Non-audit Service Fees Research Articles

Nonaudit Services and Earnings Management: UK Evidence*

AbstractUsing a sample of UK firms for the period 1996‐98, we provide empirical evidence on the relation between nonaudit services (NAS) purchase and three proxies for earnings management: (1) the likelihood that client firm accounting practices during the sample period were publicly criticized or subject to regulatory investigation; (2) the likelihood that client firms were required to restate prior financial statements or adjust current year results upon adoption of Financial Reporting Standard (FRS) No. 12, which was intended to curb opportunistic use of provisions; and (3) the mean absolute value of client discretionary working capital accruals over the sample period. The level of NAS purchase is measured, alternatively, as (1) the ratio of nonaudit to total auditor fees, (2) the natural log of NAS fees, and (3) the decile rank of a particular client's NAS fees given all NAS fees received by the audit firm practice office. With one exception, we find that all three measures of earnings management are positively and significantly associated with the three measures of NAS purchase.

The Association of Audit and Nonaudit Services Fees Between SEC and Non-SEC Investigated Firms

The purpose of this study is to explore the association of audit and nonaudit services fees of firms under SEC investigation relative to firms not under SEC investigation to ascertain whether systematic differences exist. This study is important because the issue of auditor independence raises concerns about auditor objectivity and economic bonding stemming from increasing nonaudit service fees. As gatekeepers to the public securities markets, it is important that the opinion of independent auditors provides investors with needed assurance that the financial statements of a company can be relied upon. If nonaudit fees can proxy for potential independence impairment, then a significant association between these fees and an SEC investigation may suggest that the SEC perceives firms purchasing large amounts of nonaudit services possibly lacking in independence. In OLS regression models of audit and nonaudit fees, an SEC investigation variable is significant indicating higher fees relating to an SEC investigation. Nevertheless, in a logistic regression model of SEC investigated firms audit fees is significant, but nonaudit fees is not after controlling for audit fees. This result suggests that the level of nonaudit service fees alone is not a determinant of the likelihood of an SEC investigation. Further discussion of this and other findings are provided.

Nonaudit Fees, Auditor Independence, and Bond Ratings

Recent accounting scandals and perceived audit failures have resulted in excessive criticism of the accounting and auditing professions. The financial press has expressed disdain at the presumably substandard work that was completed on audit clients, ostensibly at the expense of the public good. Our research investigates one aspect of this situation by exploring the effects that nonaudit services performed by a firm's external auditors have on perceived auditor independence in the bond market. Specifically, we analyze the effects that the magnitude and relative degree of nonaudit services have on the bond rating process. Regression results indicate that the amount of nonaudit services provided by a firm's external auditors is negatively associated with that client's bond rating. However, results of classification accuracy analyses fail to demonstrate any improvement in performance as a consequence of adding nonaudit fees to a benchmark prediction model, indicating no economic effect on the actual bond ratings. These results afford insights concerning bond rating analysts' perceptions of auditor independence and provide empirical evidence regarding the role that audit and nonaudit service fees play in establishing a firm's bond rating.

Auditor Independence, Non‐Audit Services, and Restatements: Was the U.S. Government Right?*

Do fees for non‐audit services compromise auditor's independence and result in reduced quality of financial reporting? The Sarbanes‐Oxley Act of 2002 presumes that some fees do and bans these services for audit clients. Also, some registrants voluntarily restrict their audit firms from providing legally permitted non‐audit services. Assuming that restatements of previously issued financial statements reflect low‐quality financial reporting, we investigate detailed fees for restating registrants for 1995 to 2000 and for similar nonrestating registrants. We do not find a statistically significant positive association between fees for either financial information systems design and implementation or internal audit services and restatements, but we do find some such association for unspecified non‐audit services and restatements. We find a significant negative association between tax services fees and restatements, consistent with net benefits from acquiring tax services from a registrant's audit firm. The significant associations are driven primarily by larger registrants.

Professional Service Fees and Auditor Objectivity

This study investigates whether an auditor's objectivity is impaired by nonaudit services or by the level of economic dependence on a client. Like several contemporaneous studies, we use recent mandated proxy statement audit and nonaudit fee disclosures to measure economic dependence and we use discretionary accruals as a surrogate for auditor objectivity. The results in the extant literature are mixed. We provide some explanations for those inconsistent results. First, we replicate the results of Frankel et al. (2002), finding, as they did, a significantly positive association between the relative level of nonaudit fees and discretionary accruals. Second, we document that this initial result is primarily due to small-tomedium-sized high-growth firms, especially firms having initial public offerings and in the e-commerce, biomedical, telecommunication, and pharmaceutical industries. After factoring these characteristics into the analysis, we find no evidence that the relative level of nonaudit service fees impairs an auditor's objectivity.

