asthana and boone - 2012 - abnormal audit fee and audit quality

Auditing: A Journal of Practice & Theory American Accounting Association Vol. 31, No. 3 DOI: 10.2308/ajpt-10294 August 2012 pp. 1–22 Abnormal Audit Fee and Audit Quality Sharad C. Asthana and Jeff P. Boone SUMMARY: This study tests the hypotheses that below-normal audit fees signal important nuances in the balance of bargaining power between the auditor and the client, and that such power may ultimately influence audit quality. We find that audit quality, proxied by absolute discretionary accruals and meeting or beating analysts’ earnings forecasts, declines as negative abnormal audit fees increase in magnitude, with the effect amplified as proxies for client bargaining power increase. We find that this effect is dampened in years following the Sarbanes-Oxley Act (SOX), suggesting that SOX was effective in enhancing auditor independence. Keywords: abnormal audit fees; bargaining power; economic bonding. INTRODUCTION U nderstanding the factors that lead auditors to compromise on audit quality is an important issue of concern to scholars, investors, and regulators. One possible factor that has received significant research attention is economic bonding between the auditor and client. The basic idea in these studies is that positive abnormal audit fees reflect the extent of economic bonding between the auditor and client, and greater economic bonding degrades audit quality by impairing auditor independence. Based on this premise, studies have examined the linkage between audit quality and positive abnormal audit fees, with such studies documenting a negative association. In this study, we reexamine the association between abnormal audit fees and audit quality, and we do so in a way that allows our paper to offer two important contributions to the literature. First, we incorporate into our conceptual framework insights about client bargaining power (Casterella et al. 2004) in addition to the economic bonding story that forms the conceptual framework in prior studies. Expanding the framework to consider both bargaining power and economic bonding allows us to offer a novel prediction that would not be meaningful within a framework based exclusively on economic bonding. That prediction is: audit quality will decline as negative abnormal audit fees increase in magnitude, and the magnitude of the decline will increase as proxies for client bargaining power increase. The economic bonding literature that informs prior studies places the focus on positive abnormal audit fees, predicting no association between negative abnormal audit Sharad C. Asthana and Jeff P. Boone are both Professors at The University of Texas at San Antonio. Editor’s note: Accepted by Jean Bedard. Submitted: December 2009 Accepted: March 2012 Published Online: August 2012 1 fees and audit quality, and a negative association between positive abnormal audit fees and audit quality. Second, we include in our analysis data taken from the post-Sarbanes-Oxley (SOX) period (i.e., years 2004–2009), in addition to data from the pre-SOX period (i.e., years 2000–2003). The pre-SOX period has been the data source for virtually all of the prior studies. With data taken from both the pre- and post-SOX periods, we are able to probe for a dampened association between abnormal audit fees and audit quality that would be manifest if SOX reforms meaningfully increased auditor independence or strengthened the auditor’s bargaining power, leading to higher audit quality. To date, there is only limited empirical evidence that speaks to the issue of whether SOX reforms increased audit quality. Consistent with prior research (e.g., Choi et al. 2010; Hope et al. 2009; and Higgs and Skantz 2006), we decompose total audit fees into normal and abnormal components, and test for an association between audit quality and abnormal audit fees, conditioning our tests on the sign of the abnormal audit fee metric (i.e., above-normal audit fees and below-normal audit fees). Under the bargaining power story, we expect to find that audit quality declines as negative abnormal fees increase in magnitude, with the effect amplified as proxies for client bargaining power increase. Under the economic bonding story (and consistent with prior studies), we expect to find that audit quality declines as positive abnormal fees increase in magnitude. We also partition our analysis by regulatory regime (i.e., a pre-SOX reporting period or a post-SOX reporting period) in order to assess whether the sensitivity of audit quality to abnormal audit fees differs between these two regimes. Our two proxies for audit quality are absolute discretionary accruals and meeting or beating analysts’ earnings forecasts, and our two proxies for client bargaining power reflect the importance of the client to the local practice office. Our tests produce evidence consistent with both the economic bonding story and the bargaining power story. As predicted by the economic bonding story, we