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What is the effect of the revised audit report as implement in the U.K.

on the expectation-performance gap?

Name: Kevin Bakker

Student number: 11163143

Thesis supervisor: dr. G. Georgeakopoulos

Date: 12-06-2017

Word count: 16436

MSc Accountancy & Control, specialization Accountancy

Amsterdam Business School

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Statement of Originality

This document is written by student Kevin Bakker 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 Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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Abstract

This paper examines the impact of the revised audit report on the expectation-performance gap between auditors and the users of the financial statements. The impact on the performance gap is measured with variables related to audit quality. Restatements of the financial statements and discretionary accruals are used to measure the impact of the revised audit report on audit quality. The impact on the expectation gap is measured with the increase in insight in the audit for the clients which could be expressed in the audit fee. Therefore, the audit fee is used to measure the impact on the expectation gap. The sample consists of the FTSE 350 firms on the LSE. A three year period prior to the implementation of the revised audit report, and a three year period after the implementation is used to examine the impact of the revised audit report. The findings conclude that there is no significant relation between the revised audit report and the expectation-performance gap. This is inconsistent with the expectations of the IAASB (2016) and Deloitte (2015), who expected that the revised audit report would have a positive effect on the expectation-performance gap. However, this study shows that the revised audit report does not help to close the gap between the users of the financial statements and the auditors.

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Table of contents

1. Introduction ... 5

2. Literature ... 7

2.1 Accountants’ role in capital markets ... 7

2.1.1 Conflicts in capital markets ... 8

2.1.2 Expectation-performance gap ... 9

2.2 Changes in standards ... 11

2.2.1 Revised and new ISAs ... 12

2.2.2 Research on the revised audit report... 13

2.3 Audit quality ... 14

2.3.1 Revised audit report... 14

2.3.2 Measurement of audit quality ... 14

2.4 Hypotheses development ... 17

2.5 Table with articles ... 18

3. Research methodology ...20

3.1 Sample ...20

3.2 Restatements ... 21

3.3 Modified Jones Model ...23

3.4 Audit fee ...26

4. Results ...27

4.1 Descriptive statistics ...27

4.2 Results for restatements model ...29

4.2.1 Correlation ... 29

4.2.2 Regression ... 31

4.3 Results for the discretionary accruals model ...33

4.3.1 Correlation ... 33

4.3.2 Regression ... 34

4.4 Results for the audit fee model ...36

4.4.1 Correlation ... 36

4.4.2 Regression ... 37

5. Conclusion ...39

References... 41

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1.

Introduction

The audit report is perceived by investors as a pass/fail document that does not provide any additional information besides the pass/fail conclusion (Deloitte, 2015). According to Mock Bédard, Coram, Davis, Espahbodi and Warne (2013), and Church Davis and McCracken (2008), this is due to the boilerplate language that is used in the audit report. In the past there have been attempts to change the audit report so it would be more informative for the users of the financial statements (Guy & Sullivan, 1988). However, these changes have not been successful in improving the amount of information provision (Mock, et al., 2013). Therefore, the International Auditing and Assurance Board (IAASB) had started a project that lasted five years to modify the standards concerning the audit report. In 2011 the IAASB released a consultation paper (IAASB, 2011) with proposed changes to the audit report. Involved parties were able to communicate their comments to the IAASB. These steps have led to the change in International Standards on Auditing (ISA). The IAASB changed standards 700, 260, 570, 705, 706, and included a new standard ISA 701. The changes and new standards are effective from December 15, 2016 for countries that apply the ISAs.

The biggest change is the introduction of the Key Audit Matters (KAM) paragraph, ISA 701. In the KAM paragraph the auditor has to describe the issues that required significant attention during the audit (EY, 2016). The issues in the KAM paragraph are selected from the matters that are communicated with those that are charged with governance, and are based on professional judgement of the auditor (EY, 2016). In the KAM paragraph the auditor has to describe why these issues are selected as KAM, how these issues were handled during the audit, and has to refer to the disclosures of the financial statements. Further changes in the standards require the auditor to give a more detailed description on the going concern assumptions especially for firms with going concern issues, they have to identify those charged with governance, and give information on what the auditor expects to obtain (EY, 2016).

These changes in the audit report will be beneficial for the investors, analysts and other users (IAASB, 2013). The IAASB (2013) expects the audit report to have more value for investors, increase the reporting quality, and increase the confidence of the users in the audit and the financial statements. These expectations will positively influence the expectation-performance gap between the users of the financial statements and the auditors (Porter, 1993). The expectation-performance gap is defined by Porter (1993) as the differences in the work the auditor performs during the audit, and the expectations by the users of the financial statements on what work the auditor performs during the audit. There are multiple factors that influence the gaps such as deficient performance (Gunny & Zhang, 2013), deficient standards (Mock, et al., 2013), and unrealistic

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expectations by the users (Asare & Wright, 2012). The gap between users of the audit report and the preparers leads to misinterpretation of the audit report. These misinterpretations by the users has led to numerous litigations against audit firms1. This is the motivation for the IAASB to engage in attempts to decrease the gaps (IAASB, 2011).

The aim of this research is to examine if the revised audit report succeeds in closing the gaps. Therefore, the following research question is developed: “What is the effect of the revised audit report as implemented in the U.K. on the expectation-performance gap?” The impact on the gap is measured for both parts on the gap, with audit quality and the audit fee. I expect that the revised audit report will have an effect on both gaps. The IAASB (2016) and Deloitte (2015) indicate that the revised audit report will narrow the gap. However, the research by Francis and Krishnan (2002), and Lee and Mande (2003) show that new regulation does not always have a positive effect. Therefore, the revised audit report could have a positive or a negative effect on the expectation-performance gap.

The revised ISA’s are applicable from December 15, 2016 however, the revised standards are used by early adaptors such as the United Kingdom (U.K.), Ireland, and the Netherlands. The standards are used in the U.K. and Ireland as of October, 2012, and in the Netherlands from December, 2014. For the analysis a three-year period prior to the implementation and after the implementation will be used. A three year period is chosen, within these three years there are no other factors that could influence the dependent variables. Therefore, firms listed in the Netherlands will not be used because of the insufficient data available to test three years prior and three years after the implementation. For the sample only the 350 biggest listed firms (FTSE 350) on the London Stock Exchange (LSE) are used. FTSE 350 is chosen because it is certain these firms have implemented the revised audit report (FRC, 2015; FRC, 2016), and there is enough data available for these firms. The data is retrieved from the Compustat database and Datastream database by the Wharton Research Data Services and Thomson Reuters respectively. The sample is limited to U.K. firms because of changes in culture and regulation between Ireland and the U.K., which could influence the outcomes. The used sample consists of 414 firm year observations for the years 2010-2012, and 436 firm year observations for the years 2013-2015.

