School of Accounting Seminar Series. How does mandatory IFRS adoption affect the audit service market? Chen Chen

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1 Australian School of Business Accounting School of Accounting Seminar Series Semester 1, 2014 How does mandatory IFRS adoption affect the audit service market? Chen Chen University of Auckland Date: Friday 16 th May 2014 Time: 3.00pm 4.30pm Venue: ASB Last updated: 9/05/14 CRICOS Code: 00098G

2 How Does Mandatory IFRS Adoption Affect the Audit Service Market? Chen Chen University of Auckland Zili Zhuang The Chinese University of Hong Kong Abstract Using data from 17 European countries, we examine how mandatory IFRS adoption affects the audit market and competition among auditors with different IFRS expertise. We argue that Big Four auditors have higher IFRS expertise than non-big Four auditors. Further, within the Big Four (non-big Four) audit market, PWC has (BDO and Grant Thornton have) higher expertise based on their relative market shares in the voluntary IFRS adopter market. We find that after IFRS adoption (i) audit quality of lower IFRS expertise auditors deteriorates while that of higher expertise auditors does not change; (ii) Lower IFRS expertise auditors increase audit fees more than higher expertise auditors; (iii) Higher IFRS expertise auditors gain market shares in countries with greater GAAP changes. The results hold for the overall audit market and within the non-big Four market, but not within the Big Four market, suggesting the latter are perceived as having similar IFRS expertise. Key words: IFRS adoption, audit quality, audit fees, audit expertise, Big Four auditors. Data Availability: Audit firm identities are primarily based on a dataset provided by Professor Luzi Hail, supplemented with our own hand collection. Other data are publicly available from sources identified in the paper. We would like to thank Steven Cahan, Liz Carson, Hans Christensen, Tony Kang, Xiaohong Liu, Gilad Livne, Gerald Lobo, Linda Myers, Suresh Radhakrishnan, Liu Zheng, conference participants at the 2011 AAA International Accounting Section Midyear Meeting, the 2013 EAA Annual Congress, and workshop participants at The Chinese University of Hong Kong, Monash University, Renmin University of China, Tsinghua University, and The University of Hong Kong for their helpful comments. We are grateful to Luzi Hail for sharing his auditor data with us. All errors are our own. 1

3 How Does Mandatory IFRS Adoption Affect the Audit Service Market? 1. Introduction There is a growing body of literature examining the economic consequences of the mandatory adoption of the International Financial Reporting Standards (IFRS), such as liquidity (Daske et al. [2008]), foreign mutual fund holdings (e.g., DeFond et al. [2011]), analysts forecasts (Byard, Li, and Yu [2011]), and investment efficiency (Chen, Young, and Zhuang [2013]). However, little research has directly examined the effects of IFRS adoption on the market for audit services and auditor competition. For example, we lack knowledge on whether audit quality increases, decreases, or remains constant from the pre-adoption period to the post-adoption period. It is important to understand the impacts of accounting regime changes, such as IFRS adoption, on the audit market, since such changes could affect the service quality of auditors and thus the quality of financial information supplied to users. Furthermore, audit firms differ in their expertise in IFRS. It is unclear how the effects of mandatory IFRS adoption on the quality, fees of audit services as well as markets shares differ across auditors with varying levels of IFRS expertise. We examine these issues in this paper because first, institutions and regulatory changes are expected to differentially affect different auditors (e.g., Choi et al. [2008], Francis and Wang [2008], DeFond and Lennox [2011]); and second, audit fee changes representing auditor revenue changes that help to inform the potential wealth redistribution effect among large and small auditors associated with IFRS adoption (Hail, Leuz, and Wysocki [2010]). IFRS are principles-based and fair value oriented (e.g., Ahmed, Neel, and Wang 2013). Auditors, who evaluate managers compliance with these standards, now have the difficult task of assessing whether the discretion exercised by managers, including managers fair value estimates, are in compliance with IFRS. While the audit quality is likely to be 2

4 negatively affected for all auditors due to the increased audit complexity associated with IFRS adoption, we argue that such an effect differs for auditors with different levels of expertise in IFRS. We define IFRS expertise for two levels of audit markets: the overall audit market, the Big Four audit market where clients employ Big Four auditors both before and after IFRS adoption, and the non-big Four audit market where clients employ non-big Four auditors both before and after IFRS adoption. For the overall audit market, we define the Big Four auditors as having higher IFRS expertise and the non-big Four auditors as having lower IFRS expertise. Big Four auditors are relatively more capable than non-big Four auditors of dealing with the increased audit complexity brought about by mandatory IFRS adoption for the following reasons. First, Big Four auditors have a greater capacity to provide high-quality professional judgments. They are also supported in the judgment process by a worldwide network of branches that tend to have more experience, and employ more advanced techniques (Carson [2009]). These in turn help them to obtain higher IFRS expertise more quickly than non-big Four auditors. Second, IFRS may be geared towards Big Four audit firms to some extent as they are likely to have influenced the specific standards by being involved in the standard-setting process (e.g., having representatives on the IFRS interpretation committee or writing comment letters). This gives Big Four auditors a further competitive edge in auditing IFRS-based financial reports. Third, Big Four auditors may already have experience of IFRS through serving clients who voluntarily adopted IFRS before In contrast, non-big Four auditors lack the competence in making professional judgments (Carcello, Vanstraelen, and Willenborg [2009]), and need to expend more effort than Big Four auditors in dealing with the audit complexity associated with IFRS. Within the Big Four audit market, IFRS expertise can also differ among the four audit firms. While Big Four auditors all have worldwide network of branches and all were involved 3

