This paper examines if non-audit service provision impairs auditor independence, and if the magnitude of auditor independence has changed after the 2004 Procomp scandal in Taiwan. Considering the measurement errors of discretionary accruals, we propose an alternative independence proxy- aggregate audit adjustments defined as the difference between audited earnings and un-audited earnings scaled by total assets. After controlling for the effects of financial leverage, operating and market performance, industry, company size and audit firm size, regression analysis indicates that the coefficient for non-audit fees ratio is negative and significant in 2003 and 2004. But, the absolute value of the coefficient is significantly smaller for 2004 than for 2003. Using non-audit fees to replace non-audit fees ratio to conduct regression analysis yields similar results. This finding is consistent with the notion that auditors make a trade-off between gaining service fees and avoiding litigation and reputation loss. Policy implications are also offered.
Keywords: Non-audit service, Auditor Independence, Procomp Effect, Aggregate Audit Adjustments
Introduction
This paper examines if non-audit service provision impairs auditor independence, and if the magnitude of auditor independence has changed after the Procomp scandal. Low balling exists in audit markets all over the world,1 which has led CPA firms to render more non-audit services for surviving in the industry. Proponents of non-audit service provision assert that synergies of knowledge spillover and audit efficiency arise from jointly providing audit and no-audit service (Simunic1984; Palmrose1986). However, critics contend that rendering non-audit service increases auditors' financial reliance on the client. As a result, it may cast a threat to auditor independence (Wines 1994; Beeler and Hunton 2001; Frankel, Johnson and Nelson 2002; Firth 2002). Prior empirical research has contributed little consensus on this issue. While some evidence suggests negative associations between non-auditor services and auditor independence (Wines 1994; Frankel, Johnson and Nelson 2002; Firth 2002), others state that the threat of lawsuits and reputation loss provides incentives for auditor independence and find no compromise of auditor independence (Crasewell, Stokes and Laughton 2002; Defond, Raghunnandan and Subramanyam 2002; Ashbaugh, LaFond and Mayhew 2003; Chung and Kallapur 2003; Elder, Zhou and Chen 2003).
We believe that the inconsistent finding may be attributed to the use of discretionary accruals as a proxy of auditor independence. Most prior empirical research relies on modified Jones model to estimate discretionary accruals. DeFond et al. (2002) argue that discretionary accruals is likely to be an indirect proxy, and there are empirical problems in measuring discretionary accruals. Healy (1996) points out that the existing model cannot adequately incorporate the effect of changes in business fundamentals. Discretionary accruals also confuse audit quality with earnings quality because the audited financial report is the joint product of management and the auditor. To pursue the auditor independence issue, in this paper, we propose an alternative proxy that is the difference between audited earnings and un-audited earnings scaled by total assets.2 This number (hereafter aggregate audit judgments) can more directly measure the audit adjustment and hence capture auditor independence.
Despite the mixed findings, the Sarbanes-Oxley Act in the U.S. lists eight types of services that are "unlawful" if provided to a publicly held company by its auditor after the Enron collapse. Three years after the Enron scandal, the Procomp scandal emerges in Taiwan and provokes public attention to auditor independence in providing audit service (see Appendix A for a description of the Procomp scandal). Although the Procomp scandal is not associated with non-audit service, the fast and unprecedented sanctions by Financial Supervisory Commission (FSC) and litigations against auditors by the Securities Investor and Futures Trader Protection Center in Taiwan may lead auditors to re-examine the balance between two types of incentives: service fees as opposed to litigation risk and reputation loss.3 Whether auditors will compromise independence when providing both audit and non-audit services to their client, and whether auditor independence will be enhanced after the Procomp scandal are important but unsettled issues.
This paper aims at examining whether providing non-audit service to audit clients will impair auditor independence, and whether auditor independence is enhanced after the Procomp scandal. In so doing, our paper contributes to the literature by using an alternative but more direct proxy for auditor independence. In addition, to our knowledge, our paper is the first to use field-archive data to investigate the effect of the Procomp scandal on auditor independence in the context of non-audit service provision. Finally, our study will have implications for the amendment of CPA Law that is under way in Taiwan. Our results indicate that non-audit fees ratio is significantly and negatively associated with audit judgment in both 2003 (prior to the Procomp event) and 2004 (after the event). But, as expected, the coefficient for 2003 is significantly smaller than that for 2004. Using non-audit fees (rather than non-audit fees ratio) as an independent variable suggests similar results.
