An Empirical Investigation
Fabian Meijs
September 2014
This thesis examines the firm characteristics associated with the voluntary disclosure of the new style audit report over 2013 in the Netherlands. This country was selected, as the new style audit report is already mandatory over 2013 in the UK, while in other countries firms do not yet engage in publishing their audit report ‘new style’. The research sample consists of 111 Dutch firms, of which 30 voluntary issued a new style audit report. The research, which is conducted by means of a logistic regression analysis, contains a wide range of independent variables. These variables were selected based on theories applicable to voluntary disclosure and a review of previous literature on voluntary disclosure determinants. It was found that listing age, ownership dispersion and having a Big Four auditor are significantly positively associated with the voluntary disclosure of the new style audit report. On the other hand, competitive pressure and being cross-listed exhibit a significantly negative relation with the issuance of the new style audit report. Industry-related significantly positive associations with disclosure of the new style audit report were found for firms in the sectors Industrials and Consumer Services.
Table of contents
Page
Table of contents 2
1. Introduction to the thesis 4
1.1 Introduction to the subject 4
1.2 Research question 5
1.3 Relevance 6
1.4 Methodology 7
1.5 Structure 8
2. Institutional background 9
2.1 The new style audit report 9
2.1.1 ISA 701 – Communicating key audit matters 10
2.1.2 Materiality and an overview of the scope of the audit 11
2.1.3 ISA 570 – Going concern 12
2.2 Voluntary disclosure 13
2.2.1 Agency theory 14
2.2.2 Positive accounting theory 15
2.2.3 Signaling theory 18
2.2.4 Capital need theory 19
2.2.5 Legitimacy theory 19
2.2.6 Institutional theory 19
2.2.7 Litigation cost theory 20
2.3 Measuring voluntary disclosure 21
2.4 Content analysis 22
2.5 Research models in voluntary disclosure literature 23
3. Literature review on empirical research 24
3.1 Determinants of voluntary disclosure 24
3.2 Environmental voluntary disclosure indicators 29
3.3 Determinants of early IFRS adoption 30
3.4 Conclusion 31
4. Hypotheses 37
4.1 Firm size 37
4.2 Leverage 37
4.3 Big Four auditor 38
4.4 Cross-listing 39
4.5 Board size 40
4.6 Age 41
4.7 Competitive pressure 41
4.8 Ownership dispersion 42
4.9 Industry 44
4.10 Concluding remarks 45
5. Research design 46
5.1 Research sample 46
5.2 Variables 47
5.3 Research model 52
5.4 Descriptive statistics 54
5.5 Statistical testing 56
6. Results 58
6.1 Correlation 58
6.2 Results of the statistical tests 59
6.3 Discussion of the results 62
6.4 Analysis 66
6.5 Robustness tests 71
7. Summary and conclusion 73
References 78
Appendix 85
1. Introduction to the thesis
1.1 Introduction to the subject
This thesis examines the differences in characteristics of voluntary adopters of the new style audit report compared to non-adopters in the Netherlands for the year 2013. The characteristics included in the research are primarily determined on the basis of previous literature examining the factors related to voluntary disclosure. In short, this study tries to find out what the main drivers are behind the choice to voluntarily issue a new style audit report.
The objective of the new style audit report is to provide stakeholders with more ‘behind-the-scenes’ information about the work of the auditor and about the financial state and important issues of the audited firm. The most important additions to the new style audit report in the UK are paragraphs about 1) the key audit matters/areas of particular focus, 2) materiality issues and an overview of the scope of the audit, and 3) the firm’s going concern.
According to the IAASB (2013a), the key audit matters are “those matters that, in the auditor’s professional judgment, were of most significance in the audit of the financial statements of the current period.” All key audit matters must be selected from issues communicated with the firm’s Board of Directors. A study by PwC (2014a) found that the three most reported key audit matters among Dutch listed firms are the acquisition or sale of firm activities, tax issues and the valuation of goodwill. In the paragraph about materiality it is explained what materiality exactly involves and at what percentage the materiality is set for a particular audit. The going concern paragraph states whether or not the firm can be considered as going concern. Previously, the audit report only reported about going concern in case of hesitation about the continuity of a firm.
