ERASMUS UNIVERSITY ROTTERDAM

ERASMUS SCHOOL OF ECONOMICS

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

Master Thesis:

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

Conductor: Maria Moirasgenti (student nr.: 331425)

Supervisor: E.A. de Knecht RA

Co-reader: A.H. van der Boom

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ABSTRACT

This study was conducted in order to investigate the impacts of the current financial crisis

on the auditors’ use of professional conservatism and on the audit fees, regarding Dutch

stock exchange quoted companies. Audit conservatism was tested between two periods:

first in the prior to the crisis period of 2005-2006, and second during the financial crisis

period of 2008-2009. Audit fees were tested between the years 2008 and 2009 due to

data limitations. 51 stock exchange quoted firms were selected and investigated through

multivariate pooled and linear regression analyses. Contrary to the hypothesized increased

levels of conservatism and audit fees, the Dutch auditors were found to use lower levels of

audit conservatism in their financial audit tasks and charge lower amounts of audit fees.

Acknowledgements

This study would have not been performed without the continuous guidance and help of

my supervisor, with the Erasmus School of Economics E.A. de Knecht. Additional thanks

are provided to the co-reader of this research, Dr. sc. ind. A.H. van der Boom. Special

thanks are given to my sister Rallou, my parents Kostas and Vicky Moirasgenti, my friends

across Greece and The Netherlands, and Phd. candidate Stylianos Sakkas for their

tremendous psychological support and precious willingness to share with me the pressure

and stress of the last months.

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CONTENTS

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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CHAPTER 1 – Introduction

1.1 Background

“We have an important role to play to ensure the survival of the financial system. Its

survival depends on the vigilance of regulators, the adequacy of reporting processes and

the openness of communication among all the key players. Now it is the time for external

auditors to reassess their roles and responsibilities.” (CA Magazine, “The external auditors’

pivotal role” by Bradshaw & Brown, 1988; p. 46)

This extract was taken from an article written and published in 1988. The time could not

be more right to argue that today, during the days of a financial recession, auditors and

their profession is in a high degree influenced.

This paper concerns a research that will try to shed light on the effects of the recent

financial crisis to the tasks of external financial auditing. This interest concerning the

influence of the financial crisis on the external auditing profession is originated based on

three parties: First the whole business world, second the public and third the academic

world. All previous studies have proved that auditing is severely affected by changes in the

business world, therefore the assumption exists that in this case a great influence exists.

More precisely, the focus of this research will concern the levels of the use of

conservatism in auditors’ evaluations. The levels of conservatism determine the audit fees,

consequently the impact of the current financial crisis on audit fees will be investigated as

well.

1.1.1 The current financial crisis

The financial crisis that started in 2007 indeed is a global financial crisis. It is considered

the outcome of the liquidity shortfall in the United States. Its results in the general

financial sector can be summarized in the dissolution of large financial institutions, the

huge declines in consumer growth rates, the supporting efforts of banks by the national

governments and severe downturns in the stock markets globally.

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The results and the implications from the current situation are so expanding and severe,

that all aspects of the business world are now going through a changing and developing

phase. The auditing profession is inevitably affected in a major scale. Criticism and blame

has focused on a wide range of complex and global factors in general. However, it is more

than disappointing to note that the financial audits assuring the fairness of statements by

banks declaring financial difficulties and filing for bankruptcy soon after receiving an

unqualified audit report were conducted exclusively by one of the Big Four Auditing firms,

committed to provide the highest assurance level.

The interest of this study focuses on a few economic theories that provide insights in the

function of the capital markets and on the causes and the consequences of the crisis in the

global economy. In addition, detailed references concerning the external auditing

profession are provided.

1.1.2 The external auditing profession

Audits are one form of the attestation services provided by external auditors. This

research focuses on audits of historical financial statements, in which an opinion is

expressed about the fairness of a company’s financial statements by CPA firms.

The magnitude of the financial crisis is huge enough to have influenced all the areas of

the business-financial world, including of course the auditing profession. External audit is

promoted as an assurance tool concerning all interested parties in the financial statements

of a company. This is highly to be questioned though considering the latest news. A very

well known example concerning this is the case of Lehman Brothers, one of the biggest

banks that operated in the United States of America (USA) and received an unqualified

opinion shortly before filing for bankruptcy. Because the roots of the problematic situation

expand beyond the auditors’ profession scope, but cannot be characterized as not

plausible, the question “where were the auditors?” is not as prevalent as in the past where

the big auditing scandals had taken place (Enron, A hold, Adelphia). However, since the

level of “duty” towards the public keeps on increasing, the skills concerning the financial

audits of firms in the current years need to be enriched.

The implications concerning the auditing profession, especially the independent one, are

inevitable and certainly severe. In any case, it is not to be forgotten that traditionally

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financial auditors were and still are the ones to trust the savings of a lifetime. The key

features of the profession will be analyzed in this study, along with the impacts of the

crisis on its functions.

1.1.3 Auditors’ conservatism and audit fees

Auditors’ conservatism relates to the general accounting principle of conservatism that

can be summarized in the next rule: anticipation of all losses but no anticipation of profits

(Basu, 1997).

Conservatism is a highly respected concept on audits and at the same time highly

associated with audit fees. The higher the conservatism the more the efforts and the

working hours the auditors dedicate for the conduction of their assurance tasks, resulting

in increased audit fees. It will be very interesting from a scientific point of view to

investigate how auditors’ conservatism has actually been affected during the recent

financial crisis. Comparisons with the prior-to-crisis levels of conservatism will provide us

with a clear view of these effects.

1.2 Objectives

The purpose of this research is to investigate the effects of the recent financial crisis

concerning the external auditing tasks. More specifically, the impact of the current

financial crisis on the auditors’ use of conservatism and the audit fees will be investigated.

All previous studies have proved that auditing is severely affected by changes in the

business world; consequently, a great influence in this case is expected as well.

The public -including also all related parties- is relying on auditors’ assurance about the

discovery of frauds and advice for safer and profitable money investing. A proof of high

professional standards based on the findings of this research will boost the trust and the

lost confidence on auditors, especially today that the business world is still in the midst of

a recession phase.

The motivation of this research results from the timeliness and the importance of this

issue, considering the worldwide financial circumstances and the key role of the auditing

profession. What is more, the great interest in actual practical and ethical considerations

was the motivation to investigate issues from an academic point of view.

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1.3 Problem Definition

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

“What are the effects of the current financial crisis on auditors’ conservatism and audit

fees concerning Dutch stock exchange quoted companies?”

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

a. What is the theoretical background concerning financial information?

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

world?

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

term auditors’ conservatism?

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

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

profession?

1.4 Methodology

The sample of this study will consist of Dutch listed firms audited by both the Big Four

and non-Big Four audit firms. These firms were chosen because in general firms in The

Netherlands are considered fast responding in changes and new developments. In

addition, Dutch Big Four audit firms have proved to be very innovative and competent to

consider their work effective, valid, and precise. This is highly significant since the starting

point of this crisis (severe negative facts did actually happen) is considered 2008, only two

years ago. Data prior to crisis will be gathered from years 2005-2006 and will be compared

with the data during the crisis concerning the period 2008-2009. This comparison will take

place in order to investigate the changes in auditors’ conservatism. Because three years

are considered an adequate period concerning full adjustments in Sarbanes-Oxley act of

2002 requirements, while at the same time predictions of the upcoming crisis had not still

taken place, the years of 2005-2006 have been selected. The years 2008 and 2009 are

years of proved recession. Due to absence of data, 2010 cannot be investigated. Since they

are published in the companies’ financial statements every year after June 2008, data on

audit fees and auditors will be easily collected concerning 2008 and 2009. Consequently,

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the changes in audit fees will be found through the comparison of the audit fees between

2008 and 2009 due to the lack of disclosed data concerning 2005 and 2006. Access to this

data, along with all the other financial data needed, can be provided by the Library

Databases of the Erasmus University (Erasmus School of Economics). Other online sources

of financial data are also the http://www.annualreports.com website and the

http://www.ecb.int/pub/annual/html/index.en.html, which is the official internet site of

the European Central Bank.

The variables that will be tested are auditors’ conservatism and audit fees in response to

the recent financial crisis. The current financial crisis is the independent variable and the

dependent variables consist of auditors’ conservatism and audit fees. The control variables

are presented and explained in the relative part. With the ordinary least squares (OLS) a

linear regression model will be used and estimated. More precisely, the adjusted version

of the regression model Basu created in this research will be used.

1.5 Demarcation and limitations

The findings of this research will help to understand the causes of the changes in

auditors’ conservatism, the implications concerning the auditing profession and the

business world on a second level.

As in every scientific research, limitations exist that need to be considered. First, the

period that will be investigated during the crisis is limited to the years 2008 and 2009 and

because the presence of changes could be in a premature phase this may have

implications concerning the findings. Inflation effects on audit fees, if any, should be

captured too. Lack of data in audit fees for the years 2005-2006 limits the generalization of

the findings concerning fees and makes the comparison between the periods prior and

during the crisis not possible. However, the expectation exists that these results are

representative concerning the audit firm industry.

1.6 Structure

The remainder of this study will continue according to the next structure: Chapter 2 is

focused on the economic theories and the background on financial information. Chapter 3

deals with the present global financial crisis. Insights will be provided that refer to the

causes and implications of the crisis on the business world. Chapter 4 analyzes the external

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auditing profession, the impacts of the financial crisis on it and the concept of audit

conservatism, while Chapter 5 comments on the relation between the audit conservatism

and audit fees. Chapter 6 demonstrates the methodology and findings of prior research

conducted, concerning the subject of auditors’ use of conservatism and audit fees.

Chapter 7 presents the research design that is used for the empirical part of this study and

Chapter 8 provides the presentation of the results of the empirical testing. Finally, Chapter

9 analyzes the main conclusions and the limitations of this study and makes

recommendations concerning the areas that the future research should focus on.

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CHAPTER 2 – Financial information

2.1 Introduction

From an economic perspective, information can be recognized as a business resource

and as such, it is extremely important for the survival of the businesses. The most

important characteristic is that information is produced by facts that cause the user of the

information to take an action that otherwise he/she would or could have not taken (Hall,

2008, p. 11).

Financial information’s supreme goal is to help the users of the financial statements of

the companies in their decision making process and that is the reason why the users of

financial statements are also characterized as decision makers. Auditors’ tasks are part of

the assurance services that are designed to improve the quality of information, both

financial and non-financial used by the decision makers. Conflict resolution and

uncertainty reduction are outcomes emerging also from the problematic use of financial

information.

The users of financial information and financial reporting consist of two broad

categories: external and internal. Creditors, suppliers, customers, stockholders, potential

investors, regulatory and tax authorities are namely the external users. More specifically,

this category is distinguished in institutional users such as the Securities and Exchange

Commission (SEC), banks and the Internal Revenue Service (IRS) and trading partners such

as clients and suppliers. Internal users are managers of every level and operational

personnel of the organization.

The financial statements of the companies communicate all relevant information

concerning the financial position of the company to the users. These statements though,

can be prepared according to a number of accounting and reporting methods that are able

to manipulate the content of the financial information. Managers have incentives to and

do actually misstate the accounting information concerning the firm that employs them.

At this point, the professional duty of the auditors is highlighted. Auditors are committed

to assure the public for the fairness of the reported financial statements of the firms that

are considered the sum of all the associated with the firm financial information. These

statements are considered by many as one of the triggering forces of the investing

activities.

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The importance of valid and adequate financial information is undisputed concerning

the survival and the plain functioning of the economic world. The next part of the chapter

will give insight in the financial theories that explain the nature, the scope, the treatment

and the incentives of the financial information presented in the financial statements.

2.2 Theories concerning financial and accounting information

2.2.1 Agency Theory

A very famous theory concerning managers’ decisions related to the choice and

disclosure of accounting methods is agency theory or otherwise referred to as the

“principal-agent” problem. Focusing on the relationship between the trading parties of

principals and agents, this theory recognizes the existence and importance of transaction

and information costs incurring from this relationship. The theory explained in a valid way

the incentives behind managers’ accounting methods selection.

Jensen and Meckling’s study (1976) was the primary paper that contributed to the

development of the agency theory. They used the principals and agents’ definition of the

two parties forming the agency relationship, in which a contract is used concerning the

engagement of one (or more) person –the agent- to perform a service that requires

delegated decision-making activities on behalf of another –the principal-. They relied upon

traditional economic literature that highlights the maximization of own wealth as the main

cause of people engaging in financial transactions. The relationships and conflicts between

these two parties and the efficiency of markets and other contractual mechanisms were

investigated in order to discover their effects on the minimization of the inherent costs of

the agency relationship. The agency theory considers the firm as a nexus of contracts. The

purpose of these contracts is to ensure that all related parties act for their own profit and

simultaneously for the achievement of the organization’s goals as well. The nominal

assumption of the agency theory is that the individuals will always act motivated by self-

interests, thus the key tool for a successful organization is the setting of mechanisms

adequate to ensure the benefit of both the individuals and the organization.

The incentives issue is another core element of the agency theory. Referring to that

Lambert (2001) pointed out the importance of the incentive problem in the financial world

and distinguished four common reasons resulting in the conflicts between agents and

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principals. These are signaled as effort aversion, differential risk aversion, differential time-

horizons, and effort for personal profit of every form from the side of the agent. Thus, it is

claimed in the agency theory that principals will be motivated by self-interest and that

they will demonstrate self-opportunistic behavior in their professional tasks, resulting

finally in agents receiving lower salaries from the principals. Consequently, it is argued that

in the end the agents are the ones to pay for the mistaken principals’ assumptions. Hence,

“the agents are therefore assumed to have an incentive to enter into contractual

arrangements that appear to be able to reduce their ability to undertake actions

detrimental to the interests of the principals” (Deegan and Unerman, 2006, pp. 214). The

bottom-line assumption is that the information problem that arises when agents are not

aware of when principals’ goals are met is solved with the provision of appropriate

incentives to the agents.

Agency theory is one of the fundamental theories of the economic and political science

world and contributed to the development of many more. The Efficient Market Hypothesis

is another theoretical approach that is highly associated with the role financial information

and will be analyzed in the subsequent part of this chapter.

2.2.2 The Efficient Market Hypothesis (EMH)

The Efficient Market Hypothesis is a theoretical approach that became famous in the

1960’s and has been developed by Eugene Farma. It is based in the random walk theory,

developed by Bachelier (1964) and supporting that all current information is reflected in

current security prices, consequently future price movements are random because they

are triggered by unexpected news. It supports in general that capital markets are

informationally efficient, interpreted in capital markets reacting to publicly available

information in an efficient and impartial way. The basic concept is that security prices

reflect the informative “package” of all publicly available information, while this publicly

available information emerges from more sources than just accounting disclosures. Since

the capital market is extremely competitive, the release of new information is expected to

be quickly and in a high degree adjusted in the prices of the shares.

The EMH is based in three primary arguments. First, it argues that share prices reflect

information from all kinds of sources and that accounting information is only one kind of

these sources. Thus, capital market reactions are not expected if changes in the

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accounting method occur, assuming of course that the changes do not cause differences in

the cash flows of a firm. In addition, the efficiency of the markets in the evaluation of

accounting information is considered granted. The third and last perspective is that other

potentially unverified evidence can always emerge. These three arguments were pointed

out from Watts and Zimmerman (1968) to note that increased accounting regulation has

little to do in restricting opportunistic behaviors.

The three versions of the hypothesis are namely weak, semi-strong, and strong. In its

weak form, the EMH claims that the prices of traded assets already reflect all public

available information of the past. The semi-strong version adds to the claims of the weak

version the immediate response in the prices of the traded assets of new public available

information. The strong form of the hypothesis additionally predicts the price adjustments

of the traded assets in response to hidden or inside information. From a forecasting

perspective, Timmermann and Granger (2004) argue that the EMH “crudely” notes that

calculating beforehand the returns from speculative assets is simply not possible.

The significant limitation of the EFH is that it fails to give explanations concerning the

preferences of managers in accounting methods. Opponents of the EMH argue that the

EFH is simply inefficient. In more detail, it is argued that investors’ behavior is also driven

by cognitive biases (i.e. overconfidence or overreaction) that are attributed to simple

human errors in the reasoning and information analyses. Warren Buffet, an American

billionaire and one of the most successful investors of the world, characteristically quoted

“I’d be a burglar in the street if markets were efficient.”1

Despite the severe restrictions of the EMH, it has contributed in the development of

other economic theories and approaches. The conceptual combination of the Efficient

Market Hypothesis and the Agency Theory provided the theoretical base of the Positive

accounting theory, which is the last economic approach analyzed subsequently in this

study.

1 http://www.brainyquote.com/quotes/authors/w/warren_buffett_3.html, accessed on 11th of October 2010

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2.2.3 The Positive Accounting Theory (PAT)

In general, a positive theory concentrates on the explanation and prediction of

particular phenomena. The perspective of the firm as an aggregate of contractual

arrangements along with other theoretical views of the company as an efficient

mechanism of reducing transaction costs led to the development of the Positive

Accounting Theory. The title of this theory itself reveals the dispensed importance on the

role of accounting in reducing the transaction costs of the firm emerging from information

and motivational asymmetries between the associated parties. Additionally, it is

highlighted that firms with efficient corporate governance structures focus on efficiently

written contracts for every part of the firm, including of course the accounting system. The

paper of Watts and Zimmerman (1978) is recognized as the official documented study that

resulted in the development and the recognition of the Positive Accounting theory by the

scientific world.

Positive Accounting theory focuses on the explanation and prediction of managers’

choices concerning accounting methods. The relationships between the individuals within

and outside a firm are a central point of the PAT. Insights in financial accounting’s role as a

measure to overcome the “principal-agent” problem are provided and more specifically,

how financial accounting mitigates the contradicting and costly implications of each

party’s self-interest operating behavior. Primary to the Positive Accounting theory is the

self-interest approach, which argues that contractual arrangements are inevitable in order

to achieve alignment of all the associated parties’ self-interests. The important implication

here referring to the accounting information provided by the agents is that these contracts

must take into consideration the outputs of the accounting system in order to be valid and

correctly detained. It is certainly undisputed that agents eventually select the use of

accounting methods that reflect their achievements in the most efficient way. Thus, severe

importance is given in the reduction of regulation concerning financial reporting since it is

encountered to result in unnecessary costs and complications concerning the contractual

arrangements.

