Master’s Thesis Accountancy & Controlling
Voluntary audit reviews of quarterly financial statements and firm’s credit ratings
MSc A&C Accountancy
University of Groningen, Faculty of Economics and Business January 21, 2018 T.F. (Tobias) de Pagter Student number: 1873318 Aalsmeerweg 98 1059 AP Amsterdam +316 130 72 586
E-mail: t.f.de.pagter@student.rug.nl / tobiasdepagter@live.com
Supervisor University of Groningen
V.A. Porumb
Co-assessor University of Groningen
prof. dr. D.A. de Waard
Abstract
This thesis focuses on the relationship between the voluntary purchase of audit reviews of quarterly financial statements (reviews) and firms’ credit ratings. I draw on a sample consisting of 1,849 firm-year observations, during the period 2005-2014, for Canadian non-financial listed firms. I find that a firm which voluntary purchases a review gets a higher credit rating. Supporting this conclusion, positive switchers, firms that switch from not purchasing a review to purchasing a review, receive higher credit ratings and negative switchers, firms that switch from purchasing a review to not purchasing a review, receive lower credit ratings. Taken together, these results are consistent with credit rating agencies valuing the external assurance brought by the voluntary purchase of the audit review.
Keywords: credit rating, credit rating agencies, ISRE 2400, ISR 2410, quarterly
financial statements, voluntary audit reviews
Table of contents
Abstract
2
Table of contents
3
1.
Introduction
4
2.
Institutional and Theoretical Background
8
Reviews on quarterly financial statements 8
Regulation on (reviews on) quarterly financial statements 9
Costs and benefits of reviews on quarterly financial statements 10
Credit ratings agencies and credit ratings 12
Asymmetric information 13
3.
Hypothesis development
15
4.
Research Design
17
Data collection 17 Data analysis 185.
Results
22
Descriptive statistics 22 Correlation results 22 Regression results 236.
Conclusion and discussion
25
References
27
TABLE 1: Voluntary reviews of quarterly financial statements in Canada 30
TABLE 2 – Variable Definitions 31
TABLE 3 – Descriptive Statistics 32
TABLE 4 – Correlation Matrix 33
TABLE 5 – Regression Results (hypothesis 1) 34
1. Introduction
Firms issue annual financial statements to provide information to their stakeholders on the firm’s financial performance.1 A fundamental role of the annual financial statements is the usefulness of the information for decision makers (Meigs & Meigs, 1993). To add credibility to its financial reporting, firms can hire an independent party, i.e. external auditors, to provide an external verification of the quality of financial statements (Minnis, 2011). In an auditor’s report, independent auditors give an opinion on whether the information presented in the annual financial statements of a firm is in line with generally accepted accounting standards and is free of misstatements. The auditor’s report is therefore important for firms and it can be used as a monitoring tool by stakeholders, who are able to better assess potential issues in the firms. In addition to annual financial statements, firms can also provide quarterly financial statements, which are interim financial statements of each quarter of a year. Additionally to the audit of annual financial statements, firms can choose to purchase an audit review of the quarterly financial statements (review), following the standards set by the International Federation of Accountants (IFAC) in The International Standard on Review Engagements (ISRE) 2400 and ISR 24102. In this study I assess the relationship between the voluntary purchase of reviews and firms’ credit ratings.
For the United States (US), since 2000, listed firms are required by the United States Securities and Exchange Commission (SEC) to have their quarterly financial statements reviewed by an auditor on a timely basis. In the European Union (EU), there is a directive on the harmonization of transparency requirements, 2004/109/EC3, which reformed the requirements for European interim reporting, but there is no obligation for firms to have their
1 Financial statements are compiled into a comprehensive report on the firm’s activities throughout the
preceding year.
2 ISR 2410, issued by the IFAC, is specific for reviews of interim financial statements and is effective for
quarterly financial statements reviewed (Kajüter et al., 2016). In Canada, regulation regarding a review is set by the Canadian Securities Administrators (CSA): Canadian firms are not
mandated to purchase a quarterly review by an external auditor. This means public firms in
Canada can choose whether to have their quarterly financial statements reviewed by an external auditor. The CSA mandates a disclosure when a Canadian firms chooses to have their quarterly financial statements not reviewed by an external auditor. This mandatory disclosure by non-review makes Canada an ideal country to draw a sample from because I can observe the impact of the voluntary purchase of financial statements.
When firms can voluntary choose to get their interim financial statements reviewed, they can signal the reliability of these interim financial statements (Bandyopadhyay et al., 2007). Kajüter et al., 2016 conclude that this signalling mechanism, even if the quality of the earnings is not affected, may cause investors to perceive quarterly report information to be more reliable and thus rely on it for investment decision making. If reviews are mandated, firms cannot use the signalling mechanism by voluntary purchasing an audit review of the interim financial statements. According to Bédard & Courteau (2015), the costs to review are approximately 18 percent higher for firms that choose to get a review, but they do not see an improvement in the quality of financial statements compared to firms who do not have the review costs. This contrasts the conclusion of Bandyopadhyay et al. (2007), Kajüter et al. (2016) and Manry et al. (2003), as they find that reviewed earnings show a significantly higher earnings quality than earnings that are not reviewed.4,5,6 This thesis continues on the signalling
4 Manry et al. (2003) find that firms that get interim reviews from their auditor have a stronger association
between quarterly returns and earnings.
5 Arthur Andersen LLP (1999) argue that the reviewing costs are mitigated by a reduction in the audit
work needed at the end of the year.
6 In other literature, the results are also inconclusive about the costs and benefits of the reviews by auditors
of the quarterly financial statements (Boritz, 2006; Boritz & Liu, 2006; Crawford Committee, 2003; Ettredge et al., 2000).
mechanism of a voluntary review of the interim financial statements and focuses on credit ratings of firms.
Credit ratings influence the financing structure and the going concern of a firms and it influences a firm’s cost of private debt (Gray et al., 2006). Cha, Yeo & Hwang (2016) argue that auditors when reviewing financial statements take a more conservative and timely prospect than credit rating agencies (CRAs) and in line with this, Porumb & Karaibrahimoglu (2017) argue that the voluntary purchase of a review lowers the firm’s cost of private debt. The idea is that firms that are willing to incur the cost of an audit to obtain external financing are likely to have more profitable investment opportunities, and thus lower credit risk than those unwilling to pay for an audit (Kausar et al., 2016). This raises the question, if a firm voluntary purchases an audit review, how does this affect the firm’s credit rating? The expectation in this thesis is, that there is a positive association between the voluntary purchase of a review and the firms’ credit ratings.
