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Non-audit services and financial reporting quality: evidence from 1978 to 1980

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Abstract

We provide evidence on the long-standing concern about the potential conflicts of interest of auditors that provide clients with non-audit services using rarely explored non-audit services fee data from 1978 to 1980. In this setting, we find evidence of improved earnings quality when auditors provide non-audit services, especially those related to information services. This is consistent with better audit quality resulting from knowledge spillovers in the joint offering of audit and consulting services. Events related to the 1982 repeal of mandatory non-audit services disclosures are associated with a small positive stock price reaction, suggesting that the disclosure repeal has no adverse economic consequences. Furthermore, following the repeal we find no change in the earnings quality of client firms. In sum, our data suggest that non-audit services offered by audit firms can be associated with improved audit and reporting quality in client firms via auditors’ reputational incentives, synergies, and knowledge transfers.

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Notes

  1. Andersen Consulting was engaged in a bitter dispute with Arthur Andersen & Co., starting in 1997 and ending in a separation decision in August 2000. Other big auditors also parted ways with their consulting divisions in the early 2000s. Ernst and Young sold its consulting business to Cap Gemini in 2000. PwC sold its consulting business to IBM in 2002. And KPMG Consulting spun off to become Bearing Point in January 2000.

  2. In contrast Kinney et al. (2004) find that only 5 % of public firms bought any information system-related services from their auditors by the late 1990s.

  3. When “non-audit fees become large relative to audit fees, auditor independence may be at risk” (SEC 2000). Further, Kinney et al. (2004) conjecture that “regulators seem not to be concerned that audit fees might be too high or that the audit fee itself might establish economic dependence for the auditor,” citing former SEC Chief Accountant Lynn Turner’s statements on the effect of high audit fees.

  4. Using 2000–2001 data, the only evidence of a negative relation between non-audit services and earnings quality is shown by Frankel et al. (2002) and only for a few of several tests. Subsequent research has clarified the limited nature of the Frankel et al. (2002) findings (DeFond et al. 2002; Chung and Kallapur 2003; Ashbaugh et al. 2003). Also, Kinney et al. (2004) find a positive relation between tax consulting and earnings quality.

  5. According to Zeff (2003), in 1922, the American Institute of Accountants (precursor of the AICPA) banned promotion by accounting firms, and after that, marketing campaigns for new clients did not exist.

  6. As an example of the competitive pressure faced, the Association of Data Processing Service Organizations, whose members included IBM and Honeywell, contended that the accounting firms special monopoly status to conduct audits gave them an unfair advantage in the consulting business (Hayes 1979).

  7. Our sample firms comprise approximately 67 % of the market capitalization of the entire CRSP universe for the time period of the study.

  8. We convert the non-audit services/audit fee ratio to non-audit services/total fee ratio to maintain comparability with post-2000 data used in other papers.

  9. We also examine tax fees separately (discussed in the additional analysis section) since this type of service is used by the largest number of companies. However, tax services have not been considered as affecting independence by the SEC and have never been the subject of much controversy.

  10. As mentioned earlier, around 25 % of our sample firms obtain IS consulting from their auditors. In contrast, Kinney et al. (2004) find that only 5 % of companies received IS consulting from their auditors in the late 1990s.

  11. We considered but decided against conducting two other tests. First, DeFond et al. (2002) investigate associations between the incidence of qualified opinion in distressed firms and non-audit services. However, there are almost no distressed firms in our S&P 500 sample. Second, Kinney et al. (2004) examine the association between earnings restatements and non-audit services. Obtaining data on earnings restatements for our sample period is difficult.

  12. We cannot follow the Hribar and Collins (2002) recommendation of defining accruals as the difference between earnings and cash from operations because CFO disclosure was mandated after our sample period.

  13. Sensitivity analyses with signed discretionary accruals show there is no change in our inferences.

  14. As we use lagged NAS in all our subsequent tests, we remove observations that reflect an auditor change.

  15. All t-stats are based on standard errors that are clustered by firm. Throughout our discussion of the results, we use a level of 10 % or lower two-sided significance to identify statistically significant results.

  16. Note that we cannot conduct an event study around the release of proxy statements containing non-audit services fee data because the filing dates on the microfiche versions of proxy statements were unavailable in most cases. We also investigate the short-window abnormal returns surrounding the earnings announcement dates and find no association between earnings informativeness and the three measures of auditor independence.

  17. Kinney et al. (2004) find no significant relationship between IS consulting and restatements, but that result may be driven the small number of companies that receive IS services from auditors in their sample.

  18. Brown et al. (2010) object to estimating UXNAS from contemporaneous data (i.e., most of the independent variables in Eq. (6) are measured at time t). We estimated a version of Eq. (6) with independent variables lagged by a year (t − 1) and find results similar to those reported in the paper.

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Acknowledgments

We thank our respective schools for financial support. We thank an anonymous referee, Peter Easton (editor), Ray Ball, Phil Berger, Mark DeFond, Aiyesha Dey, Bill Kinney, Doug Skinner, Hun-Tong Tan, and workshop participants at Nanyang Technological University, the International Symposium on Audit Research conference at the University of Southern California, the 2008 American Accounting Association annual meeting, and the 2009 European Accounting Association Annual Congress for helpful comments. We are grateful to the staff at the University of Chicago Regenstein Library, Northwestern University Library, and the Chicago Public Library (Main Branch) for assisting in the use of their microfiche collections of proxy statements. We thank Mark Maffet for his excellent research assistance.

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  1. Nanyang Technological University, Singapore, Singapore

    Kevin Koh

  2. Goizueta Business School, Emory University, Atlanta, GA, USA

    Shiva Rajgopal

  3. Harvard Business School, Boston, MA, USA

    Suraj Srinivasan

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Correspondence to Suraj Srinivasan.

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Koh, K., Rajgopal, S. & Srinivasan, S. Non-audit services and financial reporting quality: evidence from 1978 to 1980. Rev Account Stud 18, 1–33 (2013). https://doi.org/10.1007/s11142-012-9187-6

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