AUDITOR COMPENSATION AND AUDIT FAILURE: AN EMPIRICAL ANALYSIS* by Mukesh Bajaj Managing Director LECG, LLC. Katherine Gunny University of California - Berkeley and Atulya Sarin Professor of Finance Santa Clara University February 27, 2003 * We are grateful for helpful comments received from David Denis. Sarin acknowledges support from Dean Witter Foundation. Please address all correspondence to Atulya Sarin (Ph: 408-554-4953 Email: [email protected]).
Transcript
AUDITOR COMPENSATION AND AUDIT FAILURE: AN EMPIRICAL ANALYSIS*
by
Mukesh Bajaj Managing Director
LECG, LLC.
Katherine Gunny University of California - Berkeley
and
Atulya Sarin
Professor of Finance Santa Clara University
February 27, 2003
* We are grateful for helpful comments received from David Denis. Sarin acknowledges support from Dean Witter Foundation. Please address all correspondence to Atulya Sarin (Ph: 408-554-4953 Email: [email protected]).
AUDITOR COMPENSATION AND AUDIT FAILURE: AN EMPIRICAL ANALYSIS
Abstract
Record number of audit failures during the recent past has prompted much debate about whether
high auditor compensation, especially for nonaudit work, may have led to lax auditing standards.
We shed light on this question by comparing auditor compensation for a set of firms in which
accounting improprieties were alleged in a shareholder class action lawsuit with a set of matched
firms in the same industry and of similar size. Our evidence suggests that auditors were not
compensated differently for either their audit or consulting services over the period in which their
client was allegedly involved in an accounting fraud. However, for the set of firms with the largest
market reaction to the alleged fraud, the nonaudit component of the total fees was significantly
higher than comparable firms even after controlling for other known determinants of auditor
compensation.
AUDITOR COMPENSATION AND AUDIT FAILURE: AN EMPIRICAL ANALYSIS
1. Introduction
The recent collapse of the stock market has been accompanied by large-scale audit failures.1
Companies like Xerox, Enron and WorldCom, amongst others, have disclosed improprieties in their
financial statements in the amounts of billions of dollars. Xerox disclosed that it had incorrectly
realized $6.4 billion in revenues and overstated its pretax income by $1.41 billion over five years
from 1997 to 2001. In some of these high profile audit failures, auditor misconduct has been
alleged. For example, according to the Wall Street Journal dated January 23, 2003, the SEC is set
to file civil fraud charges against KPMG for its role in auditing Xerox. The accounting
improprieties at Enron regarding related party transactions led not only to its demise but also the
failure of its auditor, Arthur Andersen.
Record number of audit failures during the recent past, especially at some of the most well
known and valuable firms in Corporate America has prompted much debate in the popular press, by
the SEC, and in the US Congress about whether high auditor compensation, especially for nonaudit
work, may have led to lax auditing standards. Three recent legislative reforms have attempted to
address the perceived lax auditing due to auditors being compromised in their bid to attract
consulting business from their auditing clients. First, the Sarbanes-Oxley Act of 2002, in an effort
to improve audit quality, prohibits auditing firms and their personnel from providing any nonaudit
services to auditing clients contemporaneously with the audit unless the additional services are pre-
approved by the company’s audit committee. Second, in June 2002 the SEC banned auditors from
performing nonaudit services in nine specific areas that may impair independence. Also, in an
1 In 2002 a record number of restatements erased billions of dollars of previously recorded revenue from financial statements. In 2002 restatements rose 22% from 2001 and restatements of large corporations (with annual revenue over 1 billion), 74 total, was almost double that of 2001. The Wall Street Journal, “Restatements Rise 22%,” 1/21/2003.
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effort to help investors assess the independence of a firm’s auditor the SEC has changed the
disclosure requirements regarding auditor compensation. On February 6, 2003 the SEC issued
“Final Rule: Strengthening the Commission's Requirements Regarding Auditor Independence”
which adopts amendments to its existing requirements in an effort to enhance the independence of
the accountants. The amendment has three major changes to the existing rules. First, it increases
the disclosure categories of professional fees paid for audit and nonaudit services from three to four:
audit fees, audit-related fees, tax fees, and all other fees. Second, the new disclosure would require
firms to report fees for each of the two most recent fiscal years. Third, the definition of audit fee
has expanded to not only include services necessary to perform an audit in accordance with
Generally Accepted Auditing Standards (GAAS) but also may include services that generally only
the independent accountant reasonably can provide, such as comfort letters, statutory audits, attest
services, consents and assistance with and review of documents filed with the Commission. 23
Although the SEC has enacted legislation assuming consulting assignments impair auditor
independence, the evidence is mixed. On one hand it is argued that there are economies of scale
and scope that permit the auditors to perform important consulting assignments in a cost-effective
manner. Also, auditors compete on the basis of reputation, which is only acquired by a history of
credible auditing. Compromising audit quality, especially when it allows a company to present rosy
results, jeopardizes the auditor’s reputation. A second important reason for auditors to value
credible and independent audit is the threat of litigation. The liability at both the federal and state
levels and requirements of various government agencies with threat of expensive litigation for
failure (and potential criminal sanctions) provide strong incentives for auditors to remain
2 See SEC issue “Final Rule: Strengthening the Commission's Requirements Regarding Auditor Independence” 2/6/2003. 3 How clearly and what the SEC defines as audit fees, audit-related fees, tax fees, and all other fees has become a contentious issue as far as how informative the required disclosures will be to the market. See The Wall Street Journal,
4
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independent and vigilant.4 On the other hand, it has been argued that the independence of an audit
is compromised when the auditor believes large consulting fees may be at stake.5
This study attempts to empirically examine the relationship between an audit failure alleged
in a securities class action lawsuit and the various elements of auditor compensation. We find that
for our sample of 100 firms in which audit failure has been alleged in a securities class action
lawsuit, the audit fees, as well as nonaudit fees are no higher than for a matched sample.6 However
for our sample of firms with the largest market reaction to the audit failure during the period over
which the alleged fraud occurred (the “class period”), the nonaudit fees was higher than comparable
firms. This difference persists even after controlling for known determinants of auditor
compensation.
The remainder of this paper is organized as follows. Section 2 discusses the extant
theoretical and empirical evidence on auditor independence. Section 3 describes our sample
selection process and reports descriptive statistics for the sample firms. Section 4 presents evidence
on the differences in auditor compensation between our sample firms and the matched sample.
Section 5 concludes.
2. Auditor Independence
2.1 Importance of Auditor Independence
“Proposal May Blur `Audit Fees' --- Plan by the SEC to Tweak Disclosure Rules Could Aid Big U.S. Accounting Firms,” January 23, 2002. 4 See e.g. DeAngelo (1981), Watts and Zimmerman (1983), Goldman & Barley (1974), Craswell et al. (2002) 5 See Simunic 1984, Parkash and Venable 1993, Firth 1997 6 Our matching algorithm required that each matched firm have total assets within 90% and 110% of the total assets of the litigated firm and have the same SIC code (either 4,3,2, or 1-digit code). Then, we chose the firm with the closest fiscal year end to the litigated sample. Alternatively, we could have chosen our sample of matched firms based on the same SIC code and then matched on total revenue. Previous research shows that size is by far the biggest determinant of audit fees. Therefore we chose to first match on total assets (within a confidence interval) in an effort to hold constant the effect of firm size.
