ERASMUS UNIVERSITY ROTTERDAM

ERASMUS SCHOOL OF ECONOMICS

ACCOUNTING, AUDITING AND CONTROL MASTER’S PROGRAM 2009-2010

Master Thesis:

“The effects of the current financial crisis on auditors’ conservatism and audit fees, concerning stock exchange quoted firms in The Netherlands”

Conductor: Maria Moirasgenti (student nr.: 331425)

Supervisor: E.A. de Knecht RA

Co-reader: A.H. van der Boom

ABSTRACT

This study was conducted in order to investigate the impacts of the current financial crisis on the auditors’ use of professional conservatism and on the audit fees, regarding Dutch stock exchange quoted companies. Audit conservatism was tested between two periods: first in the prior to the crisis period of 2005-2006, and second during the financial crisis period of 2008-2009. Audit fees were tested between the years 2008 and 2009 due to data limitations. 51 stock exchange quoted firms were selected and investigated through multivariate pooled and linear regression analyses. Contrary to the hypothesized increased levels of conservatism and audit fees, the Dutch auditors were found to use lower levels of audit conservatism in their financial audit tasks and charge lower amounts of audit fees.

Acknowledgements

This study would have not been performed without the continuous guidance and help of my supervisor, with the Erasmus School of Economics E.A. de Knecht. Additional thanks are provided to the co-reader of this research, Dr. sc. ind. A.H. van der Boom. Special thanks are given to my sister Rallou, my parents Kostas and Vicky Moirasgenti, my friends across Greece and The Netherlands, and Phd. candidate Stylianos Sakkas for their tremendous psychological support and precious willingness to share with me the pressure and stress of the last months.


CONTENTS

Abstract………………………………………………………………………………………………………………………….p.2

Acknowledgements…………………………………………………………………………………………………………p.2

Contents…………………………………………………………………………………………………………………………p.3

CHAPTER 1-Introduction…………………………………………………………………………….…………………..p.6

1.1 Background……………………………………………………………………………………….………………………p.6

1.1.1 The current financial crisis……………………………………………………………………………………p.6

1.1.2 The external auditing profession……………………………………………………………………………p.7

1.1.3 Auditors’ conservatism and audit fees…………………………………………………………….…..…p.8

1.2 Objectives…………………………………………………………………………………………………………...... p.8

1.3 Problem definition………………………………………………………………………………………..………….p.9

1.4 Methodology………………………………………………………………………………………………………….…p.9

1.5 Demarcation and limitations………………………………………………………………………………….p.10

1.6 Structure…………………………………………………………………………………………………………………p.10

CHAPTER 2-Financial information………………………………………………………...………………………p.12

2.1 Introduction……………………………………………………………………………………………………...... p.12

2.2 Theories concerning financial and accounting information……………………………………..p.13

2.1.1 Agency Theory…………………………………………………………………………………………………….p.13

2.2.2 The efficient Market Hypothesis………………………………………………………………………….p.14

2.2.3 The Positive Accounting Theory…………………………………………………………………………..p.16

2.3 Summary…………………………………………………………………………………………………………………p.18

CHAPTER 3 – The Financial Crisis…………………………………………………………………………………..p.19

3.1 Insight in the causes of the crisis……………………………………………………………………………..p.19

3.2 Fair-value and off-balance sheet accounting: the features of controversy………………p.24

3.3 Summary…………………………………………………………………………………………………………..…….p.27

CHAPTER 4 – The external auditing profession, the impacts of the financial crisis on external auditors, audit conservatism and audit fees…………………………………………………...p.28

4.1 External Auditing………………………………………………………………………………………………….…p.28

4.2 Implications of the current financial crisis on the audit profession……………………….…p.32

4.3 Conservatism in audits…………………………………………………………………………………………….p.34

4.4 Audit fee……………………………………………………………………………………………………………..….p.39

4.5 The Association between Audit Fees and Audit Conservatism…………………………….…..p.40

4.6 Summary…………………………………………………………………………………………………………………p.41

CHAPTER 5 – Prior Research………………………………………………………………………………….……p.42

5.1 Prior Research investigation and Hypotheses development………………………………..….p.42

5.2 Summary……………………………………………………………………………………………………………….p.53

CHAPTER 6 – Research Design…………………………………………………………………………...... p.54

6.1 Research approach……………………………………………………………………………………………….p.54

6.2 Research methodology…………………………………………………………………………………………p.55

6.3 Measuring auditors’ conservatism and audit fees……………………………………………….…p.56

6.4 Control variables……………………………………………………………………………………………………..p.59

6.5 Sample selection …………………………………………………………………………………………………….p.61

6.6 Summary………………………………………………………………………………………………………………..p.63

CHAPTER 7 – Research results and analysis…………………………………………………………………..p.64

7.1 Analysis of the investigation concerning the impact of the current financial crisis on auditors’ use of conservatism……………………………………………………………………….…………..….p.64