To test if the voluntary purchase of an audit review is associated with the credit rating of a firm, I draw on a final sample of 1,849 firm-observations from which 1,355 were voluntary reviewed by an external auditor (73.28%). The data is hand-collected data for the first, second and third quarters for 502 non-financial listed firms from Canada, during the period 2005-2014. Financial listed firms are excluded from the sample because these firms are subject to special regulation (Bédard and Courteau, 2015; Kajüter et al., 2016). In this thesis, I find that firms who voluntary purchase a review, are valued with a higher credit rating by CRAs. Positive switchers receive higher credit ratings and negative switchers receive lower credit ratings which supports this conclusion. Taken together, these results are consistent with credit rating agencies valuing the external assurance brought by the voluntary purchase of the audit review.
This thesis contributes to the emerging auditing literature analyzing the benefits of audit reviews (i.e. Bédard & Courteau, 2015; Manry et al., 2003), by showing a firm’s decision to
voluntary purchase an audit review can influence the credit rating of the firms. Where previous literature is focusing on the costs and benefits a firm eventually gets, this is the first research done, as far as my knowledge goes, on the relation between the voluntary purchase of a review and the credit rating of a firm. The signalling effect may cause external credit rating agencies to perceive information in the quarterly financial statements to be more reliable and use them for setting the rating of the firm. This result can be used by governments whether to implement regulation regarding the review on quarterly financial statements and firms can influence their credit rating by voluntary purchasing a review.
The remainder of this thesis is structured as follows. Chapter 2 consists of the institutional and theoretical background, where for the institutional background I will discuss the historical perspective on reviews and for the theoretical background I make an overview on the theories regarding reviews. In chapter 3 the hypotheses will be developed. The research design is introduced in chapter 4, where subsequently the empirical results will be presented in chapter 5 and in the last chapter, chapter 6, the conclusion and discussion will be presented.
2. Institutional and Theoretical Background Reviews on quarterly financial statements
The IFAC has established standards to provide guidance on reviews on financial statements (ISRE 2400) and on reviews on interim financial statements by the firm’s auditor (ISR 2410). A practitioner can give negative assurance on financial statements, which states, on the basis of procedures which do not provide all the evidence that would be required in an audit, that the reviewed financial statements do not consist anything to believe that the financial statements are not prepared, in all material respects, in accordance with the applicable financial reporting framework (International Federation of Accountants, 2006a). The IFAC provides further guidance in ISRE 2400 how an practitioner can give negative assurance on financial statements. In addition to the ISRE 2400, the IFAC made standard ISR 2410, which is a specific standard for interim financial statements reviewed by the firm’s auditor. ISR 2410 has a comparable objective as ISRE 2400: the standard enables the auditor to express a conclusion whether, based on the review, anything has come the auditor’s attention that causes the auditor to believe that the interim financial information is not prepared, in all material respects, in accordance with an applicable financial reporting framework (International Federation of Accountants, 2006b). ISR 2410 is a standard for interim financial statements and this thesis focuses on quarterly financial statements which is a form of interim financial statements. Quarterly financial statements consists of an income statement, a balance sheet and a cash flow statement for each quarter of a year. Next to this, quarterly financial statements present an analysis and discussion on the firm’s financial condition and other information related to the firm. The comparison between quarterly financial statements and annual financial statements is that they both should be presented in accordance with an applicable framework for financial reporting. Differences are that quarterly financial statements use more estimates and these estimates are based on expectations of what will happen in the rest of the fiscal year, which
may require corrections in subsequent quarters (Canadian Institute of Chartered Accountants, 2000).
For a review, an auditor makes inquiries and uses analytical and other review procedures. The extent of the procedures for an review are lower than for an audit, and this is reflected in the assurance which a review gives. As mentioned above, a review gives negative assurance and differs from an audit which gives positive assurance. Negative assurance means nothing came to the auditors attention that requires modification on the financial statements and positive assurance means an auditor is giving an opinion that the financial statements are reasonable and fairly stated and are free from material error.
Regulation on quarterly financial statements and reviews
The Canadian Securities Administrators (CSA) do not require the review of interim financial statements by an external auditor. The (quarterly) financial statements of firms are subject to the regulations made by governmental authorities. Since 2000, The United States SEC mandates listed firms in the United States to have a timely review. With this regulation in the United States, the opportunity to use the signalling mechanism is minimized for American listed firms. The EU saw that interim reporting became more important and published the Transparency Directive (2004/109/EC) in 2004. The Transparency Directive was published because there was a need for more timely and more reliable information about the issuer’s performance over the fiscal year. The Transparency Directive made, next to annual reporting, quarterly and semi-annual reporting mandatory for issuers of securities in the EU. Since 2013, the quarterly reporting is not mandatory anymore to reduce the administrative burden for firms in the EU. Next to the regulation regarding reporting for firms in the EU, regulation regarding reviews by auditors of the quarterly financial statements differ per country. It is for example
mandatory for firms in France, and for firms in Spain, Germany and the Netherlands it is not mandatory.
In Canada, quarterly financial statements must be filed with the CSA within 45 days after the end of the quarter (60 days for venture exchange firms) (Boritz, 2006). According to Canadian Institute of Chartered Accountants (2000), a review report made by an auditor may only be seen by the audit committee of the reviewed firms. Regarding reviews, the CSA do not require Canadian firms to purchase a review on the quarterly financial statements. However, if a Canadian firm chooses not to purchase a review, the firm must disclose this in their financial statements. The CSA made some attempts to follow up the regulation set by the United States SEC for firms to have a timely review. Crawford Committee (2003) observed some of these rejected proposals to mandate quarterly reviews for Canadian firms, and the main reason of rejection was because of the lack of consensus on the costs and benefits of the reviews.