For capital markets to function well, it is essential that investors are able to get a scorecard
on how companies are performing. The scorecard is presented in the form of financial statements
that are standardized across companies and follow certain guidelines. The only way in which
financial statements are useful to investors is when they are credible. Auditors play an important
role in ensuring that accounting statements follow the generally accepted guidelines and are
accurate. Expectation is that auditors are independent and will detect and reveal any material
omissions or misstatements in the financial statements.
That auditors are perceived to be independence is also important to auditors. Auditors can
attain credibility with market participants by bonding enough wealth to make dishonest behavior
improbable.7 One important bonding source is the auditor’s reputation, which makes the audit
credible for investors. Auditors compete on the basis of reputation, which is only acquired by a
history of credible auditing. Compromising audit quality, especially when it allows a company to
present rosy results, jeopardizes the auditor’s reputation. Over time investors will respond to
systematic “bad” auditing by discounting the value of the audit and companies with little to hide
will be forced to change auditors. A second important source for auditor bonding is the threat of
litigation. The liability at both the federal and state levels and requirements of various government
agencies with threat of expensive litigation for failure (and potential criminal sanctions) also
provide incentives for auditors to remain independent and vigilant. Given the spate of high-profile
audit failures recently, the market, the press, the regulators, and the Congress have all questioned
whether the mix of policy and legal mechanisms have been effective in ensuring auditor
independence.
2.2 Compensation and Auditor Independence
7Leland and Pyle (1977), Campbell & Kracaw (1980)
6
The debate in the academic literature on the effects of the various components of auditor’s
compensation on auditor independence has produced mixed results. Some arguments in the
literature support the notion of a positive association between auditor independence and
compensation. On the other hand, economic dependence of the audit firm on a client may also
increase the likelihood that the auditor will acquiesce to management’s requests leading to lower
quality financial statements.
For example, Simunic (1984) models the joint demand for both audit and nonaudit services.
He demonstrates that when the auditor provides both services a cost savings (due to “knowledge
spillovers”) from the joint supply of these services occurs. As a result, when the same auditor
provides both services, the cost savings may benefit the accounting firm. The auditor, now earning
rents, faces a higher marginal expected loss from being dismissed by top management producing a
greater incentive for the auditor to conceal bad news or comply with management.
Another view in this literature holds that providing consulting services does not hinder
auditor independence and in some cases may enhance auditors’ incentives to stay independent.
DeAngelo (1981) concedes that increased revenues generated by auditors from consulting fees may
create an incentive for auditors to compromise their independence and report favorably in order to
retain clients. However, when auditors have more than one client there is less financial dependence
on a single client. Reputational penalties constrain the behavior of audit firms because the gains
from acquiescing to any one client’s demands are outweighed by the reputational losses that would
be imposed by other clients who need and value the audit firms with a reputation for independence.
Similarly, Goldman and Barlev (1974) argue that consulting services combined with auditing
services may create a situation in which the client’s dependence on the auditor increases because
these services enhance the auditor’s uniqueness and thus the value to the client.
7
In Table 1 we summarize the empirical research that examines the association between
Since neither auditor independence nor economic dependence is observable, researchers have used
several different variables to proxy for these variables. Table 1 displays over seven different
measures used by researchers to gauge the extent of the auditor’s dependence on the client.
Depending on the proxy, the results of these studies have led to conflicting conclusions.
Craswell et al. (2002) uses the auditor’s propensity to qualify the audit as a measure of
auditor independence. For a sample of Australian firms they find that fee dependence does not
affect the auditors propensity to qualify their audit opinion (both at the national market level and the
local market level). Francis and Reynolds (2001) test the hypothesis that fee dependence will cause
auditors to be more lenient and give clients greater discretion in accounting for accruals (both
discretionary and total accruals). Surprisingly, they find a negative association between fee
dependence and the level of accruals and suggest that reputation protection and litigation avoidance
are sufficient incentives for auditors to maintain objectivity. They also find that larger clients (for
whom auditors presumably have greater fee dependence) are more likely to receive a going concern
audit report. Similarly, DeFond et al. (2002) analyzed financially distressed firms and found no
association between audit fees and the propensity to issue a going concern audit opinion.
Some studies have shown a positive association between measures of economic dependence
and auditor independence (audit quality). Firth (1997) and Parkash and Venable (1993) show that
high agency cost firms (determined by lower levels of management ownership, lower outside
investment concentration and higher debt) recognize the potential for perceptions of independence
impairment and voluntarily limit ex ante purchases of consulting services from the auditors. Their
results suggest that auditees recognize the potential for perceptions of independence impairment and
higher agency cost firms voluntarily limit the purchase of nonaudit service. Frankel et al. (2001)
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use the level of discretionary accruals and the ability of the firm to just meet or beat earnings targets
as a proxy for financial reporting quality. They show a positive association between two measures
of nonaudit services and earnings quality.
2.3 Auditor Independence in the Enron Case
The Enron audit failure has highlighted the importance of auditor compensation and
independence in a very dramatic manner and captured the attention of the market, the press,
policymakers and the US Congress alike. On October 22, 2001 a complaint was filed alleging
violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Enron and
three Enron directors. The complaint was filed in response to the disclosure on October 17, 2001
that Enron will take $1.2 billion write-down of its net worth to account for transactions involving
related party transactions controlled by CFO, Andrew S. Fastow. On the same day, Enron froze the
assets in its 401(k) retirement plan to allow for administrative changes and by the time employees
could sell shares, the stock had collapsed. On October 22, 2001, the Securities and Exchange
Commission (SEC) requested that Enron voluntarily provide information regarding billions of
dollars in certain related party transactions connected to its former CFO, Andrew S. Fastow.
On November 11, 2001 the SEC expanded investigation to include Enron’s accounting firm,
Arthur Andersen. Then, on November 13, 2001 an amended class action complaint for violations of
the federal securities laws was filed in which Arthur Andersen along with Enron and nine company
officials were named as a defendants. On January 10, 2002, Arthur Andersen disclosed that it had
destroyed documents related to work done for Enron. On March 14, 2002 the justice department
announced that Andersen had been charged with obstruction of justice in connection with Enron
and on June 15, 2002 Andersen was found guilty of the charges.
Generally Accepted Auditing Standards (GAAS) as approved and adopted by American
Institute of Certified Public Accountants (AICPA), relate to the conduct of individual audit
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engagements and statements on Auditing Standards (AU) are recognized by the AICPA as the
interpretation of GAAS. Pursuant to AU 334.09, when the auditor examines certain related party
transactions the auditor “must obtain an understanding of the business purpose of the transaction.”
These guidelines clearly explain that the audit is not complete until the auditor fully understands the
purpose behind the related party transaction. According to AU 334.09, Enron’s complex
partnerships should have been consolidated into Enron’s financial statements between the years
1997-2001, not incorporated and restated in 2002.
In 1997-2001 Arthur Andersen’s Houston office was engaged to analyze and opine on
Enron’s financial statements, to perform review services on Enron’s interim 2001 results, and to
provide consulting, tax and due diligence services throughout 1997 through 2001. The complaint
states:
“As a result of the far reaching scope of services provided by Arthur Andersen, they were
intimately familiar with Enron’s business, including its business relationships. Arthur Andersen
received huge fees for its services to Enron. These fees were particularly important to the partners
in Andersen’s Houston office as their incomes were dependent on continued business from Enron.
