Does the “long form” auditors report improve the stability of the firm value?

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21/1/2018

Does the “long

form” auditors

report improve

the stability of the

firm value?

A step towards a smaller expectation

gap or towards more work for the

Auditor?

Michel Wang

UNIVERSITY: UNIVERSITY OF GRONINGEN

ADDRESS : KLEINE BEER 51 7904 LS HOOGEVEEN PHONE NUMBER: 0622761609

EMAIL: Wang-Michel@hotmail.com

STUDENT NR: S3261166

SUPERVISOR: DR. PROF. D.A. DE WAARD WORD COUNT: 11761

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The FRC revised the ISA 700 standard to provide a better audit report. The call came from stakeholders after several large audit frauds, the economic crisis of 2008 and such. An experiment by KPMG with the “long form” audit report was successful and this form has now become mandatory in the Netherlands. The hypotheses that this “long form” audit report will change the volatility of the firm value growth when compared with the past, other groups or even within the group has been based on the Expectation Gap theory, literature surrounding the Voluntary disclosure, Legitimacy theory and literature surrounding the Audit report. This research adds to the current literature surrounding the “long form” audit report in the Netherlands as no researches, that researches the effects of the “long form” audit report has on OOB’s, has yet to be published after the legislation has changed in 2014. It further adds to the literature surrounding voluntary disclosure and its effects on the volatility of firm value. The research is set up in the Netherlands, using data from OOB’s (Listed Firms in the Netherlands) from 2010 to the middle of 2017. Using the standard deviation of the firm value growth from 2010 to 2013 (For the standard deviation pre-voluntary period), 2013 to 2014 (For the standard deviation in the voluntary period) and 2014 to 2017 (For the standard deviation of the post voluntary period) from firms that voluntarily chose to use the “long form” audit report in the period of 2013 to 2014 and firms that chose not to. The standard deviation is then compared in multiple ways. The prior standard deviation is compared with the standard deviation after the voluntary phase for hypothesis 1. The standard deviation of the voluntary firms after the voluntary phase is compared with the standard deviation of the non-voluntary firms for hypothesis 2. The standard deviation analysis is also done per industry for hypothesis 3 and with a certain amount of materiality as dividing element for hypothesis 4. The results indicate that hypothesis 1 cannot be supported, that hypothesis 3 can be partially supported and that hypotheses 2 and 4 can be supported with statistical significance. The explanation of the unsupported hypothesis 1 can be due to the high level of legitimacy of the voluntary group. Five out of the six sectors that have been tested in hypothesis 3 show a difference in the standard deviation conforming the hypothesis. But due to the lack of quantity, the data is of insufficient significance which led to only the fact that hypothesis 3 can be confirmed for the consumer and service industry. Based on the results, I conclude that use of the “long form” audit report reduces the volatility of the firm value growth and it helps to decrease the expectation gap.

Keywords: firm value growth volatility, “long form” audit report, The

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1. Introduction

This chapter begins with an introduction to the recent changes in regulation, it explains the reasons for the revision and states what has changed in the audit report. The chapter continues with the contribution of this paper to the prior scientific research over the “long form” audit report, the volatility of firm value growth and the impact of voluntary disclosure. This chapter concludes with the scientific contribution for the agency theory and the expectation gap. Appendix 1 List of terminology is added to create more clarity in the used terminology for the reader of this thesis.

1.1 “long form” audit opinion

“The standard, one page, boilerplate audit report will be obsolete by the end of the decade.” This is a statement in the article by Bens et al (2017). The view that Mr. Bens has on the standard audit report is one that is supported by recent changes in legislation. Bens et al (2017)

stated that “The International Auditing and Assurance Standards Board (IAASB) requires that the new report to be used by global firms following IAASB standards beginning in 2016. In the US, the Public Company Accounting Standards Board (PCAOB) formally proposed the new approach first in 2013 and then issued a “re-proposal” in May 2016”. Another example of such changes is the revision by the FRC (Financial Reporting Council) on the ISA 700 standard in 2013, providing sharper standards and guidance on the form and content of the auditor’s report issued as a result of an audit performed by an independent auditor of financial statements

(Financial reporting council, 2013).

One of the reasons for the revision by the FRC (IFAC, 2015) is to restore the trust in auditors from the stakeholders, which was damaged by the economic crisis that started in 2008 and audit fraud cases such as the Enron scandal in the USA, the Parmalat scandal in Italy, the Imtech scandal in Germany and Poland, the Ahold scandal in the Netherlands and so on. However, the audit firm KPMG went further by field testing the innovative “long form” audit report with the companies Rolls Royce and New World Resources (Irvine, 2013).

Figure 1 is based on a report (NBA, 2015.) by the Koninklijke Nederlandse Beroepsorganisatie van Accountants (From here on mentioned as NBA) and shows the difference that the experimental “long form” audit report has compared with the traditional audit report that only contained the standard text and the audit opinion. It goes further than the new requirements in the ISA 700 by including;

- The continuity of the company,

- The materiality that the auditors have worked with, - The scope of the audit,

- “Key audit matters” (further mentioned as KAM), - What the auditors have found in these areas, - The responsibilities of the auditor in this audit.

Figure 1 Difference between the traditional and "long form " audit report. Adapted from NBA.nl, by NBA, 2015 retrieved from https://www.nba.nl/nieuws-en-agenda/nieuwsarchief/2015/september/nba-onderzoek-naar-uitgebreide-controleverklaring/

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4 This “long form” of audit report became mandatory for Dutch PIE category firms (Public Interest Entity), which is referred to as OOB category firms (Organisatie van Openbaar belang) in the Netherlands and will be used as such in the rest of this research, since 2014 and for all entities where the book year ends after 15th of December 2016 (NBA, 2017). De Bos and Strating (2014) indicated that OOB category firms could choose to voluntarily use the “long form” audit report in the period from January 1st_{2013 to December 31}st_{2013 (from here on}

mentioned as Voluntary period) and that roughly one third (24 out of 75) of the listed OOB category firms in the Netherlands did so. This research uses the impact of the legislative change to find out what the effects are on the volatility of the firm value growth.

