The influence of investor protection on the relationship between positive abnormal audit fees and

49 Pages·2011·0.95 MB·English

The influence of investor protection on the relationship
between positive abnormal audit fees and earnings quality.

E.N. Franken

05-10-2011
The influence of investor protection on the relationship
between positive abnormal audit fees and earnings quality

Master thesis Department Accountancy
Faculty of Economics and Business Studies
Tilburg University

Name: E.N. Franken

Date: 05-10-2011

Supervisor: L.M.L. Bruynseels (until 8-6-2011)
Supervisor: S. van der Meulen(as of 9-6-2011)
PREFACE
In 2010 I wrote my Bachelor thesis about earnings quality. I found this a very interesting topic and
decided that I wanted to include this topic in my master thesis. The topic of this thesis is also a result
and a combination of two interesting papers I read during my master study (Hope, Kang, Thomas &
Yoo, 2009 and Choi, Kim & Zang, 2010). In March 2011 I began writing this thesis. My first supervisor
L.M.L. Bruynseels provided me with useful tips in the beginning of the writing process. S. Van der
Meulen took over supervision and provided me counsel. I would like to thank both of them for their
help and supervision.
SUMMARY
The influence of investor protection on the relationship between positive abnormal audit fees and
earnings quality is the main topic of this study. First the relationship between positive abnormal audit
fees and earnings quality is examined for the total sample. Then the influence of investor protection
on the relationship between positive abnormal audit fees and earnings quality is investigated. A
sample of 2.031 firm-yearss from 7 countries in Europe for the period 2005-2009 is used to test the
hypotheses. Results do not support a relation between positive abnormal audit fees and earnings
quality. Also the influence of investor protection is not significant with respect to the relation
between positive abnormal audit fees and earnings quality.
Contents

