Managerial Auditing Journal: Article Information
Managerial Auditing Journal: Article Information
Managerial Auditing Journal: Article Information
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Abstract
Purpose – The paper aims to examine the relation between fees paid to auditors and audit quality
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Introduction
The relation between auditor independence and an auditor’s ability to conduct
high-quality audits has been widely debated by regulators, legislators, financial
statement users and researchers. Much of this discussion has been fueled by dramatic
changes in the market for accounting services during the 1990s, as well as concerns
Managerial Auditing Journal
The authors thank Jean Bedard, Douglas Carmichael, Masako Darrough, Ross Fuerman, Vol. 22 No. 8, 2007
Rebecca Rosner and Joseph Weintrop for their comments. This paper also benefited from the pp. 761-786
q Emerald Group Publishing Limited
helpful comments of Debra Jeter and Mike Stein, who served as their discussants at the 2005 0268-6902
American Accounting Association Annual Conference. DOI 10.1108/02686900710819634
MAJ that auditors are less likely to enforce GAAP to the extent that they receive large fees
22,8 from their audit clients.
Fees paid to auditors can affect audit quality in two ways: large fees paid to auditors
may increase the effort exerted by auditors, hence, increasing audit quality.
Alternatively, large fees paid to auditors, particularly those that are related to
non-audit services, make auditors more economically dependent on their clients. Such
762 financial reliance may induce a relationship whereby the auditor becomes reluctant to
make appropriate inquiries during the audit for fear of losing highly profitable fees.
Conversely, the potential for audit failure imposes significant economic costs on the
auditor (DeAngelo, 1981; Simunic, 1984). Though a number of recent studies have
examined the relationship between audit and non-audit fees and independence, they
are ambiguous as to the relationship between audit fees and auditor behavior (Larcker
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and Richardson, 2004). They also differ on how fee composition and client importance
affect auditor independence.
We believe that examining fees paid by firms in the context of auditor profitability
better captures the relation between audit quality and auditor independence. In this
regard and consistent with the discussion in Kinney and Libby (2002), we develop a
methodology that is grounded in the notion that auditor independence is influenced by
the amount of fees relative to their expected amounts; e.g. adjusted for auditor effort
and risk, rather than the level of fees received from clients. We therefore examine effort
and risk-adjusted fees rather than raw fees. Since, these attributes are unobservable,
we develop two proxies, one based on client size and the other based on estimates of
expected or normal fees paid to auditors. The former proxy assumes that a larger
company will, on average, require the auditor to exert more effort and creates more
reputation risk for the audit firm in the event of an audit failure. The latter proxy
further refines the financial linkage between the auditor and the client by estimating
expected or normal fees to be charged by the auditor predicated on client type. We
derive abnormal fees using a fee estimation model drawn from prior literature which
takes into account not only the company’s size, but also its complexity, risk, and other
factors that may affect the fees charged by the auditor. Thus, our principal objective is
to ascertain whether larger size-adjusted or abnormal fees result in a higher or lower
quality audits.
In this study, we examine fees paid to auditors during the period 2000-2003 and find
a significant positive relation between size-adjusted and abnormal total fees paid to the
auditor and two metrics used to assess audit quality – an accruals quality measure
developed by Dechow and Dichev (2002), as modified by McNichols (2002) and Francis
et al. (2005)[1] and the absolute value of performance-adjusted discretionary accruals.
We focus our analysis on the total fees paid to the auditor for two reasons. First, the
argument that non-audit fees may impair audit quality can, by extension, be applied to
all fees received by the auditor (Raghunandan et al., 2003). Second, since our sample
period spans a timeframe during which the SEC changed its classificatory scheme for
disclosing the components of fees paid to auditors, using total fees mitigates any
potential confounding fee disclosure effects. We also conduct similar tests by
separating total fees into audit and non-audit fees categories and find a positive and
significant association with both of our accruals quality metrics[2]. Our results (both
pre- and post-SOX) are consistent with economic bonding being a determinant of
auditor behavior, rather than auditor reputational concerns; however, we cannot rule
out the possibility that our empirical tests do not sufficiently capture the impact of Auditor fees and
unobserved risk, despite our attempts to do so utilizing a variety of alternative audit quality
specifications and sensitivity tests.
Our study complements and extends existing literature on several dimensions.
