Audit Fees, Non-Audit Fees and Auditor Going-Concern Reporting Decisions in the United Kingdom

The accounting profession has come under increased scrutiny over recent years about the growing number of non-audit fees received from audit clients and the possible negative impact of such fees on auditor independence. The argument advanced is that providing substantial amounts of non-audit services to clients may make it more likely that auditors concede to the wishes of the client management when difficult judgments are made. Such concerns are particularly salient in the case of reporting decisions related to going-concern uncertainties for financially stressed clients.
 This study empirically examines audit reports provided to financially stressed companies in the United Kingdom and the magnitude of audit and non-audit service fees paid to the company's auditors. We find that the magnitude of both audit fees and non-audit fees are significantly associated with the issuance of a going-concern modified audit opinion. In particular, financially stressed companies with high audit fees are more likely to receive a going-concern modified audit opinion, whereas companies with high non-audit fees are less likely to receive a going-concern modified audit opinion. Additional analyses indicate that the results are generally robust across alternative model and variable specifications. Overall, evidence supports the contention that high non-audit fees have a detrimental effect on going-concern reporting judgments for financially stressed U.K. companies.     

On the Relationship between Audit Tenure and Fees Paid to the Audit Firm and Audit Quality

Abstract

We investigate the impact of audit firm tenure, partner tenure, audit fees, fees for non-audit services and total fees on audit quality, as measured by discretionary accruals. Our sample consists of Spanish non-financial public companies for the years between 2006 and 2013. Results indicate that audit quality increases with audit firm tenure but decreases with partner tenure. Moreover, the level of fees paid to the audit firm seems to have a negative impact on audit quality, which is mainly driven by fees for audit services. In this regard, we do not observe any significant relationship between fees for non-audit services and audit quality. Our results also show that the negative relationship between either long partner tenures or high fees and audit quality does not occur when the tenure with the audit firm is long. Therefore, long audit firm tenures do not only seem to involve higher audit quality ‘per se’, but also moderate the negative effects of partner tenure and audit fees on audit quality. The results of this study, which are robust to several sensitivity checks, may be relevant for the current debate on auditor rotation and the joint provision of audit and non-audit services.     

Audit and non-audit fees and capital market perceptions of auditor independence

This study provides evidence on whether auditor independence-in-appearance, proxied by earnings response coefficients, is related to the non-audit fee ratio (non-audit to total fees from a client) or client importance (total fees from a client as a percentage of the total revenues of the audit firm). The results from large samples over the period 2001–2006 show, contrary to popular belief and the findings of some prior studies, that there is no evidence of a relation between perceived auditor independence and the non-audit fee ratio. However, perceived auditor independence is negatively associated with client importance, consistent with the economic theory of auditing. Our paper adds to the literature by examining the relative importance of non-audit fee ratios and client importance as determinants of independence-in-appearance.     

Costs Associated With Going-Concern-Modified Audit Opinions: An Analysis of the Australian Audit Market

This article examines the potential costs to Australian auditors and their clients from the issuance of first-time going-concern-modified audit opinions. We examine the population of Australian companies receiving a first-time going-concern-modified audit opinion during the period 1994–97 and a matched sample of financially distressed firms receiving a clean audit opinion. Results indicate that auditor switching is positively associated with receipt of a going-concern-modified opinion. However, we find no empirical evidence that there is a self-fulfilling prophecy of increased probability of company failure following the issuance of a going-concern-modified opinion for the Australian companies in our study. Our analyses of lost audit fees indicate that auditors issuing first-time going-concern-modified audit opinions lost proportionately more fees by losing clients (through switching or company failure) than firms not issuing a going-concern-modified opinion to financially stressed clients.     

Audit Reporting of Big 4 Versus Non-Big 4 Auditors: The Case of Ex-Andersen Clients

This paper examines audit reporting of Big 4 auditors versus non-Big 4 auditors for ex-Andersen clients and other clients. It suggests that ex-Andersen clients are more risky than other clients and are able to exert more influence than other clients on non-Big 4 auditors because they are larger in size than other non-Big 4 auditees. In addition, Big 4 auditors are more risk-averse and able to withstand clients' pressure than non-Big 4 auditors. The results show that Big 4 auditors are more likely than non-Big 4 auditors to issue going-concern opinions to ex-Andersen clients or restrict the level of discretionary accruals of those clients compared with other clients. Further, ex-Andersen clients of Big 4 auditors would have had a lower likelihood of receiving going-concern opinions or higher levels of discretionary accruals had reporting practices for other clients been applied. Ex-Andersen clients of non-Big 4 auditors would have had a higher likelihood of going-concern opinions or lower levels of discretionary accruals. Hence, the suggestion to reduce the Big 4 concentration in the audit market by allowing non-Big 4 firms a larger market share should be viewed prudently. Overall, these results are consistent with the suggestion that litigation risk and client pressure are important factors in audit reporting.     