Positive Accounting Theory relies in two different perspectives: the opportunistic and

the efficiency perspective. The opportunistic perspective is focused on the explanation of

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the role of the contractual arrangements in minimizing the agency costs emerging from

the delegated authority for decision making by the principals to the agents. It can be also

referred to as “ex ante” perspective since it is applied in the proactive approach of these

contractual arrangements. Differences in the choices of accounting methods from

different organizations are explained by this approach. The opportunistic perspective on

the other hand, is not interested in the contractual arrangements themselves that can be

costly if written in too much detail concerning the accounting choices, but is more focused

on the explanation and prediction of opportunistic behaviors from the side of the agents

that occur inevitably. It is also entitled as the “ex post” perspective because it concerns

management’s behavior after the signing of the defining responsibility contracts.

Utilizing these two different perspectives, the PAT highlights the next three principal

hypotheses as signaled in the book of Deegan and Unerman (2006). The bonus hypothesis

is based on the opportunistic perspective in that it predicts that companies will make use

of the accounting numbers reflecting the performance of the firm to determine managers’

bonuses. Consequently, managers’ self-interest will dominate their effort to show the

highest possible profits, no matter the magnitude of the manipulated financial reports.

The debt hypothesis argues that in the effort of obtaining lower cost funds, firms will hold

contractual arrangements with lenders that commit to correct value-reflecting safeguards

in management’s choice of accounting treatments. However, the opportunistic incentive

predicts that leveraged firms will select accounting methods that reduce the effects of

debt obligations. The last one is the political cost hypothesis, concerning the direct and

indirect relationships and connections between the firms and the many other external

parties. A characteristic assumption is that managers of high profit firms will make use of

accounting practices that reduce the amount of reported earnings, in order to avoid the

negative attention of politicians, which can lead to higher taxation or numerous other

measures, and the public outcry.

Despite the many useful implications emerging from the Positive Accounting Theory, a

lot of criticism has been put into its failure in the prescription issue. Its focus is the

explanation and the prediction of actual accounting practices used, but no investigating

effort is put on the study of optimal accounting standards. The contradicting theory of

normative accounting is the one trying to derive and implement in an efficient way these

optimal accounting standards-shortly signaling “what ought to be”. Another significant

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limitation of the PAT is that it restricts all aspects of the human mind and behavior by

assuming that all individuals act based solely on self-interest. While the before signaled

criticisms continue to gain defenders and accounting practice challenges its assumptions,

the Positive Accounting Theory still holds in numerous scientific studies and is still taught

in many accounting research schools.

2.3 Summary

All theories of accounting have limitations and flaws and this is the underlying

conclusion of this chapter. This chapter was dedicated in the economic theories

investigating the information gap between capital holders and managers, namely the

Agency Theory, the Efficient Market Hypothesis, and the Positive Accounting Theory.

Insight was given in the consequences of the inevitable existence of this gap, concerning

all regarding parties and the relationships between them. The current financial crisis is of

course considered as an outcome of this informational gap and will be investigated in the

subsequent chapter. Focus is concentrated on the causes and the implications of the crisis

on the business world.

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CHAPTER 3 – The Financial Crisis

3.1 Insight in the causes of the crisis

It is an undisputed fact, that the financial crisis that started in 2008 in the United States

is a global one. The collapse of major financial enterprises, the numerous dissolutions of

enterprises, the increased rates of unemployment, the extremely reduced stock prices,

and the freeze of investing and growth activity are evidence proving the pervasiveness of

the crisis. All economies, independently if they are developed or under development ones,

are suffering from increasing economic turbulence and that causes severe consequences

in every aspect of the human life. Despite the countless economic damage, the social cost

of the unfolding crisis is another impact that can be proved even more significant.

A large number of contributions exist, namely financial institutions, academic

researchers, and statistic analysts, consulting and financing enterprises that are primarily

concerned with the causes of the global financial crisis in both the short-run determinants

and the underlying structures approach. Briefly, commonly recognized core causes are the

financing of Western economies that created a huge credit debt and supported extremely

risky and complex financial instruments, corporate structures, and inadequate rules of

regulation.

Crotty (2009) locates the cause on the New Financial Architecture and the financial

deregulation and financing processes. He argues that the consequences of the crisis are

more severe, but still in the borders of a normal recession phase results due to

endogenous restrictions of the business cycle functions.

Morgan (2009) places focus on the sequential and cumulative financial failures of the

pre-crisis period, with a concentrated caution on the banking sector’s theoretical

framework and practical policies. Tregenna (2009) also focuses on the United States

banking sector and specifically on its structure and profitability, merely caused by the

rising levels of concentration.

Palma (2009) used the perspective of heterodox Keynesian-Minsky-Kindlebergian

financial economics to point out the primary mechanisms responsible for the crisis,

namely excess liquidity, income polarization, financial and productive capital conflicts, lax

regulation, rationalities and principal-agent dilemmas. He argues that the outcomes of the

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crisis are expected in a recession or crisis period, but were so severe in this case due to the

general political and resource distributional environment. Since they have transformed the

neo-liberalism theory into a constant and systematic tool for abnormal earnings, in the

first place the capital holders are the ones to be held responsible for the current situation.

Responsibility lies also in the hands of the state holders. The capitalists were able to place

their “cruel intentions” in action due to the “no compulsions on big business” approach

that the state bodies of the world adopted during the past few decades.

Diamond and Rajan (2009) offered a more detailed documentation on the causes of the

crisis. They argued that the United States financial sector flooded with new exotic financial

instruments firstly the real estate branch and then the bank balance sheets in both

commercial and investment banks. These exotic instruments, named generally Structured

Investment Vehicles (SIVs) or conduits were mainly financed with high-risk short-term

debt. SIVs are investment assets issued with some unusual, often option-like in the case of

notes or bonds, clause. Digging deeper in the search for the roots of these causes they

analyzed the problematic conditions and SIVs that led to the crisis.

The misallocation of investment was the first one to be investigated. Prior to the current-

one crises that occurred in the late 1990’s in East Asia, Argentina, Brazil, Russia and Turkey

led to emerging markets becoming more “prone” to abroad borrowing. Inevitably,

investment and consumption was reduced. Noise from the collapse of the IT bubble of

2000 was still loud, but the world’s central banks led by the Federal Reserve provided the

public with comfort through extreme accommodative monetary policies. Low interest

rates in many countries called out the need for housing. Demand for housing, as well as

prices, rose severely all over the world. The crisis though was deeper in the US because of

the securitized sub-prime mortgage loans. “Sub-prime” or “Alt-A” are not official

regulatory designations that refer to borrowers perceived to be riskier than average

borrowers due to their credit history as noted by Gorton (2009). Mortgage-Backed

Securities (MBS) are asset-backed securities, secured by a mortgage or collection of

mortgages. Securitization reassured international investors to hold home mortgage loans

directly, despite the many “disadvantages” they carry like servicing, credit quality risk and

default likelihood. The diversification of the packaged mortgages mitigated the risk,

leaving “riskier” claims to be sold to those who had the appetite and the knowledge to

hold them. Through these securitizing procedures, AA-rated portions, that are bonds

20

receiving the highest rating by the bond rating agencies like Moody’s and Standard and

Poor’s (S&P), were squeezed out from the underlying package of mortgages. As Diamond

and Rajan (2009, pp. 606) signaled “the lower quality securities issued against the initial

package of mortgages were packaged together with similar securities from other

packages, and a new range of securities, including a large quantity rated AAA, was issued

by this collateralized debt obligation”.

Since rating agencies could only process information such as the homeowner’s credit score

and the loan-to-value ratio, but not more detailed information concerning the evaluation

of the borrower’s creditworthiness, originators relied on the “house/equity’s” price rise in

the case of a needed loan repayment. Simultaneously, the creation of very complicated

securities through repeated securitization caused significant problems in valuing these

financial instruments. As long as house prices kept rising the evaluation difficulties were

overlooked. Their severe consequences though became evident immediately after the first

reductions in prices came forward and defaults started taking place. The authors find

interesting that even though, theoretically, banks were in position to realize and assess the

risk of the numerous MBSs they were holding, they kept on holding them. Banks trusted

that they were worth the risk because they were quite profitable for a period and the

uncertainty concerning the true or apparent excess returns was not at that time a

significant problem to deal with. International savings and the Federal Reserve’s

reassurances for instant lowering interest rate measures enhanced banks’ risky short-term

profit policies if they were to be increased. In general, short-term debt is cheaper in

normal circumstances than long-term obligations. However, when times are unfavorable,

illiquidity is an unwanted and negative effect that runs the situation to extremes. Thus, the

financial crisis turned out to be inevitable after all.

Banks were holding numerous securities of high risk financed with short-term debt. When

the “housing bubble” started steaming, as soon as the first house prices declined and

mortgage defaults started expanding, all MBSs started falling in value and became harder

to price and even more unprofitable to borrow. The Federal Reserve tried to mitigate the

illiquidity problem of the banks with new terms of banking borrowing but the route to the

financial collapse was predestinated. The authors describe this clearly (pp.608): as more

banks tried to sell out of their positions, prices plummeted further and concerns about

illiquidity turned to potential insolvency -despite being able to borrow against the full

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value of their illiquid assets- there was now not enough asset value to offset the liabilities.

Confusion and uncertainty from the side of the bank clients called forth many bank runs.

The chaos started in September 2008, when Lehman Brothers, the fifth biggest investment

bank of the US filed for bankruptcy. Soon after that, banks became very reluctant in

lending and interbank lending was minimized. The failures of financial institutions like

Freddie Mac (Federal Home Loan Mortgage Corporation), Fannie Mae (Federal National

Mortgage Association ), AIG (American Insurance Group ) and Lehman Brothers that

invested in the exotic financial instruments are signaled as the most characteristic.

The significance of the systemic risk present in the United States in 2007 and 2008 is

highlighted in the paper of Acharya, Philippon, Richardson, and Roubini (2009). Systemic

risk is interpreted as “widespread failures of financial institutions or freezing up of capital

markets that eventually reduce the levels of capital available in the markets” (pp. 1). In

general, the authors distinguish three phases of the financial collapse, which is shortly

recognized as the outcome of a simultaneous credit boom and a housing bubble, emerging

from the coexistence of extended leverage and preservation of the credit risk from the

financial entities. The first phase is located in 2007; when the system of sub-prime and Alt-

A mortgages held by numerous non-bank lenders fell apart. The second phase involved the

destruction of the SIVs system and conduits that took place soon after the investors

realized the degree of risk of the financial assets they were holding. The third phase was

the burst of the primary US independent broker-dealers. This fact occurred when their

liabilities took the form of repurchase agreements (REPOs), financing that was the basis of

their leveraged operations (pp. 95). Driving forces of these risky betting behaviors were

poor corporate governance driven by executive compensation incentives, loose guarantee

government policies inducing moral hazard and managements’ haul to extreme risk/return

investments.

Providing a temporal sequence of the facts, the authors recognize the initial trigger for

the worst post-war financial crisis as the housing market’s downturn in the first quarter of

2006. The housing bubble did indeed “blew up”, however it was the collapse of the two

highly levered funds invested in ABSs held by Bear Stearns that is identified as proof of the

systemic failure occurring at the time. Bear Sterns was the fifth largest investment bank

involved in a major scale in the sub-prime mortgage market and went through a bank run

in March 2008. The high systemic risk of Bear Sterns is attributed to the major interference

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of the bank with the rest counterparts of the financial industry. JP Morgan & Chase, a

major financial services provider internationally was prompted and provided US$30 billion

no recourse funding by the US government and did purchase Bear Sterns. ‘Lehman

brothers’, the fourth largest investment bank was signaled by the authors as an actual

case of materialized systemic risk. Lehman Brothers filed for bankruptcy on 12 September

2008 a fact that nobody could ever expect considering the financial place of the bank and

the prevalence of its activities. Doubts and insecurity flooded in the business industry even

though the government decided its full-blown bailout. The purchase of Merrill Lynch by

the Bank of America is signaled as a consequence of Lehman Brothers’ bankruptcy, along

with the huge increases in the cost of Morgan Stanley’s and Goldman Sachs’s five year

Credit Default Swaps protection points. A credit swap or credit derivative is an exchange of

a fixed or floating coupon against the payment of a loss caused by default on a specific

loan or bond. Lack of transparency became apparent in the whole business world, since

government bailouts continued and federal investments worth millions of dollars in the

collapsed enterprises came out public. Illiquidity and insolvency were the obvious

concerns for the investors and the Federal Reserve and the Treasury went on taking

assurance measures like bailouts and extreme favorable terms for the purchases of the

shocked entities. The authors characteristically mention that improvisation in these

measures, instead of thorough analysis and investigation, was overused. However, as it is

always the case, shallow curing was never a good healing method and the downturn

turned out to be an international fact. Moving on to suggestions for the salvation of the

wounded business world, they propose three broad recommendations to the government

sector: liquidity provision, burst prevention, and establishment of long-term solutions.

Taylor (2008) also tried to shed light on the causes of the crisis and the circumstances

that prolonged it, focusing on government policies and interventions. The main cause

presented here is a monetary excess and more specifically, the rapid change in the interest

rate policy that led to the inevitable boom and bust in the housing field.

In the paper of Reinhart and Rogoff (2008), while the government response is signaled

as one way to mitigate the results of the crisis, more emphasis is given on how dramatic

the shock of the financial markets will turn out to be. Additionally all common sources for

the crises of the last 60 years are described, defined in a broad scope as increases in asset

prices, debt, and deficits and decreases in growth patterns. A common characteristic is

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also a precedent financial liberalization, enhanced by the general technological progress

and the formation of new financial entities and instruments.

Carmassi, Gros, and Micossi (2009) named in short the cause of the global financial crisis

as the result of lax monetary policies. These policies concerned excessive leverage and

maturity transformation by the banking sector. Regulation contributed to the situation

simply by minimum and favorable to the banks’ risky financial instruments’ intervention,

allowing reckless bets on asset price increases. Innovation is the term used to name the

establishment of the new SIVs. They argue that innovation did indeed promote credit

expansion and instability, but was not the main cause of the crisis. Instead, the entire

short-term profit-seeking environment in which they were established is highlighted as the

primary factor generating them.

3.2 Fair-value and off-balance sheet accounting: the features of controversy

Lack of transparency in every aspect of the business world was also identified as one of

the two main issues that generated the crisis, from a core level perspective by Rouse

(2009). Mark-to-market valuations, in which market prices are used for the calculation of

values and losses or gains of positions, is the point of controversy that has created

numerous conflicts due to the need for accurate value-reflecting transactions. Lax

corporate governance was highlighted as the second one. Executive compensation and

lack of responsibility admittance acts are the symptoms highlighted to misuse the concept

of corporate governance.

Mark-to-market or Fair value accounting is an ambiguous subject that is discussed in

many papers. In the paper of Laux and Leuz (2009), it is argued that great pressure is put

on the accounting standard setters to loose the rules concerning “strict” fair-value

accounting. However, research has proven that no significant correlation between the fair-

value accounting practice and the expansive bank problems that led to the generalized

crisis. On the contrary, this method was used by the banks as a safeguard and provided

the necessary discretion to banks in their efforts to avoid market price traps. In addition,

they argue that even if the effect of fair-value accounting in downward routes of prices

and contagion turns out to be existent, the positive effect of timely recognition of losses is

still dominant.

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Goh, Ng, and Yong (2009) provided more insight in the fair-value accounting concept by

researching the reliance of investors for the estimates of assets reported by banks in

conformity with Statement of Financial Accounting Standards no. 157 (SFAS 157).

Significant variation in the pricing of different fair value assets was discovered, and more

specifically mark-to-model assets were priced lower than mark-to-market assets. Mark-to-

model accounting is the opposite of mark-to-market accounting that makes use of internal

assumptions and finance models for pricing purposes.

The paper of Coates (2009) expressed another weakness of the financial system that

contributed to the unpleasant crisis, which are the defective disclosure rules. Off-balance

sheet accounting was enforced inadequately, however, importance is also given to the fact

that many financial entities simply failed to estimate correctly their assets’ risks. Of course,

it was the combination of these with the no-limits subsidized home ownership policy and

the launch of mortgage-related assets with minimum government guarantee that created

the widespread damage. Caution is also given on the integration between the sectors of

the economic world, since a downturn in one sector is proved to lead to losses in others.

Political implications are also emphasized as weak proactive measures taking the form of

repeated regulation and deregulation, which was more confusing than calming for the

worrying public.

Within the same scope, the research of Whalen (2008) refers to the fair-value

accounting method that the Securities and Exchange Commission (SEC) and the Financial

Accounting Standards Board (FASB) require for the enterprises to adopt, as one of the

three fundamental reasons for the downswing of the sub-prime market. The other two are

of course the aggressive homeownership policy that took place with the support of new

exotic financial tools and the abnormally favorable attitude that the SEC and the national

bank regulators showed against the complex structured derivatives and securities leading

to severe illiquidity and distrust problems.

Murphy (2008) concentrates on the effects the severe mispricing in the Credit Default

Swaps (CDS) market that was the result of severe mispricing for these assets and

theoretical framework based on unrealistic assumptions. The housing mortgage default is

of course recognized as the initial trigger for the whole economic collapse, but the author

states that it was only a component and symptom of the deeper problem. More than $60

trillion worth credit default swaps were unregulated and contracted without even the

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minimum guarantee of adequate documentation. The bailout policy as an effective

measure against the financial downward is also criticized and was computed around $3

trillion by the time of the completion of the research with strong evidence that this

amount will turn out to be significantly higher in the course of time.

Accounting theories and practices like the fair-value accounting method are deeply

implicated form the financial crisis and have been the subject of many research papers,

some of them already signaled. In the paper of Arnold (2009,) the gaps of theory and

method in accounting research that have contributed to the current situation are being

analyzed. Methodological gaps are detected in the relationship between the academic

research world and the “accounting in action” procedures. In this case, asset valuation

methods and off-balance sheet entities are the apples of discord. Bank assets valuation

and auditors’ requirement on consolidation of off-balance sheet entities are nowadays

issues with huge impact on solvency and going-concern worries. A very indicative example

of the unlimited off-balance sheet accounting practice is the case of Citigroup, which held

$1.3 trillion worth of assets off-balance sheet in 2008. Fair-value accounting is the number

one controversial subject with critics arguing that it has contributed to abnormal credit

expansion and increased the number of risky investments by all parties, thus more solid

modification of valuation rules is needed.

