Charles Piot

External Auditors, Audit Committees and Earnings Management in France

ABSTRACT We investigate the effect of various audit quality dimensions (i.e. auditor reputation and tenure, audit committee existence and independence) on earnings management in France. We thus contribute to the empirical audit quality literature in a Continental European environment that markedly differs from the USA in terms of auditing and corporate governance. The main findings are that: (1) the presence of an audit committee (but not the committees independence) curbs upward earnings management; and (2) the presence of a Big Five auditor makes no difference regarding earnings management activities. Implications of these findings are discussed with regard to the specificities of the French auditing and governance settings. In particular, although the audit committee acts as a device to control the more egregious (i.e. income-increasing) forms of earnings management, the monitoring incentive of outside directors may be hampered by the collective board responsibility for financial reporting quality. Second, the lack of differentiation among Big Five auditors in terms of accounting conservatism is consistent with the lower litigation risk offered by the French Civil Code (vs. the US Common Law system), which is likely to eliminate the deep pockets incentive for investors.

Corporate Governance Reform and the Cost of Debt Financing of Listed French Companies

This study investigates the effects of governance characteristics on debt financing costs for listed French companies using corporate governance guidelines issued during the late nineties. Although the French system is strongly debt-oriented, creditor legal protection is weak and financial institutions have few direct internal monitoring channels (i.e., presence on the Board of Directors). We postulate, therefore, that they value the quality of corporate governance when determining loan conditions. Using a 1999-2001 sample of large, non-financial listed companies, we find an inverse relation between the ex post cost of debt and three corporate governance quality attributes: (1) Board independence, (2) the existence of a compensation committee composed of non-executive directors, and (3) the presence of significant institutional shareholders in the firm’s equity. However, the existence of an independent audit committee provides no significant benefits. These results are robust to firm size effects and to a large set of firm-specific characteristics. This study provides empirical support for the benefits of more effective monitoring of debtholders’ agency risk, but does not support accounting-auditing monitoring benefits regarding debtholders’ information risk. This might be explained by the very limited use of debt covenants in France at the time of the study. This study offers insights to financial institutions for benchmarking the quality of borrowers’ corporate governance, and in creating more optimal contract provisions in loan agreements. It also provides suggestions for corporate officers in the negotiation of interest rates with lenders.

An Evaluation of the French Experience with Joint Auditing

The Green Paper entitled “Audit policy: Lessons from the crisis” (European Commission, 2010) recommends the introduction of joint audit for European listed companies, based on the French experience, to limit the market dominance of the Big 4 and to promote audit quality. However, the regulation passed by the European Parliament in April 2014 does not require, but only encourages the use of two auditors for public-interest entities (European Parliament, 2014). Since many groups of interests tried to influence the European Commission during the consultation process, it is relevant to evaluate the costs and benefits for investors of the unique joint audit system that persists among the occidental economies. Overall, the results drawn from the academic literature involving the French audit setting suggest that the French market is slightly less concentrated than other European markets. However, joint audit does not increase the quality of accounting information, while the cost of auditing services is significantly higher in France. Together, these elements cast serious doubt on the efficiency of the French mandatory joint audit system for investors.

The Audit Market Dynamics in a Mandatory Joint Audit Setting – The French Experience

Policy makers in France have considered joint audits as a solution to mitigate the audit market concentration and the “systemic” risk associated with Big 4 auditors. We implement a Markovian analysis where audit clients chose between different types of combinations across Big 4 and smaller auditors. Our main findings support the view that the French joint audit system is effective in maintaining market openness and in mitigating the Big 4 domination in the long run. An investigation of the determinants driving changes in joint audit combinations suggests little economic support in favor of two Big 4 combinations, whereas changes in audit clients’ agency costs (e.g., higher ownership concentration) tend to explain the performance of mixed and two non-Big 4 combinations. Overall, this study supports the European Commission’s position on the potential benefits of joint audits in mitigating the market concentration; it also suggests that it might not be necessary to impose mixed joint audits to achieve that objective.