Costs and benefits of reviews on quarterly financial statements
The fundamental basis of economic decision making for a firm is to maximize benefits while minimizing costs. Analysis on costs and benefits assume that for every economic decision, something must be gained and something must be lost. For the economic decision for a firm whether to purchase a review and for an auditor to perform this review, this means the benefits have to outweigh the costs. An auditor will ask a monetary compensation to perform a review and this will be the costs for a firm who wants the review. Bédard & Courteau (2015) quantifiy the costs to purchase a review, and based on a Canadian sample the costs for firms that choose to purchase a review are approximately 18 percent higher compared to firms who do not choose to purchase this review. The purchase of a review reduces the costs for the audit for year-end because there is a reduction in audit work (Arthur Andersen LLP, 1999), but the net effect is still a significant increase in the total audit costs (Bédard & Courteau, 2015).
Kajüter et al. (2016) also look at the costs to purchase a review and see it as out-of-pocket monetary costs. Another disadvantage according to Kajüter et al. (2016) is the reporting lag the purchase of a review causes, which investors can perceive as a bad signal because of the decreased timeliness of the quarterly financial statements (Chambers & Penman, 1984).
An objective of interim financial statements is to give support for forecasts made on the annual profit or loss, where the interim financial statements are inherently based on estimates. Literature about the benefits of purchasing a review are inconclusive (i.e. Boritz, 2006; Ettredge et al., 2000). Reviews can decrease the likelihood of unintentional measurement error (Kajüter et al., 2016), yet Bédard & Courteau (2015) document that despite using various measures of earnings quality, there is no significant improvement in the quality of quarterly financial statements which are reviewed. According to their study, there is no benefit for a firm to purchase a review. When a firm chooses to purchase a review, it can choose between a timely review and a retrospective review. With a timely review the quarterly financial statements get reviewed by an auditor before the quarterly financial statements get filed. A firm can also choose to purchase a retrospective review, where the quarterly financial statements get reviewed at the end of the fiscal year. When an auditor reviews quarterly financial statements on a timely basis, Manry et al. (2003) find a stronger association between quarterly returns and (unexpected) earnings opposed to a retrospective review. Ettredge et al. (2000) also find a benefit of a timely review compared to retrospective reviews: for the fourth quarter there have to be made fewer adjustments. Another conclusion from Manry et al. (2003) is the increased likelihood of curbing earnings when purchasing a review. Both Bandyopadhyay et al. (2007) and Kajüter et al. (2016) come to the conclusion that reviewed quarterly earnings show a significantly higher quality on earnings than quarterly earnings that are not reviewed. For voluntary reviews, the signalling mechanism can be explained as a firm who discloses reliable information about itself to the user of the reviewed quarterly financial statements. According to
Bandyopadhyay et al. (2007), firms who voluntary choose to get their quarterly financial statements reviewed, can signal the reliability of these quarterly financial statements which is in line with the conclusion of Kajüter et al. (2016) and Pany & Smith (1982). Pany & Smith (1982) conclude that users of financial statements put similar weight on audits and reviews. Allee & Yohn (2009) state that firms with audited financial statements are more likely to get a loan than those without audited financial statements. The conclusions of Pany & Smith (1982) and Allee & Yohn (2009) combined would result in the conclusion that firms with reviewed financial statements are more likely to get a loan.
Credit ratings agencies and credit ratings
Credit rating agencies (CRAs) collect information about a borrower or an issuer of a debt security and publish credit ratings which represent the ability and willingness for repayment. The first credit rating agency was established in the United States in 1909 by John Moody, and this agency is still one of the major CRA. CRAs are now all over the world, and Moody’s and Standard & Poor’s control over 80% of the market and combined with Fitch they control over 94% of the market (Mihaelajméno, 2015). After the bankruptcy of Enron in 2001 and Worldcom in 2002, and the worldwide financial crisis in 2008-2009, CRAs got more attention from the public and regulators. Securities and Exchange Commission (2008) states that there were indications that credit ratings were issued by CRAs even when there were one or more issues unresolved. For example one analyst expressed concern whether they should rate a certain deal, and the answer was “it could be structured by cows and we would rate it”. In December 2008, Moody’s rated more than half of their securities AAA (the highest possible rating), and after the financial crisis in 2008-2009 nearly one-third got a lower credit rating (Benmelech & Dlugosz, 2010).
A credit rating issued by one of the major CRAs can be placed on an alphabet-oriented rating scale where AAA is the highest possible credit rating. For both S&P and Fitch, D is the lowest possible credit rating and for Moody’s the lowest possible credit rating is C. Moody’s describes AAA as firms are judged to be of the highest quality, subject to the lowest level of credit risk and C-rated firms are typically in default, with little prospect for recovery of principal or interest7. S&P describes AAA as the obligor’s capacity to meet its financial commitments on the obligation is extremely strong, and when rated D, the obligor is not able to fulfill financial commitments8. When Fitch rates a firm AAA, it denotes the lowest expectation of default risk and firms rated D indicate an issuer that in Fitch’s opinion has entered into bankruptcy filings, administration, receivership, liquidation or other formal winding-up procedure or that has otherwise ceased business9. Investors who lend money to a firm want to get their money back and can use, among other things, the credit ratings of the firm as information.
Asymmetric information
Asymmetric information in an economic transaction occurs when one party has more knowledge than the other party. Firms do have more information than their stakeholders and through (quarterly) financial statements, they provide some of the knowledge to their stakeholders. Quarterly financial statements are made by a firm and they do have an analysis and discussion on the firm’s financial condition. Based on the quarterly financial statements, investors can get insights in the firm’s performance and growth. Investors can use the firm’s performance and growth to predict future earnings and the going concern of a firm. For
7 https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_79004 8 https://www.standardandpoors.com/en_US/web/guest/article/-/view/sourceId/504352 9
investors to make decent decisions based on the quarterly financial statements, firms should be as transparent as possible and disclose valuable information.