The Financial Accounting Standards Board (FASB) and the International Accounting

Standards Board (IASB) were of course “perturbed” by the international financial collapse

and the expanded public protests. Henry and Holzman (2009) analyze the usual debate

issue of off-balance sheet accounting and refer to the change in the off-balance sheet

accounting treatment by the FASB in September 2008. The changes aimed at eliminating

the concept of QSPEs in accounting standards through the obligatory report of

securitizations and SPEs on the balance sheets. In the same concept, a staff position was

issued at the same time dramatically expanding the disclosures about derivatives, both in

qualitative and quantitative requirements (like the derivatives’ nature, potential amount

of future payments, fair-value, and provisions about coverage of potential payments).

Concerning the “hot potato” of fair-value measurement, FASB also declared clarifications

in managements’ justification for asset valuation in illiquid markets, broker quoted, and

transaction prices in inactive markets, disorderly transactions and factors determining the

temporal or not impairment of an investment. Viewing from the same perspective, the

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IASB decided on strict monitoring tactics in the US involved with fair value measurement

and financial instruments’ classification. A global advisory group forced with the task of

reviewing all reporting issues associated with the crisis was decided to be formed in a joint

action of the two regulatory boards.

3.3 Summary

This part of the study was focused on the presentation and explanation of the

fundamental causes of the still holding global financial crisis. Briefly, the causes can be

summarized in the collapse of the U.S. housing financing, the development of risky

structured financial instruments, and the establishment of inadequate banking practices

and regulation. Furthermore, a more detailed examination of the two controversial

accounting practices, namely the off-balance sheet and the fair-value reporting methods

was presented. The findings of future research will provide a clearer view for the causes

and the impacts of the financial crisis in all aspects of the business world. This study is

focused on independent auditors. Thorough and detailed analysis of the impacts of the

crisis specified on the external auditing profession along with a general analysis of

auditors’ professional code will also be provided in the subsequent chapter. Focus is

concentrated in the concept of audit conservatism, the audit fees, and the interrelations

between them.

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CHAPTER 4 – The external auditing profession, the impacts of the financial

crisis on external auditors, audit conservatism and audit fees

4.1 External Auditing

Auditing is the “accumulation and evaluation of evidence concerning information to

determine and to report on the degree of correspondence between this information and

the established criteria” (Elder, Arens & Beasly, 2006, pp. 4). Another definition of auditing

is “a form of independent attestation performed by an expert -the auditor- who expresses

an opinion about the fairness of a company’s financial statements” (Hall, 2008, pp. 36).

External audits are promoted as an assurance tool concerning all interested parties in the

financial statements of a company and need to be performed by competent and

independent Certified Public Accounting firms or Certified Public Accountants (CPAs in

both terms). That is the reason why they in addition are called independent audits.

External auditors are tasked with the duty of convincing the public that capitalist

corporations and management are not corrupt and that companies are made accountable.

More specifically, the objective of an audit of financial statements is to enable the auditor

to express an opinion whether the financial statements are prepared, in all material

respects, in accordance with an applicable financial reporting framework (International

Standards on Auditing ISA-200). From an agency theory perspective, external auditing is

considered a powerful tool for signaling or in reducing managers’ opportunistic behavior,

in cases like for example earnings management.

The profession is structured upon six basic principles of conduct, according to ISA-200 2.

At first, auditing responsibilities should be exercised with sensitive professional and moral

judgments. The second principle requires from auditors to serve the public interest, honor

the public trust, and commit to professionalism in all their duties. The highest level of

integrity is the prerequisite for the maintenance and growth of public’s confidence.

Independence both in fact and in appearance and objectivity should be carried out in all

professional responsibilities. A member should demonstrate due care in order to keep

constantly in touch with the profession’s technical and ethical standards, while improving

competence and quality regarding the auditing tasks will keep professional responsibility

in the appropriate levels. The last principle involves the examination of the scope and

2 http://web.ifac.org/clarity-center/isa-200 accessed on 12th October 2010.

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nature of the services provided by the auditor in order to maintain high professional

standards while conducting an audit.

One of the most significant facts in the history of the profession is the Sarbanes Oxley

(SOX) Act of 2002. Huge scandals of corporate and accounting frauds like the Enron case

led the American Congress to pass the SOX Act, considered from the majority of the

professionals as the most important legislation following the Securities Acts of 1933 and

1994 (Elder et. al 2006). Briefly, the provisions of the Act concern publicly held companies

and audit firms. The establishment of the Public Company Accounting Oversight Board

(PCAOB)3 and the external auditor’s report on the effectiveness of the company’s internal

control over financial reporting are attributed as the most significant regulated

constitutive elements.

With references on the relevant literature, concerning the auditing profession’s scope

and the discussion subjects, information that is more detailed will be provided. Research

has been focusing on several issues. The need for mandatory audits, going-concern

opinions, technical skills and size of audit or audited firms consist the most common ones.

While developing the Positive Accounting Theory, Jensen, and Meckling (1976) argued

that audited financial statements reduce the costs of funding. External parties rely on

auditors’ opinions in order to evaluate the financial position of the firm associated with

resources and obligations and consequently the companies are able to attract funds at a

lower cost. This leads ultimately to the increase of the value of the firm. Additionally,

increased demand for financial statement auditing is argued to take place when managers’

of firms are rewarded based on accounting results and when the firm holds debt defined

in accounting-based covenants in order to protect the debt holders’ interests, as signaled

by Deegan and Unerman (2006).

Arrunada (2004) criticizes the hyperbolic regulation of the auditing practices. He

characteristically states, “legislators have been using audit and financial crises as excuses

to introduce additional regulation into an industry already over-regulated” (pp. 635). The

method of trial and error is proposed against repeated regulation that provokes doubt and

3 “The PCAOB is a private-sector, nonprofit corporation created by the Sarbanes-Oxley Act of 2002 to oversee the auditors of public companies in order to protect investors and the public interest by promoting informative, fair, and independent audit reports. The Securities and Exchange Commission (SEC) has oversight authority over the PCAOB, including the approval of the Board’s rules, standards, and budget”. http://pcaobus.org/Pages/default.aspx accessed on 10th October 2010.

29

confusion. It is argued that markets have effective mechanisms that can locate and punish

audit failures themselves, without the introduction of new standards and rules of practice

that can be proved too “violent” and of questionable motivation. Though bankruptcies and

fraud are no special news nowadays, importance should be given in the causal reasons for

these unpleasant facts and in appropriate self-healing measures that can only come from

the driving forces of the markets. Government intervention should be limited and oriented

towards these self-healing measures and it is about time that auditing will no longer be

treated as the usual “fall guy.” The paper proceeds with references concerning the three

basic characteristics of auditing that should be taken into account when audit regulation

takes place. The first is professional judgment that enables auditors to decide on

unverifiable or costly for third parties information. The second is the specific nature of

audit quality. Focus in this case should be concentrated on the monitoring procedures

from the client’s side by the standard setting bodies. The last characteristic involves the

existence and effectiveness of private quality assurance techniques and concerns the

quality of an audit, which should be guaranteed within the borders of the specific needs

that an audit fulfils. Critic is expressed in other important issues of the auditing profession

too. The mandatory auditor rotation is argued to damage the two sides of audit quality,

namely technical competence and independence. Moreover, it has proved to be costly and

can be helpful in collusion between the audit firms that can create a form of oligopoly

market in the audit sector. The author concludes by suggesting that mandatory audits

should not expand in more firm categories than already present. Auditing and financial

reporting should be the outcome of the related parties’ requests in companies that are not

obliged to these tasks, enforcing timeliness, usefulness, and innovation in “financial

information in line with real user demand” (pp. 642).

The controversial subject of Going-Concern doubt is examined in the paper of Citron and

Taffler (2001). The self-fulfilling prophecy argument is investigated as to be the reason for

auditors not expressing a Going-Concern Opinion (GCO) when reasonable evidence

indicates such an opinion. According to the self-fulfilling prophecy theory, an event will

take place as soon as there is reference concerning it attributed completely to the

reference itself. Their research found no empirical support for such an argument. On the

contrary, three out of four reports containing a GCO were not followed by failure before

publication of a posterior set of accounts. More specifically, only the 15% of the

bankrupted companies that were examined between 1987 and 1994 were qualified with a

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GCO prior to failure. The results show that it is the financial distress causing the

bankruptcies or the going-concern opinions, and not the disclosure by itself. Results also

impressively indicate that a GCO can cause an alert mechanism that will most likely result

in the survival of the company. However, authors point out the significance of moral

compunction when auditors express such an opinion. The self interest, consideration of

decision impact on the audited companies and the possibility of lack of professional skills

in making going-concern estimations are factors influencing their decision making

process. Auditors themselves actually put focus on the self-fulfilling prophecy argument

and seem not to be guided only by the strict ethical propositions of the professional code

of conduct.

A contradicting to the before signaled research is the one of Bhimani, Gulamhussen &

Lopes (2009). They investigated the effectiveness of auditors’ GCO evaluation as an

external governance mechanism and proved that firms receiving a GCO are more likely to

default in comparison to those receiving a Clean Opinion (CO). They also found that the

size of the firm is negatively related to default, whereas the age is a contributory to default

factor.

The size of a firm and its implications on auditors’ report was the subject of the paper of

Reynolds and Francis (2001). Investigating Big Audit firms, they found no evidence

supporting favorable reporting for larger clients. However, more conservative reporting

for large clients was proved in connection with the greater litigation risk these clients face.

Roberts (2010) studied auditors’ independence in terms of impartiality or advocacy in

client conflicts. Impartiality is needed when auditors perform their auditing tasks, while

advocacy is diffused in tax settings. The results of his research proved the tendency of

auditors to exhibit self-interest in reacting to clients’ reporting preferences. As it is stated,

“experienced CPAs are as client-supportive in audit settings as they are in tax settings

when exercising their professional judgment” (pp. 29). Similar to this, he showed that

there is not a standards ruled behavior concerning impartiality in auditing followed by all

professionals.

There is a large amount of interesting and controversial issues throughout the

profession. However, more expanded reference on them lies out of the scope of this

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research. The next part will provide more insight in the implications of the crisis in the

professional auditing sector in general.

4.2 Implications of the current financial crisis on the audit profession

The pervasiveness and severe consequences of the global financial crisis can be realized

in every sector of the business world. Concerning the auditing profession, the news of the

past two years has caused doubt on the assurance character of the financial auditing tasks.

On January 28 of 2008 Lehman Brothers, one of the biggest banks operating in the USA

received an unqualified opinion on its annual accounts for the year 2007. A clean bill of

health on its quarterly accounts followed, on 10 July 2008 (Sikka, 2009, pp. 869). It is more

than suspicious for the CPA firm that provided the assurance for the fairness of the

financial statements of the bank that Lehman Brothers filed for bankruptcy on 14

September 2008. The case is almost identical for many other financial enterprises all over

the world, which received an unqualified opinion on their financial statements published

soon before their public admittance of financial difficulties or dissolution. It is even more

disturbing to find out that these financial audits were conducted exclusively by one of the

Big Four Accounting firms-PricewaterhouseCoopers (PWC), KPMG, Ernst & Young, and

Deloitte & Touche. Table 1 in the APPENDIX section shows many cases like the previous

one signaled.

Nowadays auditors are more than ever obliged to defend their profession’s reputation

and perform their tasks with the highest degree of professionalism. Serving the public in

the most efficient way should be the number one priority. Despite the fact that the

primary responsibilities for the present situation burden banks and other financial

institutions, regulatory authorities and rating agencies and not the auditors, their role

creates reasonable questions about the interconnections with the these parties. The study

of Roberts (2010) proved the tendency of auditors to exhibit self-interest in reacting to

clients’ reporting preferences, and had strong implications concerning the principles of

independence and impartiality. It is plausible to think that auditors will be asked to audit

the financial statements of an enterprise in a more lenient and favorable way in the times

of a crisis, since the users of these financial statements put a lot of importance on

auditors’ reports.

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The issues of corporate governance and lack of transparency are currently brought into

light as significant factors causing the financial crisis (Rouse, 2009). The challenges for the

auditing profession are more than obvious, and it seems that the appropriate “authorities”

have already taken some action. Revisions of auditing standards and codes of ethics are

the usual solutions, whenever the auditing industry was facing a crisis (Sikka 2009). The

most relevant to this study, are the “Re-proposed Auditing Standards related to the

Auditor’s Assessment of the Response to Risk; Proposed Conforming Amendments to

PCAOB Standards”, with direct links to the conservatism concept. Following this direction,

the study of Humphrey, Loft & Woods (2009) gives insight “in the active nature of the

regulatory responses to the crisis and the shifting and competing influences among key

regulatory and professional participants in the global audit arena”. They focus their

interest on the need for audit researchers to be more sensitive to the future revised global

financial architecture. More publicly available and accessible knowledge of the workings of

international audit practice, the regulatory networks and the forces driving regulatory

policy and its impact at the level of practice are today prerequisites, according to their

findings, for balancing the unstable financial environment.

Other attempts from appropriate authorities, in order to escape the financial reporting

issues due to the crisis are signaled in this part. The Public Company Accounting Oversight

Board (PCAOB) in the USA is at moment processing the release of some new or revised

standards, trying to heal the “wounded” trust relationship with the public. The

International Financial Reporting Standards (IFRS) is also revising IAS 37, about provisions,

contingent liabilities, and contingent assets and all the Taxonomy standards in general.

IFRS has even established the Financial Crisis Advisory Group (FCAG). It would be more

than useful if these efforts lead to, as Herrmann et al. (2009) commented, an increase in

financial quality.

It cannot be disputed that the regulating authorities and investors have traditionally put

their focus on the corporate financial statements in order to assess risks and economic

exposure. However, creative accounting has become the most usual method for managers

to manipulate of their companies’ financial statements. In the banking sector only, an

early estimate suggested that despite the development of revised and new auditing

standards, banks had around US$ 5000 billion of assets and liabilities off balance sheet

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(Financial Times, 3 June 2008; taken from Sikka, 2009). The amount is rather impressive

and reasonable doubts about the auditing tasks are created.

Traditionally, auditors were the ones to trust the savings of a lifetime. Regulating

authorities trusted the auditors when deciding about risk assessment and measures to be

taken. All in all, auditors have likely failed to prove that they are operating within an

objectivity scope, with strong-based moral values that enhance the relevant theories and

practices followed. The dominant auditing theories provided an insufficient basis for

understanding the transformations that were and can still be occurring in the international

political economy. Arnold (2009) argues that quantitative databases became the only

necessity concerning the conduction of financial audits and the professionals themselves

failed to predict and efficiently react to the effects of the crisis on financial reporting

standards, accounting firms and accounting methods. It is reasonable to argue that these

failures limit the potential of investigating, interpreting, and response to the crisis as it

continues to rise. Accounting and auditing practices are deeply implicated in the current

financial crisis and in proposals for recapitalizing financial institutions and restoring

stability to the global financial system.

Concluding, independent auditors play an important role in ensuring the integrity of

firms’ financial reports, since they can resist management’s opportunistic behavior by

emphasizing conservative financial reporting (Herrmann, Pornupatham & Vichitsarawong,

2008). Audit conservatism is a basic component of the principal standards of the

profession, focusing on this perspective and will be analyzed in the subsequent part.

4.3 Conservatism in audits

The general meaning of conservatism is caution or moderation in behavior or outlook. In

a more conceptual level, conservatism is a political attitude that advocates institutions and

traditional practices that have developed organically promoting stability and continuity.

Throughout this research, the definition that Basu (1997) used for conservatism in the

financial world will be used. Basu interpreted conservatism as “resulting in earnings

reflecting bad news more quickly than good news.”

Viewed from the same perspective, conservatism is the respected principle when the

recognition of unrealized losses is conducted within a short period, whereas the

recognition of unrealized gains is postponed until completion. Conservatism is a concept

34

generally applied in the accounting and auditing policies and procedures. Thorough

observation of accounting and auditing practices recognized models of consistently

prudent behavior as argued by Henderson, Peirson & Brown (1992). The professionals

were systematically overstating expenses and underestimating revenues in cases of

unclear estimations that required professional judgment of a higher degree. The

International Accounting Standards Board (IASB) refers to the content of “prudence” to

clarify conservatism. Prudence is defined by the International Financial Reporting

Standards (IFRS, 2004, paragraph 37)4 as “the inclusion of a degree of caution in the

exercise of the judgments needed in making the estimates required under conditions of

uncertainty, such that assets or income are not overstated and liabilities or expenses are

not understated”. Accountants and of course auditors briefly summarize conservatism in

the following rule: “anticipate no profits, but anticipate all losses” (Basu, 1997, pp. 7).

The association between audit and accounting conservatism is undisputed. The financial

statements of a company are a product of managements’ selection concerning the

accounting methods used. These statements are audited by independent auditors who

express an opinion about the true and fair view of their disclosure. Auditors’ are entitled

to require modifications or changes in the preparation and presentation of the financial

statements if they conclude this is appropriate. Consequently, audit and accounting

conservatism are considered as the same concept, in that they are both responsible for

the same outcome: fair financial statements. This is particularly the perspective

considered in the present research. Auditing conservatism is proxied with the firm’s

accountants’ use of conservatism. The majority of the scientific studies are using the same

adjustment concerning audit and accounting conservatism, by not conducting a distinction

between the two concepts form the first place.

Another existent association is between audit risk and auditors’ conservatism. Audit risk

refers to the possibility of expressing a false opinion about the fairness of a firm’s financial

statements. Generally, auditors accept a level of risk or uncertainty while conducting their

duties. Auditors must estimate carefully this amount of risk and respond to it in the most

efficient way. This is something to be achieved by using conservatism in all the “risky”

areas of the audit.

4 International Financial Reporting Standards (IFRS), (2004), Framework for the Preparation and Presentation of Financial Statements, (London, U.K.: IASCF).