7.1.1 Descriptive statistics for Model 1…………………………………………………………………………p.64

7.1.2 Pearson’s correlation testing………………………………………………………………………………p.65

7.1.3 Coefficients’ analysis - Results investigation…………………………………………………………p.68

7.1.4. Complementary evidence concerning data from 2005, 2006, 2008 and 2009……..p.71

7.2 The impact of the current financial crisis, concerning the auditors’ fees…………………p.74

7.2.1 Descriptive statistics for Model 3………………………………………………………….……………p.75

7.2.2 Pearson’s correlation testing………………………………………………………………………………..p.76

7.2.3 Coefficients’ analysis - Results investigation………………………………………………………..p.79

7.3 Summary………………………………………………………………………………………………………………...p.84

CHAPTER 8 – Conclusion and Limitations……………………...... p.85

8.1 Conclusion………………………………………………………………………………………………………………p.85

8.2 Limitations………………………………………………………………………………………………………………p.85

8.3 Further research suggestions…………………………………………………………………………….……p.85

REFERENCES………………………………………………………………………………………………………………….p.87

APENDIX…………………………………………………………………………………………………………...………….p.9

CHAPTER 1 – Introduction

1.1 Background

“We have an important role to play to ensure the survival of the financial system. Its survival depends on the vigilance of regulators, the adequacy of reporting processes and the openness of communication among all the key players. Now it is the time for external auditors to reassess their roles and responsibilities.” (CA Magazine, “The external auditors’ pivotal role” by Bradshaw & Brown, 1988; p. 46)

This extract was taken from an article written and published in 1988. The time could not be more right to argue that today, during the days of a financial recession, auditors and their profession is in a high degree influenced.

This paper concerns a research that will try to shed light on the effects of the recent financial crisis to the tasks of external financial auditing. This interest concerning the influence of the financial crisis on the external auditing profession is originated based on three parties: First the whole business world, second the public and third the academic world. All previous studies have proved that auditing is severely affected by changes in the business world, therefore the assumption exists that in this case a great influence exists. More precisely, the focus of this research will concern the levels of the use of conservatism in auditors’ evaluations. The levels of conservatism determine the audit fees, consequently the impact of the current financial crisis on audit fees will be investigated as well.

1.1.1  The current financial crisis

The financial crisis that started in 2007 indeed is a global financial crisis. It is considered the outcome of the liquidity shortfall in the United States. Its results in the general financial sector can be summarized in the dissolution of large financial institutions, the huge declines in consumer growth rates, the supporting efforts of banks by the national governments and severe downturns in the stock markets globally.

The results and the implications from the current situation are so expanding and severe, that all aspects of the business world are now going through a changing and developing phase. The auditing profession is inevitably affected in a major scale. Criticism and blame has focused on a wide range of complex and global factors in general. However, it is more than disappointing to note that the financial audits assuring the fairness of statements by banks declaring financial difficulties and filing for bankruptcy soon after receiving an unqualified audit report were conducted exclusively by one of the Big Four Auditing firms, committed to provide the highest assurance level.

The interest of this study focuses on a few economic theories that provide insights in the function of the capital markets and on the causes and the consequences of the crisis in the global economy. In addition, detailed references concerning the external auditing profession are provided.

1.1.2  The external auditing profession

Audits are one form of the attestation services provided by external auditors. This research focuses on audits of historical financial statements, in which an opinion is expressed about the fairness of a company’s financial statements by CPA firms.

The magnitude of the financial crisis is huge enough to have influenced all the areas of the business-financial world, including of course the auditing profession. External audit is promoted as an assurance tool concerning all interested parties in the financial statements of a company. This is highly to be questioned though considering the latest news. A very well known example concerning this is the case of Lehman Brothers, one of the biggest banks that operated in the United States of America (USA) and received an unqualified opinion shortly before filing for bankruptcy. Because the roots of the problematic situation expand beyond the auditors’ profession scope, but cannot be characterized as not plausible, the question “where were the auditors?” is not as prevalent as in the past where the big auditing scandals had taken place (Enron, A hold, Adelphia). However, since the level of “duty” towards the public keeps on increasing, the skills concerning the financial audits of firms in the current years need to be enriched.

The implications concerning the auditing profession, especially the independent one, are inevitable and certainly severe. In any case, it is not to be forgotten that traditionally financial auditors were and still are the ones to trust the savings of a lifetime. The key features of the profession will be analyzed in this study, along with the impacts of the crisis on its functions.

1.1.3  Auditors’ conservatism and audit fees

Auditors’ conservatism relates to the general accounting principle of conservatism that can be summarized in the next rule: anticipation of all losses but no anticipation of profits (Basu, 1997).