1. Introduction ……………………………………………………………………………………………………………………………………. 1
2. Abnormal audit fees and earnings quality ………………………………………………………………………………………. 3
2.1 Audit fees ……………………………………………………………………………………………………………………………………………3
2.2 Determinants of audit fees ………………………………………………………………………………………………………………….3
2.2.1 Auditee attributes …………………………………………………………………………………………………………………………3
2.2.2 Auditor attributes …………………………………………………………………………………………………………………………8
2.2.3 Other attributes ……………………………………………………………………………………………………………………………9
2.3 Abnormal audit fees ………………………………………………………………………………………………………………………….10
2.4 Earnings quality………………………………………………………………………………………………………………………………….11
2.5 Earnings quality measures………………………………………………………………………………………………………………….11
2.5.1 Accounting-based attributes ……………………………………………………………………………………………………… 11
2.5.2 Market-based attributes ……………………………………………………………………………………………………………..12
2.6 The relation between abnormal audit fees and earnings quality ……………………………………………………….13
3. Investor protection, abnormal audit fees and earnings quality ……………………………………………………….15
3.1 Influences of legal environment ………………………………………………………………………………………………………. 15
3.1.1 The legal environment, earnings quality and audit quality ………………………………………………………….15
3.1.2 The legal environment and audit fees …………………………………………………………………………………………16
3.2 Measuring investor protection ………………………………………………………………………………………………………….17
3.3 The influence of investor protection on abnormal audit fees and earnings quality ……………………………19
4. Research method ……………………………………………………………………………………………………………………………20
4.1 Abnormal audit fees and earnings quality ………………………………………………………………………………………….20
4.1.1 Measuring abnormal audit fees …………………………………………………………………………………………………..20
4.1.2 Measuring earnings quality …………………………………………………………………………………………………………21
4.1.3 The model for testing hypothesis 1 ……………………………………………………………………………………………..23
4.2 The influence of investor protection ………………………………………………………………………………………………….23
4.2.1 Measurement of investor protection ….………………………………………………………………………………………23
4.2.2 The model for testing hypothesis 2 ……………………………………………………………………………………………..24
4.3 Sample ………………………………………………………………………………………………………………………………………………25
4.4 Descriptive statistics ………………………………………………………………………………………………………………………….26
4.5 Correlations ……………………………………………………………………………………………………………………………………….28
4.6 Univariate analysis …………………………………………………………………………………………………………………………….29
5. Results ……………………………………………………………………………………………………………………………………………30
5.1 Estimation of normal and abnormal audit fees ………………………………………………………………………………….30
5.2 Results of hypothesis 1 …………………………………………………………………………….………………………………………30
5.3 Results of hypothesis 2 ……………………………………………………………………………………………………………………31
6. Summary and concluding remarks …………………………………………………………………………………………………..34
Literature…. …………………………………………………………………………………………………………………………………………….35
APPENDIX 1 …………………………………………………………………………………………………………………………………………….41
APPENDIX 2 …………………………………………………………………………………………………………………………………………….42
1. Introduction
This research investigates if the relationship between earnings quality and abnormal audit fees is
influenced by the level of investor protection in a specific country by using data from countries in
Europe in the period of 2005-2009. Prior research about audit fees mainly focused on the United
States. This research shows if associations also hold for Europe.
First the relation between positive abnormal audit fees and earnings quality will be tested.
Audit fees can vary a lot. The financial executives research foundation did a survey on audit fees in
2009. For public companies, the hourly audit fee rate averaged at $218. The lowest hourly rate was
$110 and the highest hourly rate was $400, both reported by large accelerated filers. Prior research
showed mixed results on the relation between audit fees and earnings quality. Moreover, most prior
studies focused on the effect of non-audit fees on earnings quality. This research uses abnormal
audit fees because they can create similar incentives for auditors to comprise earnings quality in their
reporting decisions with respect to a specific client. So, even if auditors are not allowed to perform
non-audit services for their clients, earnings quality can still be affected when the level of audit fees
is excessively high (Choi, Kim & Zang, 2010). Positive abnormal audit fees are used to examine the
effect of auditor bonding, which has a negative effect on earnings quality. These positive abnormal
fees arise when a client has to pay more than the normal level of audit fees for performed audit
services. It is said that auditors can become financially dependent on their client when these
excessive remunerations are charged.
After the relation between earnings quality and abnormal audit fees is tested, the influence
of investor protection on this relation will be examined. A study by Hope, Kang, Thomas and Yoo
(2009) examined the relation between excess auditor remuneration and the implied required rate of
return. When audit fees are abnormal, investors may perceive the auditor to be economically
bonded to the client which will lead to a lack of independence. They only found evidence of this
relation in stronger investor protection countries. It is expected that the level of investor protection
in a country will also affect the relation between abnormal audit fees and earnings quality. Hail and
Leuz (2006) suggest that audited financial statements cannot fully substitute for weaknesses in
country-level institutions. Firm-level governance may lack credibility for example when auditor
litigation risk is low. In countries where investors are better protected, the role of audited financial
statements may be more prominent. In these countries, auditors are expected to accomplish their
work with more caution so that earnings quality might rise. In settings where investors are less likely
to rely on audited financial statements, countries with weak investor protection, the impact of client-
auditor bonding should have less of an effect on investor’s decisions. If the investor protection
variable has a significant influence on the relation between abnormal audit fees and earnings quality,
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governments should think about adjusting their investor protection rules so that investors can fully
rely on audited financial statements.
Investor protection will be measured by using the Legal enforcement variable (La Porta,
Lopez-de-Silanes, Shleifer & Vishny, 1998). It is measured as the mean score across three legal
variables. For comparability reasons earnings quality will be determined by an accounting-based
attribute, discretionary accruals. Most prior studies concerning audit fees and earnings management
used this measure. In measuring abnormal audit fees prior research from Choi et al. (2010) and
Frankel, Johnson, and Nelson (2002) will be followed. Total auditor fees will be regressed on a large
number of explanatory variables and the residuals from this regression will be used as a proxy for
abnormal fees. The explanatory variables control for normal fees charged by the auditor for a given
level of effort and risk.
Results show that the relationship between positive abnormal audit fees and earnings quality
is not significant for the total sample. Also the influence of investor protection on the relation
between positive abnormal audit fees and earnings quality is found to be insignificant.
In the next section and section 3, the background for this study and hypotheses will be
discussed. In section 4, empirical models will be explained and the sample will be described. In
section 5 the main results will be discussed. Finally, section 6 concludes.

