Extended auditor’s report: The impact of environmental factors

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Extended auditor’s report: The impact of environmental factors

Master thesis Accountancy

University of Groningen, Faculty of Economics and Business

January 21, 2019 Marchel Tomo Studentnumber: 2320924 Damsport 271 9728PS Groningen Tel: +31 643518888 Email: m.p.tomo@student.rug.nl

First supervisor: R. S. Tuinsma Second supervisor: Prof. dr. D.A. de Waard

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ABSTRACT

In the aftermath of the financial crisis, financial statement users demanded more informative auditor’s reports. The regulators responded by issuing the extended auditor’s report which requires auditors to provide more transparent and informative reports. A quick review revealed that there is a large diversity of auditor’s reports in terms of structure and content. This study examined the influences of environmental factors on the extended auditor’s report. The structure and content of the extended auditor’s report is measured in three different ways: amount of words in the auditor’s report, number of Key Audit Matters and the amount of words used in the Key Audit Matters. A sample of 453 observations is used for this study. The results show no significant relationship between investor protection and extended auditor’s report. Furthermore, it is found that the cultural dimension individualism is significantly positive associated with the amount of words used in the Key Audit Matters. Finally, the study does provide evidence for the impact of the cultural dimension power distance. The results show that this cultural dimension has a significantly negative influence on all the three measures of the structure and content of the extended auditor’s report. Thus, auditor’s reports in countries with a high value of power

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1. INTRODUCTION

Nowadays we see extensive negative media attention regarding the accounting profession. This is because of several accounting scandals (e.g. Worldcom and Lehman Brothers). It was striking that auditors gave an unqualified audit opinion before many financial enterprises sought state support or even went bankrupt (Sikka, 2009). Another big audit scandal, the Enron collapse, even led to the fall of Arthur Andersen in 2001. As a consequence, the Big Five became the Big Four. The auditing profession lost the confidence of the public. The scandals and the financial crisis in 2008 has resulted in renewed interest in auditor reporting (Carson, et al., 2013). Stakeholders and politicians expressed dissatisfaction over the auditor’s work. They demanded more insight in the audit process. Even the Dutch oversight board Autoriteit Financiële Markten (AFM) stated that the level of audit quality is insufficient (AFM, 2017). Regulators had to respond to the expressed dissatisfaction over the auditor’s report.

One of the attempts to regain the public confidence is to increase transparency around the audit process by extending the auditor’s report. Besides society, the call for more detailed auditor’s reports was supported by audit professionals. Since the origin of the auditor’s report it is being discussed what the content of such a report should be. In the 1800s, auditor’s reports consisted largely of just the opinion and were very brief, often less than 50 words long (PwC, 2015). At the time of the financial crisis, the traditional auditor’s report had a pass/fail model, where the

independent auditor opines whether the financial statements are fairly presented. This boilerplate model was heavily criticized by investors and other financial statement users because of the little informative value and they demanded more transparency and insight in the auditor’s report. In response, the International Auditing and Assurance Standards Board (IAASB) issued new and amended International Standards on Auditing (ISA) in January 2015. The new standards are effective for audits of financial statements for periods ending on or after 15 December 2016 (IAASB, 2015). The aim of the standards is to provide auditor’s reports that increase the public’s confidence in both the audit process itself and the financial statements of companies (EY, 2016). Frontrunners in the world of auditing are the United Kingdom and the Netherlands. These were the first countries that extended their auditor’s report. The Financial Reporting Council (FRC) extended the auditor’s report in the ISA 700 regulations (FRC, 2016). This standard became mandatory for public interest entities in 2013. A similar standard, NV COS 702N, was introduced in 2014 for the auditor’s report in the Netherlands by the Nederlandse

Beroepsorganisatie (NBA). With these measurements the oversight boards wanted to enhance the transparency of the auditor’s report with the aim of better communication to investors (FRC, 2016).

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6 A quick review revealed that auditor’s reports issued worldwide tend to be diverse in terms of structure and content. For example, not all countries disclose the materiality used by the auditor in the auditor’s report. Choi (1974) discussed that environmental factors influence accounting and auditing practices. Frank (1979) found evidence that the cultural and economic environment in a country influences its accounting principles and reporting practices. Different national cultures and legal environments result in differences in auditor perceptions and behavior (Endrawes & Monroe, 2012).

One of the environmental factors Choi (1974) noted is the legal system. La Porta et al. (1997) distinguish two different legal systems: common law and civil law. Legislation of accounting and auditing practices tends to be more rigid in countries where the legal system is based on civil law rather than on common law (Choi, 1974). Local legal systems and law enforcements may affect the services auditors provide to their ‘important’ clients. Under the civil law and common law jurisdictions, the standard setters, the government, and the regulatory bodies treat cases

differently (Yuen, 2016). Yuen suggests that the law enforcement schemes and a country’s legal standards can affect the auditor’s behavior. This is because of the difference in levels of investor protection in the legal systems. Gore, Pope and Singh (2001) stated that there is a growing interest in the impact of different legal environments on accounting principles.

As noted by Frank (1979) another environmental factor is the culture in a country. Several studies indicate that if auditing standards are the same in different countries, their

implementation may differ due to the cultural environment. Wingate (1997) stated that culture explains the differences between accounting standards in different countries. Furthermore, the development of accounting systems in a country is influenced by culture (Collins & Bloom, 1997). In this study I investigate whether environmental factors influence the extended auditor’s report. So, the research question guiding the research is:

Do environmental factors influence the auditor’s report?