35

Basu (1997) highlighted in his study the systematic differences between bad news and

good news periods in terms of timeliness and persistence of earnings. Firms’ stock returns

were used to distinguish bad and good news and it was proved that bad news is timelier

than good news. In addition, the concurrent sensitivity of earnings to negative returns is

two to six times higher than the concurrent sensitivity of earnings in the case of positive

returns. The relatively weaker association of the concurrent cash flow-return with publicly

available good news than the concurrent earnings-return association was another one of

his findings. In addition, the author found that unexpected earnings increases are more

persistent compared to the unexpected earnings declines. The overall conclusion of this

highly significant research drawn by the measurement of the sensitivity of earnings was

that conservatism has increased overtime.

Another study concerning the accounting conservatism by Easton and Pae (2004),

distinguished conservatism in two types: conservatism due to accounting rules and

conservatism associated with investments in positive net present value projects.

Conservatism is also distinguished in ex ante conservatism and ex post conservatism in a

large number of scientific studies. “Ex ante” or “unconditional” conservatism is related to

the accounting choices that in general underestimate the book value of net assets (Beaver

& Ryan, 2005; Feltham & Olson, 1995; Penman & Zhang, 2002; Qiang, 2007; Cano-

Rodriguez, 2010; Li et al., 2007). “Ex post” or “conditional conservatism” writes down the

book value of assets under sufficiently adverse and not favorable circumstances (Basu,

1997; Ball et al. 2000; Pope & Walker 1999, 2003; Li et al., 2007; Beaver & Ryan, 2005;

Cano-Rodriguez, 2010;). Furthermore, the study of Krishnan (1994) argues that the overall

conservatism of the auditor can be viewed in the tendency of providing qualified opinions.

Findings demonstrate that any negative information gathered during the conduction of an

audit can produce the outcome of increased auditing conservatism. In addition, consistent

with the institutional theory, which argues that managers are pressured in a coercive,

mimetic, or normative way to adopt certain voluntary corporate reporting practices

(Deegan & Unerman, 2006, pp.299) increased conservatism is expected from the auditors’

side.

The study of Francis and Krishnan (1999) gave insight in the relationship between

auditor reporting conservatism and accounting accruals. More specifically, they examined

whether accounting accruals can increase the possibility of a firm receiving a modified

36

audit report concerning both issues of asset realization uncertainties and Going-Concern

difficulties. Accruals increase the inherent audit risk because they are considered as

“vulnerable” subjects of calculation errors by the authors. They indeed found that auditors

of high-accrual firms are more likely to issue modified opinions for asset realization

uncertainties and for Going-Concern problems. A second significant finding was that Big

audit firms (six at the time of the study) provided evidence of conservative professional

behavior, documenting an empirically tested reason for the perceived higher quality of

audits conducted by these firms. The higher level of conservatism by the Big audit firms is

manifested in the recognition of discretionary accruals and in a lower threshold provision

for the issuance of the two types of modified audit reports.

Consistent with the precedent findings is the study of Davis and Ashton (1997)

documenting that auditors reduce the threshold for the “substantial doubt” criterion in

order to decide on their Going-Concern opinion for highly financially distressed entities,

while assessing financial distress with a high degree. Similar results were found in Kinney’s

and Nelson’s (1996) research, revealing auditors’ tendency to disclose contingent losses in

a modified audit report in the case of limited or non-existent outcome information.

Carcello and Palmrose (1994) conducted a research that provided evidence that the

incidence and the magnitude of litigation in the case of a bankruptcy are severely lower if

a modified audit report has been previously issued. The “surprise” effect is demonstrated

as the reasoning for this finding, highly associated with third-party claims against auditors.

A modified audit report prepares stakeholders for a potential failure, thus minimizing the

possibility of sudden stock price decreases that usually result in litigation activities against

the auditing firm.

The significance of the external auditing tasks and conservatism used in them is also

highlighted in part in the paper of Bhimani, Gulamhussen & Lopes (2009). They

investigated the effectiveness of the auditor’s Going-Concern (GCO) evaluation as an

external governance mechanism. They proved that firms that receive a GCO are more

likely to default in comparison to those receiving a Clean Opinion (CO). Their findings

suggest that the information conveyed by GCO is respected by all related with the firms’

parties and these parties include of course the capital providers, banks. Considering the

fact that banks contribute significantly in firms’ liquidity, the key feature of conservatism is

pointed out here. Too much conservatism can cost a firm’s existence and can cause

37

unemployment to a few or even many employees, whereas too little can be proved not

enough. Auditors can be found in the inconvenient position of being accused for

professional negligence or even partiality and corruption.

Professional skepticism is a concept that by itself requires a significant level of

“professional” conservatism, meaning that the auditor should start and continue an audit

keeping a very objective and impartial position, reflecting the GAAP. Other issues though,

must be taken into consideration at this point, as implicated by the research of Kennedy &

Peecher (1997). Their paper examined how accurately auditors assess their own technical

knowledge and that of their subordinates. They came up to the rather disappointing

conclusion that auditors are overconfident in their technical knowledge. Audit supervisors

were proved to overestimate their own technical knowledge to predict the technical

knowledge of their subordinates. In addition, the technical knowledge gap between

supervisors and their subordinates increases the formers’ optimism about the skills of the

latter. These findings are highly associated with auditing conservatism. Overconfidence

can be easily translated into lack of due care accompanied by mistakes and failures that

are definitely not related with conservative auditing practices.

The paper of Li, Peasnell & Beekes (2007) tested the causal relationship between the

endogenous auditor choice and the magnitude of conservatism in earnings when

controlling for managers’ self-selection bias and balance sheet conservatism. Their findings

proved that no significant difference exists in earnings conservatism between Big and Non-

Big audit firms. No significant difference was found between the monitoring power of Big

and Non-Big audit firm auditors on clients’ earnings conservatism. Another issue arising

here is clientele’s size. The results of Reynolds and Francis (2001) in their investigation

concerning the magnitude of the interference between the audit reports and the size of

the client indicate the tendency of Big-firm auditors in reporting more conservatively for

larger clients.

Conservatism is a highly respected concept on audits. The ethical dilemmas, but also the

difficulties concerning the completion of a financial statement audit are daily issues an

auditor faces. However, at the same time auditors seem to be overconfident about their

skills, thus consequently less conservatism is used. If this situation remains unstable during

a crisis period then the results for the auditing profession will turn out to be catastrophic.

It will be very interesting from a scientific point of view to investigate how auditors’

38

conservatism has actually been affected during the recent financial crisis. Comparisons

with the prior-to-crisis levels of conservatism will provide us with a clear view of these

effects.

4.4 Audit fee

Audit fee is the amount payable to an auditor for the conduction of a financial audit. It is

also referred to as “auditors’ remuneration” and must be clearly distinguished from the

fees that are paid to the auditor for any other non-audit service.

A highly controversial issue that arises since the beginning of the profession, concerns

the audit fees. Since audit fees are determined by the management of the audited firms

and paid by the audited firms, auditors’ independence in fact and appearance is

reasonably questioned. It is undoubted that auditors themselves must be dedicated to the

keep the profession’s esteem in the highest level by conducting audits in accordance with

the professional standards of the appropriate regulatory boards.

The majority of the papers studying audit fees are concerned with their determinants,

price competition between audit firms and general trends in audit pricing.

Simunic (1980) was the first to conduct an innovative analysis on the pricing of audit

services. He gave insight in the dominant audit fee determinants and provided evidence

disclosing the prevalence of price competition in the market of the publicly held

companies’ audits. Moreover, he shed some light in the question arising relationship

between the employer, which is the audited company and its employee, which is the audit

firm. Although there is a contradicting interest between the two counterparties

concerning responsibility of ex-post litigation, it is argued that “liability avoidance

motivation implies that at the time of the audit there is a mutuality in the auditee’s and

auditor’s private interests vis-à-vis the external world” (pp. 188).

Following Simunic’s analysis, Hay, Knechel & Wong (2006) distinguished the attributes of

audit fees. Client attributes are size, complexity, inherent risk, and profitability, and

leverage, form of ownership, internal control policies, governance and industry. Auditor

attributes consist of auditor quality, auditor tenure, and location. Engagement attributes

are report lag, “busy” season that refers to the popular fiscal year end, audit problems,

non-audit services, and reporting issues.

39

The controlling determinant of audit fees across the literature is the audited party’s size.

Size is usually measured in terms of total assets or even total revenues and always

positively related to audit fees. In Cobbin’s (2002) international research of the audit fee

determinants, the complexity and business risk of the firm and the size of the audit firm

are also pointed out as important elements in the determination of these fees. In the

study of Owusu-Ansah, Leventis & Caramanis (2010) investigating the factors pricing audit

fees in Greece, the results prove that audit fees are positively related with company size,

Big audit firms, auditee’s financial wealth. Surprisingly, auditor change affects audit fees in

a negative way. The most important contribution of this paper is that it provided evidence

for the existence of an endogenous relationship between audit fees and audit hours. The

authors conclude by highlighting the importance of other factors that can influence audit

fees, such as Board of Directors characteristics, audit committees’ existence and dynamic

role and effective implementation of internal control measures.

A more thorough investigation of the effects of the crisis on auditors’ conservatism will

be provided in the subsequent chapter that presents prior research concerning the matter.

The remainder of this part will give insight in the tight relationship between the auditors’

use of conservatism and the audit fees.

4.5 The Association between Audit Fees and Audit Conservatism

Simply stated, audit conservatism is positively related to audit fees. This relationship is

quite easy to understand; when the use of audit conservatism is increased, more effort

and more hours are dedicated in the conduction of a financial audit. More audit hours are

compensated inevitably with higher audit fees.

Auditors’ reporting conservatism and the potential benefits from the establishment of

price premium charges were investigated by Simunic and Stein (1996). Their intention was

to demonstrate effective alternatives in order to mitigate the results of auditors’

hyperbolic use of conservatism. The empirical evidence of the study though proved to be

unenthusiastic in that there is no significant risk premium in audit fees.

In the paper of Willekens and Achmadi (2003), the issues of price competition in the

private client segment of the audit market and changes in the audit-pricing model are

examined. Evidence supports in general that increased concentration in the audit market

caused surprisingly increased instead of decreased price competition. The same results

40

were observed in the older study of Maher et al. (1992). A significant decrease in audit

fees was recorded between 1977 and 1981, which were years of increased competition in

the auditing market.

The interconnections of internal and external auditing were tested in the study of

Munro & Stewart (2010). An interesting conclusion that came out of this paper related to

audit fees is that external auditors’ lack of trust on internal audit work can result to

additional external audit fees emerging from additional audit hours. Extra fees are

undoubtedly an undesirable outcome for both the client and the audit firm, since clients

seek for the minimization of their expenditures and auditors strive hard for publics and

clientele’s trust and recognition of high professional esteem.

4.6 Summary

The focus of this chapter was towards the understanding of the external auditing

profession and the implications of the financial crisis on it. Emphasis was directed on the

professional standard of conservatism and the presentation of the incentives for increased

audit conservatism. Professional judgment and skepticism should be in the first row of

defense in the battle between the auditing profession and the current low levels of trust

from all third parties. Undoubtedly, auditors’ duty is to serve the public in an independent

and unbiased manner regardless of the environmental circumstances. Moreover, the

findings from a large number of scientific studies have shown that auditors have strong

incentives in completing their financial auditing tasks with an increased use of

conservatism. Audit fees were also analyzed, as well as the associations of audit fees and

auditors’ conservatism.

This relationship between audit fees and the degree of conservatism used by

independent auditors completing their professional tasks in a period of crisis will be

analyzed soundly in the next Chapter. An adequate number of scientific studies have

focused on the subject and their findings are almost identical. The correlation is highly

predictable: the interested in the financial statements of firm parties consider auditors as

the assurance experts in revealing the findings concerning the actual performance of the

firm. The subsequent part analyzes the results of prior research and provides sound

background concerning this expectation, and forms the model concerning the research

design of this study.

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CHAPTER 5 – Prior Research

5.1 Prior Research investigation and Hypotheses development

Conservatism in external audits has been the main subject of many scientific papers. The

most commonly investigated subjects concern the differences between the audit firms’

size and the corresponding levels of conservatism, the going-concern opinions, and the

accounting accruals. Concerning all the before signaled subjects, prior research in general,

has shown that Big audit firms report more conservatively than non-Big audit firms in all

the afore signaled subjects and that all independent auditors are more likely to issue a

going-concern opinion after the enactment of the SOX-Act of 2002.

Basu (1997) conducted an empirical study on the conservatism principle that became

the basic model for all subsequent researches concerning conservatism. The main subject

of his investigation was the systematic differences between good and bad news periods in

the persistence and timeliness of earnings. He proxies concerning positive and negative

unexpected annual stock returns to “bad” and “good” news respectively and found firstly

that earnings are timelier or concurrently sensitive in reflecting publicly available “bad”

than “good” news. More precisely, the contemporaneous sensitivity of earnings to

negative returns is two to six times than that of earnings to positive returns. Secondly, he

found that negative earnings changes are less persistent than the positive ones. In

accordance with this asymmetry, he proved that the Earnings Response Coefficients (ERCs)

are higher for the positive earnings changes than for the negative earnings changes. The

last one of his findings was the stronger association of the concurrent earnings-return

association in comparison with the concurrent cash flow-return association for publicly

available “bad news” compared to “good news.” The examination period he used was

between 1963 and 1990 and argued of for the existence of simultaneous increases in

conservatism and in auditors’ exposure to legal liability during this period. The testing

sample consisted of all the firm-year observations concerning that period and was

investigated with a “reverse” regression method he established based on the model used

by Beaver et al. (1980). His findings are overall consistent with increased conservatism

over the three decades of investigation.

Basu, Hwang & Jan (2001) examined auditors’ conservatism between the different

quarterly earnings. They argued that auditors’ legal liability incentives are accounted for

42

fourth quarter earnings being systematically different from all other interim ones, thus

auditors determine earnings of fourth quarters and their components more conservatively

than managers did. Their study first showed that fourth quarters are more likely to be

involved with higher frequencies and magnitude of losses, negative extraordinary and

special items, and negative discontinued operations. Using Basu’s (1997) model they

measured conservatism by the difference in the coefficients and adjusted R²s from the

“reverse” regressions of quarterly earnings on concurrent quarterly positive and negative

unexpected returns, covering the twenty-four year period of 1975-1998 with in total

463.440 firm-quarter observations. They concluded that the difference in timeliness of

earnings to good and bad news is greatest in the fourth quarter, also consistent with

increased auditors’ conservatism. The authors provided also evidence of rational and quick

auditor responses to changes in their environment by showing that fourth quarter

earnings are more sensitive in high auditor liability periods. The clear assumption made at

this point is that since a crisis period is similar to a fourth quarter in terms of increased

frequencies and magnitudes of losses, negative items, and discontinued operations and

legal liability exposure, increased conservatism is to be expected from the auditors’ side

emerging from the current financial downturn.

The study of Francis & Krishnan (1999), provide similar implications while emphasizing

on auditors’ conservatism in relation with accounting accruals. It is argued that since

accruals increase inherent audit risk due to their increased potential manipulation by the

managers, auditors are more likely to issue a modified report for either asset realization

doubts or going concern problems, whereas the possibility increases in the case of a high-

accrual firm. Auditors lower their threshold for issuing a modified audit report 5, posed by

the authors as “auditor reporting conservatism” resulting in a higher amount of both types

of modified audit reports. The empirical part of the research was conducted with the

probit model (two level and three level probit models) of auditor reporting developed in

Krishnan (1994) and Krishnan and Stephens (1995). The authors focused on determining if

auditors’ likelihood of issuing a modified opinion differed between high-accrual and low-

accrual firms, after controlling for other factors that influence the decision of the audit

opinion. The final sample consisted of 2.068 stock exchange quoted U.S. companies and

the respective data was collected from the years 1986 and 1987. The conclusion was that

5 Davis & Ashton (1997) suggest in a more cynical way that conservative thresholds are an easy way for auditors to be prudent and play it “safe.”

43

auditors are twice more likely to issue a modified audit opinion for high-accrual firms, and

on a second level that income-increasing accruals result in increased reporting

conservatism compared to income-decreasing accruals. Income-increasing accruals and

the selection of profit-increasing accounting practices by managers are expected in

turbulent times such as the current financial crisis period, enhancing the assumption for

increased audit conservatism during the current financial downturn. Francis & Krishnan

(1999) also extended their research by introducing the audit firm’s size variable and found

that only Big audit firms (six at the time) show evidence of reporting conservatism. This

finding contributes to the selection of this study’s sample that will consist of firms audited

by one of the Big audit firms.

Going-concern opinions were the main subject in the research of Geiger, Raghunandan

and Rama (2005) that investigated auditors’ reporting decisions associated with the

establishment of the SOX-Act. The SOX-Act was qualified as the result of enormous

legislative and media scrutiny that emerged from the continuous auditing failures of the

years before 2002. In December 2001, the congressional hearings concerning the Act

began, consequently this point was chosen as the distinguishing one for the periods

examined. The focus was concentrated in firms that had already entered bankruptcy.

Precisely, the authors examined the changes in the likelihood of bankrupt firms having

received a prior going-concern opinion. They hypothesized that auditors’ reporting

decisions would be more conservative after December 2001, leading to a higher possibility

of bankrupt firms having received a prior going-concern modified audit opinion. Their

sample consists of 226 firms that during the period between of 2000 and 2003 were

confronted with bankruptcy, and was tested through a multivariate logistic regression

model. The findings proved that after controlling for financial stress, default status, client

size, bankruptcy, and reporting lags, industry type and auditor size, auditors issued more

going-concern modified opinions after December 2001. In more detail, 70% of the

bankrupt firms had already received a going-concern opinion prior to the bankruptcy in

the 2002-2003 periods, while the percentage decreases significantly to 40% in the 2000-

2001 periods. In order to confirm the results without any limitations emerging from

environmental conditions, they tested bankrupt firms from two different but with same

circumstantial outline periods, 2002-2003 and 1991-1992 respectively, characterized as

“recovery from recession” periods and found again that auditors issued more modified

going-concern opinions in the latter period than in the precedent one. The findings were

44

the same, verifying that the changes in the going-concern rates after December 2001 are

accounted in changes in client characteristics and auditors’ reporting practices. This

tendency of increased auditors’ conservatism was already signaled by Francis & Krishnan

(1999). The statistical analysis proved in numbers that 60% of the increased likelihood of a

going-concern modified opinion after December 2001 is attributed to the increased audit

conservatism rates. This evidence also supports the existence of strong self-correcting

dynamics within the audit profession’s scope. Lastly, another interesting finding that came

into spotlight was that the increased audit conservatism is associated with delays in the

auditing procedures. The associations between the audit fees and the delays in the

assuring procedures and the recession phases of the investigated periods draw the

attention on the strong association between auditors’ conservatism, audit fees, and the

financially stressed period of the last years. It is more than reasonable to assume that this

period is demanding for the use of increased conservatism during the conduction of

independent financial audits, which results in higher audit fees.