find that absolute discretionary accruals and the probability of meeting or beating earnings forecasts both increase as positive abnormal audit fees increase. As predicted by the client bargaining power story, we find that absolute discretionary accruals and the probability of meeting or beating earnings forecasts increase with the magnitude of negative abnormal audit fees, with the effect amplified as client bargaining power increases. With respect to the effects of SOX, we find that the effects of economic bonding and client bargaining power are both dampened in the post-SOX regime, suggesting that SOX was effective in enhancing auditor independence. The evidence presented in our paper is important in at least two respects. First, our results suggest that investors, regulators, and others interested in assessing the effects of auditor remuneration on audit quality should be concerned with both above-normal and below-normal auditor remuneration, but for different reasons. The potential effect of above-normal audit fees in degrading audit quality by economically bonding the auditor with the client is well recognized and extensively investigated. Less recognized is the possibility that below-normal audit fees signal important nuances in the balance of power between the auditor and the client, and that such power may ultimately influence audit quality. Thus, our study highlights the importance of considering the bargaining power of the client when assessing audit quality. Second, our study presents the first evidence (of which we are aware) to suggest that reforms introduced by the Sarbanes-Oxley Act dampened the deleterious effects of economic bonding and client power on audit quality, and hence increased audit quality. Both of these important insights from our study increase understanding of the factors that may lead auditors to compromise on audit quality, and hence our paper should be of interest to accounting scholars, investors, and regulators. The remainder of the study is organized as follows. The second section develops our theoretical framework and presents the hypotheses that we test. We present our research design in the third 2 Asthana and Boone Auditing: A Journal of Practice & Theory August 2012 section, followed by a discussion of our sample in the fourth section and our results in the fifth section. We offer concluding comments in the sixth section. THEORETICAL FRAMEWORK AND HYPOTHESES An audit firm is not a single person ‘‘auditor’’; rather, it is a decentralized organization in which individual audit partners act as agents for the audit firm (Liu and Simunic 2005). To the extent the partnership profit-sharing plan does not effectively align the interests of the partner with that of the audit firm partners as a whole, an uncontrolled moral hazard problem exists that might result in an individual audit partner succumbing to client pressure for earnings management. This is because the individual partner captures a significant portion of the expected benefit from acquiescing to client demands, while passing to the partnership as a whole the expected cost (Trompeter 1994). What factors might lead an audit partner to compromise on audit quality? As described below, engagement profitability and client bargaining power are two possible explanations. Engagement Profitability and Economic Bonding Engagement profitability should influence audit quality for the following reason. Audit start- up costs and client switching costs allow the auditor to price audit services at a price in excess of the avoidable cost of producing the audit, and thus create for the incumbent auditor client- specific quasi-rents (DeAngelo 1981a, 1981b). The client-specific quasi-rents economically bond the auditor to the client, reduce auditor independence, and increase the likelihood that the auditor will acquiescence to a client’s demand for earnings management. However, succumbing to client pressure risks audit firm forfeiture of some or all of the quasi-rents from the firm’s entire client portfolio (if the earnings management is discovered), and additional economic loss through litigation and government penalties (DeAngelo 1981a, 1981b). The auditor will compromise audit integrity only if the expected gain (preserving the client-specific quasi-rent) exceeds the expected loss (forfeited quasi-rents from the overall client portfolio, litigation costs, and penalties), and thus the question of whether economic bonding undermines audit quality depends upon the relative magnitude of expected costs and benefits, which is an empirical question. 