5 in the IFRS standard setting process, they differ in their experience in auditing IFRS financial reports. Specifically, their markets shares in the voluntary IFRS adopter market are not onefourth each. A significantly higher market share than the peers could signify a higher level of expertise in a market segment such as an industry (Reichelt and Wang [2010]). Our data reveal that PWC has a 35% market share in the voluntary IFRS adopter market, higher than the other three. And we define PWC as having higher perceived IFRS expertise among Big Four auditors. Similarly, Within the non-big Four audit market, BDO and Grant Thornton have significantly higher market shares in the voluntary IFRS adopter market. In addition, these two auditors, like the Big Four auditors, were involved in the IFRS standard setting process. Therefore, we define BDO and Grant Thornton as having higher IFRS expertise among non-big Four auditors. Auditors with higher IFRS expertise are better prepared to cope with the audit complexity brought about by mandatory IFRS adoption than those with lower IFRS expertise. As such, we predict that the audit quality gap between these two types of auditors is greater after IFRS adoption. Compared with high IFRS expertise audit firms, the lack of IFRS expertise of low IFRS expertise auditors implies that they need to expend more effort after IFRS adoption to be competent in auditing IFRS financial reports. To the extent that audit fees reflect audit efforts, we predict that auditors with lower IFRS expertise increase audit fees more than those with higher IFRS expertise. Note that this does not necessarily imply that the former increase profits more than the latter as audit fees are their revenues and we do not have information in changes in their costs. The increased audit complexity is high in countries whose pre-adoption local GAAP are very different from IFRS than in countries where IFRS adoption involves fewer changes in GAAP. Therefore, we further expect that the above patterns in audit quality and audit fees are limited to or more pronounced in countries with greater GAAP changes. Relatedly, in countries where IFRS adoption means greater 4

6 changes in GAAP, auditors with higher IFRS expertise are expected to gain market shares from other auditors because of their relatively superior quality and a smaller increase in audit fees. Our sample contains mandatory IFRS adopters in 17 European countries. Using accrual quality and the issuance of going concern opinions as measures of audit quality, we find that compared to the pre-adoption period, the audit quality gap between Big Four (i.e., higher IFRS expertise) auditors and non-big Four (i.e., lower IFRS expertise) auditors is higher after IFRS adoption. Specifically, the audit quality of non-big Four auditors decreases from the pre-adoption to the post-adoption period, while that of Big Four auditors does not change. Therefore, the audit quality gap increases after IFRS adoption. We also find that non- Big Four auditors increase audit fees more than Big Four auditors. The two findings are more pronounced in countries where the difference between the pre-adoption domestic accounting standards and IFRS is larger. We also find that Big Four auditors market shares increase in countries with greater GAAP changes. When we examine IFRS expertise within Big Four audit firms and within non-big Four audit firms, our whole sample results hold for the non- Big Four audit market subsample, but not the Big Four audit market subsample. Overall, our evidence is consistent with the prediction that the audit quality gap between auditors with higher IFRS expertise and those with lower IFRS expertise increases after IFRS adoption, the former increases audit fees less and gains market shares from the latter in countries with greater GAAP changes. It also suggests that clients view Big Four audit firms as having about the same level of IFRS expertise but they do view non-big Four auditors as having different levels of IFRS expertise. In additional analysis, we find that our audit quality results are stronger in countries with strong institutions, but our audit fee result are not affected by the strength of a country s legal enforcement. Our results are not likely to have been driven by concurrent non-ifrs 5

7 regulatory changes in Europe (Christensen, Hail, and Leuz [2013]). Our results are also robust to the difference-in-differences design where we use matched firms in the U.S and Japan as the control sample. 1 Finally, we repeat our analysis for each individual country in our sample, and find that our results hold in multiple countries and are not driven by the few largest countries in our sample. This study contributes to the broad line of research examining the economic consequences of regulations in general and of mandatory IFRS adoption in particular. Regulations such as the Sarbanes-Oxley Act are found to have significant impacts on various aspects of auditing (e.g., DeFond and Lennox [2011]). Despite the mandatory adoption of IFRS by over 3,000 E.U. firms, there is very limited research on how this change in standards affects audits. While Kim, Liu, and Zheng [2012] and De George, Ferguson, and Spear [2013] document higher audit fees after IFRS adoption in the EU and Australia respectively, whether the increased audit fees merely represent a shock to audit costs or are associated with improved audit quality remains an open question. This study makes a distinctive contribution by showing that audit quality is not necessarily uniformly higher or lower after mandatory IFRS adoption, but depends on how IFRS affect the ability of enforcement by different types of auditors as they have different level of IFRS expertise. By showing that audit quality and audit fees for large and small auditors are affected differently by the new accounting standards, we provide important evidence on the effects of IFRS regulation on audits. We also contribute to the audit literature relating to auditors expertise. The literature has argued the industry specialists presumably have a greater knowledge of their client s industry and are better able to evaluate the client s financial statement. Our paper enriches the literature by documenting the audit specialists can also have greater knowledge of IFRS 1 We do not tabulate the difference-in-differences results because while this approach controls for contemporaneous changes in the audit market (e.g., the time-series of audit quality gap between difference auditors) unrelated to IFRS, we note that local (non-big Four) auditors in the U.S. and Japan may not be comparable to local auditors in European countries. As such, the control sample may not be a control sample. 6

