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_______________________________________________________________ Report Information from ProQuest08 March 2013 19:36_______________________________________________________________

Table of Contents

1. Abnormal Audit Fee and Audit Quality......................................................................................................... 1

2. AN EMPIRICAL INVESTIGATION OF THE EFFECTS OF MERGER AND ACQUISITION ON FIRMS'PROFITABILITY.............................................................................................................................................. 14

3. Does reduced trade tax revenue affect government spending patterns?..................................................... 27

4. THE DECLINING USE OF INTERNAL SERVICE FUNDS: HOW LOCAL GOVERNMENTS ARECHANGING THE ALLOCATION OF INDIRECT COSTS................................................................................ 43

5. International differences in IFRS policy choice: a research note.................................................................. 49

6. CITIZEN PARTICIPATION IN THE BUDGET PROCESS: THE EFFECT OF CITY MANAGERS............... 62

7. Auditor Disaffiliation Program in China and Auditor Independence............................................................. 75

8. Corporate governance, firm characteristics and risk management committee formation in Australiancompanies....................................................................................................................................................... 94

9. A Methodology for Evaluating the Cost-Effectiveness of Alternative Management Tools in Public-SectorInstitutions: An Application to Public Education............................................................................................... 109

10. The provision of non-audit services and earnings conservatism: Do New Zealand auditors compromisetheir independence?........................................................................................................................................ 130

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Abnormal Audit Fee and Audit Quality Author: Asthana, Sharad C; Boone, Jeff P

Publication info: Auditing 31. 3 (Aug 2012): 1-22.ProQuest document link

Abstract: This study tests the hypotheses that below-normal audit fees signal important nuances in the balanceof bargaining power between the auditor and the client, and that such power may ultimately influence auditquality. We find that audit quality, proxied by absolute discretionary accruals and meeting or beating analysts'earnings forecasts, declines as negative abnormal audit fees increase in magnitude, with the effect amplified asproxies for client bargaining power increase. We find that this effect is dampened in years following theSarbanes-Oxley Act (SOX), suggesting that SOX was effective in enhancing auditor independence.[PUBLICATION ABSTRACT]

Full Text: Headnote SUMMARY: This study tests the hypotheses that below-normal audit fees signal importantnuances in the balance of bargaining power between the auditor and the client, and that such power mayultimately influence audit quality. We find that audit quality, proxied by absolute discretionary accruals andmeeting or beating analysts' earnings forecasts, declines as negative abnormal audit fees increase inmagnitude, with the effect amplified as proxies for client bargaining power increase. We find that this effect isdampened in years following the Sarbanes-Oxley Act (SOX), suggesting that SOX was effective in enhancingauditor independence. Keywords: abnormal audit fees; bargaining power; economic bonding. (ProQuest: ...denotes formulae omitted.) INTRODUCTION Understanding the factors that lead auditors to compromise onaudit quality is an important issue of concern to scholars, investors, and regulators. One possible factor that hasreceived significant research attention is economic bonding between the auditor and client. The basic idea inthese studies is that positive abnormal audit fees reflect the extent of economic bonding between the auditorand client, and greater economic bonding degrades audit quality by impairing auditor independence. Based onthis premise, studies have examined the linkage between audit quality and positive abnormal audit fees, withsuch studies documenting a negative association. In this study, we reexamine the association betweenabnormal audit fees and audit quality, and we do so in a way that allows our paper to offer two importantcontributions to the literature. First, we incorporate into our conceptual framework insights about clientbargaining power (Casterella et al. 2004) in addition to the economic bonding story that forms the conceptualframework in prior studies. Expanding the framework to consider both bargaining power and economic bondingallows us to offer a novel prediction that would not be meaningful within a framework based exclusively oneconomic bonding. That prediction is: audit quality will decline as negative abnormal audit fees increase inmagnitude, and the magnitude of the decline will increase as proxies for client bargaining power increase. Theeconomic bonding literature that informs prior studies places the focus on positive abnormal audit fees,predicting no association between negative abnormal audit fees and audit quality, and a negative associationbetween positive abnormal audit fees and audit quality. Second, we include in our analysis data taken from thepost-Sarbanes-Oxley (SOX) period (i.e., years 2004-2009), in addition to data from the pre-SOX period (i.e.,years 2000-2003). The pre-SOX period has been the data source for virtually all of the prior studies. With datataken from both the pre- and post-SOX periods, we are able to probe for a dampened association betweenabnormal audit fees and audit quality that would be manifest if SOX reforms meaningfully increased auditorindependence or strengthened the auditor's bargaining power, leading to higher audit quality. To date, there isonly limited empirical evidence that speaks to the issue of whether SOX reforms increased audit quality.Consistent with prior research (e.g., Choi et al. 2010; Hope et al. 2009; and Higgs and Skantz 2006), wedecompose total audit fees into normal and abnormal components, and test for an association between audit

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quality and abnormal audit fees, conditioning our tests on the sign of the abnormal audit fee metric (i.e., above-normal audit fees and below-normal audit fees). Under the bargaining power story, we expect to find that auditquality declines as negative abnormal fees increase in magnitude, with the effect amplified as proxies for clientbargaining power increase. Under the economic bonding story (and consistent with prior studies), we expect tofind that audit quality declines as positive abnormal fees increase in magnitude. We also partition our analysisby regulatory regime (i.e., a pre-SOX reporting period or a post-SOX reporting period) in order to assesswhether the sensitivity of audit quality to abnormal audit fees differs between these two regimes. Our twoproxies for audit quality are absolute discretionary accruals and meeting or beating analysts' earnings forecasts,and our two proxies for client bargaining power reflect the importance of the client to the local practice office.Our tests produce evidence consistent with both the economic bonding story and the bargaining power story. Aspredicted by the economic bonding story, we find that absolute discretionary accruals and the probability ofmeeting or beating earnings forecasts both increase as positive abnormal audit fees increase. As predicted bythe client bargaining power story, we find that absolute discretionary accruals and the probability of meeting orbeating earnings forecasts increase with the magnitude of negative abnormal audit fees, with the effectamplified as client bargaining power increases. With respect to the effects of SOX, we find that the effects ofeconomic bonding and client bargaining power are both dampened in the post-SOX regime, suggesting thatSOX was effective in enhancing auditor independence. The evidence presented in our paper is important in atleast two respects. First, our results suggest that investors, regulators, and others interested in assessing theeffects of auditor remuneration on audit quality should be concerned with both above-normal and below-normalauditor remuneration, but for different reasons. The potential effect of above-normal audit fees in degradingaudit quality by economically bonding the auditor with the client is well recognized and extensively investigated.Less recognized is the possibility that below-normal audit fees signal important nuances in the balance of powerbetween the auditor and the client, and that such power may ultimately influence audit quality. Thus, our studyhighlights the importance of considering the bargaining power of the client when assessing audit quality.Second, our study presents the first evidence (of which we are aware) to suggest that reforms introduced by theSarbanes-Oxley Act dampened the deleterious effects of economic bonding and client power on audit quality,and hence increased audit quality. Both of these important insights from our study increase understanding ofthe factors that may lead auditors to compromise on audit quality, and hence our paper should be of interest toaccounting scholars, investors, and regulators. The remainder of the study is organized as follows. The secondsection develops our theoretical framework and presents the hypotheses that we test. We present our researchdesign in the third section, followed by a discussion of our sample in the fourth section and our results in the fifthsection. We offer concluding comments in the sixth section. THEORETICAL FRAMEWORK ANDHYPOTHESES An audit firm is not a single person ''auditor''; rather, it is a decentralized organization in whichindividual audit partners act as agents for the audit firm (Liu and Simunic 2005). To the extent the partnershipprofit-sharing plan does not effectively align the interests of the partner with that of the audit firm partners as awhole, an uncontrolled moral hazard problem exists that might result in an individual audit partner succumbingto client pressure for earnings management. This is because the individual partner captures a significant portionof the expected benefit from acquiescing to client demands, while passing to the partnership as a whole theexpected cost (Trompeter 1994). What factors might lead an audit partner to compromise on audit quality? Asdescribed below, engagement profitability and client bargaining power are two possible explanations.Engagement Profitability and Economic Bonding Engagement profitability should influence audit quality for thefollowing reason. Audit startup costs and client switching costs allow the auditor to price audit services at a pricein excess of the avoidable cost of producing the audit, and thus create for the incumbent auditor clientspecificquasi-rents (DeAngelo 1981a, 1981b). The client-specific quasi-rents economically bond the auditor to theclient, reduce auditor independence, and increase the likelihood that the auditor will acquiescence to a client'sdemand for earnings management. However, succumbing to client pressure risks audit firm forfeiture of some or

