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.     

Stock market response to analysts' perceptions and earnings in a technology-intensive environment

This paper investigates the contemporaneous stock market response to financial analysts' perceptions of the firm and accounting earnings in the telecommunication and electronics industry in Finland. Analysts' perceptions used in the study are based on the Most Admired Companies survey similar to that conducted by Fortune magazine in the United States. The results indicate the nonfinancial information of the firm measured in terms of the analysts' perceptions has value relevance in a technology-oriented stock market.     

Non-audit services, auditor quality and the value relevance of earnings

This paper tests the hypothesis that there is an inverse relation between non‐audit services (NAS) provided by a firm auditor and the value relevance of earnings (measured as the earnings response coefficient) and that this relation is weaker for firms with Big 6 auditors. The hypothesis is based on anecdotal evidence and previous research that suggests that the provision of NAS by the external auditor is likely to adversely affect investors’ perceptions of the credibility of financial reports, and that Big 6 auditors, because of reputational capital and litigation costs, are likely to mitigate the adverse effects of NAS. Results using 840 firm‐year observations of Australian companies document a statistically significant inverse relationship between NAS and the value relevance of earnings, and this inverse relationship is weaker for Big 6 auditors, therefore supporting the hypothesis.     

Environmental uncertainty and the market pricing of earnings smoothness

Environmental uncertainty induces variability in an organization's reported earnings, and accentuates the information asymmetry between its managers and outside stakeholders. Managers operating in an environment of high uncertainty, therefore, have an incentive to reduce such variability by smoothing income numbers. We investigate the stock market response to earnings smoothness for firms operating in an environment of high uncertainty. We measure income smoothing by the negative correlation of a firm's change in discretionary accruals with its change in pre-managed earnings as per Tucker and Zarowin (2006). Using future earnings response coefficient (FERC) methodology to measure the informativeness of smoothed earnings, and two measures of environmental uncertainty, this paper documents that current stock price incorporates more information about future earnings for firms operating in high uncertain environments, thus supporting the informational value view of income smoothing.     

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.     

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. (2000) 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. JEL Classification C30 · M40 · M41 · M49     

On the nonlinear relation between product market competition and earnings quality

The literature documents conflicting results regarding the influence of product market competition on earnings quality. We extend this stream of literature by incorporating competition’s effect on both the opportunities and the incentives to manage earnings. The combination of both effects results in a nonlinear relation between product market competition and earnings quality. At low competition levels, additional information associated with one more rival helps reveal earnings irregularity and deter earnings management to a larger extent than its effect on the incentives to manage earnings, suggesting a positive relation between competition and earnings quality. At high competition levels, the latter effect dominates the former. We thus predict a positive (negative) relation between competition and earnings quality at low (high) competition levels. Consistent with our hypothesis, we document an inverted U-shaped relation between earnings quality and product market competition.     

The association between management earnings forecasts, earnings management, and stock market valuation: Evidence from French IPOs

This study investigates managers' motivations to engage in earnings management through purposeful interventions in the setting of discretionary accruals, in the context of initial public offerings (IPOs) in France. Firms issuing forecasts in their prospectuses are expected to differ from nonforecasters in the level of earnings management during the year following the public offering. Within the context of contracting theory, four research questions are addressed. First, are IPO firms issuing forecasts more inclined to manage earnings 1 year after an IPO compared to nonforecasting firms? Second, is a forecasting firm's level of earnings management conditioned by earnings-forecast deviation? Third, is earnings management by IPO forecasting firms affected by contractual and governance environments? Fourth, how do investors see through earnings management following IPO earnings forecasts, i.e., how do stock market participants value earnings components (i.e., nondiscretionary and discretionary accruals)? Our findings document that in the year following an IPO, the magnitude of earnings management is much higher for forecasters than for nonforecasters. Results also show that a firm's accrual behavior is affected by earnings-forecast deviation, but the relationship is moderated by contractual and governance constraints. Finally, it would appear that French investors do not adequately readjust the relationship between reported earnings and a firm's market value for the year in which earnings are subject to manipulations.     