Discipline with Common Agency: The Case of Audit and Nonaudit Services

Using a common agency model, we investigate the interactions of a utility-maximizing auditor (the agent) with managers (who hire the agent for nonaudit services) and shareholders (who hire the agent for conducting an audit) of the same firm. In a single-period model, managerial discretion over consulting and other nonaudit service fees can influence auditors to issue unqualified opinions on reports that are more favorable than warranted. Shareholders, represented by an audit committee, cannot recover truth-telling. Removing the current restriction on contingent audit fees allows audit committees to offset the incentives provided by management and instead provide the auditor incentives to accept only truthful reports. Extending the model to a multiperiod framework, the audit committee can motivate truth-telling by making retention decisions that are contingent on outcome. Auditors will consider the impact of overreporting on their ability to generate future audit fees from the same client.

Disclosure of Fees Paid to Auditors and the Market Valuation of Earnings Surprises

We investigate if the SEC's mandated disclosure of fees for audit and nonaudit services affected the market's perception of auditor independence and earnings quality. Following the initial fee disclosures, we find that the market valuation of quarterly earnings surprises (earnings response coefficient) is significantly lower for firms with high levels of nonaudit fees than for firms with low levels of nonaudit fees. In contrast, in the year prior to the new fee disclosures, there was no reduction in earnings response coefficients for firms that subsequently reported high nonaudit fees. Our evidence suggests that mandated fee disclosures provided new information and was viewed by the market as lowering the perception of auditor independence and earnings quality.

Initial Evidence on the Association between Nonaudit Fees and Restated Financial Statements

An increasing number of firms have restated previously issued financial statements in recent years. Legislators, regulators, and others speculate that restatements are associated with fees received by auditors for nonaudit services (nonaudit fees). The current study provides empirical evidence on the association between firms that restate financial statements and the nonaudit service fees received by incumbent auditors during reporting periods that required restatement. We identify a sample of 110 firms that restated financial statements previously filed with the SEC for fiscal years 2000 or 2001, and provided relevant audit and nonaudit fee data. The SEC requires firms to disclose these fee data beginning in proxy statements filed on or after February 5, 2001. We compare the fees paid by the restatement sample with fee data for 3,481 firms that filed proxies with the SEC from February 5, 2001 to August 31, 2001 and develop benchmarks for expected nonaudit fees, fee ratio, and total fees. Using these benchmarks, we calculate the unexpected values for these measures and investigate whether restatement firms differ from the control firms. Our findings of no significant differences between the restatement and control samples for unexpected nonaudit fees, fee ratios, and total fees do not support concerns that either nonaudit fees or total fees inappropriately influence the audit and lead to restatements.

An Empirical Investigation of Audit Fees, Nonaudit Fees, and Audit Committees*

AbstractThis study examines the association between audit committee characteristics and the ratio of nonaudit service (NAS) fees to audit fees, using data gathered under the Securities and Exchange Commission's (SEC's) fee disclosure rules. Issues related to NAS fees have been of concern to practitioners, regulators, and academics for a number of years. Prior research suggests that audit committees possessing certain characteristics are important participants in the process of managing the client‐auditor relationship. We hypothesize that audit committees that are independent and active financial monitors have incentives to limit NAS fees (relative to audit fees) paid to incumbent auditors, in an effort to enhance auditor independence in either appearance or fact. Our analysis using a sample of 538 firms indicates that audit committees comprised solely of independent directors meeting at least four times annually are significantly and negatively associated with the NAS fee ratio. This evidence is consistent with audit committee members perceiving a high level of NAS fees in a negative light and taking actions to decrease the NAS fee ratio.

Corporate Governance, Fees for Non-audit Services and Accrual Choices

We examine the relation between the relative amount of fees paid to auditors for non-audit services and the behavior of accrual measures. We extend prior research in two important directions. First, using a pooled sample of 2,295 firms for the fiscal year 2000, we find very little evidence of a relation between the provision of non-audit services and measure of accruals. However, there appears to be three distinct clusters of firms where only one cluster (consisting of only about 20 percent of the sample) exhibits a statistically positive association between non-audit fees and accrual behavior. Second, we examine the corporate governance characteristics of firms in the cluster with a positive association between non-audit fees and accrual behavior relative to the remaining firms. We find that this subset of firms have a smaller market capitalization, lower institutional holdings, higher insider holdings, smaller board of directors (and audit committee), and lower percentage of independent board (and audit committee) members. These results suggest that the provision of non-audit services is potentially problematic only for a small subset of firms that appear to be de facto controlled by management.

