son - 2005 - do non-audit services influence audit quality

DO NON-AUDIT SERVICES INFLUENCE AUDIT QUALITY? by Myungsoo Son A DISSERTATION Presented to the Faculty of The Graduate College at the University of Nebraska In Partial Fulfillment of Requirements For the Degree of Doctor of Philosophy Major: Interdepartmental Area of Business (Accountancy) Under the Supervision of Professor Kung H. Chen Lincoln, Nebraska August, 2005 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. UMI Number: 3186882 INFORMATION TO USERS The quality of this reproduction is dependent upon the quality of the copy submitted. Broken or indistinct print, colored or poor quality illustrations and photographs, print bleed-through, substandard margins, and improper alignment can adversely affect reproduction. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if unauthorized copyright material had to be removed, a note will indicate the deletion. ® UMI UMI Microform 3186882 Copyright 2005 by ProQuest Information and Learning Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor, Ml 48106-1346 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. DISSERTATION TITLE DO NON-AUDIT SERVICES INFLUENCE AUDIT QUALITY? BY Myungsoo Son SUPERVISORY COMMITTEE: jproved Signature Dp. Kupi^ H. Cy\ev\ Typed Name 1 2 ,' Q & Q ‘ P i /Signature JpK, A* Typed Name Signature faO'Yort D . C Ye^lofVc -e Typed Name Signature tv. 1N/Wy 4* Typed Name / Date T ^ y ^ £ 0 , 2 0 0 5 - Signature Typed Name Signature Typed Name Lincoln Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Do Non-Audit Services Influence Audit Quality? Myungsoo Son, Ph.D. University of Nebraska, 2005 Adviser: Kung H. Chen Whether joint supply of NAS and audits influences audit quality has been a concern of many parties including SEC, investors, and critics of audit profession. Prior studies, however, have found conflicting results and no definite conclusions can be drawn on impacts of NAS on audit quality. Unlike previous studies, this study does not consider NAS to have an unidirectional linear effect on audit quality. Immaterial NAS is not likely to have significantly negative effects on auditor independence and may have positive impacts on audit quality because of “knowledge spillover”, especially for firms with short auditor tenure. Considering both the magnitude of NAS and auditor tenure effects allows this study to incorporate possibility that NAS can improve auditor competence. This study also differentiates “actual” audit quality from “appearance” audit quality by testing possibility that investors’ perception of audit quality may differ from actual audit quality. Finally, this study tests impacts of NAS on audit quality by comparing audit quality before and after Sarbanes-Oxley Act (SOX), which prohibits auditors from providing most NAS to their audit clients. If passage of SOX does indeed improve audit quality, the most noteworthy effect should be present for those firms who previously purchased large amounts of NAS. Overall, empirical results of this study fail to find positive effects of NAS, through knowledge spillover, on audit quality, but find negative effects of NAS as Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. measured by both actual and appearance proxies of audit quality. With regard to tests for effectiveness of prohibiting NAS, this study finds a moderate result that changes in financial reporting quality, after implementing SOX, vary depending on NAS purchases prior to the Act. However, there seems to be no difference in changes of perceived audit quality between firms with large NAS purchases and firms with small NAS purchases. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ACKNOW LEDGMENTS I have many wonderful memories from the past few years that I will always carry with me. I am thankful that God has been with me and helped me all the time. Dr. Chen was my mentor during my Ph.D. program. Without his guidance and advice, I would not have been able to achieve the goal. I would also like to express sincere thanks to other committee members, Dr. Crabtree, Dr. DeFusco, and Dr. McGarvey. My deepest thanks should be given to Sunny who supports me even in the hardest time and takes good care of my two children, Joseph and John. I am also grateful to my parents and mother in law who always encourage me to pursue what I plan. I am proud of having such wonderful parents. For several years, I have had the good fortune to meet colleagues who have been good friends and whose assistance has helped me successfully finish this course. Some took time to read my work and others spent time with me for lunch. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. TABLE OF CONTENTS ACKNOWLEDGEMENTS iii LIST OF FIGURES vi LIST OF TABLES vii CHAPTER 1 INTRODUCTION 1 1.1 Purpose of the Study 3 1.2 Importance of the Study 5 1.3 Results of the Study 6 1.4 Organization of the Study 7 2 BACKGROUND AND LITENATURE REVIEW 8 2.1 Regulations 8 2.1.1 SEC Final Rule S7-13-00 . 