1.2 Scientific contribution

This research on the “long form” audit report and its effects on the firm value growth

contributes to several theories and scientific literatures. The contribution has been grouped up in the following three sections; The “long form” audit report, Voluntary disclosure and volatility of firm value growth and the agency theory and expectation gap.

1.2.1 “long form” audit report

There is little research that has been published on the “long form” audit report in the Netherlands and its effects given the recent change in legislation in the Netherlands. However, there are several researchers that have researched the extended audit report prior to the passing of the legislative changes.

Gold et al. (2012), Coram et al. (2011), Chye Koh (1998) and Chong and Pflugrath (2008) all researched the effects of an expanded form of an audit report. While some researchers found evidence that financial statement users do not read an entire auditor’s report and found evidence that only the audit opinion was important, another group of researchers suggested the expanded audit report to minimize the expectation gap and other researchers provided evidence that a different audit report format did not reduce the expectation gap.

There are some researches that researches the effects of the “long form” audit report after the legislative change. However, these researches of Bens et al. (2017), Brasel et al. (2016), Reid et al. (2016) and Lennox et al. (2015) are still papers with work in progress and therefore have yet to be published at the time of writing this thesis. These researches researched the effects of the “long form” audit report with data from the UK and have led to different conclusions with one saying that the “long form” audit report does have a significant relation with lowering investor uncertainty while another says that it did not find any significant reactions to the disclosure corresponding to the ISA 700 and in the level of uncertainty. The theoretical framework chapter will go deeper into the details of these papers.

This shows that some researches provide evidence that the extended audit report does help make the expectation gap smaller and that an expanded audit report may go a long way, however not all researchers come to the same conclusion and thus do not provide one uniform conclusion as to why an expanded audit report such as the “long form” audit report would be beneficiary. The results of this research add to the literature surrounding the “long form” audit report as it will provide more evidence that the extended audit report does or does not prove to be beneficial for the firm in a more recent period. The results of this research also add to the scientific literature surrounding the “long form” audit report in the Netherlands as this research uses Dutch data to provide statistical evidence.

1.2.2 Voluntary disclosure and volatility of firm value

This research gives a view of how voluntary disclosure will affect the volatility of the firm value. This adds to the literature surrounding voluntary disclosure where Leuz and Verrecchia (2000) researched effects of German firms switching to a more disclosure rich environment on

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5 information asymmetry. Diamond and Verrecchia (1991) researched the effect that revealing private information has on a firm’s cost of capital because it minimizes the information asymmetry and therefore can attract an increased demand from large investors due to increased liquidity of its securities. Baiman and Verrecchia (1996) researched the effect of voluntary disclosure on the information asymmetry. Francis, Nanda and Olsson (2008) investigated the relations between voluntary disclosure, earnings quality and cost of capital finding results in an unconditional test that more voluntary disclosure is associated with a lower cost of capital and Lang and Lundholm (2000) examined corporate disclosure activity around seasoned equity offerings and its relationship to stock prices found evidence that firms that have “hyped” their stock have a negative return behavior in comparison to firms that maintain a consistent disclosure level. Bushee and Noe (2000) researched how disclosure practices effect the stock return volatility. This research adds to the literature as it takes a voluntary disclosure opportunity in the voluntary period and studies its effects in the following years on the volatility of the firm’s value in the Netherlands.

1.2.3 Agency theory and Expectation gap

The agency theory is described by multiple researchers in the past century such as Eisenhardt (1989) and Ross (1973) and has been revisited over the years by several researchers such as

Nyberg et al. (2010). This revisited research founds that the agency theory is still relevant in this day and age. This thesis will add to the literature surrounding the agency theory as it incorporates information from the period January 1st 2010 to September 31st 2017 after the recent changes in legislation in the Netherlands. There have been several changes in the past decade that could change the relevancy of the agency theory such as for example the

dependence on the audit report for public information has lessened as the accessibility to the internet has enabled firms to publish information more frequently.

The expectation gap has been researched by quite a few researchers. Research by

Chye Koh (1998) gave several possible ways to minimize the expectation gap and reviewed researches that tested these ways. However, these researches have been mostly based in the USA, UK and Australia. The research by Ruhnke and Schmidt (2014) studied the opinions surrounding the increase in information in the audit report, mandatory rotation and the ban on non-audit service and its perceived effects on the expectation gap. The recent legislative change in 2014 in the Netherlands has used one of these possible ways to minimize the expectation gap by expanding the audit report. This thesis will provide more information about the effects of the “long form” audit report on the expectation gap and adds to the literature surrounding the expectation gap as it uses a more recent set of data.

The rest of this research is organized as follows. Chapter 2 will provide the theoretical framework of this research and the hypotheses resulting from the theory. Chapter 3 sets up the analyses and datasets that are used to conduct the statistical tests in chapter 4. Chapter 5 concludes by using the statistical results to answer the hypotheses.

2. Background and Hypothesis development

This chapter provides an overview of prior scientific literature that this research will use. These prior literatures are used as building blocks to develop several hypotheses that this research tests.

