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*Fees Paid to Audit Firms, Accrual Choices and Corporate Governance David F. Larcker Ph 215 898 5424 Email: larcker@wharton.upenn.edu Scott A. Richardson Ph: 215 898 2063 Email: scottric@wharton.upenn.edu The Wharton School University of Pennsylvania Philadelphia, PA 19104-6365 Revised: October 28, 2003 *We appreciate the comments of Stanley Baiman, Jan Barton, Sudipta Basu, George Benston, Jeff Coulton, Richard Leftwich, Linda Myers, Grace Pownall, Stephen Taylor, an anonymous reviewer and seminar participants at Emory University. The financial support of The Wharton School and Ernst & Young LLP is gratefully acknowledged. Fees Paid to Audit Firms, Accrual Choices and Corporate Governance Abstract We examine the relation between the fees paid to auditors for audit and non-audit services and the choice of accrual measures for a large sample of firms. Similar to Frankel et al. (2002), we find that the ratio of non-audit fees to total fees has a positive relation with the absolute value of accruals. However, using latent class mixture models to identify clusters of firms with a homogenous regression structure reveals that this positive association only occurs for about 8.5 percent of the sample. In contrast to this result, we find consistent evidence of a negative relation between the level of fees paid to auditors and accruals (i.e., higher fees are ...
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Fees Paid to Audit Firms, Accrual Choices and Corporate Governance*
David F. Larcker Ph 215 898 5424 Email:larcker@wharton.upenn.eduScott A. Richardson Ph: 215 898 2063 Email:u.eptrnow@ahrtcidunn.eotscThe Wharton School University of Pennsylvania Philadelphia, PA 19104-6365 Revised: October 28, 2003
*We appreciate the comments of Stanley Baiman, Jan Barton, Sudipta Basu, George Benston, Jeff Coulton, Richard Leftwich, Linda Myers, Grace Pownall, Stephen Taylor, an anonymous reviewer and seminar participants at Emory University. The financial support of The Wharton School and Ernst & Young LLP is gratefully acknowledged.
Fees Paid to Audit Firms, Accrual Choices and Corporate Governance
Abstract
We examine the relation between the fees paid to auditors for audit and non-audit services and the choice of accrual measures for a large sample of firms. Similar to Frankel et al. (2002), we find that the ratio of non-audit fees to total fees has a positive relation with the absolute value of accruals. However, using latent class mixture models to identify clusters of firms with a homogenous regression structure reveals that this positive association only occurs for about 8.5 percent of the sample. In contrast to this result, we find consistent evidence of anegativerelation between the level of fees paid to auditors and accruals (i.e., higher fees are associated with smaller accruals). The latent class analysis also indicates that this negative relation is strongest for client firms with weak governance. Overall, our results are most consistent with auditor behavior being constrained by the reputation effects associated with allowing clients to engage in unusual accrual choices.
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Fees Paid to Audit Firms, Accrual Choices and Corporate Governance
1. Introduction The purpose of this paper is to examine the relation between the fees paid to audit firms for audit and non-audit services and the behavior of accounting accruals. This relation (if it exists) is an important input into the ongoing debate in the regulatory and academic communities about the structure of the accounting profession and the appropriateness of providing non-audit services by accounting firms. Critics contend that the extensive fees paid to auditors, especially fees for non-audit services, increase the financial reliance of the auditor on the client (e.g., Becker et al., 1998 and Magee and Tseng, 1990). As a result, independence may be compromised because the auditor becomes reluctant to raise issues with the preparation of the financial statements at the risk of foregoing lucrative fees. In contrast, DeAngelo (1981), Simunic (1984), and others argue that the auditor faces substantial economic costs when audit failures are observed. Thus, the relation between audit fees and auditor behavior is theoretically ambiguous.Prior research has examined many facets of this research question, but there is little evidence that the level of audit fees or the provision of non-audit services is associated with earnings quality. Frankel et al. (2002) claim that there is a positive relation between the provision of non-audit services and accrual measures, which implies that non-audit services impair earnings quality. However, more recent work by Antle et al. (2002), Ashbaugh et al. (2003), Kinney, Palmrose and Scholz (2003) and Chung and Kallapur (2003) have cast serious doubt on the findings and interpretations in Frankel et al. (2002).
