The impact of the Dutch accounting enforcement on the
perception of audit quality
Name: Zeeba Valiuddin Student number: 11308001
Thesis supervisor: Dr. W. Bissessur Date: June 25, 2018
Word count: 15.815
MSc Accountancy & Control, specialization Accountancy Faculty of Economics and Business, University of Amsterdam
Statement of Originality
This document is written by student Zeeba Valiuddin 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.
Abstract
In this paper the impact of the Dutch accounting enforcement ‘Authority for the Financial Markets’ (AFM) on the perception of audit quality of investors is investigated. In 2010, 2014 and 2017 the enforcement body published deficiency reports regarding the audit quality. These reports were of negative content, it showed that audits conducted by the Big Four were inadequate. Literature showed that deficiency reports lead to a negative market reaction and that investors react to negative news (Hitz et al., 2012; Autore, 2009). Therefore, I hypothesize that the reports of AFM changes the perception of audit quality of investors. The earnings response coefficient (ERC) is analyzed after a deficiency report is published by the AFM. Results showed AFM positively influence the ERC and therefore the perception of audit quality.
Contents
1 Introduction ... 6
2 Literature review ... 9
2.1 Audit quality ... 9
2.1.1 Audit quality: Market perspective ... 9
2.1.2 Audit quality: practitioner perspective ... 9
2.1.3 Audit quality: regulators perspective ... 10
2.2 Perception audit quality ... 10
2.2.1 Earnings response coefficient (ERC) ... 11
2.2.2 Other methods ... 12
2.3 Efficient market hypothesis ... 13
2.4 Reputation auditor ... 14
2.5 Accounting enforcement ... 15
2.5.1 Public Oversight by Auditor Oversight body (AOB)... 16
2.5.2 Public Company Accounting Oversight Board (PCAOB) ... 16
2.5.3 Authority for the Financial Markets (AFM)... 18
2.6 Reports of AFM ... 19
2.6.1 AFM report September 1, 2010 ... 19
2.6.2 AFM report September 25, 2014 ... 21
2.6.3 AFM rapport June 28, 2017 ... 22
3 Hypothesis development ... 25 4 Research design ... 27 4.1 Data description ... 27 4.2 Event study ... 28 4.2.1 Estimation window ... 28 4.2.2 Event window ... 29
4.3.1 Cumulative abnormal return ... 29 4.4 Independent variable ... 30 4.4.1 Unexpected earnings ... 30 4.4.2 Deficiency report ... 31 4.5 Control variables ... 31 4.5.1 Growth opportunities ... 31 4.5.2 Firmsize ... 32 4.5.3 Firm risk ... 32 4.6 Regression model ... 32 5 Results... 34 5.1 Descriptive data ... 34 5.2 Correlation... 37 5.3 Regression ... 39 6 Discussion ... 43 7 Conclusion ... 46 8 Reference ... 48
1 Introduction
The reputation of an accountant is essential in the financial market. Literature has shown that negative news can negatively impact the reputation of the accountant and therefore the credibility of accounting information (Krishnamurthy et al., 2010). One of the most significant discussions in legal and moral philosophy is the news regarding the Enron scandal (Berube, 2002). After the third-quarter earnings announcement of Enron, SEC (Securities and Exchange Commission) started questioning the auditor of Enron, namely Anderson. It reveals that sited by Anderson, Enron was able to hide billions of dollars and failed projects. Chaney and Philipich (2002) researched the impact of the Enron scandal on the reputation of the accountant. The authors analyzed the stock market reaction surrounding four announcement days, namely; restatements, error judgement, that Enron audit documents were shredded and that Andersen was creating the IOB (Independent Oversight Body). The results showed that other clients of Anderson experienced a significant negative market reaction. Investors impaired their perceived quality of the audits that was performed by Anderson. Asthana et al. (2010) also found a reputational loss of clients of Andersen after the collapse of the audit firm. Franz et al. (1998) found in their research that litigation of an audit firm affects the market value of the clients of the audit firm. These results showed that this litigation against an auditor shows as a signal of decreased audit quality and therefore audit reports aren’t as credible as before. Prior literature showed that negative news decreases the reputation of the accountant.
After the credit crisis in 2008, the Dutch accounting profession was receiving critism heavily. Therefore, the Dutch accounting enforcement ‘Authority for the Financial Markets (AFM)’ conducted inspections regarding audit quality of the Big Four companies to ensure the reliability of accounting information and restore confidence in the financial markets. In in 2009 AFM investigated the audit quality and made the results available to the public in 2010, in the so-called deficiency report. The results of the inspection showed that 63% inspected audits were inadequate. KPMG had the most number of inadequate audits, followed by Deloitte, PwC and EY. AFM concluded that auditors based their opinions on insufficient audit evidence (AFM, 2010). In 2013 another inspection was conducted and reported in 2014. The results showed that 45% of the inspected audits were inadequate. The auditors didn’t obtain enough evidence for the material parts. Therefore there is not sufficient evidence to justify the unqualified audit opinions.
AFM discussed the improvement measurements and issued fines for all the big four companies with an amount between € 845.000 and € 2.230.000 (AFM, 2014). The last deficiency report was issued in 2017, according to AFM, audit quality was still not in place. The improvement measures weren’t implemented as desired and still, 59% of the inspected audits were qualified as inadequate. This report shows negative content regarding the Dutch Big Four. The literature showed that when error/deficiency announcement regarding the audit profession by accounting enforcements are made, investors react negatively to this information (Hitz et al., 2012; Kläs and Werner., 2014). But, to date, there has been no reliable evidence of the impact of the accounting enforcement body on the reputation of the accountant in the Netherlands.
The auditors’ reputation is directly associated with perceived quality of the auditors’ report. The auditors’ report is considered as valuable information for investors since they can’t observe the true underlying performance of a company by themselves. Research showed the importance of a positive perceived audit quality. Because if the perception is not in place the efficient market hypothesis is disturbed, and in the long run auditors’ ability to keep existing clients and attract new client decreases. Therefore, this research outlines the impact of the Dutch enforcement body AFM, on the perception of audit quality. This paper seeks to address the following research question: What is the effect of the Dutch accounting enforcement ‘Authority for the Financial Markets (AFM)’ on the perception of audit quality?
In the accounting literature, the perception of audit quality is often measured by the Earnings Response Coefficient (ERC). The ERC analyzes the responsiveness of investors to earnings announcements (Hofenhels, 2016; Shahzad, 2016; Theo & Wong, 1994; Choi, 1992; Ghosh & Moon, 2005). It’s crucial for an efficient market that investors are responsive to accounting information for the capitalization of stock prices. All publicly available information should be incorporated in the stock prices. When investors perceive a negative audit quality, they don’t consider accounting information as valuable information since it’s not credible for them, therefore available information isn’t taken into consideration (Malkiel and Fama, 1970).