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2. Abnormal audit fees and earnings quality
2.1 Audit fees
Audits are mend to give a high level of assurance that financial reports are not materially misstated.
This assurance reduces the risk for stakeholders to make decisions based on incorrect numbers.
Companies believe that the assurance of an audit will provide them advantages, like a lower cost of
capital, and are therefore willing to pay for it. This payment is called the audit fee or audit
remuneration.

2.2 Determinants of audit fees
Previous research found that audit fees are dependent on a number of variables concerning the
auditor, the auditee, the engagement or other factors. The determinants most commonly used in
prior research will be discussed now using the study of Hay, Knechel and Wong (2006) which
summarizes a large body of audit fee research.

2.2.1 Auditee attributes

Size
According to previous empirical evidence, the main factor driving audit fees is the size of the auditee
or the size of the audit. The amount of variation explained by size is generally in excess of 70 percent.
(Hay et al., 2006). The relation between fees and size is expected to be positive (Simunic, 1980).
Several authors suggested that this relation is unlikely to be linear. First of all because there may
exist economies of scale. Larger audits may cost less, per unit of assets or transactions audited, than
do small audits (Pong & Whittington, 1994). Second, internal control procedures are likely to be more
sophisticated in larger companies (Karim & Moizer, 1996). These internal control systems reduce the
risk of errors and due to this the total time of the audit will decrease. Many studies dealt with this by
turning the size variable either into its square root or into a logarithmic function (Karim et al., 1996).
There are several indicator’s of a company’s size. Most studies used total assets, others
suggested turnover, sales or net profit before tax. Pong et al. (1994) argue that it is possible that both
total assets and turnover feature in a model of the determination of audit fees. According to them,
size may have more than one dimension. An audit may have two broad aspects, an audit of
transactions, which is related to turnover, and verification of assets which related is to total assets.
The use of sales as an indicator of size is criticized because the definition of sales may vary among
entities. This will result in comparability problems. Net profit before tax may not be an appropriate
measure because the bottom line is the result of many other factors besides size (Low, Tan, Koh,
1990).
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Risk
Risk is assessed by auditors at the beginning of the audit. It helps to plan the extent and scope of
audit testing so that an audit failure will be prevented. A risky company will need a higher extent and
scope of audit testing. This will automatically result in higher audit fees. The relation between
auditee risk and audit fees is thus expected to be positive.
Auditee risk is difficult to measure because it reflects multiple aspects. It reflects the nature
of the business and also the control environment instituted by the business. It includes subjective
judgments to for example the integrity of senior management and the internal control strength
(Chan, Ezzamel, Gwilliam, 1993). A measure commonly used in prior studies looks at the two balance
sheet components that are most difficult to audit and are thus of high risk, inventory and receivables
(Low et al., 1990). According to (Hay et al., 2006) inventory and receivables should be combined and
then divided by total assets to obtain the highest results. Gearing and liquidity ratio’s are also used as
a measure of risk, for example by Low et al. (1990). The ratio’s long-term liabilities to total funds and
current assets to current liabilities are recommended by Low, Koh and Tsui (1984) for assessing
gearing and liquidity respectively because they identified them as the most dominant ratio’s in their
analysis. Karim et al. (1996) use a profitability factor to determine auditee risk. They argue that
companies making accounting losses can be expected to represent a higher risk because of the
implied lack of cash flow. In addition to the presence of loss, Low et al. (1990) expect that if a
company received a ‘subject to’ qualification in the year of the audit or if contingent liabilities exist in
the year of audit, the risk will increase and hence audit fees will also increase. Hay et al. (2006) found
that systematic risk was significant and positive in 3 of 5 studies. Chan et al. (1993) state that market
based measures of risk are better proxies for clients’ operating risk though not necessarily of audit
risk.

Complexity
Complexity increases the amount of work and the time needed for the audit. Work and time will
result in higher audit fees. The relation between complexity and audit fees is thus expected to be
positive. Complexity costs should be a reflection of the nature of the business of the auditee, its
location, the quality of its internal control and the proportion of unusual transactions (Karim et al.,
1996). Pong et al. (1994) argue that this variable might interact with size variables, either because it
involves more time or more skilled labor per unit of turnover or assets audited.
The general concept of complexity has been measured in many different ways. The most
typical indicators of complexity include the number of subsidiaries, the number of foreign
subsidiaries, the proportion of foreign assets, the number of Standard Industrial Classification (SIC)
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