Loan loss provisions in large publicly quoted European banks and auditor independence

• Author: Domenico Campa,Ray Donnelly
• Published date: 01 July 2019
• DOI: http://doi.org/10.1111/ijau.12158
• Date: 01 July 2019

ORIGINAL ARTICLE

Loan loss provisions in large publicly quoted European banks

and auditor independence

Domenico Campa

1

|Ray Donnelly

2

1

International University of Monaco, Monaco

2

Department of Accounting, Finance and

Information System, University College Cork,

Cork, Ireland

Correspondence

Domenico Campa, International University of

Monaco, INSEEC U Research Center 14, rue

Hubert Clerissi, 98000 Monaco.

Email: dcampa@inseec.com

Funding information

Institute of Certified Public Accountants in

Ireland

The European Commission, citing deficiencies in the financial statements of banks

during the financial crisis, has questioned the independence of the auditors of Euro-

pean banks at the onset of the crisis. We test for evidence of impaired auditor inde-

pendence by examining if the economic bond between auditors and clients is

associated with the audit quality of banks, controlling for the strength of banking reg-

ulation of the country in which a bank operates. We find no evidence of income‐

increasing loan loss provisions being positively associated with the auditor–client

economic bond. There is no indication that auditor independence is impaired in EU

banks. Stronger country regulation is associated with more conservative provisioning

before and after the formation of the European Banking Authority. We also find that

the strength of banking regulation mitigates any tendency of auditors' independence

to be compromised by the auditor–client economic bond.

KEYWORDS

auditor independence, banking regulation, European banks, loanloss provisions

JEL CLASSIFICATION

M41; M42; G21; C23

1|INTRODUCTION

Perceived threats to the independence of statutory auditors moti-

vated the EU to reform its regulation regarding the provision of stat-

utory audits in member states (European Commission, 2016). The

reforms were prompted by the global financial crisis when doubts

pertaining to “the credibility and reliability of the audited financial

statements of banks, other financial institutions and listed compa-

nies”emerged (European Commission, 2016, p. 1). Memo 16/2244

of the European Commission states that “threats to the indepen-

dence of statutory auditors”challenge their ability “to exert thorough

professional scepticism”(European Commission, 2016, p. 1). This

paper tests for evidence of impaired auditor independence by exam-

ining if the economic bond between auditors and clients is associ-

ated with the audit (earnings) quality of large European banks

(proxied by abnormal loan loss provisions [ALLPs]), paying particular

attention to the period of the financial crisis and taking into account

the strength of banking regulation of the country in which a bank

operates.

Whereas the EU's reforms pertain to all public‐interest entities

(PIEs), they are firmly rooted in the performance of banks over the

period 2007–2009. The explanatory memorandum of the Proposal

2011/0359 “Regulation of the European Parliament and of the Coun-

cil on specific requirements regarding statutory audit of public‐interest

entities”states that, given the losses of banks, “it is difficult for many

citizens and investors to understand how auditors could give clean

audit reports to their clients (in particular banks) for those periods”

(European Commission, 2011, p. 2). Notwithstanding the views of

the European Commission, Deumes, Knechel, Meuwissen, Schelleman,

and Vanstraelen (2010) pointed out that regulatory reforms imple-

mented following a crisis are often motivated by political expediency

and the need to take action.

The financial crisis of 2007–2009 was a very deep crisis. Haldane,

(2009, p. 2) states that “some have suggested that it is the worst since

Received: 23 February 2018 Revised: 28 February 2019 Accepted: 26 March 2019

DOI: 10.1111/ijau.12158

Int J Audit. 2019;23:245–262. © 2019 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/ijau 245

the early 1970s; others, the worse since the Great Depression; others

still, the worst in human history.”There is no doubt that it put many

European banks under severe pressure (Detragiache, Tressel, & Turk‐

Ariss, 2018). The latter authors show that the average return on equity

of EU banks fell from 16.3% immediately prior to the crisis to 2.2%

during the crisis. In the regions of the EU hit hardest by the crisis, prof-

itability fell to an even greater extent.

1

The general earnings manage-

ment literature argues that companies are motivated to manage

earnings when their stock price is under stress or their earnings are

under pressure (Burgstahler & Dichev, 1997; Young, 2008). Thus, at

the onset of the financial crisis, auditors would have needed to be

especially vigilant with respect to opportunistic upward management

of earnings.

The question of whether the quality of the financial reports of

large EU banks was compromised by a deficiency in auditor indepen-

dence during the financial crisis is an important one. This is especially

true in the light of the findings of Kanagaretnam, Krishnan, and Lobo

(2010) that auditor independence is not compromised for large,

closely regulated US banks but is for smaller banks. Our EU‐base study

also offers us the opportunity to study how cross‐country differences

in the strength of banking regulation impact on auditor independence.