The literature implies that the perception of audit quality increases when there is a strong role of accounting enforcement, but this decreases when the enforcement published negative content towards the accounting profession, in the so-called ‘deficiency reports’. (Hitz et al., 2012; Kläs and Werner, 2014).
This research analyzes the perception of audit quality in the Netherlands by analyzing the ERC after AFM published a deficiency report. By measuring the ERC after deficiency reports are published, I can investigate the influence of the accounting enforcement on the perception of investors.
The results of this paper showed an increase of the ERC. This means that AFM affects the perception of audit quality in a positive way. Even though AFM published deficiency reports, whereby the accounting profession of the big four is heavily criticized, and the quality of the statutory audits is marked as inadequate, investors react responsively to earnings announcements; meaning that the impact of AFM results in a positive perception of audit quality of the Big Four by investors.
This study provides several contributions to the existing literature. First of all, there is very limited research done about the role of an enforcement body on the reaction of investors on earnings announcement. There has been a lot of research about how some factors such as negative news, firm size, firm growth and earnings persistence effects the perception of audit quality. To our knowledge, the role of enforcement body is not in debt. Another important contribution is that we extend this research by not just analyzing the stock market reaction due to negative influence of enforcement, but we analyze the stock market reaction surrounding earnings announcement that is influenced by the accounting enforcement. Therefore, not only the reaction of the market is measured, but we do also analyze what the influence is on the perception of the quality of the audit. The third contribution of these study is that there is no research done on the specific role of the accounting enforcement body in the Netherlands. Compared to other countries, Netherlands has a strong accounting enforcement body; this results might differ from other countries (Brown et al., 2014).
The remainder of this paper is organized as follows. In section 2, existing literature and relevant concepts regarding this topic are discussed. This section also deeply discusses the content of the deficiency reports published by AFM. Section 3 describes the hypothesis development and the hypothesis. In section 4 the research design of the paper is outlined by describing the data description, method and variables. Section 5 presents the empirical findings, including various checks. In section 6 the discussion is described, by comparing the empirical results with the theory. The research concludes in section 7.
2 Literature review
2.1 Audit quality
The relevance and importance of audit quality are highly acknowledged. Even though, there is no explicit, unambiguous definition of audit quality by standards or among professionals and academics (DeFond & Zhang, 2014). One of the main difficulties with this line of defining is the complexity of the concept (Francis, 2004). Accordingly, researchers have used a large number of definitions with different perspectives and interpretations. The definitions can be divided into three categories, namely the market, practitioners and regulators perspective. These definitions are discussed in this paragraph.
2.1.1 Audit quality: Market perspective
The first category is the definition that is defined from the perspective of the market. These are investors and (potentially) stakeholders that define audit quality as what they expect from an audit. Definitions from this party highlight the importance of reliability of the financial reports. DeAngelo (1981) defines this notion as the probability assessed that an auditor will identify material misstatements in the financial statement of the client and that those material misstatements are reported. Furthermore, should the auditor be competent and ethical to find irregularities and report this.
2.1.2 Audit quality: practitioner perspective
The second category is from the perspective of practitioners itself. Even though Big Four companies are extremely involved in the discussion and ethical view of audit quality, only one company of the Big Four, namely PwC, has adopted an explicit definition. The other Big Four companies use the definitions that are developed by professional institutes like Public Company Accounting Oversight Board (PCAOB), Financial Reporting Council (FRC) and the Advisory Committee on the Auditing Profession (ACAP). Overall, the definition by professional institutes states that audit quality means that the investors’ need for a reliable audit is met on the financial statement, the disclosures, internal controls and going concern warnings (PCAOB, 2013; Wallace, 1980). PwC defines audit quality as a practice where an auditor complies with the accounting and auditing standards, applying a broad and deep understanding of their clients’ business and financial environment, anticipate on issues on an early stage and exercising professional scepticism. The auditor should deeply and broadly understand the business and financial environment of the client. (Paul and Yin, 2015)
2.1.3 Audit quality: regulators perspective
The third category can be categorized as the perspective of regulators and standard setters. They focus on the compliance of professional reporting and auditing standards. Audit quality is achieved when the financial statement is in line with the applicable standards. An example is GAO standard (U.S. Government accountability office), they define audit quality as an audit that is performed in accordance with GAAP to provide assurance regarding the financial statement and the related disclosures.
While a variety of definitions of this term have been suggested, I will use the definition from the markets’ perspective since this research focusses on the perception of audit quality of investors. Therefore, this paper will use the definition suggested by DeAngelo (1998) who defines audit quality as the probability assessed that an auditor detects and reports material misstatements.
2.2 Perception audit quality
The importance of the perception of audit quality of investors can’t be overstated. The reason for this is that in the market, investors can’t directly observe the true underlying earnings of the firm. The information given by the management can exploit judgement to mislead the investors about the true underlying economic performance. Therefore, the investors need to rely on the audit performed by the auditor, who safeguard the credibility of the accounting information by verifying the information and reporting material misstatements (Healy & Wahlen, 1999).
The high perspective of audit quality is crucial for confidence in the credibility of the accounting information and therefore crucial for an efficient capital market (AFM, 2014). Because accounting information is used by investors for their decision making process regarding buying, holding or selling equity, the capital market will include correspondence and reflect this information. Furthermore, the reputational loss disturbs the ability of auditors to keep and attract clients. According to the model van Holthausen-Verrecchia (1988), the credibility of accounting information can be measured by analyzing the reaction of earnings surprises when earnings reports are published. Earnings reports are periodic reports that are published by public companies. Earnings reports include net income, earnings per share and earnings from net sales. These reports are a great tool for investors to analyze the financial health of a company and to determine whether to invest in the concerning company. Earnings reports have a greater effect on investors’ valuation of the firm, when the reported numbers in
their perception reflect the true underlying economic performance. Hence, it states that the investors’ response to the earnings reports is associated with earnings quality and therefore, the perceived audit quality; the investor’s evaluation of the ability of the auditor to detect and report material misstatements (DeAngelo, 1998). The reaction of an investors’ response to the earnings report can be measured by earnings response coefficient (ERC). It is documented extensively in the accounting literature that the ERC is positively associated with the perception of audit quality (Choi, 1992; Theo & Wong, 1993; Ghosh and Moon, 2005; Shahzad, 2016; Hofenhels, 2016).
The ERC analyses to what extent new earnings information is capitalized in the stock price. To capture how investors prices audited accounting information, the association between reported earnings audited by accountants and corresponding returns are analyzed. (Hofenhels, 2016). It is estimated in a regression of abnormal stock return on a measure of earnings surprises (Teoh & Whong, 1993). There has been some studies that investigated the perception of audit quality. Most of the papers used a quantitative study using ERC to investigate the audit quality, a couple of studies issued other methods like a qualitative study or using other proxies in a quantitative study. Different papers that measured the perception of audit quality is discussed in this paragraph.
