The UK audit report revision

The UK audit report revision

Student  number:  10858571   Date:  16-­‐06-­‐2015  

Word  count:  14331  

Thesis  supervisor:  Dr.  J.J.F.  van  Raak  

MSc  Accountancy  &  Control,  specialization  Accountancy   Faculty  of  Economics  and  Business,  University  of  Amsterdam  

Statement  of  originality    

This  document  is  written  by  student  Jara  Desart,  who  declares  to  take  full  responsibility  for  the   contents   of   this   document.   I   declare   that   the   text   and   the   work   presented   in   this   document   is   original  and  that  no  sources  other  than  those  mentioned  in  the  text  and  its  references  have  been   used   in   creating   it.   The   Faculty   of   Economic   and   Business   is   responsible   solely   for   the   supervision  of  completion  of  the  work,  not  for  the  contents.  

Abstract

In October 2012 The Financial Reporting Council has introduced the revised International Standards on Auditing in the UK, to improve the usefulness and transparency of the auditor’s process. This paper examines the effect of the revised ISAs on audit quality and the perceived usefulness of investors regarding the auditor’s report. The sample consists of firms from the FTSE350 with data available in the period of 2012 until 2014. The data is partly hand collected from the auditor’s report and partly from Compustat Global and Datastream. The effect on audit quality is measured with the Modified Jones model and the effect on the perceived usefulness of investors regarding the auditor’s report is measured with the earnings response coefficient. This study found no significant relation between the revised ISAs and audit quality. The insignificant findings could be attributable to already high enough audit quality levels, where there is not much room for improvement. Likewise, this research did not find a significant relation between the revised ISAs and the perceived usefulness of investors regarding the auditor’s report. One of the reasons this could be the case is the fact that the granularity of the reporting of risks is not yet at the desired levels. The results of this study are interesting for other countries implementing the same kind of regulations in the near future. So the overall conclusion and social contribution of this paper is that it might be necessary to re-examine the future revisions of comparable regulation before implementing it in other countries, to ensure they meet their intended goals of increasing the transparacy, decision usefulness and quality of the audit.

Content

1. Introduction P. 5

2. Literature review and hypothesis development P. 9

2.1 The role of the audit P. 9

2.1.1 The monitoring role P. 9

2.1.2 The information role P. 10

2.1.3 The insurance role P. 11

2.2 Reason for a more extensive audit report P. 11

2.3 The revised ISAs (UK and Ireland) P. 13

3. Sample and Research methodology P. 16

3.1 Sample P. 16

3.2 Research methodology P. 18

3.2.1 Methodology hypothesis one: Modified Jones model P. 18 3.2.1 Methodology hypothesis two: Earnings Response Coefficient P. 20

4. Results P. 22

4.1 Hypothesis one: Audit quality P. 23

4.1.1 Descriptive statics P. 23

4.1.2 Correlation P. 24

4.1.3 Regression analysis P. 25

4.1.4 Sensitivity analysis P. 27

4.2. Hypothesis two: Perceived investors usefulness P. 28

4.2.1 Descriptive statics P. 28 4.2.2 Correlation P. 29 4.2.3 Regression analysis P. 29 4.2.4 Sensitivity analysis P. 32 5. Conclusion P. 34 6. References P. 36

1.

Introduction

In the past years the audit profession has been the subject of a lot of scrutiny. The two main reasons for this are the financial crisis and a number of financial scandals. The financial crisis has impacted the reputation of the auditing profession and raised questions about the contribution of the auditors and their designated role and scope of auditing, both in law and in auditing standards (Humphrey, Kausar, Loft & Woods, 2011). The House of Commons Treasury Committee (2009) in the UK for example questioned the contemporary role and relevance of the audit function in light of the fact that the financial crisis had happened, even when the auditors may have performed the job that is formally required of them. This raised questions in other reports about how major financial institutions could this easily collapse when they received an unqualified audit opinion just before the crisis (Sikka, 2009). In response on these events stakeholders from investing and political backgrounds, but also from the accounting profession itself, have increased their demand for a more extensive audit report to increase transparency and audit quality. Humphrey et al. (2011) also points out the importance of greater transparency in the work performed by the auditor and a better understanding of regulatory changes on audit quality. The second reason for increased scrutiny of the audit profession results from a number of financial scandals worldwide, for example the Enron scandal, the Madoff scandal and the Worldcom scandal (Francis, 2004; Knechel, Krishnan, Pevzner, Shefchik & Velury, 2013). In the public opinion these scandals are the fault of the audit profession, because they are responsible for the credibility of the financial information of a company. Consequently, stakeholders should be able to get enough information from the auditors to evaluate their investments. However, in the past years the auditor’s report has been criticized a lot. Critics’ imply that the report is not informative enough and the process not transparent enough, to make well founded investment decisions. This is due to the fact that auditors follow a standardized format in their auditor’s report that gives little information on the activities and procedures the external auditor performs or the concerns that the auditor has about the financial position of the firm. Especially beacause the auditor’s report is the most important way for the auditor to communicate with the stakeholders. Consequently, critics have the opinion that the audit report should be as useful and meaningful as possible. Especially now, in times that the global business environment has to deal with increasingly complex financial reporting requirements, stakeholders ask for more useful information to make their decisions (IAASB, 2013).

The Financial Reporting Council (from now on FRC), the independent regulator of the UK and The Republic of Ireland, who is responsible for promoting high quality corporate governance and reporting to foster investments, has recognized this problem. The main task of the FRC is setting out the framework of codes and standards for the accounting, auditing, actuarial and investor communities and overseeing the conduct of the professionals involved (FRC, 2014). The FRC is the first regulator in the world that implemented revisions in its regulation to address the lack of transparency of the auditing process. They have revised the regulations regarding the auditor’s report commencing from October 2012, to improve the usefulness and transparency of the auditor’s report. These revisions are based on the International Standards on Auditing (UK and the republic of Ireland) (from now on ISA) starting from October 2012. Other countries have not adopted these ISAs yet. The revised ISAs are discussed in a sequential order, the first one is ISA 260 (Communication with those charged with governance). The second change is ISA 700 (The independent auditor’s report on financial statements). This ISA contains the most important changes for this study and it requires auditors to report more about the scope of their work and communicate this better to the stakeholders. ISA 700 is only required for companies which apply the UK Corporate Governance Code, other firms are also permitted to disclose on these matters voluntarily. The most striking change of ISA 700 in the auditor’s report are the three subsections, containing a description of the assessed risks of material misstatement, the concepts of materiality and a summary of the audit scope. The last three changed ISAs are ISA 705 (Modifications to the opinion in the independent auditor’s report), ISA 706 (Emphasis of matter paragraphs and other matter paragraphs in the independent auditor’s report) and ISA 720A (The auditor’s responsibilities relating to other information in documents containing audited financial statements). Another striking change you will encounter when reading the auditor report for example is the change in place of the opinion/conclusion of the auditor, which is moved to the beginning of the report. This change is made because the main user of the auditor report is only interested in the overall conclusion of the auditor and is not interested or does not have the skills to understand the remainder of the report (Mock, Be’dard, Coram, Davis, Espahbodi & Warne, 2013). This change is not required by the FRC, but the firms in the UK have made this change on voluntary basis (FRC, 2015). This change is however required in the new regulation of the IAASB for the EU starting December 2016 (IAASB, 2015).