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There are at least three economic or econometric explanations for conflicting results in the prior literature. First, the role of corporate governance has been largely ignored in the research to date. The auditor is only one of many potential monitoring mechanisms designed to mitigate the inherent agency problems in a publicly traded firm. Examining the auditor in isolation of alternate governance mechanisms provides an incomplete analysis of the determinants of earnings quality. Second, there are many ways to measure the financial connection between the auditor and client. Prior research, such as Frankel et al. (2002), has tended to focus on the provision of non-audit services (e.g., ratio of non-audit fees to total fees). However, the total fees paid to the auditor are an equally plausible measure for the dependence of the auditor on the client (DeAngelo, 1981, Reynolds and Francis, 2001, and Chung and Kallapur, 2003). Finally, different models are likely that describe the relation between audit fees and earnings quality across a large sample of firms. For example, the importance of the monitoring role served by the auditor should vary depending on the strength of the clients governance structure. Hence, using a single (pooled) regression model across a sample that is composed of different models is unlikely to provide an adequate assessment for the relation between audit fees and accrual choices. We address these limitations in prior research by using latent class mixture models to examine the relation between several audit fee measures (our proxies for auditor independence) and accrual measures (our proxies for earnings quality) for a large sample of firms for fiscal years 2000 and 2001. We find that a positive association between audit fees and unexpected accruals occurs only when audit fees are measured using the ratio of audit fees to total fees paid to the auditor and unexpected accruals are transformed using the absolute value (i.e., a non-directional measure). Moreover, the
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statistically positive association between non-audit fees and accrual behavior only occurs for approximately 8.5 percent of the total sample. This small cluster of firms, relative to the remaining clusters, has a smaller market capitalization, lower book-to-market ratio, lower institutional holdings, and higher insider holdings. Thus, concurrent weakness in corporate governance appears to be an important determinant of the relation between auditor independence and earnings quality. Although these results are provocative, we find that the relation between auditor independence and earnings quality is highly sensitive to the specific measures used in the analysis. Rather than simply using the ratio of non-audit fees to total fees, we consider four alternate measures of auditor independence. Specifically, we use the ratio of dollar (both audit and total) fees paid by the client to the auditor scaled by total fee revenue by the auditor and abnormal audit (and total) fees based on the expectation models developed by Simunic (1984) and Craswell et al. (1995). In contrast to our initial results and those reported in Frankel et al. (2002), we find a statisticallynegativerelation between auditor independence (using the four alternate measures described above) and earnings quality. Moreover, the cluster of firms with the most pronounced negative association is characterized by low market capitalization, high growth prospects, less independent boards, low institutional holdings, and high insider holdings. For these firms the auditor appears to be playing a key role in the governance process to limit abnormal accrual choices. Collectively, our results suggest that auditors are less likely to allow abnormal accrual choices for firms where they have the greatest financial interest. Overall, our results are most consistent with reputation concerns being the primary determinant of auditor behavior with respect to limiting unusual accounting
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choices of client firms (similar to the discussion in Reynolds and Francis, 2001 and Chung and Kallapur, 2003). The remainder of the paper is divided into four sections. Section 2 provides a review of the prior research examining the relation of payments to auditors and accounting choices. Section 3 describes our sample, provides descriptive statistics and justifies the use of latent class mixture models. The results are presented in Section 4 and interpretations and conclusions are provided in the Section 5.
2. Prior Research
Early research examined the relation between audit fees and non-audit fees in an attempt to identify the economies of scale that existed from the joint provision of these services (e.g., Simunic, 1984 and Palmrose, 1986). Recent research, however, has shifted focus onto the potentially detrimental aspects of the provision of non-audit services. Frankel et al. (2002) find that the provision of non-audit services is associated with (i) the likelihood of reporting earnings that meet or slightly exceed analyst expectations and (ii) the magnitude of the absolute value of abnormal accruals. Frankel et al. (2002) interpret these results as strong evidence that the provision of non-audit services reduces auditor independence and lower quality financial information.