This research contributes to the academic literature in several ways. The extended auditor’s report is, at the time of writing, implemented for five years in the UK and four years in the Netherlands. The IAASB standards only require the new regulation around the auditor’s report from the financial year 2016 (NBA, 2014), but the UK and the Netherlands implemented the extended auditor’s report on voluntary base. Because of this short timeframe, there has been little prior research about the extended auditor’s report.

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7 Previous research has focused on the individual investors’ responses to the extended audit

opinion (Lennox, Schmidt, & Thompson, 2018). This study shows that investors do not find the extended audit opinion very informative and use other sources like management disclosure to assess their risks. Other research investigates the communicative value of Key Audit Matters (Köhler, Ratzinger-Sakel, & Theis, 2016). These studies provide more insight in the audit process but there is a need for research on the determinants that influence the structure and content of the extended auditor’s report and not only the effects of the report. The interest in the auditor’s report is still growing after the accounting scandals.

Additionally, to my knowledge, this is the first research that investigates the relationship between the law jurisdiction and the auditor’s report. Researchers in the accounting literature have often studied the relationship between legal system and audit quality. Francis and Wang (2008) assume that based on the levels of investor protection, and with that the litigation risk for auditors, the audit quality differs. Bushman et al. (2004) document that financial transparency is higher in countries with a legal regime characterized by a common law legal origin. Leuz et al. (2002) found evidence that legal protection of investors, which is greater in common law

countries, decreases incentives for earnings management. The objective for this study is to prove that there may be significant differences between the auditor’s report in a common law country and on the other hand civil law country.

Moreover, I investigate the impact that cultural values have on the extended auditor’s report. Prior research has examined the impact of cultural environments on accounting systems and financial disclosures (Gray, 1988; Perera, 1989). Endrawes and Monroe (2012) found that there were significant differences between the Egyptian auditors and the Australian auditors due to their cultural values. In this study, I investigate the cultural effects on the extended auditor’s report. More specifically, I will use the dimensions Power Distance and Individualism vs. Collectivism.

The remainder of this thesis is structured as follows: Chapter two presents background

information and the theoretical framework. The third chapter provides the research methods in detail. The results are presented in chapter four. Finally, the fifth chapter discusses the

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2. THEORETICAL FRAMEWORK

In this chapter the main subject of this paper will be explained: the extended auditor’s report. The key enhancements will be mentioned. Subsequently the relationship between the variables will be justified using the agency and stakeholder theory.

2.1 The extended auditor’s report

The auditor’s report is the key deliverable addressing the output of the audit process (IAASB, 2015) and is the primary communication between the external auditor and the shareholders. As mentioned before, the boilerplate model was heavily criticized and poorly read by society. A statement about the auditor’s report in the article by Humphrey et al. (2009): “being full of general, standardize statements on the role and limitations of the audit and containing little about the specific work undertaken and findings obtained by auditors”. The critical environment which characterizes auditing can be traced to the audit expectation-performance gap (Porter, 1993). According to Porter (1993), expectation-performance gap can be defined as: “the gap between society’s expectations of auditors and auditors’ performance, as perceived by society”. The auditing profession attempt to reduce the expectation-performance gap by extending the

auditor’s report by increasing transparency and enhancing informational value. Chye Koh (1998) found evidence that educating the users, expanding the auditor’s responsibilities and expanding the audit report will minimize the gap.

The IAASB intends for its new and revised Auditor Reporting standards to result in an auditor’s report that increases the confidence in the audit of the financial statements, which is in the public interest (IAASB, 2015). Key enhancements regarding the extended auditor’s report (IAASB, 2015):

Mandatory for audits of financial statements of listed entities, voluntary application for entities other than listed entities:

• New section to communicate Key Audit Matters (KAM) • Disclosure of the name of the engagement partner For all audits:

• Opinion section required to be presented first • Enhanced auditor reporting on going concern

• Affirmative statement about the auditor’s independence and fulfillment of relevant ethical responsibilities

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9 The centerpieces of the revised auditor’s report are the Key Audit Matters. By communicating KAM, the communicative value of the auditor’s report will be enhanced by providing more transparency about the audit that was performed. Users of the financial statements are provided with additional information about those matters that, in the auditor’s professional judgment, were of most significance in the audit of the financial statements of the current period. The

communication of KAM may also provide intended users a basis to further engage with management and those charged with governance (IAASB, 2015).

The description of a KAM should be clear, concise, understandable, and entity-specific, and should provide relevant information for the intended users of the financial statements (IAASB, 2015). The auditor is required to include in the description of a KAM (IAASB, 2015):

• Why the matter is considered to be one of most significance in the audit • How the matter is addressed in the audit

• Reference to the related disclosures(s)

By adding the KAM, the auditing profession tends to demonstrate the value of the audits to the shareholders by including more firm-specific information in the auditor’s report (NBA, 2014).