Conservatism is a highly respected concept on audits and at the same time highly associated with audit fees. The higher the conservatism the more the efforts and the working hours the auditors dedicate for the conduction of their assurance tasks, resulting in increased audit fees. It will be very interesting from a scientific point of view to investigate how auditors’ conservatism has actually been affected during the recent financial crisis. Comparisons with the prior-to-crisis levels of conservatism will provide us with a clear view of these effects.

1.2  Objectives

The purpose of this research is to investigate the effects of the recent financial crisis concerning the external auditing tasks. More specifically, the impact of the current financial crisis on the auditors’ use of conservatism and the audit fees will be investigated. All previous studies have proved that auditing is severely affected by changes in the business world; consequently, a great influence in this case is expected as well.

The public -including also all related parties- is relying on auditors’ assurance about the discovery of frauds and advice for safer and profitable money investing. A proof of high professional standards based on the findings of this research will boost the trust and the lost confidence on auditors, especially today that the business world is still in the midst of a recession phase.

The motivation of this research results from the timeliness and the importance of this issue, considering the worldwide financial circumstances and the key role of the auditing profession. What is more, the great interest in actual practical and ethical considerations was the motivation to investigate issues from an academic point of view.

1.3  Problem Definition

The problem of this research can be summarized in the following question:

“What are the effects of the current financial crisis on auditors’ conservatism and audit fees concerning Dutch stock exchange quoted companies?”

In order to answer this main question the next sub-questions need to be answered:

a.  What is the theoretical background concerning financial information?

b.  What are the causes and the impacts of the present financial crisis for the business world?

c.  What is the content of the external auditors’ profession and what is the content of the term auditors’ conservatism?

d.  What is the relation between the audit conservatism and the audit fees?

e.  Based on prior research, in which way did the financial crisis influence the audit profession?

1.4  Methodology

The sample of this study will consist of Dutch listed firms audited by both the Big Four and non-Big Four audit firms. These firms were chosen because in general firms in The Netherlands are considered fast responding in changes and new developments. In addition, Dutch Big Four audit firms have proved to be very innovative and competent to consider their work effective, valid, and precise. This is highly significant since the starting point of this crisis (severe negative facts did actually happen) is considered 2008, only two years ago. Data prior to crisis will be gathered from years 2005-2006 and will be compared with the data during the crisis concerning the period 2008-2009. This comparison will take place in order to investigate the changes in auditors’ conservatism. Because three years are considered an adequate period concerning full adjustments in Sarbanes-Oxley act of 2002 requirements, while at the same time predictions of the upcoming crisis had not still taken place, the years of 2005-2006 have been selected. The years 2008 and 2009 are years of proved recession. Due to absence of data, 2010 cannot be investigated. Since they are published in the companies’ financial statements every year after June 2008, data on audit fees and auditors will be easily collected concerning 2008 and 2009. Consequently, the changes in audit fees will be found through the comparison of the audit fees between 2008 and 2009 due to the lack of disclosed data concerning 2005 and 2006. Access to this data, along with all the other financial data needed, can be provided by the Library Databases of the Erasmus University (Erasmus School of Economics). Other online sources of financial data are also the http://www.annualreports.com website and the http://www.ecb.int/pub/annual/html/index.en.html, which is the official internet site of the European Central Bank.

The variables that will be tested are auditors’ conservatism and audit fees in response to the recent financial crisis. The current financial crisis is the independent variable and the dependent variables consist of auditors’ conservatism and audit fees. The control variables are presented and explained in the relative part. With the ordinary least squares (OLS) a linear regression model will be used and estimated. More precisely, the adjusted version of the regression model Basu created in this research will be used.

1.5  Demarcation and limitations

The findings of this research will help to understand the causes of the changes in auditors’ conservatism, the implications concerning the auditing profession and the business world on a second level.

As in every scientific research, limitations exist that need to be considered. First, the period that will be investigated during the crisis is limited to the years 2008 and 2009 and because the presence of changes could be in a premature phase this may have implications concerning the findings. Inflation effects on audit fees, if any, should be captured too. Lack of data in audit fees for the years 2005-2006 limits the generalization of the findings concerning fees and makes the comparison between the periods prior and during the crisis not possible. However, the expectation exists that these results are representative concerning the audit firm industry.

1.6  Structure

The remainder of this study will continue according to the next structure: Chapter 2 is focused on the economic theories and the background on financial information. Chapter 3 deals with the present global financial crisis. Insights will be provided that refer to the causes and implications of the crisis on the business world. Chapter 4 analyzes the external auditing profession, the impacts of the financial crisis on it and the concept of audit conservatism, while Chapter 5 comments on the relation between the audit conservatism and audit fees. Chapter 6 demonstrates the methodology and findings of prior research conducted, concerning the subject of auditors’ use of conservatism and audit fees. Chapter 7 presents the research design that is used for the empirical part of this study and Chapter 8 provides the presentation of the results of the empirical testing. Finally, Chapter 9 analyzes the main conclusions and the limitations of this study and makes recommendations concerning the areas that the future research should focus on.