2.2.1 Earnings response coefficient (ERC)
Teoh & Whong (1993) investigated whether auditor size is correlated with perceived audit quality. They analyzed the differences in the ERC of firms audit by big-eight and non-big eight. In the sample the authors included listed companies from the year 1973 to 1988 who are traded on the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX) and the National Association of Security Dealers Automated Quotations (NASDAQ). In this paper, the perception of audit quality is defined as the informativeness of reported earnings. Some auditors are more perceived to follow policies that cause reported earnings than other auditors, so the perception of investors for audit quality will differ among accounting firms. They tested the issue jointly with the prediction of a modified model of Holthausen and Verrecchia (1988); earnings reports with less noise have a higher ERC. They’ve found that firms audited by the Big-Eight have significantly larger ERC than those who are audited by non- Big Eight firms. This evidence is consistent with the hypothesis that larger auditors perceived to generate more precise earnings, suggesting a higher perceived audit quality.
Balsam (2003) examined the association between perceived audit quality and auditor specialization in the period 1991 to 1999. They compared the earnings response coefficient and absolute discretionary accruals of clients that are audited by industry specialist and those who are not. They found a higher earnings quality for firms with specialized industry auditors than those who aren’t. Concluding that the perception of audit quality increases when an industry specialist audits a firm.
Hofenfels (2016) investigated the effect on the length of the relationship between the auditor and the client (auditor tenure) on the perception of audit quality in Germany. The theory suggests that companies with longer audit tenure have a higher perception of audit quality. Because of the mandatory rotation, auditors depend on the initial years of the new engagement more on the information that the management provides. Therefore, the ability to detect and report irregularities/material misstatements decrease. Also, this paper states that there is weak enforcement in Germany, this increases the risk of opportunistic earnings management, therefore investors rely less on accounting information. Hence, they hypothesized a positive association between investors’ perception of audit quality and auditor tenure. The sample used consists of German listed companies in the period 2006-2013. The study finds a non- linear effect of auditor tenure on ERC. This indicates that investors perceived audit quality is lower in the early and later years of the auditors’ tenure. The results suggest that the client-specific knowledge of an auditor is important for a higher perception of audit quality. These results are consistent with the investigation of Ghosh & Moon (2005) who concluded that when the auditor tenure increases, the financial statement is perceived as more reliable, suggesting a higher perception of audit quality.
2.2.2 Other methods
In this subparagraph, studies are discussed that examined the perception of audit quality proposing different methodologies.
Chi and Chin (2011) examined the impact of the auditor size on the perception of audit quality conducting a quantitative study. They analyzed the perception betweenBig Four auditors and non-Big Four auditors. Instead of looking at the earnings quality, they analyzed the stock market delay form 2001 to 2011 from stated owner-enterprise and non-stated-owned enterprise. They hypothesized that high-quality auditors are more likely to detect material misstatements in the financial statements of their clients and thus provide greater credibility than lower quality auditors. They found evidence for their hypothesis, firms
audited by Big 4associate with less stock price delay than firms audited by non Big 4 auditors. Concluding that investor’s perception is that Big Four auditors are more likely to detect material misstatements.
Smith (2012) examined the effect of regulatory changes by SOX on the perception of audit quality using a qualitative study. The U.S. was confronted with regulatory change. Auditing practices used the bottom-up coverage based approach (audit of internal controls from the bottom up) when they audited public companies. The SOX changed this approach to the top-down risk approach. Smith (2012) examined the change in the perception of audit quality due to regulatory change by conducting an experiment by U.S students. The results suggest that the investors’ perception of audit quality is negatively affected by the new regulation. This impact is explained by the fact that the reduction of internal control testing decreases the effectiveness of audit work.
Shahzad et al. (2017) investigated the perception of audit quality by measuring the information content earnings announcement during the global financial crisis (GFC) in the US over the period 2003-2009. The recent GFC shocked investors’ confidence in the financial market and drove them to question the audit quality around the GFC. The trust in the unqualified audit opinion decreased. Therefore, the change of perceived quality of the audit is investigated during the GFC. The information content of earnings announcement is measured as the volatility of abnormal returns three days surrounding the earnings announcements date. Prior evidence suggested that audit quality decreases during conditions in the market that are downward. This papers stated that the perception has increased during the crisis. The results of this study show that the perception of audit quality during the GFC is independent of the auditors’ size and fee dependence on clients.
2.3 Efficient market hypothesis
The efficient market hypothesis can be defined as follow: “A market in which prices always fully reflect all available information called efficient” (Malkiel and Fama, 1970). There are different levels of efficient market hypothesis, namely: strong, semi-strong and weak. The strong form test includes monopolistic information, in this case, information and trading costs are zero. Semi-strong form includes the question whether prices adjust to publicly available information and the in the weak form, information is no more than historical prices. According to Malkiel and Fama (1970), there is only an existence of semi-strong and weak hypothesis.
Several studies have found evidence that stock market reactions can be predicted, based on predictable patterns in stock returns and price irregularities. After new information is announced, the market reacts very quickly and therefore; the stock prices change almost immediately (Fama, 1991). According to the efficient market theory, all publicly available information should be incorporated immediately in the stock prices. Despite this expectation, Basu (1997) concluded that the market responds quicker to ‘bad’ news that ‘good’ news. According to the theory, good and bad news should be incorporated in the stock prices equally. Therefore, it can be concluded that the current security market is not always working perfectly efficient. According to Grossman (1981), a market cannot be perfectly efficient because then there would be no incentive for analysts to search for information to gain only a short advantage. But Malkiel (2003) argues in his paper that the market efficient theory still holds.
2.4 Reputation auditor
Audit reputation is directly related to the perceived level of auditors report and therefore the perceived audit quality (Chaney and Philipich, 2002). The importance of the reputation of the accountant can’t be overstated. The reputation of the auditor shows the confident of investors on the signal of companies that is provided in the financial statement. An unexpected decline in the auditors’ reputation should cause a strong negative effect on the market (Autore et al., 2009).
Literature shows that negative news regarding the auditor can cause reputational loss. Chaney and Philipich (2002) investigated that reputation loss auditors after the Enron scandal. The authors analyzed the stock market reaction surrounding four announcement days, namely; restatements, error judgement, that Enron audit documents were shredded and that Andersen was creating the IOB (Independent Oversight Body). The results showed that other clients of Anderson experienced a significantly negative market reaction. Investors impaired the quality of the audits that were performed by this Anderson. Asthana et al. (2010) also found a reputational loss of clients of Andersen after the collapse of the audit firm. Franz et al. (1998) found in their research that litigation of an audit firm affects the market value of the clients of the audit firm. These results showed that this litigation against an auditor firms shows as a signal of decreased audit quality and therefore audit reports aren’t as credible as before.