2.2 Agency Theory

Agency theory can be seen as the traditional theory that is used for research on reporting (An, Davey, & Eggleton, 2011). This theory explains why there is a need for an opinion of an external independent auditor. Problems exist ever since the separation of ownership and control. Jensen and Meckling (1976) define an agency relationship as “a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some services on their behalf which involves delegating some decision-making authority to the agent”. Common principal-agent relationships include the management-employee and the creditor-shareholder relationships. In this study, the shareholders are the principals and the management is the agent. If both parties are utility maximizers there is a good reason that the agent will not always act in the best interests of the principal (Jensen & Meckling, 1976). This is because of the information asymmetry that exists. Problems arise in two situations. Firstly, the principals and agents have not the same interests. Secondly, the agent has more information than the principal (Jensen & Meckling, 1976). The principal employs the agent to create value for him, but due to information asymmetry that exists, it is impossible to verify what the agent is doing and how much value he

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10 creates for the principal. To reduce potential conflicts between the principal and the agent, audits exist as a monitoring tool (Wallace, 2004; DeAngelo, 1981).

Information asymmetry also exists between the independent auditor and financial statement users (Antle, 1982). The existence of the expectation-performance gap is already mentioned. The gap consists of two major components: the reasonableness gap and the performance gap (Porter, 1993). The reasonableness gap refers to “a gap between what society expects auditors to achieve and what they can reasonably be expected to accomplish”. The performance gap refers to “a gap between what society can reasonably expect auditors to accomplish and what they are perceived to achieve”. The performance gap can be subdivided into: “a gap between the duties which can reasonably be expected of auditors and auditors’ existing duties as defined by the law and professional promulgations (‘deficient standards’)” and “a gap between the expected standard performance of auditors ‘existing duties and auditors’ perceived performance, as expected and perceived by society (‘deficient performance’)” (Porter, 1993).

Figure 1 The Audit Expectation Performance Gap (source: Porter, 1993)

The auditor’s report plays an important role in reducing the information asymmetry (Wallace, 2004). Previous research concluded that the auditor’s work is valuable for financial analysts as it increases their confidence in and reliance on financial statements (Deumes, Meuwissen, Peek, Schelleman, & Vanstraelen, 2010). Coram et al. (2011) indicates that an auditor’s report is deemed to be essential by professional financial analysts and investors. However, these users pay little attention to the content of the boilerplate auditor’s report. They suggest that users of the financial statements have a predetermined view and are mostly concerned whether the audit results in an unqualified opinion or not, since the standardized auditor’s report only serves as an affirmation to confirm their prior understanding of the firm’s financial statements.

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11 Ruhnke and Schmidt (2014) have shown that the increase of information in the audit opinion may reduce the expectation gap. By extending the auditor’s report the standard setters responded to the call for greater transparency in the audit process. Improved transparency improves trust. In sum, the extended auditor’s report provides more relevant and valuable information and more firm-specific information for the users of financial statements, which in turn can narrow the audit expectation-performance gap.

2.3 Stakeholder Theory

Beside the agency theory, the stakeholder can be seen as a reason for extending the independent auditor’s report. The stakeholder theory extends the agency theory that is only focused on the shareholders. Following the stakeholder theory, originally designed by Freeman (1984), besides shareholders there are more parties involved. Organizations must take the interests of the stakeholders in consideration. Freeman & Reed (1983) define stakeholders as: “Those groups who have a stake in the actions of the corporation”. Another definition by Freeman (1984): “Any group or individual who can affect or is affected by the achievement of the activities of an organization”. This group can include for example employees, suppliers, customers, creditors, communities and the public (Hill & Jones, 1992).

An et al. (2011) stated that firms have a responsibility towards their stakeholders to protect their rights and help them in making the right decisions. Firms have a responsibility to all their stakeholders instead of just their shareholders (Barsky, Hussein, & Jablonsky, 1999). Maltby (1998) argues that organizations that take the interests of their stakeholders in consideration, will perform better. For this reason, firms and auditors should disclose more information. By extending the auditor's report with more insight in the audit process and disclosure about the firm, all stakeholders will be provided with more useful and reliable

information. The NBA (2014) stated that not only shareholders demanded for more transparency, but the public, politicians and other stakeholders as well. The extra information provided by the extended auditor’s report can be used by society to examine the impact the firm has on their environment. The auditor’s report can also be used by, for example, future suppliers and customers to make their decisions based on the findings of the auditor.

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2.4 Legal System

Legal systems around the world can be divided in two different types: civil law and common law. This distinction is made by La Porta et al. (1998). The civil law derives from Roman law and is the oldest, the most influential, and the most widely distributed around the world (La Porta, Lopez-de-Silanes, Shleifer, & Vishny, 1998). It originates in Roman law, uses statutes and comprehensive codes as a primary means of ordering legal material, and relies on legal scholars to ascertain and formulate its rules (Merryman, 1969). The civil law tradition, also called the code law, is characterized by greater reliance on explicit laws and procedural codes and a

preference for state regulation over private litigation to resolve disputes (Francis & Wang, 2008). The common law is English in origin (La Porta et al, 1998). It is formed by judges who have to resolve specific disputes. Precedents from judicial decisions, as opposed to contributions by scholars, shape common law (La Porta et al., 1998). The common law tradition is characterized by relatively less reliance on statutes and a preference for contracts and private litigation to resolve disputes (Francis & Wang, 2008).

La Porta et al. (1998) investigated investor protection in the different types of legal systems and concluded that in civil law countries the investor protection is relatively weaker than in common law countries. Another response to the lack of legal protections that La Porta et al. (1998) have examined is the high ownership concentration. As stated by Shleifer and Vishny (1997), low investor protection can be seen as a reflection of high ownership concentration. In sum, common law countries are characterized by high investor protection and low ownership concentration. Civil law countries are characterized by low investor protection and high ownership

concentration (La Porta et al., 1998).

