Auditing, Trust and Governance

Developing Regulation in Europe

Reiner Quick, Stuart Turley, Marleen Willekens

• Publisher: Routledge
• Year: 2007
• ISBN:
  9781134060238
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The reputation of corporate reporting has been in crisis. Trust in the process of financial accounting and auditing has been undermined by a series of high profile scandals involving major corporations, including Enron, Parmalat, Ahold, and Worldcom. In response, regulators and practitioners world-wide have put forward a series of initiatives to re

1 In the name of trust

Some thoughts about trust, audit quality and audit regulation in Europe

Aasmund Eilifsen and Marleen Willekens

1 Introduction

In this book stock is taken of the wave of regulatory changes and initiatives that took place in Europe in the post-Enron era and that relate to the statutory audit function. In many countries auditor independence rules have become tighter, more precisely specified, and the auditing activity has been put under the supervision of public company oversight boards. These and other related regulatory changes exhibit close resemblance to initiatives that have been taken in the US, and are often seen as responses to the public trust crisis of the capital markets which (supposedly) existed in the aftermath of a number of corporate fraud scandals such as Enron and Parmalat.

One often quoted rationale for the expansion of auditing regulations has been to restore public trust in audited financial information such that trust in the capital markets could be regained. Trust in capital markets is a necessary condition to enable those markets to allocate capital efficiently. This rationale, however, is based on (at least) three (implicit) assumptions. First, that trust in the capital markets had been eroded below an acceptable level. Second, that the external audit function had failed or was at least a major reason why this trust had been eroded. And third, that regulation is the answer, implying that increased regulation is able to restore trust.

Given these observations, we aim to focus on a number of issues in this introductory chapter. First, we briefly elaborate on the concept of a “trust crisis,” and question whether there is/has been evidence of a trust crisis in Europe in the aftermath of the accounting scandals (section 2). Second, we take stock of the empirical evidence on audit quality from European audit research contributions (section 3). We find that this evidence is fragmented and the results are mixed and highly country specific. This in itself triggers a number of interesting questions for future audit quality research in (and outside) Europe. Third, given that audit regulations have been increased in Europe, we draw from economic theory and welfare economics and elaborate on different types of regulations and their pros and cons and position the audit regulation debate within the broader framework of corporate governance regulation and recent evolutions therein (section 4). Finally, based on the reflections discussed in this chapter, throughout the text we provide some ideas for future research in auditing in (and perhaps outside) Europe. Note that our thoughts are very clearly biased by our own research backgrounds and preferences.

2 A trust crisis – really?

According to Webster’s dictionary, trust is defined as: “(the) assured reliance on the character, ability, strength, or truth of someone or something.” From this definition, it follows that the concept of trust in general is associated with the concepts of assurance and reliability (reliance). When trust is related to capital markets, reliance on the character, ability, strength, and truth of the capital market mechanisms is what is meant. To get that kind of assured reliability, various assuring mechanisms exist or are thinkable, one of which is an external audit of the financial information provided by the corporation. Indeed, an independent audit of financial statements leads to or should lead to reasonable assurance about the reliability of the financial statements. The latter are used as a source of information by capital market participants.

A further question is whether trust in capital markets was in a crisis. Webster’s definition of crisis is as follows:

1 a the turning point for better or worse in an acute disease or fever

b a paroxysmal attack of pain, distress, or disordered function

c an emotionally significant event or radical change of status in a persons’ life >a midlife crisis<

the decisive moment (as in a literary plot)

3 a an unstable or crucial time or state of affairs in which a decisive change is impending; especially: one with the distinct possibility of a highly undesirable outcome >a financial crisis<

b a situation that has reached a critical phase >the environmental crisis<.

Clearly from these definitions it seems that a crisis is associated with change or, stated alternatively, with discontinuity. Also, a crisis very often has a negative connotation as the possibility of a highly undesirable outcome is suggested. Applied to capital markets, a crisis could refer to discontinuity of certain capital market attributes. And if trust is defined by attributes such as character, ability, strength, and truth, a capital market trust crisis implies a discontinuity (for worse) regarding these attributes. Finally, a trust crisis also suggests that assurance in these attributes has failed.