Another study that has contributed in the understanding of the timeliness in auditors’

increased levels of conservatism is that of Fargher & Jiang (2008). They hypothesized that

auditors would be more likely to issue a going-concern modified audit report to financially

stressed companies immediately after the turbulent for the independent auditing

profession period of 2000-2002. They confirmed this hypothesis after testing a sample of

1769 Australian stock exchange quoted companies for the pre-crisis period and 3344

Australian stock exchange quoted companies for the post-crisis period. The statistical

model used in was separated in a two-stage and a single-stage analysis of two multivariate

regression equations developed. In more detail, the going-concern modification rate was

increased from 8% in 1999 to 13% in 2003. However, while testing the years after the first

responding to the increased litigation, scrutiny, and public distrust against the audit

profession period, their findings provided insignificant evidence of increased audit

conservatism. This finding implies that auditors are more motivated to make use of

increased professional judgment and effort in crisis periods concerning their profession or

the business world in general. Additionally, research has shown increased audit effort after

2002 (Bedard & Johnstone, 2005) and higher levels of professional skepticism in the

conduction of financial audits after the same year (Secru et al., 2006). These studies

provide stronger support in the expectation of increased audit conservatism during the

years of the proved financial crisis of 2008-2009, especially after the high-profile

45

professional collapse caused by huge financial institutions’ bankruptcies soon after

receiving an unqualified audit report.

Herrmann, Pornupatham, Vichitsarawong (2009) examined the impact of the Asian

financial crisis on auditors’ conservatism in general, and the differences between the

conservatism of Big Four and non-Big Four auditors during the investigated period. They

examined first the link between audit firms size and audit quality (Arrunanda, 1999;

Krishnan & Schauer, 2000; Malone & Roberts, 1999; Moizer, 1997). Secondly, while

investigating the link between conservatism and audit firm size (Basu et al., 2001; Chung et

al., 2003; Lee at al., 2003), they searched for the impacts of the Asian financial crisis on

auditors’ conservatism and separated their sample in Big Four and non-Big Four auditors.

They tested a sample consisting of 311 observations during the crisis period of 1997-1998

and 978 observations during the post-crisis period of 1999-2003 and discovered that

companies audited by Big Four firms report more conservatively than companies audited

by non-Big Four firms did. They also found out that Thai companies, in general, reported

more aggressively during the financial crisis and more conservatively in the period

following the financial crisis. More specifically, during the crisis the Big Four audit clients

reported more conservatively than non-Big Four audit clients did. The findings were not

the same when it comes to the post-crisis period: no difference was discovered in the

conservatism levels between Big Four audit clients and non- Big Four audit clients.

In order to test auditors’ behavior in turbulent times concerning the dominant Big Four

audit firms operating in the Netherlands, a research was conducted by the Netherlands

Authority for the Financial Markets (AFM) in September 2010. This body was established

by the Act on the supervision of audit firms in 20066, who determined the rules and the

duties of auditors performing statutory audits. The rules concern mostly the mandatory

licenses provided by the Authority regarding statutory audits, the mandatory supervision

of the audits by the Authority, and the compliance with handouts regarding the

fundamental aspects of the external auditing profession, which are independence,

competence, objectivity, and integrity. The research was conducted in 2009 and

concerned data for the financial statement audits operated by the Big Four audit firms:

KPMG, Ernst & Young, PriceWaterhouseCoopers, and Deloitte-Touche-Tohmatsu. These

firms conduct the 80% of total Sales statutory audits in the Netherlands.

6 http://www.afm.nl/~/media/Files/wetten-regels/wta/engels/en-wta_act_on_the_supervision_of_audit_firms.ashx , accessed on 10th November

46

The research used a sample concerning data of 46 audits, reporting on the statements of

public interest entities (involved in the construction, real estate, automotive, banking and

insurance sectors, and municipalities, as well as housing associations) that are stock

exchange quoted. The findings were rather disappointing in that they showed that

auditors performed lower quality audits. Specifically, these lower quality audits were

related with lack of professional skepticism, insufficient audit evidence and

documentation, and insufficient reliance in the activities of other auditors such as the

internal auditors, the auditors of foreign subsidiaries and other experts such as IT

executives. Moreover, evidence revealed that auditors conducted insufficient system-

oriented activities and that they had insufficient involvement in other firm activities. An

inadequate system of quality assurance was also found concerning the role of the

compliance officer and the system of internal reviews, along with a reduced level of

commitment regarding the considerations of the quality in carrying out an engagement

quality control. Additionally, another significant finding was that these audits were carried

out without complete records concerning any violations discovered and the relevant

actions taken. In relation with the investigated elements of this study, the research of the

official Dutch body authorized with the supervision of the external auditors proved the use

of decreased levels of conservatism.

The focus of this research would be concentrated on clients of both types of audit firms,

however the sample used was audited exclusively by Big Four audit firms. A contradicting

phenomenon exists, in that several banks and other enterprises around the world had

received an unqualified opinion soon before they filed for bankruptcy or completely

dissolved while being audited by one of the Big Four audit firms. Since this happened right

before the “explosion” of the crisis and the auditing profession came down in the light of

the microscope and the reputation and the public view was at stake (and still is), it is

reasonably expected that during the crisis period auditors’ conservatism would be

increased. In general, there are also contradicting scientific studies concerning the quality

of audits conducted by the Big and the non-Big audit firms. A detailed explanation

concerning this “higher quality” will be provided in the research design part, where the

choice of the sample of this study will be thoroughly analyzed and explained.

Gul et al. (2008) examined in their study the relationship between the Asian financial

crisis and the Accounting conservatism and Audit fees. Their first objective was to prove

47

that the Asian financial downturn between the years 1996-1997 was indeed a crisis. As

evidence concerning this statement, the authors decided to take into account the number

of the dissolved enterprises during the years observed. As expected, the number of

deregistered firms of the years 1996 and 1997 approximately doubled compared to the

one of 1995, and became approximately ten times the number of the deregistered firms of

1994. Their second hypothesis involved conservatism and audit fees during the crisis. 2061

Hong Kong registered and deregistered firms from 1990 until 1997 consisted the sample

for the empirical tests conducted. It is important here to note that they took into account

the rarely used, adversely related to the auditing conservatism concept of accounting

conservatism. Precisely, they argued that client favorable financial statements are

preferable in years of financial downturn and constitute the result of less accounting

conservatism. The less accounting conservatism is translated in an increased audit effort.

This is due to the fact that more evidence have to be accumulated and thorough

investigation through more substantial tests and analytical procedures have to take part

that result inevitably in increased audit fees. When firms report aggressively, a suspicion

of GAAP violation comes into light. Furthermore, inaccuracies and vagueness in the

financial statements reduce the reliability of accounting numbers and financial statements’

disclosures. Despite the additional effort needed from the auditors to assure for the

fairness of the reported results, there is a higher possibility of a litigation and damaged

reputation emerging from materially misstated statements. This leads to more

conservative audit treatment and consequently higher audit fees.

Considering all the before signaled theory, the following hypothesis is formulated:

Hypothesis 1 :

The current financial crisis has resulted in increased auditing conservatism during the

crisis period compared to the prior-crisis period, concerning the Dutch stock exchange

quoted companies.

Gul et al. (2008) extended their research on the relation between the increased levels of

audit conservatism and the audit fees. Evidence proved the positive relationship between

auditors’ conservatism and audit fees. Surprisingly interesting for the authors was the fact

that during financial downturns, managerial incentives for less accounting conservatism

increases audit fees “precisely when the firms can least affords such an increase” (pp. 1).

48

They argued that the decreased accounting conservatism level is highly significant because

it also addresses a hidden cost of the financial downturns7, the indirect effect of the

existent incentive contracts. The increased managers’ pressure for favorable reporting is

the main cause of the high audit fees, since they excluded inflation impacts and financial

crisis’s impacts per se on increased audit fees by examining a longer period of time that

confirmed their findings.

Another study confirming the causes of a boost in the audit fee amounts is the one of

Gul et al. (2003) investigating discretionary accruals and their relations with managers’

incentives and audit fees. The discretionary accruals are subject of thorough accounting

treatment, since they are uncertain accruals that can be easily manipulated. Consequently,

auditors increase the level of the inherent risk appraisal of the audit procedures leading to

increased audit effort and at the bottom line to higher audit fees. The sample consisted of

648 Australian firms of the year 1993 that were tested through a multiple-regression audit

fee model with Ordinary Least Squares (OLS) regressions. They formatted the findings of

their research concerning the audit fees in arguing that there is a positive association

between discretionary accruals and audit fees, ceteris paribus. Discretionary accruals were

proved lower in amount after the enforcement SOX-Act of 2002 as examined by Lai (2003),

thus it can be argued that they are treated with higher professional skepticism and higher

conservatism by auditors. Since discretionary accruals are positively associated with audit

fees, the reasonable assumption is that higher levels of auditing conservatism are also

associated with higher audit fees. Consistent with these findings, Shengupta & Shen (2007)

also proved that firms with poorer quality accruals is associated with higher audit fees,

due to the increased audit effort and professional skepticism demanded by the CPAs.

Jarva’s (2010) research is also consistent with increased audit fees emerging from

increased professional skepticism and audit effort. He examined the consequences of SFAS

142 goodwill write-offs with a sample of 277 SFAS 142 goodwill write-offs taken from the

period between 2002 and 2005, by using a two-stage statistical approach of a propensity

score matching method followed by a regression analysis. The evidence signaled that

write-off firms pay higher future audit fees. This suggests that auditors charge higher fees

7 Gul et al. (2003) also signaled other possible costs like the reduced credibility of financial reports, increased cynicism, and loss of faith in accounting based systems and increased regulatory constraints, that are related with auditors and accountants’ conservatism.

49

due to the extra effort necessary for the goodwill amortization and impairment testing or

due to the additional risk faced by themselves.

The findings of Jarva (2010) are consisted with efficient audit pricing, as it is the case for all

the referring studies. Their findings contributed broadly to the audit fee literature and to

the formation of the second hypothesized claim of this study.

High audit fees already existed at the times right before the financial crisis’s breakdown.

In addition, the unqualified opinions presented to firms that went bankrupted soon after

these opinions came public, the investigation of the differences in the audit fees during

the current global financial crisis consists the second primary concern of this research,

which is constructed as following:

Hypothesis 2:

The current financial crisis has resulted in increased audit fees, because of the increased

audit efforts, concerning the Dutch stock exchange quoted companies.

Since the current financial crisis has undoubtedly affected the external auditing

profession in a major scale, both hypotheses are expected to be confirmed. The focus of

this research is the magnitude and the orientation of these impacts respectively. Another

interesting issue to be investigated is if conservatism plays the most important feature of

the audit fee amount, in the case of increased auditors’ conservatism. It can be argued

that it could be sidelined from the auditors’ efforts to attract more or retain their clients

by negotiating fees in order to adjust to the inevitable severe liquidity shortages emerging

from the financial downturn. A brief summary highlighting the prior research’s findings is

provided with the subsequent Table form. These prior studies, their research designs and

findings constitute the fundamental foundation of the hypothesized claims and the

empirical examination of this study.

50

Summary of prior research:

Authors

(Year)

Object Sample Methodology Outcome

Basu (1997) The conservatism

concept and the timeliness and

persistence of earnings

Every firm-year observation

between the years 1963-

1990

The “reverse” regression

model that he created

Negative earnings

changes are timelier but less

persistent, Earnings

Response Coefficients

(ERCs) are higher for

positive earnings

changes

Basu (1997) The conservatism

concept and the timeliness and

persistence of earnings

Every firm-year observation

between the years 1963-

1990

The “reverse” regression

model that he created

Negative earnings

changes are timelier but less

persistent, ERCs are higher for

positive earnings

changes

Francis & Krishnan

(1999)

Auditors’ conservatism

relation with accounting

accruals

2.068 stock exchange

quoted U.S. companies

(from the years 1986 and 1987)

Krishnan’s two level and three

level probit model

Auditors are more likely to

issue a modified audit opinion

for high-accrual firms and

income-increasing

accruals result in higher

conservatism

51

Authors (Year) Object Sample Methodology Outcome

Geiger,

Raghunandan & Rama (2005)

Auditors’

reporting decisions

associated with the

establishment of the SOX-Act

226 firms that entered into bankruptcy during the period between 2000 and 2003

Multivariate

logistic regression

model

Auditors issue more going-concern modified opinions after December 2001 and increased audit conservatism is associated with delays in audit procedures

Fargher & Jiang (2008)

Auditors’ propensity to

issue Going-Concern

Opinions after the 2000-2002

period

1769 Australian stock exchange

quoted companies for

the pre-crisis period and

3344 for the post-crisis

period

Two-stage and single-stage

analysis of two multivariate

regression equations

developed

Auditors are more likely to issue a going-concern modified audit report to financially stressed companies immediately after the crisis period, concerning the profession between 2000-2002

Gul, Srinidhi &

Shieh (2008)

The Asian

financial crisis and its impacts

on Accounting conservatism

and Audit fees

2061 Hong

Kong registered and

deregistered firms from 1990

until 1997

Basu’s

“reverse” regression

model

Accounting

conservatism dropped

significantly during the crisis

period, resulting in a

boost in auditors’

conservatism

52

and audit fees

Authors (Year) Object Sample Methodology Outcome

Gul, Chen & Tsui (2003)

Discretionary accruals,

managers’ incentives and

audit fees

648 Australian firms of the

1993 year

Multiple-regression

(same as “reverse”) audit

fee model

Discretionary accruals and

audit fees are positively

related

Jarva (2010) the Economic consequences

of SFAS 142 goodwill write-

offs

277 SFAS 142 goodwill write-

offs taken from the 2002-2005

period

Multivariate regression

analysis

Write-off firms pay higher

future audit fees

Netherlands

Authority of

Financial

Markets (2010)

Supervision of

audit firms

46 audits of

public interest

entities

conducted in

2008

Survey Big Four firms

performed low

quality audits

regarding the

investigated

statutory audits

5.2 Summary

The theoretical background concerning audit conservatism, audit fees, and their

changes due to financial crises was analyzed in the preceding part. Overall, empirical

research has found that audit conservatism and audit fees are positively related and that

in crisis periods both elements show increasing tendencies. The hypotheses developed

concern the so far not investigated financial crisis that started in 2008 and the changes

regarding the two auditing elements. The sample and the research design of the empirical

examination that will test these hypotheses will be the subject of the subsequent chapter.

The expectation is that both hypotheses will be verified, assuring that the current financial

crisis has resulted in increased auditors’ use of conservatism and audit fees.

53

CHAPTER 6 – Research Design

6.1 Research approach

The two main research approaches used to test phenomena are the qualitative and

quantitative approaches.

Qualitative research is regarded as the “inquiry” method accounted for the investigation

and understanding of more conceptual features, such as meanings, concepts,

characteristics and behaviors. In short, it investigates the way and the reasoning for

humans’ decision-making. It is involved with non-numerical data; consequently, the role of

the researcher becomes asymmetrically significant. Since it does not allow generalizations,

it is recognized as the least scientific one. The testing sample is small and specifically

chosen concerning the particular cases examined. The results are analyzed and

subjectively interpreted by the conductor of the research and can only explain the specific

subjects under investigation. The findings of such a research easily and reasonably can be

questioned considered as biased.

This study is concerned with the examination and the assessment of specific variables and

the relationship between them, consequently this kind of research, the quantitative one,

cannot be selected as the appropriate empirical method. In order to analyze and prove the

type and the magnitude of the variables and their interconnections, “harder” scientific

evidence is required such as strictly interpreted numerical data.

Quantitative research on the other hand, is regarded as the empirical investigation of

measurable properties and phenomena and the relationships among them. The aim of a

quantitative research is to determine the relationship between an independent and a

dependent (or outcome variable) feature. In addition, a quantitative research is also used

concerning the examination and the explanation of the mechanisms of treatment or

behavioral procedures. In order to test the association between the two types of variables

based on observation and/or prior research findings, specific hypotheses are developed.

The corresponding findings are attributed to the results of the mathematical models

established to correspond to the specific hypotheses.

Since it is the most appropriate and objective one, this kind of research, the quantitative

one, is the one used concerning the empirical testing in this study. Studies targeted to

54

quantifying relationships can be either descriptive, or experimental. The descriptive type is

used for simple measurement of the examined elements, no modification in conditions or

behavior is attempted. In contrast, experimental studies involve measurements that are

taken and then intervened or modified, in order to examine the results of these testing

procedures. The results of a statistical research are considered robust, reliable and can be

generalized due to the employment of scientific –mathematical- models. The data used for

quantitative research is more efficient and can test hypotheses as the ones developed in

the precedent chapter. Furthermore, the tested sample can be as large as adequate for

the establishment and the scientific recognition and approval of the statistically produced

findings. It is important though, to select a representative sample of the population so that

findings are considered unbiased, objective, and generalizing. Additionally, this type of

research has more advantages in that it is less time consuming and expensive.

The goal of this study is to determine the relationship between the emergence and the

impacts of the current financial crisis (independent element) and auditors’ conservatism

and audit fees (dependent elements). Consequently, it is clear that the quantitative type of

research instead of the qualitative one is the most suitable. The specific statistical model

used is analyzed in the subsequent parts.

6.2 Research methodology

Verschuren and Dooreward (2007) defined the quantitative types of research in surveys

and experiments. Surveys are conducted through cross-sectional and longitudinal studies

with questionnaires or interviews that are aimed to estimate the characteristics of a

population, while experiments are used to determine a cause-and-effect relationship.