It is argued in the literature that if the investors are protected, the investors can sue management and the independent auditor if an audit is found lacking and reported earnings are considered questionable (Francis & Wang, 2008). Conversely, in countries where investors are poorly protected, they lack power and incentives to sue managers and auditors. Consequently, the auditor will determine their work based on the cost minimization principle (Jaggi & Low, 2011). Prior research found that a strong legal liability regime not only deters the ex-ante financial reporting risk faced by investors (Leuz, Nanda, & Wysocki, 2003), but it also increases the auditor’s incentives to be more diligent in reporting detected material misstatements, so as to minimize the auditor’s litigation risk (Francis & Wang, 2008). Hence, audit quality differs between countries, due to the level of investor protection, and with that the litigation risk for auditors (Francis & Wang, 2008). Francis and Wang (2008) used earnings quality as a proxy for audit quality, and found evidence that earnings quality is greater as investor protection becomes stronger for firms with Big 4 auditors.

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13 As mentioned, since auditors are exposed to a greater legal liability in stricter investor protection regimes, they might be more diligent about searching for and reporting, material weaknesses. Because of this, I expect that higher investor protection has a positive influence on the extended auditor’s report. Therefore, the following hypothesis is stated:

H1: Investor protection is positively related with the structure and content of the extended auditor’s report

2.5 Culture

Besides the legal system, cultural environment differs per country. Culture refers to the collective programming of the mind that distinguishes members of one group of another (Hofstede, 2001). Culture influences the development of accounting systems in a particular country (Collins & Bloom, 1997). Gray’s (1988) theory explained that accountants apply accounting reporting rules in a way consistent with their cultural values. The influence of cultural environment on accounting standards and practices has been examined (Jaggi, 1975; Gray, 1988; Perera, 1989, Hooghiemstra et al., 2015). Previous research used the cultural dimensions distinguished by Hofstede (2001). He categorizes culture into five dimensions:

1. Power Distance

2. Individualism vs. Collectivism 3. Masculinity vs. Femininity 4. Uncertainty Avoidance

5. Long term vs. Short term oriented

Consistent with Endrawes and Monroe (2012), I take the two dimensions power distance and Individualism/Collectivism into consideration in this study. We focus on these two dimensions because evidence shows that these dimensions are related to auditor’s judgments (Endrawes and Monroe, 2012; Gray, 1988). Power Distance is described by Hofstede (2001) as “the extent to which the less powerful person in a society accepts inequality in power and considers it as normal”. In the context of auditor-client relationships, the client (firm) may be regarded as the more ‘powerful’ party (Patel, Harrison, & McKinnon, 2002). Because the firm has the option of switching to another auditor, the firm has greater bargaining power (Patel, Harrison, &

McKinnon, 2002). Patel et al. (2002) suggests that this cultural characteristic leads to auditors being more likely to accede to clients and less likely to confront them.

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14 Jaggi & Low (2000) suggest that, high Power Distance societies are secretive and do not

encourage information sharing. Thus, I expect a negative association between Power Distance and the amount of disclosure in the extended auditor’s report. Formally:

H2: Power Distance is negatively related with the structure and content of the extended auditor’s report

Individualism/Collectivism is described by Hofstede (2001) as “the relationship between the individual and the collectivity which prevails in a given society”. This dimension encourages competitive environments, which suggests that these societies would be less secretive (Jaggi & Low, 2000). Hence, I expect a positive association between Individualism and the amount of disclosure in the extended auditor’s report. Thus, I hypothesize:

H3: Individualism is positively related with the structure and content of the extended auditor’s report

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3. METHODOLOGY

In this section, I will explain how the research will be executed. Firstly, I will discuss the sample and data collection. Thereafter, the variables used in this study will be concretized. The last paragraph clarifies the chosen statistical tests.

3.1 Sample

Since the extended auditor’s report was effective as of financial year 2017 in almost all

countries, I will use hand-collected data from the annual reports of listed firms issued over 2017, from six countries to give a fair presentation of the differences in common and civil law

legislation (La Porta et al., 1997). The dataset contains 573 observations of listed firms from specifically:

• Financial Times Stock Exchange (FTSE) in the United Kingdom • AEX-index, AMX-index and ASCX-index in the Netherlands • IBEX-index, IBEX medium-index and IBEX-small cap in Spain • Hang Seng Composite Large Cap-index (HSLI) in Hong Kong • ASX 100 in Australia

• CAC 40, CAC- next 20 and CAC-mid 60 in France

The extended auditor’s reports will be derived from the annual reports. The data collected from the extended auditor’s reports are put in a database. The collected data consists of several variables from the annual reports and auditor’s reports.

Additionally, several firms are eliminated from the sample. First, firms where there was no auditor’s report available are excluded from the sample. Second, I excluded firms that are headquartered in a different country than the countries used for this study. Hence, my final sample consisted of 453 firms as depicted below.