The results of this study demonstrate that there is no relation between the revised audit report and the expectation-performance gap. Therefore, the revised audit report has no effect on audit quality or the audit fee. This is inconsistent with the expectations that there would be either a positive or a negative effect on the expectation-performance gap (Deloitte, 2015; Francis & Krishnan, 2002; IAASB, 2016; Lee & Mande, 2003). Reasons why no effect is found could be due

1 “Billion dollar lawsuit could destroy top accountancy firms” (Farrel, 2009), “Ernst & Young sued by WorldSpreads” (Healy, 2013),

“PWC sued over fraud detection failure” (McLannahan, 2016), “Hewlett-Packard to sue UK arm of auditor firm Deloitte” (Garside, 2014)

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to the already high audit and reporting quality in the U.K. (FRC, 2015). The insignificance in the audit fee could be due to the fixed contracts between audit firms and their clients (Palmrose, 1989). This research contributes to the research on the expectation-performance gap and the revised audit report. First of all, to my knowledge there is no archival research that measures the impact of the revised audit report on the expectation-performance gap. Therefore, this research shows that the implementation in the U.K. did not lead to a change in audit quality or audit fee. A reason why there is no archival research on the effect of the revised audit report is because the official implementation date is December 15, 2016, and therefore there is not yet enough data available.

The IAASB (2016) and Deloitte (2015) predicted that the revised audit report would increase the audit quality and the provision of information for investors. This research shows contradictory results, the revised audit report has no effect on audit quality and the audit fee. This research answers the questions by the IAASB (2016) and Mock et al. (2013) to further review the impact of the revised audit report.

The remainder of this paper is organized as follows. In the following section the literature on the role of the auditor, the changes in the standards, and audit quality are described. This section is based on prior literature. The third chapter explains the used methodology for this research, which includes the regression models. The fourth chapter describes the results of the analysis of the data. Lastly the conclusion summarizes the research, and provides suggestions for future research.

2.

Literature

This chapter addresses relevant literature topics, and following from these topics the hypotheses will be formulated. The literature starts with an explanation of why there is a need for auditors in capital markets, and why the ISAs are changed. Thereafter, an overview of the adjustments that are developed by the IAASB are presented. Furthermore, audit quality will be defined, and the best suited variables for this research will be explained.

2.1 Accountants’ role in capital markets

In capital markets audit services are deemed necessary to monitor the companies due to different conflicts (DeAngelo, 1981). In this chapter these conflicts will be explained with the role of the audit. Furthermore, I will discuss the difference in expectations between investors and auditors which was a reason for the IAASB to change the standards on the audit report (IAASB, 2011).

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2.1.1 Conflicts in capital markets

According to Healey and Palepu (2001), entrepreneurs (managers) and savers (investors) want to do business with each other. However, this relationship is complicated because of the difference in available information and the intentions both groups have. The difference in information is due to the fact that managers are involved in the daily business of the firm, whereas the investors observe the firm from outside (Healey & Palepu, 2001). The difference in objectives is that managers want to spend the money invested by the investors to benefit personally, and the investors want a high return on their investment (Healey & Palepu, 2001). These conflicts are also known as the “lemons problem” and “agency theory”.

The lemons problem originates from the difference in available information between investors and entrepreneurs. Akerlof (1970) clarifies this problem with an example of the secondhand automobiles market. In his example Akerlof (1970) divides the used cars in two groups, good and bad cars. Only the seller of the car knows whether the car is a good or bad car. So the seller will ask the same price for good and bad cars. Eventually buyers will realize that there are good and bad cars, and will take the probability of buying a bad car in account when offering a price for a car. Therefore, the sales price of a car drops which will make the sellers of the good cars to step out of the market, because the buyers are not willing to pay the sufficient price for the car. This will repeat itself until there are only bad cars left in the market. The principle of this theory could be applied for the stock market as well. In the stock market there are shares from good and bad companies, and the firms who supply the stock have more information on future performances of the firm compared to the buyers.

The difference in intentions is also referred to as the agency theory. In the agency theory there is a relationship with two parties who both have different interests. Jensen and Meckling (1976) state that there is a contract between a principal (investor) and the agent (entrepreneur). The authors state that the principals delegate services to the agent including decision making authority. The theory assumes that both parties are utility maximizers (Jensen & Meckling, 1976). Therefore, it is not always assumed that the agent will act in the best interest of the principal. Core, Holthausen and Larcker (1998) find in their research that firms with less effective corporate governance structures have more issues related to the agency theory. Armstrong, Ittner and Larcker (2012) find that the salary of a CEO is higher in firms that have limited corporate governance. These examples show that agents are utility maximizers when the opportunity arises. According to Watts and Zimmerman (1979), principals take these actions by the agent in account by discounting the price for a share or bond. Therefore, it would be beneficial for the agent to take actions that will prevent the agent from taking actions that are disadvantageous for

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the principals (Watts & Zimmerman, 1979). The authors state that other actions could involve the agent taking actions where the agents compensate the principals for the risk they bear. In sum, these actions are the efforts the agent could take to minimize the agency risks for the investors and the additional costs for the agent.

Another solution for the problems between the agent and principal is the audit of the financial statements. Accountants provide a monitoring and insurance role mainly for the principal (Benston, 1985). Benston (1985) states that the owners and managers benefit from the audit because, otherwise the organization will face the costs of both the outside investors and employees who assume that the organization is not operated effectively. The author states that the auditors’ expertise and integrity are valued, because that is what makes them trustworthy and cost-effective.

Wallace (2004) suggests that the audit has three roles: the monitoring role, the information role and the insurance role. With the monitoring role it is implied that the audit of the financial statements reveals the performance of the agent. Auditors improve the quality of the financial statements which is the information role of the auditor. The insurance role is through investors who can hold the accounting firm accountable for providing an inaccurate statement through lawsuits. Mansi, Maxwell and Miller (2004) find that auditor quality and tenure matter to the participants in capital markets through their insurance and information role.

The lemons problem and the agency theory are problems that arise within capital markets due to differences in information and intentions. The auditor’s role is to reduce these problems, and accomplishes this by fulfilling different roles for the users of the financial statements. This provides benefits for both the users and the preparers of the financial statements.

2.1.2 Expectation-performance gap

Benston (1985) mentions that the integrity of the accountant is important in convincing users of the financial statements that the financial statements provide a realistic view of the firm’s financial position on year-end. However, due to different scandals concerning accounting firms and their audit work whereby accounting firms have been sued (Frank, Lowe, & Smith, 2006). Accounting firms had to pay large litigation fees, which got their integrity questioned by the users of the financial statements. Mednick and Peck (1994) show that Big 5 firms spend more than 14 percent of their revenues on litigation related costs. These lawsuits do not only affect the profits of accounting firms but also the credibility of the accounting firms (Frank et al., 2006). These scandals arise through the expectation-performance gap between auditors and the users of the financial statements.