First, we examine fees paid to auditors and financial reporting quality over a period of
time consumed by sweeping changes in the business, regulatory and professional
environment faced by auditors (culminating in the passage of the SOX). Second, in 763
contrast to previous studies whose results are:
.
ambiguous as to the relation between auditor independence and audit quality;
and
.
in many instances fail to reject the null hypothesis of no association (indicative of
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With respect to the scope of services provision, the Final Rule states that “we have
determined not to adopt a total ban on non-audit-services . . . we recognize that not all
764 non-audit services pose the same risk to independence” (SEC, 2000, Section I). The
scope of services section of the Final Rule was viewed by many as a relatively benign
change as it merely clarified and conformed restrictions that already existed in the
professional literature.
After Sarbanes-Oxley. In the wake of Enron’s failure and amidst the collapse of
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Arthur Andersen, Congress stepped in and passed the Sarbanes-Oxley Act of 2002
(Sarbanes-Oxley Act, 2002). A major portion of this extensive legislation focused on
curtailing public accounting firms from rendering non-audit-related services to their
public clients. These banned non-audit services include:
.
financial information system implementation and design;
.
internal audit functions; and
.
“other services”[3].
SOX also requires public companies to make additional disclosures regarding the
services provided by, and fees paid to, their independent auditors. The new disclosure
rules, which are described in Release No. 34-47365 (SEC, 2003), expanded the existing
requirements outlined in the section above. Companies are now required to disclose
fees for the two most recent fiscal years (effective for annual filings for the first fiscal
year ending after December 15, 2003). In addition to the expanded disclosure
requirements, the new rules require audit committees to pre-approve all audit and
permissible non-audit services.
The foregoing suggests that the rendering of non-audit services impairs
independence, leads to lower quality audits and increases the likelihood of financial
reporting that violates generally accepted accounting principles (Kinney et al., 2004).
Prior research
Prior research has investigated several aspects surrounding the association between
auditor fees and audit quality. This research stream is based on the thesis that auditor
independence is vital to the production of high-quality audits. In recent years,
regulators have become increasingly focused on the reliance of audit firms on
non-audit fees (US House of Representatives, 2002; US Senate, 2002). The crux of the
issue is grounded in the notion that non-audit services provided by incumbent auditors
can negatively influence auditor judgment, which in turn impairs the auditors’ ability
to enforce GAAP. As previously described, in 2000 the SEC attempted to curtail the
types of non-audit services auditors could provide to their public clients. More recently,
Congress enacted legislation that specifically prohibits the rendering of specific
non-audit services.
Though unparalleled attention to this independence issue has persisted in the
post-Enron era, the empirical evidence surrounding auditor fees and audit quality
remains mixed. Frankel et al. (2002) find a positive association between non-audit fees
and the likelihood of reporting a small earnings surprise, the magnitude of Auditor fees and
discretionary accruals and the magnitudes of income-increasing and audit quality
income-decreasing accruals. They contend that their results provide some evidence
that firms procuring non-audit services manage earnings to a greater extent than other
firms. Conversely, Ashbaugh et al. (2003) find no association between firms’ total fees
and discretionary current accruals, nor any association between income
increasing-accruals and client fees. Similarly, Chung and Kallapur (2003) find no 765
association between several audit-fee metrics and their estimate of discretionary
accruals.
A number of papers incorporate the use of abnormal fees in their audit quality
studies. Frankel et al. (2002) estimated unexpected fee ratios but did not link
unexpected fees to earnings quality. DeFond et al. (2002) predict abnormal fees and the
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ratio of non-audit to total fees, and observe R 2s between 32 and 58 percent for their
prediction models. Their sample is comprised of financially distressed firms and 86
firms that received going concern opinions from their auditors. Their results are
consistent with higher total fees being associated with better audit quality as measured
by the type of audit opinion issued (unqualified v. going concern). DeFond et al. (2002)
also examine a sample of financially distressed firms which by construction are more
likely to be the subject of future litigation (suggesting that auditors will generally be
more cautious when auditing such companies). Larcker and Richardson (2004) also
estimate expected total and non-audit fees. They use latent class mixture analysis and
find no indication of economic bonding. However, they use no controls in their accrual
regressions and their fees are deflated by the total revenue of the audit firm. Whisenant
et al. (2003) also used abnormal fee ratio and abnormal total fees and compared them
between 110 restating firms and the Compustat universe of non-restating firms. They
found no significant differences in abnormal fees between the two groups. Reynolds
et al. (2004) examined the finding obtained by Frankel et al. (2002) and observed that
these findings were driven by small- to medium-size high-growth firms. After
controlling for a number of factors related to assets growth and IPOs, they observed no
significant association between the fee ratio and the log of total fees to the absolute
value of discretionary accruals.