1 Bargaining Power Bargaining power should influence audit quality for the following reason. Audited financial statements, and hence audit quality, are the joint effort of the auditor and the client (Antle and Nalebuff 1991) that arise from a process of negotiation between the two (Gibbins et al. 2001). The negotiation literature shows that when negotiators differ in bargaining power, the more powerful party expects greater concessions (e.g., Pruitt and Carnevale 1993; Hornstein 1965; Michener et al. 1975), and Barnes (2004) shows that audit quality may decrease as client bargaining power increases. In an experimental auditing setting, Hatfield et al. (2008) show that the effect of client bargaining power on the audited financial statements depends upon the negotiation strategy employed by the auditor, with a reciprocity negotiating strategy leading to more conservative financial statements. Thus, the question of whether client bargaining power undermines audit quality depends upon whether the auditor is able to employ a negotiating strategy that weakens the advantage held by a client with strong bargaining power. 1 See Beck et al. (1988), Magee and Tseng (1990), and Zhang (1999) for extensions of DeAngelo’s (1981a, 1981b) idea that quasi-rents impair auditor independence. Abnormal Audit Fee and Audit Quality 3 Auditing: A Journal of Practice & Theory August 2012 Abnormal Audit Fees Simunic (1980) shows that the auditor’s expected fee charged to the client is driven by the units of audit resources expended, the per-unit cost of those resources, and the auditor’s expected future loss arising from the engagement (e.g., litigation losses, government penalties). Empirically, extant research models the expected audit fee as a function of observable factors that proxy for the auditor’s cost in performing the audit, including auditor effort (i.e., resources expended and their cost), expected future litigation losses, and normal profit. If the audit fee model is well specified, the residual audit fee reflects abnormal profits from the audit engagement. To the extent that some factors are unobservable (and hence omitted from the audit fee model), the residual audit fee metric measures abnormal audit profitability with error. Abnormal audit profitability should be associated with both client bargaining power and economic bonding. With respect to the former, Casterella et al. (2004) show a negative association between proxies for client bargaining power and audit fees earned by industry specialists. Their research suggests that, ceteris paribus, below-normal audit fees may reflect billing concessions granted by the auditor due to client bargaining power. With respect to the later, Kinney and Libby (2002) note that ‘‘Unexpected fees may also better capture the profitability of the services provided more insidious effects on economic bond may result from unexpected nonaudit and audit fees that may more accurately be likened to attempted bribes.’’ Although there is scant evidence on the association between abnormally low audit fees and audit quality, a growing literature, described below, examines the association between abnormally high audit fees (as a proxy for economic bond) and audit quality. DeFond et al. (2002), Krishnan et al. (2005), Hoitash et al. (2007), and Hribar et al. (2010) test for a linear association between abnormal audit and/or engagement fees and audit quality (i.e., the curve relating audit quality to abnormal audit fees exhibits the same slope for both positive and negative abnormal audit fees). 2 DeFond et al. (2002) find no association between abnormal engagement fees and auditors’ going concern opinions during 2000–2001, while Krishnan et al. (2005) find that during year 2001, earnings response coefficients (a direct indicator of audit quality) decline as abnormal engagement fees increase. Hoitash et al. (2007) find during years 2000–2007 a positive association between abnormal engagement fees and two (inverse) audit quality metrics—the Dechow and Dichev (2002) accrual quality metric and the absolute value of performance-adjusted discretionary accruals. Hribar et al. (2010) find during years 2000 to 2007 a positive association between abnormal audit fees and accounting fraud, restatements, and SEC comment letters. 3 Larcker and Richardson (2004), Higgs and Skantz (2006), Hope et al. (2009), Mitra et al. (2009), and Choi et al. (2010) test for a nonlinear association between abnormal audit fees and audit quality (i.e., the curve relating audit quality to abnormal audit fees exhibits different slope for positive as compared to negative abnormal audit fees). Larcker and Richardson (2004) use data from 2000 and 2001 to examine absolute discretionary accruals (an inverse indicator of audit quality), and find that audit quality increases as abnormal engagement fees increase in absolute magnitude. Higgs and Skantz (2006) find that during 2000–2002, earnings response coefficients (a direct indicator of audit quality) are greater in firms with positive abnormal audit fees. Hope et al. (2009) find that during 2000–2003, equity discount rates (an inverse indicator of audit quality) increase as positive abnormal engagement fees increase, but find no association with negative 2 We refer to ‘‘engagement fees’’ when the test variable in the study was total fees (i.e., the sum of audit and nonaudit fees). 