000

MTB 0.0666 - 0.0402 - 0.0541 0.0208 0.0217 - 0.0753 0.0269 0.0191 - 0.0154 - 0.0529

ROA 0.0389 - 0.0399 0.0626 0.1121 * 0.0148 - 0.0337 -0.0444 - 0.0585 - 0.1555 * - 0.0622

R&D 0.1120 * - 0.1046 * - 0.0553 - 0.0031 - 0.0366 0.0244 0.0725 0.2180 * 0.2816 * - 0.2439 *

DIV 0.0073 0.0133 0.0699 - 0.0789 0.1862 * - 0.0082 0.0924 *

- 0.0057 0.0035 - 0.0435

SIZE 0.1679 * 0.2211 * - 0.1167 * - 0.0384 0.3332 * 0.1170 * 0.1574 * 0.0826 * 0.2024 * 0.0058

IFRS 0.0869 * 0.0899 * 0.0853 * - 0.1364 * - 0.0490 0.1228* 0.0676

0.0673 - 0.0398 - 0.0825 *

IAS24 0.0850 * 0.1263 * 0.1285 * - 0.1894 * - 0.0009 0.1353* 0.0835 * 0.0879 * - 0.0627 - 0.0851 *

VIF ----- ----- 1.34 1.13 1.32 1.63 2.36 2.95 1.41 1.09

43

Table 6: Pearson correlation matrix and VIF

MTB ROA R&D DIV SIZE IFRS IAS24

MTB 1.000

ROA 0.1731 * 1.000

R&D 0.1085 * 0.0023 1.000

DIV 0.0209 - 0.0069 - 0.0817 1.000

SIZE - 0.0273 - 0.0916 * - 0.0723 0.2174 * 1.000

IFRS 0.0395 0.1120 * 0.0109 0.0984 * 0.0449 1.000

IAS24 0.0420 0.1171 * 0.0038 0.1392 * 0.0619 0.7303 * 1.000

VIF 1.07 1.11 1.22 1.11 1.23 2.11 2.20

44

Table 7: A nominal Probit model for the selection of auditors (BIG = 0, 1, 2)

This table reports the results of the following nominal Probit model:

BIG = α0 + α00 + α1 VOTE + α2 SEP + α3 BOARDSIZE + α4 INDBOARD + α5 INDAUDC + α6 CROSS + α7 DEBT + α8 MTB + α9 ROA + α10 R&D + α11 SIZE + α12 IFRS + ε

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. CROSS identifies firms listed in U.S. stock

markets directly or through ADRs. DEBT is the ratio of the total debt to the total value of assets. MTB is the market-

to-book ratio measured as market value to 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. SIZE is the total value of equity of the firm (in millions of euros). IFRS is a

dummy variable equal to 0 for the years 2002 to 2003 and 1 for the years 2004 to 2008. *, ** and *** indicate

significance at 10%, 5% and 1% levels, respectively.

Variables Coefficient t-stat

VOTE 0.480 ** 2.22

SEP 0.091 0.44

BOARDSIZE 0.101 *** 6.24

INDBOARD 0.803 *** 2.75

INDAUDC 0.580 *** 3.42

DEBT - 0.178 - 0.48

CROSS 0.199 1.52

MTB 0.062 1.60

ROA 0.821 1.25

R&D 1.938 * 1.80

SIZE 0.016 1.26

IFRS 0.232 ** 2.01

Constant 1 0.815 * 1.93

Constant 2 2.938 *** 6.96

N

Chi2

Prob > Chi2 Pseudo R2

562

120.30

0.0000 12.62%

45

Table 8: Determinants of the number of related-party transactions

This table reports the results of the following regression:

X = ß0 + ß1 1BIG + ß2 2BIG + ß3 VOTE + ß4 SEP + ß5 BOARDSIZE + ß6 INDBOARD + ß7 INDAUDC + ß8 CROSS + ß9 DEBT + ß10 DIV + ß11 R&D + ß12 SIZE + ß13 IAS24 + ß14

Lambda1 + ß15 Lambda2 + ε

With X equal to RPT, NRPT, RRPT, TMDS or TSAF. All equations in this table are run using a binomial negative model after clustering at the firm level. We consider variables defining the number of Big auditors. Big auditors are KPMG, Ernst & Young, Deloitte and PricewaterhouseCoopers. 1BIG is a dummy variable equal to 1 if the firm has at least one Big auditor

and 0 otherwise. 2BIG is a dummy variable equal to 1 if the firm has two Big auditors and 0 otherwise. 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. CROSS identifies firms listed in U.S. stock markets directly or through ADRs. DIV is the dividend payout ratio. R&D is the ratio of investments in R&D over

total sales. SIZE is the total value of equity of the firm (in millions of euros). IAS24 is a dummy variable equal to 0 for the years 2002 to 2004 and 1 for the years 2005 to 2008. Lambda1

and Lambda2 are the inverse Mills ratios resulting from the first equation of the model. *, ** and *** indicate significance at 10%, 5% and 1% levels, respectively.