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all of the quasi-rents from the firm's entire client portfolio (if the earnings management is discovered), andadditional economic loss through litigation and government penalties (DeAngelo 1981a, 1981b). The auditor willcompromise audit integrity only if the expected gain (preserving the client-specific quasi-rent) exceeds theexpected loss (forfeited quasi-rents from the overall client portfolio, litigation costs, and penalties), and thus thequestion of whether economic bonding undermines audit quality depends upon the relative magnitude ofexpected costs and benefits, which is an empirical question.1 Bargaining Power Bargaining power shouldinfluence audit quality for the following reason. Audited financial statements, and hence audit quality, are thejoint effort of the auditor and the client (Antle and Nalebuff1991) that arise from a process of negotiationbetween the two (Gibbins et al. 2001). The negotiation literature shows that when negotiators differ inbargaining power, the more powerful party expects greater concessions (e.g., Pruitt and Carnevale 1993;Hornstein 1965; Michener et al. 1975), and Barnes (2004) shows that audit quality may decrease as clientbargaining power increases. In an experimental auditing setting, Hatfield et al. (2008) show that the effect ofclient bargaining power on the audited financial statements depends upon the negotiation strategy employed bythe auditor, with a reciprocity negotiating strategy leading to more conservative financial statements. Thus, thequestion of whether client bargaining power undermines audit quality depends upon whether the auditor is ableto employ a negotiating strategy that weakens the advantage held by a client with strong bargaining power.Abnormal Audit Fees Simunic (1980) shows that the auditor's expected fee charged to the client is driven by theunits of audit resources expended, the per-unit cost of those resources, and the auditor's expected future lossarising from the engagement (e.g., litigation losses, government penalties). Empirically, extant research modelsthe expected audit fee as a function of observable factors that proxy for the auditor's cost in performing theaudit, including auditor effort (i.e., resources expended and their cost), expected future litigation losses, andnormal profit. If the audit fee model is well specified, the residual audit fee reflects abnormal profits from theaudit engagement. To the extent that some factors are unobservable (and hence omitted from the audit feemodel), the residual audit fee metric measures abnormal audit profitability with error. Abnormal audit profitabilityshould be associated with both client bargaining power and economic bonding. With respect to the former,Casterella et al. (2004) show a negative association between proxies for client bargaining power and audit feesearned by industry specialists. Their research suggests that, ceteris paribus, below-normal audit fees mayreflect billing concessions granted by the auditor due to client bargaining power. With respect to the later,Kinney and Libby (2002) note that ''Unexpected fees may also better capture the profitability of the servicesprovided . . . more insidious effects on economic bond may result from unexpected nonaudit and audit fees thatmay more accurately be likened to attempted bribes.'' Although there is scant evidence on the associationbetween abnormally low audit fees and audit quality, a growing literature, described below, examines theassociation between abnormally high audit fees (as a proxy for economic bond) and audit quality. DeFond et al.(2002), Krishnan et al. (2005), Hoitash et al. (2007), and Hribar et al. (2010) test for a linear associationbetween abnormal audit and/or engagement fees and audit quality (i.e., the curve relating audit quality toabnormal audit fees exhibits the same slope for both positive and negative abnormal audit fees).2 DeFond et al.(2002) find no association between abnormal engagement fees and auditors' going concern opinions during2000-2001, while Krishnan et al. (2005) find that during year 2001, earnings response coefficients (a directindicator of audit quality) decline as abnormal engagement fees increase. Hoitash et al. (2007) find during years2000-2007 a positive association between abnormal engagement fees and two (inverse) audit quality metrics-the Dechow and Dichev (2002) accrual quality metric and the absolute value of performance-adjusteddiscretionary accruals. Hribar et al. (2010) find during years 2000 to 2007 a positive association betweenabnormal audit fees and accounting fraud, restatements, and SEC comment letters.3 Larcker and Richardson(2004), Higgs and Skantz (2006), Hope et al. (2009), Mitra et al. (2009), and Choi et al. (2010) test for anonlinear association between abnormal audit fees and audit quality (i.e., the curve relating audit quality toabnormal audit fees exhibits different slope for positive as compared to negative abnormal audit fees). Larcker

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and Richardson (2004) use data from 2000 and 2001 to examine absolute discretionary accruals (an inverseindicator of audit quality), and find that audit quality increases as abnormal engagement fees increase inabsolute magnitude. Higgs and Skantz (2006) find that during 2000-2002, earnings response coefficients (adirect indicator of audit quality) are greater in firms with positive abnormal audit fees. Hope et al. (2009) find thatduring 2000-2003, equity discount rates (an inverse indicator of audit quality) increase as positive abnormalengagement fees increase, but find no association with negative abnormal engagement fees. Mitra et al. (2009)find during years 2000-2005 a negative association between positive abnormal audit fees, and both absolutediscretionary accruals and incomeincreasing accruals, but find no association between negative abnormal auditfees and discretionary accruals. Choi et al. (2010) find during 2000-2003 a positive association between positiveabnormal audit fees and absolute discretionary accruals, but no association when abnormal audit fees arenegative. The weight of the preceding evidence suggests a negative association between audit quality andpositive abnormal audit fees, and no association between audit quality and negative abnormal audit fees-findings consistent with the economic bonding hypothesis. However, as discussed above, negative abnormalaudit fees may reflect client bargaining power that could degrade audit quality-with the degrading being larger inmagnitude the greater the bargaining power of the client. Also as previously discussed, the question of whetherclient bargaining power undermines audit quality ultimately depends upon whether the auditor is able to employa negotiating strategy that weakens the advantage held by a client with strong bargaining power. Thus, whetherclient bargaining power affects audit quality remains an open empirical question, leading us to specify and testthe following client bargaining power hypotheses. H1a: Audit quality will decline as below-normal audit feeincreases in magnitude. H1b: The association predicted in H1a will be amplified as proxies for client bargainingpower increase. For completeness, we also specify and test the following economic bonding hypothesis: H2:Audit quality will decline as above-normal audit fees increase in magnitude. Post-Sox Abnormal Audit Fees Inaddition to the question of client bargaining power, another as yet unanswered question is whether the auditquality/abnormal audit fee association changed following SOX. Passed in 2002 following discovery of a series ofhigh-profile financial reporting scandals, SOX seeks to improve corporate governance and enhance auditorindependence by mandating federal government oversight of auditors, enhancing audit committee auditoroversight, and limiting the opportunity for auditors to sell nonaudit services to clients (U.S. House ofRepresentatives 2002). If these reforms are sufficiently salient, they should manifest in a reduced associationbetween abnormal audit fees and audit quality post-SOX relative to pre-SOX. This leads to our final hypothesis:H3: The association between audit quality and abnormal audit fees will be attenuated in the post-SOX period ascompared to the pre-SOX period. RESEARCH DESIGN To test our hypotheses, we need to measure abnormalaudit fee and audit quality. We estimate abnormal audit fee (ABNAFEE) as the actual audit fee paid by the clientto its auditor minus the predicted (normal) audit fee, with the difference deflated by the total audit fee revenue ofthe audit office conducting the client's audit. We deflate the abnormal audit fee by total audit fee revenues of thepractice office conducting the audit in order to capture the relative profitability of the engagement to the opiningaudit office. We do so since prior research (e.g., Reynolds and Francis 2001) suggests that economic incentivesimpacting audit quality are best measured at the local office level rather than at the national firm level. Forexample, the Enron audit failure largely stemmed from decisions made in the Houston office of Arthur Andersen(Chaney and Philipich 2002). We define two separate variables from ABNAFEE. If ABNAFEE . 0 thenHIABNAFEE14ABNAFEE, and 0 otherwise. If ABNAFEE , 0 then LOABNAFEE 14 jABNAFEEj, and 0otherwise. This allows us to study the relationship of the dependent variables with the positive and negativeabnormal audit fee, separately. The predicted audit fee is estimated from an audit fee model based on extantresearch.5 All the variables used in various tests are summarized in Table 1. Audit quality is unobservable.Consistent with prior research, we define audit quality as the client's earnings quality (Higgs and Skantz 2006;Lim and Tan 2008; Davis et al. 2009; Francis and Yu 2009; Reichelt and Wang 2010; Choi et al. 2010).Following this research, we use two commonly used proxies for earnings quality: absolute discretionary

