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Financial credibility, ownership, and financing constraints in private firms

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Abstract

As shown in the international business literature, the ability of controlling owners to extract private benefits is greater in countries with weaker legal institutions. In these countries, providing credible financial information could play an especially important role in reducing information asymmetry between private firms and external providers of finance. For our sample of firms across 68 countries, we find that firms with greater financial reporting credibility (i.e., annual financial statements reviewed by an external auditor) experience significantly lower perceived problems in gaining access to external finance. Further, the impact of financial credibility in reducing financing constraints in the presence of a controlling owner is more pronounced in countries with weaker creditor rights. Given the predominance of private firms around the world, their economic significance, and the fact that an increasing number of private firms now operate in multinational environments with different institutional features, we contribute to the literature on the role of financial information, firm characteristics, and country-level institutions for an important and interesting group of firms.

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Notes

  1. If there were only benefits and no costs associated with engaging the services of an independent audit firm, all firms would hire an auditor. The fact that one-half of our private firms do not choose to have an audit suggests that there are non-trivial costs related to auditing (out-of-pocket costs, reduction in ability to extract private benefits of control, etc.). We later model the choice to have an audit, and control for this potential endogeneity in our tests.

  2. The survey data are publicly available (http://www.enterprisesurveys.org/).

  3. Our sample is also much larger than that employed by Chen et al. (2011), and includes firms from both developed and emerging markets, thus providing significant cross-country differences in the quality of country-level institutions.

  4. It is not obvious whether external auditors play a lesser or a stronger role in private firms than in public firms. On the one hand, Coffee (2005) discusses how the existence of controlling shareholders can affect auditor independence. That is, Coffee argues that it is difficult for the auditor to escape the control of the party that he or she is expected to monitor. On the other hand, the monitoring value of auditing may be higher in private firms, because they are less vulnerable to takeovers, and because they are required to disclose less non-financial information.

  5. The question of whether country-level institutions and firm-level governance mechanisms such as auditing are primarily substitutes or primarily complements is discussed further in Choi et al. (2008), Francis and Wang (2008), and Hope et al. (2009), among others.

  6. In addition, the World Bank is unlikely to be related directly to the individual firms in the survey, thereby further limiting the potential for systematic bias in survey responses.

  7. A number of recent studies employ the WBES data in a variety of contexts (http://www.enterprisesurveys.org/ResearchPapers/).

  8. Based on medians (means), the Pearson correlations are −0.34 (−0.27) and −0.33 (−0.28), respectively.

  9. Specifically, the survey does not distinguish between audits and reviews. Audits involve more work by auditors than do reviews, but clearly having the financial statements either audited or reviewed will imply higher credibility and quality than not having an independent auditor examine the statements at all.

  10. Our empirical tests include both country and industry fixed effects.

  11. Clementi and Hopenhayn (2006) further show that the sensitivity of investment to cash decreases with age and size.

  12. The sample size (and hence generalizability) is greatly reduced when using sales or total assets as alternative size proxies. Nevertheless, the use of these alternative size proxies does not change any inferences.

  13. Inferences are not affected if we use log transformations of Employ and Age.

  14. We observe that the mean ratio of within-country standard deviation to the overall standard deviation is 0.8, implying that self-reported corruption is partially country-dependent, as expected.

  15. We include country fixed effects in all tests. This is a common approach for controlling country-specific effects and addressing correlated omitted country-level variable problems (Doidge et al., 2007).

  16. We classify creditor rights scores of 3 and 4 as high, otherwise low. The sample is somewhat smaller for this test owing to the availability of creditor rights scores in Djankov et al. (2007). Note that we continue to control for variations in other country-level characteristics in these tests through the inclusion of country fixed effects.

  17. PSM implies matching on observables (our chosen matching dimensions), whereas the Heckman test is based on “unobservables.” In practice it is difficult to know which issue is more important, so for completeness we report results using both approaches.

  18. As an alternative (or additional) instrument we have used the percentage of the workforce that is unionized. Since unions’ negotiated contract terms depend in part on the firm's reported profitability, unions are likely to demand high-quality financial information that is less likely to be subject to management bias (D’Souza, Jacob, & Ramesh, 2000). Results are consistent in these specifications. We have also repeated our main tests using probit with Educ employed as an additional control variable (untabulated). No inferences are affected.

  19. Although it would be interesting to also know the specific area from which the degree was earned (e.g., accounting, finance, engineering, sociology), such detailed data are not available in our database. Furthermore, in a recent paper, Chen, Evans, and Hwang (2010) use the proportion of employees with graduate degrees (regardless of field) to proxy for employee knowledge and skill levels. Annual surveys from Spencer Stuart further suggest that most managers have engineering and/or business as their educational background. Thus we consider that our general measure of education provides us with a reliable exogenous measure for our endogeneity test. Finally, it is theoretically possible that Educ may relate indirectly to financing constraints through some other (unknown) variable. For example, a more highly educated manager may operate the firm better, leading to better firm performance and therefore fewer financing constraints. However, Gottesman and Morey (2006), and Bhagat, Bolton, and Subramanian (2010) find no relation between CEO education and firm performance.