The remainder of the paper is arranged as follows. The next section reviews the relevant literature and develops our research hypotheses. Section III describes our sample and research design. Section IV presents the empirical results. The last section summarizes our findings.
Prior Literature and Hypotheses
Recent concerns about auditor independence have focused on the provision of non-audit services to audit clients. Scholars concern that benefits either from cost savings or from fees revenue increases can strengthen the economic bond between auditors and their clients, which can further threaten auditor independence (e.g., Beck, Frecka and Solomon 1988; Beeler and Hunton 2001). However, Arrunada (1999) argues that provision of non-audit services increases the audit firm's investment in reputation capital, which the auditor is not likely to jeopardize to satisfy the demand of any one client. Following DeAngelo's (1981) "quasi rent" argument, considering future quasi rent stream will be forfeited, the auditor will not be tempted to compromise their independence. In addition, Dopuch, King and Schwartz (2004) state that provision of non-audit service increases reputation capital since the probability of misstatement risk is lowered.
Empirical tests on the association between non-audit fees and independence largely follow the research approach to earnings management via Jones model. If non-audit fees, but not the total fees, have significantly positive association with the accounting accruals, it appears that increases in non-audit fees influence auditor independence. Frankel et al. (2002) first proxy auditor independence by discretionary accruals estimated with a cross-sectional modified Jones (1991) model and use sample data from proxy statements filed with the SEC between February 2001 and June 2001 to examine this issue. They find a significant and positive relationship between non-audit services and magnitude of earnings management and conclude that financial bonding from non-audit services impairs auditor independence. Studies subsequent to Frankel et al. (2002) find contrast results because of different research designs for fees and accruals measurements. For instance, Chung and Kallapur (2003) argue that non-audit fees ratio cannot reflect the degree of economic dependence. They suggest using the ratio of client fees (or non-audit fees) to the audit firm's total revenues as a measure of client importance. They find no relationship between accruals and provision of non-audit services. Ashbaugh et al. (2003) employ performance-adjusted measures of discretionary accruals and group them into income-increasing and income-decreasing accruals. They find no association between the non-audit fees ratio and income-increasing discretionary accruals. But, income-decreasing discretionary accruals have significant relationship with non-audit fees ratio. Ashbaugh et al. (2003) conclude that auditors do not compromise their independence when clients pay high non-audit fees. Elder et al. (2003) investigate the relation between auditor size, non-audit services, and loan loss provision of commercial banks audited by Big 5 CPA firms. They find a positive relation between non-audit services and loan loss provisions. As a result, no evidence supports a relation between non-audit services and reduced auditor independence.
Other researchers use types of auditor's opinion as a surrogate for auditor independence and non-audit and audit fees as independent variables to examine their associations. Using audit qualification as a proxy for auditor independence, Wines (1994) finds that auditors of companies not receiving an audit qualification of any type derive a significantly higher proportion of their remuneration from non-audit service fees than the auditors of companies receiving at least one audit qualification for a sample of publicly listed companies in Australia. Firth (2002), using data from U.K., finds the same results. Two possible reasons exist for the observed relationship: a lack of auditor independence, and/or the consultancy services clearing up uncertainties and disagreements prior to the audit. DeFond et al. (2002) attempt to provide additional evidence by investigating another indicator of auditor independence- the auditor's willingness to issue a going concern audit opinion. Using distressed firms in U.S., they find no association between going concern opinions and either total fees or audit fees. The results are consistent with market-based incentives, such as loss of reputation and litigation costs, dominating the expected benefits from compromising auditor independence. Craswell et al. (2002) use a qualified audit opinion as an indicator of the exercise of auditor independence and measure fees dependence at both the national audit firm level as well as the local office level. They find that the level of auditor fees dependence does not affect auditor propensity to qualify their audit opinions.
In addition, Kinney, Palmrose and Scholz (2004) assume that restatements of previously issued financial statement reflect low-level auditor independence and do not find a statistically significant and positive association between non-audit fees and restatements.
