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Journal of Applied Finance & Banking, vol.2, no.2, 2012, 59-98 ISSN: 1792-6580 (print version), 1792-6599 (online) International Scientific Press, 2012 Auditor's Industry Specialization and Disclosure Quality of IAS No. 39-Related Accounts Hsiang-Tsai Chiang1 and Shu-Lin Lin2 Abstract Following International Accounting Standards (IAS) No. 39, Taiwan implemented the No. 34 and No. 36 Statement of Financial Accounting Standards (SFAS) that regulate the measurement and disclosure of financial instruments, respectively. Both IAS and Taiwan SFAS allowed companies to “reclassify” their financial assets in order to avoid having to report a huge loss as a result of the market value measurement; however, the standard also allowed some companies to hide huge losses through this reclassification. The empirical results show that, when financial statements are audited by industry specialists and auditors with market knowledge, the level of information disclosure is higher, and the auditor’s attitude is more rigorous. However, when the client is particularly important, economic factors interfere with the auditor’s attitude toward the client’s financial information disclosure. 1 2 Accounting Department, Feng Chia University, e-mail: htchiang@mail.fcu.edu.tw Ph. D. Program in Business, Feng Chia University, International Business Management Department, Hsiuping University of Science and Technology, e-mail:sue@hust.edu.tw Article Info: Received : January 23, 2012. Revised : February 16, 2012 Published online : April 15, 2012 60 Auditor’s Industry Specialization and Disclosure Quality of IAS No. 39 JEL classification numbers: M41, M42 Keywords: fair value, free cash flow, financial instrument, industry specialist, AFS financial assets 1 Introduction Relevance and reliability determine the usefulness of accounting information, but they often compete in the processing of accounting information. With the globalization of capital markets and in the knowledge economy era, accounting at fair value with relevance has become a major trend in international accounting standards. To keep Taiwan in line with the international accounting system and to enhance corporate financial information transparency, Taiwan set out Statement of Financial Accounting Standards (SFAS) No. 34, “Financial Instruments: Recognition and Measurement,” and No. 36, “Financial Instruments: Disclosure and Presentation,” in 2003 and 2005, respectively, to regulate the practice of fair value accounting. These standards have been in place since January 1, 2006. Since the 1970s, countries have embraced financial deregulation and, with it, the innovation and introduction of derivative financial instruments. Consequently, new types financial instruments3 have been introduced one after another. The applications of financial engineering and computer technology have also promoted the development of new financial instruments. Because of the characteristics of leverage and low transaction costs, new financial instruments rapidly became one of the most efficient financial tools for hedging or speculative investments in 3 Chang [14] “New financial instruments” are newly emergent financial instruments that originate from packaged derivatives to meet market demands. “Financial derivatives,” which are derived from underlying assets, such as stocks, foreign exchange, bonds, and commodities, can be roughly divided into option, forward contracts, futures, and swaps. H. Chiang and S. Lin 61 capital markets. The use of such tools should be reflected on the financial statements to enable investors to understand the risk status of the company. Accounting for financial instruments under SFAS No. 34 is classified into four categories: trading, held-to-maturity, available-for-sale, and loans and receivables. After initial recognition, trading securities, derivatives, and financial assets designated under the fair value option are measured at fair value through profit or loss. Available-for-sale (AFS) assets are measured at fair value through shareholders’ equity. Loans and receivables (L&R), as well as marketable debt securities classified as held to maturity (HTM), are measured at amortized cost. The measurement of financial assets at fair value represents the market’s expectation and assessment of the amount, time, and level of uncertainty of future cash flows of the financial instruments. Most of the current publicly quoted entities in Taiwan employ the “balance sheet date” market price as the fair value basis to measure the AFS financial assets. However, since the fair value accounting resulting from the global financial instruments is still highly controversial 4 , this study investigates whether the measurement basis is excessively optimistic or conservative. Specifically, recognition of excessively high (low) gains and recognition of insufficient (excessive) loss will lead to recognition of loss or gain in the following period. For example, when the financial tsunami broke out in 2008, in order to avoid market deterioration, the International Accounting Standards Board (IASB) amended the provisions of the IAS No. 39 regarding reclassification to allow companies to reclassify financial assets and avoid having to report a huge loss as a result of the 4 Lin and Chen [54] state that the IFRS (International Financial Reporting Standards) require many assets, liabilities, and equities be measured by fair value. However, provisions regarding fair value measurement are scattered in different standards, resulting in interference in practice and posing a complex problem to auditors of the related financial statements. 