Independence in Appearance and in Fact: An Experimental Investigation*

AbstractIn this study, we use experimental markets to assess the effect of the Security and Exchange Commission's (SEC's) new independence rule on investors' perceptions of independence, investors' payoff distributions, and market prices. The new rule requires client firms to disclose in their annual proxy statements the amount of nonaudit fees paid to their auditors. The new disclosure is intended to inform investors of auditors' incentives to compromise their independence. Our experimental design is a 2 3 between‐subjects design, where we control the presence (unbiased reports) or absence of auditor independence in fact (biased reports). While independence in fact was not immediately observable to investors, we controlled for independence in appearance by varying the public disclosure of the extent of nonaudit services provided by the auditor to the client. In one market setting, investors were not given any information about whether the auditor provided such nonaudit services; in a second setting, investors were explicitly informed that the auditor did not provide any non‐audit services; and in a third setting, investors were told that the auditor provided nonaudit services that could be perceived to have an adverse effect on independence in fact.We found that disclosures of nonaudit services reduced the accuracy of investors' beliefs of auditors' independence in fact when independence in appearance was inconsistent with independence in fact. This then caused prices of assets to deviate more from their economic predictions (lower market efficiency) in the inconsistent settings relative to the no‐disclosure and consistent settings. Thus, disclosures of fees for nonaudit services could reduce the efficiency of capital markets if such disclosures result in investors forming inaccurate beliefs of auditor independence in fact ‐ that is, auditors appear independent but they are not independent in fact, or vice versa. The latter is the maintained position of the American Institute of Certified Public Accountants (AICPA), which argued against the new rule. Further research is needed to assess the degree of correspondence between independence in fact and independence in appearance.

THE IMPACT OF NON-AUDIT SERVICE FEE DISCLOSURE REQUIREMENTS ON AUDIT FEE AND NON-AUDIT SERVICE FEE IN THE UNITED KINGDOM: AN EMPIRICAL ANALYSIS

Abstract Since the early 1990s the accounting profession has been in the midst of a debate about the deleterious effects of public accounting firms providing non-audit services to their audit clients. In response to increasing demand for regulation curbing the growth of non-audit services provided by auditing firms and to provide greater transparency of the auditor-client relationship, the SEC adopted rule amendments regarding auditor independence. One such rule requires public companies to disclose among other things, fees paid to auditors for rendering non-audit services. In the United Kingdom, the Companies Act 1989 (Disclosure of Remuneration for Non-Audit Work) 1991 Regulations required disclosure of non-audit service fees paid to the incumbent auditor for years ending on or after September 30th, 1992. The purpose of this study is to explore the effect of such disclosure requirement on audit fee and non-audit service fee. Based on a sample of 156 companies in the United Kingdom we find that there were significant differences in the level of non-audit service fee and ratio of non-audit service fee to audit fee for companies that voluntarily disclosed 1991 non-audit service fee and companies that did not disclose 1991 non-audit service fee. Also, a comparison of the trends in audit fee and non-audit service fee between these two groups from 1991 to 1994 indicated that the disclosure requirement had some limited effect in curbing the growth in non-audit service fee. Furthermore, audit fees were positively related to non-audit service fees and a first-difference regression ( Iyer & Iyer, 1996 , Maher et al., 1992 ) revealed that changes in audit fee were also positively related to changes in non-audit service fee.

Are Non-Audit Fees Associated with Restated Financial Statements? Initial Empirical Evidence

An increasing number of firms have restated previously issued financial statements in recent years. Legislators, regulators, and others speculate that restatements are associated with fees received by auditors for non-audit services (non-audit fees). The current study provides empirical evidence about the association between firms that restate financial statements and the non-audit service fees received by incumbent auditors during reporting periods that required restatement. We identify a sample of 110 firms that restated financial statements previously filed with the SEC for fiscal years 2000 or 2001, and provided relevant audit and non-audit fee data. We compare the fees paid by the restatement sample with fee data for 3,481 firms that filed proxies with the SEC from February 5, 2001 to August 31, 2001 and develop benchmarks for expected non-audit fees, fee ratio, and total fees. Using these benchmarks, we calculate the unexpected values for these measures and investigate whether restatement firms differ from the control firms. Our findings of no significant differences between the restatement and control samples for unexpected non-audit fees, fee ratios, and total fees do not support concerns that either non-audit fees or total fees inappropriately influence the audit and lead to restatements.