For 2000 alone, for example, Andersen received $25 million in fees related to the audit of Enron’s
financial statements and another $27 million nonaudit related work.” The complaint continues by
quoting a passage from Platt’s Oilgram News: “Skeptics say those huge fees, and the domination of
AA’s audit team by Enron’s bonus-driven pros, has given Enron great leeway in setting its curve,
and thus booking profits.”
It is widely believed that Arthur Andersen’s independence was impaired in the Enron case.
It has also been alleged that Arthur Andersen purposely or naively overlooked the accounting for
special purpose entities. The fact that Andersen destroyed documents and eventually was found
guilty of obstruction of justice is especially troubling.
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3. Sample Selection and Description
3.1 Audit Failure as a Proxy for Auditor Independence
The consumers of financial statements expect that an audit would detect and reveal any
misstatements of financial information. In some instances, when the audit fails to detect any error
in the financial statements and the consumers of that information incur losses, they pursue legal
action against auditors and management of the firm. We identify instances in which the consumers
of audits (investors) initiate legal action as a consequence of alleged accounting improprieties.
These instances are our proxy of audit failure.8 A caveat about our proxy is in order. Litigation
against firms for alleged accounting violation helps us to identify firms for which lack of auditor
independence has been alleged, not proven. Some of these securities class action lawsuits are
dismissed, and most are settled.9
3.1 Sample
On November 15, 2000 the SEC adopted revised auditor independence rules requiring firms
to separately disclose the amount of audit fees, nonaudit fees and systems design and
implementation fees billed by the auditor for the most recent year.10 Such disclosure permits us to
collect auditor compensation data for our sample from firms’ annual proxy statements.
Our sample begins with the universe of firms that where the subject of a class action lawsuit
filed during 2001 or 2002. We identified such firms through the Stanford Securities Class Action
Clearinghouse Database. We found 691 such complaints. The sample is further restricted to those
8 We define audit failure in the same manner as Palmrose (1988) where audit failure includes firms in which there were material misstatements whether or not auditors have obtained sufficient audit information. 9 While there are very few trials, significant settlements are often paid by firms and their auditors in such cases. See Bajaj, Mazumdar and Sarin (2003). 10 Even though the SEC required firms to disclose the amount of “Financial Information Systems Design and Implementation Fees” in the proxy statement, we exclude such fees from our measure of non-audit fees because Ernst and Young sold their information technology consulting business in May 2000 and that creates problems in comparability across auditors.
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firms with data on the amount of audit and nonaudit fees available in the proxy statements. We
further restrict the sample by excluding 14 financial institutions (SIC 6000-6999) because the
relationship between accounting numbers (specifically total assets) and the level of fees paid to a
firms auditor may be very different for financial firms as opposed to those included in the sample.
Additionally, we limit our sample to those firms that had litigation in connection with an accounting
violation. Next, we require the firms to have data on audit fees and nonaudit fees in the proxy
statements that overlap the alleged “class period” or the financial statements in question.11 We also
require our sample firms to have a matched firm, based on industry and total assets (discussed
later). This selection process resulted in 100 firms. We obtain data on firm characteristics from
Compustat and data on firms’ acquisition activity from SDC.
Panel A of Table 2 provides details on the nature of the main alleged accounting impropriety
in the complaint. An examination of the complaints indicate that the nature of the allegations vary
widely, however the most common accounting impropriety, in case of 44 firms, relate to certain
aspects of revenue recognition. Other common allegations include dealing with asset impairment,
expense recognition and debt and/or off balance sheet disclosures. Panel B provides details on how
many firms subsequently restated their earnings for at least 1 quarter overlapping our sample period
over which we collected data on audit and nonaudit fees. Of the 100 firms, 54 firms have restated
earnings or plan to restate earnings and 16 firms have filed for bankruptcy (Panel C).
In order to determine whether audit and/or nonaudit fees are higher than expected for firms
for which there is an alleged accounting allegation, we construct a matched sample based on SIC
code and size of the firms as measured by its total assets. For each firm in the litigation sample, a
matched firm was obtained by first identifying all firms in Compustat with an identical SIC code.
Out of these firms with a matched SIC code, we select the firm with total assets (measured at the
11 Of our sample of litigation firms, 7 did not have fee data overlapping the class period.
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fiscal year end overlapping the litigated firm’s class period) closest in size to the total assets of our
litigated firm to be included in our matched sample. However, we require the total assets of the
matched firm to be within 90% and 110% of the total assets of the litigated firm and the firm must
have the required audit fee data available in its proxy. If no firm is within this size interval, we
repeat the process but increase the sample of potential matches by identify all firms with a similar
three-digit SIC. If this does not produce a match we identify firms with a similar two digit SIC
code, then, if necessary, by one digit SIC code. Out of our sample of 103 litigated firms that
otherwise passed our selection criteria, we could identify 100 firms with a matched firm (our
selection process did not identify a match for three of our litigated firms). Our matched sample
consists of 33, 20, 31 and 16 firms that were match by 4, 3, 2, and 1 digit SIC, respectively.
In Table 3 we present descriptive statistics for our sample on certain variables of interest and
Analysis of Variance (Wilcoxon) test of differences in the means (medians) between the litigated
firms and the matched firms. The litigated firms have an average total assets of 10.71 billion and
median total assets of 878 million. The matched sample has a similar size as measured by the mean
(10.69 billion) and median (876 million) of total assets. Tests for the differences in means and
medians of total assets between the two samples indicate no significant difference. Similarly, all of
the variables presented in Table 3 have means/medians that are not significantly different across the
two samples except for two. The mean of foreign tax to total assets and the mean of the indicator
variable set equal to one if the firm switched auditor from the previous year are significantly
different at a 10% level. (Litigation set was more likely to have changed auditor in the preceding
year [in seven percent of the cases], versus the matched sample of firms [about 2% of the cases].)
Panel B of Table 3 presents the frequency by industry. The most represented industry is computers,
23%, and next is durable manufacturers at 22% of the sample. Overall the results in Table 3
indicate that the litigated and matched sample are similar. Given this similarity, we would also
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expect the amount of audit and nonaudit fees billed by the firm’s auditor to be similar between the
two samples.
4. Audit Failure and Auditor Compensation
4.1 Difference in Auditor Compensation for Litigated Firms
Table 4 reports the results of t-tests for differences in means (medians) in auditor
compensation between firms that had an alleged accounting failure and a matched sample of similar
sized firms in the same industry. To study whether results could be different for larger versus
smaller firms, we sort our samples into three subsamples based on the value of total assets at year-
end, corresponding to the sample year-end for which the audit fee data was collected. Subsample 1
contains the smallest firms and Subsample 3 contains the largest firms. The asset size of the
smallest group is 137 million and the largest group is 30,599 million.
Consistent with the findings that larger firms require more audit services, we observe that
both the mean and median audit fees monotonically increases with size. Indeed, the largest asset
size category for the litigated firms has a mean of 3.34 million in total audit fees which is about
fifteen times larger than the average audit fees for the smallest firms. A similar pattern holds when
we compare nonaudit and total fees. Furthermore, the influence of size on audit and nonaudit fees
is also observed in the matched sample. Overall, for the sample of litigated firms, the mean
(median) total auditor compensation is 5.3 (1.3) million.
