Corporate governance of audit firms: Assessing the usefulness of transparency reports in a Europe‐wide analysis

• Published date: 01 January 2019
• Author: Francesca Bernini,Fabio La Rosa,Carlo Caserio
• DOI: http://doi.org/10.1111/corg.12235
• Date: 01 January 2019

ORIGINAL MANUSCRIPT

Corporate governance of audit firms: Assessing the usefulness

of transparency reports in a Europe‐wide analysis

Fabio La Rosa

1

|Carlo Caserio

2

|Francesca Bernini

3

1

Faculty of Economics and Law, Kore

University of Enna, Cittadella Universitaria,

94100 Enna, Italy

2

Faculty of Economics, E‐campus University,

Via Isimbardi 10, 22060 Novedrate, Italy

3

Department of Economics and Management,

University of Pisa, Via Cosimo Ridolfi 10,

56124 Pisa, Italy

Correspondence

Fabio La Rosa, Associate Professor of Business

Administration, Faculty of Economics and Law,

Kore University of Enna, Cittadella

Universitaria, 94100 Enna, Italy.

Email: fabio.larosa@unikore.it

Abstract

Manuscript Type: Empirical

Research Question/Issue: Based on both institutionalized agency theory and meso‐

level theory, this study examines corporate governance disclosure in an audit firm's

transparency report (TR) and whether more disclosure is associated with (a) the audit

function of the country in which it is disclosed; (b) high levels of investor confidence

in public interest entities (PIEs) shown in the portfolio of the audit firm; and (c)

increased competition within the audit market.

Research Findings/Insights: On the basis of content analysis, different measures of

a corporate governance disclosure index (CGDI) are calculated for a sample of 122

auditing firms from 10 European countries over the period 2010–2012. Despite

attempts at harmonizing audit practice across the EU, results confirm the role of insti-

tutional context in explaining differences among European countries. Moreover, while

the CGDI reveals that the TR does improve investor confidence, no evidence was

found that the new disclosure requirement unsettled audit market concentration.

Theoretical/Academic Implications: Results support arguments of the institutional-

ized agency theory that audit firms’corporate governance disclosures depend on both

firm‐and country‐level factors. Moreover, the interplay between these macro and

meso factors explains the information asymmetry reduction that exists between audi-

tors and shareholders, thus improving micro‐level investor confidence.

Practitioner/Policy Implications: The study provides an analysis of audit firm trans-

parency based on the information disclosed in mandatory TRs. Policymakers and prac-

titioners may benefit from the knowledge of items included in the TRs expected to

impact on investor confidence. It also proposes the use of theTR for achieving market

competition strategies, although it may be inefficient.

KEYWORDS

Corporate Governance, Institutionalized Agency Theory, Transparency Report, Investor

Confidence, Audit Competition

1|INTRODUCTION

The scandals that occurred in the mid‐2000s and the financial crisis

that began in 2007 in the US, and still ongoing in the EU, have shown

that the audit is an important tool for ensuring the reliability of

financial statements and their credibility for all stakeholders and, in

particular, for investors. Confidence in the strength and stability of

global capital markets is now a prominent issue. Since the sound

development of financial markets depends strictly on the level of

transparency on corporate governance issues, all key players, including

Received: 5 April 2016 Revised: 23 January 2018 Accepted: 5 March 2018

DOI: 10.1111/corg.12235

14 © 2018 John Wiley & Sons Ltd Corp Govern Int Rev. 2019;27:14–32.wileyonlinelibrary.com/journal/corg

audit firms, are expected to release any information that might affect

market confidence (Kumar & Zattoni, 2014; Mallin, 2002; OECD,

2015). Although many studies discuss convergence of governance‐

related disclosure practices, little empirical evidence supports their

arguments (Markarian, Parbonetti, & Previts, 2007).

After the Eighth EC Audit Directive of 2006, which was a major

edict, audit firms operating in the EU with public interest entities (PIEs

1

)

were required to issue transparency reports (TRs) on their governance

practices. By including this requirement in the Directive, the EU has

been a front‐runner in reform, especially when compared to the US.

Since 2008, the Public Company Accounting Oversight Board

(PCAOB) has adopted rules for periodic disclosure and transparency

reports for registered audit firms that are authorized to audit public

companies. The spreading use of this process from the EU to the US

is witness to the growing interest around the globe in the transpar-

ency of audit firms themselves and, in general, these laws and regula-

tions imposing a discipline on the audit profession may contribute to a

restoration of confidence in the audit process.

