Recognizing the importance of enforcement, the “IAS Regulation” introducing mandatory IFRS reporting in the EU (EC Regulation 1606/2002) explicitly states that “a proper and rigorous enforcement regime is key to underpinning investors’ confidence in financial markets” and requires that countries take appropriate measures to ensure compliance. To facilitate a uniform enforcement of
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IFRS in the EU member states, the Committee of European Securities Regulators (CESR) issued a standard addressing a common approach to the enforcement of standards of financial information in Europe (CESR, 2003a). The standard contains 21 high-level principles of enforcement that member states should adopt in enforcing IFRS. In response, many EU countries implemented significant changes to their enforcement regimes and regulatory institutions.49 Turning specifically to the audit function, the International Auditing and Assurance Standards Board (IAASB) issued additional guidance for the auditing of IFRS financial statements (IAASB, 2003). In this section, we review the evidence related to the effectiveness of these regulations with a particular focus on the audit function in mandatory IFRS adoption.
8.1. Empirical predictions of the effects of IFRS on audit verification
Researchers suggest that a decreased emphasis on verifiability as a key concept in the development of IFRS has led to less specific and less prescriptive guidance and hence increased subjectivity in accounting measurement (Jamal et al., 2010), which consequently increase audit risks. Furthermore, studies point out that principles-based IFRS standards can exacerbate litigation risks for auditors, as they are no longer able to rely on compliance with specific guidelines or established rules as a valid defense (Diehl, 2010). The reliance on fair value measurement under IFRS also increases the effort required of auditors, especially in the verification of fair values of assets that do not have active markets (viz., specialized receivables or privately placed loans). Finally, the greater discretion available to managers under IFRS also increases the effort required on behalf of auditors to verify IFRS-based financial statements.
The increased disclosure requirements of IFRS relative to many domestic GAAP also significantly affect the audit function, as auditors must now sign off on more financial information including management’s subjective forecasts and assessments of assets and liabilities. For instance, the increased reporting requirements for transactions designated as accounting hedges call for companies to undertake and document detailed tests of hedge effectiveness. Furthermore, the IFRS provisions relating to share-based payments require substantial disclosure as to the nature and method of executive compensation plans, along with detailed information about the inputs of fair value calculations. As a result of these additional disclosures, IFRS adoption has increased the length of annual reports by up to 60% (Webb, 2006; Ernst & Young, 2005).
The general uncertainty around the introduction of IFRS may also play a contributing role in the increased compliance and audit costs faced by firms. Uncertainty about the implementation and effects of IFRS is likely to increase investor scrutiny of financial statements following IFRS adoption, resulting in an increase in the likelihood of costly litigation and regulatory interventions. Such
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concerns lead auditors to protect their reputation capital by increasing their auditing effort and/or reassessing client risk (e.g., Clarkson, Ferguson, and Hall, 2003; Francis and Krishnan, 1999), which are likely to manifest through increased audit fees.
8.2. Empirical evidence of the effects of IFRS on audit function
Based on a survey of 60 managers from Australia’s top 200 corporations, Jones and Higgins (2006) report that companies viewed their external auditors as the most involved party in the IFRS adoption process. Some of the respondents noted that auditors “would be instrumental – we don’t have a big team, so they’ll be pretty heavily involved” (Jones and Higgins, 2006, p. 640). Other managers exhibited skepticism at the role of the external auditor in the process, saying that their external auditors would not be used extensively in the transition process. The expected involvement of external auditors was greater among larger firms (top 25% of the market cap.), although empirical analysis of the audit fees under IFRS adoption, which we discuss as follows, suggests otherwise (e.g., De George, Ferguson, and Spear, 2013).
