Auditing: A Journal of Practice and Theory (Forthcoming, 2007) AUDITOR INDEPENDENCE : EVIDENCE ON THE JOINT EFFECTS OF AUDITOR TENURE AND NON-AUDIT FEES Ferdinand A Gul The Hong Kong Polytechnic University School of Accounting & Finance Hung Hom Hong Kong Tel: 852 2766 7771 Fax: 852 2365 9303 Email: afgul@inet.polyu.edu.hk & Bikki Jaggi* Rutgers University School of Business Levin Building Piscataway-NJ 08850 Tel : 732-445-3539 Fax: 732-445-3201 Email: Jaggi@rbsmail.rutgers.edu & The Hong Kong Polytechnic University Hong Kong & Gopal Krishnan George Mason University School of Management, MSN 5F4 Fairfax, VA 22030 JANUARY, 2007 _ * Correspondence Author Acknowledgement: We gratefully acknowledge valuable comments from Yaw Mensah, Suresh Radhakrishnan, Lai Kam Wah, J.B Kim, Bin Srinidhi and workshop participants at Hong Kong Polytechnic University We also thank Anthony Ng and Angel Sung for their assistance in data collection and analyses Electronic copy available at: http://ssrn.com/abstract=984656 AUDITOR INDEPENDENCE: EVIDENCE ON THE JOINT EFFECTS OF AUDITOR TENURE AND NON-AUDIT FEES Abstract This study examines whether the impact of non-audit fees on auditor independence is contingent on auditor tenure The results, based on a sample of 4,720 U.S firms for the years 2000 and 2001, show that there is a positive association between non-audit fees and positive discretionary current accruals, a proxy for auditor independence, for firms with short auditor tenure of not more than three years These findings suggest that non-audit fees may impair auditor independence when auditor tenure is short and not when auditor tenure is long Furthermore, exploratory analyses show that the positive association between non-audit fees and earnings management for firms with short auditor tenure is significant for small clients but not for large clients Taken together, these results suggest that the association between non-audit fees and auditor independence is contingent upon auditor tenure, and that high nonaudit fees have a negative impact on auditor independence when audit tenure is short and client firm size is small Keywords: Auditor independence, non-audit fees, discretionary accruals, auditor tenure Data availability: Data are available from sources identified in the paper Electronic copy available at: http://ssrn.com/abstract=984656 AUDITOR INDEPENDENCE: EVIDENCE ON THE JOINT EFFECTS OF AUDITOR TENURE AND NON-AUDIT FEES I INTRODUCTION Do non-audit services impair auditors’ independence? This question has attracted attention from regulators, researchers and the financial press In response to the concerns related to non-audit services, the U.S Congress passed the Sarbanes-Oxley Act (SOX) in 2002, which prohibits auditors from providing to their clients certain types of non-audit services To comply with SOX, the Securities and Exchange Commission (SEC) has revised the rules on auditor independence, which now limit the circumstances and remuneration for providing certain types of non-audit services (SEC 2001) In addition, the revised rules require that the client firm shall disclose all fees paid to an audit firm by separate categories, including services related to auditing, financial information system design and implementation, and others, so that investors are fully informed about the types and magnitudes of these fees The SOX and the SEC’s regulations are apparently based on the assumption that certain types of non-audit services provided by audit firms are likely to impair auditor independence, thereby reducing audit quality Several studies have examined whether there is an association between non-audit fees paid to audit firms and auditor independence.1 Of particular interest to us in this paper are the studies that examine the impact of non-audit fees on discretionary accruals, which are used as a proxy for earnings management (e.g., Francis and Ke 2002; Frankel et al 2002; DeFond et al 2002; Ashbaugh et al 2003; Chung and Kallapur 2003; Larcker and Richardson 2004) Findings of these studies are mixed Frankel et al (2002) (hereafter FJN) document that nonaudit fees are positively associated with the magnitude of discretionary accruals, suggesting that high non-audit fees are likely to impair auditor independence However, Ashbaugh et al (2003) (hereafter ALM) use a more refined measure of discretionary accruals and not find a statistically significant association between non-audit fees and positive discretionary accruals They conclude that there is no systematic evidence to support FJN’s findings that higher non-audit fees impair auditor independence Chung and Kallapur (2003) use a different non-audit fees metric and also find no support for FJN’s findings Thus, despite concerns by regulators and the financial press, there is no clear evidence that higher non-audit fees will negatively