2.1 Theoretical framework

“Financial statements are viewed as products of both markets and political processes and the interactions among individuals and groups in these processes.“ is a statement by Watts (1977) and Libby (1979) stated; “Financial statement information plays a major role in the credit evaluation phase of the commercial loan decision.” These statements show what the

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6 financial statement should and could do in an environment called an “Efficient capital

market” that is defined by Basu (1977) as the capital market where “security prices fully reflect available information in a rapid and unbiased fashion and thus provide unbiased estimates of the underlying values.” Roll (1984) provides evidence that markets are efficient because of the ability to incorporate and reflect new information rapidly. Research by

Kristoufek et al. (2013) on the efficient capital market has found evidence that the Dutch market ranks amongst the top 10 most efficient capital markets showing that the Dutch

market reflects a relatively unbiased estimate of the underlying values. These prior researches show that information is an important resource that shareholders use to rate firms and that the Dutch market data is usable for this research.

The research by Roll also mentions that there is still information in the company that is held by the agent (the management team) and not by the principle (the shareholders). This is the basis of the Agency Theory as described by Eisenhardt (1989) and Ross (1973). A research by Nyberg et al. (2010) revisited the agency theory and found significant evidence, that even though the Agency Theory is a theory formulized in the previous century, the Agency Theory is still relevant in these times. A barrier that comes forth out of the Agency theory is the fear that buyers have to trade goods as these goods could be a “lemon” (Akerlof, 1970). Akerlof contributes the fear to the uncertainty of uninformed buyers whether the quality of goods that they wish to purchase is the quality that they expect it is. This fear results in the change in firm value when the private information is revealed thanks to the efficient capital market incorporating information. The firm value growth should be

calculated by the percentage of difference in firm value over a period. The firm value can be calculated in multiple ways. Berger and Ofek (1995) for example used the Tobin’s Q-ratio to study the firm value. The Tobin’s Q-ratio is calculated as the market value of a company divided by the replacement value of the firm’s assets. However,Srinivasan and Hanssens (2009) calculated firm value as “the share price multiplied by the number of outstanding shares”. These papers show that Agency theory still is a valid theory which we need to take into consideration. The papers by Berger, Ofek, Srinivasan and Hanssens gives multiple ways to calculate the firm value.

The share prices fluctuate during the year due to several influences such as the Brexit, some legislative change etcetera. However, publication of internal information can also cause large changes in firm value strengthening the theory of the Agency theory. The sudden change in firm value after the information is published can also be attributed to the effects of the Expectation gap. This is defined by Liggio (1974) as “the difference between the levels of expected performance as envisioned by the independent accountant and by the user of financial statements.” Research by Chye Koh (1998) gave several possible ways to minimize the expectation gap. Such as educating the users, expanding the auditors’ responsibilities and expanding the audit report. The last mentioned that the possibility to minimize the expectation gap is researched by Nair and Rittenberg (1987), Kelly and Mohrwels (1989), Miller et al. (1990), Holt and Moizer (1990), Hartherly et al’s (1991, 1992) Hanks (1992), Gay and schelluch (1993) and Monroe and Woodliff (1994). These researches have been based mostly in the USA, UK and Australia. These researches have shown mostly positive results regarding the effects that an expanded audit report has on minimizing the expectation gap. These effects are due to changing the perceptions on management’s and auditors’ responsibilities and modifying the wording of the audit report. However, Hartherly et al’s (1991, 1992) researches show that the perceptions of management’s and auditors’ responsibilities were not significantly influenced by modified wording. A more recent research by Ruhnke and Schmidt (2014) found that the increase of information in the audit opinion, mandatory rotation and a ban on non-audit services may reduce the expectation gap. This means that the researches surrounding the effects

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7 of expanding the audit report, while being mostly positive, does not have one uniform conclusion. These researches also indicate that even in these digital times where information is published daily, the expectation gap still exists and should be researched further.

Prior studies also did not find a uniform conclusion as to why firms chose to commit to an increase of voluntary disclosure. Study by Leuz and Verrecchia (2000), Diamond and Verrecchia (1991) and Baiman and Verrecchia (1996) found significant evidence that “a commitment to an increased level of quantitative or qualitative disclosure reduces the possibility of information asymmetries between the firm and its shareholders or amongst potential buyers and sellers of the firm shares.” The disclosure could be mandatory as legislation does have its say, but firms may also choose to give out disclosure voluntarily.

Francis, Nanda and Olsson (2008) found evidence that voluntary disclosure is associated with a lower cost of capital. In the meanwhile, Lang and Lundholm (2000) found evidence that when “firms dramatically increase their disclosure activity prior to an offering of stock. This disclosure experience stock price increases prior to the offering but also suffer much larger price declines at the announcement of their intent to issue equity, suggesting that the disclosure increase may have been used to “Hype the stock” and the market may have partially corrected for the earlier price increase.” Ball et al. (2012) found that the increase of voluntary disclosure combined with the audited financial reporting ”is associated with management forecasts that are more frequent, specific, timely, accurate and informative to investors.” These researches show that there are multiple sides to voluntary disclosure. One is to reduce the information asymmetry while the other can be to increase the stock price prior to the offering of stock.

The reason why voluntary disclosure could aid companies could be explained with the Legitimacy Theory. The legitimacy of a firm is described as follows by (Suchman, 1995); “Legitimacy is a generalized perception or assumption that the actions of an entity are desirable, proper, or appropriate within some socially constructed system of norms, values, beliefs, and definitions” Panwar et al. (2014) found that “Legitimacy is in the eye of the beholder” meaning that “legitimacy is in part a matter of evaluators’ decision heuristics and cultural values, and are not necessarily dependent on actual knowledge or objective assessment of companies’ actions.” Leuz and Verrecchia, (2000) found significant evidence that firms that have committed to an “increased level of disclosure garner economically and statistically significant benefits”. These benefits are found in lower bid-ask spreads and higher share turnover. The strategy of voluntary disclosure is one of the legitimation strategies that have been researched by Suchman (1995) and is categorized under “Communicate honestly” and “Stockpile trust”. The increase of said legitimacy indicates to investors that the chance of loss is lower. Rabin (2000) mentioned that “People are significantly more averse to losses relative to the status quo than they are attracted by gains, and more generally that people’s utilities are determined by changes in wealth rather than absolute levels”. This loss aversion was introduced by Kahneman and Tversky (1979) and has been reviewed multiple times since it has been published, providing significant evidence that people and investors have a loss averse mentality. The combination of the higher legitimacy and the loss averse mentality of investors could be an explanation of a less volatile firm value.