Audit fee lowballing: Determinants,recovery, and future audit quality

Prior research on the link between lowballing (LB) of audit fees and audit quality is inconclusive. Using more recent data and an innovative design, we define LB engagements as those where the audit fee discount is at least 30 percent. We consider three research questions to understand the possible link between LB and audit quality. First, we investigate whether the two variables that are often associated with auditor independence in the literature—non-audit fees and client importance—are related to LB. Second, we test whether lowballing auditors recoup initial audit fee discounts in the future period. Lastly, we investigate the relation between recovery of audit fees and future audit quality. We find that non-audit fees in the first year of engagement are negatively related to the propensity to LB. LB is significantly positively related to client importance for client firms switching from a non-Big N to another non-Big N auditor while the relation is insignificant for client firms switching from a Big N to another Big N auditor. The results of non-audit fees and client importance indicate that economic dependence does not motivate audit firms to lowball. Further, lowballing auditors tend to recoup their initial fee discounts in subsequent periods via increases in audit fees. Using multiple measures of audit quality, we do not find a significant relation between recovery of audit fees and future audit quality. Overall, contrary to regulators’ concerns, our results suggest that LB does not impair audit quality.     

Was audit quality of Laventhol and Horwath poor?

Laventhol and Horwath (L&H), the then seventh largest accounting firm in the US, declared bankruptcy in November 1990. The firm claimed that its bankruptcy was due to the perception of it being a deep pocket rather than inherent deficiencies in its performance. In this study, we examine whether the audit quality of L&H was lower than other auditors. Results do not show that L&H is associated with lower quality audits either in terms of lower likelihood of issuing modified audit opinion, higher levels of discretionary accruals for its clients, or lower predictability of discretionary accruals for future non-discretionary net income for its clients than for clients of other auditors. Results of additional tests also do not suggest that auditors that take up clients of L&H report differently from L&H. This evidence does not support the proposition that L&H’s audit quality was less than audit quality of other audit firms during the period leading up to the bankruptcy.     

Non-audit fees, long-term auditor–client relationships and earnings management

We examine whether auditor independence is affected by the amount spent on non‐audit services. Faster growth in non‐audit fees and longer time periods over which non‐audit services are purchased might reduce the auditor's independence from that client. Our results do not provide any support for a relationship between non‐audit fee growth rates or the length of time of the non‐audit fee relationship with the client and discretionary accruals, our measure of earnings management. We do find some evidence that the interaction of the non‐audit fee time‐period measures and client importance is positive and significantly related to discretionary accruals.     

Fees Paid to Audit Firms, Accrual Choices, and Corporate Governance

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. Using our pooled sample, we find that the ratio of non-audit fees to total fees has a positive relation with the absolute value of accruals similar to Frankel, Johnson, and Nelson [2002]. 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% of the sample. In contrast to the fee ratio results, we find consistent evidence of a negative relation between the level of fees (both audit and non-audit) 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.     

Audit firm tenure and financial restatements: An analysis of industry specialization and fee effects

This study investigates the relation between audit firm tenure and clients’ financial restatements. Specifically, we extend the audit tenure literature by assessing restatement-based reporting failures using dimensions of auditor expertise and independence previously assumed to underlie short and long audit tenure problems. Short tenure expertise and independence effects are hypothesized using audit firm industry specialization and audit fees as proxies. Long tenure independence effects are hypothesized using nonaudit fees as a proxy. Using matched-sample logistic regression and 382 companies with and without financial restatements during 2000–2004, the results support prior findings by indicating a negative relation between the length of the auditor–client relationship and the likelihood of restatement. For short tenure engagements, we find that auditor industry specialization and audit fees are negatively related to the likelihood of restatement. This result is consistent with concerns about reduced audit quality due to a lack of client-specific knowledge and low audit fees on new audit engagements. Alternatively, the long tenure results indicate an insignificant relation between nonaudit fees and the likelihood of restatement. This finding contradicts independence concerns about nonaudit fees paid to entrenched auditors.     