Furthermore, they distinguished three categories of experimental procedures, namely

laboratory, quasi-experiment, and simulation. Quasi-experiments involve elements that

are not randomly assigned to different groups in order to measure outcomes, but grouped

according to a characteristic that they already possess. This is going to be the scientific

approach of this study, since the data tested are thoroughly selected and categorized.

Moreover, the financial crisis starting in 2008 is considered the “cause” element and

auditors’ conservatism and audit fees are considered the “effect” elements, a fact that

excludes the surveys approach from the first place.

55

This study is investigating the impacts of the global financial crisis of the last 3 years

(2008-2010) on auditors’ conservatism and the audit fees. In order to process their data,

the majority of the scientific studies investigating conservatism, either in accounting or

auditing activities, use the model of Basu (1997). As already commented, Basu used a

multivariate regression model. The ordinary least squares (OLS) method estimates the

unknown parameters in a linear regression model. This is achieved by minimizing the sum

of squared distances between the observed responses in a set of data, and the fitted

responses based on the used regression model.

The underlying assumptions of the OLS model are:

The response variables are uncorrelated with each other.

The errors have zero mean

The errors have finite second moments that are the same for all units

(Homoscedasticity)

Basu’s hypotheses concerned the systematic differences between good and bad news

periods in the timeliness and in the persistence of earnings, due to the better specification

of OLS standard errors and test statistics when the lagging variable is specified as the

dependent one. Specifically, his first and primary hypothesis was that the slope coefficient

and R2 from a regression of annual earnings on annual unexpected returns (negative for

“bad news” and positive for “good news”) are higher concerning the negative unexpected

returns than concerning the positive ones. Indeed his findings were consistent with his

prediction. The specific statistical model he used to investigate the use of conservatism is

demonstrated in the subsequent part of this chapter.

The Basu model is selected as the most appropriate regarding the conduction of this

study. The impacts of the crisis in audit fees are investigated by running the statistical

model used in Gul et al. (2003), in order to define the relationship between the dependent

and the independent variables. Overall, both analyses will consist of regression models as

far as the statistical testing is concerned.

6.3 Measuring auditors’ conservatism and audit fees

Basu (1997) measured conservatism as the asymmetrically recognized bad and good

news in contemporaneous earnings. Within the same concept, the empirical approach of

56

this study associates audit conservatism and audit fees with the estimation risk attributed

to the asymmetric recognition of bad and good news in earnings. The model he used

proxied good news by unexpected positive stock returns and bad news by unexpected

negative stock returns as presented:

Xit/Pit-1 = b0 + b1DRit + b2Rit + b3Rit * DRit + ε (1)

Where:

Xit = Earnings per Share for firm 1 in fiscal year 1

Pit-1 = Price per Share at the beginning of the fiscal year

Rit = Returns

DRit = Dummy variable, which takes the value 1 if R it < 0 (the case of negative returns) and 0

if Rit > 0 (the case of positive returns)

ε = error term

The interaction between the dummy variable and the return measures the difference in

the sensitivity of earnings concerning negative and positive returns. Referring to return,

the ratio of Return on Equity (ROE) will be used. Consequently, due to the increased

sensitivity of earnings regarding bad news than regarding good news, the coefficient b3 is

positive concerning conservative reporting. Briefly, the greater the degree of

conservatism, the greater will be the value of b3.

In order to estimate the change in auditors’ conservatism, this formula provides the

basic form regarding the modified version of Basu’s model used in this study. The

statistical testing will be conducted through a cross-sectional regression analysis for the

years before and the years during the financial crisis. Two testing procedures will be

conducted: four linear regression analyses for each one of the selected years before and

the years during the financial crisis (2005, 2006, 2008, 2009) and two pooled regression

57

analyses concerning the combined data of the two different periods, before and during

the financial crisis (2005-2006 Panel, 2008-2009 Panel). The explanation for the specific

years selected will be presented in the subsequent part concerning all the information

about the sample used.

The adjusted model is developed as follows:

Xit/Pit-1 = b0 + b1DRit + b2Rit + b3Rit * DRit + ε (2)

In detail, the coefficient relating to auditors’ conservatism in both periods (before and

during the crisis) is b3. Consistent with the developed hypothesis, the expectation is that b1

will be positive and of medium significance for the period before the financial crisis (2005-

2006), denoting the same trend in auditors’ conservatism. Additionally, according to the

presented theory b3 will turn out to be positive and of higher significance regarding the

period during the financial crisis (2008-2009), denoting a similar significant increase in the

degree of audit conservatism during the downturn years.

As commented thoroughly in the findings of prior research studies, the effects of the

financial crisis on auditors’ conservatism are expected to result simultaneously in changes

in the amounts of audit fees. These changes will be investigated using the OLS regression

model with natural log of external audit fees (LAF) as the dependent variable and

conservatism (CSV) and other control variables as independent variables. The results of

the investigation of the second hypothesis developed will be found through the empirical

model structured as follows:

LAFit = b0 + b1 CSVit + b2 SIZEit + b3 QRit + b4 LEVit + b5 INVRECit + b6 ROIit + ε (3)

Where:

LAFit = Natural log of external audit fees

58

CSVit = Dummy variable, which takes the value 1 in years of lower auditors’ conservatism

and the value 0 in years of higher auditors’ conservatism

SIZEit = Natural log of total assets

QRit = Ratio of current assets less inventory to current liabilities

LEVit = total debt to book value of equity (leverage)

INVRECit = Book value of inventory and receivables to total assets

ROIit = Earnings before extraordinary to total assets

ε = error term

Concerning the measurement of the level of audit fees, this model is used in most of the

relevant scientific studies (Gul et al., 2008; Francis & Wang, 2004; Ferguson et al., 2005).

As observed, several control variables that will be explained in detail in the next

paragraph.

6.4 Control Variables

The regression model presented will estimate the impact of the current financial crisis

on the magnitude of the audit fees. It concerns seven control variables. The control

variable CSVit, is regarded as a dummy variable that was explained previously in the

presentation of the model. To denote the absence or presence of some categorical effect

that is likely to shift the outcome, dummy or else indicator variable is one that takes only

the values of 0 or 1. Concerning the testing of the second Hypothesis, relating the use of

conservatism in auditing with the audit fees, CSVit is the most significant variable.

Continuing the investigation of the variables, the necessity exists to provide concerning

the five remaining “plain” control variables in the model more detailed information, and

the reasoning concerning their inclusion in the statistical model:

SIZE

SIZE refers to the auditee’s size. As already commented, larger firms have higher

incentives to manipulate their financial statements, either because of management

59

compensation incentives upwards, or downwards emerging from government actions and

taxing regulations.

QR

QR refers to the quick ratio, which indicates the short-term liquidity of a firm. Since it is

used to show the company’s ability to cover its short-term obligations with its own liquid

assets, the higher the ratio, the better the position of the company is.

LEV

LEV is the debt/equity ratio that measures the financial leverage of a company. It captures

the effect of the financing practices of a firm by indicating the proportion of debt and

equity that the company uses in order to finance its assets. If the ratio is high, then a

company is considered to finance aggressively its growth with debt, potentially resulting in

additional interest expenses. Additionally, firms with a LEV variable of higher degree are

exposed to higher litigation risk, consequently resulting in the expectation of increased

audit fees.

While the precedent analyzed quick ratio (QR) is informative about the short-term capital

structure of a company, the debt/equity ratio (LEV) informs about the long-term capital

structure of the company.

INVREC

INVREC is a variable associated with inventories and receivables. Firms exhibiting higher

INVREC levels are reasonably associated with more complex and time consuming financial

audits, and they are more likely to getting charged with higher audit fees.

ROI

ROI is the return on investment variable, which is generally appreciated as performance

evaluation measure. In this form, it is an indicator of the assessment of the overall audit

risk. Firms with lower ROI ratios are less likely to experience litigation risk. Consequently,

the higher the ratio, the higher the audit fees charged to a firm.

The primary expectation concerning the results of the regression analysis is that audit

fees will be found positively related to auditors’ conservatism. Stated in numbers, it is

60

expected that the coefficient b1 for the conservatism measure will be found positive and

significant. The investigation of the impacts of the crisis in audit fees will be examined with

two linear regression analyses for the years 2008 and 2009 respectively, and one pooled

regression analysis concerning the combined data of the two years, determining the

combined results.

6.5 Sample selection

Concerning the audit conservatism and the changes of the audit conservatism due to

the emergence of the global financial crisis, two periods are investigated: 2005-2006 for

the period before the financial crisis and 2008-2009 for the period during the financial

crisis. On the other hand, concerning the potential changes in audit fees due to the

emergence of the global financial crisis, only one period can be investigated and that is the

2008-2009 period. Since Dutch firms were obliged to declare their auditors’ remuneration

after July 2008, this investigated period consists of years that are both during the financial

crisis. Lack of data concerning the amounts of audit fees in the period before the

emergence of the crisis and specifically for the years 2005 and 2006 limits the conduction

of a comparison between the two different periods,

In sum, 51 Dutch stock exchange quoted firms were investigated. Specifically, 17 firms

from the Dutch AEX index, 23 firms from the Dutch AMX index, and 11 firms from the AScX

index were examined. The initial sample consisted of the 25 firms of the three separate

indexes, totaling in 75 firms. The firms were later reduced in the ones fulfilling certain

criteria. The criteria involved the existence of the firms in the four investigated years

(2005, 2006, 2008, and 2009), and of course the existence of all required data concerning

elements of the firms’ financial statements. Firms with omitting values and firms that were

not active during the investigated years were excluded from the initial sample of 75 firms

and resulted in the final used sample of 51 firms.

It is necessary to signal that the data concerning the audit fees involves solely the fees

paid regarding the financial statements’ audits of the firms.

61

Concerning the highly contradicting subject of the difference in audit quality between

the Big and the non-Big Four audit firms, there is a large number of scientific papers argue

about different findings. Lang & Maffet (2010) argue that the quality of the information

provided by accounting data is likely to be higher if such data are audited and assured by

one of the Big audit firms. Ajona et al. also (2008) hypothesized that Big firm auditors are

less tolerant of the establishment of new income-increasing manipulations and

consequently have stronger monitoring power in reducing management’s opportunistic

practices. Evidence, though, disclosed that Big audit firms superior performance in code-

law countries is only context specific, not overall general and depends on the specific

audited firm’ “audit risk model”. Consistent with the higher-quality argument of Big firm

audits, Myers et al. (2010) found that Big firm auditors after the enactment of the SOX-Act

of 2002 became more accurate in issuing Going Concern modifications8. In the study of Gul

et al. (2008), the statistical model used consisted of a variable concerning the audit firm’s

size. The content of this variable was interpreted as a proof of audit quality in that, Big

firm audits were considered as the only high quality ones. Furthermore, Hermann et al.

(2008) showed that during the Asian financial crisis of 1996-1997, Big audit firms’ clients

compared to non-Big audit firms’ clients were more sensitive to bad news than non-Big

audit firms’ clients were signaling. Big audit firms’ faster adjustments and responses in

environmental changes. However, in the same study, evidence proved no significant

difference in the use of conservatism between the two different firm categories in the

post-crisis period, indicating that non-Big firm audits are conducted with higher quality

professional standards through the presence of time. Additionally, in the paper of Cano-

Rodriguez (2010) concerning conservatism in the audits of Spanish stock exchange quoted

firms, evidence proved that in the absence of essential litigation and reputation risk Big

auditors are conducting audits of higher quality, while at the same time they tend to be

over-conservative in furious professional times. Li et al. (2007) after searching the

influence of auditor choice in earnings conservatism found no significantly stronger

monitoring power of Big firm auditors on auditee’s earnings conservatism in comparison

with the same power of non-Big firm auditors.

8 More precisely, Myers et al. (2008) compared Big and non-Big audit firms’ going concern opinions after the enactment of the SOX-Act of 2002. Their findings were consistent with increased conservatism from the non-Big audit firms and higher levels of accuracy from the Big audit firms. Their tests were based on the number of both Type 1 (i.e. auditors a issue going concern opinion to a firm that does not declare bankruptcy after all) and Type 2 misclassifications (i.e. auditors fail to predict and report a going concern modified opinion to a firm that subsequently declares bankruptcy) of going concern modified opinions.

62

Overall, theory has been contradicting concerning the Big and non-Big audit firms’

performances, however a higher number of studies have shown evidence of higher quality

audits conducted by the Big audit firms. One of the Big audit firms audits the majority of

the Dutch stock exchange quoted companies: consequently, no significance, exists in

relation with the audit firm’s size variable.

6.6 Summary

Summarizing this part, an insight in the research design of this study was presented. In

order to investigate auditors’ conservatism and audit fees during and prior to the current

financial crisis, quantitative research was selected as the most appropriate type of

research. Precisely, in order to test the hypotheses developed, the empirical method of

regression analysis with ordinary least squares (OLS) will be used. The corresponding

models were presented and the reasoning concerning their selection as well. Additionally,

an analysis of the variables of the models was provided.

The results from the statistical analysis of the models, concerning the modification of

auditors’ conservatism and audit fees, along with any other essential subjects discovered

are demonstrated and commented in the subsequent chapters.

63

CHAPTER 7 – Research results and analysis

This chapter will comment on the results of the statistical investigation conducted to

determine the impacts of the current financial crisis on auditors’ use of conservatism and

on the audit fees regarding Dutch CPAs. The analysis of the results concerning Model 2 is

demonstrated in the first part of the chapter, which focuses on the impact of the crisis on

auditors’ use of conservatism, and second concerning Model 3 in the subsequent part of

the chapter that focuses on the impact of the crisis on the level of the auditors’ fees. First,

the descriptive statistics of the sample tested will be demonstrated along with a reference

to interesting observations. Second, the evidence of the regression analyses of the two

statistical models used will be presented and a thorough analysis of this evidence will be

commented. The analysis is performed in order to interpret the corresponding numerical

findings in the examined changes in the relationships between the tested variables.

Additionally, an explanation concerning the reasoning of the findings will be commented.

The overall empirical analysis will be briefly signaled in the last part of the chapter, which

contains the summary.

7.1 Analysis of the investigation concerning the impact of the current financial crisis on

auditors’ use of conservatism

Model 2 was used to determine of the effects of the current financial crisis on auditors’

conservatism level. Model 2 was specified as:

Xit/Pit-1 = b0 + b1DRit + b2Rit + b3Rit * DRit

7.1.1 Descriptive statistics for Model 2

Table 1: Descriptive statistics concerning the sample of the pooled regression analyses

PERIODS: 2005-2006 2008-2009

VARIABLES MEAN MEDIAN ST.DEV MIN MAX MEAN MEDIAN ST.DEV MIN MAX

EPS *1,70 1,13 2,13 -2,15 10,89 *0,39 0,77 2,21 -9,43 4,63

Xit/Pit-1 21,97 15,07 31,35 0,45 227,39 19,71 14,19 24,57 0,64 227,39

Rit *19,34 19,17 16,77-

62,14 67,60 *0,21 12,37 46,91 -240 59,88

DRit 0,06 0,00 0,24 0,00 1,00 0,22 0,00 0,41 0,00 1,00Where:

64

EPS= Earnings per Share Xit/Pit = Closing Price of Share for the year prior to the investigated one used for the Price of Share of the beginning of the investigated year ROE=Return on Equity DRit=Dummy variable of the Return.

The descriptive statistics presented involve the sample used for the analyses of the

pooled regressions concerning the two investigated and compared periods of 2005-2006

and 2008-2009. The sample used consisted of 51 Dutch stock exchange quoted firms

(n=52). The demonstrated features involve basic statistical terms that are explained

subsequently. “Mean” presents the average value of the variables, while “Median”

presents the median value of the variables. “STDEV” presents the deviation from the

average value of the examined variables, “Min” presents the lowest value of the variables,

and finally “Max” gives the maximum existing value of the variables.

The 51 investigated firms were selected from the AEX, AMX, and AScX indexes after

controlling for missing and omitted data. As observed in Table A, all corresponding

features show dramatic decrease in the period 2008-2009 which is during the current

financial crisis, than in the period of 2005-2006 which is before the current financial crisis.

This is a proof regarding the severe negative effects of the crisis on the financial position of

the investigated firms and the significant amount of distress they suffer.

The most indicative features concern the mean EPS, which amounted to 1,70 in the

2005-2006 period and 0,39 in the 2008-2009 period, and the mean ROE, which was 19,34

in the 2005-2006 period and 0,21 in the 2008-2009 period. It is worth to signal that due to

the limited number of firms used in the sample, no observations were excluded as outliers.

7.1.2 Pearson’s correlation testing

The Model 2 is the statistical model used to investigate the relationships between both

the dependent variable and the independent variables. These variables may relate with

each other in a significant level, jeopardizing the validity of the results. If two or more

independent for example, variables relate with each other significantly, they are

measuring approximately the same thing, consequently each variable can only explain in

part the relationship with the other variable. This ultimately decreases the explanatory

value of each variable separately and the explanatory power of the model in total.

65

In order to examine the relationship between all the variables in Model 2, a Pearson’s

correlation test was conducted. The subsequent matrix schemes demonstrate the findings

of the tests concerning the two investigated periods prior to and during the financial crisis.

First, the matrix concerning the period prior to the financial crisis is presented.

Table 2a: Pearson’s Correlation test concerning the period 2005 -2006

Xit/Pit-1 DRit

Rit (Return

On Equity) Rit*DRit

Xit/Pit-1 Pearson

Correlation

1

Sig. (2-tailed)

N 51

DRit Pearson

Correlation

-,426** 1

Sig. (2-tailed) ,002

N 51 103

Rit

(Return On Equity)

Pearson

Correlation

,476** -,679** 1

Sig. (2-tailed) ,000 ,000

N 51 102 102

Rit*DRit Pearson

Correlation

,449** -,803** ,707** 1

Sig. (2-tailed) ,001 ,000 ,000

N 51 103 102 103

**. Correlation is significant at the 0.01 level (2-tailed).

The Pearson’s correlation matrix over this period shows that a significant negative

relationship exists between the return variable R it and the dummy return variable DR it

amounted to -0,697. The correlation coefficient may range from –1 to 1, where –1 or 1

indicates a “perfect” relationship between the variables, as can be observed by the table

in the cells showing the relationship between the exact same variables. The further the

coefficient is from 0, regardless of whether it is positive or negative, the stronger the

66

relationship between the two variables. Negative coefficients tell us that an inverse

relationship exists: when one variable increases, the other one decreases. In addition, a

significant correlation between the Xit/Pit-1 and the Rit variables amounted to +0,476 and

between the Xit/Pit-1 and the Rit*DRit variables amounted to +0,449, which is significant only

on the 0.01 level (2-tailed). All the variables are found to be statistically significant at the

0.01 confidence level. Consequently, all the presented variables will be used.