Davidson and Worrel (1990) found that “Accounting measures of financial performance are inadequate for researchers making large cross sectional comparisons across industries”. This statement shows that cross sectional comparisons, while interesting to compare, may mask individual differences as industries all have unique challenges in competition, legislation and so forth and therefore create their own “specialization” of corporate social interests (Holmes, 1977). This statement is also addressed by Carrol (1979) as he states that “the issues change and they differ for different industries”. This leads to an

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8 expectation that there will be differences in the “Lemon Problems”, Expectation gap and effects on volatility for different industries.

Because the legislative change has only recently passed, there has not been enough time for researchers to research the effects of the “long form” audit report in the Netherlands and publish their findings. There are several recent papers that have yet to be published, provided by professor V. Porumb, that have researched the “long form” audit report after the passing of the legislative change. However, these researches use the data from the UK. The geographical aspect adds to the relevancy of this research as the UK and the Netherlands have different cultural aspects and will most likely react differently to this legislative change (Hofstede, 1984). Bens et al. (2017) researched the association between the Expanded Audit Report and Investor uncertainty and concluded that the investor uncertainty was lower due to the new regulation and the effect was greater by firms with lower materiality levels and more revealed Key Audit Matters (KAM). Brasel et al. (2016) found evidence that the revealed KAM’s (herein mentioned as CAM) that these “disclosures, under certain conditions, reduce auditor liability judgements as jurors perceive that undetected fraudulent misstatements were more foreseeable to the plaintiff (i.e., the financial statement user suing the auditor.)”. Reid et al. (2016) found that the audit fees marginally increased but there is no significant relationship between the “long form” audit report and the higher audit fees. While in the meantime Lennox et al. (2015) did not find any significant reactions to the disclosure corresponding to the ISA 700 in the level of investor uncertainty. These researches find some significant relations with the “long form” audit report as the subject, but the researches are so few that most of the effects of the “long form” audit report are still unknown and not researched.

These prior researches help by providing insight in the handling of theories and the thought behind the set up itself. These theories are the building blocks on which this thesis is based. The financial statements are the periodic information that the public stakeholders use to evaluate a firm and then invest in firms. The agency theory however shows that there is a difference in knowledge and available information between the agent (management) and the principal (Stakeholders). This difference results in an expectation gap for the investor as he can only base his expectation on his knowledge and the public information while the management has private information. To narrow down the expectation gap, firms have resorted to increasing their disclosures to include non-mandatory information dubbed as voluntary disclosure. The Dutch government tries to decrease the expectation gap by implementing new legislation such as mandatory auditor rotations and the new “long form” audit report containing several items such as the materiality and the Key audit matters.

2.2 Hypotheses

The introduction and the theoretical framework paragraphs set up the current situation in the Netherlands and what is known in the scientific literature. There has been a voluntary period from January 1st 2013 to December 31st 2013. In this period firms could choose to implement the “long form” audit report. The theoretical framework paragraph indicates that researchers still do not have one uniform answer as to why 24 out of the 75 OOB category firms in the Netherlands would choose for a more expensive, extensive and voluntary audit report. Is it to reduce the problems of the agency theory by showing what the “lemon” is? Does it reduce the expectation gap by changing the perceptions of the management’s and auditors’ responsibilities? Does it appeal to the loss aversive mentality of the stakeholders or is it merely used to “Hype the stock”?

Several questions arise that is based on the current situation in the Netherlands and all the theory that is written over the years. Will the voluntary aspect of the “long form” audit report generate such legitimacy and will it reduce the expectation gap that it will stabilize the

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9 firm’s value trajectory over the years? What effect does the voluntary disclosure of the “long form” audit report by OOB category firms in the Netherlands in the voluntary period has on the volatility of the firm value growth in the period after the “long form” audit report became mandatory? What is the effect that it has on the volatility within the voluntary group itself and what effects does it have compared to the group that did not voluntarily use the “long form” audit report? These questions results in the following hypotheses;

Hypothesis 1:

The voluntary disclosure of the “long form” audit report by OOB category firms in the Netherlands in the voluntary period causes the future firm value growth to be less volatile in comparison with the past.

Hypothesis 2:

The voluntary disclosure of the “long form” audit report by OOB category firms in the Netherlands in the voluntary period causes the future firm value growth to be less volatile in comparison with the OOB category firms that did not chose to voluntarily use the “long form” audit report in the voluntary period.

Of course, these questions generate more questions such as; What are the effects of the “long form” audit report have on different industries where the companies are present in such as the financial industry, the Industrial industry, the service industry et cetera as these industries have different “specialization” of corporate social interests? Another factor that can have its impact on the volatility of the firm value growth is level of the materiality (the threshold that an auditor uses to deem a mistake a serious mistake that can have impact on how stakeholders perceive the performance of the firm) that the auditor uses to audit the firm as the materiality can vary from as low as several thousand Euros up to as high as nine hundred million Euros. Several researchers such as Messier et al. (2005) have found enough evidence to conclude that materiality depends on several factors like for example the size of the entity, how risky the auditor deems the firm, rules and regulation surrounding the level of materiality and so on. The big four audit firms base their materiality on three categories; the earnings-based, activity-based and Capital-activity-based categories. These questions form the basis of the next hypotheses; Hypothesis 3:

The voluntary disclosure of the “long form” audit report by OOB category firms in the Netherlands in the voluntary period by one industry causes the future firm value growth to have different volatility levels in comparison with the OOB category firms in other industries that have voluntarily used the “long form” audit report in the voluntary period.