9 2.1.2 Sarbanes-Oxley Act (2002) 10 2.2 Related Literature 11 2.2.1 Negative E ffects 12 2.2.2 Positive Effects 14 2.2.3 No Effects 16 2.2.4 Summary 18 3 HYPOTHESES 19 3.1 Magnitude Effects 19 3.2 Auditor Tenure E ffects 23 3.3 Auditor Independence 23 3.4 Effects of Prohibiting NAS 30 4 RESEARCH DESIGN 33 4.1 Sample Selection 33 4.2 Measures of Audit Quality 35 4.3 Model Specification 38 4.3.1 Discretionary Accrual M odel 38 4.3.2 Earnings Response Coefficient Model 44 4.3.3 Models for the Tests of Effects Prohibiting NAS 46 5 RESULTS OF EMPIRICAL TESTS 48 5.1 Descriptive Statistics 48 5.2 Discretionary Accrual T ests 52 5.3 Earnings Response Coefficient Tests 55 5.4 Effects of Prohibiting NAS 56 5.5 Summary of Hypothesis Tests 59 5.6 Sensitivity Tests 60 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. V 6 CONCLUSIONS AND IMPLICATIONS 62 6.1 Conclusions 62 6.2 Contributions 63 6.3 Limitations and Suggestions for Future Research 64 REFERENCES 97 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. vi LIST OF FIGURES 1 Overview of the Research 68 2 Relationship between NAS and Audit Quality 69 3 Hypotheses 70 4 Causal Relationship Between NAS and Financial Reporting Quality 72 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. v ii LIST OF TABLES 1 Summary of Hypotheses 73 2 Sample Selection Procedure 74 3 Distribution of Sample Firms by Industry (Defined by SIC Code) 75 4 Descriptive Statistics of Audit and Nonaudit Fees 76 5 Descriptive Statistics for Variables 78 6 Variable Definitions 81 7 Correlation Matrix 83 8 Replication of Frankel, Johnson, and Nelson (2002) 85 9 Multivariate Models of Discretionary Accruals 86 10 Multivariate Models of Earnings Response Coefficients 89 11 Multivariate Models on Changes of Discretionary Accruals 92 12 Tests of the Impact of the SOX on Audit Quality 93 13 Multivariate Models on Changes of Earnings Response Coefficients 94 14 Summary of Hypotheses Tests 95 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. [...]... providing NAS to audit clients on audit quality Frankel, Johnson and Nelson (2002) find a positive association between non -audit fees and biased financial reporting, suggesting a negative impact of non -audit fees on audit quality Using UK data, Firth (2002) finds a significant positive association between NAS fees and incidence of clean audit reports, implying that auditors who provided NAS to audit clients... to the auditor and identifying whether the fee is for 1) audit, 2) financial information system design and implementation services, or 3) all other services including audit- related, internal audit, and tax The Rule defines audit fees narrowly to include only those fees for services necessary in the audit of 10-Ks and the review of 10-Qs Fees for audit related services or other attest services - such... effects of non -audit services (NAS) on audit quality For years, regulators of auditing practices and investors have expressed concerns the possibility that NAS may compromise auditor independence and impair audit quality The former SEC Chairman Arthur Levitt stated in his address at the New York University on May 10, 2000, “Consulting and other services may shorten the distance between the auditor and... impact of non -audit services (hereafter NAS) on audit quality is an issue of great concern to investors, regulators, and accounting professionals Prior studies, however, have found conflicting results and no definite conclusions can be drawn on the impact of auditors’ NAS on audit quality Unlike previous studies, this study does not assume NAS to have unidirectional linear effects on audit quality Immaterial... effects on audit quality, NAS having positive effects on audit quality, and NAS having no association with audit quality 2.1 Regulations This section discusses two recent regulations related to this study: SEC Final Rule S 7-1 3-0 0 and SOX Reproduced with permission of the copyright owner Further reproduction prohibited without permission 9 2.1.1 SEC Final Rule S 7-1 3-0 0 Impacts of NAS on audit quality. .. possible to examine whether or not NAS improves audit quality through learning and acquisition of firm-specific knowledge In view of the possibility that investors’ perception of audit quality may differ from the actual audit quality, this study differentiates “actual” audit quality from “appearance” audit quality by using two measures of financial reporting quality: discretionary accruals (DA) and earnings... determined by both auditor independence and auditor competence NAS can play important roles in both auditor independence and auditor competence While NAS may compromise auditors’ independence, it has the potential of increasing auditors’ competence through knowledge gained from NAS Improved auditor competence increases audit quality, while impaired auditor independence decrease audit quality Studies have... jeopardy Panel B shows the net effect of NAS on audit quality Initially (when the amount of NAS is small) audit quality increases with increases in NAS However, the increase continues only up to a certain point Once NAS exceeds that point, audit quality decreases10 Thus, the relationship between non -audit fees and audit quality looks like an inverted V and is non-monotonic By contrast, most research 11 presumes... on audit quality, considering differences in the magnitude of NAS and the length of auditor tenure In addition, this study tests the impact of the SOX on audit quality The SOX prohibits almost all NAS previously provided by CPA firms to their audit clients If NAS impaired audit quality, the implementation of the SOX should improve audit quality FIGURE 1 depicts the relationships among NAS, SOX, auditor... auditor tenure, and audit quality envisioned in this research It is expected that NAS influence both auditor Reproduced with permission of the copyright owner Further reproduction prohibited without permission 5 independence and competence, two components of audit quality Auditor tenure moderates the relationship, if any, between NAS and audit quality The impacts of NAS on audit quality may differ . permission. Do Non -Audit Services Influence Audit Quality? Myungsoo Son, Ph.D. University of Nebraska, 2005 Adviser: Kung H. Chen Whether joint supply of NAS and audits influences audit quality has. to audit clients on audit quality. Frankel, Johnson and Nelson (2002) find a positive association between non -audit fees and biased financial reporting, suggesting a negative impact of non -audit. 4810 6-1 346 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. DISSERTATION TITLE DO NON -AUDIT SERVICES INFLUENCE AUDIT QUALITY? BY Myungsoo Son SUPERVISORY