The effects of corporate governance and audit and non-audit fees on IPO Value

This paper examines the effects of non-executive board members, audit committee composition and financial expertise, and fees paid to audit firms on the value of 375 UK initial public offerings (IPOs). Empirical findings show that underpricing decreases in audit fees whereas it increases in non-audit fees. A higher proportion of non-executive directors on the firm’s board and audit committees with a higher proportion of non-executive directors and financial accounting expertise of their members positively moderate the inter-relationships between underpricing and both audit and non-audit fees paid by companies going through an IPO. Further investigations using the adjusted price-to-book value as a proxy for firm value at IPO confirm our main findings that internal governance mechanisms may complement services provided by the auditors in terms of generating higher valuations. Controlling for the simultaneous determination of audit and non-audit fees, our results remain consistent.     

Audit opinion and earnings management: Evidence from Greece

This study examines the relationship between audit opinions and earnings management, as measured by discretionary accruals, for listed firms on the Athens Stock Exchange (ASE). We divide the qualified audit opinions into two categories: qualified for the going-concern uncertainty and qualified for other reasons. The results indicate that audit opinions are not related to earnings management. Client financial characteristics, such as profitability and size are determinants of the going-concern audit opinion decision. The decision of auditors to issue qualified opinions for other reasons is explained by the type of audit opinion issued in the previous year.     

Non-audit fees, institutional monitoring, and audit quality

We posit that the effect of non-audit fees on audit quality is conditional on the extent of institutional monitoring. We suggest that institutional investors have incentives and the ability to monitor financial reporting quality. Because of the reputation concerns and potential litigation exposure, auditors are likely to provide high audit quality, when they also provide non-audit services to clients, particularly when clients are subject to high institutional monitoring. We find evidence that, as non-audit fees increase, audit quality (measured by performance-adjusted discretionary current accruals and earnings-response coefficients) reduces only for clients with low institutional ownership but not for clients with high institutional ownership. Our results are robust after controlling for auditor industry specialization, firms’ operating volatility, size effect, and potential endogeneity between institutional ownership and audit quality.     

Do Big-Four affiliates earn audit fee premiums in emerging markets?

The paper investigates whether Big-Four affiliated (B4A) firms earn audit premiums in an emerging economy context, using Bangladesh as a case. The joint determination of audit and non-audit service fees is also examined using a sample of 122 companies listed in the Dhaka Stock Exchange. Our findings reveal that although the B4A firms do not generally earn a fee premium in Bangladesh, they charge higher audit fees for clients not purchasing non-audit services. This suggests that the B4A firms may actually lower audit fees to attract non-audit services, and cross subsidizes audit fees through non-audit-services fees. The lack of a B4A premium implies that there is lack of quality audit in emerging markets. We also document that audit and non-audit service fees are jointly determined in Bangladesh. Thus, we provide evidence of joint determination of audit and non-audit service fees in an emerging economy context.     

EC Green Paper Proposals and Audit Quality

In order to restore confidence in financial statements the European Commission proposes different measures to enhance audit quality. This paper examines potential effects of selected proposals on audit quality in the light of prior research findings. It concludes that an increased emphasis on substantive audit procedures may not be beneficial and that joint audits potentially improve competition and audit quality, but might increase audit fees. An appointment by a third party would strengthen auditor independence. The overall impact of a mandatory rotation of audit firms is unclear due to opposite effects on auditor competence and auditor independence. The provision of non-audit services might affect independence in appearance negatively. However, a total ban would not be necessary. Finally, a limit to the proportion of fees an audit firm can receive from a single client as well as a capping of non-audit fees seem to be desirable.     