Using publicly disclosed data on audit and non-audit fees, researchers in Taiwan also investigate the association between non-audit service provision and auditor independence. Lee, Xu and Chen (2003) find that auditors providing both services will allow higher magnitude of income-increasing accruals, where they find no significant relationship between income-decreasing accruals and provision of non-audit services. Lu (2003) investigates whether the association between non-audit fees and auditor independence is moderated by the level of engagement risks. She finds no relationship between non-audit fees ratio and the absolute value of abnormal accruals, but a significant interactive effect of engagement risk and non-audit fees, suggesting that high engagement risks leads auditor to suppress clients' earnings management. Using types of auditor reports as a dependent variable, Hu (2001) shows that provision of non-audit service is related to the type of audit report and the change of auditors. The study further indicates that the likelihood of auditor change becomes lower as the CPA firm renders both services, implying that auditor independence may be affected.
In summary, prior research yields mixed findings on the contention that non-audit services impair auditor independence. Methodological factors may account for the inconsistency. DeFond et al. (2002) argue that the use of earnings management as estimated by modified Jones model for surrogates of auditor independence is likely to be an indirect proxy, and there are empirical problems in measuring discretionary accruals. In addition, Healy (1996) points out that the obvious deficiency of the existing model lies in its inability to adequately incorporate the effect of changes in business fundamentals. For example, a firm's stage in its life cycle and the types of business changes are likely to be incorrectly classified as discretionary accruals by the current model. Discretionary accruals also confuse audit quality with earnings quality because the audited financial report is the joint product of management and the auditor.
Using audit opinion as a proxy for auditor independence, Joe (2003) examines if auditors are more likely to issue going-concern modified opinions when the client has the subject of negative press coverage prior to the date of the audit opinion. The results show that negative press coverage leads the auditor to modify the audit opinion. Thus, using opinion type as a proxy also suffers from measurement error. To mitigate the measurement problem, we propose an alternative measure as a proxy for auditor independence. This measure exploits the unique setting in Taiwan, which requires listed companies to disclose audited and un-audited earnings as well under certain circumstances. The difference between these two earnings scaled by total assets may more directly capture audit adjustment and therefore auditor independence. In addition, considering the litigation environment in Taiwan, auditor liability is far lower than that in the U.S. while the corporate frauds occur. The sanctions made by the regulatory agency also tend to be inefficient due to the prolonged procedures. Thus, we develop the following hypothesis:
H1: The provision of non-audit services will influence auditor independence.
Since the Enron collapse in 2001, there have been studies examining the market reactions to Arthur Anderson clients and other Big 4 clients. Dunne et al. (2005) find that their stock prices go down and the market suspects the quality of information provided by auditors, indicating that the event impairs CPAs reputation. In addition, Lai (2003) finds increasing number of going concern opinions issued by auditors. Krishnan（2004）supports the view that enhancing earnings conservatism becomes a common strategy to rebuild reputation for auditors. Hoitash, Markelevich and Barragato (2005) identify a significant positive association between non-audit fees and discretionary accruals in years 2000 and 2001, but no such association in post Enron years, concluding that auditor independence is improved. The above findings suggest that the behavior of stakeholders, including auditors, has been changed. In Taiwan, FSC immediately sanctions auditors involved in the Procomp scandal. The Securities Investor and Futures Trader Protection Center also files a class action against the auditors and CPA firms. The instant sanctions and legal actions increase auditors' litigation costs and reputation losses. Concerning the higher cost of litigation and reputation loss, auditors will re-examine the balance between the incentive of retaining clients and the incentive of lowering litigation risk and reputation loss, and thus become more independent. Thus, we propose the following hypothesis:
H2: In the post Procomp period, the level of auditor independence will be enhanced when jointly providing audit and non-audit services to audit clients.
Examining H2 can provide insights into how the Procomp scandal has affected auditors in Taiwan to re-examine the balance between quasi rents and litigation loss. It will also have policy implications about mechanisms for enhancing auditor independence, aside from barring non-audit services to audit clients.
