The Strength of Industry Specialization: Highlighted by the IFRS Adoption in the EU

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1 The Strength of Industry Specialization: Highlighted by the IFRS Adoption in the EU Item Type text; Electronic Thesis Authors Hall, Taylor Jane Publisher The University of Arizona. Rights Copyright is held by the author. Digital access to this material is made possible by the University Libraries, University of Arizona. Further transmission, reproduction or presentation (such as public display or performance) of protected items is prohibited except with permission of the author. Download date 30/09/ :28:55 Link to Item

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4 Abstract This study explores the impact that an audit industry specialist has on a firm s audit quality after the implementation of a large change in financial reporting regulation. One of the main goals of IFRS was to increase the comparability of financial statements. I investigate whether IFRS increased the comparability of financial statements insomuch as it affected audit industry specialists ability to transfer knowledge between clients, thereby affecting the quality of their audits. Although my results are inconclusive, the explanation may be attributed to the increase in comparability being strong enough to benefit the non-industry specialist users but not being enough to increase already high quality audits of industry specialists.

5 Hall 2 Introduction This paper examines whether the ability to transfer industry-specific codified knowledge increased after the adoption of IFRS. With the changing environment in Europe surrounding the adoption of Internal Financial Reporting Standards (IFRS), this paper delves into the effects of IFRS in relation to the original goals provided by IASB. Assuming an increase of comparability of financials across borders, auditor industry specialists should be able to provide their clients with higher quality audits. There are many studies that explore the effects of IFRS implementation. For example, there is prior literature that discusses the effects of IFRS on the comparability of financials. In addition, there is some previous literature on the overall strength of auditor industry specialists. This paper adds to prior literature by combining these two topics and exploring the effects that IFRS implementation had on the ability of industry-specialized auditors to share knowledge across borders. In 2005, all countries in the European Union (EU) were forced to adopt new regulations in an attempt to unify financial statements by eliminating the varied standards of each country into one unified set of standards. By completing this conversion, IASB hoped to improve many qualitative characteristics. Included among these are verifiability, timeliness, understandability, and comparability. Of these characteristics, this paper focuses on the comparability of financials. Unlike prior studies, I focus on the role of auditors as industry specialists in a different light. Industry specialization of audit firms within this paper refers to the decision of a firm to invest in obtaining specific accounting knowledge of regulations within one particular industry. Using the adoption of IFRS as a large change in accounting regulations across multiple countries, this paper identifies how auditors understanding of industry-specific accounting regulations supports their specializations. Further, my study contributes to prior literature that examines the association between auditor industry specialization and audit quality. Background Borders Before the implementation of IFRS, there were borders around countries, which prevented the share of information. The incongruent accounting reporting standards and regulations enforced within different countries was the major reason for the existence of these borders. For example, the presentation of financial statements varied drastically depending on whether they were created within England or France. Tsalavoutas et al. (2007) noted that upon comparison of French and UK financial statements, French companies earnings quality was much more conservative than the earnings quality of the UK companies. This highlights the large differences that existed pre-ifrs adoption. In sum, country-specific accounting regulations constrained the ability to compare methods of accounting and final financial statements across borders.

6 Hall 3 Different languages The borders that were built around countries, attributed to the incongruent accounting standards, prevented information to be spread across countries. Pre-IFRS, it was difficult to compare the financials of two foreign companies because they presented financial information in a different format. These two foreign firms metaphorically (and sometime figuratively) spoke a different language. The format that was used to prepare financials in the UK was in a different language than the financials prepared in France. For example, French accounting regulations dictating what constituted revenue for a software firm did not equate with German software revenue recognition regulations. This language barrier reduced information sharing between foreign companies, foreign investors, even auditors. The borders that were erected around countries with different accounting standards came crumbling down after the decision of mandatory adoption of IFRS within the EU. Specifically, the unification of laws and regulations removed the language barrier that impeded the communication of information. Within this paper, I conclude that a post-ifrs environment where companies across countries were forced to speak the same language will drastically improve the ability of auditor industry specialists to communicate and share information. Ultimately, this will allow auditor industry specialists to provide their clients with a higher quality audit, compared to non-industry specialist, post-ifrs implementation. Hypothesis Development Comparability Standard setters define comparability as the quality of information that enables users to identify similarities in and differences between two sets of economic phenomena. This characteristic is consistent with the FASB/IASB Conceptual Framework, which argues that comparability is the desired outcome of adopting a uniform set of standards (such as IFRS). Comparability is associated with a varied number of outcomes. According to Chairman Christopher Cox of the U.S. Securities and Exchange commission, comparability will lead to the ability of investors to easily compare disclosures issued (irrelevant of jurisdiction), to be able to weigh domestic investments against foreign investments, and to inspire confidence in the transparency of financial reporting (Cox, 2008). Cox expands, noting that increased transparency will eventually lead to increased investor confidence. Ideally, investor confidence could have positive effects on cost of capital. Investors will expect less of a return because the overall assessed risk associated with investing will decrease. Conflicting Evidence of Comparability There is conflicting prior research on the effects of the implementation of IFRS on the comparability of financials. Lang et al. (2010) showed results of increased cross-country comparability within a negative light. The authors stated that IFRS is causing information to be seen as similar when really the information is different. They further conclude that earnings presented post-ifrs attempts to create similarities for dissimilar events. Overall,

