Future Nonaudit Service Fees and Audit Quality

Abstract

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. We examine a different setting. We 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. We test our 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. Our 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. Our findings indicate that regulators should consider the multiperiod 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.

Non‐audit Services and Auditor Independence Depending on Client Performance

“…Further, Lim et al (2013), who do not consider the ratio of institutional investors, found a negative relationship between NAS and audit quality. Causholli et al (2014) found significant evidence that the purchase of future NAS is associated with impaired auditor independence in the current year. We examine whether auditor independence is compromised when audit clients with low performance have an incomeincreasing earnings management incentive.…”

“…Causholli et al. () found significant evidence that the purchase of future NAS is associated with impaired auditor independence in the current year. We examine whether auditor independence is compromised when audit clients with low performance have an income‐increasing earnings management incentive.…”

“…Additionally, regulators and researchers should analyse a company's motivation to purchase NAS from an incumbent auditor to investigate the possibility of managerial opportunism (Causholli et al. ). Management of a company that has achieved excellent performance should have no reason to manage earnings upward (Kapoor and Goel ).…”

“…To analyse the effect of the provision of NAS on auditor independence and audit quality, we consider the situation and motivation of a manager of a company who wants to receive NAS (Simunic 1984). Additionally, regulators and researchers should analyse a company's motivation to purchase NAS from an incumbent auditor to investigate the possibility of managerial opportunism (Causholli et al 2014). Management of a company that has achieved excellent performance should have no reason to manage earnings upward (Kapoor and Goel 2017).…”

Audit Fee Research on Issues Related to Ethics

“…18 There are recent studies that find results suggesting loss of independence. Some of these studies use U.S. data from before SOX (Srinidhi and Gul 2007;Gul, Jaggi, and Krishnan 2007;Krishnan, Su, and Zhang 2011;Omer, Bedard, and Falsetta 2006;Dickins 2008;Causholli, Chambers, and Payne 2014;Bell et al 2015). However, there are others that find evidence of loss of independence using more recent U.S. data (Rice and Weber 2012;Ye 2012), or data from Australia (Ye, Carson, andSimnett 2011), or New Zealand (Wang andHay 2013).…”