Research Method
Research Design
Using discretionary accruals estimated from modified Jones model to surrogate for auditor independence has been a popular approach in the extant literature. However, it has serious measurement problems as indicated by Healy (1996) and DeFond et al. (2002). As a result, we use an alternative measure by calculating the absolute value of differences between un-audited and audited earnings scaled by total assets. SFC in Taiwan requires that listed companies that have announced their earnings forecast in a year disclose their un-audited earnings by the end of January the next year. If the un-audited earnings deviate from earnings forecast by a certain percentage, companies should file an explanation to the SFC and may be subject to SFC's scrutiny. Similarly, if audited earnings deviate from un-audited earnings by a certain percentage, the companies and auditors should file an explanation to SFC. The purpose of this requirement is to prevent companies from exploiting earnings forecast to manipulate stock prices. However, this stipulation could encourage listed companies to manage earnings to meet the forecast. It could also encourage auditors to prepare audit adjustments that result in a small deviation from un-audited earnings. Given this incentive, differences between audited and un-audited earnings will more directly capture auditor independence, with larger audit adjustments representing less compromise of independence. Hsieh and Tsai (2005) suggest that the aggregate audit adjustment could be a proxy of audit quality. We use absolute value of the difference scaled by total assets at the end of the previous year as a proxy of auditor independence. If the relationship between fees and audit adjustments is negative, it implies a compromise of independence.
For testing our hypotheses, following Frankel et al. (2002), Chung and Kallapur (2003), Ashbaugh et al. (2003), we modify prior theoretical structures and form our independence testing model:
Diff = f (fees, other control variables) (1)
Where, Diff represents auditor independence measured by the absolute value of the difference between audited and un-audited earnings scaled by total assets at the end of the previous year. Most prior research uses the ratio of non-audit fees to total fees as an explanatory variable. We further disaggregate total fees into components. It permits us to test the separate incentive effects of audit and non-audit fees and mitigate correlated omitted variables bias as audit and non-audit fees are positively correlated (Frankel et al. 2002). In model 2, fees, therefore, indicates the alternative specifications of fees measurements.
We also infuse audit firm size as an additional proxy of audit quality. Prior research suggests that Big5 auditors are less likely to allow earnings management than non-Big5 auditors (Frankel et al. 2002; Defond et al.2002; Craswell et al.2002; Ashbaugh et al. 2003). Thus, our study includes a Big 4 (labeled as Big4) indicator variables. In addition, Reynolds and Francis (2001) suggest that companies having financial distress tend to manipulate their earnings and hence resist the adjustment proposed by auditors to decrease the probability of debt breach or their capital costs. We use the debt ratio (Leverage) and an indicator variable (Loss, assigned one if the firm reported a loss) to measure financial risk. Frankel et al.(2002), Ashbaugh et al. (2003) and Hoitash et al.(2005) document that institutional investors can acquire information in low cost and have specific capabilities for monitoring. As ownership held by institutional investors increases, they will not tolerate earnings management behavior. Thus, we control the percentage of shares held by institutional investors (Ins%) in the model. Dechow et al. (1995) indicate that firm performance related to earnings quality. Francis and Ke (2002), Frankel et al. (2002), Chung and Kallapur (2003), Ashbaugh et al. (2003) also include firm performance in their study. We, thereby, use abnormal returns (RET) defined as stock returns minus market returns to control for performance effects. In addition, because companies in the electronics industry recently have more financial scandals and get legal sanctions, we believe that they will have high litigation risk. Francis et al. (1994) suggest that companies with high litigation risk are more likely to manage earnings. We use an indicator variable (ID) to control for litigation risk effects, where ID equals one if the company operates in the electronics industry as coded 13 by Taiwan Stock Exchange (TSE) and GreTai Securities Trading Center (GreTai). Lastly, we control for the effect of firm size (Size) since size will be representative of any omitted variable (Becker et al. 1998; Lee et al. 2003). Size is measured by the natural logarithm of sales. Accordingly, our complete model is as follows:
(2)
For testing H1, we analyze the above model 2 and estimate the regression coefficients for data in 2003 and 2004, respectively. We expect that the coefficients of β1 will be significantly different from zero. In order to test H2, the Procomp effects, we use the F test to examine the coefficient difference between two years (2003β1= 2004 β1).