As of now, the UK is the only country in which the new style audit report is mandatory for listed firms. However, there are strong signs that from 2015 on the International Auditing and Assurance Standards Board (IAASB) will make it obligatory for all listed firms to publish new style audit reports in their Annual Report. This implies that the new style audit report will become effective for audit reports over the year 2014. However, firms under the jurisdiction of the IAASB are not yet obliged to issue new style audit reports from 2015, as the IAASB is still discussing this issue. The IAASB is an independent institution for the accountancy profession which sets “high-quality international standards for auditing, quality control, review, other assurance, and related services”, and facilitates “the convergence of international and national standards” (IAASB, 2014). As a result of the imminent new style audit report regulations, many Dutch listed firms have already voluntarily published a new style audit report over the fiscal year 2013 in cooperation with their auditor. To be precise, 32 out of 114 examined firms listed on a Dutch stock exchange (i.e. the AEX, AMX, ASCX and other stocks) have published their audit report according to the future regulations. Four of them are also listed on the London Stock Exchange, meaning that these firms were obliged to issue a new style audit report over 2013. Consequently, these firms are excluded from the sample. Two non-listed Dutch firms issuing a new style audit report over 2013, ABN AMRO and PGGM, are also included in the sample. This means that this research includes 30 voluntary adopters of the new style audit report. According to Piersma (2014), the Netherlands is the leading country when it comes to voluntarily issuing the new style audit report. This is supported by the fact that not a single firm on the major stock indices in surrounding countries like Germany, Belgium and France has published a new style audit report in 2014. That is the primary reason this thesis only concentrates on the Dutch market. This means that this study concentrates on the characteristics of Dutch firms that reported voluntarily according to the rules of the new style audit report.
1.2 Research question
In the past, there have been plenty of studies about the (management) characteristics and features of firms voluntarily disclosing information on certain issues in their Annual Report. Of course this has never been done before when it concerns the new style audit report, as this report is only issued since the beginning of 2014. This means that this is the first study investigating the relationship between firm characteristics and the voluntary issuance of the new style audit report. By investigating the Dutch firms that have voluntary issued the new style audit report, it is possible to find out whether there are associations with certain firm characteristics. As a consequence, the main research question of this study is:
What are the firm characteristics associated with the voluntary issuance of the new style audit report in the Dutch stock market?
In order to adequately answer the main research question, the following sub-questions are constructed:
1) What are the differences in the new style audit report compared to the old format audit report?
2) What are the reigning voluntary disclosure theories, and how can they be related to the voluntary issuance of the new style audit report?
3) According to previous literature, which factors are of influence on the choice whether or not to disclose voluntary items?
4) What are the appropriate hypotheses for this study?
5) What is the best research design for this study?
6) What are the results of the research regression?
7) What are the conclusions of this research?
All sub-questions are addressed throughout this study.
1.3 Relevance
Besides being the first paper examining this particular relationship, another aspect making this study interesting is the research on the new style audit report. Daboo (2013) characterizes the introduction of the new style audit report as “the most significant advance in auditor reporting in decades”. The work of an auditor involves a lot more than can be derived from the audit report. However, the audit report is the only information about the audit the public sees, and that is the reason it is so important to expand the audit report in order to provide stakeholders with more valuable information about the audited firm. The audit report is basically the representation of the audit profession towards the public.