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accruals and propensity to meet or beat earnings expectations. We also conduct additional tests using anearnings response coefficient. The first two proxies are surrogates for actual earnings management, while thelast one is related to perceived earnings quality. However, for the sake of brevity, we only report results for thefirst two, since the conclusions are similar. The tests for these proxies are discussed in more detail below.Discretionary Accruals Model The level of discretionary accruals has commonly been used as a surrogate formanagers' exercise of discretion provide by GAAP. To the extent the discretionary component of accruals isused by managers to opportunistically manage earnings and auditors allow the manipulation to remainuncorrected, discretionary accruals adversely reflect on the audit and earnings quality (Schipper 1989; Jones1991; Levitt 2000; DeFond and Park 2001). Discretionary accruals can be used for increasing or decreasingearnings depending on the incentives of managers. Since we are not looking at any specific managerialincentives, we have no directional predictions for accruals. We therefore use the absolute value of discretionaryaccruals (jDACCj) as the independent variable in our next test. Discretionary accruals (DACC) are calculatedusing the cross-sectional modified version of the Jones model (Jones 1991; Dechow et al. 1995), deflated bytotal assets, and estimated by year and for each industry. We adjust discretionary accruals for performance assuggested by Kothari et al. (2005). Following Hribar and Collins (2002), we use the difference between netincome and cash from operations, deflated by lagged assets, as our measure of total accruals (TACC). Thus:TACC 14 IBC L OANCF=LagAT; where IBC is the income before extraordinary items (Compustat cashflow item), OANCF is net cash flow from operating activities, and AT is total assets. The model to estimatediscretionary accruals is: ... (1) where Lag(AT) is total assets of prior year; DSALE is change in revenue;RECCH is the decrease in accounts receivables; PPEGT is property plant and equipment (gross total); andROA is return on assets, calculated as IBC deflated by AT. Equation (1) is estimated by year for each industry(twodigit SIC code). Then, TACC minus the predicted value from the above regression is our measure ofdiscretionary accruals. Our test of jDACCj is based on the following model: ... (2) The control variables are fromextant research. Francis and Yu (2009) show that larger offices of Big 4 auditors have higher audit quality. Thelogarithm of total office-specific audit fee of all clients in a given year (LOFFICE) is included to capture thiseffect. Reynolds and Francis (2001) provide evidence that auditors report more conservatively for larger clients.Consistent with this research, the variable INFLUENCE, defined as the ratio of a client's total fee relative to thetotal annual fee of the practice office that audits the client, is included as an independent variable. TENURE (1/0dummy variable for audit tenures of three years or less) controls for potential effect of short auditorclientassociation on audit quality (Johnson et al. 2002; Carey and Simnett 2006). Balsam et al. (2003) argue thatindustry expertise increases audit quality. We include USLEADER and CITYLEADER, consistent with Francisand Yu (2009), to control for national-level and city-level auditor industry expertise. USLEADER is an indicatorvariable that is coded 1 if the\ auditor is the national audit fee leader in that industry. CITYLEADER is similarlydefined at the city level. BUSSEG (GEOSEG) is the number of business (geographic) segments reported in theCompustat segment file. LOGMV is the natural logarithm of market value of equity at the end of the fiscal year.This variable controls for any size-related effects. Prior research (Ashbaugh et al. 2003; Butler et al. 2004;Menon and Williams 2004; Geiger and North 2006) finds LOGMV to be negatively associated to discretionaryaccruals. SGROWTH is the annual growth in sales and has been found to be positively related to discretionaryaccruals (Menon and Williams 2004). CFFO is the cash flow from operations deflated by total assets. Previousresearchers (Frankel et al. 2002; Chung and Kallapur 2003) find a negative association between discretionaryaccruals and CFFO. Hribar and Nichols (2007) find that accrual volatility may be related to firm-specificoperating characteristics as measured by the volatility of the firm's cash flows and sales. Hence, we includeSDSALES and SDCFFO (calculated as the standard deviations over the current and past four years of cashflow from operations and sales, respectively, deflated by the total assets) as control variables. Doyle et al.(2007) suggest that earnings quality may be a function of the quality of the firm's internal control. ICOPINION(number of material internal control weaknesses reported in Audit Analytics in the post-SOX period) is,

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therefore, included as a control variable. Consistent with DeFond and Jiambalvo (1994), Reynolds and Francis(2001), and Francis and Yu (2009), LEVERAGE, LOSS, and DISTRESS are included to control for the effects ofdebt and financial distress. LEVERAGE is total debt deflated by total assets. LOSS is a dichotomous variablewith a value of 1 if client has a negative net income before extraordinary items, and 0 otherwise. DISTRESS isZmijewski's (1984) measure of financial distress. B2M is the book-to-market value and captures the growthopportunities. Ashbaugh et al. (2003), Butler et al. (2004), Menon and Williams (2004), and Geiger and North(2006) suggest B2M and DACC to be negatively associated. Following Matsumoto (2002), Hribar and Nichols(2007), and Francis and Yu (2009), we include stock-return volatility (VOLATILITY) to proxy for capital marketpressures that can result in increased earnings management. FINANCED and ACQUIRED are dichotomousvariables that have values of 1 if the company was involved in significant financing activities or acquisitions,respectively, and 0 otherwise. Ashbaugh et al. (2003) and Chung and Kallapur (2003) find positive coefficientson these two variables. LAGROA is the previous year's return on assets and is included to control for priorperformance. BIG-N (a 0/1 dummy variable) and QUALIFIED (a 0/1 dummy variable) capture the effect ofauditor size and qualified opinions on earnings quality. Natural logarithm of 1 number of calendar days fromfiscal year-end to date of auditor's report (LDELAY) controls for the effect of extra effort by the auditor onearnings quality. Since restatements can influence earnings management, the dichotomous variableRESTATEMENT is added as a control variable. MBEX is a dichotomous variable with a value of 1 if the firmmeets or beats the earnings expectation (proxied by the most recent median consensus analysts forecastavailable on I/B/E/S file) by two cents or less, and 0 otherwise. Since jDACCj and MBEX can be jointlydetermined, we use Maddala's (1988) two-stage-least-squares estimation (2SLS) for Equations (2) and (3) toavoid any endogeneity problems. I_MBEX denotes the instrumented variable for MBEX from the 2SLS.6 Meet-or-Beat Earnings Expectation Model There is evidence in extant literature that managers are rewarded(penalized) for meeting (missing) earnings forecasts (Bartov et al. 2002; Kasznik and McNichols 2002; Lopezand Rees 2002) and this leads to incentives for managers to manage earnings. If auditors' incentives to curtailearnings management vary with abnormal audit fee, the propensity for meeting or beating analysts' earningsforecasts will be a function of the abnormal audit fee. We estimate the following logit model to test thisconjecture: ... (3) In Model (3), F(|) denotes the logistic cumulative probability distribution function. I_jDACCjdenotes the instrumented variable for jDACCj from the 2SLS. Following Reichelt and Wang (2010), we includethe standard deviation of analysts' earnings forecasts (SDFOR) and natural logarithm of number of analysts'forecasts (LNUMFOR) to control for characteristics of the forecasts. Additional Tests To test H1b, we furtherinteract LOABNAFEE and HIABNAFEE with two measures of clients' bargaining powers in Models (2) and (3).LARGEST is a dichotomous variable with value of 1 if the client pays the highest audit fee in the practice officethat audits the client; TOP10%INFL is a dichotomous variable with a value of 1 if INFLUENCE is in the top 10percent, and 0 otherwise. To make the interpretations of the interactions easier, we use the dichotomousversions of abnormal audit fees, DLOABNAFEE and DHIABNAFEE, where DLOABNAFEE (DHIABNAFEE) is adichotomous variable with a value of one if LOABNAFEE (DHIABNAFEE) - median value, and 0 otherwise. Totest our conjecture that SOX has dampened the association between abnormal audit fees and earningsmanagement (H3), we rerun Models (2) and (3) with an additional independent variable DSOX and interactionterms, DLOABNAFEE * DSOX and DHIABNAFEE * DSOX, where DSOX is a dichotomous variable with a valueof 1 for the period 2004-2009, and 0 otherwise.7 Adjustment for Clustering Since our data are pooled over time,the same firm may appear more than once in the sample, resulting in clustering. Clustered samples can lead tounderestimation of standard errors and overestimation of significance levels (Cameron et al. 2011). Wetherefore estimate the t-statistics adjusted for clustering using robust standard errors corrected for firm-levelclustering and heteroscedasticity, consistent with Petersen (2009) and Gow et al. (2010). SAMPLE The sampleselection procedure is outlined in Table 2. We start with 61,953 firm-year observations for the period 2000-2009available in the Audit Analytics database for non-Andersen clients. We exclude Andersen since the auditor-