These revisions have different consequences for the audit profession. The overall expectation is that investors will find the changes useful and that the audit quality will improve. PWC UK (2013) suggested for example that the auditors and the audit committee will have to work together to a greater extent, which in turn is expected to improve the audit quality. Recent studies also find that investors would like more useful information (Mock et al. 2013). Knechel et al. (2013) remarked that audit quality is determined by the quality of the audit process, however regulatory efforts to make the audit processes more standardized may have the effect of reducing the quality of an audit. The FRC however stated in the revision of ISA 700 that the explanations of the matters required to be set out in the auditor’s report by paragraph 19A shall be described in a way that enables them to relate directly to specific circumstances of the entity and are not generic of abstract matters expressed in a standardized language. So this change in regulation in the audit process is expected to increase audit quality. However, there are also studies that argue that financial statement users do not benefit from a more extensive auditor’s report (Gold, Gronewold & Pott, 2012).

Following this information it is not clear what the actual effect is of the revised ISAs. Therefore, this paper addresses the following research question: What is the effect of the implementation of the revised International Standards of Auditing commencing from October 2012 in the UK on the audit quality and what is its effect on the perceived usefulness of the auditor’s report?

There are several ways this paper contributes to exiting knowledge of previous literature. Firstly, the aim of this study is to provide archival evidence concerning the effect of the ISA (UK & Ireland) revision commencing from October 2012 on audit quality. Because the revision is only implemented end 2012 there is no archival evidence available in the existing literature. Therefore, there are only theories and speculations about their effects, which the legislation is built on. It would be interesting to know if the regulator implemented the correct revisions to achieve their intended objectives. Further, the results of this research are as well of importance to other accounting regulation organizations, because the FRC in the UK is ahead of other regulatory organizations in dealing with the problems concerning the transparency and usefulness of the existing auditor’s report. Other accounting regulatory organizations could evaluate and learn from the already existing regulations in the UK and take this into account in their own regulation revisions. Deloitte (2013) states in their newsletter resulting from the revision: “The UK is not alone in moving toward a more

discursive audit report- the Public Company Accounting Oversight Board in the USA, the European Commission and the International Auditing and Assurance Standards Board all have initiatives in this area. However, the UK has led in this area, reinforcing London’s position as a center for leadership in thinking on Corporate Governance matters.” Most of these new revisions in other countries are already at the end of their developing phase, but are still being discussed and not implemented yet. Finally, Mock et al. (2013) suggest there is only limited research on the impact of the auditor’s communication on the quality of the audited information, and when performed the results are mixed. Mock et al. think that the auditor’s communication may improve the quality of information either directly but also indirectly through disclosing the information by the auditor. My research looks at the effect of more extensive auditor’s communication through the revised auditor’s report. Results of this study can therefore contribute to the existing literature.

The research question is examined in two separate parts, first the effect of the revised ISAs on audit quality is measured using the Modified Jones model by Dechow, Sloan and Sweeney (1995). This is an earnings management model, which expects an association between the change in revenues as well as gross property plant and equipment and the amount of discretionary accruals. Secondly the effect of the revised ISAs on perceived usefulness of investor regarding the auditor’s report is tested, using the earnings response coefficient. The amount of assessed risks of material misstatement is used as a proxy for the change due to the revised ISAs. Both tests are done on a sample derived from the FTSE350, with available data for the years 2012 until 2014. The findings of both test are insignificant, indicating that the revision of the ISAs have no effect on either the audit quality and perceived usefulness of investors regarding the auditor’s report in the model of this paper. This would mean that the FRC has not succeeded in reaching their objectives to increase the usefulness and transparency of the audit process.

The remainder of this paper is structured as follows. Section two discusses the literature surrounding audit quality, perceived usefulness of investors and the revised ISAs, followed by the development of the hypotheses. Section three first explains the sample used in both hypotheses and discusses the two methodologies used to examine both hypotheses. Starting with the Modified Jones model and subsequently the earnings response coefficient. Section four proceeds with the results, divided in descriptive statics, the correlation matrix, the

regression analyses and a sensitivity analyses. The paper ends with an overall conclusion in section five.

2.

Literature review and Hypothesis development

In this part of the paper I will discuss the background of the most important notions of my research question. I will do this on the basis of existing literature. First the role of the audit is discussed, after this I explain the reasons for a more extensive audit report and I continue with the revised ISAs, eventually I will develop my hypotheses.

2.1 The role of the audit:

I start the literature review with discussing the most important roles and research surrounding auditing. Wallace (1980; 2004) gives three hypotheses of the role of the audit in a free regulated market: The monitoring role, the information role and the insurance role. These roles give an indication why it is important that the audit process and consequently the auditor’s report should be more extensive, so it is more useful for the investors and other third parties. In the next subsections I discuss these three hypotheses.

2.1.1 The monitoring role:

To explain the monitoring role I first discuss the agency theory (Watts and Zimmerman 1979,

1986a, 1986b), which is closely related with the monitoring role. The agency theory assumes

a company consists of a web of contracts. These contracts can be with different parties, like suppliers, bankers, shareholders, employee’s etcetera. The management is supposed to coordinate these groups with contracts to try to get the optimal result for every party involved. So the management in this case is the agent and the third parties who invested in the firm are the principals. The role of the auditor is to consider the interest of the third parties of a firm and its management at the same time.