7 Hall 4 this study provides evidence that the comparability produced by IFRS had a negative affect on the information environment. Li (2010) documented more positive results concerning the effects of IFRS on comparability. His results depicted a cost of equity reduction due to the implementation of IFRS. Further, his costs of equity mechanisms were increased disclosure and enhanced information comparability. Wu et al. (2010) addressed the idea of comparing foreign peers to determine the increase in comparability. Wu defined foreign peers as firms from the same industry but different countries. Foreign peers use their individual countries domestic accounting standards preadoption of IFRS and switch to IFRS subsequently. They examined the use of accountingbased Relative Performance Evaluations (RPEs), which are evaluations used to compare CEOs within their industry, pre-ifrs and post-ifrs and discover an increase in evaluations that are performed. This increase is attributed to a drastic reliance on the comparison between CEOs of an entity with CEOs of their foreign peers. This reliance on RPEs relative to their foreign peers is consistent with improved cross-country comparability subsequent to mandatory IFRS adoption. This paper displays how companies are now being compared within industries across borders after the implementation of IFRS. Defond et al (2010) explored the increase in comparability due to the mandatory IFRS adoption. They conclude that there is a significant improvement of comparability associated with mandatory IFRS adoption on cross-border investment. They further stated that the improvement is dependent on the institutional environment and the extent of the increase in the number of industry peers using the same accounting standards. Although there is conflicting evidence in relation to comparability post-ifrs, most studies support the finding of increased comparability. Assuming that comparability is increased, according to the goals set by IASB, the borders that were built around countries will no longer have the strength they originally had pre-ifrs. Any increase in comparability, therefore, should lead to an increase in the ability to compare information and communicate information between countries that previously could not speak the same language. Industry Specialization Industry specialization in audit firms arises in part from the decision of a firm to invest in obtaining specific accounting knowledge of regulations within one particular industry. The knowledge obtained through industry specialization is classified as codified knowledge. What is unique to codified knowledge is that it must be obtained. For example, codified knowledge can be developed, retained, and transferred. Carsen (2009) explains that the development of codified knowledge has led to the creation of Global Audit Firm Networks (GAFN), which is a collection of auditing firms that are organized by contractual relations between entities which develops a mutual dependency between members but the entities remain legally autonomous. For example, Deloitte has firms all over the world that communicate with each other, sharing information and experience. This network creates a