affect auditor independence Another stream of research in the auditing literature focuses on the association between auditor independence and auditor tenure (e.g., Dopuch et al 2001; Geiger and Raghunandan 2002; Johnson et al 2002; Myers et al 2003) The importance of auditor tenure is also reflected in Section 203 of the SOX, which requires a five-year rotation cycle for the external lead or reviewing audit partner A recent report of the Commission on Public Trust and Private Enterprise appointed by the Conference Board also supports the idea of auditor rotation (Conference Board 2005) However, empirical evidence to date shows that longer auditor tenure rather than shorter auditor tenure is associated with higher quality earnings (Geiger and Raghunandan 2002; Myers et al 2003) In this study, we integrate the research on auditor tenure with the research on nonaudit fees/auditor independence and argue that an investigation of the relation between audit/non-audit fees and auditor independence without consideration of auditor tenure is likely to provide an incomplete picture We, therefore, include auditor tenure in the analyses of the association between non-audit fees and auditor independence and evaluate whether auditor tenure affects this association We conjecture that non-audit fees are likely to affect auditor independence for firms with short auditor tenure, but not for firms with long auditor tenure We argue that auditors with short tenure are likely to place more emphasis on profits (quasi rents) than reputation protection (Johnson et al 2002) Furthermore, the competitive practice of low-balling could cause the auditor to be more accommodating in the early years of the engagement (Geiger and Raghunandan 2002) Under these circumstances, higher non-audit fees are likely to have an adverse effect on auditor independence for firms with short auditor tenure We also argue that auditors with short tenure are likely to be relatively unfamiliar with the clients’ accounting and control systems, which would make it easier for the clients to manage their reported earnings Thus, these two factors are likely to contribute to the negative association between non-audit fees and auditor independence for firms with short auditor tenure On the other hand, auditors who have had a long relationship with their clients are likely to be more concerned about auditor reputation protection and are less likely to be influenced by nonaudit fees In addition, they are more likely to have client-specific knowledge, which would allow them to deter earnings management more effectively Consistent with earlier studies, we use performance-adjusted discretionary accruals or REDCA (a term used by ALM)2 as a proxy for earnings management on the assumption that independent auditors should strictly monitor discretionary accruals that may be used by the firm management to manipulate the reported earnings As discussed by ALM, the use of positive REDCA, i.e., income-increasing discretionary current accruals, is generally of major concern to investors because managers are more likely to adjust earnings upwards to meet market expectations or convert losses into small positive earnings (e.g Burgstahler and Dichev 1997) The use of negative REDCA (downward adjustment of reported earnings) is, however, considered to be conservative accounting, and investors are not likely to be too concerned about its use (see also Butler et al 2004) Thus, we focus on positive REDCA, but also conduct tests on the total sample as well as on the sub-sample of firms with negative discretionary accruals Following ALM, we use the log of audit fees, the log of non-audit fees, the log of total fees and the ratio of non-audit fees to audit fees as the metrics Consistent with the literature (e.g., Johnson et al 2002), we use the cut-off point of three years for splitting the sample into short and long auditor tenure In the sensitivity tests, we also use different cut-off points for splitting the sample into long and short auditor tenure Similar to ALM’s findings, the results using the total sample show that there is no significant association between non-audit fees and REDCA When we split the sample into positive and negative discretionary accruals and include auditor tenure in the analyses, the association between non-audit fees and earnings management becomes clearer For example, when we include a dummy variable for auditor tenure (1 for short tenure < =3years, otherwise) and interact this variable with non-audit fees in the positive discretionary accruals sample, we obtain a significant positive coefficient for the interaction term In other words, firms with high non-audit fees and short tenure are associated with higher positive discretionary accruals Similar results are obtained when separate tests are conducted for firms with long and short auditor