As more fully described in our research design section, our study is different in that
we examine the association between abnormal total fees and audit quality (measured
using two proxies of accruals quality) for a large number of companies over an
extended period of time.
Empirical predictions
Any relation between the fees paid to auditors and audit quality is an important input
to the ongoing debate on how the accounting profession should be organized and
monitored. Large fees paid to auditors may increase the effort exerted by auditors,
hence, increasing the audit quality. Critics contend that large fees paid to auditors,
particularly those that are related to non-audit services, make auditors more
economically dependent on their clients (Becker et al., 1998; Magee and Tseng, 1990).
Such financial reliance may induce a relationship whereby the auditor becomes
reluctant to make appropriate inquiries during the audit for fear of losing highly
profitable fees. Conversely, others suggest that the potential for audit failure imposes
significant economic costs on the auditor (DeAngelo, 1981; Simunic, 1984). Thus, the
MAJ relationship between audit fees and auditor behavior is ambiguous (Larcker and
22,8 Richardson, 2004).
The aforementioned studies are based on data and a regulatory environment that
pre-dates the unraveling of Enron and the ultimate passage of SOX. Our study
complements and extends existing literature by examining total fees, audit and
non-audit fees and audit quality over a period of time that spans an evolving business
766 and regulatory environment.
To summarize, though the full regulatory impact of SOX is yet to be determined, to
the extent that legislators and regulators are correct in their presumption that the
rendering of non-audit services:
.
impairs independence;
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.
leads to lower quality audits; and
.
increases the likelihood of GAAP violations, then we suspect that the expanded
fee disclosures and restrictions on consulting services mandated by SOX should
be effective in curtailing auditor independence violations.
Third, we incorporate these two proxies for audit quality into an empirical analysis
that focuses on abnormal fees. Kinney and Libby (2002) suggest that “better conceptual
definitions can improve measurement of the concepts in all empirical work.” They go
on to argue that the concept of economic bonding between clients and their auditors
can be further refined through building better models that distinguish between
unexpected non-audit and audit fees. Such a distinction may flush out the more
ominous impact on economic bonding that emanates from unexpected fees and may
better capture the effects of auditor profitability on independence. Since, it is likely that
auditor independence is influenced by the amount of the total fees relative to their
expected amounts, rather than the level of fees received from clients; i.e. clients with
unusually high or low fees may influence incumbent auditor judgment (DeFond et al.,
2002), incorporating these additional measures is economically intuitive and addresses
a number of concerns surrounding the use of the level of fees without controlling for Auditor fees and
their source (Larcker and Richardson, 2004). audit quality
Fourth, we use a fee prediction model drawn from Simunic (1984), Craswell and
Francis (1999) and Hay et al. (2006). We use this fee prediction model to estimate the
unexpected portion of total fees (which we deem to represent auditor profitability),
which is the primary focus of our analysis, and conduct ancillary tests on audit and
non-audit fees. Since, audit engagement profitability is not directly observable, we use 767
the residual term generated from estimating our fee prediction model as our proxy.
Though our estimation model for abnormal fees is not a perfect substitute for
unobservable audit engagement profits (losses), after adjusting for size, complexity,
risk, and imposing tests for multicollinearity and heteroscedasticity, it is well-specified
(e.g. explanatory power ranging from 73 to 78 percent).
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Thus, with respect to the effects of client importance and auditor effort on audit
quality, we expect that including abnormal fees in our modeling will enhance our
controls beyond those obtained using only scaled fees or the ratio of non-audit fees to
total fees[4].
1999; Kothari et al., 2005), we control for firm performance by including lagged ROA
and by constructing an accrual measure that is similar to the one in Ashbaugh et al.