3 In contemporaneous unpublished research, Hollingsworth and Li (2011) investigate the pre-SOX (years 2000– 2001) versus post-SOX (years 2003–2004) linear association between audit fee ratios and ex ante cost of capital. They find evidence of a positive association between total audit fees and ex ante cost of capital during 2003– 2004, but no such association during 2000–2001. 4 Asthana and Boone Auditing: A Journal of Practice & Theory August 2012 abnormal engagement fees. Mitra et al. (2009) find during years 2000–2005 a negative association between positive abnormal audit fees, and both absolute discretionary accruals and income- increasing accruals, but find no association between negative abnormal audit fees and discretionary accruals. Choi et al. (2010) find during 2000–2003 a positive association between positive abnormal audit fees and absolute discretionary accruals, but no association when abnormal audit fees are negative. The weight of the preceding evidence suggests a negative association between audit quality and positive abnormal audit fees, and no association between audit quality and negative abnormal audit fees—findings consistent with the economic bonding hypothesis. However, as discussed above, negative abnormal audit fees may reflect client bargaining power that could degrade audit quality—with the degrading being larger in magnitude the greater the bargaining power of the client. Also as previously discussed, the question of whether client bargaining power undermines audit quality ultimately depends upon whether the auditor is able to employ a negotiating strategy that weakens the advantage held by a client with strong bargaining power. Thus, whether client bargaining power affects audit quality remains an open empirical question, leading us to specify and test the following client bargaining power hypotheses. H1a: Audit quality will decline as below-normal audit fee increases in magnitude. H1b: The association predicted in H1a will be amplified as proxies for client bargaining power increase. For completeness, we also specify and test the following economic bonding hypothesis: H2: Audit quality will decline as above-normal audit fees increase in magnitude. Post-Sox Abnormal Audit Fees In addition to the question of client bargaining power, another as yet unanswered question is whether the audit quality/abnormal audit fee association changed following SOX. Passed in 2002 following discovery of a series of high-profile financial reporting scandals, SOX seeks to improve corporate governance and enhance auditor independence by mandating federal government oversight of auditors, enhancing audit committee auditor oversight, and limiting the opportunity for auditors to sell nonaudit services to clients (U.S. House of Representatives 2002). If these reforms are sufficiently salient, they should manifest in a reduced association between abnormal audit fees and audit quality post-SOX relative to pre-SOX. This leads to our final hypothesis: H3: The association between audit quality and abnormal audit fees will be attenuated in the post-SOX period as compared to the pre-SOX period. RESEARCH DESIGN To test our hypotheses, we need to measure abnormal audit fee and audit quality. We estimate abnormal audit fee (ABNAFEE) as the actual audit fee paid by the client to its auditor minus the predicted (normal) audit fee, with the difference deflated by the total audit fee revenue of the audit office conducting the client’s audit. We deflate the abnormal audit fee by total audit fee revenues of the practice office conducting the audit in order to capture the relative profitability of the engagement to the opining audit office. 4 4 We do not deflate this measure by the total abnormal audit fee for the practice office since this results in near- zero denominator problem. Abnormal Audit Fee and Audit Quality 5 Auditing: A Journal of Practice & Theory August 2012 We do so since prior research (e.g., Reynolds and Francis 2001) suggests that economic incentives impacting audit quality are best measured at the local office level rather than at the national firm level. For example, the Enron audit failure largely stemmed from decisions made in the Houston office of Arthur Andersen (Chaney and Philipich 2002). We define two separate variables from ABNAFEE.IfABNAFEE . 0 then HIABNAFEE ¼ABNAFEE, and 0 otherwise. If ABNAFEE 0 then LOABNAFEE ¼jABNAFEEj, and 0 otherwise. This allows us to study the relationship of the dependent variables with the positive and negative abnormal audit fee, separately. The predicted audit fee is estimated from an audit fee model based on extant research. 