With the agency theory in mind I will now explain the monitoring role of the audit (Wallace, 1980 and 1987). The agency theory assumes that one party (principal) delegates its decision-making power to another party (agent). The principals of the firm want to ensure that the agent acts in a way that is in their best interest. The agent is willing to agree to be monitored if this is in his best interest, so when the benefits exceed to cost. There are two main problems

resulting from the agent-principal relationship, moral hazard and information asymmetry. Beaver (1989) states that the monitoring role of accounting tries to solve this problem. Moral hazard exists when the agent has superior information over the principal, in this situation the agent can use this information in their self-interest. The use of public disclosure is one way to overcome the problem of moral hazard. An independent outsider should audit these public disclosures. This way the audit reduces the agent’s chances to keep crucial information from their shareholders and third parties, resulting in a decrease of information asymmetry. The revised ISAs require more disclosure by the auditor on different aspects. The auditor has to describe the assessed risks of material misstatement, which provides the investor with more firm specific information about the risks a firm has to deal with in regard of its financial statement. This way the investors have additional objective information to increase their effective monitoring role.

2.1.2 The information role

The information role of auditing became more apparent since the 1960s. The auditing role became more focused on need and provision of information to enable users to take economic decisions (Higson, 2003). This role of auditing adds an extension to the monitoring role discussed before. As Wallace (1980) states, the audit is valued by investors as a means of improving the quality of financial information. Investors are able to make better investment decisions with more dependable and higher quality information. The first main benefit from the audit information role is the reduction of risk. The second benefit is the improvement of decision-making of the management and the investors. Audited information can help investors to better evaluate a firm’s performance, however it can also increase the decision making process of the managers. An auditor can assure higher quality information where the managers depend on. Managers and employees will also be more careful and accurate in preparing their records if they know they are being monitored (monitoring role) and the last benefit is making earnings of trading profits (Fama and Laffer, 1971). The revised ISAs provide more objective information for the investors, but also for the management. Auditors point out where the risks are concentrated of a firm, in regard to the financial statement. This can help the management to focus more on these areas. Investors on the other hand can use the extra objective information to make better investment decisions.

2.1.3 The insurance role:

The last role discussed by Wallace (1980) is the insurance role, which comprises of the management’s liability exposure. The liability of auditors and the firm being audited for losses to third parties, resulting from defective financial statements, can be carried jointly and severally. Menon and Williams (1994) found that investors see auditors as a guarantee of financial statement quality. Firms can shift their financial responsibility and so their expected loss of litigation with the use of auditing.

These roles give an indication of how valuable the role of the audit is according to investors. The only way the auditor communicates with the investors and other third parties is via the auditor’s report. However, investors have been critical on the lack of information the auditor’s report contains. The revised ISAs address this problem.

2.2 Reasons for a more extensive auditor report

In this part of the literature review I discuss the most important reasons for the higher demand of a more extensive auditor’s report, given by critics from the political, stakeholder and accounting profession background. I also discuss the concept of the audit expectation gap, the communication gap and information gap, which are mentioned in the study of Mock et al. (2013).

The auditor report is mainly seen as a pass/fail report, which normally presents a standard unmodified opinion. For a long time this has raised concerns about the form, content, and overall communicative value of the auditor’s report (Church, Davis & McCracken 2008; Smieliauskas, Craig & Amernic, 2008). According to Limperg (1932) changes in the needs of the community and changes in the auditing techniques result in changes in the auditor’s function. Carmicheal (2004) explains this statement, he states that the touchstone for the auditor is always to perform the work and obtain the evidence necessary to provide the assurance that society needs and reasonably expects.

Mock et al. (2013) evaluate relevant research concerning the auditor’s report. They look at what aspects of information financial statement users perceive as information that should be communicated. Subsequently they look at results from previous research which study the effects of existing auditor communication methods and other auditor communication methods currently being considered on financial statement users. Mock et al. (2013) reviewed the

audit-reporting model in connection with the financial statements based on the proposition of an existing gap between the information that is now available in the financial statements and through the auditor’s report, and the information that is perceived to be useful by some users. This gap consists of three parts: the expectation gap, the communication gap and the information gap. The IAASB (2011) refers to the expectation gap as the difference between what users expect from the audit process, and the reality of what an audit is. The information gap on the other hand reflect the difference between what information investors desire and what is available to them from existing public information (IAASB, 2011). The communication gap is closely related to this, it reflects the difference between what the users of the auditor’s report desire and understand and what is really communicated (IAASB, 2011).

Mock et al. (2013) discuss some elements of information that are perceived as useful by investors and other third parties to decrease these gaps and make the auditor’s report more useful and the audit quality indirect higher. They also indicate the way this information could be communicated. I discuss some of the relevant elements in relation with this study, the first element is the going concern opinion. Investors would like to get more information about this important part of the auditor report, which could be done with an explanatory paragraph, some extra commentary or an auditor discussion and analyses. Investors also want more details about the level of materiality. Mock et al. indicate this could be done with a simple disclosure, which is done in the revised ISA700 and will be further explained in the next paragraph. Recent research of Church et al. (2008) came to the conclusion that a high part of the investors misunderstand the concept of materiality. It might help close the existing gap for both expectation, information and communication if there were additional auditor disclosures related to materiality. This is backed up by a study of the CFA Institute (2010), which found that 77% believe that information about materiality will be useful. Further, users would perceive it useful if there is more clarification on the concept and responsibility of reasonable assurance. Investors would also find it useful if there were an explanatory paragraph, some extra commentary or an auditor discussion on significant audit risk, the way the auditor responses to mitigate these risks and the results of these procedures. This aspect is addressed in the revised ISA 700. The last element is the disclosure of the audit partner name. In the next section of the literature review named “The revised ISAs (UK and Ireland)”, the revised ISAs take some of these elements of information into account. However, the disclosure of the audit partner name is already required in the UK since fiscal year 2009. The disclosure of the

audit partners name is supposed to increase audit quality through an increase in the perceived accountability of the engagement partner (Blay, Notbohm, Schelleman & Valencia, 2012; ICAEW 2005; DeZoort, Harrison & Taylor, 2006).

The working paper from Bedard, Bera and Sirois (2014) discusses the informational value of key audit matters in the auditor’s report, they support their research with an eye-tracking study. Their main results show that the matters mentioned in the audit report affect the participants’ information search and increase their attention to financial statements disclosures mentioned in the audit report but they also reduce their level of attention to the rest of the financial statements.

There are however also studies (Asare and Wright, 2009; CAQ, 2011) who find that the auditor’s report is already useful for decision makers, because it indicates if the company will continue as a going concern and if the financial statements do not contain material misstatements. Gold et al. (2012) conclude that the audit opinion alone may signal sufficient relevant information to users. They suggested that financial statements users did not benefit from the extra information required by the revised ISA700. Another reason that investors and third parties may not benefit from a more extensive auditors report is the fact they do not read the auditor’s report. Porter, hÓgartaigh and Baskerville (2009) found evidence in the U.K. and New Zealand that 47% of the financial statement users never or rarely reads the auditor’s report. This is also the reason why the audit opinion, the conclusion of the auditor’s report is placed at the beginning of the revised auditor’s report. This way financial statement user with little time, a lack of interest or a lack of capabilities in understanding the remaining information of the auditor’s report can more easily read the main conclusion alone.