The Issue of Extended Non-Audit Service Fee Disclosures and Perceived Audit Independence: A Study of UK Fund Managers

The Issue of Extended Non-Audit Service Fee Disclosures and Perceived Audit Independence: A Study of UK Fund Managers

Do Non–Audit Service Fees Impair Auditor Independence? Evidence from Going Concern Audit Opinions

We find no significant association between non–audit service fees and impaired auditor independence, where auditor independence is surrogated by auditors’ propensity to issue going concern audit opinions. We also find no association between going concern opinions and either total fees or audit fees. In addition, our findings are robust to controlling for unexpected fees, to controlling for endogeneity among our variables, and to several alternative research design specifications. Our results are consistent with market–based incentives, such as loss of reputation and litigation costs, dominating the expected benefits from compromising auditor independence.

The Joint Determination of Audit Fees, Non-Audit Fees, and
 Abnormal Accruals

Prior research has estimated piece-meal the determinants of audit fees, non-audit fees and abnormal accruals. Intuition, informal analysis, and a variety of theories suggest that audit fees, non-audit fees, and abnormal accruals are jointly determined. We address this endogeneity issue by modeling the confluence of audit fees, fees for non-audit services and abnormal accruals in a system of simultaneous equations. Our joint estimation provides a starting point to look simultaneously at several competing theories. Using audit and non-audit fee data from the UK for 1994-2000, we find evidence consistent with knowledge spillovers (or economies of scope) from auditing to non-audit services and from non-audit services to auditing. While knowledge spillovers from non-audit services to auditing have been found in prior research [e.g. see Simunic 1984], the presence of knowledge spillovers from auditing to non-audit services is a new result. Contrary to recent results in Ferguson et al. (2001) and Frankel et al. (2002), we do not find support for the assertion that fees for non-audit services increase abnormal accruals. In fact, contrary to the results in Ashbaugh et al. (2003) and Chung and Kallapur (2003), we find that non-audit fees decrease abnormal accruals, which we attribute to the productive effects of non-audit services. We also find evidence that audit fees increase abnormal accruals, consistent with behavioral theories of unconscious influence or bias in the auditor-client relation. The findings are robust to tests with US data.

Auditor independence and fee dependence

This study investigates whether fee dependence within the audit firms’ offices jeopardises auditor independence. Fee dependence is examined at both the national audit firm level as well as the local office level and in a setting where public disclosure of fees is mandatory. We focus our tests on audit fee dependence and at the same time we control for the effects of non-audit service fee dependence post the 1989 mergers. We operationalise the exercise of independent judgement in auditing by the propensity to issue qualified audit opinions. If fee dependence affects auditors’ independent judgement, then auditors are less likely to qualify the accounts. The study's results show that the level of auditor fee dependence does not affect auditor propensity to issue unqualified audit opinions. The findings remain robust to a number of sensitivity tests including the analyses controlling for the effects of non-audit service fee dependence and other settings in which there is heightened pressure on auditors to confront the effects of fee dependence on exercising independent audit judgement.

Discussion of The Relation between Auditors' Fees for Nonaudit Services and Earnings Management

Discussion of The Relation between Auditors' Fees for Nonaudit Services and Earnings Management

The Relation between Auditors' Fees for Nonaudit Services and Earnings Management

This paper examines whether auditor fees are associated with earnings management and the market reaction to the disclosure of auditor fees. Using data collected from proxy statements, we present evidence that nonaudit fees are positively associated with small earnings surprises and the magnitude of discretionary accruals, while audit fees are negatively associated with these earnings management indicators. We also find evidence of a negative association between nonaudit fees and share values on the date the fees were disclosed, although the effect is small in economic terms.

The Relation Between Auditors' Fees for Non-Audit Services and Earnings Management

This paper examines whether auditor fees are associated with earnings management and the market reaction to the disclosure of auditor fees. Using data collected from proxy statements, we present evidence that non-audit fees are positively associated with small positive earnings surprises, the magnitude of absolute discretionary accruals, and the magnitude of income-increasing and income-decreasing discretionary accruals. In contrast, audit fees are negatively associated with these earnings management indicators. These results are robust to a variety of alternative variable definitions and model specifications. Specifically, contrary to the claims of Ashbaugh et al. (2002), the results are robust to the use of performance-matched discretionary accruals. Moreover, contrary to the claims of Francis and Ke (2002), the results for small positive earnings surprises are robust regardless of whether the comparison group is all other earnings surprises or small negative earnings surprises. Our final set of results provide evidence of a significant negative association between non-audit fees and share values on the date the fees were disclosed, although the effect is small in economic terms.