8 adoption and are better able to utilize the advantage in auditing the mandatory IFRS adopters. However, our results also indicate that market share, which are commonly used in the audit industry expertise literature may not always be the best measure of audit expertise, at least in the Big Four IFRS setting. In addition, we show that the cross-country institutional features, such as the preadoption difference between local GAAP and IFRS and legal environments, affect the audit quality and audit fee changes of Big Four and non-big Four auditors associated with IFRS adoption. Francis and Wang [2008] cast doubt on the effects of harmonizing auditing and financial reporting standards around the world. They argue that institutional factors shape auditors behavior around the world, and that mandating uniform audit and accounting standards alone may not guarantee improved audit quality. Our study provides direct answers to the question raised by Francis and Wang [2008]. Choi et al. [2008] find that Big Four audit fee premium is affected by country institutions and their results are opposite to Francis and Wang [2008]. Therefore, how institutions affect the two types of auditors differently is unresolved. We add to the audit literature by finding that the increase in audit quality gap between Big Four auditors and non-big Four auditors after mandatory IFRS adoption is more pronounced in countries with strong legal regimes, consistent with Francis and Wang [2008]. Our finding highlights the importance of institutional arrangements, rather than accounting standards alone, in shaping the outcome of financial reporting and auditing convergence. 2. Hypothesis Development 2.1. IFRS Adoption and Audit Complexity IFRS are a set of new accounting standards that are more principles-based and fair value oriented than many of the local accounting standards. We note that IFRS adoption increases audit complexity. Such increased audit complexity affect the three aspects of the 7

9 audit service market and auditor competition that we investigate: audit quality, audit fees, and audit market shares. With the mandatory adoption of IFRS, auditors now have the difficult task of assessing managers compliance with the new accounting standards including judgment on things like managers fair value estimates. Because audit firms have different expertise and experience with IFRS, the degrees of audit complexity increase differ among them. Consequently, their audit quality, audit fees, and audit market shares are likely to be affected differently by mandatory IFRS adoption. Audit quality is likely to be affected less for auditors that are more knowledgeable on IFRS and have more experience in auditing IFRSbased financial reports than for other auditors. Auditors with less IFRS expertise need to expand more effort in auditing IFRS-based financial reports than those with more IFRS expertise. To the extent that audit fees reflect audit efforts, the audit fee change related to IFRS adoption likely differs across the two types of auditors. Regarding market shares, auditors with higher IFRS expertise are likely to gain market shares from other auditors, especially in countries whose pre-ifrs GAAP is very different from IFRS (i.e., higher audit complexity) IFRS Expertise and Audit Quality When IFRS adoption is mandated, many technical verification issues, such as fair value measurements, related party disclosures, intangible asset verifications, and accounting for retirement benefits, must be addressed to certify IFRS compliance. This change requires auditors to have a greater ability to deal with principles-based compliance issues and to make professional judgments. Moreover, IFRS s introduction of more fair value accounting requires that auditors master more sophisticated valuation techniques and develop a deeper understanding of financial markets. Therefore, auditors need to acquire more expertise and 8

10 expend more effort to cope with mandatory adoption of IFRS (Kim, Liu, and Zheng [2012]). The service quality of different audit firms is affected differentially because they differ in IFRS knowledge and experience at the time of mandatory IFRS adoption. For example, in comparison with non-big Four auditors, Big Four auditors tend to have a greater capacity to provide high-quality professional judgments, as they have more resources to offer specialist training to their staff and are supported in the judgment process by a worldwide network of branches (Vera-Munoz, Ho, and Chow [2006]). 2 Dopuch and Simunic [1980] suggest that auditors in large audit firms are more competent than those in small firms. Large audit firms are better able to recruit graduates from leading universities, hire reputable and experienced specialists from the labor market, and offer specialized training to their staff. In contrast, small local auditors likely have neither the same ability nor the same degree of technical expertise when engaging in the professional decision-making process. Furthermore, some audit firms have more experience and a better understanding of IFRS than others (Hail, Leuz, and Wysocki [2010]). One reason for such differences is that some auditors are involved in the standard-setting process which could potentially make IFRS geared towards their expertise and preference. For example, all Big Four audit firms plus BDO and Grant Thornton have representatives in the IFRS Advisory Council, which is the formal advisory body to the IASB; 3 and all six have issued comment letters on IASBproposed standard changes. 4 In contrast, small local auditors do not have significant involvement in the IFRS standard-setting process. Consequently, they are likely to have a 2 Big Four auditors tend to have specialized audit knowledge stored in centralized databases for use and retrieval by offices in different countries. Examples are KPMG s KWorld and Ernst & Young s Knowledge Web (Vera- Munoz, Ho, and Chow [2006]). 3 The IFRS Advisory Council is comprised of representatives from user groups, preparers, auditors, analysts, academics, investor groups, etc. The following link provides the details: organisation/advisory-bodies/ifrs-advisory-council/ifrs-advisory-council-membership/pages/ifrs- Advisory-Council-membership.aspx 4 In addition, Big Four auditors, but not non-big Four auditors, have representatives in the IFRS Interpretation Committee. Also, 25% of previous and incumbent IASB board members worked for Big Four firms before they joined IASB, yet that percentage is zero for non-big Four auditors. Details are at 9