8 Hall 5 benefit to all offices that are a part of this GAFN and gives them a competitive edge. Within these GAFNs, codified knowledge can be shared across firms, industries, and countries. Carsen states that the differences between industries are more evident than the differences between countries regulations and, therefore, industry knowledge can overcome the regulations and still apply to the industry. This speaks to the strength of industry specific knowledge and explains audit firms motivation to specialize in a particular industry. Several studies investigate the effects of auditor industry specialization. For example, Fleming and Romanus (2007) provide direct evidence on the impact of industry specialization by showing that industry specialization increases efficiencies and constrains substantial increases in audit fees when new legislation is implemented. This conclusion is based on an increase in error detection ability, lower enforcement actions, and higher earnings quality associated with firms audited by industry specialists. In sum, this evidence shows how industry specialization allows auditors to more proficiently adapt to new requirements and regulations. Finally, the SEC Chairman also voiced his support for an increased transfer of information by stating, with an ongoing dialogue, each stakeholder can learn from others experiences (Cox, 2008). While not directly identifying auditors as one stakeholder, Cox supports the idea of sharing codified knowledge with others to help improve the efficiencies of business. While specializing in an industry afforded efficiencies pre-ifrs, a uniform set of accounting regulations across countries should allow auditors to more successfully communicate their codified knowledge across firms within an industry but in different countries. Industry Specialization & Audit Quality Balsam et al. (2003) developed a study that examined whether auditor industry specialization affected audit quality by proxing for earnings quality with the absolute level of discretionary accruals (DAC) and earnings response coefficients (ERC). This literature contributes evidence that firms audited by industry specialists show lower DAC and higher ERC than clients serviced by non-specialist auditors. They conclude that overall earnings quality is higher for clients of industry specialists. Reichelt & Wang (2009) reached similar conclusions when they research the correlation of national and city-specific industry specialist and audit quality. They discovered lower levels of abnormal accruals for firms audited by industry specialist. In addition, these firms were less likely to meet or beat analyst forecasts by a penny per share and were more likely to issue a going-concern. They concluded that all three factors provide evidence that companies audited by industry specialist received a higher quality audit. According to this research, auditor industry specialization has been a good investment pre- IFRS implementation. The evidence displayed the benefits that auditor industry specialization provided to the client and investors in the forms of lower levels of discretionary accruals, reduced likelihoods of meeting or beating analysts expectations by a penny, and increased likelihoods of going concern opinions. In sum, prior literature

9 Hall 6 indicates that auditor industry specialists provide a higher quality audit than non-industry specialists. Hypothesis In an attempt to create a unified set of accounting standards, the IASB mandated in 2005 that all firms in the EU implement IFRS. This drastic change from different standards to one unified standard provides an interesting event, which deserves exploration. In addition to timing, the relation between EU countries also is a strong factor in determining the scope of this study. There has always been a strong relationship between the EU countries due to the amount of trade that exists and also the proximity of the countries. The European Union likely represents a powerful setting for testing our predictions as prior research typically finds stronger mandatory IFRS adoption effects for European firms. To reduce the amount of data used within this study, the European Union will be represented by two countries. The two countries chosen are the United Kingdom and France. There are two characteristics that explain why these two countries are the strongest candidates for this study. The first characteristic is the large amount of interaction that takes place between the two countries due to their intertwined markets and overall geographical proximity. The second quality is the abundance of data within the two business markets that provides a large enough sample for the entire EU. Given prior literature that discusses the increase of comparability across industries in different countries post-ifrs, this paper looks into the correlation between auditor industry specialization and earnings quality pre and post-ifrs implementation. An increase in comparability post-ifrs reduces the likelihood that the transfer of information will be hindered due to the incongruence of reporting standards of foreign companies. Instead, each country is speaking the same language and communication will be easier and will carry more value. As stated, the strength of industry specific knowledge before the adoption of IFRS is strong; therefore, it is logical to conclude that the implementation of unified standards (and the reduction of country-specific regulation) will increase the ability for auditor industry specialists to share codified knowledge across borders. In addition, auditor industry specialists have been proven to provide higher quality audits than non-industry specialists. Therefore, the strength of auditor industry specialists will increase post-ifrs, compared to non-industry specialists, and I expect clients of auditors who are industry specialists will receive an even higher quality audit. Insignificant results produced by this study could be explained by the role of management incentives and national institutional factors. JeanJean & Stolowy (2008) discussed the negative effects present after the implementation of unified standards. They provided evidence that earnings management increased post-ifrs in France. Further, they believed that rather than focusing on harmonizing accounting standards, they should focus on harmonizing incentive and national institutional factors. National institutional factors, such as differences between each country s enforcement bodies, might affect how one set of