Subsequent research, however, has questioned the appropriateness of the conclusions in Frankel et al. (2002). Ashbaugh et al. (2003) find that after controlling for firm performance there is no longer a positive relation between the provision of non-audit services and measures of unexpected or abnormal accruals for a sample of 3,170 firms. Similarly, for a sample of 1,871 firms, Chung and Kallapur (2003) also fail to find any evidence of a relation between measures of unexpected accruals and measures of auditor
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independence (using a measure of client dependence as opposed to simply examining the provision of non-audit services). In addition, Ashbaugh et al. (2003) find no statistically significant association between firms meeting analyst forecasts and auditor fees, and Francis and Ke (2003) find that the association between firms meeting analyst forecasts and auditor fees is very sensitive to the choice of comparison group.
Most prior research estimates the relation between the provision of non-audit services and accruals using a relatively simple regression model between these two variables. One notable exception, however, is contained in Antle et al. (2002) who examine the relations among audit fees, non-audit fees and abnormal (or unexpected) accruals in a simultaneous equations framework. Utilizing 2,443 firm-year observations from the United Kingdom for the period 1992-2000, they find that the relation between abnormal accruals and non-audit fees isnegativeafter simultaneously estimating the determinants of audit and non-audit services and accruals. They also find similar results using a restricted sample of 1,430 U.S. firms for the year 2000.
Other measures have also been used to examine the impact of the relationship between the client firm and auditor on earnings quality. DeFond et al. (2002) using a sample of 944 financially distressed firms for the year 2000 find no evidence of an association between the issuance of a qualified audit opinion and the provision of non-audit services. Ruddock et al. (2003) using a sample of 4,708 Australian firm-year observations from 1993-2000 find no association between measures of accounting conservatism and the provision of non-audit services. Their argument is that if the provision of non-audit services encourages income increasing earnings management this will manifest via a reduction in observed accounting conservatism.
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Recent work by Kinney et al. (2003) examines the relation between earnings restatements and the provision of non-audit services. Using proprietary data for auditor fees for a matched sample of 174 firms for the period 1995-2000, they find no consistent evidence of a positive association between audit firm fees for non-audit services and restatements. Rather they find a negative association between the provision of tax services and restatements. Observing an earnings restatement, however, is open to several interpretations. The traditional view is that the earnings restatement is indicative of severe earnings management by the firm and carelessness by the auditors. Alternatively, it could be the result of an effective auditor imposing their will on the firm and forcing the restatement.
A related stream of research examines the financial dependency of the auditor-client relationship. DeAngelo (1981) develops a model where the auditor faces a conflict of interest. The auditor has to choose whether to compromise independence in return for retaining quasi-rents from key clients. The incentives to compromise independence depend on client importance (typically measured as the ratio of fee revenue from a particular client deflated by total fee revenue for the audit firm). One outcome of the financial dependency is that auditors may sacrifice their independence for more important clients. Reynolds and Francis (2001) test this prediction using client size as a proxy for audit fees and find no evidence that economic dependence impacts the audit outcome. Specifically, for a sample of 6,747 firms in 1996 they find that abnormal accruals are lower when client dependence is greater and there is a marginally significant greater likelihood of receiving a qualified audit opinion. These results suggest that litigation and reputation risk prompt auditors to curb aggressive reporting practices of firms.
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Finally, accrual behavior and corporate governance has been examined in several recent papers. Klein (2002) documents for a sample of 692 U.S. firm-years covering 1992-93 that the presence of independent outside directors on the board and audit committee is associated with lower levels of unexpected or abnormal accruals (in absoluteterms). Other examples of this type of research include Xie et al. (2002) and Jenkins (2002) who examine, among other things, the relation between board and audit committee composition and measures of unexpected or abnormal accruals. Similar to Klein (2002), these papers find that the presence of outside directors on the board and audit committee is associated with lower levels of unexpected or abnormal accruals (in absolute research highlights the importance of incorporating corporateterms). This governance in the research design. In particular, corporate governance has an impact on the demand for auditing quality and payment of audit and non-audit fees to the auditor, and can have an important impact on financial reporting quality.