Table 1: Sample distribution

Sample Distribution

Initial numbers of firms 573

Firms with no auditor’s report available 26

Firms headquartered in other country 82

Firms with no audit committee 12

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3.2 Dependent variable

3.2.1 Structure and content of the extended auditor’s report

In this study, I will proxy the structure and content of the extended auditor’s report by three variables: amount of disclosure (words) in the extended auditor’s report, number of Key Audit Matters and the number of words per Key Audit Matter. These variables are chosen in line with prior research related to the extended auditor’s report. Gutierrez et al. (2018) used the number of words in the extended auditor’s report to investigate whether the extended report influences audit fees. Other research investigated the Key Audit Matters and their informational value (Be´dard & Bera, 2018). Consistent with their research, I will use the number of words used in the auditor’s report, the number of Key Audit Matters and the number of words per Key Audit Matter as dependent variables for this study

3.3 Independent Variables

3.3.1. Legal system

The first independent variable is investor protection. Following previous research, I use the legal system as a proxy for investor protection. The common law/civil law distinction has been widely used to measure investor protection in prior research (Abughazaleh et al., 2015; Francis and Wang, 2008; Jaggi and Low, 2000). As mentioned before, we can classify national legal systems into civil and common law systems (La Porta, Lopez-De-Silanes, Shleifer, & Vishny, 1997). Consistent with Abughazaleh et al. (2015), Francis and Wang (2008) and Jaggi and Low (2000) the legal system (LS) variable is coded as one for the common law countries Australia, Hong Kong and the United Kingdom. For the civil law countries Spain, France and the Netherlands the legal system variable is coded as zero.

3.3.2 Culture

Similar to prior research (Han et al., 2010; Hooghiemstra et al., 2015; Jaggi & Low, 2000), I will use the scores from Hofstede’s (2001) framework to represent each country’s cultural values. The scores from Hofstede’s framework are the most widely used measures of national culture. In this study, I include the dimensions Individualism (IDV) and Power Distance (PD). The

country’s cultural values have been used as the firm’s cultural values, which means that all firms from a single country have the same score for a cultural value.

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3.4 Control Variables

3.4.1. Firm size

The first control variable in this study is firm size. Prior research found that firm size has a positive influence on audit quality (Watts & Zimmerman, 1990). Larger firms have more

financial resources and include more activities. Hence, because of the more complex structure it can be expected that they face a larger amount of Key Audit Matters (Aldamen, Duncan, Kelly, McNamara, & Nagel, 2011). In addition, large firms are more likely to have a broad-based ownership, which would require more detailed disclosure to meet the needs of the stakeholders (Jaggi & Low, 2000). Bos & Strating (2014) found that auditors mention less Key Audit Matters if the firm size is relatively smaller. Prior research also indicated that the firm size has a strong influence on financial disclosures (Zarzeski, 1996). Ge and McVay (2005) found that firm size is negatively associated with the disclosure of material weaknesses. This study uses the natural logarithm of the total assets as proxy for firm size, consistent with Aldamen et al. (2011).

3.4.2. Frequency of audit committee meetings

The second variable for which I will control is the amount of audit committee meetings, because they could influence the number of KAMs disclosed. De Vlaminck and Sarens (2015) have shown that the amount of audit committee meetings positively influenced the quality of financial statements, which in turn can lead to less KAMs disclosed in the auditor’s report. Yet, other research has noted that auditors spend more hours to an audit if the audit committee meets more frequently (Stewart & Munro, 2007). This could lead to more KAMs disclosed in the auditor’s report, since the audit committee discuss with the auditor on a more frequent basis.

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3.5 Statistical tests

Since I examine the relationship between multiple variables, I will perform a multiple linear regression. Because the dependent variable structure and content of the extended auditor’s report consists of three components, I will perform three multiple linear regression models for each component resulting in the following formulas:

𝑊𝑜𝑟𝑑𝑠𝐴𝑢𝑑𝑅 = 𝛼𝑖 + 𝛽𝑖1𝐿𝑆𝑖+ 𝛽𝑖2𝐼𝐷𝑉𝑖 + 𝛽𝑖3𝑃𝐷 + 𝛽𝑖4𝑆𝐼𝑍𝐸𝑖 + 𝛽𝑖5𝐴𝐶𝑀𝑖 + 𝜀𝑖 𝐾𝐴𝑀 = 𝛼𝑖+ 𝛽𝑖1𝐿𝑆𝑖+ 𝛽𝑖2𝐼𝐷𝑉𝑖 + 𝛽𝑖3𝑃𝐷 + 𝛽𝑖4𝑆𝐼𝑍𝐸𝑖+ 𝛽𝑖5𝐴𝐶𝑀𝑖+ 𝜀𝑖 𝑊𝑜𝑟𝑑𝑠𝐾𝐴𝑀 = 𝛼_𝑖+ 𝛽_𝑖1𝐿𝑆_𝑖+ 𝛽_𝑖2𝐼𝐷𝑉_𝑖 + 𝛽_𝑖3𝑃𝐷 + 𝛽_𝑖4𝑆𝐼𝑍𝐸_𝑖+ 𝛽_𝑖5𝐴𝐶𝑀_𝑖+ 𝜀_𝑖 𝛼𝑖 = 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑐𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝐵_𝑖 = 𝑠𝑙𝑜𝑝𝑒 𝜀_𝑖 = 𝑒𝑟𝑟𝑜𝑟

where: WordsAudR = amount of words used in audit report; KAM = the number of Key Audit Matters; WordsKAM = amount of words used in Key Audit Matters; LS = 1 if the firm belongs to common law countries, and 0 if the firm belongs to civil law countries; IDV = individualism value of company i; PD = power distance value of company; SIZE = firm size, proxied by log of total assets of company; ACM = number of audit committee meetings

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4. RESULTS

In this section, the results of the study are presented. The first paragraph describes the processes that are performed to have a suitable dataset. The second paragraph gives an overview of the descriptive statistics of the continuous variables. In the third paragraph, the results of the regression analyses are presented.