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client relationship might be atypical, given the woes of Andersen. After merging with Compustat we are leftwith35,081 observations. We then exclude the financial (SIC codes 6000-6900) and utility (SIC codes 4400-4900)industries, since the incentives of managers from these regulated industries may be different. This leaves uswith 28,925 observations. Missing data for estimating the variables in a modified Jones (1991) model andEquation (2) further reduce our sample size to 18,873 observations (Sample 1). Finally, I/B/E/S and CRSP dataare needed for Equation (3), which results in Sample 2 with 14,796 observations. Untabulated statistics showthat the sample industry composition is very close to that of the Compustat population. Across years,untabulated statistics generally show an even distribution of observations. Sample characteristics, includingmeasures of central tendency, are presented in Table 3. Mean (median) jDACCj and MBEX are 0.0655 (0.0418)and 0.2039 (0.0000), respectively. Mean LOABNAFEE (HIABNAFEE) is 0.0259 (0.0267). Both variables havemedian values , 0.0001. A typical client accounts for under 2 percent of the audit office's revenue (median valueof INFLUENCE). A mean value of over 10 percent for this variable suggests some large influential clients. Over23 percent of the clients have been with their auditors for three years or less. On average, firms have betweentwo and three business and geographic segments. Mean (median) log of firm market value (in $ million) is 6.15(6.14). Clients experienced a mean of 13 percent sales growth during the sample period. The median firm hadone internal control weakness reported in Audit Analytics. On average, total debt was 19 percent of firm assetsand 30 percent of the firm-years reported losses. Book value was around 59 percent of market value of the firm.While 31 percent of the firms financed during the year, 19 percent were involved in acquisition activities. Asexpected, a large proportion (80 percent) of the clients are audited by Big 4 auditors. RESULTS Results ofestimation for Models (2) and (3) are presented in Panel A of Table 4. For the sake of comparison, regressionsare reported with and without control variables. The adjusted R2 of models with controls range from 18.39percent to 20.39 percent.8 For the jDACCj regression (Equation (2)), 14 of the 26 control variables aresignificant (at 10 percent level or better). SGROWTH, SDSALES, CFFO, SDCFFO, LOSS, DISTRESS,VOLATILITY, FINANCED, and MBEX are significantly positive; LOGMV, LEVERAGE, B2M, LAGROA, and BIG-N are significantly negative. Thus, firms with more sales growth, sales volatility, cash from operations, cashvolatility, losses, distress, stock price volatility, and financing activities are more likely to have higher jDACCj.There is also a positive association between jDACCj and MBEX. On the other hand, firms with larger size,higher leverage, lower growth potential, profitability, and with BIG-N auditors are more likely to have lowerjDACCj. Both LOABNAFEE and HIABNAFEE are significant and positive. This suggests that as the magnitudeof ABNAFEE increases on either side (positive or negative), the magnitude of jDACCj increases. This supportsH1a and H2. In Model (3), since the dependent variable MBEX is a dichotomous variable, we use logisticregression to estimate the propensity to meet or beat earnings expectations. The results for Model (3) areexhibited in the last two columns of Panel A of Table 4. Twenty-one of the 28 control variables are significant:CFFO, FINANCED, ACQUIRED, SDFOR, and jDACCj are significantly positive; LOFFICE, INFLUENCE,USLEADER, BUSSEG, LOGMV, ICOPINION, LEVERAGE, LOSS, B2M, VOLATILITY, LAGROA, BIG-N,QUALIFIED, LDELAY, RESTATEMENT, and LNUMFOR are significantly negative. LOABNAFEE andHIABNAFEE are significantly positive. Thus, this test also supports H1a and H2. Tests for H1b are reported inPanels B and C of Table 4. DLOABNAFEE and DHIABNAFEE are positive and significant as predicted by H1aand H2. DLOABNAFEE * LARGEST and DLOABNAFEE * TOP10%INFL are both positive and significant at a 5percent level or better for jDACCj and MBEX. This suggests that highly influential firms with more bargainingpower get more freedom to manage their earnings, for a given level of LOABNAFEE. This supports H1b.Moreover, DHIABNAFEE * LARGEST and DHIABNAFEE * TOP10%INFL are insignificant in Panel C, asexpected, since the bargaining effect is expected on the below-normal audit fee side (firms getting discounts)and not on the above-normal audit fee side (firms paying premiums). To test H3, we rerun Equations (2) and(3), with LOABNAFEE * DSOX and HIABNAFEE * DSOX added as additional independent variables (see PanelD of Table 4). Both of these interaction terms are significantly negative for Model (2), suggesting that the

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management of jDACCj postulated in H1a and H2 has dampened post-SOX, supporting H3. However, theterms LOABNAFEE LOABNAFEE * DSOX and HIABNAFEEHIABNAFEE * DSOX are both significantlypositive at a 1 percent level, suggesting that the effects have not yet been completely erased as a result ofSOX. On the other hand, estimation of Model (3) with interactions yields insignificant interactions, suggestingthat the association of abnormal fees with MBEX is unaffected by SOX. Additional Analyses with EarningsResponse Coefficient Lim and Tan (2008) use the ERC (earnings response coefficient) as a proxy for investors'perception of earnings quality and, in turn, audit quality. We run the ERC model with interactions of unexpectedearnings (UE) with LOABNAFEE and HIABNAFEE. The independent variables in this model are based onFrancis andKe (2006), Limand Tan (2008), Wilson (2008), and Ghosh et al. (2009). We do not report detailedresults for the sake of brevity. However, coefficients of UE * LOABNAFEE and UE * HIABNAFEE are bothnegative, suggesting that the market perceives that audit quality declines with LOABNAFEE and HIABNAFEE,consistent with results reported for jDACCj and MBEX. Tests of Robustness We conduct several tests ofrobustness discussed below to convince ourselves that our results are not driven by any bias or modelmisspecification. 1. We first test for possible endogeneity bias in our audit fee model that potentially couldintroduce error into our measurement of ABNAFEE. The concern arises because Whisenant et al. (2003)suggest that audit and nonaudit fees are simultaneously determined, and thus not exogenous. To rule out thispossibility, we run Davidson and MacKinnon's (1993) endogeneity test. The null hypothesis of no endogeneity isnot rejected. 2. Unlike prior studies, we focus on audit fee revenue rather than nonaudit fee revenue as a sourceof impaired audit quality. We do so for two reasons. First, audit fee revenue is a recurring annuity whereasnonaudit fee revenue, with the exception of revenues from tax services, is not. Recurring engagements (ascompared to nonrecurring engagements) create greater incentive for the auditor to compromise independence.Second, reforms enacted by the Sarbanes-Oxley Act of 2002 have significantly reduced the scope of nonauditservices that auditors can provide to their clients while also expanding the scope of work required in the audit.Together, these two factors suggest that in the current milieu, audit fees emerge as a potentially importantdeterminant of audit quality.10 Recent research (Choi et al. 2010) has, therefore, focused on audit fees.However, as a robustness check, we repeat all of our tests with total engagement fee (i.e., the sum of audit andnonaudit fees) and arrive at similar conclusions. 3. We try an alternate specification for our models. Instead ofthe split-linear regression, we estimate the arctan regressions suggested by Freeman and Tse (1992) as below:... This specification yields interesting conclusions. The relationship of jDACCj with HIABNAFEE (LOABNAFEE)is S-shaped (inverse S-shaped). The flat curve around HIABNAFEE 14 LOABNAFEE 14 0 suggests that theauditors do not impair their independence until positive abnormal fee from a client exceeds what the auditorcould earn by simply resigning from this client and contracting with a new one.11 Similarly, on the negativeabnormal audit fee side, the auditor may have a pecking order. Initially they would grant their influential clients(with bargaining powers) fee discounts, and as the client gains more bargaining power, the auditor may alsoallow earnings management. The flattening of the curve for extreme departures from normal fee suggests thatthe auditors have a threshold or tolerance level for earnings management, and as the firm tries to reportextremely high levels of discretionary, accruals the auditors start resisting. 4. Since audit fee data becameavailable on Audit Analytics in 2000, one could question how the investors derive their ''normal'' audit fees toassess the audit quality in the year 2000. We rerun our analyses without the year 2000 data and ourconclusions do not change qualitatively. For Model (2), the coefficients of LOABNAFEE and HIABNAFEE are0.0251 (p140.0049) and 0.0316 (p140.0136), respectively; for Model (3), the coefficients of LOABNAFEE andHIABNAFEE are 1.9900 (p , 0.0001) and 1.2004 (p 14 0.0004), respectively. 5. Since quality of corporategovernance may also affect earnings quality, as a sensitivity analysis we add the Gompers et al. (2003) index ofcorporate governance to our regressions and obtain similar results. We do not report these findings as our mainresults since the sample size after merging with the Gompers' database was considerably smaller. 6. To theextent that the first few years of the auditor-client relationship might be atypical, we run our tests excluding the