The next table presents the relevant information for the period 2008-2009, during the

current financial crisis.

Table 2b: Pearson’s Correlation test concerning the period 2008 -2009

XPricePrev DRit

Rit (Return

On Equity) RitDRit

XPricePrev Pearson Correlation 1

Sig. (2-tailed)

N 102

DRit Pearson Correlation -,456** 1

Sig. (2-tailed) ,000

N 102 102

Rit (Return On Equity) Pearson Correlation ,501** -,510** 1

Sig. (2-tailed) ,000 ,000

N 101 101 101

Rit*DRit Pearson Correlation ,468** -,501** ,850** 1

Sig. (2-tailed) ,000 ,000 ,000

N 102 102 101 102

**. Correlation is significant at the 0.01 level (2-tailed).

The Pearson’s correlation matrix concerning this period shows again that a significant

negative relationship exists between the return variable R it and the dummy return variable

DRit amounted to -0,510. A significant correlation is shown between the dependent Xit/Pit-1

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and the Rit variables amounted to +0,501 and between the X it/Pit-1 and the Rit*DRit variables

amounted to +0,468, which is significant in the 0.01 level (2-tailed). Again, all the variables

are found to be statistically significant at the 0.01 confidence level. Consequently, all the

presented variables will be used as well.

7.1.3 Coefficients’ analysis - Results investigation

The subsequent tables demonstrate the results regarding the coefficients of the

variables concerning the pooled regressions conducted in order to examine the effects of

the current global financial crisis on auditors’ conservatism, as generated by the E-views

computer program. Because of the extended options on the pooled regression method of

analysis that is used in this study, combining data of more than one year in each examined

period, concerning this empirical analysis the E-views program was selected instead of the

more common SPSS program. In order to determine whether omitting a variable is likely to

result in specification bias or whether the variable is irrelevant, it is easier using the E-

views software program to try alternative versions of an OLS model.

The tables presented subsequently, concern the pooled regression analyses conducted

for the two investigated periods prior to and during the financial crisis respectively.

Table 5: Results of the pooled regression analysis for the 2005-2006 period

Dependent Variable: Xit/Pit-1 (Conservatism)Method: Panel Least Squares Periods included: 2Cross-sections included: 51Xit/Pit-1=b0+b1*DRit+b2*Rit+b3*Rit*DRit

Coefficient Std. Error t-Statistic Prob.

b0 (constant) 0.119369 0.057147 2.088794 0.0423b1 (dummy Return on Equity- DRit) 0.032213 0.170847 0.188548 0.8513b2 (Return on Equity- Rit) 0.002381 0.002550 0.933679 0.3553b3 (sensitivity of earnings to negative and positive returns- Rit*DRit) 0.013453*** 0.007752 1.735462 0.0894

Model SummaryR-squared 0.774969Adjusted R-squared 0.515694S.E. of regression 0.136417

*,**,*** indicate significance at 0.01, 0.05, 0.10 significance level

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An important element of this and the subsequent table is the R squared. It indicates that

only the 77,5% of the dependent Xit/Pit-1 variable is explained by the included independent

variables, by reflecting the correlation coefficient of the model.

The coefficient of determination (R-squared) measures how good the regression line of

the sample fits in the data. It can take values from 0 to 1, while the larger the value, the

better the goodness of the fit is. R squared increases with the addition of extra variables in

the regression. A bigger R squared though, does not mean a more scientific model. The

addition of extra variables may be completely irrelevant. The choice of the variables

should be guided strictly by theory and specific hypotheses. Furthermore, in cases with

many variables in the regression it is better to use the Adjusted R-squared, but this does

fact does not affect this regression analysis’ conduction.

Table 6: Results of the pooled regression analysis for the 2008-2009 period

Dependent Variable: Xit/Pit-1 (Conservatism)Method: Panel Least SquaresSample 2008-2009Periods included: 2Cross-sections included: 51Xit/Pit-1=b0+b1*DRit+b2*Rit+b3*Rit*DRit

Coefficient Std. Error t-Statistic Prob.

b0 (constant) 0.046549 0.049482 0.940729 0.3517b1 (dummy Return on Equity- DRit) 0.066475 0.179170 0.371014 0.7123b2 (Return on Equity- Rit) 0.002481 0.001582 1.568573 0.1235b3 (sensitivity of earnings to negative and positive returns- Rit*DRit) 0.006355* 0.002361 2.692002 0.0098

Model SummaryR-squared 0.734228Adjusted R-squared 0.434527S.E. of regression 0.245812

*,**,*** indicate significance at 0.01, 0.05, 0.10 significance level

The E-views program used for the empirical research of this study generates in general

the standardized coefficient, which is preferred compared to the simple coefficient one.

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Consequently, by analyzing the outcome information of the pooled regression analysis,

Model 2 is formulated as:

a) Xit/Pit-1= 0,112 + 0,032*DRit+ 0,002*Rit+ 0,013*Rit*DRit ,

concerning the period 2005-2006

b) Xit/Pit-1= 0,046 + 0,066*DRit+ 0,002*Rit+ 0,006*Rit*DRit ,

concerning the period 2008-2009

According to the presented results, the b3 coefficient is the most significant variable,

indicating the financial crisis’ effects on auditors’ conservatism. Precisely, for the period

2005-2006, b3 = 0,013. This value is significant at the 0,10 significance level and as

predicted, it is positively related with the X it/Pit-1 variable, measuring auditors’

conservatism. Regarding the 2008-2009 period, b3 = 0,006 and that is a significant value in

the 0,01 significance level. The relation between the sensitivity of earnings to positive or

negative returns that proxies auditors’ conservatism and the ratio of earnings per share

(EPS) to the price of the share at the beginning of the year, is also positive but in a

decreased level, contradicting Hypothesis 1. According to this Hypothesis, the b 3 of the

2005 and 2006 years should be lower in value than the b3 of the 2008 and 2009 years.

However, 0,013 > 0,006, which is not consistent with the stated predictions. Overall, the

pooled regression analysis shows that auditors’ conservatism was in fact higher in the

years before the financial crisis, than in the years during the financial crisis. This is opposite

to the prediction of higher conservatism levels in the years during the financial crisis

compared to the years before the financial crisis.

Similar evidence was found in the study of Herrmann et al. (2008) though, which

showed increased levels concerning auditors’ conservatism in the subsequent of the crisis

years compared to the years during the financial crisis. In periods of crisis, auditors are

according to this evidence found more confused in comparison with the years before or

after a financial crisis, regarding to their use of conservatism.

The results of the statistical model show relatively lower audit conservatism during the

years of the financial crisis compared to the years before the emergence of the crisis. It

can be argued that these findings are partly associated with the Dutch accounting

regulations’ system. The Netherlands is a code law country; all laws and consequently

70

accounting regulations are strictly prescribed and defined in detail. Consequently, less

professional judgment is required. Auditors are likely to rely in the prescribed standards

and practices seeking for the assurance of their professional due care, instead of

exercising high professional judgment and make efforts in order to adjust to the increased

levels of audit skepticism that is required in turbulent times.

Recent developments in the Dutch auditing profession though are in a higher degree

associated with the particular results. Specifically, the recent research conducted by the

Netherlands Authority for Financial Markets (2010) found that Big Four auditors were

performing lower quality statutory audits during 2008, which was the first year of the

crisis. The quality of the audits are in a significant degree related with the levels of

professional conservatism, in that high quality audits are conducted with the use of higher

conservatism levels.

So far, these two studies are the only ones investigating auditors’ behavior in the last 2

years (2008 and 2009) and they have both found evidence of limited loyalty in the high

professional standards regarding financial statement audits.

Complementary evidence is presented, concerning the results generated by the linear

regression analysis conducted for each investigated year.

7.1.4. Complementary evidence concerning data for the years 2005, 2006, 2008 and 2009

The subsequently presented tables contain information about the coefficient results

after running a simple linear regression analysis using Model 2 for each year separately.

This statistical investigation was conducted in order to provide additional support to the

primary pooled regression analyses of the investigated periods. However, evidence turn

out to be mixed and consequently do not fulfill their goal, in that these results cannot be

considered as scientifically robust.

The lower validity level of the linear regression analyses is also shown by the lower value

of the R, and Adjusted R squared.

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Table 7a: Linear regression analysis for the year 2005

Dependent Variable: Xit/Pit-1 (Conservatism)Method: Least SquaresSample (adjusted): 1 51Xit/Pit-1=b0+b1*DRit+b2*Rit+b3*Rit*DRit

Coefficient Std. Error t-Statistic Prob.

b0 (constant) 0.102877 0.072819 1.412773 0.1646b1 (dummy return on equity- DRit) -0.109904 0.184970 -0.594172 0.5554b2 (return on equity- Rit) 0.003878 0.003136 1.236567 0.2227b3 (sensitivity of earnings to negative and positive returns- Rit*DRit) 0.004028 0.006027 0.668284 0.5074

Model SummaryR-squared 0.249980Adjusted R-squared 0.199979S.E. of regression 0.222742

*,**,*** indicate significance at 0.01, 0.05, 0.10 significance level

Table 7b: Linear regression analysis for the year 2006

Dependent Variable: Xit/Pit-1 (Conservatism)Method: Least SquaresSample (adjusted): 1 51Xit/Pit-1=b0+b1*DRit+b2*Rit+b3*Rit*DRit

Coefficient Std. Error t-Statistic Prob.

b0 (constant) 0.135292 0.038301 3.532360 0.0009b1 (dummy return on equity- DRit) -0.220671 0.265775 -0.830295 0.4106b2 (return on equity- Rit) 0.000588 0.001467 0.400521 0.6906b3 (sensitivity of earnings to negative and positive returns- Rit*DRit) -0.001488 0.009178 -0.162088 0.8719

Model SummaryR-squared 0.105665Adjusted R-squared 0.048579 S.E. of regression 0.125253

*,**,*** indicate significance at 0.01, 0.05, 0.10 significance level

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Table 7c: Linear regression analysis for the year 2008

Dependent Variable: Xit/Pit-1 (Conservatism)Method: Least SquaresSample (adjusted): 1 51Xit/Pit-1=b0+b1*DRit+b2*Rit+b3*Rit*DRit

Coefficient Std. Error t-Statistic Prob.

b0 (constant) 0.040159 0.015771 2.546447 0.0143b1 (dummy return on equity- DRit) -0.090427** 0.037378 -2.419222 0.0196b2 (return on equity- Rit) 0.001922* 0.000405 4.743966 0.0000b3 (sensitivity of earnings to negative and positive returns- Rit*DRit) -0.001158*** 0.000586 -1.976487 0.0541

Model SummaryR-squared 0.503369Adjusted R-squared 0.470980S.E. of regression 0.093950

*,**,*** indicate significance at 0.01, 0.05, 0.10 significance level

Table 7d: Linear regression analysis for the year 2009

Dependent Variable: Xit/Pit-1 (Ratio of earning to previous price year)Method: Least SquaresSample (adjusted): 1 51Xit/Pit-1=b0+b1*DRit+b2*Rit+b3*Rit*DRit

Coefficient Std. Error t-Statistic Prob.

b0 (constant) 0.054431 0.086957 0.625949 0.5344

b1 (dummy return on equity- DRit)-0.324860** 0.152921 -2.124365 0.0389

b2 (return on equity- Rit) 0.002774 0.004861 0.570705 0.5709b3 (sensitivity of earnings to negative and positive returns- Rit*DRit) 0.001817 0.005087 0.357134 0.7226

Model SummaryR-squared 0.411633Adjusted R-squared 0.374077S.E. of regression 0.349777

*,**,*** indicate significance at 0.01, 0.05, 0.10 significance level

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The value of the coefficient as the outcome of the separate linear regression analyses

conducted b3 varies regarding to each examined year, even in the years consisting one

investigated period. For instance, b3= 0,004 and positively related with conservatism in

2005, while at the same time b3= - 0,001 and negatively related with conservatism in 2006.

The results are contradicting with each other, in the sense that both years are included in

the prior to the crisis years and should at least show the same sign. However, the value of

each coefficient is considered insignificant.

The case remains the same concerning the second investigated period of 2008-2009,

which is during the current financial crisis. The coefficient b3 equals to - 0,001 for 2008 and

0,002 for 2009 respectively.

Consequently, no robust conclusion can be stated regarding the evidence of the sole linear

regression analyses of the four investigated years. The impacts of the crisis on auditors’

conservatism can be explained only from the results of the two conducted pooled

regression analyses concerning the two investigated periods before and during the current

financial crisis.

Concluding this part, Hypothesis 1 was not confirmed. Auditors make use of less

professional conservatism, while conducting audits of financial statements during the

current crisis period than in the years before the financial crisis. Hypothesis 2, following

Hypothesis 1, signaled the relationship between the current financial and the expected

increased levels of conservatism during the current crisis with the amounts of the audit

fees. The increased levels of audit fees were hypothesized, originating from the increased

use of audit conservatism. The results of the Model 3 investigating this Hypothesis are

demonstrated and commented on the subsequent part.

7.2 The impact of the current financial crisis, concerning the auditors’ fees

As stated in the research design part, the sample for the investigation of the relationship

between the emergence of the current crisis and the audit fees will be limited in the

period 2008-2009. Lack of data for the years 2005-2006, which consists the period before

the current financial crisis, is attributed to the fact that Dutch stock exchange quoted firms

were not obliged to declare their paid amounts of audit fees before 2008. Contrary to the

previous Model 2 method of investigation, the empirical analysis concerning Model 3 will

be conducted using the linear regression method due to the limited amount of the

investigated years.

74

A pooled regression analysis will be conducted additionally for the two examined years,

both during the current financial crisis, but its findings are not considered as valid as the

ones generated by the linear regression method.

Model 3 was specified as:

LAFit = b0 + b1 CSVit + b2 SIZEit + b3 QRit + b4 LEVit + b5 INVRECit + b6 ROIit

7.2.1 Descriptive statistics for Model 3

The subsequent tables contain the description of the sample used in order to investigate

the changes in auditors’ fees in relation with the current financial crisis. The description

concerns the variables forming Model 3, which were produced by certain financial

elements derived from the firms’ reports.

Table 8: Descriptive statistics concerning the sample of the linear regression analyses

YEAR:2008VARIABLES: MEAN MEDIAN ST.DEV MIN MAXLAF 0,4334856 0,3679147 0,8666023 -1,3187588 3,7150837CSV 1 1 0 1 1SIZE 3,2846716 3,282998 0,7381846 1,78044693 5,3017022QR 1,0381858 0,9192385 0,7476751 0,10237155 4,8568637LEV 0,9943605 0,8258015 0,8157817 0 3,3855422InVREC 0,4243657 0,3484227 0,4738197 0,00705467 2,9208192ROI 0,0325625 0,0531162 0,1242431 -0,4781492 0,277135Audit fees **132,75247 2,333 809,4464 0,048 5189

YEAR:2009VARIABLES: MEAN MEDIAN ST.DEV MIN MAXLAF 0,3491675 0,2552725 0,8221802 -1,3187588 3,6823256CSV 1 1 0 1 1SIZE 3,3428261 3,2206148 0,8438311 1,74727971 6,2773786QR 1,101269 0,9316952 0,9779419 0,07575758 6,6311812LEV 0,7999485 0,6274416 0,8074121 0 4,1213873InVREC 0,3712019 0,291078 0,3523816 1,1127E-05 1,6570335ROI 0,0313749 0,0375558 0,1327138 -0,5736986 0,3020946Audit fees **111,85216 1,8 716,6275 0,048 4812

Where:

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LAFit = Natural log of external audit feesCSVit = Dummy variable, which takes the value 1 in years of lower auditors’ conservatism and the value 0 in years of higher auditors’ conservatism SIZEit = Natural log of total assetsQRit = Ratio of current assets less inventory to current liabilities LEVit = total debt to book value of equity (leverage), INVREC it = Book value of inventory and receivables to total assets ROIit = Earnings before extraordinary to total assets.*Numbers are provided in thousands (x1000).

The most interesting element of the descriptive statistics table is the simple numerical

change in the level of the audit fees between 2008 and 2009. As observed, the average

amount of the audit fees stated in the last row of the “MEAN” column is amounted to

132,75247 € in 2008 and 111,85216 € in 2009. Consequently, the actual amount of audit

fees decreased in the second year of the period during the financial crisis. This can be

signaled as an indicator for the results of the statistical regression analysis testing the

impacts of the financial crisis on auditors’ conservatism.

Overall, the majority of the other variables are slightly decreased, demonstrating the

general influence of the crisis on the financial prosperity of the sampling firms.

The variables are calculated using data from the financial statements of the tested firms.

Descriptive statistics for the corresponding data used are provided in Table B in the

APENDIX part.

7.2.2 Pearson’s correlation testing

Two Pearson correlation tests were conducted for the two investigated years

respectively. The matrix of the first test is presented in the next page.

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Table 9a: Pearson’s Correlation test for the year 2008

LAF CSV SIZE QR LEV INVREC ROI

LAF Pearson 1

Sig. (2-tailed)

N 41

CSV Pearson .

Sig. (2-tailed) .

N

SIZE Pearson ,747** 1

Sig. (2-tailed) ,000

N 41 51

QR Pearson -,232 -,299* 1

Sig. (2-tailed) ,144 ,033

N 41 51 51

LEV Pearson ,096 ,076 -,225 1

Sig. (2-tailed) ,550 ,598 ,113

N 41 51 51 51

INVREC Pearson ,049 -,215 -,005 -,003 1

Sig. (2-tailed) ,763 ,129 ,972 ,981

N 41 51 51 51 51

ROI Pearson ,220 ,078 ,005 -,047 ,272 1

Sig. (2-tailed) ,179 ,594 ,975 ,749 ,058

N 39 49 49 49 49 49

a. Because at least one of the variables is constant, this cannot be computed.