2.5 Accounting enforcement
According to Brown et al. (2014), accounting enforcement is an independent unit that supervises accounting firms to ensure that accounting information complies with accounting standards and accounting norms, to safeguard the audit quality of audit firms. The government should appoint this independent unit as the legal enforcement body.
Literature has investigated the impacts of those accounting enforcements. Kothari (2000) has found an relation between the attributes of a countries legal system and the quality of financial reporting. It states that better accounting enforcement leads to a positive impact on financial information and financial reporting. In particular, the quality of financial information is a function of two elements, namely: the quality of accounting standards and the degree of regulatory enforcement in the concerning country (Kothari, 2000). When adequate enforcement is absent, accounting standards will be inconsequential.
Brown et al. (2014) argued that the role of accounting enforcement is crucial for the quality of the financial reporting, with respect to the application of the International Financial Reporting Standards (IFRS). The use of IFRS promotes the comparability and transparency of financial statements, and hence, it improves the quality of financial reporting. Chang et al. (2012) also discussed that companies with stronger enforcement are strengthened by the motivation of the auditor to comply with IFRS. There has been found evidence that listed companies in the Netherlands have on average a stronger regulation, and therefore, they scored above the median for the comparison of the adoption of IFRS compared to other countries (Brown et al. 2014).
In the section below relevant accounting literature of three accounting enforcements is discussed. The first accounting enforcement discussed is the German AOB, this body is allowed to report deficiencies regarding accounting practices in Germany. It’s interesting to discuss this impact since this enforcement strategy is comparable to the Dutch accounting enforcement strategy. Secondly, the impacts of the U.S. accounting enforcement PCAOB is reviewed, because of their strong enforcement and they’ve also issued reports regarding the audit quality. Lastly, literature regarding the Dutch accounting enforcement body itself; AFM, is discussed.
2.5.1 Public Oversight by Auditor Oversight body (AOB)
Since the mandatory adoption of IFRS came into account, there has been an establishment of two-tier German enforcement body. The enforcement consist of a private body called the DPR and BaFin. The DPR investigates the compliance of published financial reports with IFRS. The DPR was established in 2004 and operates since 2005. This body conducts reviews of financial reports of listed firms in Germany. Error findings refer to BaFin as the institution has the power to mandate firms to disclose the error findings of DPR. Furthermore, Germany established new rules for independence for auditors and restructuring oversight for auditors. The reason for stronger enforcement was to increase the reliability of financial reports (Hitz et al., 2011).
Hitz et al. (2011) analyzed the impact of the change of enforcement on the extent of earnings management of companies. They’ve found the significant reaction of investors around the publication of error findings; this reaction is consistent with the negative signalling content. Meaning that when an error is put out, investors react negatively. The results of the paper emphasize the importance of accounting enforcement. The degree of enforcement is positively related to earnings quality and stock liquidity. When German enforcement mechanism penalizes infringing firms and their managers, the market reacts negatively. Suggesting a prerequisite for deterring companies from reporting inaccurate reports.
Kläs and Werner (2014) investigated whether investors errors detected in financial statement attributes to the responsible of the auditor and whether this decreases the reputation of the auditor. They’ve found a negative cumulative abnormal return, and this is especially higher when a Big Four company audits the company. Furthermore, the reaction of investors is more pronounced when the reported error is larger. So, the results imply different reactions of investors various to the magnitude of errors.
2.5.2 Public Company Accounting Oversight Board (PCAOB)
The Public Company Accounting Oversight Board (PCAOB) is a nonprofit corporation that oversees the audits of public companies to protect investors and the public interest by promoting independent, informative and accurate audit reports. The PCAOB is created by the Sarbanes-Oxley act of 2002. This was the first time in the U.S. where oversight of independent and external bodies were mandatory. Before this, the accounting profession was self-regulated. The PBAOC is responsible for 1) Providing a license to public accounting
firms that prepare audit reports. 2) Adopting audit quality controls, ethics, independence and other standards related to the preparation of audit reports. 3) Conduct inspections of public licensed accounting firms under section 104. 4) Conduct investigations and disciplinary proceedings and impose sanctions. 5) Perform duties to improve the quality of audits. 6) Enforce compliance. 7) Set a budget to manage operations of the board. (Sarbanes-Oxley act, 2002). According to the literature, PCAOB can be categorized as enforcement. (Preiato, Brown, & Tarca, 2015).
Gunny and Zhang (2013) investigated the inspection results of PCAOB of audits can distinguish audit quality during the period inspected. They hypothesized that audit quality is lower for inspected audit receiving a serious deficiency report from PCAOB compared to an auditor receiving a clean opinion. They find that inspection reports with serious deficiencies are associated with higher abnormal current accruals and thus a lower audit quality. This paper implies that when auditors receive a report with serious deficiencies from the enforcement PCAOB, the perception of audit quality is lower than those auditors who received a clean opinion.
DeFond and Lennox (2017) investigated if the inspections of PCAOB affects the quality of internal control audits. Internal controls are critical in assuring high quality of financial reporting because auditors rely on the internal controls of a company when they are auditing their financial statements. In the period of 2005 to 2009, the Securities and Exchange Commission (SEC) speculated that audit quality was inadequate because auditors were systematically failing to detect and report material misstatements. These concerns heightened when clean opinions were provided, while the financial reports contain material misstatements, and thus these companies should have received an adverse opinion. In response to this, PCAOB increased their inspections on assessing whether audit firms had sufficient evidence to support their opinions regarding the internal control. The authors found evidence that the increase in the inspections of PCAOB led to higher rates of deficiencies in the internal control audits. After the increased inspections, there has been an increase in issuance of adverse opinions by the auditors. Overall, the findings suggest that the inspections of PCAOB lead to improved audit quality.
Aobdia and Shroff (2017) investigated whether greater regulatory oversight by PCOAB increases the perceived value of audits. They compared the audit market share of companies with the inception of such oversight with companies who are not subject to similar oversight. The paper focuses on the effect of oversight on the change in auditor market share.
The paper hypothesized that if auditors perform audits with greater regulatory oversight, auditees and investors perceived a greater value of an audit. The authors analyzed 36 countries in the period 2003 to 2013. Overall, the results of this paper suggest that enforcement of auditors’ oversight helps to increase the assurance value of an audit. The market share of the average auditor increase with 3, 5 to 6, 4% after the announcement that PCAOB inspects the auditor. These results implicate that the greater public oversight increases the assurance value of an audit.
2.5.3 Authority for the Financial Markets (AFM)
The Dutch accounting enforcement body in the Netherlands is called ‘Autoriteit Financiele Markten’ (AFM). Since 1st March 2002 AFM is according to the Dutch Law of financial supervision, responsible for the supervision of the operations of the financial markets. AFM is a self-governing independent unit with duties assigned by the Minister of Finance (AFM; 2014; Hayes et al., 2014).