Panel A shows that the average audit fees are a little higher for the litigated firms than in the
matched sample for all but the smallest firms, however the difference is not statistically significant.
In fact, mean (median) total audit compensation between the samples is quite similar, 1.36 (.40)
million for the litigation sample and 1.31 (.51) million for the matched sample. The remaining four
panels reveal that the mean and median for nonaudit fees, total fees, nonaudit fees as a fraction of
total fees and as a fraction of audit fees, respectively, is somewhat higher for the firms involved in
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litigation, but the difference is not statistically significant. The results do not provide support for
the hypothesis that firms involved in an accounting impropriety had relatively higher audit
compensation.
Table 5 reports means and medians of audit and nonaudit fees by industries for which there
are at least 10 firms represented by the sample (Computers, Durable Manufacturers, Services,
Utilities). Panels B and C report total fees by industry and show that only the utility industry has
higher nonaudit fees and total fees that are weakly significant at a 10% level. However, for the
other three industries the fee (audit, nonaudit and total) differences are statistically insignificant.
Since only the utilities industry shows a weakly significant difference across the two samples, the
results provide little support for the hypothesis that the fees paid to a firm’s auditor impair auditor
independence or effectiveness.
In Table 6 we examine two sub-samples of the litigation sample. In particular, we analyze
the sub-sample of firms that subsequently filed for bankruptcy and firms that subsequently restated
earnings. Our results reveal no significant difference between the litigation firms and the matched
sample firms. Panel A reveals that the 16 firms in the litigation sample that subsequently went
bankrupt did not pay their auditors more relative to the matched sample. Interestingly, the mean
nonaudit fees for the litigation sample (2.2 million) is almost double that of the matched sample (1.2
million), however the difference is not significant.
Firms that report financial statements that are later determined to be inaccurate or fraudulent
oftentimes are required to restate earnings. A report prepared by the U.S. General Accounting
Office (GAO) found that 10 percent of publicly traded companies restated financial statements
because of accounting irregularities from January 1997 to June 2002. 12 "In a number of the
restating companies we identified, corporate management, boards of directors, and auditors failed in
15
their roles, as have securities analysts and credit rating agencies that did not identify problems
before investors and creditors lost billions of dollars," the study said.
However, Panel B shows that the mean/median difference between the fees from the
litigated sample and the matched sample are not significantly different for any fee component. The
mean (median) audit compensation between the samples is quite similar, 1.4 (.56) million for the
litigation sample and 1.3 (.65) million for the matched sample. The mean nonaudit compensation
between the samples is larger for the litigation sample but the median is larger for the matched
sample.
However, not all restatements necessarily represent serious misstatements. GAAP do not
always provide a uniquely correct answer on accounting treatment, nor would a rigid system of
rules be always consistent with the objectives underlying GAAP. As the importance of intangibles
and complexity of businesses grows, the scope for ambiguities in GAAP grows as well. Moreover,
after high-profile audit failures in the Enron and other cases, auditors and firms may well be
restating results in an effort to be more conservative in the current environment. Therefore, it is not
necessarily the case that all restatements represent significant audit failures. In an attempt to
quantify the severity of the audit failure we calculated change in value of the firm’s common equity
from the day with the highest stock price in the class period to the day after the class period. Firms
with the greatest decline in stock price are assumed to represent the most severe audit failures in
market’s judgment.
4.2 Severity of the Alleged Audit Failure
Our sample of litigation firms are those in which audit failure has been alleged, not proven.
In fact, many shareholder class actions are dismissed by courts before any violation is proven.
Almost all of the rest are settled out of court. Clearly, class action lawsuits are filed in many cases
even when no audit failure has occurred. To improve the signal to noise ratio for our proxy, we sort
our sample of litigation firms based on the magnitude of the stock price decline between the highest
stock price during the class period and the end of the class period (which is usually when
“corrective disclosure” is made). The interpretation of our proxy for “audit failure” could be
confounded by the issue that class action laws may provide incentives to sue firms with negative
abnormal returns preceding the class period13. It may be the case that a large decline in stock price
leads to the initiation of a lawsuit. However, given this possible limitation, we believe our proxy
does do a good job capturing the most severe audit failures in market’s judgment.
Table 7 reports the results for a third of our firms with the largest decline in market value,
the middle third and the one’s with the least decline in market value of their stock. The group of
firms with the highest market reaction lost on average 81% of their value while the firms with the
lowest market reaction lost 25%. Our findings in Panel A indicate that, for firms with the most
severe audit failures, audit fees are no different between the litigated firms and their matched
sample. However, the litigated firms have significantly higher nonaudit fees. The differences in
nonaudit fees measured as a fraction of total fees and as normalized by audit fees, are higher for the
litigation subsample, but the p-values for the difference would make it significant at the 10% level
in one-tailed test only. The mean (median) difference between the fees from the litigated sample
and the matched sample is 10.7% (10.2%) and 173.4% (73.1%) for the fraction of nonaudit fees to
total and fraction of nonaudit fees to audit fees, respectively. The findings in Panel B and Panel C,
for the middle third and the least severe audit failures the test statistics show there are no
statistically significant differences for all fee components except in one case. The fraction of
October 2002 13 See Kellogg (1984)
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nonaudit fees to total fees for the least severe audit failure are statistically significant at a 10% level
but in the direction opposite to that suggested by the fee dependence argument.
4.3 Multivariate Analysis
In the appendix to this paper, we develop a model to explain the cross-sectional differences
in for the natural log of total fees, audit fees, nonaudit fees and two ratio measures of consulting
fees: the ratio of nonaudit fees to total fees and the ratio of nonaudit fees to audit fees. Several
determinants of fees paid to a firm’s auditor have been well documented in the academic literature.
Our model has similar explanatory power to other fee structure models used the prior literature14.
Our results are similar whether we use the litigation, matched or combined sample.15 The appendix
provides details on the empirical estimation and results of the model.
Table 8 presents the results from the cross-sectional regressions relating audit compensation
to an indicator variable equal to one if the firm is in the litigation sample and various control
variables. The litigation indicator dummy is the variable of interest used to test the conjecture that
firms involved in an audit failure paid relatively higher compensation to their auditors. We also
include an indicator variable equal to one if the firm restated earnings. The log of total assets, the
ratio of foreign income taxes to total sales and return on assets all significantly explain the level of
audit fees. However, our results indicate that, after controlling for other factors that may explain
fees, the difference in fees between the litigation sample and the matched sample are not
statistically different. Our variable of interest, the indicator variable for the litigation sample, is not
significant at explaining the level of audit, nonaudit, total fees or the ratio of consulting fees: the
ratio of nonaudit fees to total fees and the ratio of nonaudit fees to audit fees.
14 See for example: Craswell et al. (1995), Seetharaman et al. (2002), Firth (1997), Parkash and Venable (1993) 15 See Appendix, Tables A-1, A-2 & A-3
18
The results from Table 8 are not consistent with the hypothesis that auditors are overpaid
(audit and/or nonaudit) fees in order to overlook various GAAP rules and acquiesce to
management’s requests leading to lower quality financial statements. However, statistical inference
on the litigation indicator variable could be affected by multicollinearity. Multicollinearity could
exist if there is a large correlation between our indicator variable of interest and any of the control
variables. The largest correlations among the control variables are between the litigation indicator
and foreign tax to total sales ( -.12), the change indicator (+.12) and the acquisition indicator (+.11),
with all other correlations less than + .05.