4.1 Dataset adjustments

Before performing the regression analysis, several adjustments have to be made to get a suitable dataset. As stated in the method section, the data was hand-collected from annual reports. Since the sample consists of firms from different countries, each firm uses a different currency in their annual report. Therefore, all annual reports issued in another currency than euro are converted to euro. The conversion rate of 31 December 2017 is used. Furthermore, the natural logarithm for the control variable firm size is taken to detect outliers. Additionally, I used the technique of winsorizing for this variable to minimize the influence of the extreme values. In the process of winsorizing, the outliers detected are replaced by the mean plus/minus three times the standard deviation. This is necessary for continuous variables with large distributions, because outliers skew the normal distribution of data which can lead to distorted results (Field, 2013).

4.2 Descriptive statistics

In Table 2, the descriptive statistics of the continuous variables used in this study are shown. The table presents the mean, standard deviation, minimum and maximum of the variables. In Panel A, I provide information pertaining to the dependent variable, the structure and the content of the auditor’s report. The results indicate that the average extended auditor’s report consists of

3342,55 words and 3,44 Key Audit Matters. The average words used in the Key Audit Matters is 1392,22. Panel B presents the descriptive statistics of the independent variables. The average firm has total assets of approximately €9,98 billion and has 5,62 meetings in the year with a minimum of 2 meetings and maximum of 19 meetings.

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Table 2: Descriptive Statistics

Descriptive Statistics

Panel A: Dependent variable: extended auditor’s report

N Mean SD Min Max

WordsAudR KAM WordsKAM 453 3342,55 1403,68 1270 11175 453 3,44 1,47 1 10 453 1392,22 915,19 216 12908

Panel B: Independent variables

N Mean SD Min Max

PD IDV SIZE ACM 453 49,64 14,74 35 68 453 72,56 19,85 25 90 453 9,98 0,81 7,55 12,32 453 5,62 2,48 2 19

The independent variable legal system is not presented in the table above. This is a dummy variable, which makes it less relevant to provide information about the mean, standard deviation, the minimum and maximum. In table 3, the descriptive statistics for legal system is presented.

Table 3: Descriptive Statistics Legal system

Independent variable: Legal system

Country Legal system Number of firms

Australia Common law 95

France Civil law 110

Hong Kong Common law 40

Netherlands Civil law 53

Spain Civil law 65

United Kingdom Common law 90

Total 453

Table 3 shows that the final sample consisted of 453 firms from six countries. Three are civil law countries with 225 observations and three are common law countries with 228 observations.

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4.3 Assumptions of Multiple Linear Regression

There are some assumptions that need to be checked prior to a multiple linear regression, to make sure that the data is appropriate, which increases the reliability. These assumptions are normality, linearity, homoscedasticity, and absence of multicollinearity.

The first assumption that I checked was homoscedasticity. It was checked whether the residuals have the same variance. The size of the error has to vary across the values of the independent variable. The scatterplots of the residuals are shown in Appendix A. In the second scatterplot, the data do not have an obvious pattern, so it is homoscedastic. The first and third scatterplots

(WordsAudR and WordsKAM) of the residuals shows a little difference in the variance, so it suggests that the homoscedasticity assumption for this model is violated. Hence, the results from these models should be used with caution due to the unreliability of the model created by this assumption violation. For this reason, I transformed the variables to deal with heteroscedasticity. The independent variable WordsAudR is transformed to LogWordsAudR, the natural logarithm of the amount of words used in the auditor’s report. The other independent variable is

transformed to LogWordsKAM, the natural logarithm of the amount of words used in the Key Audit Matters. The fourth and fifth scatterplots are the scatterplots of the transformed variable. These scatterplots show that the transformed variables have no obvious pattern, thus these variables are now also homoscedastic.

Second, I check for the assumption for normality. The residuals of the regression should be normally distributed. I have done this by examining a normal Predict Probability (P-P) plot. For this, I refer to Appendix B. As seen, the little circles follow the normality line and there are no drastic deviations. Hence, I can assume that the data was normally distributed. Because all the residuals are normally distributed and homoscedastic, I can assume that they are also linear. Finally, the absence of multicollinearity was checked. This is important when performing a multiple linear regression. Multicollinearity can lead to overlapping, which influence the coefficients because they represent the same data. Hence, the disturbance can lead to unreliable data. I have checked for multicollinearity in two ways.

I have computed the Pearson correlation analysis. In this process it is checked if there exists a correlation between all the variables. The correlation matrix is shown in Appendix C. As stated by Blumberg, Cooper and Schindler (2014), a correlation coefficient below -.8 and above .8 indicates multicollinearity. As shown, none of the variables that interact with each other show a correlation below or above these boundaries. Hence, following the Pearson correlation analysis, multicollinearity does not exist. The results also indicate that the legal system and cultural dimension individualism are positively associated with the three measures of the structure and

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22 content of the auditor’s report, as expected. Moreover, the other cultural dimension power

distance is negatively associated with the structure and content of the auditor’s report. Another way to check the multicollinearity is by obtaining the variance inflation factors (VIFs). If these VIFS are higher than 10, multicollinearity could be problematic. I have presented the highest VIF of every model in the regression table. These VIFs were all less than 4, hence

multicollinearity should not be problematic.