5 All the variables used in various tests are summarized in Table 1. Audit quality is unobservable. Consistent with prior research, we define audit quality as the client’s earnings quality (Higgs and Skantz 2006; Lim and Tan 2008; Davis et al. 2009; Francis and Yu 2009; Reichelt and Wang 2010; Choi et al. 2010). Following this research, we use two commonly used proxies for earnings quality: absolute discretionary accruals and propensity to meet or beat earnings expectations. We also conduct additional tests using an earnings response coefficient. The first two proxies are surrogates for actual earnings management, while the last one is related to perceived earnings quality. However, for the sake of brevity, we only report results for the first two, since the conclusions are similar. The tests for these proxies are discussed in more detail below. Discretionary Accruals Model The level of discretionary accruals has commonly been used as a surrogate for managers’ exercise of discretion provide by GAAP. To the extent the discretionary component of accruals is used by managers to opportunistically manage earnings and auditors allow the manipulation to remain uncorrected, discretionary accruals adversely reflect on the audit and earnings quality (Schipper 1989; Jones 1991; Levitt 2000; DeFond and Park 2001). Discretionary accruals can be used for increasing or decreasing earnings depending on the incentives of managers. Since we are not looking at any specific managerial incentives, we have no directional predictions for accruals. We therefore use the absolute value of discretionary accruals (jDACCj) as the independent variable in our next test. Discretionary accruals (DACC) are calculated using the cross-sectional modified version of the Jones model (Jones 1991; Dechow et al. 1995), deflated by total assets, and estimated by year and for each industry. We adjust discretionary accruals for performance as suggested by Kothari et al. (2005). Following Hribar and Collins (2002), we use the difference between net income and cash from operations, deflated by lagged assets, as our measure of total accruals (TACC). Thus: TACC ¼ðIBC À OANCFÞ=LagðATÞ; where IBC is the income before extraordinary items (Compustat cash flow item), OANCF is net cash flow from operating activities, and AT is total assets. The model to estimate discretionary accruals is: TACC ¼ h 1 þ h 2 ½1=LagðATÞ þ h 3 ½ DSALE þ RECCH fg =LagðATÞ þ h 4 ½PPEGT=LagðATÞ þh 5 ROA þerror: ð1Þ 5 Our audit fee model is based on models used in Ghosh and Lustgarten (2006), Craswell and Francis (1999), Craswell et al. (1995), and Simon and Francis (1988). The adjusted-R 2 of this model is over 81 percent. However, we do not report details for the sake of brevity. Detailed specifications are available from the authors on request. 6 Asthana and Boone Auditing: A Journal of Practice & Theory August 2012 TABLE 1 Variable Definitions (In Alphabetical Order) Variable Definition ABNAFEE Actual audit fee minus predicted (normal) audit fee deflated by the total revenue of the auditor office that audits the client. ACQUIRED A dichotomous variable with value of 1 if the firm indulged in acquisition activities, and 0 otherwise. B2M Book-to-market equity ratio. BIG-N A dichotomous variable with value of 1 if the auditor is one of the Big 4 (or Big 5), and 0 otherwise. BUSSEG Number of business segments reported in Compustat segment file. CFFO Cash flow from operations divided by total assets. CITYLEADER Following Francis and Yu (2009), a dichotomous variable with value of 1 if an audit office has the highest total client audit fees in an industry within that city in a specific year, and 0 otherwise. jDACCj Absolute discretionary accruals are calculated using the cross-sectional version of the Jones (1991) model as in Dechow et al. (1995) with performance adjustment (Kothari et al. 2005), deflated by total assets and estimated by year and for each two-digit SIC code. We use the difference between net income and cash from operations as our measure of total accruals (Hribar and Collins 2002). DELAY Number of calendar days from fiscal year-end to date of auditor’s report. DISTRESS Zmijewski’s (1984) financial distress measure. DSOX A dichotomous variable with value of 1 for fiscal years 2004–09, and 0 otherwise. We choose 2004 as the cutoff since this was the implementation year for SOX 404(b). FINANCED A dichotomous variable with value of 1 if number of outstanding shares increased by at least 10 percent or long-term debt increased by at least 20 percent during the year (Geiger and North 2006). GEOSEG Number of geographic segments reported in Compustat segment file. HIABNAFEE Equal to ABNAFEE if ABNAFEE . 