Model 1 Model 2 Model 3 Model 4 Model 5

Variables RPT NRPT RRPT TMDS TSAF

Coef. t-stat Coef. t-stat Coef. t-stat Coef. t-stat Coef. t-stat

1BIG - 0.208 - 1.28 - 0.133 - 0.49 - 0.233 - 1.40 0.737 * 1.78 - 0.454 ** - 2.37

2BIG - 0.497 *** - 2.92 - 0.514 * - 1.82 - 0.440 ** - 2.52 0.647 1.57 - 0.915 *** - 4.39

VOTE - 0.021 - 0.11 0.045 0.17 - 0.184 ** - 0.74 - 1.184 *** - 3.72 0.738 *** 2.89

SEP - 0.048 - 0.31 - 0.234 - 1.12 0.082 0.45 - 0.309 - 1.49 0.076 0.35

BOARDSIZE 0.042 1.43 0.051 1.19 0.031 0.92 0.013 0.26 0.061 1.45

INDBOARD - 0.505 - 1.64 - 0.335 - 0.79 - 0.711 * - 1.89 - 1.319 ** - 2.49 0.063 0.14

INDAUDC 0.146 0.68 0.471 1.52 - 0.132 - 0.53 0.314 0.95 0.020 0.07

DEBT 1.369 *** 4.85 1.527 *** 3.85 1.168 *** 3.37 1.379 *** 3.11 1.531 *** 4.05

CROSS 0.126 1.16 - 0.004 - 0.03 0.220 * 1.73 - 0.344 ** - 2.24 0.451 *** 2.90

DIV - 1.331 - 1.51 - 0.838 - 1.15 - 1.747 - 0.89 - 3.435 ** - 2.35 - 0.412 - 0.39

R&D - 0.612 - 0.55 - 0.638 - 0.42 - 0.979 - 0.68 - 1.276 - 0.81 - 0.200 - 0.13

SIZE 0.048 *** 4.68 0.050 *** 3.41 0.041 *** 3.29 0.034 ** 2.29 0.051 *** 3.60

IAS24 0.401 *** 4.29 0.436 *** 3.34 0.352 *** 3.16 0.769 *** 5.03 0.051 1.17

CONS - 0.180 - 0.20 - 1.952 - 1.50 0.335 0.31 0.455 0.29 - 1.837 - 1.45

Lambda1 - 0.097 - 1.09 - 0.226 - 1.54 0.017 0.17 0.812 0.49 - 0.174 - 1.39

Lambda2 - 0.076 - 0.86 - 0.224 * - 1.72 0.080 0.79 0.176 1.07 - 0.197 - 1.60

N

Chi2 Prob > Chi2

562

121.02 0.0000

562

69.69 0.0092

562

95.02 0.0001

562

139.56 0.0000

562

94.76 0.0000

46

Table 9: Determinants of the number of related-party transactions before IAS 24


X = ß0 + ß1 1BIG + ß2 2BIG + ß3 VOTE + ß4 SEP + ß5 BOARDSIZE + ß6 INDBOARD + ß7 INDAUDC + ß8 CROSS + ß9 DEBT + ß10 DIV + ß11 R&D + ß12 SIZE + ß13 Lambda1 + ß14

Lambda2 + ε

With X equal to RPT, NRPT, RRPT, TMDS or TSAF. All equations in this table are run using a binomial negative model after clustering at the firm level. We consider variables defining the number of Big auditors. Big auditors are KPMG, Ernst & Young, Deloitte and PricewaterhouseCoopers. 1BIG is a dummy variable equal to 1 if the firm has at least one Big auditor


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. CROSS identifies firms listed in U.S. stock markets directly or through ADRs. DIV is the dividend payout ratio. R&D is the ratio of investments in R&D over

total sales. SIZE is the total value of equity of the firm (in millions of euros). Lambda1 and Lambda2 are the inverse Mills ratios resulting from the first equation of the model. *, ** and