4.4 Regression Analyses

In this paragraph, the results of the hypothesis tested are presented. Since I measure the

dependent variable by three variables, which means that I tested the same test three times, each with another dependent variable. For this reason, three figures are presented. Model 1 shows the results of the tested control variables. In model 2, 3, 4 the independent variables are added. Model 5 presents all the variables combined in one test.

4.4.1 Words Auditor’s Report

The results of the first linear regression, testing whether the amount of words is associated with the legal system and cultural dimensions, are shown in figure 2. As model 1 shows, the control variables clarify 11.4% of the words used in the auditor’s report. The beta of the control variable SIZE is significantly positive, which means there is a significantly positively association

between the firm size and the amount of words used in the auditor’s report. In other words, the larger the firm is, the more will be disclosed in the auditor’s report. Unexpectedly, the control variable ACM is not significant. In model 2 the independent variable LS is added. The beta referring to the relation between investor protection and the amount of words used in the auditor’s report is positive. In other words, the auditor’s reports in common law countries consists of more words compared to the reports in civil law countries. However, the relationship is not significant. For this reason, H1 cannot be fully supported. The beta belonging to the

relation between PD and the amount of words used is, as expected, significantly negative. H2 can still be accepted. The cultural dimension IDV shows a significantly positive association with the amount of words disclosed in the report. Yet, model 5 shows the betas of all the independent variables are significantly negative. The cultural dimension individualism has now a negative beta. This can be explained by the fact that the coefficients from IDV in model 4 and 5 are very small. Hence, H3 cannot be fully supported. Furthermore, model 5 shows that the independent variables explain 30.2% of the words used in the extended auditor’s report.

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Figure 2

Dependent Variable: LogWordsAudR

Model 1 Model 2 Model 3 Model 4 Model 5

Step and Variables B SE B SE B SE B SE B SE Intercept 6.552*** .198 6.552*** .198 6.841*** .186 6.216*** 0.204 7.368*** .224 Control Variables SIZE .152*** .020 .150*** .020 .166*** .019 .157*** .020 .186*** .018 ACM -.004 .007 -.004 .007 -.002 .006 -.005 .006 -.003 .006 Independent Variables LS .035 .032 -.206*** .036 PD -.009*** .001 -.016*** .002 IDV .004*** .001 -.003*** .001 R Square .114 .116 .247 .162 .302 Adjusted R Square .110 .110 .242 .157 .294 Highest VIF 1.025 1.034 1.033 1.028 3.241 * Significant at 10% level (p<0.1) ** Significant at 5% level (p<0.05) *** Significant at 1% level (p<0.01)

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4.4.2 Key Audit Matters

In figure 3, the results of the regression with the dependent variable Key Audit Matters is shown. In model 1, the control variables clarify 18.6% of the number of Key Audit Matters. The control variable firm size is highly significant with the number of Key Audit Matters. Model 2 shows that the independent variable LS has a positive association with the amount of Key Audit Matters, but it is not a significant association. Model 5 also shows no significant relation, so H1 cannot be accepted. As I expected, the beta belonging to the relation PD and the number of Key Audit Matters is significantly negative. This is also the case in model 5. Hence, H2 can still be fully accepted. The cultural dimension IDV has a significantly positive beta in model 4. In model 5 the beta is still positive, but not significant anymore. Furthermore, model 5 shows that the independent variables clarify 23.8% of the number of Key Audit Matters.

4.4.3 Words Key Audit Matters

Figure 4 presents the relationship between the independent variables and the amount of words used in the Key Audit Matters. The control variables clarify 21.4% of the amount of words used in the Key Audit Matters. Again, the beta referring to the relationship between firm size and the amount of words used in the report is highly significant. Unexpectedly, model 1 shows that the beta belonging to the frequency of audit committee meetings is not significantly associated with the amount of words used in the Key Audit Matters. This indicates that the frequency of audit committee meetings does not influence the auditor’s report. The independent variable LS does not have a significant correlation with the amount of words used in the Key Audit Matters. Because the betas referring to the relation between LS and the three measures of the auditor’s report is not significant, H1 is rejected. The betas referring to the relation between the cultural dimension PD and the amount of words used in the Key Audit Matters are both significantly negative, as expected. This was also the case for the relationships between PD and the other two measures of the auditor’s report. In other words, PD has a negative influence on the auditor’s report. Hence, H2 is accepted. The relation between IDV and the amount of words used in the Key Audit Matters is, as expected, significantly positive. This suggests that the cultural

dimension IDV is only significantly positively related with the amount of words used in the Key Audit Matters. Thus, H3 is partial supported.

