The impact of audit characteristics, audit fees on classification shifting: evidence from Germany

• DOI: https://doi.org/10.1108/IJAIM-12-2021-0252
• Published date: 12 April 2022
• Date: 12 April 2022
• Pages: 408-426
• Subject Matter: Accounting & finance,Accounting/accountancy,Accounting methods/systems
• Author: Muhammad Usman,Ernest Ezeani,Rami Ibrahim A. Salem,Xi Song

The impact of audit

characteristics, audit fees on

classif‌ication shifting: evidence

from Germany

Muhammad Usman

Department of Accounting and Finance, University of Central Lancashire,

Preston, UK

Ernest Ezeani

Department of Accounting Finance and Banking,

Manchester Metropolitan University, Manchester, UK

Rami Ibrahim A. Salem

Department of Accounting and Finance, University of Central Lancashire, Preston,

UK and Department of Accounting and Finance, University of Gharyan, Libya, and

Xi Song

Department of Accounting and Finance, University of Central Lancashire,

Preston, UK

Abstract

Purpose –This paper aims to examinethe relationship between audit characteristics (ACs)and audit fees

on classif‌icationshifting (CS) among German-listed non-f‌inancialf‌irms.

Design/methodology/approach –Using a sample of 130 German-listed (Deutscher Aktienindex, Mid

Cap dax and Small caps Index) f‌irms from 2010 until 2019, this study investigated the impact of audit

committeesize, audit committee meetings, audit committee f‌inancialexpertise and audit fees on CS.

Findings –This study found the evidenceof CS, meaning that managers misclassify recurring expensesin

the income statement into non-recurring expenses to inf‌late core earnings. This study also found that the

audit fee ratio, audit committeef‌inancial expertise and frequency of audit meetings are negativelyassociated

with CS among German-listedf‌irms. However, the audit committeesize does not inf‌luence CS.

Research limitations/implications –This study will help the board improve its internal auditing

practices and provide essential information to investors to assess how ACs affect the quality off‌inancial repor ting.

Originality/value –This study focused on a bank-oriented economy, i.e. Germany, with lower investor

protection and low transparency.This paper documents new evidence on how ACs and audit fees impact CS

among German f‌irms, as most of the previous studies on CS mainly focusedon market-oriented economies

such as the UK and the USA.

Keywords Earning management, Classif‌ication shifting, Audit characteristics, Audit fees,

Corporate governance

Paper type Research paper

1. Introduction

Financial earnings are of great interestto stakeholders of the company, as it empowers them

to differentiate among low and high-performing companies and make effective f‌inancial

IJAIM

30,3

408

Received13 December 2021

Revised4 March 2022

Accepted17 March 2022

InternationalJournal of

Accounting& Information

Management

Vol.30 No. 3, 2022

pp. 408-426

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-12-2021-0252

The current issue and full text archive of this journal is available on Emerald Insight at:

https://www.emerald.com/insight/1834-7649.htm

decisions. However, previousstudies pointed out that managers have an opportunity to use

their discretion and manipulate reported earnings to gain personal benef‌its for themselves

or the company (Leuz et al., 2003;Prior et al., 2008;Komal et al.,2021). Prior earnings

management literature mainly used accrual and real earnings management (Peasnell et al.,

2000;Roychowdhury, 2006;Zang, 2012;Assenso-Okofo et al., 2020). Classif‌ication shifting

(CS) is a recently established methodof earnings manipulation. McVay (2006) def‌ined CS as

a strategy whereby managers shift core expenses such as general, selling and

administrativeexpenditures within the income statement to boost core earningsand have no

impact on bottom line income. International Financial Reporting Standards (IFRS) provide

f‌irms with an opportunity to disclose earnings before exceptional or non-recurring items.

Zalata and Roberts (2016) pointed out that such classif‌ication of earnings enhances

comparability of time-series measures, as non-recurring items have fewer implications for

future prof‌its. However, Fan et al. (2010) indicated that management uses CS to accomplish

specif‌ic earnings benchmarks, precisely when they are restrainedfrom using discretionary

accruals to manipulateearnings.

Previous studies highlighted that market-oriented economies such as the UK and the

USA have a higher transparency and investor protectionlevel (Antoniou et al., 2008;Ezeani

et al., 2022a;Ezeani et al., 2022b). They also argued that countries such as Germany, Japan

and France are bank-oriented economies, where f‌irms operate in an environment of lower

transparency and lower investor protection. Similarly, Leuz et al. (2003) found that

companies manipulate their earnings more in code-law countries such as Germany than in

common-law countries, as the investorprotection is relatively lower. Furthermore, Leuz and

Verrecchia (2000) argue that German reporting standards allow management to manage

earnings using “silent reserves”,encouraging f‌irms to apply tax avoidance strategies. They

also pointed out that their disclosures lack details and do not often meet analysts’

information needs. However, thesestudies mainly used accrual earnings management (Van

Tendeloo and Vanstraelen, 2005;Kouki, 2018). Therefore, it would be interesting to see

whether German f‌irms engagein CS.

A strong audit committee is essential, as they establish a formof monitoring, curb managers’

opportunistic behaviour and reduce information asymmetry (Jung et al.,2016;Hammami and

Zadeh, 2019). Prior studies reported that audit characteristics (ACs) restrain managers from

engaging in accrual earnings management and real earnings management (Prawitt et al.,2009;

Alzoubi, 2018;Salem et al.,2021). Unlike accrual earnings management, Athanasakou et al.

(2009) argued that CS is more of a disclosure issue, as it has no impact on the net income, making

it diff‌icult to detect. Zalata and Roberts (2016) found that ACs mitigate CS in the UK. However,

Germany has a low transparency level and weaker investor protection rights (Ezeani et al.,

2022a), which offers an interesting setting to examine the impact of ACs o n CS.

We used 820 f‌irm-year observations from 2010 to 2019 to examine whether German

companies engage in CS and founda positive association between unexpected core earnings

and non-recurring items, conf‌irming that German companies engage in CS. Following

previous studies, we examined the effectof ACs and audit fees on CS using audit committee

size, audit committee f‌inancial experts and frequency of audit committee meetings as

proxies for ACs (Vafeas, 2005;Zalata and Roberts, 2016). We found that CS is negatively

related to the audit fee ratio, which aligns with the idea that a high auditor fee ref‌lects a

better audit quality. In line with Zalata and Roberts(2016), we found a negative relationship

between audit meetings and CS frequency, implying that active audit committees have

suff‌icient time to cover sophisticated issues such as CS. Similarly, we show that audit

committee f‌inancial expertise is inversely related to CS. We found no relation between

Impact of audit

characteristics

409