Given this simple analysis of the concept of trust crisis, it would be interesting to investigate whether indeed the “necessary conditions” for a trust crisis did hold at the time that the new regulations were installed. That is, is there evidence of discontinuity in the character, ability, strength, or truth of European capital markets around and after the time of the Enron-Andersen collapse? For only if this is the case, can a trust crisis be used as the rationale for stricter regulations of the assurance mechanisms, including the audit. A huge challenge is to specify how these attributes are to be measured. Questions that could be addressed include: did the relative importance of alternative financing mechanisms, such as bank lending, increase in Europe as a result of the Enron debacle (character)? Were there significant drops in market capitalization in the European capital markets (ability)? What happened to market volumes and stock market performance in the different European markets (strength)? And what about the value relevance of the accounting numbers? Did it change as a result of the Enron debacle (truth)?

3 Empirical audit quality evidence from Europe

In the auditing literature audit quality is often related to the ability of the auditor to detect material misstatements in the financial statements (competence) and his/her willingness to issue an appropriate audit report based on the audit findings (independence). A standard reference is DeAngelo (1981: 186), who defines audit quality as the “market-assessed joint probability that a given auditor both discover (a) breach in the client’s accounting system, and (b) report the breach.” Audit quality is in most cases unobservable for parties not involved in the audit, including regulators. Details of the audit (production) process, such as audit planning, risk assessments, performed audit procedures, and evaluation of audit evidence, are not publicly disclosed. Normally the audit report is the only observable outcome of a statutory audit, and in most cases this is an unmodified (clean) report.

Serious audit quality deficiencies may result in an “audit failure.” One may state that an audit failure occurs when the auditor fails to issue a modified report when appropriate. Audit quality and audit failure rates are negatively correlated. Given this specification of audit failure, two distinct circumstances are associated with an audit failure. First, the auditor may have violated professional standards and regulations. Second, the auditor may have complied with professional standards and regulations, but still fail to detect all material misstatements. The latter reflects that an audit never will perfectly reveal the true state of the financial statements. Reducing the risk of not detecting all material misstatements to zero to obtain absolute assurance that the financial statements are free of all material misstatements is rarely attainable or cost beneficial (Eilifsen et al. 2006: 635). This is recognized in fundamental audit concepts such as “audit risk” and “reasonable assurance” and is communicated in the audit report.¹

As indicated above, audit quality is largely unobservable. Evidence from the US suggests that known audit failures with material consequences are relatively infrequent for publicly listed companies (Francis 2004). We are not aware of systematic European evidence on audit failure rates (as indicated by, for example, business failure rates, litigation cases, findings from inspections of auditors, and disciplinary cases against auditors). As audit working papers and “audit production” data in general are not accessible for research purposes, it is difficult to evaluate the quality of audit engagements. Even in the US, where a rich body of audit quality research has emerged since the 1980s, the evidence is rather limited in scope for that reason. Audit quality has typically been investigated through proxy measures. An important development in audit quality research is based on the premise that “differences” in audit quality exist and can be inferred by comparing different groups or classes of auditors and audit firms (Francis 2004: 352). In other words, it is assumed that audit quality is constant for a particular group of auditors. Most audit quality research builds its theoretical arguments on DeAngelo (1981), who posits that audit-firm size affects audit quality and that larger audit firms provide higher audit quality because they have more to lose from acting opportunistically (i.e. failing to report detected breaches). As audit-firm size is a tangible measure, it has served as a surrogate for audit quality in many studies. According to other more recently researched audit quality proxies auditor groupings are specified in different ways, for example by identifying industry specialist audit firms (partners) as higher-quality auditors (Ferguson et al. 2003, Francis et al. 2005).

Whether the specified auditor groupings indeed relate to higher audit quality has been typically tested by looking at whether audits performed by such auditors are related to (1) higher audit fee premiums (Simunic 1980, Ireland and Lennox 2002), (2) less earnings management in client financial statements (Becker et al. 1998, Francis et al. 1999), (3) higher likelihood of issuing a going-concern opinion for distressed firms (Ireland 2003), (4) fewer regulatory sanctions against such auditors (Feroz et al. 1991), and (5) fewer litigation cases against such auditors (Palmrose 1988). The US evidence that follows this research approach is quite rich (see Francis 2004 for a review of the US evidence). Due to institutional differences between US and European countries, and across European countries, not all designs are equally relevant in a European setting. For example, due to the lack of litigation cases in Europe there are no studies that tested audit-firm size proxies against occurrence of litigation. European studies typically focus on audit pricing, earnings management, and audit reporting. We therefore concentrate on European evidence from selected studies,² using one of these three common approaches toward audit quality. Note that not all European countries have been equally subject to audit quality research.