Examining the factors associated with voluntarily providing a new style audit report improves the understanding of investors and other stakeholders about a firm’s reporting strategy. By linking the voluntary disclosure of the new style audit report to various voluntary disclosure theories, managers’ motives behind voluntary disclosure can be recognized. Moreover, with the results of this study, stakeholders are able to assess which firm characteristics determine innovation, as the new style audit report is a very innovative addition to the audit. Knowing these characteristics may be of influence on the decision to invest in a firm, since innovativeness in financial reporting may be an indication of innovativeness in business operations, which might lead to enhanced future growth prospects. The results of this study can also be used by standard-setters when asking the question which kind of firms should be subjected to this new regulation. Suppose that firm size is found to be significantly positively associated with the voluntary issuance of the new style audit report. When that happens, it might be a confirmation to the IAASB that their (likely) decision to impose this regulation only on listed firms is a good choice.
1.4 Methodology
This study tries to link the voluntary issuance of the new style audit report to the prevalent voluntary disclosure theories. Therefore, this study discusses several theories that can be applied to voluntary disclosure practices, namely the agency theory, positive accounting theory, signaling theory, capital need theory, legitimacy theory and institutional theory. Based on a review of previous literature about the determinants of voluntary disclosure, the firm characteristics that will be included in the hypotheses and regression model are established. After constructing the hypotheses, the Dutch firms fitting in the research are determined. In order to distinguish voluntary audit report issuers from old format audit report issuers, a dummy variable is constructed which assigns a value of ‘1’ to voluntary issuers and a value of ‘0’ otherwise. Next, to investigate the factors attributable to the voluntary issuers, a regression model will be developed. This model includes the voluntary disclosure firm characteristics found by previous literature. By running the regression, it is possible to examine the factors that are significantly related to the firms voluntarily issuing the new style audit report. The results will be analyzed and compared with theory, expectations and results of prior research.
1.5 Structure
The paper is organized as follows. Section 2 provides an overview of the background and implications of the new style audit report and a discussion of theories and practices applicable to voluntary disclosure. Section 3 deals with a study of previous empirical literature on the subject this paper investigates. In Section 4, the hypotheses are constructed and motivated. Section 5 discusses the research method, the sample, and the proxies that are used in the regression model. In Section 6 the results will be reviewed and analyzed. Finally, Section 7 provides the summary and conclusion of this thesis.
2. Institutional background
The first part of this section provides a background of the new style audit report. Thereafter, the most prominent voluntary disclosure theories are discussed. The remainder of this section is about the ways to measure voluntary disclosure, the recognition of new style audit report adopters and the research models applied in previous literature. The main objective of this section is to find links between the new style audit report and the theories applicable to voluntary disclosure.
2.1 The new style audit report
Currently, the UK is the only jurisdiction in which the issuance of a new style audit report is mandatory for all listed firms. The new style audit report in the UK is effective since January 1, 2014. According to the Financial Reporting Council (FRC), the objective of the new style audit report is “to enhance the transparency of the auditor’s report with the aim of better communication to investors” (FRC, 2013). In the UK, the FRC is the body in charge of the promotion of high quality corporate governance and reporting. The style audit report was implemented by the Auditing Practices Board (APB), which is one of the six divisions of the FRC (FRC, 2013).
In other countries, the choice to issue a new style audit report is still voluntary. However, the IAASB, which is the independent standard setting body of the International Federation of Accountants (IFAC), has hinted that it wants to make the new style audit report mandatory from 2015 (Piersma, 2014). It seems like only some Dutch firms already anticipate on the proposed new style audit report, since they are the forerunners of the voluntary disclosure of the new style audit report. In 2014, 28 firms listed on the NYSE Euronext Amsterdam and 2 non-listed Dutch firms have voluntarily issued a new style audit report. To put this into perspective, none of the listed firms in the surrounding countries France, Germany and Belgium has done so.
The IAASB (2013b) lists several advantages of the new style audit report. First of all, the transparency of the audit increases. Second, management might shift focus to items that recur in the audit report by covering them more extensively in their annual report. This increases financial reporting quality. Third, reporting key audit matters might renew the auditor’s attention on the issues to be covered. This would lead to more professional skepticism, hence resulting in a higher audit quality. Fourth, communication between auditor and management might improve, as there will be more dialogue about the reported key audit matters.