10 Hall 7 accounting regulations is applied and enforced across countries. This, in turn, may limit auditor s transfer of knowledge between two firms within different countries and, therefore, cause an insignificant finding. While I recognize the strength of national institutional factors as a hindrance to increased information sharing across clients in different countries, I expect audit quality to increase post-ifrs for clients of industry specialists. Thus, I test the following hypothesis. Hypothesis: Auditor industry specialists will be able to provide higher quality audits post- IFRS relative to auditors who are not industry specialists. Empirical Model I estimate discretionary accruals, (DAC), using the cross-sectional version of the Jones (1991) model as in DeFond and Jiambalvo (1994). I use the Jones model because prior research examining the relative performance of alternative DAC models has shown that the cross-sectional version of the Jones model is the best measure of the discretionary portion of total accruals (see Bartov et al. 2000). Total accruals are regressed on the change in sales and the level of property, plant, and equipment for each year using all firm-years with the same 2-digit SIC code. The model is as follows: where TACC is total accruals, REV is revenues in year t less revenues in year t-1, PPE is gross property, plant, and equipment, A is total assets, ε is the residual, and the subscripts i and t denote firm and year. The residual (ε) represents DAC for firm i in year t. Our multivariate model then regresses the absolute value of DAC on our industry specialization variable and control variables based on prior work (e.g., Reynolds and Francis 2000; Becker et al. 1998; Warfield et al. 1995): Abs(DACit) = a0 + a1*spit + a2*ltait + a3*cfoit + a4*levit + a5*abs(tacc)it + a6post + a7sp*post + E it where SP is our industry specialization measure, determined by the firm s use of an industry specialist to complete the firm year s audit. LTA is the log of total assets and is used as a proxy for firm size, CFO is cash flow from operations scaled by assets, LEV is the ratio of long-term debt to total assets, and Abs(TACC) is the absolute value of total accruals, Post is a dummy variable representing firm years post-ifrs implementation, SP*Post is the interaction variable representing industry specialist post-ifrs, and the subscripts i and t denote firm and year, respectively. Six versions of this model are estimated to correspond to the six measures that represent SP. Becker et al. (1998) and Reynolds and Francis (2000) include firm size and cash flow from operations as variables that influence discretionary accruals. Leverage is included, as in

11 Hall 8 Reynolds and Francis (2000), because prior research has documented that firms with high levels of debt have an incentive to engage in earnings management to increase earnings (see Watts and Zimmerman 1986). Finally, we include total absolute accruals as a control for the firm s accruals-generating potential (Becker et al. 1998). After controlling for the other specified factors, the difference in the absolute value of DAC between clients of specialist post-ifrs and pre-ifrs is captured by α7 in Equation (2). If the reports issued by clients of specialist auditors post-ifrs are of higher quality, we would expect the absolute value of DAC to be lower, which implies that the coefficient α7 will be negative. While we are not testing the effect of our control variables (LTA, CFO, LEV, abs(tacc), and Post) on the absolute value of discretionary accruals, based upon our intuition and the research referred to above we expect the coefficient on LTA, CFO, and LEV to be negative, and that on abs(tacc) and Post to be positive. Results Following are the descriptive statistic tables of the results of the study: Table 1 Descriptive Statistics Variable N Mean Median Minimum Maximum Standard Deviation abs_dac Ind_Spec LTA CF Lev E ABS_TACC E post E Table 2 - Frequency year Frequency Percent Sum The tables above indicate the attributes of the sample of data used within this study. It provides some meaningful information, of which are bolded. Of all of the data used within

12 the study, industry specialists, as shown in Table 1, represent 37% of the firm years. Additionally, the post-ifrs data, displayed in Table 1, makes up 40% of the total sample. Finally, Table 2 explains the distribution of samples taken from each year included within the study. Hall 9

13 Hall 10 Following are the correlation tables for the variables used within the study: Table 3 Correlation abs_dac Ind_Spec LTA CF Lev ABS_TACC post post_sp abs_dac 1 Ind_Spec <.0001 LTA <.0001 <.0001 CF < <.0001 Lev <.0001 ABS_TACC post <.0001 <.0001 <.0001 < post_sp <.0001 < <.0001 Table 3 explains the correlation that each variable has to every other variable within the study. There are two categories of numbers provided for each analysis, magnitude and p- value. When the p-value of the analysis is significant, the magnitude is analyzed to determine if there are any correlation factors that may disrupt the regression analysis. The correlation problems arise when the magnitude is high. The conclusion provided by this correlation table is that there are no multicolinearity problems within this study.

14 Hall 11 Following are the tables that reflect the regression analysis performed in the study for the formula provided above: Table 4 Variance Analysis Analysis of Variance Source DF Sum of Mean F Value Pr > F Squares Square Model <.0001 Error Corrected Total Root MSE R-Square Dependent Mean Adj R-Sq 0.03 Coeff Var Table 5 Parameter Estimates Parameter Estimates Variable DF Parameter Standard t Value P-value Estimate Error Intercept <.0001 Ind_Spec LTA <.0001 CF <.0001 Lev ABS_TACC post post_sp HighLit The information above can provide some interesting information on the topics of this study, even though not all of the variables are significant. The two important variables within this regression model were the post and the post_sp variables. Originally, these two variables were expected to be negative and significant. According to Table 5, the post variable fulfilled this expectation with a negative and significant coefficient (according to a p-value less than.10). This result supports the assumption that the implementation of IFRS within the EU did increase the audit quality of non-specialist by the comparability of financial statements. The results of the post_sp variable are less telling than the post variable. Displayed within Table 5, the coefficient is a positive number and is insignificant. This result implies that the audit quality of firms that switched to IFRS was not magnified significantly by the use of an industry specialist. The results suggest the possibility that the implementation of IFRS did