Before we discuss the European audit quality evidence, we would like to emphasize that other specifications of audit quality (than those discussed above) exist or are thinkable. Other dimensions of audit quality, for example, relate to the number of misstatements that are detected (see Eilifsen and Messier 2000), or the number of restatements of financial statements demanded by the auditor (see Kinney et al. 2004).

3.1 Quality differentiation inferred from audit fee studies

Following the seminal audit fee study by Simunic (1980), numerous audit fee studies have been executed worldwide (see Hay et al. 2006 for an overview). The vast majority of studies are performed on samples of publicly held client firms and report higher audit fees for Big N audit firms. The latter result may reflect higher audit quality, but, given the high level of supplier concentration in the audit market, it may also be an indication of oligopolistic rents earned by the Big N audit firms. The European evidence indicates that audit fee differentiation between Big N and non-Big N audit firms, and even within the group of Big N firms, is country specific. Further, European evidence on the effect of auditor specialization on audit fees is not conclusive.

Although the private client segment of the audit market is quite significant in Europe, most European studies investigate audit pricing based on samples of publicly held clients. The evidence for the latter segment deviates from the US findings, and is not unilaterally consistent with significantly higher fees charged by Big N audit firms. There is evidence of Big N premia in the UK (see, for example, Taffler and Ramalinggam 1982, Chan et al. 1993, Pong and Whittington 1994, Ireland and Lennox 2002,³ Pong 2004), Ireland (Simon and Taylor 2002), and Italy (Cameran 2005); but not in Denmark (Thinggaard and Kiertzer 2005, unpublished), the Netherlands (Langendijk 1997), and Norway (Firth 1997). Further, the observed Big N premium was attributed to PwC⁴ in Ireland and KPMG in Italy. In addition, Langendijk (1997) does find a premium attributed to KPMG in the Netherlands; Thinggaard and Kiertzer (2005) a PwC fee premium for small companies and a PwC fee discount for large companies in Denmark; and Firth (1997) reported weak evidence of a fee premium for Arthur Andersen in Norway.

Audit fee premiums, and thus potentially audit quality, may also be related to audit firms’ and auditors’ industry expertise. Langendijk’s (1997) findings suggest that industry specialist audit firms in the financial services industry in the Netherlands do not earn a higher fee than non-specialists. In contrast, Basioudis and Francis (2006, unpublished) find that city-specific industry leaders in the UK earn a premium relative to other Big Four auditors, while no premium for national industry leadership is present in their data.

Another relevant question in a European context is whether price differentiation is observed in the private client market segment?⁵ Willekens and Achmadi (2003) investigate the private client segment of the Belgian audit market. They report that audit pricing is significantly positively associated with the incumbent auditor’s market share. They also report a drop in the Bi...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Figures
• Tables
• Contributors
• Foreword
• 1. In the Name of Trust: Some Thoughts About Trust, Audit Quality and Audit Regulation In Europe
• 2. Audit Regulation In Belgium: Overregulation In a Limited Capital Market Oriented Country?
• 3. An Account of Accountants: Audit Regulation and the Audit Profession In Denmark
• 4. Developments In Auditing Regulation In Finland: From a National to an International Framework
• 5. The Regulatory Response In France to Accounting Scandals
• 6. Audit Regulation In Germany: Improvements Driven By Internationalization
• 7. Auditing In Italy: The Development of a Highly-Regulated Setting Before and After the Parmalat Case
• 8. The Auditing Profession In the Netherlands: From Limperg’s Principles to Detailed Rules
• 9. The Development of the Auditing Profession In Spain: Fast Evolution In a Highly Regulated Environment
• 10. Developments In the Framework of Auditing Regulation In the United Kingdom
• 11. Regulation and Trust In Auditing In Russia
• 12. Auditing In the United States: From Laissez Faire to Government Control In 70 Years
• 13. Understanding Regulation In Its Global Context