In fact, disclosures through TR may signal the quality of services

by the audit firms (IOSCO, 2009). Especially the governance of audit

firms “is perceived to have a significant influence on audit quality

and an audit firm's ability to continuously provide audit services to

the market”(IOSCO, 2009, p. 6), and “some of these disclosures may

be relevant to evaluating audit quality or the availability and delivery

of audit services among audit firms”(p. 9). This has also been empiri-

cally supported by a recent analysis of the Financial Reporting Council

outlining that audit “firms are now describing in greater detail the pro-

cesses they have in place to achieve a high standard of audit quality”

(FRC, 2015, p. 7) and by Deumes, Schelleman, Vander Bauwhede,

and Vanstraelen (2012), who find that providing a statement on the

effectiveness of internal quality control system is a means for audit

firms to signal audit quality.

Although TR should be considered an appropriate resource for all

stakeholders, it should be of importance mainly to the investor market.

If, as in the past, the purpose of the audit was to “improve the degree of

trust of the target users of the financial situations […] by expressing an

opinion by an auditor”(ISA No. 200), now this purpose is meaningfully

bolstered by theTR. While previous research sought to relate TR disclo-

sures to the professional needs of accounting and audit practitioners

(Pott, Mock, & Watrin, 2008) or to audit firm clients (Deumes et al.,

2012), a study relating the governance disclosures included in the TR

to the needs of investors and other users of audit data still does not

exist. Therefore, the recent EC Audit Directive requiring external trans-

parency reporting by European audit firms promotes research on how

the new level of mandatory disclosure influences investors and audit

markets. This paper examines the informational value of theTRs pre-

sented by European audit firms serving PIEs. Specifically, this work is

aimed at verifying whether the type, quantity, and qualityof disclosures

released by audit firms from ten Western European countries has any

bearing on investor confidence and audit market competition.

Our theoretical arguments draw on the meso theory of manage-

ment (Bamberger, 2008) and the institutionalized agency theory

(Aguilera & Jackson, 2003). A meso‐level theory involves at least

two levels of analysis—micro and macro level—that are linked through

bridging propositions that aggregate the effects of lower‐level

variables and relate them to higher‐level variables (House, Rousseau,

& Thomas‐Hunt, 1995). Research on the meso level focuses on the

influences of interorganizational factors between audit firms and their

clients. In this work, the meso‐level theory aims to link the micro‐insti-

tutions (PIEs and their investors) with external meso‐institutional

players, such as audit firms. An audit firm plays an institutional role

for all the investors interested in its client firms. Therefore, as investor

confidence varies among the countries because of different legal and

auditing environments (institutional macro‐variables), the same occurs

with the auditfirm through its TR (institutionalmeso‐variable) for all its

client firms (micro‐institution variable).

Within this framework, we apply agency theory to the relationship

between auditors (agent) and shareholders (principal). The divergence in

goals between these actors may occur when auditors discretionally

decide what and how to disclose in the TR addressed to the market.

Agency theory suggests firm‐level governance mechanisms such as

the effectiveness of the governance and ownership structure or partner

remuneration may influence investor confidence. Then, we consider the

role of institutional national factors, specifically related to the audit

quality environment. Therefore, under the institutionalized agency per-

spective, auditors may still be viewed as agents with authority delegated

from investors, but their intentions would also be driven by values and

norms within a given institutional environment (Seal, 2006). By

connecting the routine nature of auditing practices with external insti-

tutional influences, the institutionalized agency theory represents a

more appropriate framework for understanding how governance disclo-

sures impact on investor confidence and market competition.

In other words, since our theoretical framework integrates

agency, institutional and meso theories, we propose that client firm‐

level mechanisms such as investor confidence related to PIEs do not

function in isolation but are reinforced by elements of the external

governance practices provided by an audit firm's TR, as well as the

audit level of a given country. A study on all three levels–macro, meso

and micro–may yield important insights for our understanding of audit

firm corporate governance.

To this end, using a dataset of 122 audit firms and 770 listed PIE

observations, a preliminary test is conducted to see whether audit

firms in countries with a developed audit function do in fact present

higher levels of disclosure than do audit firms residing in countries

with a less developed audit activity. Subsequently, we examine

whether higher amounts of disclosure correspond to higher levels of

investor confidence, thanks to a reduction of information asymmetry.

Finally, it is investigated whether higher amounts of disclosure affect

audit market competition, measured as an increase in the number of

PIEs audited by non‐Big 4 audit firms.

This study contributes to the corporate governance and disclo-

sure literature in the following ways. First, it expands on Deumes

et al.'s (2012) investigation by including ten European countries in

the sample and by examining the role of institutional factors in

explaining differences among TRs across Europe. For example, it has

been found that while in Anglo‐American countries the auditing pro-

fession is focused primarily on protecting the private interests of the

profession, in code law countries the auditing profession tends to

defend both the public interest and its private interests (Lesage,

Hottegindre, & Baker, 2016). This comparison detects the degree of

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