The main objective of AFM is to restore the confidence of businesses and investors in the financial market (savings, investment, insurance and loans). Since 2006, AFM is licensed to supervise accounting firms, their main objective of this supervision is to increase and sustainably safeguard the quality of audits and to ensure this in the longer term. By performing their supervision activities, AFM aims to contribute to the health and economic reputation of the Netherlands (AFM, 2014). The authorities of AFM is defined in several Dutch laws. In the act on the Supervision of Audit Firms (Wet toezicht accountantsorganisaties, Wta) the legislation and rules of accounting firms and auditors are defined.
To fulfil their supervision role, AFM conducts inspections on statutory audits. The primary aim of the inspections of inspections is to protect the interest of stakeholders and strengthen their confidence (Schoten, 2015). The investor should be assured that the accounting information of the firm is reliable and relevant (Jensen & Meckling, 1976). Based on the Dutch law Wta, AFM is competent to take enforcement actions when the audits of accounting firms are not in place. They can obtain informal measures like a discussion with the firm and a warning letter and publishing reports about the audit quality. But they can also take formal measures, namely: issuing a construction, imposing a civil penalty or an administrative penalty. The AFM may also decide to institute disciplinary proceedings against the accounting firms. (Wtfv, 1:94).
There have been very limited studies that investigated the role of AFM in the accounting practices in the Netherlands. There has been a study by Van Erp (2009) that examined the effect of error announcement in reports of oversight bodies in the Netherlands (the so-called ‘shaming and naming’) on the decision making process of the consumer/stakeholders. She stated that the negative signalling of enforcements negatively impacts stakeholders. Meaning that consumer turns away from purchases, lenders turning away from procuring money or suppliers that revoke.
2.6 Reports of AFM
Since 2007 Big Four companies (Deloitte, EY, KPMG and PwC) have licenses at the AFM, this means that they are under the supervision of AFM. Accounting firms need to show that they are practising their audits in compliance with the Dutch law Wta (Wet toezicht accountantsorganisaties). The AFM conducts regulatory inspections to analyze to what extent audit firms comply with the law. The accounting enforcement investigates audits of companies with the public interest; these are listed companies, bank and insurers.
After the credit crisis, in 2008, AFM conducted their first regular statutory inspections of the Big Four. The AFM concluded that auditors need to be more critical when they are auditing financial reports. Measures were discussed with the concerned accounting firms to improve their audit quality.
In 2009, the second regular inspection was conducted. This time, the results of the inspection were reported and published in 2010, the so-called deficiency reports. This reports show deficiencies of accounting practices according to the enforcement body (ISA, 2010). The results of the third inspection were published in 2014 and the fourth inspection in 2017. AFM conducted a different kind of enforcement strategies when publishing deficiency reports namely: reporting results anonymously, not anonymous and reporting measures to improve the audit quality non-anonymously. The reports published by the AFM are extensively discussed in this paragraph.
2.6.1 AFM report September 1, 2010
In 2010 on September the 1st AFM published the first report with the results of the statutory
inspections called ‘Report on general findings regarding audit quality and quality monitoring’. The inspection of the audit in this report is focused on the financial year of 2008.
In 2008 the Big Four had a market share of 60% of the statutory audits in the Netherlands and a market share of 90% of the statutory audits of companies with public interest. The inspections focus on sectors with the public interest, therefore, they inspected companies in the financial, construction/real estate and automotive sector. After the credit crisis, the public interest in the financial position and performance of the financial sector increased. Because of the decline in liquidity, companies were under pressure to present their financial position in the most favourable way as possible. The construction/real estate and the automotive sector were of considerable public interest because of the problematic refinancing; this creates a more going concern risk.
During the inspections, AFM carries tests of the effectiveness of the quality control system of the accounting firms to a limited number of statutory audits. AFM selects specific parts of the audits and quality control system, conducting the so-called risk-based approach. The regular inspection included 46 statutory audits, of which 22 audits were obtained from companies with public interest and 24 companies of non-public interest. Where 11 companies were from the financial sector, 19 from construction/, 8 from automotive and the remaining 8 involves other sectors.
The report shows that 63% of the inspected audits had severe weaknesses. The deficiencies occurred in all the inspected sectors. There were incidents whereby the auditors did not react appropriately to signals of the quality of the financial reports. There were even cases where auditors have been unfairly issuing unqualified audit opinions. Therefore it is stated that AFM has insufficient prove that material misstatements are detected and reported. In general, the following deficiencies are detected:
- The auditors based their opinion on inadequate audit evidence.
One of the reasons for this deficiency is the insufficient professional sceptic behavior of the auditor when obtaining audit evidence. The enforcement defined professional scepticism as the behavior that an auditor unbiased evaluates the value of audit evidence. He should also be alert and take documentation into question, as to the reliability and credibility. Audit evidence should not only be obtained from the party , but also from external sources. Because of the missing professional scepticism, the auditors failed to assess the existence of and valuation assets, indicate misrepresentation, to assess the going concern assumptions and the evaluation of the completeness of earnings.
- The auditor that was responsible for the concerning audit was insufficiently involved with the audit, and therefore the auditor was not able to fulfil the audit quality of the engagement.
- All relevant audit evidence was not included in the audit files.
Compared to the previous inspection of 2008, the awareness of the Big Four has improved. But at the same time, the AFM reported that they find that the accounting firms had systematic deficiencies as a result that the audit quality was inadequate. The results of the inspections are anonymous, but the report says that there are differences in the audit quality of the various accounting firms.
Based on their findings, AFM mentioned in their report to take formal enforcement actions. This report includes instructions, penalty payments and administrative penalties. Furthermore, AFM submitted complaints to the Disciplinary Court for Auditors against external auditors of the Big Four.
2.6.2 AFM report September 25, 2014
The second report regarding the audit quality of the Big Four was published in 2014 on September the 25th called ‘Results of the inspection of the quality of statutory audits at the
Big 4 audit firms’. Between April 2013 and the end of July 2014, AFM inspected the statutory audits of theBig Four. In this report findings and conclusions are subject to the concerning audit firms, using the so-called ‘name and shame’ strategy. The reason for this approach is to gain transparency regarding the quality of audit of the concerning Big Four firm. Naming the audit firm enables investors and lenders to compare audit firms when it comes to the extent to which standards are met. These reports are also useful for audit committees for selecting an external auditor.
The inspections focused on the material parts of the audits. If AFM concluded that the auditors did not obtain sufficient audit evidence for a material part, then the auditor did also not obtain sufficient evidence to justify the audit opinion they issued. When this is the case, AFM categorized the statutory audit as inadequate.