(2003):
1
CA ¼ a þ bðDREVÞ þ gðROAt21 Þ þ 1t ð1Þ
TAt21
^ 1 ^ ^
ECA ¼ a þ bðDREV 2 DARÞ þ gðROAt21 Þ ð2Þ
TAt21
where current accruals (CA) is net income before extraordinary items (Compustat data
item 123) plus depreciation and amortization (Compustat data item 125) minus
operating cash flows (Compustat data item 308), scaled by beginning of year total
assets. TAt2 1 is total assets at the beginning of the fiscal year and DREV is equal to
net sales (Compustat data item 12) in year t less net sales in year t 2 1, scaled by
beginning of year total assets, and DAR is equal to accounts receivable (Compustat
data item 2) in year t less accounts receivable in year t 2 1, scaled by beginning of year
total assets. We first estimate equation (1) separately for each two-digit SIC code and
then use the parameters from equation (1) to estimate the expected current accruals
(ECA) using equation (2). REDCA is the difference between CA and ECA and
represents our measure for discretionary current accruals. We winsorize the 1 percent
extreme values from each tail and use the absolute value of REDCA, denoted
ABSREDCA, as our measure for the combined effect of income-increasing and
income-decreasing evidence of earnings management.
Accrual estimation error metric (FLOSAQ). Dechow and Dichev (2002) argue that
uncertainty in accruals can best be measured by the extent to which working capital
accruals map into cash flow realizations. The key insight to their model is that accruals
quality is affected by measurement error in accruals, irrespective of management’s
purpose (e.g. imposing intentional or unintentional errors in the estimation of accruals).
According to Francis et al. (2005) and from a practical perspective, the Dechow and
Dichev (D&D) model is limited to current accruals (because of the long lead/lags
between noncurrent accruals and ultimate cash flow realizations). Thus, consistent
with McNichols (2002), they augment the D&D model by incorporating the
fundamental variables included in the modified Jones model (e.g. property, plant and
equipment and changes in revenues). This augmented model produces a better
specified expectations model and, therefore, a better set of residuals. Following Francis Auditor fees and
et al. (2005), we estimate a cross-sectional accrual model as depicted in the following audit quality
equation:
22,8
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Table I.
Descriptive statistics
Variable Year N Mean Median SD
a
Panel A: non-deflated variables (in $000’s)
Total fees 2000 2,476 2,058.480 564.000 5,898.258
2001 4,016 1,454.994 362.760 4,666.295
2002 3,949 1,379.138 387.000 4,009.384
2003 3,419 1,469.476 465.000 3,906.040
Audit fees 2000 2,476 582.651 231.000 1,513.101
2001 4,016 494.585 188.173 1,187.006
2002 3,949 694.321 240.000 1,675.866
2003 3,419 870.702 305.570 2,347.812
Non-audit 2000 2,476 1,475.829 304.325 4,853.174
2001 4,016 960.409 148.000 3,745.256
2002 3,949 684.817 113.000 2,735.396
2003 3,419 598.773 123.894 2,029.480
Total assets 2000 2,476 2,391.321 308.278 9,296.745
2001 4,016 1,768.819 157.953 7,705.136
2002 3,949 1,862.065 162.306 7,636.657
2003 3,419 2,221.477 217.327 8,699.858
Panel B: deflated variables
Total fees 2000 2,476 47.775 33.335 55.458
2001 4,016 43.512 32.662 40.722
2002 3,949 44.918 33.906 42.713
2003 3,419 44.141 34.968 42.076
Audit fees 2000 2,476 17.044 13.801 14.244
2001 4,016 20.809 16.888 17.208
2002 3,949 27.254 21.198 28.295
2003 3,419 28.795 23.173 24.935
Non-audit 2000 2,476 30.732 17.169 48.667
2001 4,016 22.719 12.735 32.500
2002 3,949 17.691 9.696 26.806
2003 3,419 15.365 9.135 29.397
ABSREDCA 2000 2,476 0.502 0.099 1.120
2001 4,016 0.275 0.100 0.604
2002 3,949 0.278 0.076 0.655
2003 3,419 0.201 0.074 0.495
(continued)
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771
Table I.
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22,8
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MAJ
Table I.
Variable Year N Mean Median SD
773
Table I.
