Audit Fees

Angie.Dangerfield

Sujets

• management
• managers

Informations

• Publié par: Ormya
• Nombre de lectures: 11
• Langue: English

Extrait

Auditor Independence and Earnings’ Quality: Evidence for
∗Market Discipline vs. Proscriptive Regulation

James Brown
Montana State University

Dino Falaschetti
Montana State University

Michael Orlando
Federal Reserve Bank of Kansas City

September 1, 2006


Abstract

Received research largely argues against auditor independence influencing
the quality of earnings’ reports, but encounters several difficulties in doing
so. Addressing these difficulties, we build additional confidence that
auditor independence improves earnings’ quality, though any such effect
appears to be small. Moreover, our research facilitates a more careful
inference from audit fee data about the efficacy of Sarbanes-Oxley’s
restriction on consulting for audit clients. Here, we develop more
defensible evidence that moving past the Securities and Exchange
Commission’s (SEC’s) fee disclosure mandates to proscribe non-audit
services diminished financial market opportunities.



JEL: G14, G38, K22, M42

Keywords: Auditor Independence, Audit Fees, Non-Audit Services,
Corporate Governance, Sarbanes-Oxley

∗ We thank Dan Covitz, Rob Fleck, Steven Hansen, Andy Hanssen, Mary Sullivan, Doug Young,
participants at the 2006 meeting of the Washington Area Finance Association at George Washington
stUniversity (WAFA) and the 81 Annual Conference of the Western Economic Association (WEA), and
seminar audiences at Montana State University for helping us think about this research.
Auditor Independence and Earnings’ Quality: Evidence for
Market Discipline vs. Proscriptive Regulation

September 1, 2006


Abstract

Does auditor “independence” improve the quality of financial disclosures?
Popular characterizations of recent governance scandals strongly answer
“yes.” Scholarly evidence appears less decisive, however, in part because
it ignores several hypotheses about how independence can influence
earnings’ quality. We examine proxy data on fees for audit and non-audit
services (NAS) to address this issue as follows.

1. We relax a priori linear restrictions in the literature, which assume
that independence affects earnings’ quality in only one direction.

2. We offer a finer evaluation of how markets value independence by
better measuring unexpected disclosures and examining whether audit
fee disclosures improve the efficiency of market valuations; and

3. We look beyond internal effects of independence to consider the
potential for one firm’s governance choice to influence other firms’
financial market opportunities.

In each case, we find evidence that auditor independence does not, by
itself, materially degrade the quality of financial disclosures (either
internally or externally). To the extent that significant relationships appear
in our data, they are consistent with disclosure mandates exhausting
opportunities to enhance financial market performance, and thus with
proscriptive regulation (e.g., Sarbanes-Oxley’s restriction on NAS) having
foreclosed such opportunities.

JEL: G14, G38, K22, M42

Keywords: Auditor Independence, Audit Fees, Non-Audit Services,
Corporate Governance, Sarbanes-Oxley 1. Introduction
High profile accounting scandals (e.g., Enron, WorldCom) squarely placed the topic
of corporate governance in front of popular and business media. A widely held belief
emerged that letting accountants consult for audit-clients compromises auditors’
independence and thus diminishes the quality of earnings’ reports (e.g., see Romano,
12004; Weil, 2004). Citing such conflicts of interest, US legislators built considerable
support for the Sarbanes-Oxley Act of 2002 (SOX, hereafter), part of which restricts
2accountants from producing non-audit services (NAS).
This support appears at odds, however, with scholarly examinations of disclosure
mandates that preceded SOX – i.e., previous Securities and Exchange Commission
(SEC) requirements that audit clients formally disclose fees paid for audit and non-
audit services. These studies offer limited evidence that markets value the
information that such disclosures make available (e.g., see Glezen and Millar, 1985;
Frankel et al., 2002; Ashbaugh et al., 2003), and employ such results to not only
argue against disclosure mandates, but also against proscriptive regulations like SOX
3(e.g., see DeFond et al., 2002).
We critically evaluate these results and find them wanting on several margins.
Received research ignores, for example, several channels through which information
about “fee dependence” can be influential. In addition, it leaves open the question of