Table 9 presents the results of the same cross-sectional regressions presented in Table 8, but
we limit the sample to the third of our firms with the largest decline in market value. Our results
indicate that for these firms with the most severe audit failures, the three measures of nonaudit fees
(Model 2, Model 4 and Model 5) are significantly different, at a 1% level, between the litigated
firms and their match. In contrast, there is no significant difference between the litigated and match
sample in explaining the cross-sectional variation in the log of audit fees.
The results (not presented) for the middle third and the least severe audit failures show no
significant difference between the two samples16. Taken together, the results from Table 9 are
consistent with the hypothesis the auditor’s independence may be compromised in their bid to
attract consulting business from their auditing clients. However, given the small size of our sub-
sample (66 firms) we can not make a conclusive argument.
5. Summary and Implications
Record number of audit failures during the recent past has prompted much debate in the popular
press, policy circles and in the US Congress about whether high auditor compensation, especially
for nonaudit work, may have led to lax auditing standards. We shed light on this question by
19
comparing auditor compensation for a set of firms in which accounting improprieties were alleged
in a shareholder class action lawsuit with a set of matched firms in the same industry and of similar
size. Our evidence suggests that auditors were not compensated differently for either their audit or
consulting services over the period in which their client was allegedly involved in an accounting
fraud. However, for the set of firms with the largest market reaction to the alleged fraud, the
nonaudit component of the total fees was significantly higher then comparable firms even after
controlling for other known determinants of auditor compensation.
While our analysis documents that nonaudit fees are indeed higher than normal in cases for
which there was a severe audit failure, this result should be interpreted with caution. There may be
perfectly valid business reasons for companies to use the auditors for consulting activities more than
similar sized firms in the same industry. Therefore, higher compensation for consulting activities
cannot be interpreted as evidence of lack of auditor independence. Any allegation of auditor
integrity being compromised can only be made based on analysis of facts and circumstances.
16 Results available upon request
20
References
Antle R., 1982, The auditor as an economic agent, Journal of Accounting Review 20, 503-527. Ashbaugh, H., R. LaFond, and B. Mayhew, 2002, Do Non-Audit Services Compromise Auditor Independence? Further Evidence, working paper, University of Wisconsin, Madison. Bajaj, M., S. Mazumdar, and A. Sarin, 2003, Securities Class Action Settlements: An Empirical Analysis, forthcoming Santa Clara Law Review. Beatty, R.P., 1989, Auditor reputation and the pricing of initial public offerings, The Accounting Review 64, 693-709. Beck, P.J., T.J. Frecka, and I. Solomon, 1988a, A model of the market for MAS and audit services: knowledge spillovers and auditor-auditee bonding, Journal of Accounting Literature 7, 50-64. Campbell, T.S. and W.A. Kracaw, 1980, Information Production, Market Signalling, and the Theory of Financial Intermediation. The Journal of Finance 35, 863-82. Craswell, A., J. Francis, S. Taylor, 1995, Auditor brand name reputations and industry specializations. Journal of Accounting and Economics 20, 297-312. Craswell, A., D. Stokes, and J. Laughton, 2002, Auditor independence and fee dependence, Journal of Accounting and Economics 33, 253-275. Datar, S.M., G.A. Feltham and J.S. Hughes, 1991, The role of audits and audit quality in valuing new issues, Journal of Accounting and Eoconomics 14, 1-39. DeAngelo, L.E., 1981, Auditor size and auditor quality, Journal of Accounting and Economics 3, 183-199. DeFond, M., K. Raghunandan, K.R. Subramanyam, 2002, Do non-audit service fees impair auditor independence? Evidence from going concern audit opinions, working paper, USC and Texas A&M. Francis, J., 1984, The effect of audit firm size on audit prices: A study of the Austrailian market, Journal of Accounting and Economics 6, 133-151. Francis, J. and D. Simon, 1987, A test of audit pricing in the small-client segment of the U.S. audit market, The Accounting Review 62, 145-157. Francis, J. and D. Stokes, 1986, Audit prices, product differentiation, and scale economies: Further evidence from the Australian audit market, Journal of Accounting Research 24, 383-393. Firth, M., 1997, The provision of non-audit services by accounting firms to their audit clients, Contemporary Accounting Research 14, 1-11.
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Frankel, R., Johnson, M. and Nelson K., 2002, The Relation between Auditors’ Fees for Nonaudit Services and Earnings Management, The Accounting Review, 77 Supplement, 71-105. Glezen, G.W. and J.A. Miller, 1985, An empirical investigation of stockholders reaction to disclosures required by ASR No. 250, Journal of Accounting Research 23, 859-870. Goldman, A. and B. Barlev, 1974, The auditor-firm conflict of interest: Its implications for independence, The Accounting Review, 707-18. Kellogg, R.L., 1984, Accounting Activities, Security Prices, and Class Action Lawsuits. Journal of Accounting & Economics, Vol. 6, Iss. 3, 185-204. Kinney, W., Z. Palmrose and S. Scholz, 2003, Auditor Independence and Non-audit services: What do Restatements Suggest?, working paper, University of Texas at Austin, University of Southern California, University of Kansas. Knapp, M., 1985, Audit conflict: an empirical study of the perceived ability of auditors to resist management pressure. The Accounting Review 60, 202-211. Leland, H.E. and D.H. Pyle., 1977, Information Assymetries, Financial Structure, and Financial Intermediation. The Journal of Finance 32, 371-88. Palmrose, Z.V., 1986, Audit fees and auditor size: Further evidence, Journal of Accounting Review 24, 97-110. Palmrose, Z.V., 1988, An analysis of auditor litigation and audit service quality, Journal of Accounting Review 63, 55-73. Palmrose, Z.V., 1997, Who got sued?, Journal of Accountancy 183, 67-69. Parkash, M., C. Venable, Auditee incentives for auditor independence: the case of non-audit services, The Accounting Review 68: 113-133. Reynolds, K., J. Francis, 2001, Does size matter? The influence of large clients on office-level auditor reporting decisions, Journal of Accounting and Economics 30, 375-400. Rubin, M.A., 1988, Municipal Audit Fee Determinants, The Accounting Review, 219-236. Scheiner, J.H. and J.E. Kiger, 1982, An empirical investigation of auditor involvement in non-audit services, Journal of Accounting Research 20, 482-496. Seetharaman, A., F. Gul and S. Lynn, 2002, Litigation risk and audit fees: evidence from UK firms cross-listed on US markets, Journal of Accounting and Economics 33, 91-115. Shockley, D., 1981, Perceptions of auditor’s independence: an empirical analysis, The Accounting Review 61, 785-800.