MAJ average non-audit fees (2 50 percent). Overall, it appears that mean audit fees increase
22,8 monotonically over the sample period, while average non-audit fees decrease
monotonically over the same time frame. One potential reason for the observed
increase in audit fees and the observed decline in non-audit fees is the reclassification
of certain services rendered by the auditor and not the actual services (non-audit fees to
audit fees – see additional tests section).
774 Table I – Panel C presents correlations among variables used in our analyses. Total
fees are positively correlated with audit and non-audit fees. Audit fees and non-audit
fees are positively correlated, suggesting that a company with more audit services has
more non-audit services. Contrary to most previous studies, we find a significant
association between the level of deflated fees (total, audit, and non-audit) and the level
of absolute discretionary accruals. Similarly, we observe a positive and significant
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correlation between total fees and audit fees and our measure of accruals quality
(FLOSAQ). The correlation between FLOSAQ and non-audit fees is not significant.
These results suggest that higher fees are associated with lower audit quality – which
is consistent with the presence of an auditor dependency problem.
Methodology
Previous studies have modeled fees as a function of size, risk, complexity, auditor type
and tenure, monitoring, and additional work. Our fee prediction model draws on
Simunic (1984), Craswell and Francis (1999), Larcker and Richardson (2004) and Hay
et al. (2006). These prior studies have found audit and total fee prediction models to
have good explanatory power (adj. R 2 of 0.70 or better) and are robust to different
samples, time periods and sensitivity analyses for model misspecification (Chan et al.,
1993).
We expect that large, more complex clients will have to pay more to their auditors,
therefore we control for client size by including the natural log of total assets. We
capture audit complexity using the square root of the number of subsidiaries, the
square root of the number of business segments, and identify whether the company has
foreign operations. It is also expected that riskier clients will have to pay more to
auditors. We proxy for risk using liquidity and return on assets ratios, and identify
companies with net losses. Auditors often have to perform additional work related to
receivable confirmations, inventory-related activities, mergers and acquisitions and
equity issues. We capture them through mergers and acquisitions activity, the relative
size of accounts receivable and inventory, and new equity issues. We identify an
alternative source for firm monitoring by looking at the percentage of shares owned by
institutions and expect it to be positively associated with fees. Additionally, we proxy
for auditor characteristics by identifying BIG5 auditors and engagement tenure.
We model expected or normal fees using the following equation and consider the
residual term as our estimate of the abnormal portion of total fees:
LTFEE ¼ a þ b1 LNTA þ b2 SEG þ b3 SUBS þ b4 FOREIGN þ b5 LOSS Auditor fees and
audit quality
þ b6 LIQ þ b7 ROA þ b8 MERGER þ b9 INVREC þ b10 FINANCE
775
LTFEE is the natural logarithm of total fees. LNTA is the natural logarithm of total
assets (Compustat data item 6), SEG is the square root of the number of segments,
where the number of segments is obtained from Research Insight, SUBS represents the
square root of the number of subsidiaries (retrieved from Compact Disclosure),
FOREIGN is an indicator variable equal to 1 if the audit client has foreign operations
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(zero otherwise), LOSS is an indicator variable equal to one if the audit client reported
negative net income in either of the two previous fiscal years (zero otherwise), LIQ is
the ratio of current assets (Compustat data item 4) divided by current liabilities
(Compustat data item 5), ROA equals return on assets, defined as net income divided
by total assets. MERGER is an indicator variable taking the value of 1 if the client
engaged in merger activity during year t (zero otherwise), INVREC is calculated as
inventory plus accounts receivable (Compustat data items 2 þ 3) divided by total
assets, FINANCE is an indicator variable equal to one if the audit client issues
long-term equity (Compustat data item 108 . 5 percent of beginning total assets) in
the current fiscal year (zero otherwise), INSTITOWN is the percentage of shares owned
by institutions (obtained from Research Insight), BIG5 is an indicator variable equal to
one when the auditor is a member of the BIG5[8] (zero otherwise), and TENURE is the
number of engagement years, measured as the number of years under engagement
over the last ten years.