62 Auditor’s Industry Specialization and Disclosure Quality of IAS No. 39 market value measurement5. Some banks even proposed to suspend fair value accounting. Hence, investors rely heavily on the professional judgment of auditors for the appropriateness of the fair value measurement and disclosure of financial assets. Regarding the presentation of financial assets on statements by the listed companies in Taiwan, L&R refers to financial industries, while financial assets that cannot be classified as trading assets or assets held to maturity are categorized as AFS financial assets. If there is an active market price on the balance sheet date, the account is an “AFS financial asset”, and the assets are measured and recognized as the unrealized gain or loss at market price. If the financial asset has no active market price, the account is a “cost-measurement financial asset,” and the cost of the financial assets is regarded as the measurement basis. In this study, we focus the research on “AFS financial asset” accounts to test the information disclosure and compare the difference between the company’s free cash flow and the value of the AFS financial assets to verify the auditor’s attitude toward the client’s measurement of financial assets at market value. Table 1, which summarizes the AFS financial assets by fair value measurement and disclosures of Taiwanese listed companies from 2006 to 2009, shows that 42.84 percent of companies have an AFS financial asset account on their financial statements but only 42.39 percent of those companies disclosed “fair value adjustment AFS” in their financial statements’ footnotes 6 . The accounting 5 The amended IAS No. 39 issued by IASB in October 2008 confirms that, in a few circumstances, companies can reclassify the trading category into the AFS, HTM, or L&R category. 6 Taiwan SFAS No.34: when enterprises prepare their financial statements that should be expressed in a different name or any other classification for the evaluation and related financial assets recognized through profit or loss, that is, the fair value adjustment, AFS is used to record the difference between the total cost and total fair value of the financial assets, the fair value adjustment account is identified using AFS assets, and the unrealized gain or loss account is identified using shareholders’ equity. H. Chiang and S. Lin 63 standards also provide that unrealized gains and losses resulting from the AFS financial asset at fair value be listed under the shareholder’s equity, but only 58.78 percent of companies indicated this data, so more than half of the companies failed to provide complete information on financial instrument evaluation. Johnson et al. [47] pointed out that auditors that have a wealth of industry knowledge have the enhanced ability to detect fraud, thereby enhancing the audit quality and earnings quality. Francis and Yu [32] and Reichelt and Wang [60] suggested that auditors from major accounting firms have more exchange opportunities in terms of audit experience and consulting subjects, which can improve their ability to detect fraud or and require the company to make corrections based upon the auditor’s opinions, resulting in higher audit quality. This study employs the highest level of industrial audit experience as a proxy for industrial specialist auditor to test the financial instrument information disclosure and the auditors’ attitude toward the evaluation of financial assets at market value. Most studies related to audit quality focus on earnings management, auditor tenure, or the impact of providing audit or non-audit services and audit fees on auditor independence [23, 29, 42, 50, 57, 59, 61]. Such studies also address the correlation between market share and audit quality from the perspective of price competition (low-balling strategy) and audit service [13, 20, 40, 46]. Studies on issues of the measurement and disclosure of financial instruments from the perspective of auditor-client relationship are limited. Prior studies have focused on the operational activities of derivative financial instruments by management for speculative or hedging purposes. Based on a speculative purpose, the operations of derivative financial instruments can increase the volatility of company earnings; the risk management activities can reduce the volatility of cash flow, stabilize company earnings, and enhance company values [11, 35, 37]. This paper contributes to the literature by introducing the AFS financial assets measured at market price on the balance sheet date from the perspective of the industrial specialist auditor-client relationship and 64 Auditor’s Industry Specialization and Disclosure Quality