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first three years of new clients. The results are not altered qualitatively. For Model (2), the coefficients ofLOABNAFEE and HIABNAFEE are 0.0153 (p140.0016) and 0.0233 (p 14 0.0011), respectively; for Model (3),the coefficients of LOABNAFEE and HIABNAFEE are 1.3200 (p140.0002) and 0.3991 (p140.0813),respectively. 7. Firms that have consistent positive or negative abnormal fees across years might have differentmotivations from firms that switch between the two categories. We split the sample into firms that have five ormore years with abnormal audit fees of the same sign and those that do not. Our hypotheses hold for bothsubsets, suggesting that our results are applicable to both categories of firms. 8. We try different cutoffs for thetenure variable to see if the results are sensitive to the definition of tenure. We try five years and also twodummy variables for three years or under and more than nine years. Our main conclusions are not affected. 9.The pricing of audit engagements for accelerated filers may be different from that of nonaccelerated filers, sinceaccelerated filers could have a higher audit fee due to more internal control work. The pricing of materialweaknesses may also be different. If the size variable in the audit fee model is unable to control for theseeffects, the conclusions might be biased. To ascertain that the results are not different for accelerated/non-accelerated filers, we run the tests separately for the two filing categories. We do not find any evidence of anycategory leading the results. For example, in Model (2) for accelerated filers, the coefficients of LOABNAFEEand HIABNAFEE are 0.0095 (significant at 1 percent) and 0.0054 (significant at 10 percent), respectively; fornon-accelerated filers, the coefficients of LOABNAFEE and HIABNAFEE are 0.0147 (significant at 10 percent)and 0.0202 (significant at 5 percent), respectively. 10. As with any ratio, the scaling of abnormal audit fee by thetotal revenue of the audit office might introduce inflation (deflation) of the same numerator for smaller (larger)audit offices. To ascertain if this scaling affects our results, we rerun all the tests with unscaled abnormal auditfees. The coefficients of LOABNAFEE and HIABNAFEE continue to be positive and significant at a 5 percentlevel or better for both Models (2) and (3). 11. Prior research (e.g., Bedard and Johnstone 2004; Johnstone andBedard 2001, 2003) suggests that proxies for audit risk used in extant research may be inadequate. There maybe above-normal effort in cases of earnings manipulation risk and corporate governance risk (Bedard andJohnstone 2004) that are not captured by the audit fee model. This extra effort may result in an abnormally highaudit fee and lead to higher audit quality. Extending this argument, below-normal audit fees may representabbreviated audit efforts, and not clients' bargaining power, leading to poorer quality audits. In the absence ofdata on engagement hours and staffmix, we utilize the number of days between fiscal year-end and release ofthe audit report as a proxy for audit effort. We include this variable, square of the variable, and natural logarithmof the variable in our audit fee model, in an effort to control for auditor effort that is in response to missing auditrisk factors. All of our conclusions are supported as before. Additionally, unless the missing measures for auditrisk are correlated with bargaining power, the differential variation of audit quality with clients' bargaining power(documented in Panel C of Table 4) gives additional credibility to our results. However, to the extent that we areunable to control for audit risks in our model, the factors discussed above continue as limitations of ourresearch. 12. In Panels B, C, and D of Table 4, we use logistic regressions for the dichotomous dependentvariable MBEX, along with interaction terms. Norton et al. (2004) caution that since logistic regressions arenonlinear models, the interaction terms must be interpreted in a different way. They show that the marginaleffect of a change in both interacted variables is not equal to the marginal effect of the change in just theinteraction term. They suggest applying the INTEFF function in Stata for estimating the correct marginal effectof the interaction term. As a robustness check, we run the INTEFF function as detailed in Norton et al. (2004).Our conclusions are unchanged, suggesting that the results reported in Panels B, C, and D are robust. Oneconstraint with the INTEFF procedure is that it works for only one interaction term. In Panel D, for the SOXtests, we have two interaction terms. We therefore run two separate tests with INTEFF for each interaction term.In addition, to convince ourselves that our interpretation of the interaction effects is correct, we run the aboveregressions with MBEX replaced with a continuous variable, excess earnings defined as the reported earningsper share minus the analyst forecast. Since this dependent variable is not a dichotomous variable, we no longer

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have to use the logistic regression. We are able to replicate all the results reported before. This further providesassurance that our interpretation of the interaction terms is reliable. CONCLUSION Auditors are hired andcompensated by their clients, and this creates an economic bond between the two. The question of whether thiseconomic bond ultimately leads to reduced audit quality remains an important public policy issue and has beenthe topic of prior research. We extend this research by examining the role of client bargaining power in additionto economic bonding as a determinant of audit quality. In our study, we examine the association betweenabnormal audit fees and two audit quality proxies: (1) abnormal discretionary accruals and (2) the probability ofmeeting or beating analysts' consensus earnings forecasts. Above-normal audit fees suggest quasi-rentsarising from a highly profitable audit engagement, while below-normal audit fees suggest the client has strongbargaining power (and hence is able to negotiate billing concessions). Both factors-quasi-rents and clientbargaining power-may lead the auditor to succumb to client pressure for earnings management. Thus, absoluteabnormal audit fees reflect the presence of these independence-impairing underlying factors and is our variableof interest. As hypothesized, we find that audit quality declines as actual audit fees depart from ''normal'' feelevels. Our finding that audit quality declines as positive abnormal audit fees increase in magnitude is consistentwith prior research. New to the literature is our finding that audit quality declines as negative abnormal auditfees increase in magnitude, with the decline increasing in magnitude as proxies for client bargaining powerincrease. We also examine whether the audit quality/abnormal audit fee association changed followingimplementation of SOX, and use this examination as a means of testing whether SOX was effective inincreasing auditor independence. We find evidence that this association in the post-SOX era is milder than inthe pre-SOX era. Thus, SOX reforms increase the risk of and reduce the gain from succumbing to clientpressure and compromising audit quality. It is important to note that our results regarding abnormally high or lowaudit fees could be attributable not to economic bonding or client bargaining power, but rather to factors that arenot captured by our audit fee model. Alternative explanations that we cannot investigate due to data limitationsinclude such items as audit team composition (i.e., the relative allocation of audit hours between partners,managers, and staff), the audit work allocation between interim and year-end, the influence of internal auditassistance, the relative quality of client financial reporting systems, and individual differential audit firmproduction functions. Accordingly, the reader should remain mindful of this limitation when interpreting ourevidence. Overall, our study increases understanding of the factors that may lead auditors to compromise onaudit quality, and hence our paper should be of interest to accounting scholars, investors, and regulators.Footnote 1 See Beck et al. (1988), Magee and Tseng (1990), and Zhang (1999) for extensions of DeAngelo's(1981a, 1981b) idea that quasi-rents impair auditor independence. 2 We refer to ''engagement fees'' when thetest variable in the study was total fees (i.e., the sum of audit and nonaudit fees). 3 In contemporaneousunpublished research, Hollingsworth and Li (2011) investigate the pre-SOX (years 2000- 2001) versus post-SOX (years 2003-2004) linear association between audit fee ratios and ex ante cost of capital. They findevidence of a positive association between total audit fees and ex ante cost of capital during 2003- 2004, but nosuch association during 2000-2001. 4 We do not deflate this measure by the total abnormal audit fee for thepractice office since this results in nearzero denominator problem. 5 Our audit fee model is based on modelsused in Ghosh and Lustgarten (2006), Craswell and Francis (1999), Craswell et al. (1995), and Simon andFrancis (1988). The adjusted-R2 of this model is over 81 percent. However, we do not report details for the sakeof brevity. Detailed specifications are available from the authors on request. 6 See Rusticus and Larcker (2010)for a more detailed discussion of instrumental variable estimation. 7 One of the SOX provisions to affect theaudit relationship was the requirement that auditors evaluate and report on management's assessment of theeffectiveness of the firm's internal controls (SOX Section 404(b) [U.S. House of Representatives 2002]). SinceSOX Section 404(b) was implemented for fiscal years ending on or after November 15, 2004 (per SEC ReleaseNo. 33-8392, issued February 24, 2004), we classify 2000-2003 as the pre-SOX period and 2004-2009 as thepost-SOX period. However, using 2002 as the cutoffdoes not alter the conclusions. 8 Tests for outliers are