In summary, the literature examining the relation between audit fees and/or non-audit services with accrual behavior findsvirtually nostatistical evidence for a relation between auditor independence and earnings quality. Moreover, the results and interpretations in prior research are statistically fragile and quite sensitive to changes in research design and variable measurement. We extend the existing literature by examining a more complete set of measures for both earnings quality and auditor independence, relaxing the assumption that a single regression model describes the relation between auditor independence and earnings quality, and explicitly analyzing the role of corporate governance on the auditor-client relation.
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3. Methodological Approach
3.1 Sample
Our initial sample consists of 5,815 firm-years that report data on audit and non-audit fees paid for fiscal years 2000 and 2001. These data were obtained directly from Standard & Poors.1 In order to reduce the impact of very small firms and auditors, we restrict our sample to clients of Arthur Andersen, Ernst & Young, Deloitte & Touche, KPMG, and PricewaterhouseCoopers (i.e., the Big Five) plusGrant Thornton and BDO Seidman(reducing the sample by 355 observations). Firms are retained for subsequent analysis if they have sufficient Compustat data for computing the accrual measures used in our analysis. We also exclude financial institutions from the sample (SIC codes between 6000 and 6999). This reduces the sample by 357 observations. The 5,103 firm-years (3,424 firms) in our final sample span many sectors of the economy (Table 1, Panel A). The industries most represented in our sample are business services (16.46 percent of the sample), chemicals (9.21 percent), electrical (9.21 percent) and industrials (6.75 percent). These percentages are similar to the breakdown for the Compustat population.
The mean (median) of operating cash flow is equal to four (seven) percent of assets, for book-to-market ratio is equal to 0.78 (0.52) and for market capitalization of about $2,806 ($271) million. These numbers compare with a mean (median) book-to-market ratio of 0.92 (0.58) and a mean (median) market capitalization of $2,910 ($139) million for all firms on Compustat for the 2000-2001 period.
3.2 Measurement of Auditor Independence
1It is important to note that the SEC disclosures with respect to audit fees are limited. Total fees and audit specific fees are disclosed but the remaining other fee category is not well defined. 9
We employ five different measures of the fees paid to auditors. First, we calculate the fee ratio as the ratio of non-audit fees to total fees paid to the auditor (the sum of audit and non-audit fees). Similar to prior research (e.g., Frankel et al., 2002), the mean (median) firm pays roughly the same amount for non-audit and audit services (see Table 2). However, there is considerable cross-sectional variation in this measure (denoted asRATIO). AlthoughRATIOhas some intuitive appeal for measuring the financial linkage between an auditor and a client, the size of payments to the auditor is not captured by this measure. That is, a client with one dollar of audit and non-audit payments produces the same score as a client with ten million dollars of audit and non-audit payments.
In an effort to incorporate payment size into our analysis, we focus on the importance of a particular client to the audit firm. In particular, we measure client importance as the ratio of fees paid by the client firm to the total revenue of the auditor for that year. As in Chung and Kallapur (2003), we obtain the total fee revenue for each auditor fromAccounting Today. We calculate two basic measures of client importance. NONAUDFEE, uses non-audit fees to compute client importance, andTOTFEEuses total fees (both audit and non-audit). We use both measures because the quasi rents could be greater for non-audit services than audit services. The mean (median) firm pays total fees that are approximately three (one) percent of total revenue for their auditor and non-audit fees that are approximately two (one-half) percent of total revenue for their auditor (Table 2, Panel A). As would be expected, these three measures of payments to the auditor exhibit large, positive correlations (Table 2, Panel B). In section 4.3 we introduce our final two measures of auditor independence that focus on abnormal fee levels.
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