of IAS No. 39 the market share of an auditor and discusses the auditor’s attitude toward the appropriateness of measuring financial instruments at market value and the adequacy of disclosures. Using the market price on the balance sheet date to measure the value of AFS financial assets represents the company management’s belief that such assets can create value for the company in the future. The book value of the AFS financial asset account on the financial statement is the amount agreed to after the auditor’s discussion with the client and application of professional judgment. Windsor and Ashkanasy [67] indicated that, when the auditor is subject to moral reasoning, the auditor is less likely to reject negotiation pressure from the company’s management. Because of the gray areas in professional judgment as it relates to audit practices and the difficulty of implementing the fair value assessment review procedure 7 , external users cannot discern the auditor’s assessment process from the amount reported on the financial statement8, let alone know whether the auditor confirmed the appropriateness of measuring the financial statement at market value. The external user cannot know whether the auditor’s measurement is due to the client-auditor relationship, the auditor’s market share factors, or direct adoption of the client’s hypotheses and assessment methods. In discussing company value, Jensen [44] proposed the free cash flow hypothesis and defined the free cash flow as the remaining cash flow after implementing all the investment programs at net present value. Copeland et al. [18] 7 The determination of fair value is usually involved with the subjective judgment of the management, which may affect the nature of applicable control procedures. Meanwhile, the false presentation of fair value may also increase with the increasing complexity of provisions related to accounting and financial reporting. 8 The estimation of the fair value of these assets or liabilities may refer to specific measurement methods (i.e., the discounted cash flow method) or estimation reports by independent experts. H. Chiang and S. Lin 65 measured company value using the free cash flow method to measure the company-held cash that can be returned to shareholders and debtors without endangering the survival and development of the company. Hence, we adopt the commonly used free cash flow method proposed by most scholars in the finance literature [51, 53] to verify the impact of the auditor-client relationship and auditor market share on the measurement of AFS financial assets and the clients’ information disclosure. The remainder of this paper reviews the literature and develops the research hypotheses related to the relationships between industry specialist auditors and their clients, and auditor market share and the measurement and disclosure of financial instruments, empirically testing the hypotheses and providing conclusions regarding the results. 2 Literature Review and Hypotheses Development 2.1 Accounting treatment of financial instruments Financial instruments with high leverage characteristics and price volatility involve a high financial risk and a high off-balance sheet risk. Based on the new financial instrument’s level of innovation and variety, the American Financial Accounting Standards Board (FASB) issued the SFAS No.52 in 1981, which is the first criteria accounting treatment of derivatives. Since then, FASB has released SFAS No. 105, No. 107 and No. 119 to strengthen the information disclosure in the fair value and the risk of financial instruments. In 1998, FASB issued No.133 for all the accounting treatments of derivatives to provide a complete set of criteria. In the same year, the IASB issued IAS No.39, which referred to SFAS No.115 and No.133. The accounting and auditing standards in Taiwan are similar to those in the United States. In order to connect with international accounting standards, the Taiwan Financial Accounting Committee and regulator competent authorities 66 Auditor’s Industry Specialization and Disclosure Quality of IAS No. 39 followed the IAS No. 39 and issued Taiwan SFAS No. 349 and No. 36. Afterward, the evaluation of financial instruments was changed from the lower of cost and market to fair value. For financial derivative transactions, the method of disclosure in financial statement footnotes was replaced with the booked measurement at fair value. The more explicit regulations on the accounting of financial instruments are intended to help users assess the risks related to financial instruments more accurately. Studies on the use of financial instruments include those on the selection of hedging tools, hedging strategies, and the use of derivative financial instruments in risk management and in reducing cash flow fluctuations [43, 45, 63]. The new financial instruments can also reduce fluctuations in earnings and enhance the value of the company [2, 6, 11, 27, 38, 58]. Allayannis et al. [3] found that the derivative instrument-hedging activities of companies with strong corporate governance mechanisms can improve company value. Tsao et al. [66] discussed the level of use of derivative