3. Hypotheses development
In quarterly financial statements there are estimates and expectations which needs judgment from the firm’s personnel (Mendenhall & Nichols, 1988) and give the firm opportunity to manipulate the quarterly financial statements. Based on ISR 2410, an auditor can provide a negative assurance on the published quarterly financial statements if nothing came to the auditor’s attention to believe the quarterly financial statements were not prepared in accordance with an applicable financial reporting framework (International Federation of Accountants, 2006b). In Canada, public firms can choose to voluntary purchase a review. According to Porumb & Karaibrahimoglu (2017) one of the benefits to voluntary purchase a review is the lower cost of private debt for a firm. The idea is that firms that are willing to incur the cost of an audit to obtain external financing are likely to have more profitable investment opportunities, and thus lower credit risk, than those unwilling to pay for an audit (Kausar et al., 2016).
The cost of private debt for a firm is also influenced by the credit rating a firm gets, with a higher credit rating translating into a lower cost of debt (Gray et al., 2006). The characteristics of the reviews makes it likely that CRAs reward firms that voluntary purchase reviews with higher credit ratings. Because both the voluntary review and the credit rating of a firm have a negative effect on the cost of private debt, I expect a positive association between the voluntary purchase of a review and the credit rating of a firm. Therefore, the first hypothesis in this thesis is:
H1: Firms who voluntary purchase a review have a higher credit rating than firms with
In the sample that I employ there are positive switcher firms, defined as companies that did not purchase reviews and subsequently switched to purchase reviews in the sample period. Firms, in the used sample, who first purchased reviews on quarterly financial statements and stopped purchasing these reviews in a certain year are the opposite of the positive switchers and are defined as negative switchers. Based on the signalling mechanism, a switch from no review to purchase this review means more reliability of quarterly financial statements. In contrast, firms who stop purchasing a review will have less reliable quarterly financial statements. It is possible that ratings agencies use these effects in their credit ratings and based on this, the following hypotheses are tested:
H2a: Firms who switch from no review to voluntary purchasing a review obtain higher
credit ratings.
4. Research Design
The aim of this thesis is to analyze if there is a positive correlation between the voluntary purchase of a review and the credit rating of a firm. Next to that, we also analyze of positive switching (negative switching) has a positive (negative) correlation with the credit rating of a firm. In this chapter the data collection and the data analysis will be explained.
Data collection
Firms in Canada are not mandated to purchase a review on their quarterly financial statements. Since 2004, the CSA mandates a disclosure when a Canadian firm chooses to have their quarterly financial statements not reviewed by an external auditor. With this regulation by the CSA, Canada is a great country to draw a sample from and the starting point of this sample is all listed Canadian firms in the Compustat database between 2005 and 2014. The characteristics of firms are collected from the Compustat database and whether firms purchased a review is hand-collected from the SEDAR website. SEDAR is the official site that provides access to most public securities documents and information filed by issuers with the thirteen provincial and territorial securities regulatory authorities ("Canadian Securities Administrators" or "CSA") in the SEDAR filing system.10 Financial listed firms are excluded from the sample
because these firms are subject to special regulation (Bédard and Courteau, 2015; Kajüter et al., 2016). The initial sample consists of a total of 22,026 firm-year observations from 3,575 firms. 7,283 quarterly financial statements were excluded because they were from financial listed firms, and 11,430 quarterly financial statements were excluded because needed information in the Compustat database was missing for these firms. Of the 3,313 quarterly financial statements, 1,464 observations were excluded because there was no data or the data was ambiguous on the credit rating of the firms. The final sample consists of 1,849 quarterly financial statements from
10 https://www.sedar.com/homepage_en.htm
502 firms from which 1,355 were voluntary reviewed by an external auditor (73.28%). As shown in Table 1, in 2005, 97 out of 123 of the quarterly financial statements were reviewed (78.87%) and this evolved to 152 out of 218 (69.72%) in 2014.
<INSERT TABLE 1 – Voluntary reviews of quarterly financial statements in Canada>
This distribution is somewhat higher than previous research, as percentages of firms who purchase a review is respectively 63.9% (Porumb & Karaibrahimoglu, 2017), 59% (Bédard & Courteau, 2015) and 58.6% (Boritz & Liu, 2006) in previous research. All these researchers have used a sample based on Canadian firms but because of the use of other dependent and independent variables this difference can be explained.
Data analysis
To test hypothesis 1, if the voluntary purchase of a review has a positive effect on the credit rating of a firm, the following model will be used:
Rating = α + β1 Review + β2 Size + β3 ROA + β4 Tang + β5 CR + β6 Lev + β7 CapEx + β8
Zscore + β9 Auditor + β10 Big4 + β8 Fees + β9 Ind + β10 Year + ε (1)
To test hypothesis 2a, if switching from not voluntary purchasing a review to voluntary purchasing a review (positive switching) has a positive effect on the credit rating of a firm, and to test hypothesis 2b, if switching from voluntary purchasing a review to not voluntary purchasing a review (negative switching) has a negative effect on the credit rating of a firm, the following model will be used:
Rating = α + β1 Switch + β2 Size + β3 ROA + β4 Tang + β5 CR + β6 Lev + β7 CapEx + β8
Zscore + β9 Auditor + β10 Big4 + β8 Fees + β9 Ind + β10 Year + ε (2)
< INSERT TABLE 2: Variable definitions >
The dependent variable in both Model 1 and Model 2 is the credit rating of a firm (Rating). This variable is based on a ranking from 1 to 27, where 1 represents the lowest credit rating S&P gives (D) and 27 represents the highest credit rating S&P gives (AAA). In Model 1, the independent variable is whether a firm voluntary purchased a review (Review). This is a dummy variable which has a value of 0 if there is not voluntary purchased a review and has a value of 1 if the is voluntary purchased a review which is in line with previous research (i.e. Boritz & Liu, 2006; Bédard & Courteau, 2015; Porumb & Karaibrahimoglu, 2017). In Model 2, the independent variable is whether a firm is a positive or negative switcher (Switch). If a firm switches from not voluntary purchasing a review to voluntary purchasing a review (positive switching), the dummy variable Switch gets a value of 1. If a firm switches from voluntary purchasing a review to not voluntary purchasing a review (negative switching), the dummy variable Switch also gets a value of 1. If there is no positive or negative switch the value of this dummy variable is 0.
