Investors' perceptions of nonaudit services and their type in Germany: The financial crisis as a turning point

• Author: Steffen Umlauf,Aasmund Eilifsen,Reiner Quick,Florian Schmidt
• DOI: http://doi.org/10.1111/ijau.12121
• Date: 01 July 2018
• Published date: 01 July 2018

ORIGINAL ARTICLE

Investors'perceptions of nonaudit services and their type in

Germany: The financial crisis as a turning point

Aasmund Eilifsen

1

|Reiner Quick

2

|Florian Schmidt

2

|Steffen Umlauf

2

1

Department of Accounting, Auditing and

Law, NHH Norwegian School of Economics,

Bergen, Norway

2

Department of Accounting and Auditing,

Darmstadt University of Technology,

Darmstadt, Germany

Correspondence

Aasmund Eilifsen, Norwegian School of

Economics, Hellev. 30, 5045 Bergen, Norway.

Email: aasmund.eilifsen@nhh.no

As a result of mistrust in the auditing profession, legislators and regulators continue to

impose restrictions to the joint provision of audit and nonaudit services (NAS) to pro-

tect investors' interests. However, investors may perceive NAS differently than legis-

lators, and it is an open question whether a ban on NAS always aligns with investors'

interests. Little evidence exists on investors' perceptions of auditor‐provided NAS in

the continental European regulatory environment, including Germany. The unique

features of the German legal and regulatory environment raise questions of its ability

to comfort investors that auditors resist client‐induced biases in financial reporting.

To empirically investigate and test this, we use earnings response coefficients (ERC)

to measure investors' perceptions of earnings quality and examine the associations

between ERC and NAS fees. Surprisingly, we do not find significant associations

between ERC and NAS fees for our entire sample period 2005–2015. For further

examination, we split the sample before and after the financial crisis in 2008–2009.

The findings indicate that, in the pre‐financial crisis period 2005–2007, investors per-

ceive large NAS fees negatively, and this concern also extends to the components of

the NAS fees. In contrast, in the post‐financial crisis period 2010–2015, investors per-

ceive large NAS fees positively and favorable perceptions of tax services are the

driver of this result. We discuss the findings in light of the regulatory initiatives in

the aftermath of the financial crisis, and the recent EU supranational prohibitions of

NAS and the German application of these.

KEYWORDS

Auditor independence, continentalEurope, financial crisis, investorperceptions, non audit services,

regulation

1|INTRODUCTION

Research, regulators, and the auditing profession recognize that a

“perception”that an auditor's independence is impaired by high levels

of nonaudit services (NAS) is potentially as serious as a factual impair-

ment (DeAngelo, 1981a; Francis & Ke, 2006). As a result of mistrust in

the auditing profession, legislators and regulators continue to impose

restrictions to the joint provision of audit and NAS to protect

investors' interests (Deutscher Bundestag, 2016; EU, 2014; European

Commission [EC], 2011). However, investors may perceive NAS

differently than legislators, and it is an open question whether a ban

on NAS always aligns with investors' interests.

This paper uses earnings response coefficients (ERC) to measure

investors' perceptions of earnings quality and examines the associa-

tions between ERC and NAS fees. Prior research evidence in Anglo‐

American environments on capital market participants' perceptions

of NAS is mixed but favors the conclusion that investors perceive

large auditor‐provided NAS negatively or are indifferent (Francis,

2006). Limited inconclusive evidence exists on investor perceptions

of the components of NAS (Mishra, Raghunandan, & Rama, 2005),

1

Received: 8 September 2017 Revised: 26 March 2018 Accepted: 28 March 2018

DOI: 10.1111/ijau.12121

298 © 2018 John Wiley & Sons Ltd Int J Audit. 2018;22:298–316.wileyonlinelibrary.com/journal/ijau

and some studies report tax services to be more positively perceived

(e.g., Krishnan, Visvanathan, & Yu, 2013).

This study is one of a few to assess the economic consequences

of NAS provision, including NAS components, from an investor per-

spective and applied to an institutional setting the previous literature

has not yet dealt with. Compared with the Anglo‐American setting,

the unique features of the German regulatory environment seem not

well suited to comfort investors' concerns for the provision of NAS.

Surprisingly, for our sample period 2005–2015 we are unable to con-

clude that large provisions of NAS and any of its components concern

investors. This leads us to examine whether the financial crisis in

2008–2009 may have affected investors' perceptions of auditor‐

provided NAS. Our results indicate that, in the pre‐financial crisis

period 2005–2007, investors perceive large NAS fees negatively,

and this concern also extends to the components of the NAS fees.

The financial crisis period 2008–2009 shows similar results except

for insignificance for the tax services fee component. In contrast, in

the post‐financial crisis period 2010–2015, investors perceive large

NAS fees positively and favorable perceptions of tax services drive

this result.