Hypothesis 4:

A lower percentage materiality reported in the “long form” audit report in the voluntary period by OOB category firms in the Netherlands per category causes future firm value growth to be more volatile than prior years.

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3. Empirical Analyses

This chapter provides more information surrounding the sample and the research design. The research design is done by describing the different research methods that the four hypotheses need in order to provide sufficient significant evidence to answer the hypotheses.

3.1 Research design

3.1.1. Dependent Variable – Volatility of firm value growth

Prior research surrounding the volatility of firm value growth used various methods to measure the volatility of firm value. Lindenberg and Ross (1981) defined Tobin’s Q as “the ratio of the firm’s market value to the replacement cost of its assets”. However, some researchers such as Villalonga and Amit (2006) used a market-to-book value as a proxy for Tobin’s Q, and used the market value of common equity plus book value of preferred stock and debt as a proxy for the firm’s market value and the market value of common equity is the number of common shares outstanding times the share price at fiscal yearend. Villalonga and Amit (2006) stated that “this measure is being increasingly used to avoid the arbitrary assumptions about depreciation and inflation rates that more sophisticated measures of Q require, also in light of the high correlation between adjusted and unadjusted measures”

This view is also shared by Srinivasan and Hanssens (2008) as they said that firm value is the ultimate metric of shareholder value as this is the value that the shareholders can get for the firm. The research by Srinivasan and Hanssens (2008) used this value to show the effects of the “long form” audit report on the firm itself. The advantage that firm value has on share prices is that the share prices could be less relevant due to an issuance or buy-backs of shares. However firm value growth is not only defined by the “long form” audit report but also the performance of the firm itself due to marketing, efficiency or technological breakthroughs and external events such as conjuncture, presidential elections, Brexit, scandals and such. This research uses the same proxy as Villalonga and Amit (2006) have used in their research for defining the firm value to avoid the needed assumptions about depreciation and inflation rates that the Tobin’s Q requires.

To find the volatility of the firm’s value growth Shiller (1980) used the Simple Efficient Markets Model that calculates the real price of a share at the hand of the dividend that it pays, discounted with the constant real discount factor. However, research by Shiller (1980), Schwert (1989) and Nazir et al. (2010) use a simpler measure of volatility: the standard deviation of P. (Growth rate of firm’s value in this research) I will use this method to measure the volatility of the firm value growth because of its simplicity and the historic characteristics of the data. This measurement will also negate the cyclical fluctuations of the conjuncture as the standard deviation takes the difference between the firm specific P and the average P. The conjecture and the average P follow the same cycle and the standard deviation will negate the effects of the conjecture. However, companies that declare bankruptcy will create a standard deviation of 100%. These companies will therefore be excluded from the sample.

3.1.2. Dividing factors

The data collected will be further analyzed. This population is then divided into two groups: the voluntary group and the non-voluntary group. The voluntary group consists of OOB category Dutch firms that voluntarily disclosed the “long form” audit report in the voluntary period when this was allowed and not mandatory. The non-voluntary group consists of OOB category Dutch firms that chose not to disclose the “long form” audit report in voluntary period that this was allowed and not mandatory.

The standard deviation of the share price from the years 2010 to the middle of 2017 will be collected and further divided into three groups; the period prior to the “long form” audit

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11 report (January 1st 2010 to December 31st 2012 which will be mentioned as the pre-voluntary period), the voluntary period itself (January 1st 2013 to December 31st 2013) and the period where disclosure of the “long form” audit report (January 1st 2014 to September 31st 2017 which will be mentioned as the post voluntary period) is mandatory.

The dividing factors that will be used are the three periods mentioned above, whether the organization has voluntary disclosed or not, the industry where the organization is active and whether the used materiality is high or low. Paragraph 3.3 will go into further detail on how these dividing factors will be used to test the hypotheses.

3.2. Sample

The Dutch listed OOB category firms form the population. The group will be divided as stated above into the voluntary group and the non-voluntary group. Whether a company discloses its risks in form of Key Audit Matters in the voluntary period or not, is used as a proxy for the division between the voluntary group and the non-voluntary group. The information will be gathered from a database provided by Professor doctor D. A. de Waard about 75 Dutch OOB category firms that have been listed on the AEx, AMx and the ASCx over the period from January 1st of 2013 towards December 31st of

2015. The firm value over the period January 1st

2010 to the September 31st 2017 will be collected from DATASTEAM.

The initial sample consists of 76 Dutch listed OOB category companies from the AEx, AMx and the ASCx stock markets as Philips has split up into Philips Lightning and Koninklijke Philips Electronics N.V. The companies that have filed for bankruptcy or that have been

removed from the stock markets are excluded from this sample as their information will create a single standard deviation of 100% and thus will interfere with the results. These companies are Docdata, Macintosh and TNT Express. OOB’s such as Arseus and Refresco Gerber are excluded because the information surrounding their firm value was unavailable in DATASTREAM. This results in the sample of 71 organizations of which the information can be found in the DATASTREAM and will be used in this thesis. Figure 2 shows us that there are 21 companies that voluntarily disclose the “long form” audit report in 2013 to 2014 (group 1) and 50 companies that chose not to disclose the “long form” audit report in 2013 to 2014 (group 2). Figure 2 shows the division between the voluntary group and non-voluntary group in the different sectors where the firms are active.

3.3. Hypotheses 3.3.1. Hypothesis 1

The first hypothesis is analyzed by the Time series analysis. This model tests the differences between two periods for the same selection. In the case of the first hypothesis the volatility of the firm value growth in the pre-voluntary period will be compared to the volatility of the firm value growth in the post voluntary period for the voluntary group. This will generate the evidence needed to answer hypothesis 1 and indicate if there is a significant difference between the period before and after the use of the “long form” audit report. This will be done by using the statistic program SPSS and the one-way ANOVA with the percentage of growth in the dependent list and the periods as a factor.

