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    Future Nonaudit Service Fees and Audit Quality.
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services 
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    Title:
    Future Nonaudit Service Fees and Audit Quality.
    Practical Implications:

    The results indicate that prior to the Sarbanes-Oxley Act, rewards to the auditor in the form of future additional nonaudit service fees from current-year high fee-growth-opportunity clients adversely affects audit quality. This effect is particularly strong among companies with powerful incentives to manage earnings. The findings indicate that regulators should consider the multi-period nature of the client-auditor relationship when contemplating policies that restrict nonaudit services, as well as the overall environment in which audit partners operate. This might include partner compensation arrangements that put pressure on audit partners to focus on increasing revenue at the expense of audit quality.

    Citation:

    Causholli, M., D. J. Chambers, and J. L. Payne. 2014. Future Nonaudit Service Fees and Audit Quality. Contemporary Accounting Research 31 (3): 681-712.

    Keywords:
    auditor independence, revenue, auditor-client relationships, financial management, auditing, non-audit services
    Purpose of the Study:

    Prior to the Sarbanes-Oxley Act of 2002, audit partners experienced economic pressure to grow revenue from the sale of nonaudit services to their audit clients. To an auditor who is highly rewarded for revenue generation and growth, nonaudit services may represent a particularly strengthened economic bond with the client. Prior research shows that, in general, nonaudit service fees received in the current period do not impair audit quality. The authors examine a different setting. Future nonaudit fees present an important source of career advancement and a source of particularly strengthened economic bond with the client. They propose that auditor independence can become impaired, and audit quality compromised, when clients that currently purchase relatively low amounts of nonaudit services, increase their purchases of nonaudit services from the auditor in the subsequent period. They test the prediction in the context of earnings management as a proxy for audit quality, measured by (a) performance-adjusted discretionary accruals and (b) classification shifting of core expenses.

    Design/Method/ Approach:

    The authors obtain the data on the Big-N clients’ audit and nonaudit fees from Audit Analytics, the data on client characteristics from COMPUSTAT, and the data on stock returns from CRSP for fiscal years 2000-2001. The Accruals Model has a sample of 4,078. The Classification-shifting Model has a sample of 3,361.

    Findings:
    • The results show that earnings management is higher for high fee-growth-opportunity clients who increase their future nonaudit services (NAS) purchases from the auditor.
    • Both forms of earnings management are higher for companies with relatively low NAS in the current year that simultaneously increase future NAS purchases from the auditor.
    • The negative effect of future NAS is even more pronounced in companies that have greater incentives to manage earnings such as those that meet or just beat earnings forecasts or those that issue equity and less likely to occur in companies with strong corporate governance.
    • When using the absolute value of discretionary accruals to proxy for earnings management, the authors find that future increases in NAS fees are positively associated with the absolute discretionary accruals for high fee-growth-opportunity clients. This association continues to hold when the authors separate total discretionary accruals into income-increasing and income-decreasing accruals.
    • When using the association between unexpected core earnings and income-decreasing special items as the proxy for classification shifting, the authors find that the association becomes more positive, indicating greater classification shifting for high fee growth opportunity clients who increase future NAS purchases.
    Category:
    Independence & Ethics
    Sub-category:
    Non-audit Services