11 disadvantage in terms of IFRS expertise. The differences in IFRS expertise can also result from different levels of experience in auditing IFRS reporting prior to For example, the Big Four were more likely to serve as auditors for European firms that voluntary adopted IFRS before 2005, and the spillovers of their accumulated knowledge help other offices in IFRS auditing. 5 As such, Big Four auditors have higher IFRS expertise than non-big Four auditors. However, even within Big Four (or within non-big Four) audit firms, the market shares of all voluntary adopters are not divided evenly. A specific audit firm may audit a higher percentage of those voluntary IFRS adopters than others. Market shares are viewed as an indication of auditor expertise in a particular segment of the audit market (e.g., Mayhew and Wilkins [2003]; Reichelt and Wang [2010]). In our case, a higher market share of the voluntary adopters market before 2005 signifies higher IFRS expertise. While the market share argument implies that Big Four have more IFRS knowledge than non-big Four auditors, it also implies that within Big Four (or within non-big Four) audit firms, those with higher markets shares in the voluntary IFRS adopter market are perceived to have higher IFRS expertise than their peers. IFRS adoption also increases managers flexibility in accounting choices. When managers are offered more flexibility in the financial reporting process, they may have greater incentives to use this flexibility to their own advantage. Given the potential for managers to engage in opportunistic behavior, auditors have to negotiate with them to discuss their subjective estimates or choices in financial reports. A principles-based system arguably requires auditors to use their judgment and stand up to their clients to a much greater extent than they would under a rules-based system (e.g., Lambert [2010]). Ceteris paribus, auditors that have more specialized expertise in IFRS are more able to judge the appropriateness of 5 We find that 88% of voluntary IFRS adopter firms are audited by Big Four auditors. 10

12 clients use of IFRS-allowed flexibility in financial reporting. 6 The larger the difference between the pre-adoption local accounting standards and IFRS, the more complex the auditor s job is likely to become after IFRS adoption. Our arguments imply that the larger the difference between local GAAP and IFRS, the larger the advantage that auditors with IFRS expertise have over other auditors in competence upon the transition to IFRS. Based on the discussion, we expect the following: H1: The audit quality difference between auditors with higher and lower IFRS expertise increases after mandatory IFRS adoption. Such an increase is more pronounced in or limited to countries with greater GAAP changes IFRS Expertise and Audit Fees Kim, Liu, and Zheng [2012] argue that two factors predict the change in audit fees after IFRS adoption in opposite directions. First, if IFRS adoption increases financial reporting quality, then the likelihood of financial misstatement is lower. Consequently, audit risk and audit fees would be lower. Alternatively, IFRS require auditors to make more complex estimates and use greater professional judgment, since IFRS are comprehensive, fair value oriented, and principles based (KPMG [2007], Deloitte [2008]). IFRS involve more footnote disclosure, requiring the auditor to certify financial information of a different nature than was previously reported under domestic GAAP (Webb [2006]). This implies that audit fees would be higher after IFRS adoption. Empirically, Kim, Liu, and Zheng [2012] and De George, Ferguson, Spear [2013] find that audit fees are higher after IFRS adoption, suggesting that the increase in audit complexity dominates the financial reporting quality factor in affecting audit fees. Furthermore, greater flexibility in managers financial reporting 6 Auditor independence is also important factor for audit quality. DeAngelo [1981] argues that auditors commitment to independence is positively related to audit firm size because larger auditors have higher quasirents. Our argument implies that larger auditors tend to have higher IFRS expertise. Following DeAngelo [1981], they also tend to be more independent. 11

13 process allowed under IFRS increases audit risk, in turn also increasing audit fees. As discussed earlier, auditors with higher IFRS expertise have greater capabilities for coping with audit complexity than those with lower IFRS expertise. This implies that the incremental costs incurred by these auditors during the switch from local accounting standards to IFRS are lower than those for other auditors. Correspondingly, we expect that auditors with lower IFRS expertise increase fees more than auditors with higher expertise do. When the difference between local GAAP and IFRS is large, auditors with lower IFRS expertise have to expend more effort to deal with the increased audit complexity than when the difference between local GAAP and IFRS is small. Therefore, the higher increase in audit fees by auditors with lower IFRS expertise in the post-adoption period is more pronounced when the GAAP difference is larger. In other words, we expect the following: H2: Audit fees increase more after mandatory IFRS adoption for auditors with lower IFRS expertise than for auditors with higher IFRS expertise. Such an audit fee change pattern is more pronounced in or limited to countries with greater GAAP changes IFRS Expertise and Audit Market Shares To provide a comprehensive examination of the impacts of IFRS adoption on the audit market and auditor competition, we also investigate market share changes resulting from auditor switches when transitioning to IFRS. We first note that a larger GAAP change can reduce the incumbent auditor s competitive advantage due to its lack of IFRS expertise, while the impact is much reduced when the transitioning to IFRS results in a smaller GAAP change. Therefore, we expect auditor switch and thus market share changes to mainly take place in countries with greater GAAP changes. Furthermore, if the increased quality gap between auditors with higher IFRS expertise and those with lower expertise, and that the latter increases audit fees more than the former, 12