financial instruments and discretionary accruals in earnings management, as well as the impact of the shareholding structure on the selection of earnings management. They found that the use of derivative financial instruments in earnings management is positively correlated to company value. When the corporate mechanism of the company is relatively weaker, additional discretionary accruals will be used for the purpose of earnings management. The literature shows that the financial instrument transactions in general industries are focused on hedging in response to competition and customer demands and in order to avoid risks that arise from their own businesses. In recent years, such operations have even been used for earnings management purposes. However, discussions on the relationship between the presentation and exposure 9 Taiwan SAFS No.34 was issued in December 2003 with reference to U.S. SAFS No.115, first time amended with reference to IAS No.39 was issued in September 2005 and became effective since January 1, 2006, and was revised a second time because of the financial crisis of 2008. H. Chiang and S. Lin 67 of financial instruments on financial statements and audit quality are inadequate. 2.2 Auditor-client relationship The primary function of auditing, a highly professional service industry that requires higher moral standards than other profit-making industries, is to limit reporting discrepancies and to reduce information asymmetry. Grant and Schlesinger [36] proposed methods to improve corporate profitability, including the new client development strategy with the purpose of attracting new customers, the market penetration strategy with the purpose of enhancing customer return rates, and the extension of customer relationships. These three methods reflect the audit market: the first two relate to product differentiation, indicating the investment returns of accounting firms that have industry specialization, the client importance, and the auditor’s market share. The third represents the auditor’s tenure. Taiwan’s auditing environment differs from those of other countries in that the audit reports show the audit firm’s name and two partner names, rather than just the name of the audit firm. In cases of audit failure, the auditor bears personal responsibility. Therefore, audit quality and the accounting firm are less closely correlated in Taiwan than they are in other countries, and the audit quality is subject mostly to the personal factors related to the auditor. Fan et al. [25] stated that the professional expertise of auditors is built from the accumulation of work experience in an industry; industry specialists obtain experience from the audit process in a specific industry. Years of audit experience can help the auditor to understand the client’s operational process and improve the auditor’s problem-solving capabilities. Because of the differences in industry characteristics, accounting education does not offer a specific course for specific industries in school; most accountants can only accumulate their industry knowledge and ability through experience.This study measures auditor industry specialty by 68 Auditor’s Industry Specialization and Disclosure Quality of IAS No. 39 accumulating the number of audits years and adopts the highest level of industrial audit experience as a proxy for industry specialization. The literature suggests several ideas regarding the impact of the auditor tenure on audit quality. Those who support the rotation of auditors believe that it can enhance audit market competition, reduce audit fees [24, 65], and improve the independence of auditors, thereby enhancing audit quality [10, 16]. Those opposed to rotation suggest that rotation increases the cost of the initial audit and interferes with the auditors’ ability to accumulate knowledge about specific customers [33], audit quality [34, 56], and the ability to reduce the number of frauds on the financial statements [9, 48]. The US Sarbanes-Oxley Act of 2002 mandates a five-year rotation for the lead and reviewing partners. In April 2003, Taiwan amended the regulation for auditing listed companies such that, if the lead or concurring partner has performed audit services for a company in five consecutive years, then that company is subject to the regulator’s “substantive review” procedure and a five-year mandatory partner rotation. Since the sample period of this study is between 2006 and 2009 and none of the sample companies changed auditors, we do not include “auditor tenure” in our empirical models. 2.3 Measurement and disclosure of financial assets and client importance With the high competition and saturation of the audit market, auditors’ rising economic reliance on clients may damage their independence. The audit fee is the major income of accounting firms, so when the client is an important one, the auditor may have considerable incentive to compromise. DeAngelo [21] indicated that client importance reflects the percentage of future rent from the client against other clients such that, the higher the percentage, the more important the client. Reynolds and Francis [61] discussed the impact of client size on the