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Figure 3

Dependent Variable: KAM

Step and Variables B SE B SE B SE B SE B SE Intercept -4.402*** .778 -4.399*** .776 -3.696*** .767 -5.550*** .805 -3.815*** .956 Control Variables SIZE .788*** .079 .777*** .079 .824*** .077 .805 .077 .843*** .078 ACM -.005 .025 -.003 .025 -.001 .025 -.007 .025 -.003 .025 Independent Variables LS .205 .125 -.227 .155 PD -.022*** .004 -.024** .007 IDV .014*** .003 .002 .005 R Square .186 .190 .233 .220 .238 Adjusted R Square .182 .185 .228 .215 .230 Highest VIF 1.025 1.034 1.033 1.028 3.241 * Significant at 10% level (p<0.1) ** Significant at 5% level (p<0.05) *** Significant at 1% level (p<0.01)

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Figure 4

Dependent Variable: LogWordsKAM

Step and Variables B SE B SE B SE B SE B SE Intercept 4.218*** .263 4.219*** .263 4.386*** .264 3.873*** .274 4.079*** .328 Control Variables SIZE .293*** .027 .289*** .027 .301*** .026 .298*** .026 .301*** .027 ACM -.007 .009 -.006 .009 -.006 .009 -.008 .008 -.007 .009 Independent Variables LS .063 .042 -.012 .053 PD -.005*** .001 -.003* .003 IDV .004*** .001 .003* .002 R Square .214 .217 .236 .240 .242 Adjusted R Square .210 .212 .231 .235 .233 Highest VIF 1.025 1.034 1.033 1.028 3.241 * Significant at 10% level (p<0.1) ** Significant at 5% level (p<0.05) *** Significant at 1% level (p<0.01)

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5. CONCLUSION & FUTURE RESEARCH

5.1 Conclusion

The aim of this study has been the empirical examination of the influence of environmental factors on the extended auditor’s report. First, to determine whether the legal environment is positively associated with the structure and content of the extended auditor’s report. Second, to determine whether cultural dimensions are associated with the extended auditor’s report.

Specifically, to determine if the cultural dimension power distance is negatively associated with the extended auditor’s report. Furthermore, I expected a positive relation between the cultural dimension individualism and extended auditor’s report.

The results show that there was no significant positive relationship between the legal system and extended auditor’s report. Although, I do find that auditors in common law countries disclose more in the extended auditor’s report than auditors in civil law countries do, the association was not significant. This means that there is no significant evidence that auditors in common law countries, where there is a greater legal liability, disclose more in the extended auditor’s report compared than auditors in civil law countries do. Hence, the first hypothesis was rejected. Besides the legal system, this study examined the impact of cultural values on the extended auditor’s report. Based on the literature review, a negative association between power distance and the extended auditor’s report was expected. The results of the regression show that power distance was significantly negatively associated with the structure and content of the auditor’s report. This means that this study has evidenced that the greater the power distance in a particular country, the less the disclosure in the auditor’s report. Therefore, the second

hypothesis was accepted. This suggests it less likely that auditors, in countries with a high value of power distance, confront management of the audited firm on their material weaknesses. This also can be explained by the fact that these countries are more secretive (Jaggi & Low, 2000). For the cultural dimension individualism, a positive relation with the auditor’s report was expected. The results show that individualism was significantly positively associated with only one of the three measures of the dependent variable. An auditor in a country with a high value for the cultural dimension individualism is more likely to use more words in the Key Audit Matters. Thus, the third hypothesis is partial supported. The evidence provided by this study extends the literature on the influence of cultural values on the accounting and auditing profession.

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28 This study has certain limitations. One limitation of this study relates to the measurement of the variable investor protection. In this study, the common law/civil law dichotomy is used as proxy for investor protection. As stated by Francis & Wang (2008) investor protection also operates through corporate law and securities law. This can explain why the results of the first hypothesis was not as significant as expected. Another limitation of this study is the generalizability. The sample only consists of listed firms. Larger firms are more likely to be audited by large (Big4) audit firms. Larger audit firms have more financial resources and are exposed to a greater legal liability, suggesting that Big 4 auditors are more diligent about searching and reporting for material weaknesses. This means that the results cannot be generalized to smaller firms and firms that are audited by non-Big 4 firms. The final limitation of this study can be ascribed to the fact that the cultural values from Hofstede’s cultural framework (2001) may have become outdated because of trends in business and industrial changes. The framework is developed more than 15 years ago, and cultural values can change over time.

5.2 Future Research

As mentioned, this study only used one dimension of investor protection. Future research could incorporate corporate law and securities law to their study, to get more evidence about the influences of investor protection on the auditor’s report. Further research could also investigate whether the environmental factors also have their impact on the auditor’s report from smaller firms. This can be explained by the fact that almost all listed firms are audited by Big4 auditors and provide different audit quality than non-Big4 auditors (DeAngelo, 1981). The final limitation of this study can be subjected to the fact that only two cultural dimensions are taken from

Hofstede’s cultural framework (2001). These two dimensions are chosen, because evidence shows that these dimensions are related to auditor’s judgements (Endrawes & Monroe, 2012). Further research might incorporate all the cultural variables of the framework to get a broader view of the cultural impact on the extended auditor’s report.

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APPENDICES

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Appendix C: Multicollinearity

Correlation Matrix

1 2 3 4 5 6 7 8 1 LogWordsAudR 1.00 2 KAM .660** 1.00 3 LogWordsKAM .745** .786** 1.00 4 LS .078 .106* .102* 1.00 5 PD -.333** -.176** -.107* -.564** 1.00 6 IDV .205** .165** .140** .263** -.730** 1.00 7 SIZE .336** .431** .461** .083 .094* -.046 1.00 8 ACM .025 .059 .039 -.039 .048 .011 .157** 1.00

Notes: * Significant at 0.05 (two-tailed test)

Extended auditor’s report: The impact of environmental factors