Estimation results
The results of our total fee (hereinafter referred to in this section as “fees”) estimation
model are presented in Table II. To capture changes in expected or normal fees over
time and to ensure that reported t-statistics are not unduly overstated due to
time-series correlation, we estimates our regressions separately each year[9]. Overall,
our model appears to be well specified, producing adjusted R 2 s ranging from 0.728 to
0.793[10]. We observe a positive association between fees and client size and audit
complexity. Our model documents a negative association between good performers
(ROA, LIQ) and fees and a positive association between fees and more risky firms
(LOSS). Our results suggest a premium to BIG5 auditors but are not consistent with
auditors having longer tenure[11]. Similarly, our model also supports the notion that
additional work is needed for firms with large receivables, inventories merger activity
and activities associated with new financing. We use the residuals generated from
estimating equation (4) as our measure of abnormal fees, which in turn is used to assess
the degree of bonding between the client and the auditor in subsequent analyses.
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Table II.
predictions
Abnormal total fee
(lTOTAL) Dependent variable
Independent variables 2000 2001 2002 2003
þ b12 CFO þ 1
Additionally, we estimate similar models to equations (5) and (6) using previously
estimated abnormal fees instead of the deflated fees:
FLOSAQ ¼ a þ b1 Abnormal total fees þ b2 LNTA þ b3 Cycle þ b4 PropLoss
ð7Þ
þ b5 StdSales þ b6 StdCFO þ 1
scaled by beginning of year total assets. LNMVE is the natural log of the firm’s price
per share at fiscal year end (Compustat data item 199) multiplied by the number of
shares outstanding (Compustat data item 25), LEVERAGE is defined as the firm’s total
assets less its book value (Compustat data item 60), divided by total assets. MB is the
market-to-book ratio, which is defined as market value of equity divided by book value.
LITIGATION is captured by an indicator variable set at 1 if the firm operates in a
high-litigation industry, and 0 otherwise (high-litigation industries are industries with
SIC codes of 2833-2836, 3570-3577, 3600-3674, 5200-5961, and 7370). LOSS is also an
indictor set at 1 if the firm reports a net loss in the current fiscal year, and 0 otherwise.
CFO represents cash flow from operations (Compustat data item 308), scaled by
beginning of year total assets. All other variables are as previously defined.
The results of estimating equations (5) and (6) are displayed in Table III (Panels A
and B). We observe that total fees are significant and positively related to both
FLOSAQ and ABSREDCA; i.e. the higher the deflated total fees the lower the quality.
This association is significant and consistent with the univariate results presented in
the previous section and remains stable throughout our sample period. The coefficients
on the control variables are, by and large, also consistent over time[12].
Since, the results in Table III may suffer from a scaling limitation (e.g. both large
and small clients could potentially have similar scaled fees), we expand our analysis by
substituting deflated total fees with abnormal total fees (equations (7) and (8)). As
previously discussed, since we consider the residual term as our estimate for the
abnormal portion of total fees (equation (4)), our measure represents a log dollar
amount and does not suffer from the limitation above. Nevertheless, we observe similar
results to those reported in Table III over the entire sample period. Table IV reports
that abnormal total fees are consistently positively and significantly associated with
both FLOSAQ and absolute abnormal accruals, consistent with audit quality being
compromised for clients who pay total fees beyond their expected values[13]. These
results provide evidence in support of the view delineated above and those suggested
in Kinney and Libby (2002); i.e. that economic bonding between clients and incumbent
auditors can be empirically discerned by segregating the unexpected portion of the
total fees. Our results are also consistent with higher fee premiums (abnormal fees)
being associated with lower audit quality and suggest that more profitable clients on
average have more influence over their auditors, who in turn may be more likely to
succumb to client pressure to misapply GAAP.
Auditor fees and
Independent
variables 2000 2001 2002 2003 audit quality
Panel A: association between total fees and accrual quality a
Intercept 0.0066, 0.79 0.0154, 2.02 * * 0.0291, 2.74 * * * 0.0192, 1.73 *
Total fees 0.00007, 4.35 * * * 0.00007, 3.55 * * * 0.0002, 6.67 * * * 0.0002, 5.37 * * *
LNTA 20.0046, 28.59 * * * 20.0046, 29.85 * * * 20.0060, 29.46 * * * 20.0056, 28.72 * * *
Cycle 0.0107, 7.64 * * * 0.0092, 6.97 * * * 0.0074, 3.98 * * * 0.0094, 4.86 * * * 779
PropLoss 0.0086, 2.50 * * 0.0162, 5.14 * * * 0.0254, 5.77 * * * 0.0189, 4.08 * * *
StdSales 0.0535, 12.96 * * * 0.0570, 14.31 * * * 0.0833, 15.91 * * * 0.0872, 14.89 * * *
StdOCF 0.0986, 8.69 * * * 0.0809, 9.98 * * * 0.0748, 7.72 * * * 0.0734, 6.36 * * *
N 1,320 2,414 2,470 2,179
Adj. R 2 0.4268 0.3596 0.3308 0.3005
Panel B: association between total fees and Absolute discretionary accruals b
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Additional tests
Audit and non-audit fees
The principal focus of our paper examines the association between total fees and audit
quality. By using total fees, we assume the impact of audit and non-audit fees on audit
quality is similar. To further enhance our understanding of the effects of client
importance and auditor effort on audit quality, we relax this assumption and extend
our analyses by:
. separating total fees into audit and non-audit fees categories; and
.