Figure 2 Division voluntary and mandatory group

Sector Group 1 Group 2 Total

Industrial 5 23 28 Financial 1 7 8 Service 7 11 18 Consumer 3 3 6 Investment 3 3 6 Technology 2 3 5 Total 21 50 71

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3.3.2. Hypothesis 2

The second hypothesis is analyzed with the Differences-in-differences (DID) model. This test will be done to compare and analyze the differences between the voluntary group and the non-voluntary group in the post voluntary period. This will be done by selecting both the voluntary- and non-voluntary group in the post voluntary period, using the One-Way ANOVA in the statistical program SPSS with the percentage of growth in the dependent list and the division in voluntary group as a factor. The DID is hereby effectively attempting to “mimic an experimental research design using observational data, by studying the effect of a treatment on a “treatment group” versus a “control group” in a natural experiment” Angrist and Pischke (2008). The comparison between the voluntary group and the non-voluntary group will answer hypothesis 2 and show whether there is a difference between the two groups.

3.2.3 Hypothesis 3

The next analysis is the Cross-sectional analysis. This analysis provides a cross-section in all the industries that the selection is active in. The data that is used will be processed the same way as with the DID model as it also uses data that compares the voluntary group with the non-voluntary group. However, the difference is that this analysis will create an overview with the results over all industries (Industrial, Financial, Service, Consumer, Investment and Technology). This analysis will analyze the information generated per industry and the answer on hypothesis 3 will be based on the evidence that this analysis produces.

The last hypothesis is analyzed with the Time series analysis. The dividing factor is the level of materiality in the “long form” audit report in 2013 to 2014 to generate

information for hypothesis 4. Due to the relative low amount of organizations reporting their level of materiality in the voluntary period, the levels of materiality in the period 2014-2015 have been used as the base. First these companies will be divided into three categories (Earnings-based, Activity-based and Capital-based) the average percentage level of

materiality will be calculated in the voluntary group, the firms in the voluntary group below that level is group 1 and the firms in the voluntary group that use a materiality level above that level is group 2. This will be done with the One-Way ANOVA with the percentage of growth in the dependent list and the division between high and low materiality as a factor. This analysis will test whether there is a difference in future firm value growth volatility between these two groups.

3.2.5. Auditors analysis

The nature of the quantitative research design and the lack of literature on the effects of the “long form” audit report causes the research to rely on theory. Interviews with auditors from varying levels (starter level, senior level, management level and senior management level) are taken in order to add practical knowledge to this thesis.

These interviews start with the four hypotheses and the auditors will be asked what kind of results the differing hypotheses will reveal. The base of the expectations will be recorded. Afterwards the statistical results of the hypotheses will be shown and they will be discussed with the auditors. These insights will be incorporated in chapters four and five.

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4. Research results

This chapter contains the results from the statistical analyses, as described in the research design in chapter 3. The empirical results are analyzed and the significance level is tested with the significance threshold of 0,05 percent to determine whether there is enough statistical evidence to state that the hypotheses in chapter 2 can be confirmed or not. The tables that SPSS has generated have been added in Appendix 2 Tables.

4.1 Empirical Results 4.1.1. Hypothesis 1

Table 1 shows the descriptives for the time series analysis for hypothesis 1. In this analysis the volatility of the firm value growth for the voluntary group in the pre-voluntary period (identified as group 1 in the table) is compared with the volatility of the firm value growth for the voluntary group in the post voluntary period (identified as group 3 in the table). This is done to generate evidence to test the hypothesis that the volatility of the firm value growth for the voluntary group in the post voluntary period is lower than the volatility of the firm value growth for the voluntary group in the pre-voluntary period.

The descriptives indicate that the average firm value growth in the pre-voluntary period (,00165) is lower than the average firm value growth in the post voluntary period (,00657). There is also a different standard deviation as the standard deviation of the average firm value growth in the pre-voluntary period (,085955) is higher than the standard deviation of the average firm value growth in the post voluntary period (,074034).

The group 2 describes the information of the voluntary period which is the only year that organizations could voluntarily choose to report conform the “long form” audit report. This information could be disruptive as the average firm value growth (,03138) and the standard deviation (,113055) is very high, therefore the voluntary period has been excluded from the period before and the period afterwards.

Table 2 shows the results of the One-Way ANOVA analysis. This analysis shows a statistical significance of ,000 which is lower than the significance threshold of ,05 resulting in the conclusion that there is a difference between the standard deviation and thus the volatility of the firm value growth of the three different periods (pre-voluntary period, voluntary period and post voluntary period). However, the hypothesis asks for a more

detailed result to provide evidence that there is a difference between the pre-voluntary period and the post voluntary period and it also requires a direction to conform or discard the

hypothesis. This is the reason why the One-Way ANOVA also allows for a multiple comparisons analysis that shows the significance between the different periods. Table 3 indicates that there is a significance of ,143 between pre-voluntary period and post voluntary period. This significance is above the threshold of ,05 and therefore we have not enough statistical evidence to conform hypothesis 1.

The DID analysis tests for a significant difference in the volatility of the firm value growth between the voluntary group and the non-voluntary group in the post voluntary period. This analysis generates the statistics in table 4. These descriptives indicate that on average the firm value growth of the voluntary group (,00618) does not grow as fast as the firm value of the non-voluntary group (,013106). The standard deviation of the voluntary group (,073093) however, is lower than the standard deviation of the non-voluntary group (,103106).