2.3 The revised ISAs (UK and Ireland)

I continue with presenting the actual revisions made to the International Standards of Accounting by the FRC for the UK and Ireland. First I discuss which revisions were made to the ISAs and secondly I discuss the expected benefits they are supposed to have. I use the consultation papers of the FRC (2012; 2013) and different opinions from accounting firms like Deloitte, institute of chartered accountants, investment management associations etc. to explain their expectations. I proceed by briefly discussing all of the revised ISAs (ISA 260, ISA 700, ISA 705, ISA 706 and ISA 720A).

ISA 260 deals with the auditor’s responsibility to communicate with those charged with governance in an audit of financial statements. Those charged with governance may assist the auditor in understanding the entity and its environment, in identifying appropriate sources of audit evidence, and in providing information about specific transactions or events. This ISA helps in fulfilling their responsibility to oversee the financial reporting process, which consequently helps in reducing risks of material misstatements.

ISA 700 deals with the establishment of standards and provides guidance on the form and content of the auditor’s report issued as a result of an audit performed by an independent auditor of the financial statements (FRC, 2013). There are several changes concerning this ISA. Firstly it extended the clarification of the scope of the audit on financial statements. It now has to contain the following sentence: “and to identify any information that is apparently incorrect based on, or materially inconsistent with, the knowledge acquired by us in the course of performing the audit”. The second change extends the auditor’s report by requiring the auditor to report by exception if the board’s statement in the annual report setting out the basis on which the board considers that the annual report is fair, balanced and understandable and provides the information necessary for users to assess the entity’s performance, business model and strategy, is inconsistent with the knowledge acquired by the auditor in the course of performing the audit. And if the matters disclosed in the section of the annual report describing the work of the audit committee do not appropriately address matters communicated by the auditor to the audit committee. The last change in the auditor’s report resulting from the revised ISA 700 consists of three different extra subsections (FRC, 2013; Collings, 2013). This is the most important change for the second hypothesis, regarding the perceived investor’s usefulness. The first subsection is a description of the assessed risks of material misstatement that have been identified by the auditor that had the greatest effect on the overall strategy, resource allocation and the direction of the audit engagement team’s effort. The second subsection is about how the auditor has applied the concepts of materiality in planning and performing the audit. It should contain a threshold used by the auditor indicating the materiality for the financial statements as a whole. The last subsection consists of a summary of the audit scope and an explanation of how the scope was responsive to the assessed risks of material misstatement and the auditor’s application of the concept of materiality as disclosed in the audit report.

ISAs 705 and 706 deal with to what degree the form and content of the auditor’s report are affected when the auditor expresses a modified opinion or includes an Emphasis of Matter paragraph or an Other Matter paragraph in the auditor’s report. No changes were made to the underlying concepts of these ISAs. They only require more clarification to ensure no misusing.

ISA 720A deals with the auditor’s responsibilities relating to other information in documents containing audited financial statements. The main change requires the auditor to also read other information to identify any information that is apparently incorrect based on, or materially inconsistent with, the knowledge acquired by the auditor in the course of performing the audit.

There are several benefits expected from the revised ISAs. First of all, the enhanced external auditor’s communication with the audit committee (Deloitte, 2013). The audit quality could increase through better communication and discussion of relevant information the audit committee possesses. The new regulations should also enhance the communication between the auditor and those charged with governance, for example through more robust dialogue about the key audit matters that will be communicated in the auditor’s report. This benefits the work of the auditor and could in turn increase audit quality. Another benefit of the new regulation is the renewed focus of the auditor on matters to be reported, which could indirectly result in an increase in professional skepticism, among other contributors to audit quality (IAASB, 2015 and Deloitte, 2013).

Evaluating these benefits resulting from the revised ISAs I developed the following hypothesis:

H1: The revised International Standards of Auditing (UK & Ireland) commencing from

October 2012 increase audit quality.

Another benefit communicated by Deloitte (2013) is the enhanced communicative value of the auditor’s report, providing more transparency about the audit that was performed. This addresses one of the main critics the audit profession has endured after the financial crisis. Especially the ISA700 requires extra information for the investors about the concept of materiality, assessed risks of material misstatements and a summary of the audit scope. The last benefit is addressed by the FRC (2015), which is of the opinion that standardized

language has less communicative value and it provides less incentive for stakeholders to read the auditor’s report, than more company specific information would. The additional sections under the revised ISA 700 give room for more specific firm information. So financial statement users should perceive the new auditor report as more informative and useful. Which in turn should increase the number of financial statement users that actually read the auditor’s report.

Evaluating these benefits resulting from the revised ISAs I developed my second hypothesis: H2: The revised International Standards of Auditing (UK & Ireland) commencing from

October 2012 enhance decision usefulness.

3.

Sample and Research methodology

In this part I explain the research methodology used to answer the research question. The first part consists of a discussion of the sample and continues with an explanation of the research methodology.

3.1 Sample

The sample consists of firms listed in the United Kingdom, because the revised ISAs are implemented in this country. The ISAs are also implemented in the Republic of Ireland, however firms from the Irish Stock Exchange are not included in the sample, because differences between the UK and Ireland could bias the results and could be difficult to interpret. The UK is a large market and accordingly there is sufficient data available to measure the effect of the revised ISAs. A part of the data is hand-collected and therefore the sample is kept at a restricted size and only consists of publicly available firms from the London Stock Exchange FTSE 350 index, with the required data available. The FTSE is chosen because this index contains the largest capitalized firms of the London Stock Exchange and it is most likely that these firms provide the most data required for this research. The data is retrieved from Compustat Global Fundamental Annual, Compustat Global Security Daily and Datastream. The auditor’s reports are hand-collected from annual reports on the public websites of the sample firms. They are firstly collected to verify in which years the firm implemented the revised ISAs. Furthermore they are collected to measure the amount of assessed risks of material misstatement, which is used as a proxy in the second hypothesis. The revised ISAs are effective for audits of financial statements for

periods commencing on or after 1 October 2012. This means that the last year before the implementation of the revised ISAs is for the most firms fiscal year 2012 and the first year after the implementation is fiscal year 2013. However, some firms have different fiscal years and because of this they only implement the new ISA’s for fiscal year 2014. Consequently, I only use data from the fiscal years of 2012, 2013 and 2014.

