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Review of Quantitative Finance and Accounting

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01-08-2013 | Original Research

Non-audit fees, institutional monitoring, and audit quality

Authors: Chee Yeow Lim, David K. Ding, Charlie Charoenwong

Published in: Review of Quantitative Finance and Accounting | Issue 2/2013

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Abstract

We posit that the effect of non-audit fees on audit quality is conditional on the extent of institutional monitoring. We suggest that institutional investors have incentives and the ability to monitor financial reporting quality. Because of the reputation concerns and potential litigation exposure, auditors are likely to provide high audit quality, when they also provide non-audit services to clients, particularly when clients are subject to high institutional monitoring. We find evidence that, as non-audit fees increase, audit quality (measured by performance-adjusted discretionary current accruals and earnings-response coefficients) reduces only for clients with low institutional ownership but not for clients with high institutional ownership. Our results are robust after controlling for auditor industry specialization, firms’ operating volatility, size effect, and potential endogeneity between institutional ownership and audit quality.

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Prior studies also use the issuance of going concern opinions and incidence of restatements as alternative proxies for audit quality (e.g., DeFond et al. 2002; Kinney et al. 2004). We do not use these two proxies because of the small sample size. For example, the study by DeFond et al. (2002) only includes 96 firms that receive going concern opinions while the study by Kinney et al. (2004) has only 187 restating firms.

For brevity, we refer to all three measures as proxies for non-audit fees, although total fees (which include non-audit fees) is more related to total economic bonding.

For example, auditors are more likely to agree with managers’ financial-reporting preferences when the risk of losing the client is high (Farmer et al. 1987) and when accounting standards require a greater level of judgment (Magee and Tseng 1990; Trompeter 1994).

Bushee (2001) classifies institutions into three categories: transient institutions, which hold diversified portfolios with high turnover; dedicated institutions, which hold concentrated portfolios with low turnover; and quasi-indexers, which hold diversified portfolios with low turnover. We use aggregate institutional ownership due to data unavailability.

The distribution of the non-audit fees and total fees are non-normal, and hence following prior studies (e.g. Frankel et al. 2002; DeFond et al. 2002), we log-transformed the non-audit and total fee variables. Our measure for client importance (ratio of non-audit fees to total fees received by the auditor) is also non-normal and highly skewed. Hence, we follow Frankel et al. (2002) and Lim and Tan (2008) by rank-transforming the variable. The rank-transformation substantially reduced the skewness and kurtosis of the variable.

According to Zmijewski (1984), a positive score is an indicator of greater than 50 % likelihood of bankruptcy.

The apparent high mean and median values of APA_DCA is due to the absolute transformation. The signed mean and median discretionary current accruals are −0.062 and −0.018 respectively.

Total fees are the aggregate value and are meaningful only if both the audit and non-audit fees have similar effects on economic bonding. Srinidhi and Gul (2007) find that audit (non-audit) fees are positively (negatively) associated with accrual quality. Hence, our results suggest that the negative relation between total fees and discretionary current accruals is driven by the beneficial effect of audit fees on audit quality. Our untabulated results indicate that audit fees are negatively and significantly associated with discretionary current accruals (t = −3.11, p < 0.01).

The Audit Analytics database record the date when proxy statements on fee information are filed with the SEC. Most filings occur three to 4 months after the fiscal year end. We tracked the dates recorded in Audit Analytics to ensure that the fee information is available to investors when firms make the first quarterly earnings announcements after the fiscal year end.

The number of firms audited by non-Big 5 auditors and the extent of institutional ownership of these firms are very small in comparison to firms audited by Big 5 auditors. For example, in the discretionary current accruals test, 772 firms are audited by non-big 5, compared to 5,951 firms audited by Big 5. The mean (median) institutional ownership of firms audited by non-big 5 auditors is only 13 % (4 %) whereas the mean (median) institutional ownership of firms audited by Big 5 auditors is 40 % (39 %). Hence, we do not include those firms audited by non-Big 5 auditors in our main analysis because of the small number and low institutional ownership.

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Title: Non-audit fees, institutional monitoring, and audit quality
Authors: Chee Yeow Lim
David K. Ding
Charlie Charoenwong
Publication date: 01-08-2013
Publisher: Springer US
Published in: Review of Quantitative Finance and Accounting / Issue 2/2013
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-012-0312-1

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