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14 Table 5 shows the ANOVA analysis that indicates that there is a significant difference between the volatility of the firm value growth between the voluntary group and the non-voluntary group in the post non-voluntary period. The significance of the test is 0,047 which is under the threshold of 0,05. Therefore, we can conclude that there is a significant difference, as there is enough statistical evidence. This combined with the information in the descriptives that indicate that the volatility of the voluntary group is lower than the volatility of the non-voluntary group is enough to provide direction to the One-Way ANOVA to confirm hypothesis 2.

The cross-sectional analysis searches for a significant difference in volatility between the voluntary group and the non-voluntary group in the post voluntary period for the different industries. This cross-sectional analysis allows for a more detailed look in the differences per industry.

Table 18 shows the results for all the six industries. The first three rows of the cross-section show the means of the firm value growth and their comparison. The results show differing results. The mean of the firm value growth of the voluntary group is lower than the mean of the non-voluntary group in the industrial, consumer and investment sectors but higher for the other three sectors. The three rows thereafter show the standard deviation of the firm value growth of the organizations and whether this standard deviation of the voluntary group is higher than the standard deviation of the non-voluntary group or not. The last three rows indicate whether hypothesis 3 can be confirmed for the specific industry. This depends on the presence of significant difference in row seven and whether the volatility of the firm value growth of the voluntary group is lower than the volatility of the firm value growth of the non-voluntary group.

The table shows that five of the six industries show a standard deviation confirming the hypothesis. The reason that only two of the five industries show a significant difference conform the hypothesis can be because of the lacking amount of data. The financial industry

Industrial Financial Service Consumer Investment Technology

Mean voluntary group ,00864 ,01110 ,00302 ,00378 ,00471 ,01328 Mean non-voluntary group ,01435 ,00050 ,02319 ,02178 ,01141 ,00728 Comparison Means 1<2 1>2 1>2 1<2 1<2 1>2 Standard deviation voluntary group ,07578 ,07143 ,077759 ,076142 ,070906 ,056129 Standard deviation non-voluntary group ,10065 ,08568 ,143256 ,135211 ,061942 ,093152 Comparison Standard deviation 1<2 1<2 1<2 1<2 1>2 1<2 Significance ,423 ,582 ,023 ,027 ,409 ,584 Threshold ,05 ,05 ,05 ,05 ,05 ,05 Conform Hypothesis 3 X X V V X X Table 18

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15 only has one organization and the technological industry has two organizations that

voluntarily disclosed the “long form” audit report. Therefore, hypothesis 3 is confirmed for the service and consumer industries and not for the other industries.

The following analysis tests whether the volatility of the firm value growth of the organizations that are audited with a lower percentage materiality (mentioned as group 2) is higher than the organizations that are audited with a higher percentage materiality (mentioned as group 1). This is divided into three categories; the earnings-based, capital-based and

activity-based categories. And the three categories have been combined to get a general answer.

Table 28 shows the results for all categories. The first three rows of the cross-section show the means of the firm value growth and their comparison. The results show differing results. The mean of the firm value growth of the group 1 is lower than the mean of the group 2 in the

earnings, activity and total category but is higher for the capital-based category. The three rows thereafter show the standard deviation of the firm value growth of the organizations and whether this standard deviation of group 2 is higher than the standard deviation of group 1 or not. The last three rows indicate whether hypothesis 4 can be confirmed for the specific industry. This depends on the presence of significant difference in row seven and whether the volatility of the firm value growth of group 1 is lower than the volatility of the firm value growth of the group 2

The table shows that the standard deviation of group 1 is lower than that of group 2 indicating that the direction of hypothesis 4 is correct. However, we can see that the statistical significance of the capital-based and activity-based cannot be established. This is due to the comparatively small sample that this thesis uses as there is only six organizations in the capital-based category and only eight in the activity-based category. But when all the information is compiled in the total column, we van conclude that the standard deviation of the firm value growth of the group 1 is lower than group 2 and that there is a significant statistical difference between group 1 and group 2. This allows the conclusion that there is sufficient statistical evidence to conclude that the volatility of the firm value growth of the group with a higher percentage of materiality is lower than the volatility of the firm value growth of the group with a lower percentage of materiality. Thus, we can accept hypothesis 4.

Earnings Capital Activity Total

Mean group 1 ,01668 ,00202 ,00047 ,00504 Mean group 2 ,30081 ,00169 ,00586 ,20944 Comparison Means 1<2 1>2 1<2 1<2 Standard deviation group 1 ,134021 ,067457 ,062470 ,082788 Standard deviation group 2 ,755081 ,120603 ,112828 ,690516 Comparison Standard deviation 1<2 1<2 1<2 1<2 Significance ,000 ,981 ,689 ,000 Threshold ,05 ,05 ,05 ,05 Conform Hypothesis 4 V X X V Table 28

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5. Conclusion and discussion

This thesis investigates whether the voluntary disclosure of the “long form” audit report in the Netherlands has decreased the volatility of the firm value growth. It specifically tested the following hypotheses

Hypothesis 1:

The voluntary disclosure of the “long form” audit report by OOB category firms in the Netherlands in the voluntary period causes the future firm value growth to be less volatile in comparison with the past.

Hypothesis 2:

The voluntary disclosure of the “long form” audit report by OOB category firms in the Netherlands in the voluntary period causes the future firm value growth to be less volatile in comparison with the OOB category firms that did not chose to voluntarily use the “long form” audit report in the voluntary period.

Hypothesis 3:

The voluntary disclosure of the “long form” audit report by OOB category firms in the Netherlands in the voluntary period by one industry causes the future firm value growth to have different volatility levels in comparison with the OOB category firms in other industries that have voluntarily used the “long form” audit report in the voluntary period.

Hypothesis 4:

A lower percentage materiality reported in the “long form” audit report in the voluntary period by OOB category firms in the Netherlands per category causes future firm value growth to be more volatile than prior years.