The first hypothesis compares the audit quality between the year prior to the implementation of the revised ISAs and the first year after the implementation. So only two years of each firm are taken into account, 2012 and 2013 or 2013 and 2014. I take of each firm these two consecutive years because it provides data for a direct test of the effect of the revised ISAs on audit quality, with the least chance of confounding effects influencing the results. The final sample consists of 218 firms with all the data available to measure audit quality and to measure the control variables, so the sample includes a total of 436 observations. The sample excludes firms from the financial sector, measured by the SIC-code. They are excluded because they are exposed to different regulation (Francis and YU, 2009). Table 1 presents the process that resulted in the final sample.

TABLE 1

Sample set hypothesis one

Firms Observations

FTSE350 350 700

Data missing in Compustat - 16 - 32

Financial sector - 111 - 222

Audit report not changed - 5 - 10

Final sample 218 436

The second hypothesis looks at the difference in magnitude of investor’s reaction on the revised auditor report. This is done with a comparison between firms based on the number of assessed risks of material misstatements. The expectation is that a firm with a high amount of addressed risks provides more useful information and therefore the reaction of the investors will be higher in comparison with a firm with less addressed risks. Therefore, the sample for the second hypothesis only consists of data from the year after the implementation of the revised ISAs, so for the most firms this means the year 2013 and for the late adopters 2014. The sample set of hypothesis one is also used for the second hypothesis. However, there were five more companies with missing data. In addition forty firms are deleted from the sample because they had multiple stock price data in Compustat, such as firms that have shares

outstanding on different stock exchange markets, LSE, Euronext Amsterdam and NYSE as does Royal Dutch Shell. To calculate the return on shares it is more convenient to use firms with single stock price data. This resulted in a final sample of 173 observations.

TABLE 2

Sample set hypothesis two

Observations

FTSE350 350

Data missing in Compustat - 21

Financial sector - 111

Audit report not changed - 5

Firms with multiple stock price data in Compustat - 39

Outlier - 2

Final sample 172

3.2 Research methodology

In this part of the paper the research methodology is discussed. Two different methods are used to examine H1 and H2.

3.2.1 Methodology hypothesis one: Modified Jones model

For the first hypothesis I measure the effect of the revised ISAs on audit quality. This is done with the use of The Modified Jones model by Dechow et al. (1995). This is an earnings management model. It expects an association between change in revenues as well as gross property, plant, equipment and the amount of discretionary accruals. The non-discretionary accruals are determined through a regression using the time-series model (Jones, 1991). The modified version of Dechow et al. (1995) added the difference in accounts receivables as a factor in the regression term and implicitly assumes that earnings management conducted by the company causes the change in accounts receivables. The model equates the total accruals against total assets, the change in revenue and receivables and the gross property, plant and equipment, the residual of this formula represents the part of the total accruals not explained by the non-discretionary accruals and will therefore indicate the discretionary accruals.

TACCit/TAt-­‐1  =  α(1/TAt-­‐1)  +  β1((ΔREVit  -­‐  ΔRECit)/TAt-­‐1  )+  β2(PPEit/TAt-­‐1  )+  εit (1)  

Where:

TACCit : Total Accruals in year t for company i, are calculated by the following model: TACCit = EBXIit - CFOit

EBXIit : Earnings before extraordinary items and discontinued operations CFOit : Operating cash flows (from continuing operations)

TAit-1 : Total assets in year t-1 for company i

∆REVit : Difference in revenues between year t and t-1 for company i

∆RECit : Difference in accounts receivables between year t and t-1 for company i PPEit : Gross property, plant, equipment in year t of company i

εit : Discretionary accruals

Total accruals are calculated directly through the cash flow statement, as suggested by Hribar and Collins (2002). They argue that the balance sheet based approach, which is also used often in prior research, is in some circumstances inferior to the cash flow statement based approach.

The residual of model one represents the discretionary accruals, which is consequently the dependent variable in model two. The discretionary accruals are regressed against the independent variable revised and a couple of control variables.

DACCit  =  β0  +  β1REVISEDit  +  β2LEVERAGEit  +  β3CFOit  +  β4LOSSit  +  β5SIZEit  +  β6ROAit  +  εit (2)    

Where:

DACC : Discretionary accruals, estimated as the residual from model (1)

REVISED: Dummy variable one if the audit report confirms with the new implemented ISAs commencing from October 2012 and zero otherwise.

LEVERAGE: Leverage ratio (= total liabilities / total assets)

CFO : Scaled cash flow from operations (= cash flow from operations / total assets) LOSS : Dummy variable equals 1 if the firm’s net income is negative, otherwise 0 SIZE: Natural logarithm of total assets at year end.

ROA: Return on Assets

ε: Error term

To examine the effect of the new revised ISAs on audit quality, the dummy variable REVISED is applied. The measure of audit quality is retrieved from the residual of model one and is regressed against the dummy variable REVISED. The dummy variable indicates one if the auditor’s report confirms with the new implemented ISAs commencing from October 2012 and zero if the audit report does not implement the revised standards. I also add a number of variables to the regression model to control for other events influencing audit quality. The control variables are based on prior. To control for the greater incentive to

manage earnings I control for leverage (Blay et al. 2014). The expectation is that LEVERAGE has a positive effect on discretionary accruals, lowering the audit quality. In addition I expect a negative relation between discretionary accruals and the cash flow from operations (CFO) (Dechow et al. 1995). The control variable LOSS is expected to have a negative effect on discretionary accruals, because firms with negative earnings have a lower incentive to manage earnings (Francis and Yu, 2009). I also predict the control variable SIZE to have a negative effect on discretionary accruals, because by Becker, DeFond, Jiambalvo and Subramanyam (1998) find a negative relation between accruals and size. The last control variable return on assets (ROA) is also expected to have a negative influence on discretionary accruals (Carcello and Li, 2013)

There could be potential bias in the measurement of the first hypothesis because it basically compares two consecutive years and there could be other events influencing the audit quality. However, I will use for each firm the two years that follow directly after each other, so 2012 and 2013 or 2013 and 2014. One year before the implementation of the revised ISAs and the first year after the implementation. This way there is only limited chance for other events influencing the audit quality during this sampling time and consequently the results. Another limitation of this study is that there is no possibility to examine data of more than one year after the revision of the ISAs. It could be the case that the audit firms and clients have to get used to the new regulations and need a period of time to get acquainted with them before they will result in higher audit quality. However, because the regulation is still very new there is only data available for a direct test of two consecutive years.