**. Correlation is significant at the 0.01 level (2-tailed).

*. Correlation is significant at the 0.05 level (2-tailed).

Overall, the table provides evidence of insignificant correlation between the examined

variables. A strong positive correlation exists as expected, between the dependent

variable LAF and the independent variable SIZE, valued at +0,747 and significant to the

0.01 significance level (2-tailed). This is consistent with the findings of prior research,

which has shown that the size of the firm is the most important determinant of the

amount of the audit fees (Simunic; 1980, Hay, Knechel & Wong; 2006, Cobbin; 2002,

Owusu-Ansah, Leventis & Caramanis; 2010).

77

The second strong correlation found is a negative one, between two independent

variables, the QR (Quick Ratio) variable and the SIZE variable, amounted to -0,299, which is

significant in the 0.01 01 significance level (2-tailed). No other significant correlation

between the variables was discovered.

According to these findings, there is no strong correlation between the variables of the

model, consequently its explanatory power is considered as adequate in providing

scientific evidence. Similar results correspond to the Pearson correlation test conducted

for the year 2009.

Table 9b: Pearson’s Correlation test for the year 2009

LAF CSV SIZE QR LEV INVREC ROI

LAF Pearson 1

Sig. (2-tailed)

N

CSV Pearson 1

Sig. (2-tailed)

N

SIZE Pearson ,633** 1

Sig. (2-tailed) ,000

N 45 51

QR Pearson -,191 -,275 1

Sig. (2-tailed) ,210 ,051

N 45 51 51

LEV Pearson ,193 ,053 -,221 1

Sig. (2-tailed) ,203 ,711 ,120

N 45 51 51 51

INVREC Pearson ,000 -,277* -,103 ,005 1

Sig. (2-tailed) ,997 ,049 ,471 ,975

N 45 51 51 51 51

ROI Pearson -,070 ,134 ,166 -,254 ,087 1

Sig. (2-tailed) ,647 ,349 ,246 ,072 ,542

N 45 51 51 51 51 51

a. a. Because at least one of the variables is constant, this cannot be computed.

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**. Correlation is significant at the 0.01 level (2-tailed).

*. Correlation is significant at the 0.05 level (2-tailed).

Table 9b demonstrates no significant correlation between the examined variables,

able to jeopardize the explanatory power of the model used. A positive correlation exists

between the dependent LAF variable and the independent SIZE variable amounted to

+0,633, which is significant in the 0.01 level (2-tailed). An important negative correlation is

observed in 2009 between the dependent variables INVREC and SIZE that equals to -0,277.

Consequently, it is proved that no strong correlation exists between the variables of the

model and its explanatory power is considered as adequate in generating robust results.

In addition, the APENDIX section provides the Pearson correlation test for the pooled

regression analysis of the years 2008 and 2009 together. Since Model 3 will be analyzed

only by the linear regression analyses of the years, no further comments on the Pearson

correlation test for the pooled regression is considered necessary. The next part of the

chapter consists of the coefficient results and analysis from the empirical testing.

7.2.3 Coefficients’ analysis - Results investigation

Table 10 contains the coefficient results generated by the linear regression of Model 3 by the E-views computer program concerning the first year of the crisis.

Table 10: Results of the linear regression analysis for the year 2008

Dependent Variable: LAF (Natural log of audit fees)Method: Least SquaresSample (adjusted): 51LAF=b1*CSV+b2*SIZE+b3*QR+b4*LEV+b5*INVREC+b6*ROI (no constant term)

Coefficient Std. Error t-Statistic Prob.

b1 (conservatism dummy-CSV) -3.034780* 0.608940 -4.983710 0.0000b2 (auditee’s size-SIZE) 0.923337* 0.150616 6.130414 0.0000b3 (quick ratio-QR) 0.072869 0.190935 0.381643 0.7052b4 (debt/equity ratio-LEV) 0.127765 0.127768 0.999971 0.3246b5 (inv+rec/total assets-INVREC) 0.400920*** 0.212388 1.887673 0.0679b6 (return on investment-ROI) -0.179190 0.812039 -0.220666 0.8267

Model SummaryR-squared 0.573765Adjusted R-squared 0.509184S.E. of Regression 0.590000*,**,*** indicate significance at 0.01, 0.05, 0.10 significance level

79

According to these findings, the Model 3 is now formulated as:

LAFit = b0 -3,035 CSVit + 0,932 SIZEit +0,073 QRit + 0,127 LEVit + 0,4 INVRECit

-0,179 ROIit

Inconsistent with the expectations, the dependent variable LAF is found negatively

related with the audit conservatism level. CSV is a dummy variable, taking the value 0

since 2008 was hypothesized as a year of increased audit conservatism. Precisely, the

coefficient b1 = -3,035 that measures the effect of conservatism on the audit fees, is

negative and significant in the 0.01 level (2-tailed).

Hypothesis 2 stated that increased audit conservatism would result in increased audit

fees due to the increased audit efforts, a claim that is rejected by the results of the

empirical investigation. At this point, it is worth to signal however, that auditors’

conservatism was found decreased in the years during the financial crisis, rejecting

Hypothesis 1 needed to investigate Hypothesis 2.

The evidence arising from this empirical analysis and the actual audit fee amounts reveal a

price competition trend in the audit sector, starting from 2008, the first year of the

financial crisis. This fact is additionally consistent with the rejection of Hypothesis 1, since

evidence proved that auditors were less conservatism during the crisis years than in the

years before the crisis. Decreased conservatism is related lower audit effort and

consequently with lower audit fees. This argument is consistent with the lower quality

audits found by the research of the Netherlands Authority for Financial Markets in 2009,

regarding statutory audits conducted in 2008.

Furthermore, the findings of this regression analysis are inconsistent with the results of

the study of Gul et al. (2003) concerning the impact of the Asian financial crisis of 1996-

1997, which has shown increased audit fees during the crisis years. However, the findings

of this research also showed increased use of auditors’ conservatism, a fact that was not

verified from the statistical tests of this research. The different results of this research and

the afore-mentioned one can be attributed to a large number of factors though. It is

undoubted that the magnitude of the consequences of the global crisis is more prevalent

and severe compared to the precedent Asian one. In the 12 years that have intervened,

highly significant developments of the audit profession have taken place along with the

establishment of new structured financial instruments generated to finance investments

that are much more complicated to audit. Additionally, the Dutch accounting system is less

80

flexible as far as the adjustment in new environmental circumstances is concerned, since it

is specified by code law legislation.

Another strong relation was found between the SIZE variable and LAF. The coefficient of

the SIZE variable, b2, amounts to +0,923. This value is significant in the 0.01 level (2-tailed).

Indeed, prior research has shown that the size of the audited firm is probably the most

significant determinant if the audit fees, related with litigation risk, the “big pocket”

theory, audit hours and complexity of the financial audits (Simunic; 1980, Hay, Knechel &

Wong; 2006, Cobbin; 2002, Owusu-Ansah, Leventis & Caramanis; 2010).

The third important relationship discovered was the one between LAF and the dependent

variable INVREC. The corresponding coefficient b5 is again positive and equal to +0,4 that is

significant in the 0.1 level (2-tailed).

The analysis of the coefficients of the variables used in the model, concerning 2009 is

provided at this point, in order to establish the results of 2008.

Table 11: Results of the linear regression analysis for the year 2009

Dependent Variable: LAF (Natural log of audit fees)Method: Least SquaresSample (adjusted): 51LAF=b1*CSV+b2*SIZE+b3*QR+b4*LEV+b5*INVREC+b6*ROI (no constant term)

Coefficient Std. Error t-Statistic Prob.

b1 (conservatism dummy-CSV) -2.424243* 0.570076 -4.252494 0.0001b2 (auditee’s size-SIZE) 0.697685* 0.130387 5.350888 0.0000b3 (quick ratio-QR) 0.081575 0.104271 0.782333 0.4387b4 (debt/equity ratio-LEV) 0.129521 0.121506 1.065959 0.2930b5 (inv+rec/total assets-INVREC) 0.623401*** 0.367060 1.698365 0.0974B6 (return on investment-ROI) -0.506234 1.008620 -0.501907 0.6186

Model SummaryR-squared 0.459104Adjusted R-squared 0.389759S.E. of regression 0.642270

*,**,*** indicate significance at 0.01, 0.05, 0.10 significance level

81

According to the presented findings, Model 3 is now formulated as:

LAFit = b0 -2,424 CSVit + 0,697 SIZEit +0,082 QRit + 0,130 LEVit + 0,623 INVRECit

-0,506 ROIit

The results of 2009 are found similar to the ones of 2008. More specifically, a negative relation was proved concerning audit conservatism and the audit fees. The coefficient b1 = -2,424 that measures the effect of conservatism on the audit fees, is negative and significant in the 0.01 level (2-tailed). It is reduced compared to the 2008 value of -3,035, indicating a less negative relationship between the dependent and the independent variable in 2009. These results are found to be consistent with the findings of the prior research concerning the audit fees, which are commented in the previous analysis and in chapter 4.

The second strong relationship discovered was found between the SIZE variable and

LAF. The coefficient b2 of the SIZE variable is equal to +0,697, which is significant in the

0.01 level (2-tailed). Compared to the year 2008, the coefficient b2 has decreased, but in an

insignificant degree.

In addition, the INVREC variable is positively associated with the dependent LAF

variable. Its coefficient b5 is equal to +0,623 that is significant in the 0.10 level (2-tailed). In

comparison with 2008, the coefficient of the INVREC variable has decreased, again though

in an insignificant level.

The coefficients of the variables of Model 3 are slightly increased in 2008, compared to

the ones in 2009, except for the INVREC coefficient, which reduced in a minor scale.

Combining the coefficient results with the average of the audit fee amounts demonstrated

in the descriptive statistics table, it is argued that the amount of audit fees has decreased

during the second year of the crisis. It is also argued that the decreased amount of audit

fees relates to the media scrutiny and public criticism generated by the many bankruptcies

of banks that had previously received an unqualified audit opinion.

Overall, the two Hypotheses developed in this scientific research are rejected. Increased

audit conservatism is indeed associated with higher audit fees; however, this was not the

case concerning the investigated Dutch firms audited by the Big Four audit firms. Dutch

auditors’ are found to be less conservative during the financial crisis period, and the Dutch

audit fees are found to support negative tendencies through the years of the financial

crisis instead of positive ones, as hypothesized.

82

Since the auditing profession is an evolving organism that should adjust to the

environmental changes, it can be argued that the financial crisis per se has been partly

involved with the lower amount of audit fees. Furthermore, the small investigated period

examined concerning the two first years of the financial downturn can comprise a bias in

the procedure of the research and the interpretation of its results. However the rejection

of Hypothesis 1 & and Hypothesis 2 is in accordance with the results of the research

conducted by the Netherlands Authority for Financial Markets, which became available to

the public in September 2010. The findings showed that Dutch Big Firm auditors were

involved with low quality statutory audits during the financial crisis, specifically in 2008. It

seems as if the auditors are currently more concerned with the commercial part of their

profession resulting in lower and more competitive fees charged by using decreased levels

of professional conservatism, which could lead to the inevitable sacrifice of the quality of

their audit tasks.

In association with the Agency Theory, the results of this research can be attributed to

the incentive contracts of both the managers and the auditors. In such negative financial

circumstances as the current ones, managers are likely to support aggressive reporting

practices to manipulate the firm’s financial statements in a more favorable and profitable

way, motivated by self-interests. Auditors are additionally found weak and in fact,

unwilling to prevent such opportunistic behavior as shown by the lower amounts of audit

conservatism and audit fees charged. Furthermore, it is argued that the independent

auditing profession in The Netherlands is going through a price competition phase, as

shown by the lower amounts of fees charged and the findings of the Authority of Financial

Markets concerning lower quality audits completed by the Big Four Auditors.

The analysis of the empirical investigation of the variables of this research has reached

its end at this point. Additionally, a pooled regression analysis was also conducted in order

to test the impacts of the current crisis in the audit fees, concerning the years 2008-2009,

as a complementary statistical research. Since the R squared of the regression is very low,

the interpretation of such a pooled analysis could be problematic. This in addition, is

attributed to the fact that the examined period of 2008-2009, which is during the current

financial crisis, cannot be compared with another period due to lack of data.

Consequently, the results of the pooled regression analysis cannot be considered

83

scientifically robust and will not be commented. Table C in the APENDIX section contains

the results of this pooled regression analysis.

7.3 Summary

This chapter was dedicated to the empirical investigation and analysis of the developed

Hypotheses, concerning the impacts of the current financial crisis on auditors’ use

conservatism and the audit fees. The two developed statistical models were regressed, in

order to demonstrate robust scientific results concerning the hypothesized claims. In order

to provide more thorough analysis of the examined sample and to analyze the explanatory

power of the statistical models used to determine the relationships between the

dependent and the independent variables, descriptive statistics and Pearson correlation

tests were conducted and presented.

Descriptive statistics and Pearson correlation tests were conducted and presented Model

2 tested the effect of the crisis on auditors’ level of professional conservatism. The testing

was conducted by a pooled regression analysis between the periods of 2005-2006 and

2008-2009, prior to and during the emergence of the current crisis. The outcome of this

analysis contradicted Hypothesis 1, by providing evidence of increased conservatism in the

period 2005-2006. It was expected on the contrary, that auditors make use of increased

conservatism during the financial crisis period of 2008-2009.

Concerning Hypothesis 2, Model 3 was tested in order to determine the effect of the

crisis on the audit fees. Because of the increased levels of conservatism that were

hypothesized, audit fees were expected to show increased amounts. Evidence generated

by the coefficient results and analysis, signaled a negative relation of the auditors’

conservatism and audit fees, rejecting hypothesis 2.

A reasoning concerning the produced results was also demonstrated, in order to explain

the rejected Hypotheses and the findings of the empirical research. A brief reference to

the causes of these results along with a presentation of the limitations of the research and

subjects arising for further research is provided in the subsequent concluding chapter.

84

CHAPTER 8 – Conclusion, Limitations, and Further research suggestions

8.1 Conclusion

The goal of this research was to investigate potential differences in auditors’

conservatism and audit fees in The Netherlands, attributed to the current global financial

crisis that emerged in 2008. The results of the empirical investigation of the tested

variables found that Dutch auditors are found to be less conservative while performing

their professional tasks during the financial crisis period between the years 2008 and 2009

in comparison with the period between the years 2005 and 2006, prior to the crisis’ boost.

In addition, lower amounts of audit fees were charged in 2009 compared to the ones

charged in 2008. This indicates that the external auditing profession in The Netherlands is

experiencing nowadays a turbulent phase, emerging from price competition practices and

lower quality audits. The research provides evidence regarded to the Big Four audit firms,

as the tested sample concerning 51 Dutch stock exchange quoted firms was audited

exclusively by the Big Four audit firms.

8.2 Limitations

This research had faced certain limitations that can partly affect its findings, as every

scientific study conducted. First, the sample was limited to 51 firms. The rest of the

scientific studies investigating audit conservatism and audit fees in crisis periods were

using samples of hundreds or even thousands of firms, as shown in the prior research part.

Additionally, lack of data regarding the audit fees in the years prior to the crisis has limited

the investigation of the audit fee development between the years during the current

financial crisis. However, the overall validity of the research is considered as scientifically

adequate to produce robust results.

8.3 Further research suggestions

It is suggested that further research shall focus on the tendency of the audit

conservatism and audit fees, through a bigger period, concerning all the financial crisis

years. The association between audit quality and audit conservatism firstly, and audit

quality and audit fees secondly is likely to produce interesting findings regarding the

general scope of the external auditing profession. Additionally, in order to examine

accounting policies and discover relevant auditing weaknesses, the common or recently

85

introduced accounting and reporting practices used in the financial statements of the firms

during the current crisis period shall be investigated.

86

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APENDIX

Table A*

*The table was originally published in Sikka’s paper “Financial crisis and the silence of the auditors” Accounting, Organizations and Society, pp.870.

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Table B: Descriptive statistics concerning the elements of the financial statements used for the formation of the variables, concerning Model 3

Years:2008,2009

VARIABLES MEANMEDIAN ST.DEV MIN MAX

Debt 2130,46 415,45 4642,29 0,00 24466,57Inventories 1017,68 141,35 3119,16 0,00 19132,18Current Assets 3656,98 737,80 11196,98 5,00 83697,26Current Liabilities 3123,61 539,34 9845,20 6,09 75769,82Common Equity 4185,53 596,33 14104,14 12,53 95228,84Book Value Per Share 11,77 7,48 15,94 0,09 135,56Common Shares Out. 405,43 72,91 976,99 7,39 6157,37Income Bef.Ext. Items 557,01 55,55 2191,02 -1044,00 18016,92Total assets 2008-2009

27990,44

1764,82

188835,27 55,88

1893994,00

Audit Fees 121,816 1,995757,8136

4 0,048 5.189,000Earnings Per Share 0,39 0,77 2,21 -9,43 4,63Return On Equity 0,21 12,37 46,91 -240,82 59,88Net Income 510,61 40,79 2145,32 -1113,00 17881,47Total Receivables 1763,16 316,18 6746,79 0,66 55904,92

Table C: Results of the pooled regression testing concerning the investigation of the audit fees in relation with the emergence of the financial crisis in the years 2008-2009

Dependent Variable: LAFMethod: Panel Least SquaresPeriods included: 2Cross-sections included: 49LAF=b1*CSV+b2*SIZE+b3*QR+b4*LEV+b5*INVREC+b6*ROI (no constant term)

Coefficient Std. Error t-Statistic Prob.

b1 (conservatism dummy-CSV) 0.129445 0.435818 0.297015 0.7672b2 (auditee’s size-SIZE) 0.121406 0.103419 1.173919 0.2438b3 (quick ratio-QR) -0.160031*** 0.090709 -1.764222 0.0814b4 (debt/equity ratio-LEV) -0.238801* 0.090662 -2.633954 0.01b5 (inv+rec/total assets-INVREC) -0.061332 0.168829 -0.363279 0.7173b6 (return on investment-ROI) 0.207141 0.708222 0.292481 0.7706

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Model SummaryR-squared 0.122648Adjusted R-squared 0.069795S.E. of regression 0.637069

*,**,*** indicate significance at 0.01, 0.05, 0.10 significance level

94