The financial crisis motivated changes in EU regulation pertaining to

banks. Prior to 2007 the strength of banking regulation varied sub-

stantially between countries in the EU. It is this variation that affords

us the opportunity to study the impact of different standards of bank-

ing regulation on auditor independence. After the financial crisis, reg-

ulation became much more uniform across the EU.

2

Thus, in addition,

we have the opportunity to investigate the consequences of any

changes in banking regulation occasioned by the financial crisis on

the audit quality of EU banks.

The literature on the independence of auditors and its relation with

the quality of the audit is extensive but it is largely US based.

Basioudis, Papakonstantinou, and Geiger (2008) asserted that it is

not correct to extrapolate the findings in one country even to coun-

tries that appear to be similar. Given that the USA is subject to stricter

enforcement and is a more litigious environment (Coffee, 2007; Li,

Beekes, & Peasnell, 2009), the results of audit research there cannot

simply be applied to the EU. Ferguson, Seow, and Young (2004), using

UK data, suggested that auditor independence of mind is impaired by

the provision of nonaudit services (NASs) while the overwhelming

result of the extensive US literature is that auditor independence of

mind or fact is not impaired by the provision of NASs (DeFond &

Zhang, 2014). The regulations governing auditing were changed after

the accounting scandals (e.g., Enron, Parmalat) at the turn of the cen-

tury, and there is little EU‐based evidence since the post‐Enron regu-

lations came into force. A notable exception is Campa and Donnelly

(2016). However, that paper deals with large nonfinancial UK compa-

nies, whereas the current paper aims to address the specific issue of

the audit quality among EU banks that triggered the most recent revi-

sion in EU regulation.

We analyze a panel of data over the 9‐year period 2006–2014 on

large publicly quoted European banks using only accounts prepared

under International Financial Reporting Standards (IFRS) to aid

comparability. Furthermore, we split the period covered by the sample

into two subperiods: 2006–2010, which includes the financial crisis,

and 2011–2014, which is a period during which banking regulation

in the EU became more uniform across countries following the foun-

dation of the EBA in late 2010. In the first subperiod we can test if

the strength of banking regulation in a bank's country of origin impacts

on auditor independence and by comparing both subperiods we can

also observe if the foundation of the EBA has any impact on the rela-

tion between auditor independence and banking regulation. We esti-

mate ALLPs and unexpected fees paid to the auditors as well as the

NASs fee ratio, as our primary measures of earnings quality and the

economic bond with the auditor, respectively. Higher levels of earn-

ings quality are taken to be indicative of higher audit quality. We

pay particular attention to negative, or income‐increasing, ALLPs and

their association with unexpected total fees, unexpected NASs fees

and the NASs fee ratio. This is motivated by knowing, with the benefit

of hindsight, that the loan loss provisions (LLPs) of banks are consid-

ered to have been understated at the onset of the financial crisis. If

unexpected NASs fees are positively related to the absolute value of

negative ALLPs we infer that auditor independence is compromised

by the economic bond created by the fees.

Our results show that a deficiency in auditor independence does

not underlie any underprovisioning by publicly quoted banks in the

EU. We also report evidence of the influence of regulation in the

banking industry mitigating any tendency of auditors' independence

to be compromised by the economic bond created by fees paid by

their clients. This finding is consistent with that of Kanagaretnam

et al. (2010) for the USA. There is also some evidence of spillover

effects from the provision of NASs. They are evidenced by a negative

relation between ALLPs, particularly income‐increasing ALLPs, and

unexpected NASs fees, for banks operating in countries where bank-

ing regulation is strong and only in the period prior to the formation

of the EBA; that is, when country‐specific regulation is more

important.

The remainder of the paper is organized as follows. Section 2

frames the study in terms of the extant literature. Section 3 develops

the main hypotheses, details the sample selection procedure, and

describes the methodology. Section 4 discusses the empirical results.

Finally, Section 5 concludes by highlighting the study's main

implications.

2|LITERATURE REVIEW

Audit quality is a fundamental but not directly observable input into

financial reporting quality (Deumes et al., 2010). The latter demands

that the financial reports of a company faithfully represent the

company's underlying economics (DeFond & Zhang, 2014). The supply

of audit quality is determined by the auditor's competence and inde-

pendence (Watts & Zimmerman, 1981). Regulators are worried about

the impact of NASs fees on auditor independence (Securities and

Exchange Commission [SEC], 2000; Krishnan, Sami, & Zhang, 2005;

European Commission, 2011, 2016), and thus academic research has

246 CAMPA AND DONNELLY