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The expectation-performance gap originates from the difference in expectation of what the users of the financial statements expect the auditor should do and what work the auditor actually performs during the audit (Porter, 1993). Porter (1993) constructed a model to show the difference in expectations between the auditors and society (figure 1). The model presents an overview of the differences in expectations, reality, and reasonableness. There are two main gaps the performance gap and the reasonableness gap. The performance gap is the difference in what society may expect the auditor to perform during the audit, and the actual activities the auditor performs during the audit. The reasonableness gap is the gap of what society expects the auditor to do, and what the auditor reasonably could do during the audit. These gaps originate through deficient performance by auditors (Gunny & Zhang, 2013), deficient standards by the regulators (Mock, et al., 2013), and unrealistic expectations by society (Asare & Wright, 2012). Deficient performance by auditors is when the auditor fails to find a mistake in the financial statements. Deficient standards are applicable when the standards for auditors that are imposed by standard setters do not require enough from the auditor to provide an adequate opinion. Unrealistic expectations come forth from the users of the financial statements where they expect too much from the auditors.

There are multiple factors that contribute to the expectation-performance gap, which makes it difficult to measure and to close the gap. Prior research has examined attempts to decrease the gap (Guy & Sullivan, 1988; Monroe & Woodliff, 1994), and searched for ways to decrease the gap (Wolf, Tackett, & Claypool, 1999; Fadzly & Ahmad, 2004; Monroe & Woodliff, 1993). However, the outcome of these studies did not result in the elimination of the expectation-performance gap.

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Church et al. (2008) state that the expectation-performance gap still exists through the traditional audit report. The traditional audit report provides the conclusion of the auditors’ findings. Furthermore, the report is filled with difficult wording, which explains where the auditor is not responsible for (Church et al., 2008). The authors find that the users of the financial statements perceive the traditional audit report as a pass/fail report; due to the “boilerplate” language that is used. The authors mention that the traditional audit report provides insufficient information for the users of the financial statements. It is unclear for the users what role the auditors have, what their responsibilities are, and the level of assurance they provide (Church et al. 2008). The authors conclude that the traditional audit report primarily has symbolic value, and provides little communicative value for the users of the financial statements.

Mock et al. (2013) researched what should be included in the new audit report as an answer for regulators to provide comments on their proposed revisions. Mock et al. (2013) found supporting evidence for the conclusion of Church et al. (2008) that the audit report has symbolic value for investors. Furthermore, they find that investors would value additional information surrounding the audit, and the firm in the form of financial and non-financial information. Both researches conclude that the revised audit report should not be written in a boilerplate language.

The expectation-performance gap still exists after numerous attempts to close the gap. Standard setters have tried to close the gap by adjusting their standards. Nevertheless, not all these attempts have been proven to be successful (Mock, et al., 2013).

2.2 Changes in standards

After a five year program the IAASB has changed their standards regarding the audit report (Deloitte, 2015). Previous attempts to reduce the expectation-performance gap were negatively criticized by the literature (Mock, et al., 2013). However, the authors state that the current approach by the IAASB differs from previous attempts. In 2011 the IAASB released the consultation paper enhancing the value of auditor reporting. Herein, they acknowledge that the traditional audit report was not sufficient anymore (IAASB, 2011). The intention of the consultation paper was to receive feedback on the proposed changes to the ISAs. This consultation report is the basis for the revised audit report, and is based on prior research on the audit report. The remainder of this paragraph will be used to give an overview of the changes in the standards, and a review of current research on the revised audit report.

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2.2.1 Revised and new ISAs

The IAASB has changed their standards associated with the audit report. They changed the following ISAs 700, 705, 706, 720, 570, 260. The changes required the implementation of a new standard, ISA 701. ISA 700 is mainly adjusted to facilitate all the changes in the other standards. Other adjustments in ISA 700 acquire the auditor to insert a statement of independence, and discuss examples of relevant ethical issues (IAASB, 2013). In ISA 705, it is demonstrated what the auditor has to describe in the audit report when the auditor has to express a modified opinion. ISA 706 is adjusted to clarify the difference and relation among the emphasis of matter paragraph, other matter paragraphs, and the key audit matters. Standard 720 requires the auditor to comment on other information that is included in the financial statements. In the modified ISA 570 the auditor is required to report more extensively on going concern and issues related to going concern. The revised ISA 260 provides guidelines on what the auditor has to communicate with those that are charged with governance.

The biggest change is the implementation of ISA 701, where the IAASB introduces the KAM paragraph. The KAM section is there to provide the user of the financial statement with the most significant matters the auditor encountered during the audit based on the auditor’s professional judgement (Deloitte, 2015). The KAM’s are selected from the matters that are communicated with those charged with governance (audit committee) (PWC, 2015). It is not the intention to create a long list of all the matters that are communicated. Therefore, the auditor has to select the matters that required the most significant attention during the audit (PWC, 2015). From the most significant matters the auditor has to determine which ones are appropriate to address in the auditor’s report. The auditor could exclude a KAM when law or regulation rule out the disclosure of the matter (IAASB, 2016). In the explanation of the KAM’s the auditor should include at least the following: a mention to the relevant disclosure in the financial statements, explain why the auditor selected this matter, why it was significant, and explain how the matter was addressed in the audit (Deloitte, 2015). The U.K. Financial Reporting Council (FRC) conducted a survey wherein they found that the top five KAM’s were: impairment of assets, tax, goodwill impairment, management override of controls, and fraud in revenue recognition (EY, 2016).

The changes in the standards allow more transparency on the work the auditor has performed. With the KAM paragraph the auditors inform the users of the financial statements which sections of the financial statements required additional attention. This could help to reduce the expectation-performance gap between auditors and the users of the financial statements.

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2.2.2 Research on the revised audit report

Because the standards were effective from December 15, 2016 there are not many researches published on the impact of these changes. The available research on the revised audit report is executed in the form of experiments. The researchers measured the impact of the KAM paragraph on different parties that use the financial statements.

Brasel, Doxey, Grenier and Reffett (2016) conducted an experiment to examine if the KAM paragraph increases the litigation risk for auditors. The authors state that accounting and law firms are concerned that jurors will increase the fines when accountants are being prosecuted. This will be because, the auditors provide more information on the work they performed. The authors find that audit reports with a KAM paragraph can reduce jurors’ liability judgements because the jurors have more information to anticipate the mistake.

The impact of the ISA 700 on the expectation-performance gap is researched by Gold, Gronewold and Pott (2012). The authors conducted an experiment where they used German auditors and users of the financial statement to record the different perceptions of responsibility for the auditor. The authors find that the expectation-performance gap still exists, and the users of the financial statements still expect more responsibility from the auditor. The authors conclude that the traditional audit report is sufficient in providing relevant information for the users of the financial statements.

