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

Published date12 April 2022
Date12 April 2022
Subject MatterAccounting & finance,Accounting/accountancy,Accounting methods/systems
AuthorMuhammad 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
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
Received13 December 2021
Revised4 March 2022
Accepted17 March 2022
InternationalJournal of
Accounting& Information
Vol.30 No. 3, 2022
pp. 408-426
© Emerald Publishing Limited
DOI 10.1108/IJAIM-12-2021-0252
The current issue and full text archive of this journal is available on Emerald Insight at:
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

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