*** indicate significance at 10%, 5% and 1% levels, respectively.




1BIG - 0.716 *** - 2.79 - 0.849 ** - 2.23 - 0.486 * - 1.80 - 0.075 - 0.16 - 0.901 *** - 2.82

2BIG - 1.064 *** - 3.94 - 1.358 *** - 3.43 - 0.728 *** - 2.56 - 0.192 - 0.41 - 1.415 *** - 4.24

VOTE 0.693 2.05 0.721 1.43 0.761 * 1.91 0.062 0.12 0.961 ** 2.21

SEP 0.330 1.28 0.325 0.97 0.342 1.19 - 0.553 - 1.59 0.697 ** 2.22

BOARDSIZE 0.038 0.87 0.077 1.25 0.016 0.33 0.017 0.27 0.032 0.60

INDBOARD 0.756 1.47 0.985 1.32 0.614 1.09 0.518 0.66 0.964 1.41

INDAUDC - 0.061 - 0.21 0.442 1.02 - 0.462 - 1.35 0.019 0.04 - 0.325 - 0.09

DEBT 1.478 *** 3.09 1.730 *** 2.67 0.316 ** 2.33 1.441 ** 2.09 1.675 *** 2.83

CROSS 0.292 1.58 0.186 0.74 0.376 * 1.85 - 0.273 - 1.07 0.497 ** 2.19

DIV 2.728 0.83 - 10.776 * - 1.79 9.510 *** 3.28 - 0.898 - 0.22 4.879 1.38

R&D 1.148 0.65 1.624 0.64 0.204 0.11 0.156 0.07 1.596 0.60

SIZE 0.081 *** 4.43 0.116 *** 4.73 0.053 ** 2.53 0.044 ** 2.03 0.080 *** 3.52

CONS - 1.210 - 0.92 - 2.958 - 1.51 - 0.036 - 0.21 0.802 0.44 - 2.234 - 1.34

Lambda1 0.061 0.38 0.240 0.95 0.023 0.17 0.298 1.07 - 0.007 - 0.04

Lambda2 - 0.107 - 0.88 - 0.229 - 1.24 - 0.069 - 0.48 0.256 1.35 - 0.149 - 0.96

N Chi2

Prob > Chi2

254 66.66

0.0000

254 60.40

0.0000

254 48.44

0.0000

254 31.09

0.0054

254 64.50

0.0000

47

Table 10: Determinants of the number of related-party transactions after IAS 24


X = ß0 + ß1 1BIG + ß2 2BIG + ß3 VOTE + ß4 SEP + ß5 BOARDSIZE + ß6 INDBOARD + ß7 INDAUDC + ß8 CROSS + ß9 DEBT + ß10 DIV + ß11 R&D + ß12 SIZE + ß13 Lambda1 + ß14

Lambda2 + ε

With X equal to RPT, NRPT, RRPT, TMDS or TSAF. All equations in this table are run using a binomial negative model after clustering at the firm level. We consider variables defining

the number of Big auditors. Big auditors are KPMG, Ernst & Young, Deloitte and PricewaterhouseCoopers. 1BIG is a dummy variable equal to 1 if the firm has at least one Big auditor


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. CROSS identifies firms listed in U.S. stock markets directly or through ADRs. DIV is the dividend payout ratio. R&D is the ratio of investments in R&D over

total sales. SIZE is the total value of equity of the firm (in millions of euros). Lambda1 and Lambda2 are the inverse Mills ratios resulting from the first equation of the model. *, ** and

*** indicate significance at 10%, 5% and 1% levels, respectively.




1BIG 0.144 0.70 0.918 ** 1.97 - 0.525 ** - 1.96 1.469 ** 1.97 - 0.177 - 0.75

2BIG - 0.052 - 0.25 0.649 1.37 - 0.628 *** - 2.33 1.486 ** 1.96 - 0.529 ** - 2.17

VOTE - 0.281 - 1.34 - 0.213 - 0.67 - 0.598 * - 1.95 - 1.414 *** - 3.73 0.670 ** 2.00

SEP - 0.323 * - 1.88 - 0.644 *** - 2.54 - 0.074 - 0.32 - 0.146 - 0.59 - 0.490 * - 1.83

BOARDSIZE 0.062 * 1.76 0.412 0.77 0.064 1.42 0.046 0.71 0.087 1.42

INDBOARD - 1.223 *** - 3.22 - 1.145 ** - 2.19 - 1.364 *** - 2.70 - 1.863 *** - 2.95 - 0.694 - 1.13

INDAUDC 0.571 ** 2.13 0.683 * 1.75 0.384 1.10 0.810 * 1.79 0.559 1.25

DEBT 1.256 *** 3.59 1.484 *** 2.93 0.932 * 1.94 1.052 * 1.86 1.507 *** 3.01

CROSS 0.184 1.50 0.056 0.32 0.193 1.15 - 0.207 - 1.05 0.563 *** 2.75

DIV - 1.364 ** - 2.04 0.643 0.72 - 4.582 *** - 3.45 - 3.096 ** - 2.14 - 0.627 - 0.73

R&D - 1.235 - 0.91 - 1.812 - 0.91 - 1.058 - 0.55 - 1.753 - 0.86 - 0.771 - 0.40

SIZE 0.022 ** 2.01 0.003 0.17 0.032 ** 1.96 0.028 1.52 0.027 1.52

CONS 0.274 0.25 - 1.625 - 1.03 1.469 1.02 - 0.570 - 0.27 - 1.711 - 0.94

Lambda1 - 0.104 - 0.95 - 0.366 * - 1.91 0.151 1.15 0.032 0.15 - 0.204 - 1.18

Lambda2 - 0.143 - 1.19 - 0.301 * - 1.71 0.094 0.61 - 0.021 - 0.09 - 0.327 - 1.64

N

Chi2

Prob > Chi2

306

89.67

0.0000

306

51.85

0.0000

306

72.74

0.0000

306

70.83

0.0000

306

61.64

0.0000

48

Figure 1: The average number of RPTs per special report over the sample period 2002–2008

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

1

2

3

4

5

2002 2003 2004 2005 2006 2007 2008

RPT NRPT

RRPT TMDS

TSAF

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Does Auditors’ Reputation ‘Discourage’ Related-Party Transactions The French Case

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