Christensen, Glover and Wolfe (2014) researched the impact of the KAM paragraph on investors. The authors conducted an experiment due to the proposition by the standard setters to include the KAM paragraph in the audit report. The authors state that the standard setters are concerned that nonprofessional investors cannot use the extra information provided in the revised audit report. Therefore, the authors used alumni from a public university’s business school, and only used participants that have some familiarity with investments in companies. Christensen et al. (2014) find that investors who received an audit report with a KAM paragraph in which there is an uncertain fair value estimate, the investors would stop investing in this firm compared to the firms with the regular audit report. This implies that the users of the financial statement do not have enough knowledge on the subject to make adequate decisions based on the KAM paragraph. The findings in these studies suggest that the KAM paragraph will have a positive effect on auditors and jurors. However, the outcome of the research by Christensen et al. (2014), and Gold et al. (2012) implies the KAM paragraph does not help to reduce the expectation-performance gap. These studies show that the revised audit report does not have the hoped-for effect on the users of the financial statements. However, these are experimental studies which makes it difficult to use these outcomes as representative for the entire population.

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2.3 Audit quality

The changes in the audit report are designed to decrease the information gap (IAASB, 2011). However, the changes could have an impact on the audit quality as well according to the IAASB (2016). Deloitte (2015) suggests that the quality of the audit will improve even though there are no changes in the underlying work that will be performed during the audit. This could mean that the revised audit report could influence the information and performance gap. Therefore, prior research on audit quality will be used to find a way to measure the impact on the performance gap.

2.3.1 Revised audit report

Deloitte (2015) describes in their report that audit quality will improve because the auditor will increase its focus on significant areas of the audit. This will be due to the KAM paragraph where auditors have to disclose more information on key areas of the audit. Other parts of the revised audit report that could influence the audit quality are the increased focus on going concern and the increased communications with those charged with governance. With the new standards the auditor is obliged to have a more robust dialogue with those charged with governance. However, not everyone is convinced that the quality will improve, and it will be difficult to measure the impact on audit quality (IAASB, 2016).

Other factors that could influence the quality of the audit are the increased transparency in the underlying work performed by the auditor. For firms that voluntary disclose more information Cheng, Dhaliwal and Zhang (2013), and Lai, Liu and Wang (2014) find that they invest more efficiently. This means that these firms do not have the problem of overinvestment (investing in negative projects) or underinvestment (not able to gather enough resources to invest). Healy and Palepu (2001) find through a literature study that voluntary disclosures improve liquidity for stock, reduce the cost of capital, and increase the following by financial analysts. The revised audit report will enable the auditor to disclose more information on the work that is performed during the audit. This could lead to an increase in audit quality, and will help to reduce the performance gap.

2.3.2 Measurement of audit quality

DeAngelo (1981) defines audit quality as the ability of an auditor to discover an error or a breach in the system or to hold off the pressure exerted by the client to prevent follow up work in the case of a detected breach. Knechel, Krishnan, Pevzner, Shefchik and Velury (2013) challenge this definition, and state that it depends from which point of view the definition of audit quality is relevant. For example the authors incline that the users of the financial statements might perceive

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a good quality audit when there are no material misstatements, and the auditors might perceive the audit of high quality when all the required rules are followed. The authors state that there is not one general definition for audit quality defined in the literature and developed a balanced scorecard for audit quality. I will use this scorecard to find suitable audit quality proxies for this research.

In their “balanced scorecard” Knechel et al. (2013) indicate four categories: inputs, process, outcomes, and context. The inputs, and process are difficult to observe externally, and require inside information. Output variables are based on the outcomes in the financial reports. Context based variables depend on standards and regulation the audit has to comply with. The aim of this research is to investigate if the change in standard has an impact on audit quality. Therefore, inputs, processes, and context are not the appropriate categories with proxies for audit quality. From the outcome based variables the best suited variables for this research will be selected. Examples of outcomes are: adverse outcomes (restatements), financial reporting quality (accruals), audit reports (going concern), and regulatory reviews of audit firms (accounting standards). However, Knechel et al. (2013) state that going concern as a measure of audit quality is a difficult measure with high levels of type 1 and type 2 errors. The influence of accounting standards will be examined in this research. Therefore, going concern and regulatory review of audit firms are not the appropriate measures to measure the quality of the audit. Based on these conclusions proxies will be generated from adverse outcomes and financial reporting quality.

An example of an adverse outcome is a restatement of the financial statements due to improper accounting techniques. Managers feel pressured by capital markets to adopt aggressive accounting policies, where they try to manage their earnings (Richardson, Tuna, & Wu, 2002). The role of the auditor is to detect these actions and enforce the management of the firm to correct their financial statements, so they give a realistic view of the firm’s financial position. An accounting restatement is a failure of the accountant to identify a material misstatement before financial statements are published (Eilifsen & Messier, 2000). This shows that the auditor has missed a mistake with material consequences for the users or did not put in the sufficient amount of work during the audit. Restatements are one of the most unmistakable forms of improper accounting.

Prior research has used restatements as an approach to measure audit quality. Romanus, Maher and Fleming (2008) find through restatements that when firms use specialized auditors the likelihood of a restatement is lower. Richardson, Tuna and Wu (2002) find that firms with excessive accruals have an increased likelihood of restatements. Agrawal and Chadha (2005) researched if corporate governance has an impact on accounting restatements. The researchers find that when corporate governance boards have an independent director with financial proficiency the

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likelihood of restatements is lower. In the research by Abbott, Parker and Peters (2004) accounting restatements are used to examine if the involvement of the audit committee has an impact on audit quality. The researchers find that more independent, and involved audit committees have less accounting restatements. These studies show that restatements are a reliable proxy to measure audit quality.

The use of accruals is seen as an indication of financial reporting quality because managers use discretionary accruals to manipulate their earnings (Cohen & Zarowin, 2010). So, less accruals gives less room for management to have participated in accrual based earnings management. Rangan (1998) found evidence that managers use accruals for earnings management before seasoned equity offerings. The researcher concludes that firms upwardly report their earnings through accruals prior to seasoned equity offerings and have poor stock performance in the years following the seasoned equity offerings. Francis (2011) assumes that financial statements are cooperatively produced by the auditor and the client. The auditor can exert pressure on the client to adjust the financial statements if they deem the financial statements do not represent the actual situation. Therefore, accruals are used to measure audit quality, with less accruals there is less room for management to manage their earnings.

Prior research found through accruals that Big 6 auditors provide better quality, because firms with Big 6 auditors have less estimated discretionary accruals (Francis, Maydew, & Sparks, 1999). However, Francis (2011) states that cross-sectional variation in statistical properties of earnings do not necessarily prove the financial statements are misstated. Even though Francis (2011) finds that accruals do not necessarily prove a misstatement, accruals are used in multiple researches to measure audit quality. For example Reichelt and Wang (2010) use accruals to measure if auditor industry expertise has an impact on audit quality. Hossain (2013) finds that the implementation of new regulation has a positive impact on audit quality. Discretionary accruals are a widely used measure to use audit quality, and the research by Hossain (2013) shows that it is a suitable proxy to measure the impact of a change in regulation on audit quality.

