Understanding ownership structures is critical to good audit quality and good governance
In today’s global business landscape, ownership structures are frequently complex and can result in conflicts between, on the one hand, shareholders who want executives to maximise company value, and on the other, executives who may act in their own interests rather than those of the business. Some companies also face increased risks where there are tensions between controlling shareholders who seek to extract private benefits and the remaining shareholders who bear the costs.
Ownership structures and associated governance risks significantly influence the demand for external assurance and information, which allows all parties to feel they are being fairly treated. Audit professionals must therefore be able to navigate the complexities of ownership and risk to ensure financial reporting is accurate and market integrity is maintained.
By mitigating potential sources of conflict in the relations between different shareholders and stakeholders, audit professionals enhance corporate governance. But they also need to be aware of the roles company ownership and associated risks play in shaping the demand for external information, and as a consequence the impact that different kinds of complex ownership structures have on audit fees.
Ownership structure is pivotal in determining the need for external assurance and information. In countries with dispersed ownership, such as the US and the UK, conflicts between shareholders and managers arise from the separation of ownership and control, which can lead to information asymmetry between managers and outside investors.
External auditing bridges this gap by reducing any imbalance in the information available to the different parties and providing assurance on financial reports. External investors require extensive disclosure and timely financial reporting to effectively monitor management.
As conflicts between shareholders and managers are greater where ownership concentration is either low or very high, investors and managers alike in these contexts demand greater assurance to deal with the litigation risk. This heightened litigation risk amplifies auditors’ exposure to risk and so raises their fees.
In contrast, countries with concentrated ownership, such as Germany, France and Switzerland, experience conflicts between controlling and minority shareholders. Here, major blockholders or those with a majority stake address any potential information imbalance through private channels, reducing the importance of public disclosure. The demand for external assurance that does exist in the stakeholder model primarily stems from the specific needs of blockholders rather than public investors.
The lower litigation risk reduces auditors’ focus on business risks in their fees. As a result, audit fees in stakeholder countries follow blockholders’ demand. When a shareholder starts creating a significant stake in a company, fees initially increase as ownership rises, as the shareholders seek to gain board influence and demand more auditing. However, beyond a tipping point, fees fall as private channels suffice for sharing information, and controlling owners look to minimise costs.
To determine the levels of risk in complex ownership models, auditors should identify the entity’s ownership bands.
Under 5%: manager opportunism risk highest:
However, even in the stakeholder model, ownership structures are often complex rather than binary; there isn’t just one controlling shareholder on one side and many minority shareholders on the other.
Instead, most such companies have a mix of ownership entities. In the middle range, there are powerful institutional investors, family shareholders, non-financial corporations, governments and foundations, each holding small but significant ownership packages (typically between 5% and 10%). Despite their relatively small stakes, these blockholders are important in monitoring the controlling shareholder since they have the financial means and the motivation to do so.
While the controlling owner in a stakeholder model does not rely much on public reporting for decision-making (they have access to private information channels), the smaller blockholders want greater assurance to protect their interests in the event of heightened potential conflicts with the controlling shareholder.
Concentration of ownership in the hands of a few dominant shareholders reduces the need for public reporting, but smaller owners looking to keep major owners in check will demand further assurance during critical situations. This intricate dynamic flattens the relationship between ownership and audit fees in stakeholder countries and increases audit fees.
To effectively address the challenges posed by complex ownership structures, auditors should evaluate shareholders’ power and the resulting impact on the different conflicts between managers, controlling shareholders and minority shareholders.
This involves examining ownership bands, mapping blockholders’ influence on the board, and considering the different relationships between ownership and audit fees in dispersed and concentrated ownership countries. Doing this will allow auditors to better determine the areas they need to focus on and tailor their audit planning accordingly.
It is a complex dynamic where an understanding of the following two factors is key:
Audit planning should also pressure-test for ‘red zones’ where conflicts spike.
Proper governance and an understanding of the risks emerging from the conflicting objectives of the different stakeholders resulting from complex ownership structures are critical for audit committees, investors and society as a whole.
By considering ownership dispersion, access to private and public information, and the varying needs of blockholders, auditors can provide effective assurance that aligns with the demands of different ownership models. Ultimately, mastering ownership complexity enables audit professionals to uphold audit quality, bolster market confidence, and facilitate informed decision-making.
Raúl Barroso, professor, IESEG School of Management; Chiraz Ben Ali and Cedric Lesage, professors, John Molson School of Business, Concordia University; Daniel Oyon, professor, HEC Lausanne, Université de Lausanne