Sample and Data Source
This study employs audit fees data publicly disclosed by companies listed in TSE and GreTai for 2003 and 2004. Starting in 2002, listed companies are required to disclose non-audit fees information provided that these companies pay non-audit fees and audit fees to a same audit firm with the ratio more than 25% or the non-audit fees being more than NTD 500,000 (about USD 15,295).4 In addition, companies meeting one of the following two situations are required to disclose audit fees information: (1) The company changes its audit firm and audit fees is less than that of the previous year. (2) Audit fees are less than at least 15% of the previous year's amount. Companies meeting one of the above situations constitute a sample of 213 and 164 for 2003 and 2004, respectively. However, companies in the latter two situations do not necessarily disclose non-audit fees information; we thus exclude 25 and 38 observations respectively. Similarly, some companies disclose only non-audit fees without audit fees or have incomplete disclosure on other financial data. These companies are further excluded. In addition, data provided by financial service companies are excluded, because including the financial service industry in the analysis will twist empirical results. Finally, we have 56 and 38 observations for each year.
Fees data are extracted from footnotes of the annual financial reports of each company. The annual financial reports are posted on Market Observation Post System website. Other information on company characteristics, financial data, and ownership structure for each company is obtained from the Finance File and Directorship File of Taiwan Economic Journal Data Base (hereafter TEJ).
Table 1 explains the data selection method. Table 2 shows the distribution of sample firms across the industries as classified by TSE and GreTai. It shows that 70% of our sample is from the electronics industry. Though we exclude financial service companies from analysis, the number of companies in this sector is half of that in the electronics industry, indicating that both industries demand more non-audit services.
Table 1. Sample selection
2003
2004
total
Initial Sample With Fees disclosures
213
164
377
Missing Audit Fees Data
(0)
(1)
1
Missing Non-audit Fees Data
(25)
(38)
63
Firms in Financial Service Industries
(21)
(22)
43
Missing Aggregate Audit Adjustments Data
(95)
(50)
145
Other Information Incomplete
(16)
(15)
31
Total
56
38
94
Table 2. Sample distribution by industries
Industry
code
2003
2004
total
Cement
1
1
0
1
Food
2
1
2
3
Plastic
3
1
1
2
Textile
4
1
0
1
Electric machinery
5
1
1
2
Appliance cable
6
1
0
1
Paper
8
1
0
1
Steel iron
10
1
2
3
Rubber
11
2
1
3
Automobile
12
2
3
5
Electronics
13
38
25
63
Construction
14
1
1
2
Department store
18
1
0
1
Other
20
4
2
6
Total
56
38
94
Empirical Results
Sample Characteristics
The descriptive statistics for our variables are in Table 3 and Table 4. The total fees are, on average, about NTD 5,100 thousands (about USD 156,011) for 2003 and 2004. The mean of audit fees is equal to NTD 3,408 thousands (about USD 104,252) and NTD 3,276 thousands (about USD 100,614) respectively. That is 12% higher than that of Chang and Tsao (2005), which use data for 2002. The ratio of non audit fees to total fees represents about 32% for both years. The non-audit fees are about to NTD 1,665 thousands (about USD 50,933) and NTD 1,889 thousands (about USD 57,785) respectively. Average audit fees decrease by 4% from 2003 to 2004, whereas non-audit fees represent a 14% increase. The fees trend shows that audit firms become more dependent on non-audit services revenues.
The average of aggregate audit adjustments in 2004 is 0.016, which is twice higher than that of 2003 (0.007). The higher amount of aggregate audit adjustments indicates that auditor independence is improved during the period of 2004. Therefore, the preliminary analysis provides evidence consistent with hypothesis 2 about the Procomp effect. As a validation, we also find that the percentage of firms receiving qualified and modified unqualified opinions is 54% and 56% for 2003 and 2004 respectively, inferring that auditors lightly tend to become conservative in 2004.
Regarding the control variables, the average firm size for 2003 and 2004 is respectively 0.059 and 0.073 with significant difference. Liability to asset ratio is 49% for both years. About 13% of the companies incur loss in 2003, which is approximately four times the rate in 2004 (3%). About 85-90% of companies in the sample employ Big4 audit firms. Average ownership by institutional investors is 38% for 2003 and 2004. Abnormal stock returns differ greatly between these two years. On average, companies earn a return that is 7% higher than the market index in 2003, whereas companies earn a return less than market index by 11% in 2004.