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conducted on all the regressions using Belsley et al.'s (1980) procedure. Results (not reported) do not changequalitatively when influential outliers are removed. Thus, our conclusions are not driven by outliers. 9 As anextra precaution, we reestimate the audit fee model using two-stage least squares as a control for potentialendogeneity bias. None of our conclusions are affected significantly. For Model (2), the coefficients ofLOABNAFEE and HIABNAFEE are 0.0238 (p , 0.0001) and 0.0154 (p 14 0.0138), respectively; for Model (3),the coefficients of LOABNAFEE and HIABNAFEE are 1.3262 (p , 0.0001) and 0.4209 (p 14 0.0522),respectively. 10 Findings of Hope et al. (2009) support this approach. They report that their results of positiveassociation between cost of equity capital and excess auditor remuneration only hold for audit fee and not fornonaudit fee. 11 We thank one of our reviewers for this insight. References REFERENCES Antle, R., and B.Nalebuff. 1991. Conservatism and auditor-client negotiations. Journal of Accounting Research 29 (Supplement):31-54. Ashbaugh, H., R. LaFond, and B. Mayhew. 2003. Do nonaudit services compromise auditorindependence? Further evidence. The Accounting Review 78 (3): 611-639. Balsam, S., J. Krishnan, and J.Yang. 2003. Auditor industry specialization and earnings quality. Auditing: A Journal of Practice &Theory 22 (2):71-97. Barnes, P. 2004. The auditor's going concern decision and Types I and II errors: The Coase theorem,transaction costs, bargaining power and attempts to mislead. Journal of Accounting and Public Policy 23 (6):415-440. Bartov, E., D. Givoly, and C. Hayn. 2002. The rewards to meeting or beating earnings expectations.Journal of Accounting and Economics 33 (2): 173-204. Beck, P., T. Frecka, and I. Solomon. 1988. A model ofthe market for MAS and audit services: Knowledge spillovers and auditor-auditee bonding. Journal ofAccounting Literature 7: 50-64. Bedard, J. C., and K. Johnstone. 2004. Earnings manipulation risk, corporategovernance risk, and auditor's planning and pricing decisions. The Accounting Review 79 (2): 277-304. Belsley,D. A., E. Kuh, and R. E. Welsch. 1980. Regression Diagnostics: Identifying Influential Data and Sources ofCollinearity. New York, NY: John Wiley &Sons. Butler, M., A. J. Leone, and M. Willenborg. 2004. An empiricalanalysis of auditor reporting and its association with abnormal accruals. Journal of Accounting and Economics37 (2): 139-165. Cameron, A. C., J. G. Gelbach, and D. L. Miller. 2011. Robust inference with multi-wayclustering. Journal of Business and Economic Statistics 29 (2): 238-249. Carey, P., and R. Simnett. 2006. Auditpartner tenure and audit quality. The Accounting Review 81 (3): 653- 676. Casterella, J., J. Francis, B. Lewis,and P. Walker. 2004. Auditor industry specialization, client bargaining power, and audit pricing. Auditing: AJournal of Practice &Theory 23 (1): 123-140. Chaney, P. K., and K. L. Philipich. 2002. Shredded reputation: Thecost of audit failure. Journal of Accounting Research 40 (4): 1221-1245. Choi, J., J. Kim, and Y. Zang. 2010.The association between audit quality and abnormal audit fees. Auditing: A Journal of Practice &Theory 29 (2):115-140. Chung, H., and S. Kallapur. 2003. Client importance, nonaudit services, and abnormal accruals. TheAccounting Review 78 (4): 931-956. Craswell, A., and J. Francis. 1999. Pricing initial audits engagements: Atest of competing theories. The Accounting Review 74 (2): 201-215. Craswell, A., J. Francis, and S. Taylor.1995. Auditor brand name reputations and industry specialization. Journal of Accounting and Economics 20 (3):297-322. Davidson, R., and J. G. MacKinnon. 1993. Estimation and Inference in Econometrics. New York, NY:Oxford University Press. Davis, L., B. Soo, and G. Trompeter. 2009. Auditor tenure and the ability to meet orbeat earnings forecasts. Contemporary Accounting Research 26 (2): 517-548. DeAngelo, L. 1981a. Auditorindependence, ''low balling,'' and disclosure regulation. Journal of Accounting and Economics 3 (2): 113-127.DeAngelo, L. 1981b. Auditor size and audit quality. Journal of Accounting and Economics 3 (3): 183-199.Dechow, P., and I. Dichev. 2002. The quality of accruals and earnings: The role of accrual estimation errors.The Accounting Review 77 (Supplement): 35-59. Dechow, P., R. Sloan, and A. Sweeney. 1995. Detectingearnings management. The Accounting Review 70 (2): 193-225. DeFond, M. L., and J. Jiambalvo. 1994. Debtcovenant violation and manipulation of accruals. Journal of Accounting and Economics 17 (1/2): 145-176.DeFond, M. L., and C. W. Park. 2001. The reversal of abnormal accruals and the market valuation of earningssurprises. The Accounting Review 76 (3): 375-404. DeFond, M., K. Raghunandan, and K. Subramanyam. 2002.Do nonaudit service fees impair auditor independence? Evidence from going concern audit opinions. Journal of

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Subject: Auditing; Quality; Public Company Accounting Reform&Investor Protection Act 2002-US; Studies;Fees&charges

Location: United States--US

Classification: 4130: Auditing, 4320: Legislation, 9130: Experiment/theoretical treatment, 9190: United States

Publication title: Auditing

Volume: 31

Issue: 3

Pages: 1-22

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Number of pages: 22

Publication year: 2012

Publication date: Aug 2012

Year: 2012

Publisher: American Accounting Association

Place of publication: Sarasota

Country of publication: United States

Journal subject: Business And Economics--Accounting

ISSN: 02780380

Source type: Scholarly Journals

Language of publication: English

Document type: Feature

Document feature: Equations;Tables;References

ProQuest document ID: 1143891718

Document URL: http://search.proquest.com/docview/1143891718?accountid=86413

Copyright: Copyright American Accounting Association Aug 2012

Last updated: 2012-11-09

Database: Accounting&Tax

_______________________________________________________________ Document 2 of 10

AN EMPIRICAL INVESTIGATION OF THE EFFECTS OF MERGER AND ACQUISITION ON FIRMS'PROFITABILITY Author: Ferrer, Rodiel C

Publication info: Academy of Accounting and Financial Studies Journal 16. 3 (2012): 31-55.ProQuest document link

Abstract: This study is considered a causal and correlational research, which aims to determine the relationshipof the mergers and acquisitions to the firm's profitability. It is a quantitative study that measured the effects ofmergers and acquisitions on return on assets and return on equity of the companies. Besides knowing therelationship, this study also obtained an estimate of the possible impact of the independent variable to thedependent variables. This study covered all the listed companies in the Philippines Stock Exchange for theyears 2006 until 2010. This covered companies from the different sectors of the economy, which comprise of 30companies in the financial sector, 75 firms in the industrial sector, 39 businesses classified as holding firms, 39companies in the property sector, 54 businesses in the service sector and 22 companies in the mining and oilsector. The research made use of two linear regressions to analyze the effect of having a merger or acquisitionon the profitability of the companies. Findings suggest that there is significant negative relation of merger andreturn on equity, having a merger or acquisition to return on equity implies that most mergers and acquisitionsdo harm to the financial well-being of the companies, rather than good. Furthermore, merger and acquisitionprovide an insignificant relation to the return on total assets, as evidenced by the insignificant p-value. As a

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result, the finding of this variable provides empirical evidence that having a merger and acquisition does notaffect the return on assets ratio of companies in the Philippines.