Coming forth from the framework by Knechel et al. (2013) restatements of the financial statements and discretionary accruals are valid proxies to measure the quality of the audit. These proxies are used in prior research to measure the effect of a certain aspect on audit quality (Stanley & DeZoort, 2007; Romanus et al. 2008; Chin & Chi, 2009; Jackson et al. 2008; Reichelt & Wang, 2010; Hossain, 2013).

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2.4 Hypotheses development

Due to the improved communication with those charged with governance, the increased focus on significant aspects of the audit, and increased focus on going concern the revised audit report should improve the quality of the audit (Deloitte, 2015). According to the IAASB (2011) the increased dialogue and the increased transparency might improve the quality of the audit. Furthermore, prior research found evidence that firms with increased voluntary disclosures perform better (Healey & Palepu, 2001; Cheng et al., 2013; Lai et al., 2014). The same effect could be applicable for the quality of the audit due to the revised audit report. Change of accounting standards in the past did not always lead to an increase in audit quality (Francis & Krishnan, 2002; Lee & Mande, 2003). These studies found that the private securities litigation reform act in 1995 had a negative effect on the quality of the audit. The research by Francis, and Krishnan (2002) and Lee, and Mande (2003) shows that a change in regulation will not always have positive effect on audit quality. Deloitte (2015) and research on voluntary disclosures (Cheng et al., 2013; Lai et al., 2014) implies that the revised audit report will increase audit quality. That means there is no exclusive evidence that the revised audit report will increase the quality of the audit. Therefore, the following hypothesis is developed:

H1: The revised audit report is associated with audit quality.

Audit quality is a difficult concept that is problematic to quantify according to Knechel et al. (2013). Using the research of Knechel et al. (2013), two measures for audit quality will be used to measure the effect of the revised audit report on audit quality. This is the reason why hypothesis 1 is split up in two hypotheses. Where, the first sub-hypothesis measures the effect of the revised audit report on the amount of restatements. Prior research has used restatements to measure the effect of a certain event on audit quality. Such as: the impact of audit firm tenure (Stanley & DeZoort, 2007), the impact of the audit firm industry specialization (Romanus et al., 2008), and auditor industry expertise (Chin & Chi, 2009) on restatements. The second sub-hypothesis examines the effect of the revised audit report on discretionary accruals. In prior research this is used to measure the effect of auditor rotation (Jackson et al., 2008), auditor expertise (Reichelt & Wang, 2010), and new regulation for auditors (Hossain, 2013) on discretionary accruals. The studies show that restatements and discretionary accruals are suitable measures to measure audit quality for different events. This has led to the following sub-hypotheses:

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H1b: The revised audit report is associated with the absolute value of discretionary accruals.

The research by Gold et al. (2012), and Christensen et al. (2014) indicates that the KAM paragraph in the revised audit report does not have the effect on the expectation-performance gap as expected by the IAASB (IAASB, 2011). However, these studies are experimental, and focus on investors and users of the financial statements. There is yet to my knowledge no evidence on the effect of the revised audit report on the clients who are responsible for hiring auditors. The client is provided with more information on what work the auditor performs during the audit, and is more involved in the audit due to the increased discussion with those charged with governance. The client will have more insight on the effort the auditor has to put in the audit, which could be reflected in the agreed audit fee. Prior research has used the audit fee to measure the relation with earnings management (Abbot, Parker, & Peters, 2006), discretionary accruals and incentives (Gul, Chen, & Tsui, 2003), and the influence of board characteristics (Carcello, Hermanson, Neal, & Riley, 2002). This gives an indication that the audit fee can be used to measure different effects. This has led to the following hypothesis:

H2: The revised audit report is associated with the audit fee.

2.5 Table with articles

On the next page a table with an overview of the articles that are used to develop the regression models, and are used to reflect the outcomes of the regressions.

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Table 1: Summary of used articles on audit quality

Author(s) Research subject Sample data Sample years Proxy Model Findings

Stanley and DeZoort (2007)

The impact of audit firm tenure and restatements.

191 Restatement

observations 2000-2004 Restatements

Restatement dummy variable

Firms with long audit tenure have less restatements.

Romanus, Maher and Fleming (2008)

The impact of auditor industry specialization on audit quality.

986 Restatement

observations 1998-2003 Restatements

Restatement dummy variable

Firms with industry specialized audit have less restatements.

Chin and Chi (2009)

The impact of industry expert auditors on restatements.

326 Restatement

observations 1990-2004 Restatements

Restatement dummy variable

Earnings quality is higher for firms audited by an big4 industry specialist. Jackson, Moldrich and Roebuck (2008)

The effect of audit firm rotation on audit quality.

1750 Firm-year

observations 1995-2003 Discretionary accruals Modified Jones

Audit tenure has no effect on discretionary accruals.

Reichelt and Wang (2010)

The effect of auditor industry expertise on audit quality.

21.583 Firm-year

observations 2003-2007 Discretionary accruals Modified Jones

Clients of national and city-specific auditors have the lowest abnormal accruals.

Hossain (2013)

The impact of CLERP 9 on audit quality and

independence.

6656 Firm-year

observations 2002-2008 Discretionary accruals Modified Jones

Implementation of new regulation helps improving audit quality.

Abbott, Parker and Peters (2006)

The authors research the association between audit fees and earnings management.

429 Public non-regulated big 5 audited

companies 2000 Audit fee Log of total audit fees

Downwards earnings management leads to a lower audit fee.

Gul, Chen and Tsui (2003)

The relation of discretionary accruals, incentives and audit fees.

648 Firms from the Australian

stock exchange 1993 Audit fee Log of total audit fees

Firms with more discretionary accruals require higher audit fees.

Carcello, Hermanson, Neal and Riley (2002)

The influende of board charachteristics on the audit fee.

258 Fortune

1000 firms 1992-1993 Audit fee Log of total audit fees

Independent boards require higher audit fees.

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3.

Research methodology

This chapter elaborates on the methodology that will be used to examine the effect of the revised audit report on the expectation-performance gap. The research is archival based which means that the information is retrieved from databases. Within this chapter the selection and cleaning of the data will be described. Furthermore, the regression models, and how they are developed will be explained.

3.1 Sample

The new standards will be effective for periods ending on or after December 15, 2016, for jurisdictions that use the ISAs. However, there are early adopters of the standards such as the U.K., Ireland, and the Netherlands. In the U.K. and Ireland the standards were effective from the first of October 2012 (PWC, 2015). The effective date in the Netherlands was December 21, 2014, and was only mandatory for companies with public interest (PWC, 2015). The impact on the expectation-performance gap will be measured with a sample of U.K. firms in this study.