incorporating estimates of abnormal audit and non-audit fees, similar to our
analysis when using total fees[14].
We then modify equations (7) and (8) by separating total fees into its audit and
non-audit fee categories.
MAJ
Independent
22,8 variables 2000 2001 2002 2003
The results (untabulated) show that the coefficient on audit fees is positive and
significant in all years in both models (except for the year 2000 when regressing the
fees on ABSREDCA). The slope coefficient on non-audit fees is positive and significant
in 2002 and 2003 (when regressing the fees on FLOSAQ) and in 2000 and 2001 (when
regressing the fees on ABSREDCA), but not significant in all other years. Though
these results are not as robust as those presented in Table III (the total fee analysis),
they remain consistent with the economic bonding hypothesis. The consistent
significance of the coefficient on audit fees may suggest that economic bonding arises
primarily from audit services and not non-audit services (contrary to the assertions of
regulators and the subsequent passage of SOX). The signs and significance of the
control variable coefficients also remain similar to their counterparts in Table III.
We also jointly examine the association between abnormal audit and abnormal Auditor fees and
non-audit fees, and audit quality and estimate the following models: audit quality
FLOSAQ ¼ a þ b1 Abnormal Audit FEE þ b2 Abnormal Non – Audit FEE
ð9Þ
þ b3 LNTA þ b4 Cycle þ b5 PropLoss þ b6 StdSales þ b7 StdCFO þ 1
781
ABSREDCA ¼a þ b1 Abnormal Audit FEE þ b2 Abnormal Non 2 Audit FEE
When comparing audit and non-audit fees before and after the SOX, some concerns
may be raised regarding the comparability of fees given the reclassification and the
changes between the SEC rules in 2000 and 2003. To address the potential effects of
reclassification, we conduct additional analyses.
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Fees paid to auditors in 2002 were reported under the old rules in 2002; however, in
2003, the SEC required companies to present fees paid to auditors in 2002 under a new
regulation (to enhance comparability with 2003). Since, fees paid by companies in 2002
were reported under both the old and new rules, we are presented with a unique
opportunity to study the effects of this reclassification. We contacted Standard & Poors
and requested the data as was reported under the old rules for 2002. We then conduct
our primary tests using the original data for 2002 (untabulated) and obtain exactly the
same results as those based on the new 2002 data. Both measures of the audit and
non-audit fees (both deflated and abnormal) are positively and significantly associated
with FLOSAQ in 2002. Additionally, consistent with the results discussed in the
previous section, audit (non-audit) fees are significantly (not significantly) associated
with absolute REDCA.
2000-2003 and their association with audit quality. This timeframe is of particular
interest because fees paid to auditors during this period occurred amidst sweeping
changes in the business, regulatory and professional environment faced by auditors.
We study fees paid to auditors within the context that auditor profitability better
captures the relation between audit quality and auditor independence. Using client size
and estimates of expected fees paid to auditors to proxy for unobservable auditor risk
and effort, we find a statistically significant positive association between total fees and
two measures of audit quality – the standard deviation of residuals from regressions
relating current accruals to cash flows (FLOSAQ) and the absolute value of
performance-adjusted discretionary accruals (ABSREDCA) across all years
(2000-2003). We also conduct similar tests on the separate categories of audit and
non-audit fees and find a positive, but inconsistently significant association with our
two audit quality metrics. Overall, our results are consistent with economic bonding
rather then auditor reputation concerns.