3.2.2 Methodology hypothesis two: The earnings response coefficient

The second hypothesis looks at the reaction of investors on the revised ISAs. The focus for the second hypothesis is on the revised ISA 700, which requires a description of the assessed risks of material misstatement, the concepts of materiality and a summary of the audit scope. The hypothesis specifically focuses on the description of the assessed risks of material misstatement that have been identified by the auditor which had the greatest effect on the overall strategy, resource allocation and the direction of the audit engagement team’s effort. This is the main part of the auditor’s report that does not make use of standardized language and consequently contains more specific firm information than other parts of the auditor’s report. The number of specific assessed risks of material misstatements that are discussed in the auditor’s report are included in the model. The expectation is that investors will consider

firm specific information useful. So the number of specific assessed risks of material misstatements should be positively related to the perceived usefulness of investors1. The perceived usefulness of investors is measured with the earnings respond coefficient (ERC) after the release of the revised audit report. The ERC is a measure of the extent to which new earnings information is capitalized in stock prices (Teoh and Wong, 1993). Stock prices reflect all relevant information as soon as it becomes publicly available, so changes in the stock price reflects the flow of information available to the market. The revised auditor’s report is useful for investors if the information auditor’s disclose can influence their investments decisions. So the information should contain some relevant new information, like something the investors did not know already or information that is now assured by an objective auditor. Higher informational value of the auditor’s report should be indicated with an increase in the magnitude of the ERC. The variable of interest is RISKS*EPS and is expected to be positive related to the dependent variable RETURN. The same set of control variables are used in this model. Prior research shows mixed results regarding the effect of size on ERC (Easton and Zmijewski, 1989; Lipe, 1990). The reasoning behind the effect of size on the ERC is that larger firms can be less risky as small firms and therefore investors response less severe to earnings announcements from larger firms. The control variable LOSS has a lower persistence (Hayn, 1995), which is one of the determinants of the magnitude of an investor’s response to unexpected earnings announcements (Kormendi and Lipe, 1987). The control variable LEVERAGE is considered as relevant information in market reaction to unexpected firm earnings (Moradi, Salehi and Erfanian, 2010). The reaction of investors on the revised audit report is measured with the following model.

RET=  α  +β1EPS+  β2RISK+  β3RISK*EPS+  β4CFO+  β5SIZE+  β6LEVERAGE+  β7LOSS+  β8ROA+ε   (3)

RET: Return on share from the beginning of the fiscal year and the announcement date of the audit report. RET is calculated with the following model:

!"#$% =!!"+ !"#!"− !!" − 1 !!" − 1

Where:   !!!= share price at time t

DIV!!= received dividend per share during the year (Total dividend / Outstanding

shares)

!!!−1 = share price at the beginning of the year                                                                                                                          

1  _{This is supported by The Investment Management Association, which has organized the inaugural auditor reporting awards} in 2014. This award looks at the first firms who implemented the revised ISAs into their auditor’s report. They concluded that Rolls Royce group PLC had the most insightful auditor report with the highest amount of material risks recognized. This indicates that this organization also uses the number of specific assessed risks of material misstatements as a proxy for insightfulness, which increases the perceived usefulness of investors.  

EPS: Earnings per Share (excluding extraordinary items) RISK: Number of assessed risks of material misstatement

CFO : Scaled cash flow from operations (= cash flow from operations / total assets) SIZE: Natural logarithm of total assets at year end.

LEVERAGE: Leverage ratio (= total liabilities / total assets)

LOSS : Dummy variable equals 1 if the firm’s net income is negative, otherwise 0. ROA: Return on Assets

ε : Error term

The share price at time t, to calculate the return, is extracted three months after the fiscal year end of a company. This date differs significantly between companies because of the different fiscal year that is applicable per company. Three month’s seems like the appropriate amount of time to prepare and publish the annual report, which includes the audit report. This is checked with the average time elapsed before publication of the annual report of this sample. The three-month benchmark is also used by Carcello and Li (2013) in their study to the effect of the required engagement partner disclosure on the auditor’s report.

Using the ERC as a measure for perceived usefulness introduces a possible limitation. The auditor’s report is published at the same time as the annual report, it is possible that the results are influenced by the content of the annual report instead of the extra firm specific information presented in the auditor’s report.

4.

Results

The results are discussed in the following paragraph, starting with hypothesis one regarding audit quality, subsequently followed by the results of hypothesis two regarding perceived usefulness of investors.

4.1 Hypothesis one: Audit quality

The following section examines the hypothesis one, which is related to the effect of the revised ISAs on audit quality. This section is divided in the descriptive statics, correlation, regression analysis and a sensitivity analysis.

4.1.1 Descriptive statics

First the descriptive statics of the year before the revision of the auditor’s report and the year after the revision of the auditor’s report are shown and compared in Table 3.

TABLE 3

Descriptive Statics hypothesis one Before revision (n=218) After revision (n=218)

Indepen. T-test Sig. Min. Max. Mean _Deviation Std. Min. Max. Mean _Deviation Std.

DACC -0.40 0.33 0.00 0.076 -0.33 0.41 0.00 0.073 -0.310 0.757 REV. 0.00 0.00 0 0.000 1.00 1.00 1 0.000 LEV. 0.06 1.21 0.57 0.202 0.07 1.30 0.57 0.210 -0.001 0.999 CFO -0.08 0.35 0.11 0.069 -0.32 0.32 0.11 0.077 0.100 0.920 SIZE 2.26 5.39 3.30 0.644 2.18 5.34 3.31 0.641 -0.011 0.991 LOSS 0.00 1.00 0.11 0.308 0.00 1.00 0.14 0.345 -1.087 0.278 ROA -0.34 0.33 0.06 0.078 -0.58 0.49 0.06 0.088 0.752 0.453 Note: REV: A revised auditor’s report; LEV: Leverage; CFO: Cash flow from operations; SIZE= Size; LOSS= loss dummy equals one; ROA: Return on assets

In the year before the revision the mean of the independent variable of interest REVISED is zero and after the revision this variable equals one. Indicating that the sample indeed represents an equal amount of firms before and after the revision of the ISAs. The remainder of the variables have comparable means between the years before and after the revision. The biggest change is seen in the variable LOSS from 0.11 to 0.14, which indicates an increase of 3% of firms, which operate at a loss. In previous literature (Dechow, 2013) a small profit is often associated with earnings management. In this case the use of positive discretionary accruals could be used to change a small loss into a small profit because of management incentives. A small increase in LOSS could indicate that there is less use of discretionary accruals to turn a small loss into a profit, and therefore result in higher audit quality. The sample consist of two observations per firm in consecutive years, therefore it is logical that the differences in the mean of the variables are not that far apart from each other, otherwise this would indicate a significant change in the firms over one year, which is unusual. The mean of the dependent variable discretionary accruals (DACC) is exactly the same. At first impression this would indicate that the audit quality has not improved after the revision of the auditor’s report. The independent t-test shows there are no significant differences in the reported variables for the firms after the revision of the ISAs.