Full Text: Headnote ABSTRACT Economic advantage and competitive edge is the name of the game. Businesscombination is one proven and tested method by companies wanting to grow and gobble up a larger marketshare. The emerging business scenario created an additional burden to the already struggling corporations'existence, in almost all types of industry, which is due to the ever increasing demand for innovative strategies.To survive the dog-eats-dog world of competitiveness, a number of these players engage in businesscombination - wherein two or more companies incorporate into a single accounting entity. This study isconsidered a causal and correlational research, which aims to determine the relationship of the mergers andacquisitions to the firm's profitability. It is a quantitative study that measured the effects of mergers andacquisitions on return on assets and return on equity of the companies. Besides knowing the relationship, thisstudy also obtained an estimate of the possible impact of the independent variable to the dependent variables.This study covered all the listed companies in the Philippines Stock Exchange for the years 2006 until 2010.This covered companies from the different sectors of the economy, which comprise of 30 companies in thefinancial sector, 75 firms in the industrial sector, 39 businesses classified as holding firms, 39 companies in theproperty sector, 54 businesses in the service sector and 22 companies in the mining and oil sector. Theresearch made use of two linear regressions to analyze the effect of having a merger or acquisition on theprofitability of the companies. Two separate regressions are needed because profitability would be proxy by twodifferent but widely used variables: the return on equity and the return on assets ratio. Since the study coveredthe entire publicly listed companies in the Philippines for the period 2006 until 2010, this essentially means thatpanel data was used in the study. Hence, the appropriate panel analysis was conducted. Findings suggest thatthere is significant negative relation of merger and return on equity, having a merger or acquisition to return onequity implies that most mergers and acquisitions do harm to the financial well-being of the companies, ratherthan good. Furthermore, merger and acquisition provide an insignificant relation to the return on total assets, asevidenced by the insignificant p-value. As a result, the finding of this variable provides empirical evidence thathaving a merger and acquisition does not affect the return on assets ratio of companies in the Philippines.Keywords: Merger and Acquisition, Firms' Profitability, Panel Analysis, Return on Equity and Return on Asset.(ProQuest: ... denotes formulae omitted.) INTRODUCTION With the rapid advancement in technology, theglobal business industry is also at the forefront of such changes. For the past couple of years, we havewitnessed the introduction of new products in the market. Over-capacity indeed is the glaring issue here for thevery basic of the Law of Demand &Supply seems to have been ignored entirely. In the face of this predicament,firms need to reinvent ways of coping with the harsh reality of the industry. Should production be cut or totallycease from operation and rely solely on robust branding, or be more market pro-active and buy-up fledglingcompetition to emerge as the "last-man-standing"? Economic advantage and competitive edge is the name ofthe game. Business combination is one proven and tested method by companies wanting to grow and gobbleup a larger market share. The emerging business scenario created an additional burden to the alreadystruggling corporations' existence, in almost all types of industry, which is due to the ever increasing demand forinnovative strategies. To survive the dog-eats-dog world of competitiveness, a number of these players engagein business combination - wherein two or more companies incorporate into a single accounting entity. It is acommon practice for companies who underwent such combination to still continue with their product or brandsand distinct identities. However, after the business combination has commenced, the combined companies willnow share a common culture and mission aside from bearing the same corporate name. The major types ofbusiness combination as follows: mergers, consolidations and stock acquisitions. Merger is the combination oftwo or more entities by purchase acquisition whereby the identity of one of the entities remain while the othersare being dissolved. The reasons behind the merger transactions are basically gaining market share,competitive advantage, increasing revenues and risk and product diversifications. With the global financial

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crises, it is noticeable that mergers and acquisitions have considerably increased. Corporations employed suchcombination not only for the sake of competitiveness but to maintain a firm foothold in the industry as well. Thishas lead to the significant transformation in the business landscape. Though one question that hounds theindustry, will the entities be able to handle the ramifications of the merger coupled with the risks involved in suchactivity and will the business combination improve the profitability of the firms. This paper investigates the effectof merger and acquisition on firm's profitability in terms of return on equity and return on assets. REVIEW OFRELATED LITERATURE According to Yurtoglo, there are three usual effects of merger and acquisitions:financial performance, industry and aggregate concentration levels and social welfare. The financialperformance of the company would definitely be affected by the business combination, as a result of synergiesor disruption that may either increase or decrease the company's operating performance. On the other hand,the combination of two or more companies would decrease the number of players in a given industry. Finally,Yurtoglo indicated that as a result of the changes in financial performance and aggregate concentration levels,the social welfare of the people would also be affected by merger or acquisition. For example, the recentacquisition of Equitable PCI by Banko De Oro (BDO) led to the rise of BDO as the number one bank in thePhilippines, in terms of assets and amount of deposits. In addition to this, BDO also received increased marketpresence, as a result of converting the former Equitable PCI banks into BDO banks. This, in effect, made the lifeof BDO depositors and the society at large easier, since they have more alternatives on which branch they optto conduct their transaction. There had been numerous studies from different countries conducted on the effectof merger or acquisition on the financial profitability of the companies. Ollinger, Nguyen, Blayney, Chambersand Nelson (2006) provided empirical evidence that merger and acquisition improved the labor productivity inthe food sector. Holmstrom (2001) examined changes in the merger activity and corporate governancemechanism in the United States. He concluded that there is a rise in merger and acquisition activity for theperiod 1980 until 1999 and that the corporate governance mechanism has evolved from leveraged hostiletakeovers and buyouts in the 1980s to incentive-based compensation in the last portion of the 1990s. Kemal(2011) investigated the effects of merger or acquisition on the different financial ratios of companies in thebanking industry of Pakistan for the years 2006 until 2009. They found evidence that mergers or acquisitionsactually worsen the liquidity, profitability, return on investment and market stock ratios of the banks while thesolvency ratio is the only one that improved. Altunbas and Ibanes (2004) provided evidence that bank mergersin Europe resulted to an improvement on the companies' return on capital, particularly on cross-border mergers,as a result of organizational and strategic fits. They found out that the improved performance can primarily beattributed to the broad similarities between merger participants. Altunbas and Ibanes (2004) separated theiranalysis between domestic and cross-border mergers and acquisitions and found evidence that financialinnovation, capitalization and investment in technology resulted to an enhanced performance for domesticmergers while differences in loan and risks strategies boost the performance of cross-border businesscombinations. On the flip side, they indicated that the disparities in earnings, loans and deposit strategiesbrought about damaging consequences for domestic mergers while inconsistencies in capitalization, technologyand financial innovation promulgated harmful effects on cross-border mergers and acquisitions. Hu (2009)examined the long-term financial performance of Chinese-acquiring companies during the post-acquisitionperiod and found that the buying companies receive no significant positive abnormal returns over one yearfollowing the merger or acquisition. However, he was also able to establish that acquiring companies receivesignificant positive abnormal returns three years after the merger or acquisition. In addition, he was able todetermine that only acquirers using asset acquisitions experience positive abnormal returns aver the three yearperiod. In contrast, even if the overall result over the one year period is insignificant, Hu (2009) found evidencethat acquirers using tender offers receive positive abnormal returns. In summary, Hu (2009) indicated that thetype of transaction, the industry characteristics and the year of acquisition have a significant influence on theacquirer's financial performance over the long term. Mantravadi and Reddy (2008) found empirical evidence