Next to the dependent and independent variables, in this thesis there will be used control variables. Control variables are held constant during the testing, it is not part of the experiment but it can have effect on the results. The first control variables is Size, because it controls for the complexity of a firm. Boritz & Liu (2006) present evidence that complexity of a firm is correlated positively with the voluntary purchase of a review. Size is measured as the total assets in euros in the previous year. Capital Expenditure is the capital expenditure divided by total assets in the previous year where the capital expenditure is the monetary value which is used
for new investments and new projects. This control variable is the second variable which is used to control for the complexity of a firm. Leverage is measured as the total liabilities divided by total assets in the previous year, and according to Ghosh (2007), firms with higher leverage have a lower firm value. Next to this, Chung & Kallapur (2002) state that Leverage affects the magnitude of discretionary accruals, so Leverage is included as control variable. Chung & Kallapur (2002) also state that ROA affect the magnitude of discretionary accruals and therefore
ROA, which is measured as the earnings before interest and taxes (EBIT) divided by total assets
in the previous year, is also included as control variable. Assets that are more tangible sustain more external financing, tangibility increases the value that can be captured by creditors in default (Almeida & Campello, 2007) and in this thesis there will be used the control variable
Tangibility which is measured as the net property, plant, and equipment divided by total assets
in the previous year. The current ratio is a liquidity ratio that measures whether a firm has enough resources to meet its short-term obligations. Because that is exactly what a credit rating is doing, in this thesis there will be controlled for Current Ratio which is measured as the current assets divided by current liabilities in the previous year. The riskiness of a firm, defined by a Zscore, is measured by Altman’s (1968) measure of default risk.
In this thesis, there will also be control variables for the auditor and fees regarding the auditor. As previous literature states (i.e. DeAngelo, 1981; Francis, 2004), the audit quality of Big 4 auditors, Deloitte, EY, KPMG or PwC, is higher than the audit quality of non-Big 4 auditors. Because firms who are audited by a Big 4 firm have more incentives to purchase a review than firms who are audited by a non-Big 4 firm, there will be used a control variable for this. Big4 equals 1 if a firm is audited by one of the Big 4 auditors (Deloitte, EY, KPMG or PwC) in the previous year and 0 otherwise. Big4 will be used next to auditor (auditor) which has a different value for each audit firm. The total fees paid to an auditor in a year will be controlled as well, because when the fees are higher it can also result in a higher review quality.
The control variable Fees will be used in this thesis, and is measures as the total fees to an auditor in the previous year.
The last variables which will be used as control variables are Industry and Year. Industry will be used to control for cross-sectional differences and is a dummy variable which gets a value of 1 if a firm is in 1 of the 10 sectors and 0 otherwise. Year will be used to control for time-series differences and if quarterly financial statements are from one of the 10 years (2005-2014) it gets a value of 1 and 0 otherwise.
5. Results
The research results will be presented in this chapter. First an overview is given of the descriptive statistics and afterwards the degree of correlation between the variables is discussed. The linear regression model used in this study will be treated as the final part in this chapter.
Descriptive statistics
The minimum, the maximum, the mean and the standard deviation of the dependent and independent variables constitute the descriptive statistics. The data is included in Table 3 and Table 2 contains the descriptions of the variables used. The final sample of 1,849 quarterly financial statements from 502 firms from which 1,355 were voluntary reviewed by an external auditor, which can be seen in the table as the mean (73.28%) for this variable. The firm size of the sample measured in total assets lie between 7,000 and 79,671,000 where the average Return on Assets is -42.11% and the highest Return on Assets is 61.98%. From the 1,849 observations, 84.42% is audited by a Big 4 auditor (Deloitte, EY, KPMG or PwC).
<INSERT TABLE 3: Descriptive Statistics (hypothesis 1)>
Correlation results
The Pearson correlation coefficient (r) is a measure of the linear correlation between two variables X and Y and has a value between -1 and +1, where -1 is a perfect negative correlation, and +1 is a perfect positive correlation. The Pearson correlation coefficients are show in Table 4 and the variables have been tested for multicollinearity, looking at whether the independent variables are too much correlated to each other (value greater than 0.7). No independent variables are omitted, but the correlation coefficient between the Firm Size and the Total Fees (r = 0.5566) is high, but that seems logical because bigger firms have more to audit.
<INSERT TABLE 4: Correlation Matrix (hypothesis 1)>
The dependent variable, Credit Rating, is significantly correlated at the 1% level with the independent variables Audit Review (r = 0.1456), Firm Size (r = 0.2725), Current Ratio (r = -0.0504), Capital Expenditure (r = -0.0712), Auditor (r = -0.1591), Big 4 auditor (r = 0.2344) and Total Fees (r = 0.2746). For this thesis, Audit Review is positively correlated with Credit Rating and the correlation between Audit Review and other independent variables like Firm Size, Tangiblity and Riskiness are significantly positive correlated at the 1% level which is in line with previous research.
Regression results
A linear regression analysis was performed to test if firms who voluntary purchase a review do get a higher credit rating than firms who do not voluntary purchase a review (hypothesis 1), and outcomes are shown in Table 5. Next to the outcomes, the total observations (1,849), the adjusted R-squared (0.2940) and the F value (27.06) are also included in Table 5.
<INSERT TABLE 5: Regression Results (hypothesis 1)>
In line with the expectations in this thesis, and confirming hypothesis 1, the coefficient of Audit Review (Review) is significantly positive at the 1% level (β = 1.15447, p < 0,01). Hypothesis 1 gets accepted and this can be interpreted that if a firm voluntary purchases a review, their credit rating will be higher.
For some of the control variables there is a significant relation with the credit rating of a firm (Firm Size (Size), Leverage (Lev), Capital Expenditure (CapEx), Auditor (Auditor) and
Big 4 auditor (Big4)). The size of a firm and if the firm is audited by a Big 4 auditor are both significantly positive associated at the 1% level with the credit rating of a firm (β = 0.0002392, p < 0,01; β = 3.663373, p < 0,01 ). The leverage of a firm is significantly negative associated at the 1% level with the credit rating of a firm (β = -0.567719, p < 0,01; β = -.3301095, p < 0,01). The capital expenditure of a firm is significantly negative associated at the 10% level with the credit rating of a firm (β = -1.315703, p < 0,10). For the other control variables (Return on Asset
(ROA), Tangibility (Tang), Current Ratio (CR), Riskiness (Zscore)) there is no significant
relation with the credit rating of a firm.