The sample consists of the top 350 companies listed on the LSE. Companies on the FTSE 350 will be used because it is certain that the audit reports for these companies are composed according to the new standards (FRC, 2015; FRC, 2016). Furthermore, they are chosen, because there will be more information available in the Wharton Research Data Service database and the Thomson Reuters database. Companies listed on the Irish Stock exchange will not be used due to the differences in regulations and culture with companies listed on the LSE. These differences could influence the audit quality. I will not use data from the Netherlands due to the date of implementation, which makes less data available.

The data is retrieved from the Compustat – Capital IQ database from the Wharton Research Data Services and the Datastream database from Thomson Reuters. The data is from 2009 till 2015 so there are three years prior to the implementation of the revised audit report and three years with the implementation of the revised audit report. Data from 2009 is included in the sample to calculate the differences between the financial situation on 1-1-2010 and 31-12-2010, and will not be used in the analysis. Data from the year 2016 will not be used because there is not enough data available for this year in the databases. A three-year time period is chosen, because it might take time before auditors correctly implement the standards. Within this three-year period there are no other factors that could significantly influence the quality of the audit.

The two datasets are uploaded in STATA and merged together based on the International Securities Identification Number (ISIN). In table 2, an overview is provided with what data is

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deleted from the sample. First, financial institutions are excluded from the sample. The financial firms are excluded from the sample based on their Standard Industrial Code (SIC). The SIC code indicates in what industry the company in the sample is operating. Observations with codes 60 till 67 are deleted from the sample because, companies with these codes are financial firms. Financial institutions are excluded from the sample due to their uncommon procedures (Dechow, Sloan, & Sweeney, 1995; Jackson et al., 2008). Following the deletion of the financial institutions, the firm years with missing observations are deleted. After the creation of the prior year values, the years without a prior year are deleted. This step deleted all the 2009 observations. Lastly, after calculating the needed variables the incomplete observations are deleted. This leaves a total sample of 850 firm year observations.

3.2 Restatements

In the case of a restatement previously published financial statements are adjusted, because they contained a mistake that was not identified by the auditor. This indicates deficient performance by the auditor, and is therefore associated with low audit quality. There is a link with low audit quality because the auditor failed to detect a misstatement in the financial statements during the audit. The consequences of an accounting restatement are disadvantageous for a firm. They lead to a decrease in expected earnings and increase the cost of equity (Hribar & Jenkins, 2004). The restatement of financial statements that received an unqualified opinion, gets the validity of the auditor questioned (Stanley & DeZoort, 2007). This indicates that a restatement has negative consequences for the auditor and the client. It provides motivation for both the auditor and the client to make sure the financial statements are adequate and do not require a restatement the year following the audit.

Restatements are used as sub-hypothesis H1a to measure the effect of the revised audit report on audit quality. The regression model will be formed based on prior literature that researched audit quality through restatements (Romanus et al., 2008; Stanley & DeZoort, 2007;

2010-2012 2013-2015

Old audit report Revised audit report

Firm year observations 1054 1054

Financial firms (SIC 60-67) (326) (344)

Missing observations (215) (141)

Missing observations after calculations (99) (133)

Total 414 436

Table 2 Sample size

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Chin & Chi, 2009). The model by Romanus et al. (2008) measured if the use of industry expert auditors has an effect on restatements. Stanley and DeZoort (2007) examined the effect of the audit tenure on audit fees and restatements. Chin and Chi (2009) developed a model to measure increased industry expertise and restatements. The models by these researchers are chosen because they are published in good quality journals and are cited by other researchers. By using these studies the following regression model is developed:

𝑅𝐸𝑆 = 𝛽0+ 𝛽1𝑅𝐸𝑉𝑡+ 𝛽2𝐿𝐸𝑉𝑡+ 𝛽3𝑆𝐼𝑍𝐸𝑡+ 𝛽4𝑅𝑂𝐴𝑡+ 𝛽5𝐷𝐼𝑆𝑇𝑡+ 𝛽6𝐴𝐶𝐼𝑡+ 𝜀 (1)

where:

RES = 1 if financial statements were restated, 0 otherwise;

REV = 1 if the audit report was a revised audit report, 0 otherwise; LEV = total debt divided by total assets;

SIZE = log of total assets;

ROA = return on assets, net income divided by lagged total assets;

DIST = 1 if the firm was in financial distress (negative cash flow or loss after abnormal items), 0 otherwise (Jackson, Moldrich, & Roebuck, 2008); ACI = the percentage of independent members of the audit committee.

The revised audit report is measured with a dummy variable revised (REV) where 1 is an audit report drawn up according to the new ISAs, and 0 for the traditional audit report. Audit quality is measured with the dummy variable for restatements (RES) where 1 is a firm that revised their financial statements, and 0 for firms without revised financial statements. These variables will be run in a regression analysis to find a relation with each other. The models include control variables to reduce the impact from other factors that influence audit quality. The control variables are retrieved from prior research on audit quality.

Firms that engage in earnings management are more likely to issue a restatement (Callen, Robb, and Segal, 2004; Richardson et al., 2002). Therefore, control variables directed at reasons or opportunities for firms to manipulate their earnings are included (LEV, SIZE, ROA, and DIST). These variables are related with the amount of outside pressure, scrutiny from outsiders, and pressure to meet targets. These indicators for pressures are used in prior literature to control for factors that could influence the amount of restatements (Romanus et al., 2008; Stanley & DeZoort, 2007; Chin & Chi, 2009).

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Firms with debt agreements that include covenants directed at accounting outcomes are more likely to use earnings management when they are going to violate their covenants (DeFond & Jiambalvo, 1994). Therefore, the leverage (LEV) control variable is included to proxy for the pressure of debt covenants. I expect a positive relation between the likelihood of a restatement and LEV (Romanus et al., 2008).

A control variable for firm size (SIZE) is included because larger firms might be under more scrutiny compared to smaller firms (Romanus et al., 2008). This gives bigger firms less room to participate in earnings management. Firms that are performing well are less inclined to manage their earnings (Ferguson, Seow, & Young, 2004). Therefore, return on assets (ROA) is included as a control variable for firm performance. I predict that SIZE and ROA have a negative effect on restatements.

Jackson et al. (2008) use the dummy variable distress (DIST) for when a firm is financially in distress. Where 1 is acknowledged to companies that were in financial distress the year before, and 0 otherwise. The DIST dummy variable is included because, firms that are in distress have more incentive to manipulate their financial statements to meet expectations. I expect that firms in distress have a positive relation with restatements.

Audit committee independence (ACI) is included as a variable where the percentage of independent audit committee member is indicated. Klein (2002) finds that there is a negative relation between audit committee independence and abnormal accruals. The independence of the audit committee has an influence on audit quality, which is the reason why the independence of the audit committee is included as a control variable. I expect that the independence of the audit committee has a negative relation with restatements.

