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    Nonaudit Services and Earnings Management in the Pre-SOX and...
    research summary posted March 2, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.09 Individual & Team Conduct - e.g., premature signoff, underreporting hours, 09.0 Auditor Judgment 
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    Title:
    Nonaudit Services and Earnings Management in the Pre-SOX and Post-SOX Eras
    Practical Implications:

    The observed decline in NAS over the period 2000-2005 provides a demarcation of situations in the pre-SOX period where auditor independence was potentially more or less impaired, either because of the presence of specific NAS that was considered harmful or because general economic dependence had adverse effects on auditor independence, or both. In contrast to the concern that NAS-based incentives led auditors to overlook overstatements by companies, they may have led them to allow downward earnings management.

    For more information on this study, please contact Jayanthi Krishnan.

    Citation:

    Krishnan, J., L. Su, and Y. Zhang. 2011. Nonaudit Services and Earnings Management in the Pre-SOX and Post-SOX Eras. Auditing: A Journal of Practice & Theory 30 (3):103-123. 

    Keywords:
    nonaudit services; earnings management; Sarbanes-Oxley Act
    Purpose of the Study:

    Concerns about the impact of auditor-provided nonaudit services (NAS) on auditor independence arise because of (1) auditors' economic dependence on their clients, and (2) some specific types of NAS, which the Securities and Exchange Commission (SEC) argues can harm auditor objectivity. The SEC's prohibition in 2003 of specific kinds of NAS led to a significant decline in NAS between 2000-2001 and 2004-2005. This paper argues that this decline in observed NAS fees can be used to identify firms that had a greater likelihood of impaired auditor independence in the pre-SOX period. 

    Design/Method/ Approach:

    The authors used performance-adjusted discretionary accruals (PPDA) to estimate parameters in their model, which tested the effect of non-audit fee change and its interactive effect with SOX on earnings management. With data on auditor fees from the Audit Analytics database for years 2000, 2001, 2004, and 2005, the process yielded a final sample of 1,768 unique firms and 7,072 observations after deleting unrelated cases.

    Findings:

    The authors expected that firms with greater declines would show greater earnings management in the pre-SOX period, and this difference to be eliminated in the post-SOX period. The results are consistent with these expectations. However, the results reported hold only for negative discretionary accruals. That is, any impairment of auditor independence resulting from NAS is observed only for downward earnings management. Thus, it seems likely that income-increasing earnings management is not associated with NAS, possibly because litigation concerns counterbalance any incentives for impaired independence. For downward earnings management, litigation concerns are less acute, and that may explain the results. The results hold when the authors control (in sensitivity tests using a smaller sample) for the effectiveness of the audit committee.

    Category:
    Auditor Judgment, Independence & Ethics
    Sub-category:
    Individual & team conduct (e.g. premature signoff - underreporting hours)