Table 5 presents the correlations of variables for pooling data. The aggregate audit adjustment has negative correlations with Big4 and abnormal return, but do not find significant correlations with others. The correlations among variables are generally small in absolute value with the largest correlation equal to 0.25. We also use two statistical methods to assess multicollinearity. They are tolerance statistics and the variance inflation factor (VIF). The tolerance value for each independent variable in our model exceeds 0.1. Values of variance inflation factors for our predictors are all less than 10. We therefore conclude that multicollinearity is not a distinct problem in our study.
Table 3. Descriptive statistics of 2003
2003 Year
N
Mean
Median
Std
Max
Min
Non-audit Fees Ratio
56
0.308
0.298
0.016
0.622
0.065
Total Fees
56
4984.68
3904
3214.60
13587
1532
Audit Fees
56
3408.25
2525
2487.537
12704
1080
Non-audit Fees
56
1665.605
1175
1416.371
7400
260
Diff
56
0.007
0.001
0.001
0.076
0
CPA Opinion
56
0.540
1
0.253
1
0
Size
56
0.059
0.076
0.142
0.441
-0.470
Leverage
56
0.494
0.503
0.144
0.773
0.086
Loss
56
0.130
0
0.111
1
0
Big4
56
0.894
1
0.31
1
0
INS%
56
0.378
0.337
0.223
0.953
0.038
RET
56
0.066
-0.083
0.464
2.046
-0.451
Industry
56
0.770
1
0.181
1
0
Table 4. Descriptive statistics of 2004
2004 Year
N
Mean
Median
Std
Max
Min
Non-audit Fees Ratio
38
0.288
0.282
0.031
0.683
0.065
Total Fees
38
4655.850
4018
2705.480
12414
1337
Audit Fees
38
3276.092
2689.50
2031.049
12099
300
Non-audit Fees
38
1888.658
1197.500
2035.543
12003
50
Diff
38
0.016
0.003
0.004
0.373
0
CPA Opinion
38
0.560
1
0.252
1
0
Size
38
0.073
0.086
0.117
0.253
-0.323
Leverage
38
0.487
0.488
0.141
0.760
0.227
Loss
38
0.026
0
0.026
1
0
Big4
38
0.850
1
0.134
1
0
INS%
38
0.378
0.326
0.216
0.802
0.011
RET
38
-0.117
-0.090
0.315
0.461
-0.718
Industry
38
0.740
1
0.181
1
0
Diff = the absolute value of difference between un-audited and audited earnings scaled by assets.
CPA Opinion = 1 if qualified or modified unqualified auditor reports, and 0 otherwise.
No-audit Fees Ratio = non-audit fees divided by total fees.
Total Fees = the natural log of the total fees.
Audit Fees = the natural log of the audit fees.
Non-audit Fees = the natural log of the non-audit fees.
Size = the natural log of net sales.
Leverage = debt over by assets.
Loss = 1if the firm reports loss in the observed year, and 0 otherwise.
Big4 = 1 if the firm is audited by Big 4 audit firms, and 0 otherwise.
Ins% = ownership by institutional investors.
RET = stock return minus market return.
ID = 1 if industry code is equal to 13,and 0 otherwise.
Table 5. Pearson correlation
Diff = the absolute value of difference between un-audited and audited earnings scaled by assets.
Non-audit Fees Ratio =non-audit fees divided by total fees.
Total Fees = the natural log of the total fees.
Audit Fees = the natural log of the audit fees.
Non-audit Fees = the natural log of the non-audit fees.
†*,**, *** are significant levels at 0.1, 0.05, and 0.01respectively.
Size = the natural log of net sales.
Leverage = debt divided by assets.
Loss = 1if the firm reports loss in observe year, and 0 otherwise.
Big4 = 1 if the firm is audited by Big 4 audit firms, and 0 otherwise.
Ins% = ownership by institutional investors.
RET = stock return minus market return.
ID = 1 if industry code is equal to 13,and 0 otherwise.
Regression Results
Table 6 demonstrates that the ratio of non-audit fees to total fees (i.e., non-audit fees ratio) is negatively related to the aggregate audit adjustments for both years (p=0.0298; 0.0518) with the magnitude of coefficients being greater in 2004 (-0.098) than in 2003 (-0.200). Using non-audit fees rather than non-audit fees ratio as an explanatory variable indicates that the coefficient of non-audit fees is negative (non-significant) in 2003 while positive and significant in 2004 (p=0.0164). These results suggest that more non-audit fees lead to less aggregate audit adjustments, implying auditors' compromise of independence. But, the tendency diminishes and auditors even become more independent despite the increase in non-audit fees in 2004.