4.1.2 Correlation

Table four displays the correlation between the various variables of hypothesis one. The dependent variable discretionary accruals, is negatively and significantly correlated with the cash flow from operations and loss. This indicates that the discretionary accruals decrease and therefore the audit quality increases with an increase in cash flow from operations. The negative correlation between the discretionary accruals and loss shows that a firm with a loss uses less discretionary accruals. This is in line with the explanation of earnings management as mentioned in the previous paragraph. The dependent variable discretionary accruals is positively and significantly related to return on assets, suggesting that audit quality decreases if the return on assets increases. The variable of interest, REVISED, is not at all correlated with discretionary accruals, which is not in line with the expectations of hypothesis one. The correlation matrix points out that the revision of the ISAs is not related to the level of audit quality measured in this model. Furthermore the table shows that there is no significant correlation between the dependent variable and the independent variables LEVERAGE and SIZE. The overall correlation between the independent variables and control variables are not very high which suggest there are no multicollinearity problems. The VIF level is measured to control for this problem and VIF scores are all below three, which indicate that there is no multicollinearity. Multicollinearity is a problem when the VIF is above ten (Anderson, Black, Hair and Tatham, 1995).

TABLE 4

Pearson correlation matrix

DACC REVISED LEV. CFO SIZE LOSS ROA

DACC 1 REVISED 0.000 1 LEV. -0.025 0.006 1 CFO -0.373** -0.010 0.064 1 SIZE 0.067 0.001 0.207** -0.512** 1 LOSS -0.405** 0.049 0.015 -0.173** -0.054 1 ROA 0.048** -0.036 -0.030 0.486** -0.050 -0.641** 1 ** indicates a significant level of 0.01 (two-tailed)

Note: REVISED: A revised auditor’s report; LEV: Leverage; CFO: Cash flow from operations; SIZE= Size; LOSS= loss dummy equals one; ROA: Return on assets

4.1.3 Regression analyses

The regression analyses for the first hypothesis measuring the effect of the revised auditor’s report on audit quality is summarized in table 5 and shows the effect of the independent variables on the dependent variable discretionary accruals. The adjusted R-square is 0.71 indicating that the independent variable of interest and the control variables explain 71% of

the total variation in absolute value of the discretionary accruals. The P-value is less than 0.000, which implies that the model is significant. This is also shown by the F-value of 178.84, which is higher than the required 2.12 (p=0.05), which indicates that the model as a whole has statistically significant predictive capabilities.

TABLE 5

Regression analyses on the dependent variable discretionary accruals (DACC) DACCit = β0 + β1REVISEDit + β2LEVERAGEit + β3CFOit + β4LOSSit + β5SIZEit + β6ROAit + εit

N=436 Unstandardized Coefficients B Std. Error Sig. Intercept 0.048 0.012 0.000 REVISED 0.003 0.004 0.373 LEV -0.018 0.010 0.058 CFO -0.818 0.031 0.000 SIZE 0.000 0.003 0.968 LOSS 0.005 0.008 0.549 ROA 0.792 0.035 0.000 Adjusted R2 _0.710 P-value 0.000 F-value 178.84

Note: REVISED: A revised auditor’s report; LEV: Leverage; CFO: Cash flow from operations; SIZE= Size; LOSS= loss dummy equals one; ROA: Return on assets

The independent variable of interest REVISED has no significant effect (β=0.373) on DACC. This implies that the revision of the ISAs commencing from October 2012 has no significant effect on the audit quality, so hypothesis one is rejected. There are several possible reasons why I do not find a significant effect of the revised ISAs on audit quality. First of all the IAASB (2015) and Deloitte (2013) argued that a possible benefit of the new regulation would be the renewed focus of the auditor on matters to be reported, which could indirectly result in an increase in professional skepticism, among other contributors to audit quality. However, Francis (2004) claims you cannot simply assume that extra regulation will lead to higher audit quality because the accountability and audit quality are already at high levels. If audit quality is already high there is just a limited opportunity to increase it further, it might be the case that the revision of the ISAs is not enough to accomplish this. Another reason is related to the information role of the audit as described by Wallace (1995), this paper indicates that the main benefits of the information role are the reduction of risk and improvement of decision-making of the management and investors. The new revisions require auditor’s to point out where the most important risks are concentrated in a firm, in regard to their financial statement. This can help the management to focus more in these areas. However, the results of

this paper do not find a decrease in discretionary accruals, this could indicate that the new identified information does not increase reporting quality. This could be the case because the UK Corporate Governance Code already requires a section on “the significant issues that the committee considered in relation to the financial statements and how they are addressed”. Significant issues reported by the Audit Committee do not have to be the same as the risks of material misstatement identified by the auditors, however it is not unreasonable to expect they do align. The FRC (2015) concluded after a numerical analysis that the average number of issues addressed by the Audit Committee and assessed in the auditor’s report are roughly the same, 4.3 and 4.2 respectively. They also indicate that 74 percent of those issues are of a similar nature. So the risks of material misstatements assessed by the auditor due to the revision of the ISAs does not provide a lot of new information to management or investors, only 26 percent of the identified risks provide new information.

Table 5 also summarizes the effect of the control variables on audit quality. The variable LEVERAGE is not significant at a 5% level, which would indicate that leverage has no significant effect on audit quality. This result is not in line with previous research. Watts and Zimmerman (1986) found for example that a firm with a higher debt to equity ratio makes more use of income increasing accounting measures, this means a positive relation between leverage and discretionary accruals. This is however not found in this study. The second control variable cash flow from operations has a negatively (β=-0.818) and significantly (p<0.000) effect on the dependent variable. This is in line with previous research of Dechow et al. (1995), who argue that the discretionary accruals are dependent on the cash flow from operations. Cash flow from operations is therefore added to the Modified Jones model by Kasznik (1999) to control for their effect on discretionary accruals. The third and the fourth control variables SIZE and LOSS, respectively, have no significant effect on the dependent variable. So the slight increase in the mean of LOSS as shown in Table 3 has no significant effect of the DACC. The last control variable ROA has a significant (p<0.000) and positive (β=0.792) effect on DACC. Suggesting that audit quality decreases as the return on assets increases. The effect of ROA and DACC is researched by Kothari, Leon and Wasley (2005), they found that a discretionary accruals model with an earnings performance measure (like ROA) show negative discretionary accruals.