AFM conducted for every Big Four company an inspection over 10 statutory audits. Of the total of 40 statutory audits, 18 were classified as inadequate. KPMG had the most inadequate audits with seven, followed by Deloitte and PwC with four inadequate audits and three for EY. In the report of 2010, AFM concluded that 52% of the statutory audits didn’t have enough audit evidence to issue an unqualified audit opinion. In the report of 2014, this
number decreased to 45%. But, this is still not the desired results stated AFM. Even though the statutory audits has slightly improved since 2010, the inadequate audits are still too high. The most occurring deficiencies were as follow:
- The auditor that conducted control tests to establish internal controls were insufficient.
Auditors were obtaining an insufficient understanding of the design of the internal controls of the audited companies. There was a minimum number of tests obtained to get an opinion about the internal controls.
- Auditor fails to carry out substantive analytical procedures
The substantive analytical procedures are established to conclude that there are no material misstatements in the accounting information of the company. The number of analytical procedures that should have be done by the accounting firms is insufficient. For of the most substantive analytical procedures, the auditor used untested information whether it is accurate.
- Insufficient scepticism/critical behavior when obtaining audit evidence
The auditor should have critically evaluated audit evidence that it does not contradict other audit evidence. AFM found that auditors didn’t estimate whether reported revenue was realistic or not. They were also not critical enough regarding management information
In conclusion, AFM discussed the improvement measures extensively to increase the audit quality of the big firms. They also mentioned their report to apply formal enforcement actions. As a result of the previous inspections and to take action against the shortcomings that are reported in 2014, AFM handed out fines. Which was for Deloitte an amount of EUR 1.810.000, EY 2.230.000, KPMG 1.245.000 and PwC 845.000.
2.6.3 AFM rapport June 28, 2017
The most recent report is issued on 28 June 2017, called ‘Quality of PIE audit firms – Findings of the assessment of the implementation and embedding of improvement programs at PIE audit firms and the inspection of the quality of the statutory audits at the Big Four audit firms’. Between May 2016 and May, 2017 AFM assessed the implementation and the embedding of the improvement measures of the PIE audit firms. In this report the Big Eight is included, these are the Big Four audit firms: Deloitte, EY, KPMG, PwC and other public interest entities (PIE) Accon, BDO, Baker Tilly Berk and Mazars. The report of 2017 is
twofold, on the one hand, it discusses the results of the assessment regarding the improvement measures for the Big Eight, and on the other hand, they showed results of the quality of the Big Four.
As a result of the disappointing results of 2010 and 2014, the importance of urgent improvement of the quality of statutory audits can’t be overstated. Based on the assessment, the implementation and embedding of improvement are moving too slowly. Furthermore, the inspected statutory audits of the Big Four has still serious deficiencies. The results of this inspection were not satisfactory according to the enforcement. The PIE audit firms did not meet the required expectations regarding the improvement measures. These firms failed to safeguard the statutory audits. The AFM assessed the improvement on three pillars. First, to what extent the company is in control, secondly the behavior and culture and lastly the internal supervision.
From its regular inspections, AFM inspected 32 statutory audits of the Big Four companies. Again, the results are not satisfying according to AFM. 19 statutory audits are still classified as inadequate, divided by three inadequate audits by Deloitte, four at PwC, and six at KPMG and EY. The most deficiencies that are analyzed are similar to the inspection of the last time (report 2014). The International Forum of Independent Audit Regulators (IFIAR) says that the number of inadequate numbers is still too high.
The AFM mentions encouraging the desired changes for the audit firms by intensifying their supervision role, like carrying more inspections on the statutory audits to assess the quality of the audit.
Overall, the reports of 2010, 2014 and 2017 show that the accounting practice in the Netherlands has serious structural deficiencies. Unqualified audit opinions are unfairly granted, therefore, a lot of the statutory audits are qualified as inadequate. In table 1 the results of the statutory inspections of AFM is summarized.
Table 1. Results inspections AFM
Report Inspection conducted Inadequate audits Percentage of inadequate audits
September 1, 2010 46 29 63%
September 25, 2014 40 18 45%
June 28, 2017 32 19 59%
Total 118 66 55%
This table shows the results of the inspections conducted by AFM regarding the audit quality of Big Four companies.
3 Hypothesis development
Studies have shown that perception of audit quality is positively related to earnings persistence, the predictability of earnings, growth opportunities, industry membership, audit size, auditor specialization and auditor tenure (Balsam, 2003; Hofenhels, 2016; Teoh and Wong, 1993). This notion is in many kinds of literature measured by the ERC. Literature has shown that stronger enforcement lead to higher audit quality because firms tend to comply better with accounting standards like IFRS. This implies that stronger enforcement leads to the higher perception of audit quality (Brown et al., 2014; Kothari, 2000).
Furthermore, literature showed that the investors react negatively to error announcements/deficiency reports of accounting enforcements. Kläs and Werner (2014) found a decrease in cumulative abnormal return due to error announcements. Hitz et al. (2011) also found a significant negative reaction of investors surrounding publication of error findings of the German accounting enforcement.
There is clear evidence that investors react significantly negative at the moment accounting enforcement bodies publish adverse content regarding the audit quality. Studies have also shown a negative perception of audit quality on negative news like litigation and scandals. However, no studies are adopted that investigates the impact of accounting enforcements on the perception of audit quality. It is questionable what the market reaction is of investors surrounding earnings announcements that are influenced by the negative signalling content of accounting enforcements.
In the Netherlands, the AFM has published deficiency reports regarding the audit quality of the big four accounting firms. It’s questionable whether investors still rely on the accounting information after enforcement bodies have announced serious deficiencies of accounting practices. This paper takes a step further than previous studies that outline the role of enforcement bodies. Instead of just analyzing the market reaction surrounding the error/deficiency announcement, the ERC is calculated to investigate the perception of audit quality (Gunny and Zhang, 2013; Hitz et al., 2012; Kläs and Werner, 2014). Therefore, not only the reaction is shown, but the perception of audit quality is measured, by analyzing the reaction of abnormal stock returns to unexpected earnings; ERC.
AFM discussed has discussed which audit quality is below the norm in al of their three reports published in 2010, 2014 and 2017. This gives investors negative signalling content, the paper of Gunny and Zhang (2013) implies that this leads to a negative perception
of audit quality. By comparing the ERC in the year after a deficiency report was published in those years that there wasn’t a publication of AFM the influence of the enforcement body can be analyzed. The ERC analyses to what extent new earnings information is capitalized in the stock price, so, the efficient market hypothesis is tested.