Auditor specialization, perceived audit quality, and audit fees in the local government audit market

Prior governmental research implies a positive relation between auditor specialization and audit quality, but the effect of specialization on audit fees is mixed. However, no single governmental study investigates the effect of auditor specialization on both audit quality and audit fees. Also, prior studies focus on either large- or small audit firms and often employ indirect proxies for audit quality. We study the effects of auditor specialization on perceived audit quality and audit fees. Our data represent both Big 5 and smaller audit firms and include three market-based measures of specialization. We survey 241 Florida local government finance directors and find that specialization is positively associated with perceived audit quality but not with audit fees. We also find that Big 5 auditors, often used as a proxy for higher audit quality in prior research, are not uniformly associated with increased perceived audit quality but consistently charge higher audit fees. Our results confirm a relation between measures of audit firm specialization and audit quality and raise questions regarding audit firm size and audit quality in the municipal sector. Our findings suggest that engaging specialized auditors may be good policy for many local governments.     

Earnings quality: Some evidence on the role of auditor tenure and auditors’ industry expertise

Prior studies suggest that auditors with short tenure are associated with lower earnings quality because of the lack of client-specific knowledge and/or low balling. In this study, we examine whether industry specialization of auditors and low balling affect the association between auditor tenure and earnings quality. We find that the association between shorter auditor tenure and lower earnings quality is weaker for firms audited by industry specialists compared to non-specialists. In addition, we do not find results consistent with the low balling explanation.     

The impact of product market competition on earnings quality

The objective of this paper is to examine the impact of product market competition on earnings quality. Based on a sample from the US manufacturing sector for the period 1996–2005, we find consistent evidence showing a positive relation between product market competition and earnings quality. Additional tests also confirm a positive relation between product market competition and the precision of public and private information held by investors and analysts. We also provide evidence that firms competing in concentrated and heterogeneous industries are associated with a number of earnings attributes and information quality not shared by those competing in concentrated but homogeneous industries. These findings are consistent with the intuition that firms enjoying a monopolistic advantage tend to avoid the attention of their competitors and politicians by creating a more opaque information environment.     

Audit report information content and the provision of non-audit services: Evidence from Spanish lending decisions

This study examines whether auditor economic independence affects the information content of going concern audit reports in the European setting. We conduct an experiment where 80 experienced Spanish loan officers from the second largest European commercial bank review a loan request under two lending scenarios: (1) a potential borrower receiving an unqualified but modified going concern opinion, and (2) a potential borrower receiving a qualified going concern opinion. Auditor economic independence, measured by the provision of non-audit services (NAS), is manipulated (absence vs. presence of significant NAS). We find that a qualified going concern audit report is interpreted as a primary warning signal (death penalty). However, the provision of NAS acts as a second order mechanism that only activates loan officers’ professional skepticism in the case of an unqualified but modified going concern report scenario. Therefore, we find evidence suggesting that the potential negative impact of a perceived lack of auditor independence depends on the nature of the audit report. Our findings have important implications for the European regulator, which is currently considering establishing an auditor independence regulation framework similar to that in the United States of America.     

The effect of the summer doldrums on the market reaction to earnings announcements

Hong and Yu (2009) document a significant decrease in trading volume and returns during the summer months. Given the tendency of noise traders to buy shares following both positive and negative earnings surprises (Lee, 1992), we hypothesize that reduced trading activity by noise-traders results in less of an earnings announcement premium during the summer. Consistent with our hypothesis, we find lower abnormal returns surrounding summer earnings announcements compared to non-summer announcements. We also find lower abnormal returns in the ten days prior to the announcement, consistent with less front-running by sophisticated investors. Finally, we show that these summer effects are stronger in recent years characterized by more online trading and greater noise trader participation.     

Macro information environment change and the quality of management earnings forecasts

The 1990s were characterized by substantial increases in the performance of and investor reliance on financial analysts. Because managers possess superior private information and issue forecasts to align investors’ expectations with their own, we predict that managers increased the quality of their earnings forecasts during the 1990s in order to keep pace with the improved forward-looking information provided by financial analysts, upon which investors increasingly relied. Using a sample of 2,437 management earnings forecasts, we document an increase in management earnings forecast precision, management earnings forecast accuracy, and managers’ tendency to explain earnings forecasts in 1993–1996 relative to 1983–1986. Given that these forecast characteristics are linked to greater informativeness and credibility, we also document that the information content of management earnings forecasts, as measured by the strength of share price responses to forecast news, increased in 1993–1996 relative to 1983–1986. As expected, the increased information content of management forecasts primarily occurred for firms covered by financial analysts.