tenure The results on the firms with negative discretionary accruals, however, show no significant association These findings thus indicate that there is an upward adjustment of reported earnings when non-audit fees are high and auditor tenure is short On the other hand, the results for firms with long auditor tenure show that there is no significant association between positive discretionary accruals and non-audit fees These findings suggest that auditor independence may be compromised when non-audit fees are high and auditor tenure is short In other words, our results show that the relation between non-audit fees and auditor independence is conditional on auditor tenure As an exploratory analysis, we examine whether the association between non-audit fees and discretionary accruals for firms with short auditor tenure differs between large and small client firms It has been argued in the literature that auditors of large firms are more likely to remain independent because of client visibility and reputation protection (e.g., Reynolds and Francis 2001; Larcker and Richardson 2004; Barton 2005) It is also possible that auditors may face bigger challenges early in their tenure when the client firm is small because these firms may have weak accounting systems Consequently, these small firms may purchase more non-audit services to improve their accounting systems Thus, in our exploratory analysis, we test whether there is comparatively higher earnings management in small firms when auditor tenure is short and non-audit fees are high Our findings show that there is a positive association between non-audit fees and positive discretionary accruals for relatively small firms with shorter auditor tenure Additional research, beyond the scope of the present study, is warranted to establish whether higher discretionary accruals in small firms are caused by higher non-audit fees or the weak accounting and internal control systems within client firms This study makes the following contributions to the existing literature on auditor independence First, the findings provide evidence that the association between non-audit fees and auditor independence depends on auditor tenure Second, the findings show that the concerns expressed by regulators and in the financial press regarding the role of non-audit fees on auditor independence are justified only when auditor tenure is short, but not when auditor tenure is long Third, the results support earlier findings that longer auditor tenure does not lead to reduced audit and financial reporting quality (e.g., Myers et al 2003) This finding thus suggests that the system of voluntary auditor rotation, which results in shorter auditor tenure, is linked to poorer audit quality when non-audit fees are large Fourth, the results suggest that client size is also likely to play a role in the linkage between non-audit fees, auditor tenure and auditor independence The remainder of the paper is organized as follows In part two, we develop a hypothesis for the study, and part three discusses the research methodology The results are discussed in part four, and conclusions are presented in part five II HYPOTHESIS Auditor Tenure, Non-Audit Fees and Auditor Independence Auditor independence has been the subject of considerable debate for some time, and it has been examined from the perspectives of both non-audit fees and auditor tenure The existing studies on the association between non-audit fees and auditor independence have evaluated whether higher non-audit fees create an economic bond between the auditor and the client, which enables the client firm to exert influence over the auditors’ decisions and make auditors less independent as non-audit fees increase.3 However, as pointed out earlier, the findings of empirical studies using discretionary accruals as a proxy for auditor independence provide conflicting evidence The impact of auditor tenure on auditor independence has also attracted attention from regulatory agencies, congressional bodies, the Conference Board, the popular press as well as academics (e.g., U.S Senate 1977; AICPA 1978; Wall Street Journal 1991; SEC 1994; Conference Board 2005) A recent report of the Commission appointed by the Conference Board states that “when there is confluence of circumstances that could put in question the audit firm’s independence, the Commission believes that audit committees should carefully consider rotation of audit firm (p 39)” In addition, the report illustrates the existence of certain circumstances that merit consideration of rotation, and recommends serious consideration of auditor rotation when the audit firm “has been employed for a substantial period of time, e.g over ten years” Auditor rotation is supported on the ground that longer auditor tenure leads to economic bonding between the auditor and client