Auditor mergers,audit quality and audit fees: Evidence from the PricewaterhouseCoopers merger in the UK

Focusing on the merger of Price Waterhouse and Coopers & Lybrand in 1998, we document increased audit quality (measured by earnings quality of the clients) for the merged firm and other big-X auditors (The big-X auditors are Ernst & Young, Deloitte, KPMG and Arthur Anderson.) during the post-merger period because: (1) controlling for economic conditions, clients of big-X auditors have lower levels of absolute discretionary accruals and (2) the value relevance of earnings has significantly increased. Furthermore, we find evidence that in the post-merger period, there is a significant increase in audit fees for PricewaterhouseCoopers and other big-X client firms, which suggests that the effect of collectively enhanced market power of big-X auditors (which tends to increase audit fees) dominates the effect of cost savings from the merger (which tends to lower audit fees). The results have implications for regulators and policy makers.     

The effect of mandatory auditor assignment and non-audit service on audit fees: Evidence from Korea

In Korea, regulators could assign auditors to firms. We investigate the relationship among audit fees, mandatory auditor assignment, and the joint provision of non-audit and auditor services in Korea. We find that assigned auditors charge significantly higher audit fees than freely selected auditors. We also find that the joint provision of non-audit and audit services does intensify the relation between auditor assignment and audit fees. Combined with the results of other studies that have shown that firms audited by assigned auditors report smaller amounts of discretionary accruals than firms audited by freely selected auditors, our results suggest the possibility that mandatory auditor assignment may improve auditor independence.     

Independent and joint effects of audit partner tenure and non-audit fees on audit quality

We examine the individual and joint effects of auditors’ non-audit services (NAS)/abnormal NAS fees and length of audit partner tenure on audit quality. Our results raise questions about the ‘one size fits all’ approach imposed by the current audit partner rotation requirement in Australia as a result of (1) a learning differentiation that we observe between Big 4 and non-Big 4 auditors and (2) higher discretionary accruals associated with non-Big 4 auditors. We find abnormal NAS fees to have a positive association with both absolute and positive (income-increasing) values of discretionary accruals for firms with short audit partner tenure. NAS/abnormal NAS fees are also negatively associated with the issuance of going concern opinions to financially distressed firms when partner tenure is short. In terms of policy implications, regulators are able to gauge the efficacy of the CLERP 9 reforms which currently impose a five year mandatory audit partner rotation requirement.     

An examination of the influence of mutual CFO/audit firm tenure on audit quality

This study examines whether the extent of professional relationships between an audit firm and their client’s CFO influences audit quality. If regulators’ concerns that the relationship that develops over time between an audit firm and their client’s CFO impairs auditor judgment are justified, then we should observe a negative relationship between the length of audit firm’s tenure with their client’s CFO and audit quality. The results suggest that mutual audit firm-CFO tenure is associated with lower audit quality measured by the magnitude of discretionary accruals, the reduced incidence of issuance of going-concern audit opinions for distressed companies, and an increased likelihood of the receipt of an Accounting and Auditing Enforcement Release (AAER) from the US. Securities and Exchange Commission (SEC). These affects are concentrated in a subsample of firms with higher levels of corporate governance concerns. These findings have implications for policies related to audit firm rotation. Specifically, the results suggest that regulators need to consider other relationships underlying audit firm tenure, such as the relationships that form between audit firm and client personnel, when evaluating audit firm rotation policies.     

CAP Forum on Enron: Former Audit Firm Personnel as CFOs: Effect on Earnings Management*

Corporate hiring of former audit personnel to fill key financial positions is a practice that has attracted attention from the media, the accounting profession, and regulators. The concern is that the former external auditor who now holds a key position with the client may be able to circumvent the audit or exert pressure on the audit team and adversely influence audit quality. We compare a sample of 172 test companies that appointed to the position of chief financial officer (CFO) personnel who are former employees of the companies' auditors, with a control sample of companies that appointed new CFOs who were not affiliated with their auditors. We investigate whether the level of discretionary accruals is greater for the test sample compared with the control sample during the two years following appointment of the CFO. Both univariate and multivariate results for signed discretionary accruals suggest some support for the hypothesis that firms with affiliated CFOs are associated with greater earnings management than firms with unaffiliated CFOs. Furthermore, the results for signed discretionary accruals suggest that the association is stronger for nonpartners who moved from the audit firm to the client with little or no time gap. On average, the results for absolute discretionary accruals do not suggest differences in earnings management between affiliated and unaffiliated CFOs. However, they do indicate some earnings management relative to unaffiliated CFOs by CFOs who had little or no time gap between leaving the audit firm and joining the client firm, although at a weaker level of significance.