The impact of the Multi-jurisdiction Disclosure System on audit fees of cross-listed Canadian firms

The Multi-jurisdiction Disclosure System (MJDS), a treaty between Canada and the United States (U.S.), was intended to facilitate the cross-listing of a firm's securities in the neighboring country. Under this system, eligible Canadian companies are allowed to use home-country documents to meet U.S. disclosure requirements and these documents are generally not reviewed by the Securities and Exchange Commission (SEC). We posit that the single-reporting requirement and lower SEC scrutiny may result in lower audit fees for MJDS firms. Based on audit-fee disclosures mandated by the SEC rule-making authority granted by the Sarbanes-Oxley Act of 2002, we find a negative association between audit fees paid by U.S. cross-listed Canadian companies and their use of the MJDS. This result suggests that the lower audit fees provide an economic incentive to use the MJDS. Thus, our study provides evidence that the implementation of the MJDS may help facilitate cross-border listings by reducing audit costs. Additionally, this study confirms, for Canadian firms, some of the audit-fee determinants reported in earlier studies.     

The superiority and disciplining role of independent analysts

We show that although forecasts of independent analysts are less accurate ex post, they yield forecast errors that are more strongly associated with abnormal stock returns. This suggests that forecasts of independent analysts are superior to those of nonindependent analysts in representing ex ante market expectations. We also show that forecasts of nonindependent analysts become more accurate and less biased, and produce forecast errors more strongly associated with abnormal stock returns when independent analysts are following the same firms than when they are not. This suggests that the presence of independent analysts disciplines the behavior of nonindependent analysts.     

Auditor rotation and the appearance of independence: Evidence from non-professional investors

We examine the impact of audit firm versus partner rotation on non-professional investors’ independence-related perceptions, extending prior research on auditor rotation and independence in fact. Arguments for mandatory audit firm rotation continue to be made by regulators and investor groups based, in part, on the idea that firm rotation will incrementally strengthen independence in appearance relative to audit partner rotation. We report the results of two experiments. The first examines 5-year audit firm versus partner rotation under relatively weak or strong audit committees. We find no statistically significant difference in beliefs about how much of an income reducing audit difference management will record, or in beliefs about auditor independence, between the two auditor rotation conditions. On the other hand, we find that non-professional investors do believe more of the audit difference will be recorded, and the auditors will be more independent, under a strong audit committee than a relatively weak audit committee. The second experiment provides further evidence on audit firm versus partner rotation by examining a setting involving a 26-year audit firm–client relationship. Again, no statistically significant differences between the two auditor rotation conditions were found. These findings suggest that compared to audit partner rotation, audit firm rotation does not strengthen independence in appearance among non-professional investors and that non-professional investors recognize the value of strong audit committees.     

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.     

The impact of securities regulation on the earnings properties of European cross-listed firms

The objective of this study was to determine if the securities regulation in a foreign country is related to the earnings quality of European firms cross-listed in Europe. The study compared the post-listing earnings quality of 112 European firms cross-listed in 13 European stock exchanges during 1989–2001 to those of a controlled sample of non-cross-listed firms. Earnings quality was assessed by the use of reporting discretion to manage earnings. The regulatory strictness was represented by three indices of securities regulation.Empirical results provide some support to a positive association between earnings quality and the foreign securities regulation, suggesting that the foreign regulatory requirements have little or no effect on the reported earnings of European firms cross-listed in European exchanges.     

Information content of earnings announcements in the New Zealand equity market,a longitudinal analysis

We compute abnormal return variance and abnormal trading volume in the 3‐day window surrounding earnings announcements to examine the information content of earnings announcements in the New Zealand equity market over the past 16 years. We find that the information content of earnings announcements has increased significantly over time, and this finding holds true for both interim and preliminary earnings announcements. We find evidence that earnings announcements with June year‐ends exhibit a higher level of information content and experience a more pronounced rising trend as compared to earnings announcements with non‐June year‐ends. Several firm characteristics appear to relate to the level of the information content of earnings announcements as well as to compound the trend over time. We document an important finding that the information content of earnings announcements increases remarkably in the period after the adoption of the International Financial Reporting Standards (IFRS).