firms, which may result in familiarity and personal connections between the auditor and client firms Hence, auditors are more likely to compromise their independence as auditor tenure increases Auditor rotation is thus suggested as a way to enhance auditor independence on the assumption that it would enable auditors to resist management pressure and exercise greater objectivity (e.g., Brody and Moscove 1998) Similarly, Wolf et al (1999) argue that auditor independence and objectivity will be enhanced if audit firms relinquish their clients periodically There is, however, no empirical evidence to support the argument that longer auditor tenure is associated with lower auditor independence In contrast to the argument supporting shorter auditor tenure, the other school of thought suggests that threats to independence may be greatest during the first few years of an auditor-client relationship because the “recently acquired quasi-rents of incumbency may make new auditors more vulnerable to threats of dismissal in earlier years of auditor-client relationships” (Geiger and Raghunandan 2002, p.68) Apart from the independence argument, it is also suggested that short tenure is associated with lower audit quality because the auditor is unfamiliar with the client’s accounting system and firm characteristics (e.g., PriceWaterhouseCoopers 2002).4 Similar arguments are also evident from the discussion in the literature on audit failures, which suggest that audit failures occur almost three times more often when an audit firm performs its first or second audit of a given client (AICPA 1992) The findings of a recent study also provide support for this argument by documenting lower earnings quality for clients with shorter auditor tenure (Myers et al 2003) On balance, the evidence suggests that short auditor tenure is associated with lower earnings quality because the auditor lacks independence or is unfamiliar with the client’s accounting system and firm characteristics, or perhaps both.5 Based on the evidence related to the impact of short auditor tenure on earnings management, we conjecture that there will be a negative association between non-audit fees and auditor independence for firms with short auditor tenure The arguments below are presented in support of our conjecture Prior research suggests that auditor incentives are traded off between the auditor’s desire to protect firm reputation (brand name) and to maintain profits (quasi rents) from the auditor-client relationship (Citron and Taffler 1992; Johnson et al 2002) The desire to maintain profits or quasi rents from an existing client relationship in the early years of the engagement could cause the auditor to be more accommodating to the client Geiger and Raghunandan (2002) argue that auditors are willing to be more accommodating to the client in the early years of an audit, because they are influenced by their desire to limit their losses on the current engagement as a result of the competitive practice of low-balling and to be able to ensure continuity of the engagement Thus, it can be argued that a client would purchase non-audit services in the early years of an engagement and persuade the auditor not to conduct in-depth analyses which may uncover earnings management It is also possible that the auditor may face special audit problems earlier in the tenure because of unfamiliarity with the client’s business, and thus may have difficulty in detecting earnings management Based on these arguments, we conjecture that large non-audit fees combined with short auditor tenure are likely to be associated with higher earnings management On the other hand, an auditor with a relatively longer tenure and an established relationship with the client over a period of time is likely to place more emphasis on reputation protection than profit, and is less likely to be affected by high non-audit fees As a result of the long tenure, the auditor will have a better understanding of the client’s accounting system and be in a better position to detect earnings management Consequently, we argue that because of a combination of reputation protection and better understanding of the client’s accounting system, high nonaudit fees are unlikely to be associated with earnings management when auditor tenure is long We develop the following hypothesis to test the impact of auditor tenure on the association between auditor independence and non-audit fees: H1: Higher non-audit fees are associated with higher discretionary accruals when auditor tenure is short III RESEARCH METHODLOGY 10 Warfield, T., J Wild, and K Wild 1995 Managerial ownership, accounting choices and informativeness of earnings Journal of Accounting and Economics 20: 61-91 White, H A 1980 Heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity Econometrica 48: 817-838 Wolf, F.R., J.A Tackett, and