0, and 0 otherwise. I_jDACCj Implies the instrumented variable for jDACCj from Maddala’s (1988) 2SLS estimation. I_MBEX Implies the instrumented variable for MBEX from Maddala’s (1988) 2SLS estimation. ICOPINION Number of material internal control weaknesses reported in Audit Analytics. INFLUENCE Following Reynolds and Francis (2001), ratio of a client’s total fee relative to the total annual fee of the practice office that audits the client. LAGROA Lagged value of return on asset. LARGEST A dichotomous variable with value of 1 if the client pays the highest audit fee in the practice office that audits the client. LDELAY Natural logarithm of DELAY variable plus one day. LEVERAGE Total debt deflated by total assets. LNUMFOR Natural logarithm of the number of analysts’ forecasts. LOABNAFEE Equal to jABNAFEEj if ABNAFEE is less than or equal to 0, and 0 otherwise. LOFFICE Following Francis and Yu (2009), the natural logarithm of total annual audit fee of the practice office that audits the client. LOGMV Natural logarithm of the market value of equity (in $ million) at the end of the fiscal year. LOSS A dichotomous variable with value of 1 if client has a negative net income before extraordinary items, and 0 otherwise. MBEX A dichotomous variable with value of 1 if the firm meets or beats the earnings expectation (proxied by the most recent median consensus analyst forecast available on I/B/E/S file) by two cents or less, and 0 otherwise. (continued on next page) Abnormal Audit Fee and Audit Quality 7 Auditing: A Journal of Practice & Theory August 2012 where Lag(AT) is total assets of prior year; DSALE is change in revenue; RECCH is the decrease in accounts receivables; PPEGT is property plant and equipment (gross total); and ROA is return on assets, calculated as IBC deflated by AT. Equation (1) is estimated by year for each industry (two- digit SIC code). Then, TACC minus the predicted value from the above regression is our measure of discretionary accruals. Our test of jDACCj is based on the following model: jDACCj¼a 0 þ a 1 LOABNAFEE þa 2 HIABNAFEE þa 3 LOFFICE þa 4 INFLUENCE þ a 5 TENURE þa 6 USLEADER þa 7 CITYLEADER þa 8 BUSSEG þa 9 GEOSEG þ a 10 LOGMV þa 11 SGROWTH þ a 12 SDSALES þa 13 CFFO þa 14 SDCFFO þ a 15 ICOPINION þa 16 LEVERAGE þa 17 LOSS þa 18 DISTRESS þa 19 B2M þ a 20 VOLATILITY þa 21 FINANCED þa 22 ACQUIRED þa 23 LAGROA þ a 24 BIG-N þ a 25 QUALIFIED þa 26 LDELAY þa 27 RESTATEMENT þ a 28 I MBEX þ error: ð2Þ The control variables are from extant research. Francis and Yu (2009) show that larger offices of Big 4 auditors have higher audit quality. The logarithm of total office-specific audit fee of all clients in a given year (LOFFICE) is included to capture this effect. Reynolds and Francis (2001) provide evidence that auditors report more conservatively for larger clients. Consistent with this research, the variable INFLUENCE, defined as the ratio of a client’s total fee relative to the total annual fee of the practice office that audits the client, is included as an independent variable. TENURE (1/0 dummy variable for audit tenures of three years or less) controls for potential effect of short auditor- client association on audit quality (Johnson et al. 2002; Carey and Simnett 2006). Balsam et al. (2003) argue that industry expertise increases audit quality. We include USLEADER and CITYLEADER, consistent with Francis and Yu (2009), to control for national-level and city-level auditor industry expertise. USLEADER is an indicator variable that is coded 1 if the TABLE 1 (continued) Variable Definition QUALIFIED A dichotomous variable with value of 1 if audit opinion is a qualified opinion, and 0 otherwise. RESTATEMENT A dichotomous variable with value of 1 if the client issues a restatement in the current fiscal year, and 0 otherwise. SDCFFO Standard deviation of cash flow from operations deflated by total assets, calculated over the current and prior four years. SDFOR Standard deviation of analysts’ earnings forecasts. SDSALES Standard deviation of sales deflated by total assets, calculated over the current and prior four years. SGROWTH Sales growth rate. TENURE A dichotomous variable with value of 1 if auditor has been with the client for three years or less, and 0 otherwise. TOP10%INFL A dichotomous variable with value of 1 if INFLUENCE is in the top 10 percent, and 0 otherwise. USLEADER Following Francis and Yu (2009), a dichotomous variable with value of 1 if an auditor has the highest total client audit fees in an industry in the country in a specific year, and 0 otherwise. VOLATILITY Standard deviation of daily returns for the past year obtained from CRSP. 8 Asthana and Boone Auditing: A Journal of Practice & Theory August 2012 auditor is the national audit fee leader in that industry. CITYLEADER is similarly defined at the city level. BUSSEG (GEOSEG) is the number of business (geographic) segments reported in the Compustat segment file. LOGMV is the natural logarithm of market value of equity at the end of the fiscal year. This variable controls for any size-related effects. Prior research (Ashbaugh et al. 2003; Butler et al. 2004; Menon and Williams 2004; Geiger and North 2006) finds LOGMV to be negatively associated to discretionary accruals. SGROWTH is the annual growth in sales and has been found to be positively related to discretionary accruals (Menon and Williams 2004). CFFO is the cash flow from operations deflated by total assets. Previous researchers (Frankel et al. 2002; Chung and Kallapur 2003) find a negative association between discretionary accruals and CFFO. Hribar and Nichols (2007) find that accrual volatility may be related to firm-specific operating characteristics as measured by the volatility of the firm’s cash flows