The Impact of Fair Value Measurement on Audit Fees: Evidence from Financial Institutions in 24 European Countries

• Date: 01 November 2016
• Author: Margarita Mejia‐Likosova,Irina Alexeyeva
• DOI: http://doi.org/10.1111/ijau.12075
• Published date: 01 November 2016

The Impact of Fair Value Measurement on Audit Fees: Evidence from Financial

Institutions in 24 European Countries

Irina Alexeyeva

1

and Margarita Mejia-Likosova

2

1

Umeå School of Business and Economics, Umeå, Sweden

2

University of Tübingen, Tübingen, Germany

The purpose of the study is to investigate the relationship between fair value measurement and audit fees. Using a

sample of 177 banks from 24 European countries over the period 2008–13, we find that high uncertainty fair value

assets are positively related to audit fees. The result is consistent with the suggestion that more complex estimates

require greater audit effort. To provide more insight into the impact of fair value measurement on audit fees, we

examine this relation under institutional settings with different strength of regulations. The results suggest that the

strength of a country's institutional setting is positivelyrelated to effort spent on evaluation of higheruncertainty fair

value inputs.The finding is consistent with theprediction that auditors expendmore effort in more stronglyregulated

settings due to higher potential litigation costs.Finally, we find thatthe total proportion of fair-valued assets does not

affect audit fees. The result can be attributed to the composition of the total proportion of fair-valued assets which is

dominated by low uncertainty (Level 1) inputs.

Key words: Audit fees, banking industry, fair value measurement, IFRS 7

INTRODUCTION

The purpose of the study is to examine the effect of fair

value measurement on audit fees based on a sample of

listed banks from 24 European countries. The study is

motivated by the introduction of fair value hierarchy in

IFRS 7 implying a progressively increasing level of risk

involved in the evaluation of fair value estimates. Prior

studies suggest that fair value measurement will

considerablyaffect the complexity of the auditprocess (Bell

& Griffin, 2012;Christensen, Glover & Wood, 2012; Bratten

et al., 2013). However, there is little known about a possible

association between fair value estimation and audit fees.

Only a handful of studies (Ettredge, Xu & Yi, 2014;

Goncharov, Riedl & Sellhorn, 2014) empirically investigate

this association and theyreport inconsistent evidence.

The use of fair value is emphasized by IFRS standards

adopted by the European Union since 2005. IFRS 7

Financial Instruments, requiring the disclosure of financial

instruments,came into force in 2007. The amendedversion

of the standard has been applied since 2009, imposing

obligation to provide a detailed disclosure of fair value

measurement on three levels of the fair value hierarchy.

Applicationof three levels of inputs impliesa progressively

growing level of subjectivity involved in the estimation

process. This accordingly increases the level of complexity

and the risks involved in the evaluation of fair value

estimates. Prior studies progressively relate complexity

and risks to Level 2 and Level 3 inputs. However, the

greatest concern regarding Level 3 inputs is related to the

absence of observed prices (Song, Thomas & Yi, 2010; Bell

& Griffin, 2012; Christensen et al., 2012).

The growing level of complexity and risk implies a

corresponding effect on audit effort and audit fees. The

International Federation of Accountants (IFAC) highlights

the importance of the deep insight into management's

assumptions/methods in order to comprehensively

evaluate their reasonableness. In cases of high estimation

uncertainty, the proper evaluation of managements'

assumptions/methods, may, however, not be enough. To

further explore the degree of estimation uncertainty,

auditors have to evaluate the outcomes for similar

accounting estimates (IAASB, 2010, ¶¶15–16). The

necessity of external, rather than internal, information can

additionallyincrease audit effort and audit cost. Therefore,

the evaluation of higheruncertainty estimates (Level 2 and

Level 3) requires greater audit effort. Furthermore, a

growing level of uncertainty involved in the evaluation of

Level 2 and Level 3 inputs can considerably increase the

possibility of audit errors and the possibility of litigation

risk. Altogether, higher audit effort accompanied by

higher risk of litigation will, therefore, likely result in

higher audit fees.

Tworecent studies (Ettredgeet al., 2014; Goncharov et al.,

2014) have empirically investigated the impactof fair value

measurement on audit fees. Using a sample of public US

bank holding companies, Ettredge et al. (2014) document

a positive relationship between the proportion of fair-

valued assets and audit fees. The finding suggests that

audit risk and effort increase with the proportion of fair-

valued assets. The study further reports the increasingly

positive impact of three levels of inputs on audit fees.

Goncharov et al. (2014) study European real estate

companies and find that audit fees are lower for firms

having an above-average proportion of fair-valued assets.

They attribute the result to the reduced level of effort and

risk. Goncharov et al. (2014) further report an increase in

audit fees accompanied by the increased complexity and

risk of fair value estimation (Level 2 and Level 3). While

in the first study all three levels of fair value estimates

positively affect audit cost, in the second study audit fees

are driven only by higher uncertainty fair value assets.

However, given just two articles published, the evidence

on how fair value measurement affects audit fees is very

limited.

Prior cross-country studies show that country's

institutional environment has a considerable impact on

auditors' behavior and audit fees. Using a sample from 15

countries, Choi et al. (2008) document an increase in audit

Correspondence to: Irina Alexeyeva, Umeå School of Business and

Economics, Umeå University, Biblioteksgränd 6, 901 87 Umeå, Sweden.

Email: irina.alexeyeva@umu.se

International Journal of Auditing doi: 10.1111/ijau.12075

Int. J. Audit. 20:255–266 (2016)

©2016 John Wiley& Sons Ltd ISSN 1090-6738