Simunic, D., 1980, The pricing of audit services: theory and evidence, Journal of Accounting Research 18, 161-190. Simunic, D., 1984, Auditing, consulting, and auditor independence, Journal of Accounting Research 22, 679-702. Simunic, D. and M. Stein, 1996, The impact of litigation risk on audit pricing: a review of the economics and the evidence, Auditing: A Journal of Practice and Theory 15, 119-134. Teoh, S.H., I. Welch, ad T.J. Wong., 1993, Perceived auditor quality and the earnings response coefficient, The Accounting Review 68, 246-66. Watts, R., J. Zimmerman, 1983, Agency problems, auditing and the theory of the firm, Journal of Law and Economics 26-4, 613-633. Watts, R., J. Zimmerman, 1986, Positive Accounting Theory, Prentice Hall, Englewood Cliffs, New Jersey. Wright, A., 1983, The impact of CPA-firm size on auditor disclosure preferences, The Accounting Review 58, 621-32.
23
Table 1Impact of Compensation Structure on Auditor Independence
"No" indicates no relation and blanks indicates no tests were performed.
Author Proxy for Independence Audit Fees
Consulting Fees
Total Fees
Consulting Fees/Total
Fees
Consulting Fees/ Audit
Fees
Audit Fees/Total
Fees
Alternative Proxy for the Economic Dependence of the Auditor to the Audite*
Craswell, Stokes and Laughton (2002)1
Propensity to qualify the audit No No No
Francis and Reynolds (2001)2 Level of discretionary accruals - -
Level of total accruals -
Propensity to issue a going concern audit opinion
+
DeFond, Raghunandan and Subramanyam (2002)
Propensity to issue a going concern audit opinion
+ + No
Frankel, Johnson and Nelsen (2002)3
Firm just meets or beats the consensus analyst forecast
+ +
Firm reports a small increase in earnings relative to the prior year
- -
Firm has income increasing discretionary accruals
+ +
Parkash and Venable (1993) Firms with relatively higher perceived agency costs (lower levels of management ownership, lower levels of outside investment concentration, higher levels of debt) are assumed to require more independent audits.
-
* Alternative Proxy for economic dependence:1. The observation's audit fees divided by (1) total office audit and consulting fees (2) total national audit and consulting fees.2. The observation's sales divided by the sum of sales of each pulicly-listed company audited by the office.3. Percentile rank, by auditor, of the amount of nonaudit fees disclosed by each firm.
Table 2Characteristics of Allegation
Number of Firms
Panel A: Nature of the Alleged Accounting ImproprietyRevenue recognition 48Asset impairment 12Debt and/or off balance sheet disclosures 9Expense recognition 6Failure to properly disclose risk 6Accounts Receivable 5Failure to disclose a contingent liability 3Improper accounting 3Multiple - allegations 3Failure to properly disclose an accounting change 2Accounting fraud 2Overstated assets and earnings 2Reserve accounting 2
Panel B: Restatement of earningsRestated earnings 54No restatement of earnings 49
Panel C: BankruptcyFirms that subsequently filed for Bankruptcy 16No Bankruptcy filing 87
Sample consists of 103 firms alleged to have been involved in an accounting impropriety.
Table 3Descriptive Statistics
Litigation Sample Matched SampleMean Median Minimum Maximum Mean Median Minimum Maximum
Total Assets 10,713.52 878.74 0.25 284,421.00 10,696.39 876.69 0.25 303,100.00
Long Term Debt / Total Assets 0.23 0.20 - 2.20 0.23 0.19 - 0.79
Market -to- Book 1.69 0.86 0.03 10.55 1.87 0.72 0.01 19.07 Indicator equal to 1 if Big 5 auditor, otherwise 0 0.95 0.95 Indicator variable equal to one if attempted to acquire 50% of another firm, otherwise zero 0.58 0.47 Indicator equal to 1 if auditor change from previous year, otherwise 0 0.07 * 0.02
Frequency by Industry Mining & Construction 1 Food 1 Textiles, Printing & Publishing 4
* indicates significant differences between our sample and the matched sample at a 10% level.
The litigation sample consists of 100 firms alleged to have been involved in an accounting impropriety. The matched sample consists of 100 firms matched by SIC and total assets to the litigated firms. Financial variables are obtained from COMPUSTAT. Data on auditor compensation are obtained from proxy statements. Data on acquisition activity are obtained from SDC. All dollar values are expressed in millions.
Table 4
Fee Structure Catagorized by Size
Firms Involved in Litigation Matched Sample DifferenceMean Median Mean Median Mean Median
Panel A: Audit Fees Ranked by Total AssetsSmallest 220,346 171,500 225,442 159,000 (5,100) 18,700
The litigation sample consists of 100 firms alleged to have been involved in an accounting impropriety. The matched sample consists of 100 firms matched by SIC and total assets to the litigated firms. Financial variable are obtained from COMPUSTAT. Data on auditor compensation are obtained from proxy statements. The sample firms are ranked according to their asset size and placed in three groups. The asset size of the smallest group is 137 million and the largest group is 30,599 million.
Table 5
Fee Structure Catagorized by Industry
Firms Involved in Litigation Matched Sample Difference
* indicates significant differences between our sample and the matched sample at a 10% level.
The litigation sample consists of 100 firms alleged to have been involved in an accounting impropriety. The matched sample consists of 100 firms matched by SIC and total assets to the litigated firms. Financial variable are obtained from COMPUSTAT. Data on auditor compensation are obtained from proxy statements. SIC codes correspond to industries as follows: Durable Manufacturers (3000-3999, excluding 3570-3579 and 3670-3679), Utilities (4900-4999), Services (7000-8999, excludes 7370-7379) and Computers (7370-7379,3570-3579,3670-3679).
Table 6
Fee Structure for Firms that Restated Earnings/ Filed for Bankruptcy
Firms Involved in Litigation Matched Sample
Difference between the fees from the litigated sample and the
matched sampleMean Median Mean Median Mean Median
Panel A: Fees for firms that subsequently filed for BankruptcyTotal Fees 2,911,751 927,250 1,781,902 731,875 1,129,850 (220) Audit Fees 690,428 325,000 628,345 235,875 62,083 32,571
Nonaudit Fees 2,221,324 385,500 1,153,557 287,313 1,067,770 (46,780) Fraction of Nonaudit Fees to Total Fees 49.5% 48.4% 52.7% 56.7% -3.2% 0.6%Fraction of Nonaudit Fees to Audit Fees 282.1% 93.8% 168.1% 131.7% 114.0% 2.7%
Non-Audit Fees 4,246,830 794,250 3,027,496 1,192,000 1,219,335 71,401 Fraction of Non-audit Fees to Total Fees 58.7% 59.4% 55.8% 59.5% 3.0% 2.7%Fraction of Nonaudit Fees to Audit Fees 263.3% 146.4% 199.7% 147.2% 63.6% 17.4%
Panel A consists of the 16 litigation firms who subsequently filed for bankruptcy and Panel B consists of the 54 litigation firms who subsequently restated earnings. Data on auditor compensation are obtained from proxy statements.
Table 7
Total Fee Structure Catagorized By Serverity of the Audit Failure
Firms Involved in Litigation Matched Sample
Difference between the fees from the litigated sample and the
Non-Audit Fees 6,800,464 1,309,000 6,965,354 2,197,000 (164,890) (64,600) Fraction of Non-audit Fees to Total Fees 57.4% 62.3% 64.6% 65.5% -7.2% * -4.2% *Fraction of Non-audit Fees to Audit Fees 209.5% 165.4% 271.4% 190.3% -62.0% -75.4%
* indicates significant differences between our sample and the matched sample at a 10% level.** indicates significant differences between our sample and the matched sample at a 5% level.
