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  • James L Fuehrmeyer
    An Empirical Analysis of Auditor Independence in the Banking...
    research summary posted March 19, 2013 by James L Fuehrmeyer, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 04.03 Non-Audit Services 
    Title:
    An Empirical Analysis of Auditor Independence in the Banking Industry
    Practical Implications:

    The results suggest that fees paid to auditors, even for non-audit services, can potentially threaten auditor independence, particularly among banks that are not subject to the same level of regulatory scrutiny as large banks.

    Citation:

    Kanagaretnam, K., G. V. Krishnan, and G. J. Lobo. 2010. An Empirical Analysis of Auditor Independence in the Banking Industry. The Accounting Review 85 (6): 2011-2046.

    Keywords:
    auditor independence; earnings management; auditor fees; bank loan
    Purpose of the Study:

    Auditor independence is vital to maintaining public confidence in capital markets and to the integrity of corporate financial statements. The objective of this study is to examine auditor independence in the banking industry.

    • The study provides evidence on the relation between fees paid to auditors of banks and the extent of earnings management via loan loss provisions (LLPs).
    • The study is timely and relevant given the recent banking crisis and that governments around the world are contemplating new banking regulations.
    • The research informs policymakers on the relationship that existed between fees paid to auditors and the extent of earnings management in banks prior to the current banking crisis.
    • Authors examine difference between large and small firms that face different levels of regulation. Small firms are not subject to regulation under the Federal Deposit Insurance Corporation Improvement Act (FICIA) of 1991.
    Design/Method/ Approach:

    The authors collected 1,740 bank-year observations over the years 2000–2006. The authors determine abnormal LLPs and examine the association between abnormal LLPs and unexplained total fees and unexplained non-audit fees. They then examine whether the association is different depending on whether the bank is small (total assets of less than $500 million or less than $1 billion, effective 2005, or non-accelerated filers under Section 404 of Sarbanes-Oxley Act, effective 2004) or large.

    Findings:
    • For large banks, there is no relationship between abnormal LLPs and unexplained total fees or unexplained non-audit fees.
    • For small banks, higher unexplained total fees and unexplained non-audit fees are positively associated with income-increasing earnings management through LLPs. Higher unexplained total fees and unexplained non-audit fees are negatively associated with income-decreasing earnings management through LLPs. These two results provide evidence that banks that pay higher audit fees engage in more earnings management.
  • The Auditing Section
    The Impact of Nonaudit Service Fee Levels on Investors’ P...
    research summary posted May 7, 2012 by The Auditing Section, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services 
    Title:
    The Impact of Nonaudit Service Fee Levels on Investors’ Perception of Auditor Independence
    Practical Implications:

    The results of this study are important to both investors and regulators.  For investors, the results may highlight that, despite the presence of non-audit fees, it is possible that the audit firm may be independent in fact.  For standard setters, the study sheds some light on how the public perception of the external auditor as an independent professional, given the levels of nonaudit fees, plays a vital role in the success of the financial markets even when the auditor is independent in fact.  The study also has implications to auditors and clients who might be motivated to change the levels of nonaudit services and/or fees given investors’ negative reactions to them. 

    Citation:

    Davis, S. M. and D. Hollie. 2008. The Impact of Nonaudit Service Fee Levels on Investors’ Perception of Auditor Independence. Behavioral Research in Accounting 20 (1): 31-44.

    Keywords:
    auditor independence; nonaudit fee ratios; disclosure; investor perception; market efficiency
    Purpose of the Study:

    Since the passage of the Sarbanes-Oxley Act of 2002 there has been a substantial increase in the level of scrutiny over auditor independence. Specifically, one of the provisions of the legislation prohibits audit firms from providing certain non-audit services to their audit clients. The main purpose of this provision is to increase investor perception of auditor independence by reducing the potential conflicts of interest between auditors and their clients.  Prior research on the impact of nonaudit services fees on the appearance of auditor independence has produced mixed findings.  However, prior research has not focused on the level of fee ratios (nonaudit fees to total fees).  The current study examines the effects of non-audit fee ratios on investor perception of auditor independence and on market behavior.  Below are the specific objectives that the authors address in their study: 

    • Examine the effect of various fee ratios (nonaudit fees to total fees) on investors’ assessment of auditor independence and market outcomes.
    • Examine whether investor perception of auditor independence differs as the fee ratio increases.
    • Examine whether investor’s pricing errors (i.e., the price paid less the stated value) increase as the fee ratio increases. 
    Design/Method/ Approach:

    The authors collected their evidence via an investor trading experiment involving 48 MBA students.  Participants are assigned the role of an investor and are provided with an auditor’s report detailing an estimate of the value of an asset in question, as well as a ratio of their non-audit fees compared to total audit fees.  The nonaudit fee ratio varies across participants and is either 0, 25, 50, or 75 percent.  Investors read a statement explaining SEC concerns about non-audit fees and then make a judgment about their belief that the auditor is biased/unbiased and an indication of their confidence level in this judgment. Investors then provide a best estimate of their belief of the asset value and begin trading shares of the company. Data collection was performed prior to 2008.