Hypothesis 2a states that firms who switch from no voluntary purchase of a review to voluntary purchase a review do get a higher credit rating. A linear regression analysis was performed to test for this and the results combined with the total observations (434), the adjusted R-squared (0.2877) and the F value (6.07) are shown in Table 6 Panel A. There is a significant positive relation at the 1% level between positive switching and the credit rating of a firm (β = 3.933557, p < 0,01) and thereby hypothesis 2a gets accepted. To test for the negative switchers, a linear regression was also performed and the results combined with the total observations (1,137), the adjusted R-squared (0.3433) and the F value (22.96) are shown in Table 6 Panel B. The coefficient of Switching (Switch) for negative switchers is significantly negative at the 1% level (β = -2.252887, p < 0,01). With this results, hypothesis 2b gets accepted and this means that firms who voluntary switch from purchasing a review to not purchasing this review anymore, do get lower credit ratings.
6. Conclusion and discussion
In this final chapter, the research questions will be answered with the results of the previous chapter and the hypotheses will be examined in more detail. Furthermore, the limitations of this research will be described and recommendations will be made for follow-up research.
This study examined whether there is a relationship between the purchase of a voluntary review and the credit rating of a firm. Previous research on voluntary reviews did research on the costs and benefits of the voluntary purchase of a review, but as far as I know this is the first research that links the voluntary purchase of a review with the credit rating of a firm. Based on the results, I conclude that there is a significant positive relationship between the voluntary purchase of a review and the credit rating of a Canadian firm. Next to that, I also tested what the effect for positive switchers and negative switchers is on the credit rating of that firm. For the positive switchers, firms who first did not purchase a review and switched to purchasing this review, there is a significant positive relationship with the credit rating a firm obtains. The negative switchers, firms who switch from review to no review, also has a significant relationship with the credit rating, but this one is negative which means negative switchers obtain a lower credit rating. The different hypotheses will be discussed separately below.
The final sample consists of 1,849 firm-year observations from 502 non-financial listed Canadian firms, during the period 2005-2014. The main research question, researched in hypothesis 1, was if a firm obtains a higher credit rating if it chooses to voluntary purchase a review. Based on the linear regression analysis, there is a significant positive correlation which results in the conclusion that a voluntary purchase will increase the credit rating a company obtains. Porumb & Karaibrahimoglu (2017) state that one of the benefits to voluntary purchase a review is the lower cost of private debt for a firm. Combined with the lower credit risk found by Kausar et al. (2016), the results of this thesis confirm that CRAs reward firms who voluntary
purchase a review with higher credit ratings. Because Canadian firms have the option to voluntary purchase a review, they have the opportunity to use the signalling mechanism. The results of this thesis suggest that the signalling mechanism is working for Canadian firms and give them the opportunity to get a higher credit rating. With the signalling mechanism, firms can show the reliability of the quarterly financial statements (Bandyopadhyay et al., 2007; Kajüter et al., 2016) and to get more support for hypothesis 1, I researched if positive (negative) switchers obtain a higher (lower) credit rating. Hypothesis 2a gets accepted because there is a positive correlation between positive switchers and the credit rating of those companies. In line with the expectations and previous literature, hypothesis 2b gets accepted as well: negative switchers obtain a lower credit rating. Both the results for hypothesis 2a and hypothesis 2b makes the case of hypothesis 1 stronger.
The debate about mandating reviews on quarterly financial statements (i.e. Crawford Committee, 2003) gets an useful insight through this thesis, since mandating the review leave firms no opportunity to signal their strengths by purchasing a review. The sample only included Canadian firms, which is a potential limitation of this thesis and opens the opportunity for further cross-country research. This is supported by the respectively low observations for positive and negative switchers. Another potential limitation of this thesis is that not enough control variables are used to exactly see the influence the review has on the credit rating of a firm. The last recommendation for further research is to do for example a difference in differences research between voluntary and mandatory purchase of reviews and the credit rating of a firm.
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TABLE 1
Voluntary reviews of quarterly financial statements in Canada
Year Voluntary reviews Total observations %
2005 97 123 78,87 2006 120 148 81,08 2007 120 157 76,43 2008 129 176 73,30 2009 142 185 76,76 2010 139 185 75,14 2011 157 220 71,36 2012 139 201 69,15 2013 160 236 67,80 2014 152 218 69,72 Total 1,355 1,849 73,28
TABLE 2 Variable Definitions
Credit Rating (Rating) Rating is based on a ranking from 1 to 27, where 1 represents
the lowest credit rating S&P gives (D) and 27 represents the highest credit rating S&P gives (AAA).
Audit Review (Review) Review equals 1 if a firm has purchased a voluntary audit
review in the previous year and 0 otherwise.
Switching (Switch) Switch equals 1 if a firm has switched from not voluntary
purchasing a review to voluntary purchasing a review (positive switching) or if a firm has switched from voluntary purchasing a review to not voluntary purchasing a review (negative switching) and 0 otherwise.
Firm Size (Size) Size is the Total Assets in euros in the previous year.
Return on Asset (ROA) ROA is the earnings before interest and taxes (EBIT) divided
by total assets in the previous year.
Tangibility (Tang) Tang is the net property, plant, and equipment divided by
total assets in the previous year.
Current Ratio (CR) CR is the current assets divided by current liabilities in the
previous year.
Leverage (Lev) Lev is the total liabilities divided by total assets in the
previous year.
Capital Expenditure (CapEx) CapEx is the capital expenditure divided by total assets in the previous year.
Riskiness (Zscore) Altman’s (1968) measure of default risk, computed as Z = 0.012 (working capital/total assets) + 0.014 (retained earnings/total assets) + 0.033 (EBIT/total assets) + 0.006 (market value of equity/book value of total liabilities) + 0.999 (sales/total assets)
Auditor (Auditor) Auditor gets a different value for each audit firm.
Big 4 auditor (Big4) Big4 equals 1 if a firm is audited by one of the Big 4 auditors
(Deloitte, EY, KPMG or PwC) in the previous year and 0 otherwise.
Total Fees (Fees) Fees is the total fees to an auditor in the previous year.