and sales. Hence, we include SDSALES and SDCFFO (calculated as the standard deviations over the current and past four years of cash flow from operations and sales, respectively, deflated by the total assets) as control variables. Doyle et al. (2007) suggest that earnings quality may be a function of the quality of the firm’s internal control. ICOPINION (number of material internal control weaknesses reported in Audit Analytics in the post-SOX period) is, therefore, included as a control variable. Consistent with DeFond and Jiambalvo (1994), Reynolds and Francis (2001), and Francis and Yu (2009), LEVERAGE, LOSS,andDISTRESS are included to control for the effects of debt and financial distress. LEVERAGE is total debt deflated by total assets. LOSS is a dichotomous variable with a value of 1 if client has a negative net income before extraordinary items, and 0 otherwise. DISTRESS is Zmijewski’s (1984) measure of financial distress. B2M is the book-to-market value and captures the growth opportunities. Ashbaugh et al. (2003), Butler et al. (2004), Menon and Williams (2004), and Geiger and North (2006) suggest B2M and DACC to be negatively associated. Following Matsumoto (2002), Hribar and Nichols (2007), and Francis and Yu (2009), we include stock-return volatility (VOLATILITY) to proxy for capital market pressures that can result in increased earnings management. FINANCED and ACQUIRED are dichotomous variables that have values of 1 if the company was involved in significant financing activities or acquisitions, respectively, and 0 otherwise. Ashbaugh et al. (2003) and Chung and Kallapur (2003) find positive coefficients on these two variables. LAGROA is the previous year’s return on assets and is included to control for prior performance. BIG-N (a 0/1 dummy variable) and QUALIFIED (a 0/1 dummy variable) capture the effect of auditor size and qualified opinions on earnings quality. Natural logarithm of 1 þ number of calendar days from fiscal year-end to date of auditor’s report (LDELAY) controls for the effect of extra effort by the auditor on earnings quality. Since restatements can influence earnings management, the dichotomous variable RESTATEMENT is added as a control variable. MBEX is a dichotomous variable with a value of 1 if the firm meets or beats the earnings expectation (proxied by the most recent median consensus analysts forecast available on I/B/E/S file) by two cents or less, and 0 otherwise. Since jDACCj and MBEX can be jointly determined, we use Maddala’s (1988) two-stage-least-squares estimation (2SLS) for Equations (2) and (3) to avoid any endogeneity problems. I_MBEX denotes the instrumented variable for MBEX from the 2SLS. 6 Meet-or-Beat Earnings Expectation Model There is evidence in extant literature that managers are rewarded (penalized) for meeting (missing) earnings forecasts (Bartov et al. 2002; Kasznik and McNichols 2002; Lopez and Rees 2002) and this leads to incentives for managers to manage earnings. If auditors’ incentives to curtail earnings management vary with abnormal audit fee, the propensity for meeting or beating analysts’ 6 See Rusticus and Larcker (2010) for a more detailed discussion of instrumental variable estimation. Abnormal Audit Fee and Audit Quality 9 Auditing: A Journal of Practice & Theory August 2012 earnings forecasts will be a function of the abnormal audit fee. We estimate the following logit model to test this conjecture: ProbðMBEX ¼ 1Þ ¼ Fðb 0 þ b 1 LOABNAFEE þb 2 HIABNAFEE þb 3 LOFFICE þ b 4 INFLUENCE þb 5 TENURE þb 6 USLEADER þb 7 CITYLEADER þ b 8 BUSSEG þb 9 GEOSEG þb 10 LOGMV þb 11 SGROWTH þ b 12 SDSALES þb 13 CFFO þ b 14 SDCFFO þb 15 ICOPINION þ b 16 LEVERAGE þb 17 LOSS þb 18 DISTRESS þb 19 B2M þ b 20 VOLATILITY þb 21 FINANCED þb 22 ACQUIRED þb 23 LAGROA þ b 24 BIG-N þ b 25 QUALIFIED þb 26 LDELAY þb 27 RESTATEMENT þ b 28 I jDACCjþb 29 SDFOR þb 30 LNUMFORÞ: ð3Þ In Model (3), F(  ) denotes the logistic cumulative probability distribution function. I_jDACCj denotes the instrumented variable for jDACCj from the 2SLS. Following Reichelt and Wang (2010), we include the standard deviation of analysts’ earnings forecasts (SDFOR) and natural logarithm of number of analysts’ forecasts (LNUMFOR) to control for characteristics of the forecasts. Additional Tests To test H1b, we further interact LOABNAFEE and HIABNAFEE with two measures of clients’ bargaining powers in Models (2) and (3). LARGEST is a dichotomous variable with value of 1 if the client pays the highest audit fee in the practice office that audits the client; TOP10%INFL is a dichotomous variable with a value of 1 if INFLUENCE is in the top 10 percent, and 0 otherwise. To make the interpretations of the interactions easier, we use the dichotomous versions of abnormal audit fees, DLOABNAFEE and DHIABNAFEE, where DLOABNAFEE (DHIABNAFEE)isa dichotomous variable with a value of one if LOABNAFEE (DHIABNAFEE) ! median value, and 0 otherwise. To test our conjecture that SOX has dampened the association between abnormal audit fees and earnings management (H3), we rerun Models (2) and (3) with an additional independent variable DSOX and interaction terms, DLOABNAFEE à DSOX and DHIABNAFEE à DSOX, where DSOX is a dichotomous variable with a value of 1 for the period 2004–2009, and 0 otherwise. 