15 Hall 12 increase comparability enough to benefit the non-industry specialist users but was not strong enough to increase the audit quality of industry specialist users. Conclusion This study began on the basis of an increase in comparability of financial statements after the implementation of IFRS, according to the goals of the IASB. With an increase of comparability, it was hypothesized that auditors would be more able to share information between client firms across countries, increasing the audit quality for clients. Specifically, auditors often look to provide their clients with a unique service that involves the acquisition of industry specialization. Given the increased relevance of shared information between two firms in the same industry, I hypothesized that IFRS would provide auditors who are industry specialists an incremental advantage and lead to higher quality audits for their clients. The results of this study were limited to the significance of only one of the important variables. The negative and significant value of the post variable spoke to the increase in audit quality of the non-industry specialist audit client firms after the implementation of IFRS. This finding confirms the assumption that the comparability of financial statements increased post-ifrs and allowed information to flow more smoothly over boarders for non-industry specialists. The insignificance of the post_sp variable may be explained by a weaker increase in comparability than originally predicted, of which did not provide the industry specialists with enough comparability to impact their overall audit quality. Limitations The variation of the data can be attributed to the choice of my audit quality measure. In this study, audit quality was measured by the absolute value of the discretionary accruals (abs_dac). The existence of the absolute value within this variable eliminates the differentiation of positive and negative accruals. The existence of some positive accruals is seen as an indication of a lower audit quality while the existence of some negative accruals is seen as an indication of conservatism and higher audit quality (ex. reserve accounts). Using the absolute value of the discretionary accruals eliminates the differentiation and limits the usefulness of the variable. Additionally, my sample data was limited to two countries, the United Kingdom and France. This is just a small sample of the industries within the EU and may not reflect an accurate representation of the total effects of the implementation of IFRS. Future Studies This study has created intriguing questions that can be further researched with similar studies in the future. In addition to exploring the effects of different audit quality measurements and a different set of data from other EU countries, there are other factors to explore that may have an impact on the results.

16 Hall 13 This study examined the effects an industry specialist may have on the audit quality of firms after the implementation of a large set of new accounting regulations. The data may provide some interesting results when applied to a specific set of industries. If the implementation of IFRS had a larger impact on the comparability component on one specific industry, the use of an industry specialist may result in a higher audit quality. Looking for a significant increase in audit quality based on industry specific data may provide a unique outlook on the strength of auditor industry specialization.

17 Hall 14 Works Cited Balsam, Steven, Jagan Krishnan, and Joon S. Yang. "Auditor industry specialization and earnings quality." Auditing: A Journal of Practice & Theory 22.2 (2003): Carson, Elizabeth. "Industry specialization by global audit firm networks." The Accounting Review 84.2 (2009): Cox, Christopher. Speech by SEC Chairman: International Financial Reporting Standards: The Promise of Transparency and Comparability for the Benefit of Investors Around the Globe, DeFond, Mark, et al. "The impact of mandatory IFRS adoption on foreign mutual fund ownership: The role of comparability." Journal of Accounting and Economics 51.3 (2011): Fleming, Damon, and Robin Romanus. "Auditor industry specialization and audit fees surrounding Section 404 implementation." Available at SSRN (2007). Lang, M., M. Maffett, and E. Owens. "Earnings comovement and accounting comparability: The effects of mandatory IFRS adoption." Unpublished working paper (2010). Li, Siqi. "Does mandatory adoption of international financial reporting standards in the European Union reduce the cost of equity capital?." The Accounting Review 85.2 (2010): Reichelt, Kenneth J., and Dechun Wang. "National and Office Specific Measures of Auditor Industry Expertise and Effects on Audit Quality." Journal of Accounting Research 48.3 (2009): Tsalavoutas, I., and L. Evans. "Comparing International Financial Reporting Standards (IFRSs) and Greek GAAP: financial statements effects." Workshop on Accounting in Europe Wu, Joanna Shuang, and Ivy Zhang. "Accounting integration and comparability: Evidence from relative performance evaluation around IFRS adoption." Simon School Working Paper No (2010).