Industry (Ind) Ind makes a classification into 10 different sectors and if a
firm is in one of this sectors it equals 1 and 0 otherwise. Year (Year) Year makes a classification into 10 different years
(2005-2014) and if quarterly financial statements are from one of this years it equals 1 and 0 otherwise.
TABLE 3 Descriptive Statistics
Variable Mean Standard Deviation Minimum Maximum
Credit Rating (Rating) 15.07896 7.878078 1 27
Audit Review (Review) .7328286 .4426023 0 1
Firm Size (Size) 4297.012 9435.241 .007 79671
Return on Asset (ROA) -.4210532 4.669549 -152.643 .619776
Tangibility (Tang) .4567831 .3062802 0 1
Current Ratio (CR) 2.166288 4.463033 0 92.2192
Leverage (Lev) .2279115 .7461626 0 18.7558
Capital Expenditure (CapEx) .0967571 .2221998 0 7.99154
Riskiness (Zscore) .6553955 2.752946 -44.363 94.3711
Auditor (Auditor) 6.730124 2.785275 4 24
Big 4 auditor (Big4) .8442401 .3627256 0 1
Total Fees (Fees) 1736367 3356308 0 6.70e+07
This table displays information regarding the descriptive statistics and displays information regarding the dependent variable and the independent variables. Credit Rating (Rating) is based on a ranking from 1 to 27, where 1 represents the lowest credit rating S&P gives (D) and 27 represents the highest credit rating S&P gives (AAA); Audit Review (Review) equals 1 if a firm has purchased a voluntary audit review in the previous year and 0 otherwise; Firm Size (Size) is the Total Assets in euros in the previous year; Return on Asset (ROA) is the earnings before interest and taxes (EBIT) divided by total assets in the previous year; Tangibility (Tang) is the net property, plant, and equipment divided by total assets in the previous year; Current Ratio (CR) is the current assets divided by current liabilities in the previous year; Leverage (Lev) is the total liabilities divided by total assets in the previous year; Capital Expenditure (CapEx) is the capital expenditure divided by total assets in the previous year; Riskiness (Zscore) is Altman’s (1968) measure of default risk, computed as Z = 0.012 (working capital/total assets) + 0.014 (retained earnings/total assets) + 0.033 (EBIT/total assets) + 0.006 (market value of equity/book value of total liabilities) + 0.999 (sales/total assets); Auditor (Auditor) gets a different value for each audit firm; Big 4 auditor (Big4) equals 1 if a firm is audited by one of the Big 4 auditors (Deloitte, EY, KPMG or PwC) in the previous year and 0 otherwise; Total Fees (Fees) is the total fees to an auditor in the previous year.
TABLE 4 Correlation Matrix
Variable 1 2 3 4 5 6 7 8 9 10 11 12
Credit Rating (Rating) 1 1.000
Audit Review (Review) 2 0.1456* 1.000
Firm Size (Size) 3 0.2725* 0.1853* 1.000
Return on Asset (ROA) 4 0.0215 0.0230 0.0199 1.000
Tangibility (Tang) 5 -0.0145 0.0913* 0.1232* 0.0601* 1.000
Current Ratio (CR) 6 -0.0504* -0.0221 -0.0408* 0.0181 -0.0895* 1.000
Leverage (Lev) 7 -0.0149 -0.0040 -0.0040 -0.4903* -0.0343* -0.0116 1.000
Capital Expenditure (CapEx) 8 -0.0712* -0.0029 -0.0288* -0.1760* 0.2803* -0.0266 -0.0141 1.000
Riskiness (Zscore) 9 0.0287 0.0413* 0.0118 0.4643* -0.0038 0.0428* -0.3725* -0.0795* 1.000
Auditor (Auditor) 10 -0.1591* -0.1835* -0.0956* -0.0350* -0.0495* 0.0156 0.0082 0.0186 -0.0272 1.000
Big 4 auditor (Big4) 11 0.2344* 0.2679* 0.1499* 0.0880* -0.0092 -0.0279* -0.0366* -0.0643* 0.1127* -0.4034* 1.000
Total Fees (Fees) 12 0.2746* 0.2341* 0.5566* 0.0574* -0.0078 -0.0607* 0.0108 -0.0565* 0.0219 -0.1799* 0.2132* 1.000 This table displays information regarding the Pearson correlation coefficients and a * indicates that the correlation is significant at the 1% level for a two-tailed test. Credit Rating (Rating) is based on a ranking from 1 to 27, where 1 represents the lowest credit rating S&P gives (D) and 27 represents the highest credit rating S&P gives (AAA); Audit Review (Review) equals 1 if a firm has purchased a voluntary audit review in the previous year and 0 otherwise; Firm Size (Size) is the Total Assets in euros in the previous year; Return on Asset (ROA) is the earnings before interest and taxes (EBIT) divided by total assets in the previous year; Tangibility (Tang) is the net property, plant, and equipment divided by total assets in the previous year; Current Ratio (CR) is the current assets divided by current liabilities in the previous year; Leverage (Lev) is the total liabilities divided by total assets in the previous year; Capital Expenditure (CapEx) is the capital expenditure divided by total assets in the previous year; Riskiness (Zscore) is Altman’s (1968) measure of default risk, computed as Z = 0.012 (working capital/total assets) + 0.014 (retained earnings/total assets) + 0.033 (EBIT/total assets) + 0.006 (market value of equity/book value of total liabilities) + 0.999 (sales/total assets); Auditor (Auditor) gets a different value for each audit firm; Big 4 auditor (Big4) equals 1 if a firm is audited by one of the Big 4 auditors (Deloitte, EY, KPMG or PwC) in the previous year and 0 otherwise; Total Fees (Fees) is the total fees to an auditor in the previous year.
TABLE 5
Regression Results (Hypothesis 1)
Effect of Audit Review (Review) on Credit Rating (Rating).
