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    Does Mandated Disclosure Induce a Structural Change in the...
    research summary posted October 13, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 09.0 Auditor Judgment, 09.06 Adequacy of Disclosure 
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    Title:
    Does Mandated Disclosure Induce a Structural Change in the Determinants of Nonaudit Service Purchases?
    Practical Implications:

    The authors contribute to the literature in three ways. First, the results provide support for the agency-based demand for publicly available audit quality signals in a powerful test setting. They find SOX supply-side approach of banning certain NAS may have hurt some registrants if those banned NAS services previously served to increase overall audit quality. Second, the evidence provided herein suggests that registrants learned from the market’s negative price protection reaction and, in accordance with agency theory, recalibrated their subsequent year NAS purchases. Finally, the results provide archival, empirical support for the audit committee incentive arguments of Gaynor et al.

    Citation:

    Abbott, L. J., S. Parker, and G. F. Peters. 2011. Does Mandated Disclosure Induce a Structural Change in the Determinants of Nonaudit Service Purchases? Auditing: A Journal of Practice & Theory 30 (2): 51-76.

    Keywords:
    auditor fees, mandatory disclosures, nonaudit services
    Purpose of the Study:

    The impact of nonaudit services (NAS) on perceived audit quality has been the subject of a considerable amount of prior research. This stream of research includes investigations of stock and bond markets’ reactions to NAS disclosure as a proxy for perceived auditor independence. In this study, the authors investigate whether the introduction of mandated NAS disclosures is associated with structural changes in the relations between certain company characteristics and NAS purchases in pre- and post-disclosure settings. The authors accomplish this by comparing NAS purchases made in 2000 (pre-disclosure) with those made by the same set of firms (employing the same auditor) in 2001 (post-disclosure). 

    By examining the impact of mandated NAS disclosure on NAS purchasing behavior, the study seeks to provide evidence on the potential regulatory efficacy of disclosure requirements such as the Securities and Exchange Commission’s (SEC) Auditor Independence Rules of 2000, which mandated audit fee and NAS disclosures. During the rule-making deliberations, the SEC adopted a demand-side approach to regulating NAS purchases. In particular, the SEC sought to let the market decide the optimal level of NAS purchases by imposing a mandatory NAS disclosure regime. However, the subsequent Sarbanes-Oxley Act (SOX) took a supply-side approach to the NAS issue by banning several NAS services. Consequently, the test setting represents a unique window of opportunity since it occurs after the Auditor Independence Rules of 2000, but before the SEC altered the NAS definitions and before SOX.

    Design/Method/ Approach:

    For comparative purposes, the authors utilize the sample previously used in Abbott et al. The original sample consisted of the 310 nonfinancial firms filing proxies with the SEC between February 5, 2001, and March 16, 2001. The final sample used by the authors is a sample of 338 firms available for both 2000 and 2001.

    Findings:
    • The authors find little support for an agency-based model for NAS purchases in a nondisclosure environment.
    • In contrast, the authors document statistically significant structural differences in the relation between the NAS/audit fee ratio and three of the four primary agency conflict variables when switching to a disclosure environment.
    • They also find similar results when they use the same model to predict which firms were more likely to reduce 2001 NAS purchases relative to 2000 NAS purchases.
    • They document that inside ownership and financing activity become statistically significant determinants of NAS purchasing behavior in the disclosure environment.
    • In addition, the positive association between company size and the demand for NAS decreases during the post-disclosure environment, consistent with the larger agency costs of larger firms.
    • They also document a statistically significant increase in the magnitude of the audit committee effectiveness coefficient for the subsequent year NAS purchases.
    • The agency-based model’s R2 increases over 70 percent from the initial year (i.e., nondisclosure environment) to the subsequent year of NAS disclosure (i.e., disclosure environment).
    Category:
    Auditor Judgment, Independence & Ethics
    Sub-category:
    Adequacy of Disclosure, Non-audit Services