The litigation sample consists of 100 firms alleged to have been involved in an accounting impropriety. The matched sample consists of 100 firms matched by SIC and total assets to the litigated firms. The severity of the audit failure was calculated as the market reaction to the alleged accounting impropriety. The group of firms with the highest market reaction lost 81% of their value while the firms with the lowest market reaction lost 25% of their value during the period of the alleged impropriety. Data on auditor compensation are obtained from proxy statements.
Panel A: Audit Fees by max/min change in price during the class period/after the class period (1/3 of sample with the most severe audit failure)
Panel B:Audit fees by max/min change in price during the class period/after the class period (middle 1/3 of the sample sorted by severity of audit failure)
Panel C: Audit Fees by max/min change in price during the class period/after the class period (1/3 of sample with the least severe audit failure)
Cross-Sectional Regressions Relating Auditor Compensation to Firm Attributes
Indicator equal to 1 if Big 5 auditor, otherwise 0 -0.099 -0.323 -0.272 0.065 -0.649
0.46 0.14 0.18 0.37 0.46Indicator equal to 1 if auditor change from previous year, otherwise 0 0.066 0.095 0.190 -0.160 0.873
0.62 0.66 0.34 0.02 0.32
Adj. R2 0.60 0.60 0.67 0.21 0.08
Coefficient estimates of ordinary least square regressions relating auditor compensation to an indicator variable equal to one if the firm is in the sample of litigation firms zero otherwise and various firm specifice characteristics. The sample consists of 200 firms. Financial variable are obtained from COMPUSTAT. Data on auditor compensation are obtained from proxy statements. Data on acquisition activity are obtained from SDC. p-values are reported below the coefficient estimate.
Indicator equal to 1 if Big 5 auditor, otherwise 0 -0.216 -0.045 -0.131 0.204 0.634
0.25 0.86 0.62 0.08 0.72Indicator equal to 1 if auditor change from previous year, otherwise 0 0.152 -0.634 -0.285 -0.518 -2.742
0.56 0.09 0.44 0.00 0.27
Adj. R2 0.49 0.46 0.56 0.23 0.00
Coefficient estimates of ordinary least square regressions relating auditor compensation to an indicator variable equal to one if the firm is in the sample of litigation firms zero otherwise and various firm specifice characteristics. The sample consists of 66 firms. Financial variable are obtained from COMPUSTAT. Data on auditor compensation are obtained from proxy statements. Data on acquisition activity are obtained from SDC. p-values are reported below the coefficient estimate.
Cross-Sectional Regressions Relating Fees Billed By Auditors to Firm Attributes for the Set of Firms with the Most Severe Audit Failure
Appendix: Determinants of Auditor Compensation
In this appendix, we develop a model to explain the cross-sectional differences in the
auditors compensation, specifically, the total fees, audit fees, the nonaudit fees, the ratio of nonaudit
fees to total fees and the ratio of nonaudit fees to total fees across firms. In particular, we use a
multivariate regression approach, in which we utilize known determinants of auditor compensation
as independent variables, in addition to an indicator variable equal to one if the firm is in the
litigation sample and to see if this variable is significant.
A. Fee Structure Model
The determinants of fees paid to a firm’s auditor have been well documented in the
academic literature. We rely on Craswell et al. (1995) and Seetharaman et al. (2002) to develop a
model that explains the cross-sectional variation in audit fees. Similarly, we examine Firth (1997)
and Parkash and Venable (1993) to develop a model that explains the cross-sectional variation in
nonaudit fees. These studies provide evidence that several factors contribute to the purchase of both
audit and nonaudit service including auditee size, auditor-auditee risk sharing and audit complexity.
Firm Size:
Seetharaman et al. find evidence consistent with the hypothesis that above-average litigation
risk motivates the auditors to (1) increase effort in a defense against the likelihood of future
litigation and/or (2) charge a premium to cover possible future litigation losses. This is consistent
with the theory underlying Simunic (1980) and Simunic and Stein (1996) that audit fees reflect risk
differences across liability regimes. Auditors are expected to charge a fee that covers the cost of the
audit plus the expected value of possible future loses associated litigation. Large firms may
represent potential “deep pockets” and be a more attractive target for litigation. Consequently, we
control for auditee size by including the log of total assets. Simunic (1980) provides evidence that
24
auditor lawsuits typically involve a problem with asset valuation, thus we use total assets to control
for size instead of revenue or market value. Prior studies have shown auditee size to be statistically
and economically significant at explaining cross-sectional variations in fees. We expect the
coefficient on the natural log of total assets to be positive.
Audit Complexity:
Consistent with prior research, we would expect audit complexity to be positively related to
the amount of audit and nonaudit fees. We control for cross sectional differences in audit
complexity using the ratio of the absolute value of foreign tax to total sales and an indicator
variable, which is set equal to one if the firm tried to acquire more than 50% of another firm during
the sample period. We expect total audit hours to increase with the complexity of the audit, and
therefore audit fees. In the same way, as audit complexity increases we expect firms to benefit
more from consulting services. For example, some of the firms in our sample disclosed the type of
nonaudit services provided by the auditor. Firms appear to provide different mixes of nonaudit
services to clients, however tax consulting and preparation appears to be the most common. Other
prominent service lines include audit related services (accounting advice), review of financial
statement and mergers and acquisition consulting service. Both components of fee structure should
increase as audit complexity increases, thus we predict the signs on these two variables to be
positive.17
Debt Ratio:
Palmrose (1997) shows that auditor litigation often involves financial distressed clients.
Since there is evidence that audit fees are litigation risk adjusted, we predict an inverse relationship
17The model was also estimated with alternative proxies for audit complexity: Herfindahl Index for the amount of sales in each operating segment and geographic segment, the square root of the number of operating segments for the firm, the square root of the number of acquisitions of the firm to proxy for audit complexity. These variables for audit complexity are significantly correlated with FTAX and ACQ, thus the results are consistent with those reported in Table 9.
25
between audit fees and the probability of financial failure18. We use the ratio of long-term debt to
total assets and the return on assets to proxy for cross sectional differences in financial condition. It
is difficult to predict financial failure but we use excessive leverage and poor profitability to proxy
for this probability19. Given the inverse relationship prediction, we expect the coefficient on ratio of
long term debt to total assets to be negative and the coefficient on return on equity to be positive.
Similar arguments can be made for the relationship between consulting fees and the probability of
financial failure.
Growth:
The ratio of the market value of equity to the book value of equity measures the firm’s
future investment opportunities. The higher the ratio, the greater the value of growth opportunities.
As a result, we include this variable to control for the effect that rapidly growing firms may demand
more audit and consulting services.
Auditor Reputation:
Prior research has documented that a brand name price premium exists for Big Five auditors
(Francis and Simon 1988, Francis 1984, Francis and Stokes 1987, Palmrose 1986). Therefore, we
include an indicator variable equal to one if the firm employs a Big 5 auditor (Arthur Andersen,
PriceWaterhouseCoopers, Ernst & Young, KPMG, Deloitte & Touche) and zero otherwise. We
expect the coefficient on this indicator variable to be positively associated with audit fees, reflecting
the fact that larger audit firms charge a premium. Similarly, since Big 5 audit firms are larger and
may be more able to provide nonaudit services, we expect a positive association between the Big 5
auditor indicator variable and nonaudit fees.
