Audit Quality and Classification Shifting: Evidence from UK and Germany

Abstract

Purpose – We examine the impact of audit quality (AQ) on Classification Shifting (CS) among non-financial firms operating in the UK and Germany.

Methodology – This paper used various audit committee variables (size, meetings, gender diversity, and financial expertise) to measure AQ and its impact on CS. We used a total of 2110 firm-year observations from 2010 to 2019.

Findings - We found that the presence of female members on the audit committee and audit committee financial expertise deter the UK and German managers from shifting core expenses and revenue items into special items to inflate core earnings. However, audit committee size is positively related to CS among German firms but has no impact on UK firms. We also document evidence that audit committee meetings restrain UK managers from engaging in CS. However, we found no impact on CS among German firms. Our results hold even after employing several tests.

Originality - Most CS studies used market-oriented economies such as the USA and UK and ignored bank-based economies such as Germany, France, and Japan. We provide a comparison among bank and market-oriented economies on whether the AQ has a similar impact on CS or not among them.

Implications - Overall, our findings provide broad support in an international setting for the board to improve its auditing practices and offer essential information to investors to assess how AQ affects the financial reporting process.