Rating = α + β1 Review + β2 Size + β3 ROA + β4 Tang + β5 CR + β6 Lev + β7 CapEx + β8 Zscore + β9
Auditor + β10 Big4 + β8 Fees + β9 Ind + β10 Year + ε
Variable Coefficient Standard Error
Audit Review (Review) 1.15447 *** .3959803
Firm Size (Size) .0002392 *** .0000215
Return on Asset (ROA) -.0188663 .0361306
Tangibility (Tang) -.326297 .7162655
Current Ratio (CR) -.0382095 .03595
Leverage (Lev) -.567719 *** .2165415
Capital Expenditure (CapEx) -1.315703 * .7436828
Riskiness (Zscore) -.0178627 .0596306
Auditor (Auditor) -.3301095 *** .062126
Big 4 auditor (Big4) 3.663373 *** .5009012
Total Fees (Fees) 7.22e-08 5.84e-08
Year-fixed effects Yes
Industry-fixed effects Yes
Observations 1,849
Adjusted R-squared 0.2831
F value 27.06 0.000
This table displays information regarding the regression results, based on 1,849 firm-year observations, during the period 2005-2014, for non-financial listed firms from Canada. A *, ** or ***, indicates a significance of respectively 10% (p < 0.10), 5% (p < 0.05) or 1% (p < 0.01) for a one-tailed test. Credit Rating (Rating) is based on a ranking from 1 to 27, where 1 represents the lowest credit rating S&P gives (D) and 27 represents the highest credit rating S&P gives (AAA); Audit Review (Review) equals 1 if a firm has purchased a voluntary audit review in the previous year and 0 otherwise; Firm Size (Size) is the Total Assets in euros in the previous year; Return on Asset (ROA) is the earnings before interest and taxes (EBIT) divided by total assets in the previous year; Tangibility (Tang) is the net property, plant, and equipment divided by total assets in the previous year; Current Ratio (CR) is the current assets divided by current liabilities in the previous year; Leverage (Lev) is the total liabilities divided by total assets in the previous year; Capital Expenditure (CapEx) is the capital expenditure divided by total assets in the previous year; Riskiness (Zscore) is Altman’s (1968) measure of default risk, computed as Z = 0.012 (working capital/total assets) + 0.014 (retained earnings/total assets) + 0.033 (EBIT/total assets) + 0.006 (market value of equity/book value of total liabilities) + 0.999 (sales/total assets); Auditor (Auditor) gets a different value for each audit firm; Big 4 auditor (Big4) equals 1 if a firm is audited by one of the Big 4 auditors (Deloitte, EY, KPMG or PwC) in the previous year and 0 otherwise; Total Fees (Fees) is the total fees to an auditor in the previous year. For the Year and Industry dummies there are 4 variables omitted because of multicollinearity: YearDummy1, YearDummy3, IndustryDummy5 and IndustryDummy7.
TABLE 6
Regression Results (Hypotheses 2a and 2b)
Effect of Switching (Switch) on Credit Rating (Rating).
Rating = α + β1 Switch + β2 Size + β3 ROA + β4 Tang + β5 CR + β6 Lev + β7 CapEx + β8 Zscore + β9
Auditor + β10 Big4 + β8 Fees + β9 Ind + β10 Year + ε
Panel A
Positive Switch Sample N = 434
Panel B
Negative Switch Sample N = 1,177
Variable Coef. Std. Err. Coef. Std. Err.
Switching (Switch) 3.933557 *** .9215373 -2.252887 *** .642608 Firm Size (Size) -.0000313 .0004911 .0002288 *** .0000222 Return on Asset (ROA) -.0032203 .0538464 .6732056 *** .1767273 Tangibility (Tang) -2.469343 * 1.461919 1.570954 * .9523685 Current Ratio (CR) -.0101698 .0542148 -.1062026 ** .0523744 Leverage (Lev) -.0309612 .2748912 -1.978107 ** .8870941 Capital Expenditure (CapEx) 2.213543 2.656883 -9.21285 *** 2.412113 Riskiness (Zscore) .9056637 *** .3169773 .0269564 .0656154 Auditor (Auditor) -.0732025 .1301908 -.4670211 *** .0756639 Big 4 auditor (Big4) 2.842476 *** .8397242 3.132889 *** .7666014 Total Fees (Fees) 1.33e-06 * 7.35e-07 -1.12e-08 5.71e-08
Year-fixed effects Yes
Industry-fixed effects Yes
Observations 434 1,177
Adjusted R-squared 0.2403 0.4333
F value 6.07 0.000 22,96 0.000
This table displays information regarding the regression results, based on 434 year observations (positive switch sample) and 1,177 firm-year observations (negative switch sample), during the period 2005-2014, for non-financial listed firms from Canada. A *, ** or ***, indicates a significance of respectively 10% (p < 0.10), 5% (p < 0.05) or 1% (p < 0.01) for a one-tailed test. Credit Rating (Rating) is based on a ranking from 1 to 27, where 1 represents the lowest credit rating S&P gives (D) and 27 represents the highest credit rating S&P gives (AAA); Switching (Switch) equals 1 if a firm has switched from not voluntary purchasing a review to voluntary purchasing a review (positive switching) or if a firm has switched from voluntary purchasing a review to not voluntary purchasing a review (negative switching) and 0 otherwise.; Firm Size (Size) is the Total Assets in euros in the previous year; Return on Asset (ROA) is the earnings before interest and taxes (EBIT) divided by total assets in the previous year; Tangibility (Tang) is the net property, plant, and equipment divided by total assets in the previous year; Current Ratio (CR) is the current assets divided by current liabilities in the previous year; Leverage (Lev) is the total liabilities divided by total assets in the previous year; Capital Expenditure (CapEx) is the capital expenditure divided by total assets in the previous year; Riskiness (Zscore) is Altman’s (1968) measure of default risk, computed as Z = 0.012 (working capital/total assets) + 0.014 (retained earnings/total assets) + 0.033 (EBIT/total assets) + 0.006 (market value of equity/book value of total liabilities) + 0.999 (sales/total assets); Auditor (Auditor) gets a different value for each audit firm; Big 4 auditor (Big4) equals 1 if a firm is audited by one of the Big 4 auditors (Deloitte, EY, KPMG or PwC) in the previous year and 0 otherwise; Total Fees (Fees) is the total fees to an auditor in the previous year.For the Year and Industry dummies in both
analysis, there are 4 variables omitted because of multicollinearity: YearDummy1, YearDummy2, IndustryDummy7 and IndustryDummy9 and for Panel B IndustryDummy5 is also omitted because of multicollinearity.