3.3 Modified Jones Model

Discretionary accruals are used by managers to manage their earnings (Cohen, Dey, & Lys, 2008; Zang, 2012). The job of the auditor is to identify the accruals that are used to manage earnings, and make sure these are corrected in the financial statements. The less discretionary accruals the higher the quality of the financial statements, and gives an indication of the quality of the audit (Romanus et al., 2008). The total accruals can be divided in the discretionary accruals which are used for earnings management and nondiscretionary accruals which are the normal accruals (Jones, 1991).

Dechow et al. (1995) test multiple accrual-based models designed to detect earnings management. The researchers conclude that their modified version of the model designed by Jones (1991) has the most power in detecting earnings management. The Jones model includes property

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plant and equipment, and changes in revenue to control the changes in nondiscretionary accruals caused by changing conditions (Jones, 1991). Dechow et al. (1995) include the net receivables in the Jones model to eliminate error when discretion is exercised over revenues. This model is used in several studies for earnings management, and audit quality (Kwon, Lim, & Simnett, 2014; Minuttie-Meza, 2013; Bergstresser & Philippon, 2004).

To measure the effect of the revised audit report on discretionary accruals a regression model is developed. This model is based on the studies by Reichelt and Wang (2010), Jackson, Moldrich and Roebuck (2008), and Hossain (2013). Reichelt and Wang (2010) find that firms with national and city-specific industry specialist auditors have less abnormal accruals, which implies a better quality of the audit. Jackson et al. (2008) find that audit tenure has no effect on discretionary accruals. Hossain (2013) finds that after the introduction of a new regulation the audit quality improves. The authors use the modified Jones model by Dechow et al. (1995) with the performance-matched calculation by Kothari, Leone, and Wasley (2005).

𝑇𝐴𝐶𝐶 = (𝐸𝐵𝑋𝐼 − 𝐶𝐹𝑂)/𝐴𝑇𝑡−1 (2)

where:

TACC = total accruals;

EBXI = earnings before extraordinary items and discontinued operations; CFO = operating cash flows (from continuing operations); and

AT = total assets.

Equation 2 will be used to calculate the total accruals (TACC). The TACC are calculated by extracting the operating cash flows from the earnings before extraordinary items, and are scaled by the lagged total assets (𝐴𝑇𝑡−1). Collins and Hribar (2002) state that TACC should calculated

through the cash flow statement. The authors state that the frequency and magnitude of errors when balance sheet based accruals are used to calculate discretionary accruals can be substantial.

𝑇𝐴𝐶𝐶𝑡= 𝛼1(1 𝐴𝑇⁄ 𝑡−1) + 𝛼2(∆𝑅𝐸𝑉𝑇𝑡− ∆𝑅𝐸𝐶𝑇𝑡)/𝐴𝑇𝑡−1+ 𝛼3(𝑃𝑃𝐸𝑡/𝐴𝑇𝑡−1) +

𝛼4 (𝑅𝑂𝐴𝑡) + 𝜀 (3)

where:

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ΔRECT = net receivables in year t less net receivables in year t-1 scaled by lagged assets; and

PPE = property plant and equipment in year t scaled by lagged assets.

Equation 3 is used to run a regression. The residual of the regression are the discretionary accruals. This will be used in equation 5 to calculate if the introduction of the revised audit report has an effect on the discretionary accruals. This model includes return on investment (ROA) to match for performance (Kothari et al., 2005). The authors find that performance-matched discretionary accruals increase the reliability of the inferences from earnings management research.

𝑇𝐴𝐶𝐶 = 𝐷𝐴 + 𝑁𝐷𝐴 (4)

where:

DA = discretionary accruals; and NDA = nondiscretionary accruals.

Equation 4 is used to calculate the nondiscretionary accruals.

𝐷𝐴 = 𝛽0+ 𝛽1𝑅𝐸𝑉𝑡+ 𝛽2𝐿𝐸𝑉𝑡+ 𝛽3𝑆𝐼𝑍𝐸𝑡+ 𝛽4𝑅𝑂𝐴𝑡+ 𝛽5𝐷𝐼𝑆𝑇𝑡+ 𝛽6𝐴𝐶𝐼𝑡+ 𝜀 (5)

With this regression model the effect of the revised audit report on discretionary accruals will be measured. The discretionary accruals are calculated with equation 3 and will be used to proxy for audit quality in equation 5. Just as in the model for restatements (equation 1) the revised audit report will be measured with a dummy variable. The model includes control variables for factors that have an effect on discretionary accruals.

The control variables are the same as in the regression model for restatements. Restatements and discretionary accruals are related, and are both caused by pressure exerted by capital markets according to Romanus et al. (2008). Therefore, the same control variables are suitable for both models.

LEV is included as a control variable to proxy for the characteristics of the risks the client has (Hossain, 2013). I expect that LEV will have a positive relation with discretionary accruals. SIZE and ROA are included to control for the size of the company and the performance (Reichelt & Wang, 2010). I expect SIZE and ROA to have a negative effect on the amount of discretionary accruals. The DIST control variable is included to control for the financial situation the firm is in.

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This could put extra pressure on a firm to manage their earnings through discretionary accruals (Jackson et al., 2008). I expect that firms in financial distress have a positive relation with discretionary accruals. The independence of the audit committee is added as a control variable based on the research by Klein (2002). I expect that the independence of the audit committee has a negative relation with the amount of discretionary accruals.

3.4 Audit fee

The previous models were focused on the impact of the revised audit report on the performance gap, this model will focus on the impact on the expectation gap. Previous experimental studies show that the revised audit report does not reduce the expectation gap between auditors and the users of the financial statements. With this model the effect of the revised audit report on the audit fee will be examined. A change in audit fee could indicate a change in the expectation gap.

In the literature there are multiple researches that measure the impact of certain aspects of firms on the audit fee. I will use the following articles to develop the best suited model to measure the effect of the revised audit report: Abbott, Parker and Peters (2006), Gul Chen and Tsui (2003), and Carcello, Hermanson, Neal and Riley (2002). The study by Abbott et al. (2006) examines the relation with audit fees and earnings management. In the research by Gul et al. (2003) the relation with discretionary accruals, management incentives and the audit fee is researched. Carcello et al. (2002) seek for a relation between board characteristics and the audit fee. These studies measure the effect on audit quality from different aspects of a firm. Because, these studies are different they can be used to define different control variables. These studies are published in high quality journals which gives an indication these models are well developed. Based on these studies the following model is developed:

𝐴𝐹𝐸𝐸 = 𝛽0+ 𝛽1𝑅𝐸𝑉𝑡+ 𝛽2𝐼𝑁𝑉𝑡+ 𝛽3𝑅𝐸𝐶𝑡+ 𝛽4𝐿𝐸𝑉𝑡+ 𝛽5𝑆𝐼𝑍𝐸𝑡+ 𝛽6𝐴𝐶𝐼𝑡+ 𝜖 (6)

where:

AFEE = the log of audit fees;

INV = the log of inventory divided by total assets; and REC = receivables divided by total assets.