Change in Auditor:
18 See Seetharaman et al. (2002)
26
We include an indicator variable equal to one if the firm changed auditors from the previous
year for two reasons. DeAngelo’s (1981) low balling model predicts a differential pricing of new
audit engagements. Simon and Francis (1988) find for a large sample of firms changing auditors
there is evidence of a substantial audit fee discount in initial year. Second, when there has been a
change in auditors during the year, fees paid to both the predecessor and successor auditor are not
disclosed. The SEC rules only require the fee disclosure for the accountant who renders an audit
opinion on the most recent year's financial statements. As a result, we include this variable to
control for a potential “low ball” effect or the possibility that some audit fees billed by a
predecessor auditor will not be disclosed. In this case, only a portion of the firm’s total expenditure
on audit fees for the fiscal year end will be reflected in the disclosure. As a result, we predict a
negative association between this variable and both audit and nonaudit fees.
We estimate the following OLS regressions:
Feen= bo + b1[indicator equal to one if match sample] + b2[log(total assets)] + b3[absolute value of
The error term, υ, is assumed to have the normal OLS regression properties.
Fee1 = Log( Total Fees)
Fee2 = Log (Audit Fees)
Fee3 = Log (Nonaudit Fees)
19 The model was also estimated with alternative proxies for litigation risk/financial condition: the current ratio, quick ratio, an indicator variable for an operating loss in the past 3 years, the Altman Z-score. These results are generally consistent with those reported in Table 9.
27
Fee4 = Nonaudit Fees/Total Fees
Fee5 = Nonaudit Fees/Audit Fees
The SEC and the popular press seem to be concerned about how the provision of nonaudit
service creates incentives for the auditor to reduce independence. DeAngelo (1981) argues that
audit reports may be compromised due to market power exercised by audit clients, thus high total
fees may threaten auditor independence. As a result, the economic bond between the auditor and
the client may be affected by not only nonaudit fees but also total fees billed by the auditor.
Therefore, we examine the audit fees (Fee2) and nonaudit fees (Fee3) in isolation and also total fees
billed by the auditor (Fee1). Because the fee data (total, audit, nonaudit fees billed) are not normally
distributed, we transform them by adding one and taking their natural log.
In 1978, the SEC adopted Accounting Series Release (ASR) No. 250, which required firms
to disclose total nonaudit services as a percentage of total audit fees. As a result, prior research uses
the ratio of nonaudit fees to total fees as a measure of nonaudit services20. Ashbaugh et al. (2002)
argue that fee levels lead to a more powerful test of independence (over ratios) because the ratio of
nonaudit fees to total fees does not necessarily capture the economic bond between the client and
the audit firm. For example, the least amount of audit fees billed by an auditor in our sample is
$46,000 and this variable is 34.8% for that firm. For this firm the ratio is reasonably high, however
the total fees billed are quite low and may be economically insignificant to the audit firm. Despite
its weakness as an independent variable, we still estimate the model using the fraction of nonaudit
fees as a percentage of total fees (audit fees), Fee4 (Fee5) as our independent variable for sake of
comparison with the prior literature.
The parameter estimates of our OLS regression results for the sample of litigation firms are
reported in Table A-1. (Please provide Table A-1, which has all of the independent variables,
28
29
except the litigation dummy.) Our model (with industry variables) explains 67% of Total Fees,
62% of Audit Fees, 60% of Nonaudit Fees and 21% of the ratio of nonaudit fees to total fees. The
relatively lower explanatory power for two models with a measure of nonaudit fee as the dependent
variable, Fee 3 and Fee 4, is indicative of the fact that firms have alternatives when it comes to
consulting services, they do not need to purchase nonaudit services from their auditor. Our models
without industry variables have similar explanatory power to the models in Craswell et al. (1995),
and Seetharaman et al. (2002).
Consistent with prior models, we find that firms with greater total assets and lower return on
assets purchase more services from their auditor (both audit and nonaudit services). In every case
these relations are significant at the 5% level, except for return on assets for Model 4. The proxies
for audit complexity (the ratio of the absolute value of foreign tax to total assets and an acquisition
indicator variable) have the predicted sign, however they are not significant across models. Foreign
tax to total sales is significantly positive for explaining audit-fees but not nonaudit fees. The
acquisition indicator variable is significant at explaining the level of nonaudit service (Model 3 and
4) but not audit services. The ratio of long-term debt to total assets is negative but not significant.
The Big 5 indicator variable and the auditor change indicator variable only have the predicted sign
for Model 4, however they are not significant across models. High multicolinearity between these
variables and the size variable may explain the reason they do not have the predicted sign.
20 Scheiner and Kiger (1982), Gezen and Millar (1985), Parkash and Venable (1993), Firth (1997), Frankel et al. (2002)
Table A-1
Cross-Sectional Regressions Relating Fees Billed By Auditors to Firm Attributes
Indicator equal to 1 if Big 5 auditor, otherwise 0 -0.107 -0.199 -0.133 0.066 -0.044
0.62 0.58 0.70 0.56 0.98Indicator equal to 1 if auditor change from previous year, otherwise 0 0.036 0.085 0.204 -0.188 1.355
0.83 0.76 0.43 0.03 0.28
Adj. R2 0.57 0.54 0.61 0.20 0.02
Coefficient estimates of ordinary least square regressions relating auditor compensation to various firm specific characteristics. The sample consists of 100 firms alleged to have been involved in an accounting impropriety. Financial variable are obtained from COMPUSTAT. Data on auditor compensation are obtained from proxy statements. Data on acquisition activity are obtained from SDC. p-values are reported below the coefficient estimate.
Table A-2
Cross-Sectional Regressions Relating Fees Billed By Auditors to Firm Attributes
Indicator equal to 1 if Big 5 auditor, otherwise 0 -0.043 -0.363 -0.315 0.060 -1.156
0.80 0.16 0.19 0.53 0.19Indicator equal to 1 if auditor change from previous year, otherwise 0 -0.003 -0.063 -0.065 -0.097 -0.762
0.99 0.87 0.85 0.50 0.56
Adj. R2 0.67 0.69 0.75 0.21 0.18
Coefficient estimates of ordinary least square regressions relating auditor compensation to various firm specific characteristics. The sample consists of 100 firms. Financial variable are obtained from COMPUSTAT. Data on auditor compensation are obtained from proxy statements. Data on acquisition activity are obtained from SDC. p-values are reported below the coefficient estimate.
Table A-3
Cross-Sectional Regressions Relating Fees Billed By Auditors to Firm Attributes
Indicator equal to 1 if Big 5 auditor, otherwise 0 -0.098 -0.321 -0.271 0.065 -0.665
0.46 0.14 0.18 0.37 0.45Indicator equal to 1 if auditor change from previous year, otherwise 0 0.066 0.099 0.193 -0.158 0.966
0.62 0.64 0.33 0.02 0.26
Adj. R2 0.61 0.60 0.67 0.21 0.09
Coefficient estimates of ordinary least square regressions relating auditor compensation to various firm specific characteristics. The sample consists of 200 firms. Financial variable are obtained from COMPUSTAT. Data on auditor compensation are obtained from proxy statements. Data on acquisition activity are obtained from SDC. p-values are reported below the coefficient estimate.
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