These hypotheses have been statistically tested and analyzed with the help of prior literature. However, due to the recent nature of the “long form” audit report and the lack of new literature on the effects of the “long form” audit report, eight auditors from several levels (starter level, senior level, management level and senior management level) have helped by stating their expectations that has been developed in their career as auditor. The results have also been discussed with these auditors and they have given their thoughts about this thesis. They have shown that the reality is more nuanced than the hypotheses that come forth out of the literature. These expectations and discussions have been incorporated in this chapter to add practical knowledge to this theoretical thesis.

5.1 Hypotheses

No significant difference between the volatility of the firm value growth of the voluntary group in the pre-voluntary period and the post voluntary period have been found with a significance level of 0,05 in contrary to the formed hypothesis and the underlying literature. This result has been discussed with several auditors and they expected this result. The reason of their expectation was due to the striving behavior of the voluntary group. The voluntary disclosure of the “long form” audit report did lower the expectation gap and lower the information asymmetry as Leuz and Verrecchia (2000) found, however the effect of the added form of voluntary disclosure could be minimized due to the striving behavior of the organizations and the similar voluntary disclosure strategy in other years. Another possible explanation is that the legitimacy of the organizations as described by Panwar et al. (2014)

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17 “long form” audit report did not significantly change the legitimacy of the organization. We have found insufficient statistical evidence to accept hypothesis 1.

We have found that there is enough significant evidence to conclude that the volatility of the firm value growth of the voluntary group in the post voluntary period is lower than of the control group in the same period. This is conform the researches of Ruhnke and Schmidt (2014),Francis, Nanda and Olsson (2008) and other researchers mentioned in this thesis. This result is conform the expectations of the questioned auditors. These auditors expected the difference in volatility between the two groups to be at its peak in the initial year and slowly decline in the years thereafter as the organizations and its stakeholders slowly get used to the new format. Based on the information that the statistics and literature provide, we can accept hypothesis 2.

We have found that there is enough significant evidence to conclude that the volatility of the firm value growth of the voluntary group in the post voluntary period is lower than the volatility of the firm value growth of the non-voluntary group in the post voluntary period for the service industry and the consumer industry. The research by Davidson and Worrel (1990)

indicated that the measures of financial performance is inadequate to make large cross sectional comparisons across industries. This is shown in the results as there is not enough evidence to conclude the same for the industrial industry, financial industry, investment industry and the technology industry even when the standard deviation differed quite much. An explanation for this could be that the amount of data was insufficient to get a significant statistical answer. These results have also been discussed with several auditors and they expected mixed results as the largest factor would be what kind of organizations are in what kind of sectors. They expected the mix between the voluntary and non-voluntary

organizations to influence the results. The statistical results show that five of the six industries showed the expected direction and two of these results were statistically significant. Therefore, we can only accept and hypothesis 3 for the consumer and service industry.

We have found sufficient evidence to conclude that the group with a high materiality in the earnings-based category has a lower volatility of firm value growth in comparison to the group with a low materiality. However, the same could not be said for the groups in the capital-based category and the activity-based category. While the groups with a high

materiality in these categories do have a lower standard deviation of the firm value growth in comparison to the groups with a low materiality, there is insufficient evidence to conclude that the group with a high materiality in the capital-based category and the activity-based category have a lower volatility of firm value growth. A possible reason for this is that there is an insufficient amount of data as the capital-based category has six organizations divided into two groups and the activity-based category has eleven organizations divided into two groups. To accept or discard hypothesis 4, additional analysis had been done that has gathered all information and analyzed it via the One-Way ANOVA analysis. There is sufficient statistical evidence to conclude that the volatility of the firm value growth of the group with a higher percentage of materiality is lower than the volatility of the firm value growth of the group with a lower percentage of materiality. This is conform the research of

Messier et al. (2005) and the expectations of the questioned auditors as they expected that the reason for a high materiality is linked with a lower perceived risk by the external auditor. This lower perceived risk is likely to resound with the stakeholders resulting into the lower volatility. Thus, we can accept hypothesis 4.

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18 Overall, these results indicate that the voluntary usage of the “long form” audit report has caused a lower volatility for the organizations that chose to in comparison to the

organizations that chose not to use the “long form” audit report. The results also indicate that the reporting of the usage of a higher materiality by the auditor helps in stabilizing the volatility of the firm value growth of the organizations.

5.2 Contribution to the literature

These results contribute to the growing literature on the “long form” audit report in the Netherlands and the effects of this due to the recent change in the legislation in the

Netherlands. My results provide an updated view over the effects of the “long form” audit opinion with the data running from January 2013 to September 2017. These results also provide evidence that the voluntary usage of the extended audit report does help decrease the volatility of the firm value growth when compared to organizations that used the extended audit report due to legislative change. The results indicated that it has decreased the expectation gap. This thesis therefore has contributed to the literature surrounding the expectation gap as well as the literature surrounding the volatility of the firm value growth and the voluntary disclosure.

5.3 Limitations

This thesis is still subject to several limitations. Firstly, I acknowledge that there are multiple factors playing into the firm value growth. Even though this thesis has taken multiple factors that define firm value into consideration, there are still several external factors such as the presidential elections in America in 2016, the Brexit and political unrest in several nations worldwide, just to name a few. These incidental and unique factors were not taken into consideration for this thesis because their effects would be too big of a challenge to quantify per company. A research on these effects would be so detailed that it would surpass the allowed timetable for this master’s thesis.

Secondly, if I could redo this thesis I would have used more independent variables to measure the effect of the “long form” audit report. The sample size could be expanded by for example adding the US, UK and even more years. There have been several examples of questions that have popped up during the thesis that could be interesting. Like how the “Long form” audit report could influence the legitimacy and the factors of legitimacy, whether there would be significant differences between the audit firms that made the “Long form” audit report and such. These questions form a solid recommendation for the future researches.

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