Kim, Liu, and Zheng (2012) examine the effect of the IFRS mandate on audit pricing. They argue that because IFRS are comprehensive, fair value oriented, and principles based, they require more complex estimates and judgments by preparers and auditors, thus increasing the level of uncertainty and risk of misstatement. Accordingly, they predict that IFRS increase audit fees and that, all else remaining equal, this effect should be stronger in countries with more robust legal regimes, as auditors face higher legal liabilities in these countries. The authors empirically test these predictions using a broad sample of EU firms from 11 IFRS-adopting countries as treatment firms and firms in 3 non-adopting OECD countries (Japan, Canada, and the US) as a control group. They report evidence of an IFRS-related audit fee premium that rises in reporting complexity and decreases in reporting quality and in strength of a country’s legal regime. However, their use of Japan, the US, and Canada as a control sample may affect their findings, as these countries have different enforcement structures and firms with significantly different reporting incentives compared with EU countries. They also do not consider changes in regulations and enforcements that have concurrently occurred with IFRS adoption in some EU countries. Although they attempt to overcome this contamination concern by using information from a survey capturing the adequacy of firms’ implementation of audit and accounting practices, their analysis does not account for concurrent regulatory changes.50 Thus, any
50 They specifically calculate a country-level measure of concurrent reforms using data from the Annual
Executive Opinion Survey conducted by the Institute for Management Development. Although the primary purpose of the survey is to provide quantifiable measurements of management practices, labour relations, and corruption, the survey explicitly asks respondents to evaluate the extent to which auditing and accounting practices are implemented in their firms adequately and the extent to which corporate boards supervise company management effectively. The authors measure the changes in these scores from the pre-IFRS to post-IFRS periods.
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observed fee increases may simply be in response to increased regulatory and investor scrutiny, rather than auditing IFRS numbers per se.
Focusing on a single country, De George et al. (2013) examine the costs of audit verification for a sample of 907 listed Australian firms, which cover approximately 80% of the total market capitalization on the Australian Stock Exchange. Using a traditional audit fee determinants model the authors find an economy-wide increase in the mean level of audit costs of approximately 23% in the IFRS transition year, relative to pre-IFRS years, that declines to an increase of 8% in later years. In addition, when they examine annual fee changes, they estimate an abnormal IFRS-related increase in audit fees in excess of 8% that is incremental to the normal yearly fee increases observed in the pre- IFRS period. They also find that smaller client firms incur disproportionately more IFRS-related audit costs relative to larger client firms. Finally, using a self-constructed measure of IFRS audit complexity based on a survey of senior audit managers and partners, they document that audit fees are increasing along with the complexity of IFRS audits. As in any study of mandatory IFRS adoption, confounding events remain a concern.
Based on a sample of New Zealand firms, Griffin, Lont, and Sun (2009) examine the effect of the transition to IFRS on audit verification costs. The authors implement a standard audit fee determinants model augmented with temporal indicator variables corresponding to the IFRS mandate for 653 firm-year observations over the sample 2002-2007 period. After controlling for company size, complexity, and risk, they find a reliable increase in audit fees around the transition to IFRS (2004-2006). They also find a general decrease in non-audit fees over their sample period, although they do not find that this change is related to the IFRS mandate.
Shifting away from audit fees, Nobes and Zeff (2008) conduct an exploratory study of the heterogeneity of auditors’ statements related to IFRS compliance. Examining the audit reports of all companies in the main stock indices of Australia, France, Germany, Spain, and the UK for the 2005- 2006 fiscal period, they find a “widespread failure to assert compliance with IFRS when compliance has probably been achieved.” In particular, the audit reports of firms domiciled in France and Spain uniformly refer to compliance with EU IFRS only, i.e., “IFRS as adopted by the EU.” However, for some firms in the UK and Germany, audit reports assert dual compliance to both local standards and “IFRS as issued by the IASB.” Even more dissimilar, audit reports of Australian firms refer only to compliance with “Accounting Standards in Australia,” even though these standards are based closely and in some instances exactly on IFRS. Nobes and Zeff (2008) argue that these differences in auditors’ statements about firm-level IFRS compliance may create problems for investor confidence and comparability. They call for uniformity in audit report language to assert compliance with IFRS.
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Loyeung, Matolcsy, Weber, and Wells (2011) attempt to link IFRS adoption errors to audit quality for a sample of 184 Australian firms (from S&P/ASX 500) for which IFRS-compliant earnings turned out to be either overstated or understated. They report that these accounting errors were caused by 19 different accounting standards, indicating a broad difficulty in implementing IFRS. They also find that these transition errors were positively associated with IFRS-related changes in audit fees and bid-ask spreads, but negatively related to the tenure of CEOs and CFOs who were qualified accountants.
Overall, the evidence suggests that IFRS adoption has generally increased the audit fees of firms. However, at the same time, there appears to be a need for more audit- and accounting-related work to mitigate accounting errors under IFRS. Future research must focus on linking this audit literature better to the other observed effects of IFRS. To what extent does the greater auditor effort, as observed in the IFRS-related audit premium, translate into higher reporting quality and help attain benefits for capital market participants? Future research can also examine whether the integration of capital markets increases after IFRS adoption and whether greater arm’s length transactions are changing the nature of the audit function. What are the implications of increased comparability of financial reporting for auditor judgments and decisions?