This finding is consistent with the notion that when auditors weigh more on non-audit service fees than on the litigation risk and reputation loss, they tend to compromise their independence in performing financial statement assurance. This tendency occurs because litigation risk and reputation loss are low. However, when litigation risk and reputation loss are more severe, auditors will re-consider the trade-off between these types of incentives (Arrunada1999; Palmrose 1999; Dopuch et al.2001). As a result, auditors will become more independent by asking more conservative accounting treatments. Thus, we observe that auditors' adjustment is negatively related to non-audit fees ratio (and non-audit fees) in 2003 in which the legal environment cannot efficiently sanction auditors' mis-behavior. However, the legal environment becomes more stringent as a response to the Procomp scandal in 2004. We therefore observe that the coefficient of non-audit fees ratio becomes less negative in 2004. The coefficient of non-audit fees even becomes positive. F tests indicate that the differences in the coefficients for non-audit fees ratio and for non-audit fees between 2003 and 2004 are statistically significant (F values are 6.09 and 4.24 respectively). The results are consist with Krishnan（2004）and Hoitash et al.(2005) arguments that Enron event leads auditors to become conservative. Overall, our results support H1 and H2.
With respect to other explanatory and control variables, we find that only a few variables are significant. Of particular interest is Big4 which has a negative relationship with aggregate audit adjustment. It might indicate that auditors of Big 4 require less adjustment than those of non-Big 4. This explanation cannot account for the magnitude of coefficients in both years. Although the coefficients for Big4 in both years are negative, the absolute value is larger for 2004 than for 2003 (p values are < 0.03). An alternative explanation is that companies self-select auditors and therefore Big 4 auditors require less degree of adjustment for the clients that select Big 4 as auditors. In addition, Big 4 auditors are more careful in selecting and retaining clients after the Procomp scandal and hence their clients are less aggressive in financial reporting. As a result, Big 4 auditors require even less adjustment for their clients in 2004. RET has a positive but insignificant association with aggregate audit adjustment in 2003, but the coefficient becomes negative and significant in 2004. This might support the previous explanation that auditors are more conservative in selecting and retaining audit clients in 2004. The more selective the client screening, the less is the required audit adjustment.
To test the robustness of our results, we replicate our analysis using different samples: (1) a sample that excludes upward audit adjustment; or (2) a sample of firms operating in the electronics industry. We retain only the sample with downward audit adjustments because income-increasing earnings management is more concerned than income-decreasing earnings management by the public and the regulatory agency (Ashbaugh et al. 2003; Lee et al. 2005). In addition, downward audit adjustment corresponds more closely to auditor independence. We include only electronics companies as an alternative sample because they may be subject to higher litigation risk. The results from all of the regressions (presented in Panel A and Panel B of Table 7) report little difference from those in Table 6. Both tables consistently show that the coefficient for non-audit fees ratio is negative and significant in 2003, but positive in 2004. The coefficient for non-audit fees is negative in 2003 but positive and significant in 2004. Thus, our findings are not sensitive to our sample-selection criteria.
Table 6. Regressions of aggregate audit adjustments and audit and
non-audit fees
Model:
2003
2004
2003
2004
Non-audit Fees Ratio
-0.200**
-0.098**
Audit fees
0.007
-0.032
Non-audit Fees
-0.003
0.014**
Size
0.021
-0.127
-0.017
-0.109
Leverage
-0.019
0.046
-0.023
0.037
Loss
0.009
-0.001
0.007
0.006
Big4
-0.015**
-0.072***
-0.018**
-0.093***
Ins %
-0.005
-0.005
-0.007
0.004
RET
6-E4
-0.054*
7-E4
-0.067**
Industry
0.006
0.024
0.006
0.023
Adj-R Square
0.104
0.277
0.111
0.324
Model F
1.81
2.82
1.78
3.03
n
56
38
56
38
Hypotheses/
F Test
H0:β2003= β2004
H0:β2003= β2004
6.09 ***
5.60** (audit fees)
4.24** (non-audit fees)
Diff = the absolute value of difference between un-audited and audited earnings scaled by assets.