14 then auditors with higher IFRS expertise will are expected to gain market shares from other auditors. We have the following hypothesis: H3: Clients of auditors with lower IFRS expertise switch to auditors with higher IFRS expertise. Such a change of market share is limited to countries with greater GAAP changes We categorize auditors with higher or lower IFRS expertise in three different settings. The first is based on the whole audit market, where Big Four auditors are perceived to have higher IFRS expertise and non-big Four auditors lower IFRS expertise. The second is based on the audit market within Big Four auditors, where the Big Four auditor(s) with distinctively higher market shares of voluntary IFRS adopters before 2005 are perceived to have more IFRS expertise. The third is based on the audit market within non-big Four auditors, where again the non-big Four auditor(s) with significantly higher market shares of voluntary IFRS adopters are perceived to have more IFRS expertise. 3. Research Design 3.1. Audit Firm IFRS Expertise and Audit Complexity We use three samples to test our hypotheses. The first sample is the whole audit market that consists of the Big Four market and the non-big Four market. In this setting, we use the Big Four status to define higher IFRS expertise, because they have more network support and experience with IFRS (e.g., through involvement in standard setting and auditing voluntary IFRS adopters before 2005) in comparison to non-big Four auditors as discussed in Section 2. The second sample is the Big Four audit market subsample consisting of firms that employ Big Four auditors in both the pre- and post-ifrs periods. The third sample is the non-big Four audit market subsample consisting of firms that employ non-big Four auditors in both the pre- and the post-ifrs periods. For these two subsamples, we follow the literature 13

15 on industry expertise (Mayhew and Wilkins [2003]; Reichelt and Wang [2010]) and classify a particular auditor s level of IFRS expertise according to its market share in the voluntary IFRS adopter market. Specifically, in the Big Four audit market for voluntary IFRS adopters, PWC has a 35% market share in Ernst & Young and KPMG have a 25% market share each, whereas Deloitte has a 15% market share. In the non-big Four market for voluntary IFRS adopters, BDO has a 39% market share and Grant Thornton has a 37% market share. The third highest market share for the voluntary adopter market for a non-big Four auditor is 11% and the audit firm is Moore Stephens. Following Reichelt and Wang [2010], we use market shares to define the IFRS expertise in two ways. The first is that an auditor has high IFRS expertise if the auditor has the largest market share in the voluntary IFRS adopter sample in 2004 and the different between its market share and the second largest market share is at least 10%. The second is that an auditor has high IFRS expertise if the auditor has a market share greater than 30% in the voluntary IFRS adopter sample in Satisfying both definitions, PWC is classified as having high IFRS expertise among the Big Four auditors. BDO and Grant Thornton are classified as the IFRS expertise in among the non-big Four auditors, again satisfying both definitions. Following Kim, Liu, and Zheng [2012], we use the Absence score and Divergence score from Ding et al. [2007] to construct the audit complexity measure. Ding et al. [2007] classify the difference between local GAAP and IFRS along two dimensions: the Absence score is based on the number of accounting rules regarding particular accounting issues that are missing in the (pre-ifrs) local GAAP, but that are explicitly in IFRS; the Divergence score is based on the number of accounting rules regarding the same accounting issue that differ between local GAAP and IFRS. We define an indicator variable, COMPLEX, that equals one if the change in audit complexity measured by the sum of the Absence score and 14

16 the Divergence score from Ding et al. [2007] is above the sample median, and zero otherwise. Countries with COMPLEX equal to one have greater GAAP changes after IFRS adoption, and thus greater increased audit complexity Research Design for Audit Quality The literature assumes that audit quality can be inferred by examining clients earnings properties and implied earnings management behavior (e.g., Becker et al. [1998]). Following prior audit research, we use the following audit quality measures: (1) accrual quality developed by Dechow and Dichev [2002] (e.g., Francis and Yu 2009); 7 and (2) going concern opinions (e.g., Francis and Yu 2009). Specifically, to test H1, we estimate the following three models, each using a different audit quality measure. 8 The first regression model uses accrual quality to measure audit quality: AQ = α0 + α1post + α2exp + α3post*exp + βkcontvk + Country Effects + Industry Effects + ε (1) where AQ is the accrual quality measure based on Dechow and Dichev [2002]. AQ for year t is the standard deviation of the residuals for a firm calculated over the past five years (i.e., year t-4 through year t). 9 Consistent with prior studies (e.g., Francis et al. [2005]), we run the Dechow and Dichev [2002] model for each two-digit SIC industry-year group with at least 20 observations in the group. 10 POST is an indicator variable that equals one for the post-ifrs period (2005/ ), and zero for the pre-ifrs period ( /2005). The adoption year is labeled 2005 for firms with a December fiscal year end, and 2006 for firms with a 7 Using discretionary accruals and small positive net income to proxy for audit quality does not alter our inferences. 8 For notational simplicity, we omit the firm-year subscripts i,t in the equations and tables. 9 We only use AQ values in 2004 or 2005 and in 2009 to avoid estimating AQ with numbers generated with both local accounting standards and IFRS (e.g., AQ for 2007 involves accrual residuals for years ). 10 In robustness tests, we also use the Fama and French s [1997] industry classification. The inferences remain unchanged. 15