  20. Heckman, Ichimura, and Todd (1998), and Li and Prabhala (2007) provide support for matching as an econometric technique for addressing endogeneity based on observables (see also Lawrence, Minutti-Meza, & Zhang, 2011).

  21. We also conduct tests to check whether the matched sample is balanced. Specifically, we check for difference in means of Educ and Employ between the two groups. We find that the differences in means are statistically insignificant for both of these variables, implying that the matched sample is well balanced along these dimensions.

  22. In addition to the above tests, we further evaluate the impact of potential confounding variables by following the approach suggested by Larcker and Rusticus (2010) and find that the “impact threshold for confounding variables” (ITCV) is reasonably high at 1.3%, compared with the benchmarks derived using the coefficients on control variables in the same regression. Comparison of the ITCV with the impact of control variables using “partial” correlations reveals that only Control and Corrupt are close to the ITCV, at 1.3% and 1.5%, respectively. Comparison of the ITCV with the impact of control variables using “raw” correlations shows that the ITCV is comfortably greater than all the other raw impacts.

  23. Hope (2003) provides details on the CIFAR scores including a variety of validity tests. Note that our sample is reduced to 10,188 in this test (with FinCred) owing to the non-availability of CIFAR scores for many sample countries.

  24. The results of these sensitivity analyses are not tabulated for brevity.

  25. We have also controlled for “loan age” (i.e., the current year minus the year the most recent loan was approved). As expected, we find a negative and significant coefficient on loan age, and no inferences are affected.

  26. Firms that are owned by a single owner may differ substantially from multi-owner firms. We provide separate results for firms with a single owner (i.e., 100% ownership concentration) vs firms with more than one owner. We note that our results for both FinCred and the interaction effect hold when one owner does not own the entire firm. As an additional test, we repeat tests with a continuous measure of ownership concentration measured as the percentage stake held by the largest shareholder. We continue to find evidence that financing credibility reduces financing constraints, and that the constraint-reducing effect of financial credibility increases with ownership concentration.

  27. We have also partitioned the sample based on these variables. For example, similar to our results for Hypothesis 3 using creditor rights, when partitioning on the median gross national income per capita, we find that the main effect of FinCred is negative and significant in both subsamples, but that the interaction effect is significant only in the countries with below-median income. Furthermore, the vast majority (89.54%) of our sample observations are from countries classified by the United Nations as “developing.” We find that results are consistent when including only developing countries. However, for the small sample of developed-country firms, the estimated coefficients on our test variables are not statistically significant.

  28. In other words, our predictions do not rely on the choice of audit being made at the firm level, but only that some firms employ an auditor while others do not.

  29. Twelve countries comprising 4096 observations are excluded when using a cut-off of 80%. We have also performed this test using cut-offs of 75%, 85%, 90%, or 95%.

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Acknowledgements

The authors are grateful for comments received from three anonymous reviewers, John Cantwell (Editor-in-Chief), Andrew Karolyi, and David Reeb (Editors), and workshop participants at the Norwegian School of Economics and Business Administration, ESSEC, National University of Singapore, Singapore Management University, the Financial Accounting and Reporting Section Midyear Meeting (New Orleans), the International Section Midyear Meeting (St Pete's), the LBS Transatlantic Doctoral Conference, the 2nd Annual Corporate Governance and Fraud Prevention Conference (George Mason), the American Accounting Association Annual Meeting (New York), the Financial Economics and Accounting Conference (Rutgers), and the University of Technology Sydney Summer Symposium (Sydney). Hope acknowledges the financial support of the Deloitte Professorship.

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Authors and Affiliations

  1. Rotman School of Management, University of Toronto, Toronto, Canada

    Ole-Kristian Hope

  2. John T. Steed School of Accounting, Michael F. Price College of Business, University of Oklahoma, Norman, USA

    Wayne Thomas

  3. Carlson School of Management, University of Minnesota, Minneapolis, USA

    Dushyantkumar Vyas

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  1. Ole-Kristian Hope
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  2. Wayne Thomas
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Correspondence to Ole-Kristian Hope.

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Accepted by David Reeb, Editor in Chief, 27 March 2011. This paper has been with the author for five revisions.

APPENDIX

APPENDIX

Table A1

Table A1 Definitions of main variables
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Hope, OK., Thomas, W. & Vyas, D. Financial credibility, ownership, and financing constraints in private firms. J Int Bus Stud 42, 935–957 (2011). https://doi.org/10.1057/jibs.2011.23

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