Because investors react negatively to error/deficiency announcement of accounting enforcements, this paper hypothesizes that the perception of audit quality in the Netherlands is also negatively influenced since investors react to negative news (Hitz et al., 2012; Autore, 2009). A negative influence results to the fact that investors will react weaker on earnings announcements because they don’t perceive these earnings as credibly since in their perception material misstatements aren’t detected/reported. Therefore a change in the ERC is predicted. The following hypothesizes are defined:
H1: The ERC of Dutch listed companies audited by Big Four companies significantly changes after AFM published the deficiency report regarding the audit quality compared to the years there wasn’t a publication
4 Research design
4.1 Data description
The reports of AFM are subjected to public firms that are audited by the Big Four. Public firms are listed companies. Therefore, the initial sample consists of Dutch listed companies that are traded on Euronext Amsterdam. We analyze the ERC in the year right after AFM has published a deficiency report. AFM has published the reports in 2010, 2014 and 2017. This research is going to analyze the earnings announcements of the period 2010 to 2017. Because annual earnings announcements are subjected to the previous year, earnings announcement in the period 2011 to 2018 are analyzed. Data is retrieved from Datastream. In the period 2010 to 2018, 115 different firms were traded on the Dutch security market. 90% of these companies were audited by the Big Four; this results in a sample of 103 firms. To run the regression, I need all data for the dependent, independent and control variables. Therefore, missing values are dropped in the analyses. Eventually, 78 different firms in the period 2010 to 2018 are observed. In table 2 the number of observed firms per year is described.
Table 2. Sample Year the earnings announcement subject to
Year earnings announcement Observations
2010 2011 61 2011 2012 62 2012 2013 60 2013 2014 59 2014 2015 63 2015 2016 70 2016 2017 74 2017 2018 70 Total 519
This table shows the observations for the full sample in the period 2011 to 2018. Earnings reports subject to the results of the prior year.
4.2 Event study
Event study will be used to measure the impact of the Dutch accounting enforcement on the perception of audit quality.The event study is a method that considers if the value of a firm changes after a certain event has happened. The impact of the enforcement is measured by analyzing the ERC, which is measured by the CAR. The event that impacts the CAR is earnings announcements. This paper focuses on the annual earnings announcement rather than semi-annual or quarterly, because annual reports have been scrutinized by an auditor and are therefore perceived as more reliable (Dhaliwal et al., 1991). The announcement dates of the annual reports are retrieved from Datastream.
The event studies test the semi-strong efficient market hypothesis. There should be fluctuations in the stock prices surrounding the event if there is not then the market isn’t efficient; because the market should incorporate all new information in the stock prices (Brown et al., 1980).
The event studies have three measurement periods, namely the estimation window this is the period prior the event, event window this is the period where the event takes place and the post-event window this is the period after the event has taken place (Mackinlay, 1997).
4.2.1 Estimation window
The estimation window is the period prior to the event. The estimation period measures the normal stock return of the company. This period should not overlap the period of the event itself. This design provides estimators for the parameters of the normal return model which are not affected by returns surrounding the event window. It is important to measure the length of the estimation window (‘L1’). According to the paper of MacKinlay (1997) a length for estimation window of 120 days prior the event, ending 30 days prior the event is used. This parameter estimates the normal performance model.
4.2.2 Event window
The second measurement period is the event itself, the event, in this case, is the earnings announcement. Consistent with the paper of MacKinlay (1997) the length of the event window should be one day prior the event, the day itself and one day after the event (‘L2’). The cumulative abnormal return (CAR) is measured as the 3-day cumulative return.
The last measurement period is the post-event window. On occasion the post-event window is included with the estimation window, to measure the normal return model.
4.3 Dependent variable
In this paragraph, the dependent variable is discussed, namely: perception of audit quality. Consistent with prior literature this variable will be measured using ERC. The ERC is the market’s responsiveness to earnings announcement. The ERC is compared to the period that there were deficiency reports published to the period that there weren’t. This variable is measured by calculating the proportion between the cumulative abnormal returns (CAR) and unexpected earnings. These two variables are discussed in this paragraph.
4.3.1 Cumulative abnormal return
Abnormal return is the difference between the expected return and the actual return of a stock. The observations of the abnormal returns must be aggregated to draw overall inferences about the event; this gives us cumulative abnormal returns (CAR). Consistent with prior literature, 3- days of cumulative abnormal return is calculated surrounding the event (-1,1).
The formula for abnormal returns is as follow:
CARit= Rit-E(Rit)
T
t=1
CAR = Cumulative abnormal return for firm i in period t Rit = Observed stock return for firm i in period t E(rit) = Expected stock return for firm i in period t
The observed stock return stands for the actual stock return of firm i in period t. These prices can be retrieved from Datastream. These prices can be considered a highly
reliable given the extensive use of professionals of this database. The returns for the event window are calculated as follow:
𝑅 = 𝑃 − 𝑃 𝑃
Rit = Observed stock return for firm i in period t Pit = Stock price at event window for firm i in period t Pit+1 = Stock price at event window for firm i in period t+1
The expected stock return can be calculated through different kind of techniques. Peterson (1989) categorizes these techniques into three sections, namely the market model, mean adjusted model and market adjusted model. In this paper, I employ the market model according to the recommendations from Barber et al. (1997) and Bartholdy et al. (2007). In this model, the returns on security are regressed against the concurrent return of the market. The market model assumes a linear relation between market return and security return.
4.4 Independent variable
4.4.1 Unexpected earnings
To measure the ERC, the slope coefficient between CAR and unexpected earnings (UX) are measured. The UX is the difference between actual earnings and the market’s expectations on earnings. Instead of using Earnings before Interest and Tax (EBIT) and Return on Equity (ROE), the earnings per share (EPS) is used as a proxy for earnings; because the EPS is consistently presented and forecasted for each firm every year. Also, EPS has a clear link to equity valuation (Damodaran, 2005).
The analyst’ consensus forecast is the proxy for the expected EPS. This is the mean of the reported earnings forecast for a company from all the analysts. Using analysts’ consensus EPS we assume that the forecast stern from rational predictions, therefore taking all reporting earnings together, the forecast should be an accurate picture of the markets’ expectation (Schipper, 1991). This data is retrieved from the database Datastream.
Information about analysts’ forecast is continuously being updated and made available throughout the year (Ball et al., 1968). In this paper, the most recent consensus is used because prior information is incorporated in the expectations, and therefore more
accurate (Thomas, 2002). The most recent available data was one month prior to the earnings announcement.
The actual EPS is the actual annual reported earnings divided by the outstanding shares. The formula for UX is as follows:
𝑈𝑋 = 𝐸𝑃𝑆 − 𝐸(𝐸𝑃𝑆 ) UXit = Unexpected earnings for firm i in period t EPSit = Observed earnings per share for firm i in period t
E(EPSit) = Analysts’ consensus earnings per share forecast for firm i in period t
4.4.2 Deficiency report
The independent variable in this paper is the effect of enforcement. The proxy for the role of the Dutch accounting enforcement is the issuance of the deficiency report in 2010, 2014 and 2017. Dummy variable DEF is included, where 1 stands for the issuance of the AFM report in the period after the earnings announcement.