1 Ezzamel, Gwilliam, and Holland (1996) document a similar perception for UK companies.
2 See “Title II – Auditor Independence” of the Sarbanes-Oxley Act of 2002 (HR 3763), summarized in our
Appendix A. The bill passed the House by a roll call vote of 423-3 and the Senate by a vote of 99-0 on
July 25, 2002 (Source: Thomas (a service of the Library of Congress), accessed April 12, 2005 at
http://thomas.loc.gov/home/thomas.html).
3 In addition, popular calls to loosen SOX and its regulatory constraint on producing NAS appear to be
growing. The US Chamber of Commerce (2006, p. 16), for example, argued that prohibiting “Big Four
firms” from “audit assignments when they have performed disqualifying services in prior years” unduly
restricts competition.
1how data from fee disclosures can inform regulations that would prescribe how
market participants organize their governance services. Addressing these issues, we
find more defensible evidence that mandating the disclosure of accounting fees can
productively strengthen market discipline, though any such effect appears to be small.
Moreover, to the extent that regulatory opportunities to enhance financial market
efficiency existed, our evidence is consistent with disclosure mandates having
exhausted them – i.e., any strengthening of market discipline that resulted from these
mandates may have fully internalized the costs and benefits of commingling audit and
non-audit services. Our research design thus offers more defensible evidence against
the efficacy of SOX in having moved past disclosure mandates to restrict auditors
from producing NAS.
These contributions come from a more firmly grounded empirical investigation of
how auditor independence relates to financial statement integrity. In the following
section, we review the literature to identify channels through which auditor
independence can plausibly influence earnings’ quality without being detected by
received research designs. This review highlights several channels as being worthy
of investigation.
1. In addition to threatening the integrity of financial disclosures, jointly
producing audit and non-audit services can leverage scope economies to
4improve disclosure-quality. But while such economies can offset associated
agency costs, and thus give rise to a non-monotonic relationship between

4 Banks, for example, exhibit qualitatively similar economies when jointly producing lending and
underwriting services (see, e.g., Drucker and Puri, forthcoming).
2audit quality and auditor “independence,” contributions to the literature have
a priori restricted this relationship to being linear.
2. If markets are efficient and auditor independence matters, then equity prices
should respond to disclosures about unexpected independence.
Contributions to the literature, however, examined how markets responded
to “gross” disclosures – i.e., disclosures that confound expected and
5unexpected independence. Even if auditor independence influences
earnings’ quality, the errors-in-variable problem that this treatment creates
can attenuate coefficient estimates of interest and thus hide evidence of an
effect.
3. Received research designs attempt to measure the own-firm effect of auditor
independence on the quality of earnings’ reports. They do not consider,
however, the potential for disclosures about auditor independence at one
firm to inform markets about others. Understanding the extent of such
informational externalities is important for evaluating the efficiency-
consequences of mandated disclosures and more proscriptive governance
regulations.
Each of these difficulties can bias inference toward rejecting the hypothesis that
separating the production of audit and non-audit services expands financial market
opportunities. After carefully addressing these issues in Section 3, however, we find

5 To be sure, the literature does not completely ignore this issue. DeFond et al. (2002) and Frankel et al.
(2002), for example, evaluated how proxies for earnings’ quality relate to measures of “unexpected” non-
audit fees. These measures ignore, however, the potential for organizational features (e.g., audit committee
independence) to substitute for auditor independence in producing corporate governance services
(Falaschetti and Orlando, 2004). Moreover, while information sets must be available before they can
facilitate expectations, DeFond et al. (2002) and Frankel et al. (2002) estimate “expec