7 Adjustment for Clustering Since our data are pooled over time, the same firm may appear more than once in the sample, resulting in clustering. Clustered samples can lead to underestimation of standard errors and overestimation of significance levels (Cameron et al. 2011). We therefore estimate the t-statistics adjusted for clustering using robust standard errors corrected for firm-level clustering and heteroscedasticity, consistent with Petersen (2009) and Gow et al. (2010). 7 One of the SOX provisions to affect the audit relationship was the requirement that auditors evaluate and report on management’s assessment of the effectiveness of the firm’s internal controls (SOX Section 404(b) [U.S. House of Representatives 2002]). Since SOX Section 404(b) was implemented for fiscal years ending on or after November 15, 2004 (per SEC Release No. 33-8392, issued February 24, 2004), we classify 2000–2003 as the pre-SOX period and 2004–2009 as the post-SOX period. However, using 2002 as the cutoff does not alter the conclusions. 10 Asthana and Boone Auditing: A Journal of Practice & Theory August 2012 [...]... audit fee model This extra effort may result in an abnormally high audit fee and lead to higher audit quality Extending this argument, below-normal audit fees may represent abbreviated audit efforts, and not clients’ bargaining power, leading to poorer quality audits In the absence of data on engagement hours and staff mix, we utilize the number of days between fiscal year-end and release of the audit. .. results of positive association between cost of equity capital and excess auditor remuneration only hold for audit fee and not for nonaudit fee We thank one of our reviewers for this insight Auditing: A Journal of Practice & Theory August 2012 Abnormal Audit Fee and Audit Quality 17 7 Firms that have consistent positive or negative abnormal fees across years might have different motivations from firms... as a determinant of audit quality In our study, we examine the association between abnormal audit fees and two audit quality proxies: (1) abnormal discretionary accruals and (2) the probability of meeting or beating analysts’ consensus earnings forecasts Above-normal audit fees suggest quasi-rents arising from a highly profitable audit engagement, while below-normal audit fees suggest the client has... VOLATILITY, LAGROA, BIG-N, QUALIFIED, LDELAY, RESTATEMENT, and LNUMFOR are significantly negative LOABNAFEE and HIABNAFEE are significantly positive Thus, this test also supports H1a and H2 Tests for H1b are reported in Panels B and C of Table 4 DLOABNAFEE and DHIABNAFEE are positive and significant as predicted by H1a and H2 DLOABNAFEE à LARGEST and DLOABNAFEE à TOP10%INFL are both positive and significant at... interest to accounting scholars, investors, and regulators REFERENCES Antle, R., and B Nalebuff 1991 Conservatism and auditor-client negotiations Journal of Accounting Research 29 (Supplement): 31–54 Auditing: A Journal of Practice & Theory August 2012 Abnormal Audit Fee and Audit Quality 19 Ashbaugh, H., R LaFond, and B Mayhew 2003 Do nonaudit services compromise auditor independence? Further evidence... ‘‘normal’’ fee levels Our finding that audit quality declines as positive abnormal audit fees increase in magnitude is consistent with prior research New to the literature is our finding that audit quality declines as negative abnormal audit fees increase in magnitude, with the decline increasing in magnitude as proxies for client bargaining power increase We also examine whether the audit quality /abnormal audit. .. Practice & Theory August 2012 Abnormal Audit Fee and Audit Quality 13 TABLE 4 Multivariate Analysis Panel A: Analysis of Earnings Quality and Abnormal Audit Fees Dependent Variable Variable Intercept LOABNAFEE HIABNAFEE LOFFICE INFLUENCE TENURE USLEADER CITYLEADER BUSSEG GEOSEG LOGMV SGROWTH SDSALES CFFO SDCFFO ICOPINION LEVERAGE LOSS DISTRESS B2M VOLATILITY FINANCED ACQUIRED LAGROA BIG-N QUALIFIED LDELAY... cost of audit failure Journal of Accounting Research 40 (4): 1221–1245 Choi, J., J Kim, and Y Zang 2010 The association between audit quality and abnormal audit fees Auditing: A Journal of Practice & Theory 29 (2): 115–140 Chung, H., and S Kallapur 2003 Client importance, nonaudit services, and abnormal accruals The Accounting Review 78 (4): 931–956 Craswell, A., and J Francis 1999 Pricing initial audits... 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Under the bargaining power story, we expect to find that audit quality declines as negative abnormal fees increase. between abnormal audit fees and audit quality (i.e., the curve relating audit quality to abnormal audit fees exhibits different slope for positive as compared to negative abnormal audit fees).