Our findings for the pre‐financial crisis period give support to the

presumption that large NAS weakened German investors' trust in the

financial statements. Thus, we have a case for stricter regulations of

the provision of NAS. The findings for the years following the crisis

indicate, however, that large NAS fees result in a higher perceived

financial reporting quality by investors. This suggests that investors'

concerns for auditor independence no longer dominate perceived ben-

efits from auditor‐provided NAS, such as reduced transaction costs

and knowledge spillover benefits from NAS that improve the quality

or efficiency of the audit.

2

A priori, it was not clear to us how the financial crisis would affect

investors' perceptions of auditor‐provided NAS. Turmoil in the finan-

cial markets during the financial crisis in 2008–2009 initiated heavy

criticism of the auditing profession (e.g., Arnold, 2009; Sikka, 2009).

The crisis could, therefore, have drawn investors' attention to the

potential problems with NAS provision and provoked their skepticism

of earnings numbers (e.g., Kwon, Park, & Yu, 2017). Also possible, and

consistent with our findings, is that investors may have recognized

that the crisis could have served as a disciplining mechanism to miti-

gate weaknesses in earnings quality (Eilifsen & Knivsflå, 2013; Francis,

Hasan, & Wu, 2013). During and in the immediate aftermath of the

financial crisis, regulators such as the EC strongly signaled future tight-

ening of auditor regulations, including more restrictions on the provi-

sion of NAS to audit clients (e.g., EC, 2008, 2010). We observe

significantly lower NAS fees in the post‐crises period compared with

the pre‐crisis period. Thus, the finding of a positive perception associ-

ated with tax services in the post‐crises period is in the context of

significantly lower fee levels. The lower NAS fees could signal to

investors the avoidance of NAS with a higher risk to independence,

leading to a predominance of perceived knowledge spillovers benefits

over independence concerns. Thus, the financial crisis and regulatory

signals may have prevented supervisory boards, audit committees,

and auditors from taking unwarranted risks with respect to indepen-

dence to a degree sufficiently to calm investors' independence con-

cerns. Our analyses and results do not, however, fully unveil the

underlying cause(s) of the change in investors' perceptions of audi-

tor‐provided NAS after the financial crisis.

In 2014 the EU approved new regulations of the auditing sector

and introduced supranational prohibitions of NAS for public interest

entities (PIEs), a so‐called “black list”of prohibited NAS (EU, 2014).

3

In addition, a cap on the provision of NAS was introduced. In the appli-

cation of the new EU regulations, the German Parliament decided in

2016 to use the EU option to allow valuation and certain tax services

on the “black list,”and not to use the option to deviate from the EU

upper limit cap of 70% of NAS fees relative to the audit fee.

4

Our find-

ings give arguments in support of the stricter regulation of auditor‐

provided NAS in Germany and give support to the German decision

to use the option to allow certain tax services on the EU “black list.”

Section 2 discusses specific features of the German setting that

may be relevant for German investors' perceptions of auditor‐

provided NAS, and NAS regulation in Germany and the EU in our sam-

ple period. Section 3 reviews relevant research literature and develops

the hypotheses. Section 4 presents the sample, tests, including a

description of our methodology, and results. Section 5 gives a sum-

mary and conclusions.

2|SPECIFICS OF THE GERMAN SETTING

2.1 |Litigation risk and oversight setting

German investors' perceptions of auditor‐provided NAS may be

influenced by certain specifics of the German regulatory environment,

particularly auditors' litigation risk, public oversight of auditors, and

the regulation of the provision of NAS, including the disclosure of

auditor fees. These German specifics are presented in the following

and serve, together with prior research, to motivate the hypotheses.

The literature indicates that the investor protection environment

and auditors' litigation exposures affect financial reporting and audit

quality (e.g., Ball, Kothari, & Robin, 2000; Ball & Shivakumar, 2008;

Choi & Wong, 2007; Djankov, McLiesh, & Shleifer, 2007; Francis,

Khurana, & Pereira, 2003; Francis & Wang, 2008; Gul, Zhou, & Zhu,

2013; Leuz, Nanda, & Wysocki, 2003). Investor protection is consid-

ered being weak in Germany (Djankov et al., 2007; Gul et al., 2013;

La Porta, Lopez‐de‐Silanes, Sheifer, & Vishney, 1998; La Porta,

Lopez‐de‐Silanes, Sheifer, & Vishney, 2000). For example, Gul et al.

(2013) derive scores of investor protection based on a factor analysis

on four investor protection indexes (anti‐director rights index, index of

disclosure requirement, index of liability standard, and index of public

enforcement). They report a score of −2.071 for Germany, while the

USA and the UK score 0.253 and 0.939 respectively. Only two of

the 30 countries in the sample have a lower investor protection score

than Germany.

Litigation exposure is viewed as perhaps the most effective mech-

anisms to discipline auditors. The German Commercial Code caps

auditors' liabilities for negligent misconduct toward audit clients; set

at €4 million for listed clients. The scope for third parties to pursue

actions against auditors is very limited; the German Civil Code requires

that an intentional violation is established. The intent requirement

severely restricts investors from suing auditors for tort actions. Given

EILIFSEN ET AL.299