17 non-december fiscal year end. EXP is an indicator variable that equals one if the firm is audited an auditor with higher IFRS expertise, and zero if it audited by an auditor with lower IFRS expertise. 11 In the full sample consisting of both the Big Four audit market and the non- Big Four audit market, EXP equals one if the auditor is a Big Four auditor, and zero otherwise. In the Big Four audit market subsample, EXP equals one if the auditor is PWC, and zero otherwise. In the non-big Four subsample, EXP equals one is the auditor is BDO or Grant Thornton, and zero otherwise. Since higher standard deviations of residual accruals imply lower audit quality, we predicts that α3 is negative. In addition to country and industry effects, we include five control variables (CONTVk) following Dechow and Dichev [2002] and Francis et al. [2005]. TA is the natural logarithm of year-end total assets in millions of U.S. dollars. OC is the natural logarithm of a firm s operating cycle, where operating cycle equals the sum of turnover days for accounts receivables and inventories. NEGEARN is the incidence of negative earnings over the past ten years. (CFO) is the standard deviation of a firm s cash flows from operations, calculated over the past ten years. (SALE) is the standard deviation of a firm s sales, calculated over the past ten years. Consistent with Francis et al. [2005], we require at least five observations in each rolling 10-year window to calculate (CFO) ands (SALE). Our second measure of audit quality is the likelihood of issuing first-time going concern opinions for financially distressed firms. 12 We run the following logistic regression. Logit(Pr(GC=1)) = α0 + α1post +α2exp + α3post*big4 + βkcontvk + Country Effects + Industry Effects + ε (2) where GC is an indicator variable that equals one if the firm receives a first-time going concern opinion, and zero otherwise. The going-concern model follows Francis and Yu 11 For French firms audited by two auditors simultaneously, we define the EXP indicator as equal to one if one of the auditors is a Big Four auditor, and zero otherwise. This applies to our whole sample tests and the within Big Four sample tests. 12 Following Francis and Yu [2009], we define a firm-year observation as financially distressed if the firm has a negative net income or negative operating cash flows in the year. 16

18 [2009]. In addition to country and industry effects, we include the following control variables, as in Francis and Yu [2009]. TA is the natural logarithm of total assets. AGE is the natural logarithm of the number of years that the client firm appears in Worldscope. LEV is the yearend total liabilities divided by year-end total assets. LOSS is an indicator variable that equals one for observations with annual net income less than 0, and zero otherwise. CLEV is the change of LEV. RET is the firm s cumulative stock return over the current year. CFO is the operating cash flow scaled by total assets for the current year. FINANCE is an indicator variable that equals one if the client has a new issuance of equity or debt over the subsequent fiscal year (i.e., positive EISSUE or positive DISSUE), and zero otherwise. ZSCORE is Altman s [1968] Z-score. VOL is the standard deviation of monthly stock returns over the current year. INVEST is cash and cash equivalents scaled by total assets. We predict that α3 is positive. We also add the three-way interaction term POST*EXP* COMPLEX, as well as the relevant two-way interaction terms and main effect involving COMPLEX to equations (1) and (2). We call these equations augmented equations (1) to (2). Our hypothesis predicts that the coefficient on POST*EXP* COMPLEX is negative in augmented equations (1) and positive in augmented equation (2) Research Design for Audit Fees To conduct the audit fee test, we run the following regression: AUDFEE = α0 + α1post + α2exp + α3post*exp + βkcontvk + Country Effects + Industry Effects + ε (3) where AUDITFEE is the natural logarithm of audit fees in thousands of U.S. dollars. In addition to country and industry effects, the following control variables are included, as in Kim, Liu, and Zheng [2012]. TA is the natural logarithm of total assets. INVREC is the sum of inventories and receivables divided by total assets. NBS is the natural logarithm of 1 plus 17

19 the number of business segments. NGS is the natural logarithm of 1 plus the number of geographical segments. LEV is the year-end total liabilities divided by year-end total assets. LOSS is an indicator variable that equals one for observations with annual net income less than 0, and zero otherwise. QUICK is the quick ratio, equal to quick assets divided by current liabilities. MTB is the ratio of the firm s market value to the book value of its common equity. SPECIAL is an indicator variable that equals one if the firm reports special items, and zero otherwise. QUALIFIED is an indicator variable that equals one if the firm receives qualified opinion, and zero otherwise. MERGE is an indicator variable that equals one if the firm is engaged in a merger or acquisition, and zero otherwise. FINANCE is an indicator variable that equals one if the client has a new issuance of equity or debt over the subsequent fiscal year (i.e., positive EISSUE or positive DISSUE), and zero otherwise. XLIST is an indicator variable that equals one if the firm is cross listed on any U.S. stock exchanges, and zero otherwise. We predict that α3 is negative. We add the three-way interaction term POST*EXP* COMPLEX, as well as the relevant two-way interaction terms and main effect involving COMPLEX to equation (3) and call it augmented equation (3). Our hypothesis H2 predicts that the coefficient on POST* EXP* COMPLEX is negative in augmented equation (3) Research Design for Market Shares To test the market share changes around IFRS, we run the following regression: EXP = α0 + α1post + α2post*δcomplex + βkcontvk + Country Effects + Industry Effects + ε (4) It is worth mentioning that in our market share test we require that the firm is present in all the five years between 2003 and 2007 so that we can measure whether auditors lose existing clients to each other. The dependent variable is the EXP indicator variable. POST is 18