    Findings:
    • The disclosure of nonaudit fees reduces the accuracy of investor perception of auditor independence.
    • Even when the auditor is independent in fact, investors perceive that independence is compromised when nonaudit fees are disclosed.
    • The magnitude of nonaudit fees to total fees matters.  Investors are more inclined to perceive that independence is impaired as the fee ratio increases.
    • Investors have higher asset pricing errors, thus, lower market efficiency, as the fee ratio increases.
    • Investor perceptions of auditor independence decline and market outcomes are less efficient as the nonaudit fee ratio increases (i.e., from 0% to 25% to 50%), but both become constant when the level of nonaudit fees equals or exceeds total fees (i.e., at the 50% and 75% ratio). 
    Category:
    Independence & Ethics
    Sub-category:
    Non-audit Services
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  • The Auditing Section
    Do Investors’ Perceptions Vary with Types of Nonaudit F...
    research summary posted April 13, 2012 by The Auditing Section, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 04.01 Scope of Services, 04.02 Impact of Fees on Decisions by Auditors & Management, 04.03 Non-Audit Services, 04.08 Impact of SEC Rules Changes/SarbOx 
    Title:
    Do Investors’ Perceptions Vary with Types of Nonaudit Fees? Evidence from Auditor Ratification Voting
    Practical Implications:

    This paper added to the discussion on what types of services audit firms should and should not provide to their audit clients. The evidence in this paper supports the view that investors do not view tax services provided to audit clients in the same light as audit-related services.  The findings of this study are relevant to managers and boards of directors who purchase non-audit services (audit-related, tax or other) from the external auditor.  This study is also useful to practicing auditors to address audit committee concerns on non-audit services.

    Citation:

    Mishra, S., K. Raghunandan, and D.V. Rama. 2005. Do Investors’ Perceptions Vary with Types of Nonaudit Fees? Evidence from Auditor Ratification Voting. Auditing: A Journal of Practice & Theory 24 (2): 9-25.

    Keywords:
    audit fees; audit committees
    Purpose of the Study:

    Beginning in 2001, the Securities and Exchange Commission (SEC) required registrants to disclose fees paid to auditors in the following categories: audit, financial information system design and implementation (FISDI), and other fees.  In 2003 the SEC updated the disclosure requirements by adding two new fee categories: tax fees and audit-related fees (which were previously reported in “other fees”) and eliminating FISDI, based on the prohibition of these services by the Sarbanes-Oxley Act.  The SEC  suggested the expanded disclosure would provide better information for investors to determine for themselves if auditor ndependence is impaired as a result of non-audit services provided and the nature of fee arrangements.            

    The SEC asserted that investors and financial statement users would view audit-related and tax fees more favorably than “other” fees.  The authors test this assertion by examining the relation between shareholder auditor ratification votes and ratios of audit-related, tax, and other fees to audit fees.  If investors view audit-related and tax fees differently than other non-audit fees then the authors expect auditor ratification voting to vary by fee ratio.      

    Design/Method/ Approach:

    Using firms in the S&P 1500 the authors select a sample of 248 firms that submit auditor ratification for shareholder vote during 2003.  The authors then gather the results of the ratification votes for these firms from the subsequent Form 10-Q or 10-K filings. The authors also gather company financial information from various public sources and evaluate the impact of fee ratios on the outcome of shareholder ratification votes.

    Findings:
    • Shareholders voting against auditor ratification increased substantially from 2001 to 2002 to 2003.  The authors posit that this result is largely driven by Andersen’s failures and Enron’s demise. As expected, other fees impact shareholder ratification votes unfavorably.
    • Tax fees impact shareholder ratification votes unfavorably; which is contrary to the SEC assertion that investors view these tax fees favorably.  However, this supports the PCAOB’s actions in 2005 relating to restricting some auditor-provided tax services.
    • Audit-related fees are viewed favorably by investors, which is consistent with the SEC’s assertion and opposite of the result of tax fees.
    • Overall, the results support the SEC assertion of a need for separate categories of non-audit fees (audit-related, tax and other) as shareholder voting on auditor ratification appears to be influenced by these non-audit fees. 
    Category:
    Standard Setting, Auditor Selection and Auditor Changes
    Sub-category:
    Impact of SOX, Scope of Services, Impact of Fees on Decisions by Auditors & Managmeent, Non-audit Services, Impact of SEC Rules Changes/SarBox
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