G.A Claypool 1999 Audit disaster futures : Antidotes for the expectations gap? Managerial Auditing Journal 14(9): 468-478 Wright, P., S P Ferris, A Sarin, and V Awasthi 1996 Impact of corporate insider, blockholder, and institutional equity ownership on firm risk taking Academy of Management Journal 39(2): 441-463 29 Table Sample Firms by SIC code for years 2000 and 2001 N Agriculture (0100-0999) % Compustat (%) 0.0 0.4 52 1.1 2.6 Food (2000-2111) 105 2.2 2.3 Textiles and print/publishing (2200-2799) 278 5.9 4.9 Chemicals (2800-2824, 2840-2999) 117 2.5 2.5 Pharmaceuticals (2830-2836) 364 7.7 6.0 187 1248 261 4.0 26.4 5.5 4.4 22.6 7.2 Mining and Construction (1000-1999, excluding 1300-1399) Extractive (1300-1399, 2900-2999) Durable manufactures (3000-3999, excluding 3570-3579 and 3670-3679) Transportation (4000-4899) Utilities (4900-4999) 179 3.8 3.2 Retail (5000-5999) 552 11.7 11.1 Services (7000-8999, excluding 7370-7379) 460 9.8 11.9 Computers (3570-3579, 3670-3679, 7370-7379) 894 18.9 19.8 23 0.5 1.0 4720 100.0 100.0 Others Total 30 Table Descriptive Statistics of Variables Used in Discretionary Accruals Analysis Variable Panel A: Mean Std Mean Total sample (n=4720) REDCA -1.41% AUDFEE 0.59 NONAUDFEE 1.34 TOTALFEE 1.93 FEERATIO 48.19% TENURE 8.61 ASSETS 2595.83 BIG5 0.93 PRECURRACCL -0.05 MVE 3318.52 MERGEACQ 0.36 FINANCING 0.21 LEV 0.49 MVBV 2.98 LITIGATION 0.29 DLOSS 0.40 CFO 0.03 INST_HOLDING 41.91% YEARDUM 0.61 Panel B: Median Std Tenure 3 (n=1777) 11.42% 5.90% 16.52% 8.46% 4.62% 12.39% 0.41 0.18 0.69 0.53 0.20 1.23 1.12 0.18 5.00 1.12 0.19 4.10 1.53 0.39 5.47 1.65 0.41 5.12 46.82% 46.82% 23.66% 46.82% 47.57% 22.55% 2.63 3.00 0.65 9.64 8.00 4.79 1230.11 213.37 4179.66 2323.57 238.75 11281.63 0.85 1.00 0.36 0.94 1.00 0.24 -0.24 0.00 0.99 -0.05 0.00 0.46 1262.39 210.50 4841.26 2853.95 252.33 15307.43 0.36 0.00 0.48 0.34 0.00 0.47 0.25 0.00 0.43 0.22 0.00 0.41 0.49 0.42 0.48 0.47 0.44 0.32 5.63 2.04 43.62 2.87 1.98 13.23 0.31 0.00 0.46 0.30 0.00 0.46 0.44 0.00 0.50 0.36 0.00 0.48 -0.09 0.03 0.62 -0.01 0.04 0.26 34.71% 28.74% 26.20% 40.81% 38.53% 26.21% 0.42 0.00 0.49 0.57 1.00 0.49 31 REDCA = the discretionary current accruals measure controlling for performance by including the prior years’ ROA in the estimation of expected accruals PREDCA AUDFEE NONAUDFEE TOTALFEE FEERATIO TENURE ASSETS BIG5 PRECURRACCL = = = = = = = = = MVE MERGEACQ FINANCING = = = Positive REDCA audit fee in millions of dollars non-audit fee in millions of dollars sum of audit fee and non-audit fee non-audit fee divided by total fee number of years the auditor has been auditing the client firm total assets in millions of dollars if the firm is audited by Big 5, and otherwise last year’s total current accruals equal to net income before extraordinary items plus depreciation and amortization minus operating cash flows scaled by beginning of year total assets the firm’s market value of equity if the firm is engaged in a merger or acquisition, and otherwise if MERGEACQ is not equal to and any of the following conditions apply: long-term debt increased by 20 percent or more, number of shares outstanding increased by 10 percent or more after controlling for stock splits, and otherwise LEV MVBV LITIGATION = = = firm’s total assets less its book value divided by its total assets firm’s market-to-book ratio defined as its market value of equity divided by book values if the firm operates within a high-litigation industry, otherwise, where high-litigation industries are industries with SIC codes of 2833-2836, 3570-3577, 3600-3674, 5200-5961, 7370-7374 DLOSS CFO INST_HOLDING = = = YEARDUM = if the firm reports a negative net income for the year, and otherwise firm’s cash flow from operations scaled by beginning of the year total assets percentage of shares held by institutional owners if fiscal year is 2001, if fiscal year is 2000 32 Table Regression Results on the Association between Audit Fee Metrics and Discretionary Accruals (REDCA) on Total Sample for Years 2000 and 2001 LOGREDCA = α + β1 FEE + β BIG5 + β PRECURRACCL + β LNMVE + β MERGEACQ + β FINANCING + β LEV + β MVBE + β LITIGATION + β 10 DLOSS + β 11CFO + β 12 INST _ HOLDING + β 13 LOGTEN + β 14YEARDUM + ε Fee Metric (N=4720) Variable LAF INTERCEPT LAF LNAF LTOTALFEE FEERATIO BIG5 PRECURRACCL LNMVE MERGEACQ FINANCING LEV MVBV LITIGATION DLOSS CFO INST_HOLDING LOGTEN YEARDUM Adjusted R-sq -3.26** -0.11** LNAF -2.91** LTOTALFEE -3.09** FEERATIO -2.82** -0.02 -0.07** 0.03 -0.31** -0.01 0.08 0.13* 0.03 0.00 0.16** 0.41** -0.25** -0.35** -0.09** 0.04 0.11 0.02 -0.32** -0.03* 0.06 0.13** -0.03 0.00 0.19** 0.39** -0.27** -0.37** -0.10** 0.04 0.10 0.03 -0.32** -0.01 0.08 0.10** 0.01 0.00 0.18** 0.41** -0.26** -0.35** -0.10** 0.03 0.03 0.03 0.01 -0.32** -0.04** 0.05 0.13** -0.05 0.00 0.19** 0.39** -0.28** -0.38** -0.10** 0.04 0.10 ** Statistically significant at the