4.1.4 Sensitivity analysis

In the previous regression the relationship between the revised ISA’s and audit quality is demonstrated. In this section a sensitivity analysis is performed to investigate whether the results from Table 5 are not attributable to the method of measuring audit quality. I measure audit quality based on discretionary accruals. In this analysis another measure is used to determine audit quality, based on the research of Bailey and Gramling (2005). They suggest audit fees as a possible indicator for audit quality. The expectation is that audit fees have a positive relation with audit quality. Indicating that more hours of work on an audit results to higher audit quality but also into higher audit fees. The variable FEES is collected from Datastream, however for 22 firms the audit fee data is missing, so there are 44 less observations in this sample. This results in a sample size with 392 observations. The variable FEES is measured with the natural logarithm of audit fees. The results of the sensitivity analysis are summarized in table 6.

TABLE 6

Sensitivity test: regression analyses on the dependent variable audit fees (FEES) FEESit  =  β0  +  β1REVISEDit  +  β2LEVERAGEit  +  β3CFOit  +  β4LOSSit  +  β5SIZEit  +  β6ROAit  +  εit

N= 392 Unstandardized Coefficients B Std. Error Sig. Intercept 1.878 0.240 0.000 REVISED 0.007 0.078 0.924 LEV 0.513 0.194 0.009 CFO 1.280 0.641 0.046 SIZE 1.469 0.062 0.000 LOSS 0.215 0.157 0.173 ROA 0.390 0.693 0.574 Adjusted R2 _0.609 P-value 0.000 F-value 102.512

Note: REVISED: A revised auditor’s report; LEV: Leverage; CFO: Cash flow from operations; SIZE= Size; LOSS= loss dummy equals one; ROA: Return on assets

The adjusted R-square of this model (0.609) is weaker than the previous results in table 5, but the independent variable and control variable still explain 60.9 percent of the total variation in the absolute value of audit fees. The level of significance has remained the same at 0.000, which indicate that the overall model is significant. The F-value decreased but is still above the required 2.10 (p=0.005). The regression with a new construction for audit quality results is the same conclusion as the previous regression from table 5. The variable of interest REVISED is insignificant, which indicate that the revision of the ISAs do not have a significant effect on audit quality. Therefore we cannot accept hypothesis one. The overall conclusion of the sensitivity test is that the results hold after the new construction of audit

quality, which implies that the results are not affected by the method of measuring audit quality and are relatively robust

4.2 Hypothesis two: Perceived usefulness of investors

This part of the results describes the findings of the second hypothesis, relating to the perceived usefulness.

4.2.1 Descriptive statics

Table 7 displays the statics of the second hypothesis. The dependent variable RETURN has a positive mean, indicating that the average firm rewards its investor with a positive return on their investments. The independent variable of interest RISKS has a mean value of 4.19, which suggest that on average an auditor indicates four material risks, which a firm has to deal with. The maximum value of RISKS is ten and originates from the annual report of Rolls Royce Holding PLC, this firm is also rewarded by the Investment Management Association for the most insightful auditors report in the Inaugural Auditor Reporting Awards of 2014. The earnings per share mean is 0.389 suggesting that the average firm operates at a profit. The control variables used in the second hypothesis are the same as the ones used in hypothesis one. The means are quite similar, the LOSS variable for example is 0.12 which indicates that 12% of the firms operate at a loss.

TABLE 7

Descriptive statics hypothesis two

N= 172 Min. Max. Mean Std. Deviation

RETURN -0.65 1.08 0.14 0.285 RISKS 2 10 4.19 1.403 EPS -1.57 3.66 0.39 0.544 RISK*EPS -7.86 14.65 1.57 2.392 LEV 0.09 1.15 0.56 0.197 CFO -0.09 0.32 0.11 0.073 SIZE 2.22 4.83 3.20 0.548 LOSS 0 1 0.12 0.321 ROA -0.31 0.28 0.06 0.074

Note: RETURN= Return on share; RISKS: Number of risks in auditor’s report; EPS: Earnings per share; LEV: Leverage; CFO: Cash flow from operations; SIZE= Size; LOSS= loss dummy equals one; ROA: Return on assets

4.2.2 Correlation

Table 8 summarizes the correlation between the dependent variable RETURN, the independent variables and the control variables. The centered variables of EPS, RISK and

EPS*RISK are used in this correlation matrix. The dependent variable RETURN is significantly correlated with the independent variables RISKS and EPS and the control variables LOSS and ROA. The correlation between return and risk is negative indicating that a higher return on shares is associated with a lower amount of specific assessed risks of material misstatements in the auditor’s report. As expected there is a positive correlation between the dependent variable return and the independent variables earnings per share and return on assets. The control variable LOSS is negatively correlated with the variable return as expected, if a firm operates at a loss there will be less return on shares. It is also interesting to notice that the variable RISKS is positively and significantly correlated with the variables LEV and SIZE. Indicating that bigger firms and firms with a higher leverage ratio are associated with auditor’s report with a higher amount of specific assessed risks of material misstatements. A reason behind this could be that firms with higher leverage have more material risks, like a higher probability of default. This could have consequences for the number of risks of material misstatements that are assessed in the auditor’s report. A larger firm is often more complex and could therefore be exposed to more risks.

TABLE 8

Pearson correlation matrix

N=172

RE-TURN

RISK EPS RISKS

*EPS

LEV CFO SIZE LOSS ROA

RETURN 1 RISK -0.163* 1 EPS 0.198** -0.059 1 RISKS*EPS -0.028 0.212** -0.048 1 LEV 0.064 0.311** 0.003 -0.055 1 CFO 0.113 -0.106 0.227** -0.061 -0.034 1 SIZE 0.013 0.404** 0.147 0.061 0.273** -0.211** 1 LOSS -2.65** 0.068 -0.399** -0.061 0.019 -0.034 -0.062 1 ROA 0.217** -0.169* 0.590** -0.047 -0.068 -0.157* -0.150* -0.669** 1 * indicates a significant level of 0.01 (two-tailed)

** indicates a significant level of 0.01 (two-tailed)

Note: RETURN= Return on share; RISKS: Number of risks in auditor’s report; EPS: Earnings per share; LEV: Leverage; CFO: Cash flow from operations; SIZE= Size; LOSS= loss dummy equals one; ROA: Return on assets

4.2.3 Regression analyses

The model for the second hypothesis contains an interaction term, therefore the model is first checked for multicollinearity. The interaction term RISKS*EPS causes some multicollinearity problems, the VIF measure is more than 15 for the variable EPS and RISKS*EPS, which indicates multicollinearity. Previous literature often uses a score of ten as a maximum VIF-score (Anderson et al., 1995). To prevent multicollinearity problems the independent