4.5 Control variables
To mitigate the effect of factors on dependent variables, this paper included some control variables. According to the literature, three categories are related to the influence of the perception of audit quality. These are: growth prospective (Collin and Kothari, 1989; Lai and Krishnan, 2009), Earnings persistence (Kormendi and Lipe, 1987; Zmijewski, 1989; Lipe, 1990) and firm risk (Collins and Kothari, 1989; Higgs and Skantz, 2006; Lai and Krishnan, 2009). Each control variable is discussed in this paragraph.
4.5.1 Growth opportunities
There is a significant relationship between growth opportunities and the ERC. When growth opportunities increase the association between annual stock returns and dividends also increases; because companies with greater growth opportunities have higher earnings. Therefore, investors react stronger to earnings announcement of companies who are associated with higher with growth opportunities (Hasanzade et al., 2013).
The paper uses the market to book value for each company every year as a proxy for growth opportunity. The difference between these two numbers represents the value of investment opportunities of the firm. Growth opportunities affect future earnings, so the
higher the market to book value, the higher does the market expect to have growth in earnings. (Collins & Kothari, 1989)The proxy for growth opportunity is defined as MB_RATIO.
4.5.2 Firmsize
Hassanzade et al. (2013) found a positive relationship between the firm size and earnings response coefficient. There has been empirical evidence that a change in results has a bigger impact on small-sized firms than bigger firms. To control factor, the variable SIZE is added in the regression. The size is measured by the total assets per balance date in the concerning year (Collins et al., 1987).
4.5.3 Firm risk
The relationship between earnings response coefficient and systematic risk is a significant negative. It is expected that when a company is riskier, the riskier the expected future return is and therefore the lower its value for a risk taker is. The riskier the future returns are, the lower investment market reaction to dividend changes there would be. Consistent with the theory of Kothari et al. (1989) this paper uses the beta of each firm in every year to measure the systematic risk. The higher the beta, the higher the risk and therefore the ERC impairs. The firm risk is in this paper defined as RISK.
4.6 Regression model
In this research, an OLS regression is performed to measure the influence of enforcement on the perception of audit quality. As suspected, the publishing of AFM’s report will impact the firms ERC. Based on literature review ERC is measured as the slope of the basic regression:
𝐶𝐴𝑅 = 𝛽 + 𝛽 ∗ 𝑈𝑛𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛𝑠
In this case, the firm's EPS would be the parameter 𝛽 . On normal circumstances and also based on the law of large numbers the estimator b1 is an unbiased estimator of the true population parameter and hence measures the actual populations ERC score. Theoretically speaking there can be factors (such as the AMF publication) which may impact the ERC. Since, essentially the ERC is the slope of a regression so, we can express the additional factors impacting EPS as a mediator and hence introduce them through an interaction effect with the main variable (unexpected returns). Thus, our model expands to:
𝐶𝐴𝑅 = 𝛽 + 𝛽 ∗ 𝑈𝑛𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 + 𝛽 ∗ 𝑈𝑛𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 ∗ 𝐴𝐹𝑀 AFM is a dummy variable where it takes the value 1 as AFM has published the report in the year before the earnings announcement.
To control external factors, the control variables are appended in the regression. Based on the research of McKay et al. (2012) who adopted similar research, the following regression model is defined:
𝐶𝐴𝑅 = 𝛽 + 𝛽 ∗ 𝑈𝑋 + 𝛽 ∗ 𝑈𝑋 ∗ 𝐴𝐹𝑀 + 𝑀𝐵 + 𝑆𝐼𝑍𝐸 + 𝑅𝐼𝑆𝐾 + 𝜇 CAR = Cumulative abnormal return
UX = Unexpected return
AFM = Issuance of deficiency report by AFM
MB_Ratio = Market/book value to measure growth opportunities for firm i in period t SIZE = Firm size measured by total assets for firm i in period t
RISK = Systematic risk measured by the beta for firm i in period t
A significant change in the event window when AFM reports are published means that the enforcement has influences the perception of audit quality; when the ERC decreases the perception of audit quality decreases ceteris paribus. This condition means there isn’t an efficient market since investors don’t capitalize new accounting information in the stock market (Brown and Warner, 1980).
5 Results
In this paper, the main question was: “What is the effect of the accounting enforcement (AFM) on the perception of audit quality?”
To investigate this question, the following hypothesis was described: “H1: The ERC of listed companies audited by Big Four companies significantly changes after AFM published the deficiency report regarding the audit quality compared to the years there wasn’t a publication”.
All the results of the regression that are formulated in table 6 and 7 stern from yearly regressions from the period 2010 to 2018. The coefficients reported in the table are the average of the coefficients of the 9 years. The results of the research are discussed in this chapter. First, the descriptive data is discussed followed by the correlation and then the regression.
5.1 Descriptive data
The normal distribution is tested to meet the criteria of a regression. As showed in graph 1, the CAR is centred around 0% and decreasing in frequency further away from the average. This shows the tendency of a normal distribution, so this shows that there seem to be no problems with the model. Scatter plot of residuals shows no sign of patterns or trends and the fact that the residuals do not have a conic shape tells us that there is no heteroscedasticity. Graph 1. Histogram of residuals
The descriptive data of the dependent, independent, control and interaction variable is shown in table 3. The mean, observations and standard error, minimum and maximum is described in the table. These variables help to determine how the accounting enforcement AFM influences the perception of audit quality. As described in the table, the total observations are 519. The mean of CAR is 0.00 and standard error of 0.06.
Table 3. Descriptive data
Variable Observations Mean Std. err. Min. Max.
CAR Unexpected earnings 519 519 0,00 0.55 0,06 3.80 0,21 -23.82 0,36 72.36 Size 519 14.38 2.52 6.43 20.96 Risk 519 0.84 0.65 -1.15 5.03 Growth 519 2.27 4.28 -50.53 52.83 Interaction 519 0.12 1.20 -23.82 6.65
This table shows the total of descriptive data for the full sample; this includes firms traded in Amsterdam at Euronext between 2010 and 2018 and audited by a Big Four. CAR is the cumulative abnormal return three days surrounding the earnings announcement. The abnormal returns are the difference between actual and expected stock return. Expected returns are measured by the market model. Unexpected earnings is the independent variable measured by the difference between actual and unexpected earnings per share (EPS). Expected EPS are the consensus analyst earnings forecast. Actual EPS are the earnings showed in the annual report of the concerning company divided by the total outstanding shares. Size, risk and growth are control variables. Size is the frim size measured by total assets. The risk is the beta of the concerning company and growth is the growth expectation of company x measured by the market to book ratio. Interaction is the variable is the unexpected earnings * AFM report. AFM report is the dummy variable; it takes the value 1 if AFM published a deficiency report prior the earnings announcement. All data is retrieved from Datastream.