20 an indicator variable that equals one for observations in the adoption period (2005/ ), and zero for the pre-adoption period ( /2005). Following the literature (e.g., Landsman, Nelson and Rountree [2009]), we include the following control variables. EMV is the natural logarithm of year-end market value of equity in millions of U.S. dollars. TURN is the sales divided by year-end total assets. LEV is the year-end total liabilities divided by yearend total assets. LOSS is an indicator variable that equals one for observations with annual net income less than 0, and zero otherwise. MTB is the ratio of the firm s market value to the book value of its common equity. FINANCE is an indicator variable that equals one if the client has a new issuance of equity or debt over the subsequent fiscal year (i.e., positive EISSUE or positive DISSUE), and zero otherwise. MERGE is an indicator variable that equals one if the firm is engaged in a merger or acquisition, and zero otherwise. ROA is the net income divided by total assets. XLIST is an indicator variable that equals one if the firm is cross listed on any U.S. stock exchanges, and zero otherwise. GROWTH is the annual percentage change in sales. ANALYST is the natural logarithm of 1 plus the number of analysts following the firm (from I/B/E/S). NEWLISTING is an indicator variable that equals one for firm-year observations of firms that were first listed in the years , and zero otherwise. Our hypothesis H3 predicts that α2 is positive. Throughout the paper, we report test statistics based on robust standard errors clustered at the firm level Sample and Empirical Results 4.1. Sample and Descriptive Statistics We obtain an initial sample of 24,112 firm-year observations from Worldscope. It contains all mandatory IFRS adopters in the 17 European countries of Austria, Belgium, 13 The inferences do not change if we use standard errors clustered by country. 19

21 Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom (U.K.). The sample covers the period We exclude firms in the banking, insurance, or other financial services industries. We further require firms to have non-missing values on our test and control variables. Because of missing values associated with different variables, the samples used in different regressions differ. The final treatment sample contains 3,268 firm-year observations for the accrual quality test, 3,662 firm-year observations for the going concern test, and 10,514 firm-year observations for the audit fee test and 9,380 firm-year observations for market share test. 14 Worldscope only provides the identities of incumbent auditors for the most recent year (i.e., current year ), and does not have historical audit firm identities. To get accurate information on which auditors a firm employed in each year in the past, we use handcollected audit firm identities for each firm in each year. 15 To mitigate the undue influence of outliers, all the continuous variables are winsorized at the 1 st and 99 th percentiles. [Insert Table 1 about here] Table 1 provides the summary of sample observations by country. Most of the IFRS mandatory adopters are from U.K.. Table 2 provides univariate tests for dependent variables used in our regression analysis. We report the mean value of difference of variables between IFRS expertise and non IFRS expertise, for the pre-adoption period (pre-ifrs) and postadoption period (post-ifrs) in our three different settings. 14 Untabulated results show that our findings remain unchanged if we require a common sample in all the four tests. 15 We thank Luzi Hail for sharing his auditor identity dataset with us. We supplemented that dataset with our own hand collection of audit firm identities. 20

22 Panel A of Table 2 shows the univarite test for our full sample where we compare the difference of audit quality, audit fee and market share between Big Four auditor and non-big Four auditors. Column (1) in Panel A shows the audit quality measured by clients standard deviation of accrual residuals (i.e., the Dechow and Dichev [2002] model) is higher for Big Four auditors than non-big Four auditors in our sample and in both the pre-ifrs period and post-ifrs period as indicated by the significantly negative values in difference. However, the audit quality gap increases significantly from the pre-ifrs period to the post-ifrs period (the gap widens from to ). Untabulated t test indicates that the Big Four audit quality does not change from pre-ifrs period to post-ifrs period, but the non-big Four audit quality significantly decreases from the pre-ifrs period (0.057) to the post-ifrs period (0.081) with a p-value of Using clients likelihood of receiving a first-time going concern audit opinion as a measure of audit quality, Column (2) shows again that the audit quality gap between Big Four and non-big Four auditors increases significantly in the post-ifrs period. In particular, non- Big Four auditors reduce the likelihood of issuing first-time going concern audit opinion significantly after IFRS adoption. In summary, the univariate statistics in Column (1) and Column (2) suggest increased audit quality gap between Big Four and non-big Four auditors for IFRS mandatory adopters in the post-adoption period and it is mainly due to the worsened audit quality provided by non-big Four auditors. Column (3) of Panel A displays the audit fee pattern. It is easy to identify that the audit fee gap between Big Four and non-big Four auditors becomes smaller in the post-ifrs period for the treatment firms (with a decrease of 0.111). Column (4) of Panel A shows the Big Four auditors market share across the pre-ifrs period and post-ifrs period. It is found that Big Four auditors market share doesn t change significantly in our event period. 21