Our study is subject to a number of limitations. First, we utilize accruals to
construct our measure of earnings quality. Using accruals might be a noisy proxy for
management’s discretion over earnings. Though we have attempted to control for the
effects of performance differences on accruals, any association we find between auditor
fees and abnormal accruals could be the result of measurement error rather than a
reflection of management behavior. Second, our sample spans a timeframe consumed
by sweeping business and regulatory changes and that requires public companies to
self-report information about auditor fees (whose classification involves subjective
judgments). Third, we include abnormal fees (total, audit and non-audit) in our
empirical analysis to address concerns relative to client importance and fee
composition. Though we compute abnormal fees using fee prediction models that
appear to be well-specified, we cannot rule out the possibility of an unknown degree of
model misstatement, and omitted variables, on our results. Lastly, it is conceivable that
our results are driven by the inability of our empirical analyses to adequately capture
the impact of unobservable risk. Though we attempt to explore this possibility
employing a variety of alternatives, our results remain qualitatively unchanged. Thus,
we defer further investigation of this limitation to future research.
Notes
1. This measure attempts to assess how well earnings map into cash flows. It utilizes the
standard deviation of residuals from regressions that relate current accruals to cash flows.
For purposes of this study, we refer to this measure as FLOSAQ.
MAJ 2. We also include sensitivity checks to control for the potential impact of the SEC’s change in
mandated fee component disclosures relative to fee paid to auditors by their clients.
22,8
3. “Other services” include bookkeeping; appraisal, valuation services and fairness opinions;
actuarial services; management functions and human resources; broker-dealer, investment
adviser, and investment banking; legal services unrelated to the audit; and any other
services that the PCAOB determines should be restricted (Sarbanes-Oxley Act, 2002).
784 4. Larcker and Richardson (2004) argue that “although RATIO has some intuitive appeal for
measuring the financial linkage between an auditor and client, the size of the fee payments to
the audit firm (both audit and non-audit) is not captured by this measure. That is, a client
with $1 of audit and non-audit payments produces the same score as a client with $10 million
of audit and non-audit payments”.
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5. As in Menon and Williams (2004) among others, we also separate accruals into their income
increasing and income decreasing components in the additional tests section.
6. We re-calculate total accruals using cash flows extracted directly from the statement of cash
flows (as suggested by Hribar and Collins, 2002) and obtain qualitatively similar results.
7. The decline in mean total fees between years 2000 and 2001 could potentially be attributed to
the fact that our sample firms are different between these years, e.g. many smaller firms
reported audit and non-audit fees for the first time in 2001.
8. Even though Arthur Andersen did not exist throughout our sample period we use BIG5 to
capture auditing performed by any of the BIG5 auditing firms.
9. Since, our sample spans a turbulent period and is exposed to significant changes in
legislative and reporting requirements, it is likely that expected effort and risk, and hence,
expected fees, will change between the years examined.
10. The adjusted R 2s for our total fees prediction model are consistent with those found in
previous studies.
11. It is generally expected that an auditor with longer tenure will earn a premium. However, our
sample covers a sensitive time period wherein many of Arthur Andersen’s clients were
forced to shop for an auditor (and possibly pay a premium to new auditors with no tenure).
12. We assess the potential presence of multicollinearity by examining the significance of our
independent variables and calculating the Variance Inflation Factors. Our results suggest
that multicollinearity should not impact our results. We also use White’s (1980) consistent
standard errors to control for heteroscedasticity in the error terms for our main results. Our
results remain similar to those reported.
13. Consistent with Hribar and Nichols (2006), we investigate whether there is a difference in the
relationship between our fee variables and income increasing or income decreasing
discretionary accruals, we partition the sample into two groups based on the sign of a firm’s
discretionary accruals (REDCA). We replicate the results presented in Table IV for each of
the two groups and observe that abnormal total fees is positively related to positive
discretionary accruals and negatively related to negative discretionary accruals. Our
significant results indicate that economic bonding, as measured by abnormal total fees, is
associated with both income increasing and income decreasing earning management.
14. We estimate expected or normal audit fees by employing the same methodology used for
total fees. Our results (untabulated) are similar to the results of estimating total fees
presented in Table II.
15. Prior to our 2002 data, many such services were included in the NAS category.
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Corresponding author
Rani Hoitash can be contacted at: [email protected]
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