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that, overall, companies in India are experiencing slight increases in their profitability following the merger oracquisition. However, the impact is different when the different industries are considered in isolation. Theyindicated that businesses in the banking and finance industry and pharmaceutical companies receive slightpositive impact in their profitability while companies in the textile and electrical equipment sectors obtained anegative impact on their performance. In contrast, they depicted that firms in the chemicals and agri-productsindustry experience a significant decline in their profitability, as measured by their return on investment andreturn on assets, after the merger or acquisition. Wong, Cheung and Mun (2009) conducted their research usingmarket measures, specifically the relationship between security returns and returns on the market portfolio, onthe Asian markets, particularly Hong Kong, China, Taiwan, Singapore, South Korea and Japan. They providedempirical evidence that stockholders of target firms regard merger or acquisition as bad news while theshareholders in the acquiring company regard it as good news. They found out that there is no abnormal returnto the shareholders of target firms surrounding the announcement period. They attributed this to the low marketvalue of the shares before the announcement period as the results of either poor financial performance of thetarget company or an information leakage with regards to the features of the takeover, such as the acquiringprices. In contrast, they regard the decreasing market value after the announcement as the reaction of themarket to the news. On the other hand, Wong et. al (2009) also furnished proof that the market value of thebuying company's shares receives abnormal returns right after the announcement of the acquisition, dependingon the type of acquisitions. Yen and Andre (2010) cited several evidences that shareholders of acquiring firmseither suffer losses, as a result of merger or acquisition, or, at best, break even. They investigated the effects ofconcentrated ownership, governance mechanisms and legal protection on corporate performance of acquiringfirms. As a result, they found out that buying firms with shareholders owning 25% to 30% of the company tendsto improve their operating performance within the next three years following the business combination. Theyindicated that their result is actually in conformity with the prior literature providing that firm value rises asownership of the largest shareholders. This finding may have been the result of the agency problem. Whenindividuals own a larger portion of the corporation, their financial well-being is linked more closely to theperformance of the said business, which creates an incentive on that individual's part to ensure that theoperations of the firm would be profitable. In contrast, if an individual owns only a small portion of a corporation,their financial well-being may be less affected compared to that of the controlling shareholder. In addition, thatperson would most likely have no capacity to influence corporate decisions, as a result of his small interest.Hence, a corporation with shareholders owning a huge chunk of its corporate ownership tends to have highercorporate performance after merger or acquisition, than businesses whose ownership is levelled out among ahandful of shareholders. Williams (2010) and Lafosse (1999) provided further evidences that may explain theeffects of merger and acquisition on the profitability of the companies. Williams (2010) indicated that companiesoften overlook the marketing synergies that may result from mergers and acquisitions, which actually result toeither its failure or undermines the benefit that acquiring firms get from such business combination. Heexplained that operating synergies on marketing components can also be obtained from mergers andacquisitions, particularly in a horizontal integration. Lafosse (1999) provided empirical evidence that theaccounting method (pooling or purchasing) used to consider the merger activity does not give target firmsabnormal returns. However, upon separating their analysis between firms listed in the NASDAQ and companiestraded in the NYSE, they found out that target companies listed in the NASDAQ tend to have higher premiumspaid by the acquirers for their shares. Singh and Zollo (1999) provided empirical evidence that knowledgecodification has a significant positive impact on the post-acquisition financial performance of companies in thebanking industry while experience accumulation on mergers or acquisitions provides no such impact.Knowledge codification is defined as the process of converting tacit knowledge or the type of knowledge that isdifficult to transmit to another person into explicit knowledge or knowledge that can easily be transmitted(turing.edu). An example of tacit knowledge is the capability of swimming. Any swimmer can easily describe the

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proper way of swimming, yet after hearing the lecture, the person who does not know how to swim would still beunable to swim. On the other hand, explicit knowledge can readily be seen in manuals, lectures and cookinginstructions. Singh and Zollo (1999) also expressed a direct relation between the level of integration andfinancial performance while a negative relation is exhibited by the replacement of top management to corporateperformance. Ismail, Abdou and Annis (2011) pointed out that these studies have conflicting results, primarilybecause of the differences in the scope and measures used by the contrasting studies. Some studies focusedon a particular industry, such as the steel industry, construction sector and railroad industry while others tookinto account all the listed companies in their area (Ismail et. al, 2011). Hence, it is not really surprising thatstudies focusing on the food sector would have different results from studies engaged in the telecommunicationsector or that studies concentrating on American firms would have different findings as a similar study onCanada or Germany. On the other hand, the studies also differ on the measures used to signify profitability.According to Ismail et. al (2011), a handful studies used either market measures, such as market power, bookto market ratio and cumulative abnormal returns, or accounting measures like operating income over sales,sales ratio and solvency to signify the company's operating performance. In contrast, Ismail et. al (2011)indicated that some studies used a combination of both market-measures and accounting-measures whileothers used qualitative-measures, particularly the theoretical researches. Either way, the studies falling in eachof the four categories depicted conflicting results. The inconsistent result can primarily be attributed to thecombination of the differences in both the scope and the measures used to signify operating performance.STATEMENT OF THE PROBLEM Accounting is the tool often used to simplify the complex environment of thebusiness world, where every now and then countless transactions are involved. Over the years, business hasdeveloped and diversified into various forms and methodologies. This has induced the need for a specializedsystem of monitoring and evaluation of its objective, to earn profit, without jeopardizing ethics and the welfare ofits various stakeholders. Audit is one of these resulting systems. The primary objective of audits is to ascertainthe validity and reliability of information and to administer an assessment of a system's internal controls.Classifications of audit include: operational audit, financial audit, compliance audit, information systems audit,and investigative or forensic audit. Financial statements are the primary source of quantitative financialinformation regarding important aspects about a company that is useful to a wide range of users in makingeconomic decisions. In order to ensure the veracity of the reported information, financial statements should beaudited by independent certified public accountants (CPAs). The CPA is guided by generally accepted auditingstandards (GAAS) in conducting the audit examination and in rendering an opinion as to whether such financialstatements were presented fairly and in conformity with the generally accepted accounting principles (GAAP).Nonetheless, it is still the management of the business enterprise that is principally liable for the preparation andpresentation of financial statements that conform to GAAP. Management approval is essential to enact anychanges or adjustments needed to rectify material misstatements discovered in the audit. If such approval is notobtained, the CPA practitioner would be obliged to make the necessary modification in the "IndependentAuditor's Report." Racasa (2003) Companies use the annual reports as the primary mode of communication tocorrespond with stakeholders (Botosan, 1997; and Lang and Lundholm, 1993). It is through these reports,where companies disclose relevant information that plays a crucial role in the decision-making processes.Cooke claims that it is important to assess the extent of disclosures made by a corporation, as stakeholders relyheavily on these pieces of information when making different types of decisions (Cooke, 1989). These pieces ofinformation are crucial in the decision-making processes regarding the allocation of scarce resources forstakeholders. The problem addressed by this paper is: What effect does merger or acquisition have on acompany's profitability? Null Hypotheses Null Hypothesis (Hoi): Merger and acquisition has no significant effecton return on total assets. Null Hypothesis (Ho2): Merger and acquisition has no significant effect on return onequity. THEORETICAL FRAMEWORK The different theories underlying the study includes the transaction costtheory, technological competence theory and internalization theory. Transaction cost theory actually

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encompasses the other two theories and, hence, could be designated as the "parent" theory. Transaction costtheory Transaction cost theory addresses the problem of organizing interdependencies among many individuals(Hennart, 2001). Hennart (2001) explained transaction costs as "the information, enforcement and bargainingcosts incurred by economic agents, as a result of bounded rationality and opportunism." Bounded rationality,also known as cognitive limitation, is the idea that an individual's decision, although rational, is limited by theinformation they have, their capacity to evaluate the information available and the amount of time to makedecisions (Jones, 1999). Opportunism, on the other hand, is discussed by Williamson (1981), as the tendencyof individuals to pursue actions that would maximize their self-interests. Klein (2006) explained thatopportunistic individuals cannot be relied on to retain their promises, to fulfill their obligations and to respect theinterests of their trading partners. Hence, safeguards should be placed. Here is a brief discussion of thetransaction cost framework. The transaction cost framework, which was adapted from the study of Mikkonen,signified that companies incur two types of transaction costs, namely external or market transaction costs andinternal or bureaucratic transaction costs. External transaction costs comprise of expenses that the companywould incur if it chooses to engage in a transaction with another company. On the other hand, internaltransaction costs consist of the expenses that the company would incur, if it chooses to produce the product in-house. This is actually the same expenses that the company will incur, if it chooses to merge with anothercompany. There are two human factors within the framework: bounded rationality and opportunism. In contrast,t