23 Panel B of Table 2 displays the comparison of difference in audit quality, audit fee and market share between PWC and other three Big Four auditors for our Big Four auditor sample. In fact, we don t find any significant change for the difference in the Pre and Post IFRS period. Panel C of Table 2 displays the comparison of difference in audit quality, audit fee and market share between BDO/Grant Thornton and other non-big Four auditors for our non- Big Four auditor sample. We find the audit quality gap becomes widen after IFRS adoption and the audit fee gap has the similar pattern. The last but not least, we also find the market share of BDO/Grant Thornton increase significantly for our non-big Four Sample. [Insert Table 2 about here] 4.2. Audit Quality Test Table 3 reports results for testing H1, which is concerned with the differential impacts on audit quality of IFRS expertise and non-ifrs expertise brought about by mandatory IFRS adoption. Panel A shows the results when Big Four auditor is used to proxy for IFRS expertise in our full sample. As shown in column (1) of Panel A, the coefficient on POST is positive and significant (coefficient = 0.025, t = 2.20), suggesting that the audit quality of non-big Four auditors in our mandatory IFRS adopters decreases from the pre-adoption to the post-adoption period. Our interested coefficient, the coefficient on POST *BIG4 is negative and significant (coefficient = , t = -2.34), suggesting that Big Four auditors audit quality increases relative to non-big Four auditors in the post-adoption period. The combination of coefficients POST+POST*BIG4 is insignificant (p-value = 0.555), indicating that Big Four audit quality of mandatory IFRS adopters does not change from the preadoption to the post-adoption period. In summary: first, the audit quality of non-big Four 22

24 auditors in our sample deteriorates after IFRS adoption; second, the audit quality of Big Four auditors remains unchanged from the pre-adoption to the post-adoption period; and third, after IFRS adoption, the audit quality gap between Big Four and non-big Four auditors increases, consistent with H1. Column (2) of Panel A reports the test result when the three-way interaction term POST* BIG4* COMPLEX as well as the relevant two-way interaction terms are added into equations (1). Our interested coefficient, the coefficient on POST*BIG4* COMPLEX is negative and significant at the 0.05 level (coefficient = , t =-2.25), and the coefficient on POST *BIG4 is still negative and significant at the 0.10 level (coefficient = , t =- 1.74). These results indicate that in the countries with greater IFRS changes, the increased audit quality gap between Big Four and non-big Four auditors becomes larger, which is also consistent with our H1. Column (3) of Panel A presents the test result using the likelihood of issuing a first time going-concern opinion as a measure of audit quality. The coefficients on POST is negatively significant, suggesting that non-big Four auditors are less likely to issue first time going-concern audit opinions in the post IFRS adoption period. Our interested coefficient, the coefficient on POST*BIG4 is positive and significant at the 0.05 level (coefficient = 0.419, χ 2 = 4.35), suggesting that Big Four auditors are more likely to issue first time going-concern audit opinions to their clients in the post IFRS period compared to their non-big Four counterparts. The combination of coefficients POST+POST*EXP is insignificant (p-value = 0.716), indicating that Big Four auditors tendency of issuing going-concern audit opinion doesn t change from the pre-adoption to the post-adoption period. To summarize, the audit quality of non-big Four auditors decreases in the post-adoption period whereas the audit quality of Big Four auditors remain unchanged. Therefore, the audit quality gap between Big Four and non-big Four auditors becomes larger as a result of IFRS adoption. 23

25 Column (4) of Panel A reports the test result when the three-way interaction term POST* BIG4* COMPLEX as well as the relevant two-way interaction terms are added into equations (2). Our interested coefficient, the coefficient on POST*BIG4* COMPLEX is positive and significant at the 0.05 level (coefficient = 0.128, χ 2 = 4.20), and the coefficient on POST *BIG4 is still positive and significant at the 0.10 level. These results indicate that in the countries with greater IFRS related changes, the increased audit quality gap between Big Four and non-big Four auditors becomes larger, which is consistent with our H1. Panel B of Table 3 reports the results for audit quality test in the Big Four sample only. In this sample, PWC is defined as IFRS expertise. Our interested coefficients, the coefficients of POST*EXP in column (1) and column (3) are found to be insignificant, suggesting that PWC as the IFRS expertise in Big Four auditors, doesn t have any role in the audit quality of mandatory IFRS adopters. Similarly, the coefficients of POST*EXP* COMPLEX in column (2) and column (4) are also found to be insignificant, suggesting the IFRS expertise in Big Four auditors doesn t play any role in audit quality in the countries with greater changes of IFRS. Panel C of Table 3 reports the results for audit quality test in the non-big Four sample only. In this sample, BDO and Grant Thornton is defined as IFRS expertise. Our interested coefficients, the coefficient of POST*EXP in column (1) is found to be significantly negative, suggesting that BDO and Grant Thornton as the IFRS expertise in non-big Four auditors, provide better audit quality in terms of accrual quality to the mandatory IFRS adopters in the post IFRS period. Similarly, the coefficient of POST*EXP in column (3) is found to be significantly positive, indicating the IFRS expertise in non-big Four auditor group provide better audit quality in terms of issuing more first time going-concern audit opinion to the mandatory IFRS adopters in the post IFRS period. Turning to the coefficients of POST*EXP* COMPLEX in column (2) and column (4), they are also found to be 24