In this model the same dummy variable for the revised audit report will be used to measure the effect of the revised audit report. The audit fee is measured as the log of the audit fee. This is

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used in the regression to find the relation between the audit fee and the revised audit report. This model also includes control variables for other factors that could influence the audit fee.

The control variables inventory (INV), receivables (REC), leverage (LEV), and size (SIZE) are included because, these are expected to be associated with higher complexity of the audit (Francis & Wang, 2005). The complexity of the audit is related with the audit fee therefore, these control variables are included. INV and REC are calculated as a proportion of the total assets. LEV is calculated by scaling debt with total assets. SIZE is calculated by the log of the total assets. I expect that these control variables will have a positive effect on the audit fee.

The independence of the audit committee is included as a control variable for the audit fee based the research by Abbot, Parker, Peters, and Raghunandan (2003). The researchers find that the audit fee is significantly associated with the audit fee. Therefore, the percentage of independent audit committee members is included as a control variable. I expect that this will have a positive effect on the audit fee.

4.

Results

In this chapter I will discuss the results of the three regression models. First, I will discuss the descriptive statistics for the variables that are used in the regression models. Secondly, the Pearson correlation results and regression outcomes will be discussed for each regression model. The findings will be explained and compared to results in prior research.

4.1 Descriptive statistics

In this section, the descriptive statistics will be explained for all of the variables that are included in the regression models. All the variables are included in the descriptive statistics table at once because most of the variables are used in the three models. Therefore, it would be repetitive to interpret the descriptive statistics for each regression model. For the analysis the means will be compared with each other, and the significance of the change is calculated with a t-test.

The descriptive statistics in table 3 are all the variables that are used in the correlation and regressions. Before the descriptive statistics, the variables are tested for normality. The normality of the distribution of the variables is checked on the basis of the skewness and kurtosis. In a perfect normal distribution, the skewness and kurtosis are 0 (DeCarlo, 1997). Therefore, for the variables with high values for kurtosis and skewness STATA is used to find the best suited transformation to create normality. From the analysis with STATA, the natural logarithm is found as the best suited method to transform the variables. The natural logarithm is applied on the variable SIZE, AFEE, and INV. After the transformation of the variables, all variables except the dummy

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variables are winsorized at the 1st and 99th percentile (Stanley & DeZoort, 2007). This is done to filter out potential outliers that could influence the outcome of the analysis. In table 3, the difference is shown between the implementation of the revised audit report and the traditional version of the audit report. The t-test is included to show if the difference between the means is statistically significant, the amount of * behind the t-test outcomes indicate at what level the t-test is significant.

The mean for restatements seems substantially higher for the years where the revised audit report is implemented. The t-test shows that the mean changed significantly compared to the period where the traditional audit report was used. This implies that there were more firms with restated financial statements when the revised audit report was implemented. The means for discretionary accruals and audit fees increase slightly, which could indicate that there is an increase in discretionary accruals and audit fees. However, these changes are not significant. Whenever an outcome is not substantiated by the significance, the change could be due to coincidence.

The mean for leverage is significantly higher in the years with a revised audit report. This could imply that firms had a higher debt to assets ratio when the revised audit report was implemented. According to DeFond and Jiambalvo (1994) firms with debt agreements are more likely to engage in earnings management, which could have an impact on restatements, discretionary accruals, and the audit fee. The mean for ROA decreased significantly compared to the years without a revised audit report. This could suggest that the revised audit report has a negative effect on the performance of firms. Ferguson et al. (2004) find that firms that perform better are less inclined to engage in earnings management. Within this sample the performance of firms’ declines after the implementation of the revised audit report which could indicate that more firms are inclined to engage in earnings management activities. The mean for financially distressed firms changed significantly. This implies that there were more firms in financial distress after the revised audit report was implemented. This finding is in line with the decrease in performance by firms. Jackson et al. (2008) find that firms that are financially in distress are more inclined to engage in earnings management. Therefore, the increase in firms that are financially distressed could have a positive effect on the amount of restatements and discretionary accruals. The percentage of independent audit committee members is significantly lower in the years when the revised audit report is implemented. This implies that when the revised audit report was implemented, the audit committee had less independent members. Abbott et al. (2003) find that the audit fee increases when the audit committee is more independent. This could imply that the audit fee will decrease in the years the revised audit report is implemented.

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The overall results of the descriptive statistics indicate that firms are performing worse after the implementation of the revised audit report. This could have an effect on the amount of restatements, discretionary accruals, and the audit fee. However, the change in means for the dependent variable restatement increased significantly after the revised audit report was introduced. This could indicate that the revised audit has a positive influence on the amount of restatements, which is an indication that hypothesis 1a can be supported. The change in means for the dependent variables DA and AFEE is not significant. This indicates that the revised audit report has no effect on these variables, and that there is support for hypothesis 1b and 2.

4.2 Results for restatements model

In this paragraph, the results for the regression model that measures the impact of the revised audit report on restatements of the financial statements will be discussed. First, the Pearson correlation coefficients for the restatements regression model will be explained. Second, the outcomes of the regression model are presented. The results of the regression will be evaluated on the basis of the hypothesis and will be compared to prior research.

4.2.1 Correlation

In table 4, the Pearson correlation matrix is shown for the variables in the restatements regression model. With the correlation the linear relation between two variables is shown, a value of 1

Variable+ Mean Min. Max. Std. Dev. Mean Min. Max. Std. Dev. T-test

RES .0024 0 1 .0491 .0114 0 1 .1065 -3.74*** DA .0950 -.1921 .1598 .0626 .0971 -.1597 .1625 .0642 -0.68 AFEE 14.11 11.39 17.50 1.31 14.19 11.39 17.50 1.29 -1.22 REV 0 0 0 0 1 1 1 0 -LEV .2058 .00024 .6408 .1465 .2294 .0002 .6408 .1426 -3.26*** SIZE 8.18 5.32 12.58 1.51 8.28 5.32 12.58 1.49 -1.30 ROA .0735 -.0931 .2921 .0589 .0587 -.0931 .2921 .0649 5.10*** DIST .0893 0 1 .2856 .1330 0 1 .3399 -3.10*** ACI 99.12 50 100 5.59 96.15 50 100 10.78 10.79*** INV -3.056 -8.50 -.1735 1.59 -3.14 -8.50 -.1735 1.5707 1.09 REC 0.1336 .0050 .4138 .0940 0.1325 .0050 .4138 0.0904 0.23

Old audit report (2010-2012) Revised audit report (2013-2015)

Observations 414 Observations 436

Descriptive statistics Table 3

*/**/*** significant at p-value 0.10/0.05/0.01 respectively + For an explanation of the variables see appendix A.

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