The effect of insured liabilities on the demand for external audits: The case of privately‐held United States banks

• Author: Brad J. Reed,Jamie Hoelscher,Gregory Sierra
• Published date: 01 July 2019
• Date: 01 July 2019
• DOI: http://doi.org/10.1002/jcaf.22392

BLIND PEER REVIEW

The effect of insured liabilities on the demand for external audits:

The case of privately-held United States banks

Jamie Hoelscher | Brad J. Reed | Gregory Sierra

Department of Accounting, Southern Illinois

University Edwardsville, Edwardsville,

Illinois

Correspondence

Gregory Sierra, Department of Accounting,

Southern Illinois University Edwardsville,

Campus Box 1104, Edwardsville, IL 62026.

Email: gsierra@siue.edu

Abstract

We examine the relationship between government insurance for bank deposits and

bank management's voluntary audit choice for a set of privately-held U.S. banks.

Unlikely publicly-traded banks, U.S. regulations do not require pr ivate banks to

obtain annual audits. However, all U.S. banks have the feature of insurance on cus-

tomer deposits that is provided by the Federal Deposit Insurance Corporation—these

insured customer deposits comprise a significant portion of the debt of most banks.

Consistent with prior research we find that the voluntary choice to be audited is posi-

tively related to agency costs asmeasured by the size of bank assets. Our results show

a negative association between a bank's insured deposits and the choice to be audited

but (consistent with prior literature) a positive association with uninsured liabilities.

In addition, we hypothesize and find that the bank's voluntary audit choice is posi-

tively related to the bank's growth rate and related to the bank's primary federal regu-

lator. Taken together, these findings are consistent with the notion that audits create

value primarily for uninsured depositors and have implications for bank managers,

their customers, and regulators.

KEYWORDS

audit, banking, deposit insurance, regulation, voluntary audit choice

1|INTRODUCTION

We extend the voluntary audit demand literature by examining

the effect of deposit insurance on the demand for external

audits. Prior research has investigated the demand for auditing

using an agency cost framework and has demonstrated a posi-

tive association between increased leverage and increased pro-

pensity to demand external audit. Menon and Williams (1994)

hypothesize that external audit serves as insurance for creditors.

Using publicly available data, we investigate the voluntary

demand for auditing services in the presence of insured liabili-

ties and explore whether actual insurance for creditors attenu-

ates audit demand.

We overcome data limitations in prior literature due to small

sample sizes. Because public U.S. companies are required to

be audited, the voluntary audit literature has often used smaller

samples of private companies. Limited data on private

companies can and perhaps has hindered more research into

voluntary audit demand. By studying private U.S. banks we

overcome research limitations due to limited numbers of

observations and time span. All banks in the United States are

required to file Call reports with their banking regulator. Call

reports contain audit choice and financial statement informa-

tion prepared in accordance with generally accepted account-

ing principles (GAAP). The data cover thousands of banks

over more than 20 years. In addition to providing financial

information on the Call report, banks indicate whether finan-

cial statements are audited.

One characteristic unique to banks is the insurance pro-

vided by the Federal Deposit Insurance Corporation (FDIC)

on the bank's deposits. We use this feature of bank capital

structure to examine the effect of insured liabilities versus

Received: 30 March 2019 Accepted: 15 April 2019

DOI: 10.1002/jcaf.22392

8© 2019 Wiley Periodicals, Inc. J Corp Acct Fin. 2019;30:8–19.wileyonlinelibrary.com/journal/jcaf