Fees is defined as follows:
Non-audit Fees Ratio = non-audit fees divided by total fees.
Audit Fees = the natural log of the audit fees.
Non-audit Fees = the natural log of the non-audit fees.
Size = the natural log of net sales.
Leverage = debt divided by assets.
Loss = 1 if the firm reports loss in the observed year, and 0 otherwise.
Big4 = 1 if the firm is audited by Big 4 audit firms, and 0 otherwise.
Ins% = ownership by institutional investors.
RET = stock return minus market return.
ID = 1 if industry code is equal to 13, and 0 otherwise.
†*,**, *** are significant levels at 0.1, 0.05, and 0.01, respectively.
††Hypotheses/ F test is for testing the difference of coefficients for fees variables between 2003 and 2004.
Table 7. Regression analysis using different samples
Model:
2003
2004
2003
2004
Panel A. Sample of downward audit adjustments
Non-audit Fees Ratio
-0.028**
0.134
Audit Fees
0.009**
-0.355
Non-audit Fees
-0.006
0.686**
Adj-R Square
0.120
0.358
0.467
0.469
Model F
1.94***
2.68***
9.38***
3.36**
Hypotheses/
F test
3.73**
6.13*** (Audit Fees)
4.58**(Non-audit Fees)
Panel B. Sample of the electronics industry
Non-audit Fees Ratio
-0.052**
0.061
Audit Fees
0.012**
-0.036
Non-audit Fees
-0.010
0.007**
Adj-R Square
0.153
0.358
0.469
0.469
Model F
2.08***
2.68***
9.38***
3.36**
Hypotheses/
F test
2.87*
6.83*** (Audit Fees)
2.79**(Non-audit Fees)
Diff = the absolute value of difference between un-audited and audited earnings scaled by assets.
Fees is defined as follows:
Non-audit Fees Ratio = non-audit fees divided by total fees.
Audit Fees = the natural log of the audit fees.
Non-audit Fees = the natural log of the non-audit fees.
Size = the natural log of net sales.
Leverage = debt divided by assets.
Loss = 1 if the firm reports loss in the observed year, and 0 otherwise.
Big4 = 1 if the firm is audited by Big 4 audit firms, and 0 otherwise.
Ins% = ownership by institutional investors.
RET = stock return minus market return.
ID = 1 if industry code is equal to 13, and 0 otherwise.
†*,**, *** are significant levels at 0.1, 0.05, and 0.01, respectively.
††Hypotheses/F test is for testing the difference in coefficients for fees variables between 2003 and 2004.
†††This table only reports results of fees variables in the model.
Conclusion
This paper aims at examining whether provision of non-audit service to audit clients impairs auditor independence, and whether the 2004 Procomp scandal has an effect on enhancing auditor independence. Using publicly disclosed fees data for fiscal years of 2003 and 2004, we empirically test the associations between non-audit service provision and auditor independence for both years. We use the ratio of non-audit fees to audit fees (i.e., non-audit fees ratio) and non-audit fees as alternative surrogates for the provision of non-audit service. To mitigate the measurement problem with the use of modified Jones model to estimate discretionary accruals as a surrogate for auditor independence, we adopt an alternative surrogate. This measure is calculated by taking the absolute value of the difference between audited earnings and un-audited earnings scaled by total assets. Listed companies in Taiwan are required to announce their un-audited earnings by the end of January if they have announced earnings forecast in the previous year. This requirement provides an unique opportunity to get access to the official un-audited earnings data.
After controlling for the effects of financial leverage, operating and market performance, industry, company size and audit firm size, regression analysis indicates that the coefficient for non-audit fees ratio is negative and significant in both years. But, the absolute value of the coefficient is significantly smaller for 2004 than for 2003. This finding supports the claim that provision of non-audit service increases auditors' financial reliance on their audit clients and therefore impairs their independence by requiring less audit adjustment. Further, it indicates that auditor independence is enhanced after the Procomp scandal. Using non-audit fees to replace non-audit fees ratio to conduct regression analysis yields similar results. But, the Procomp effect is even stronger. While the coefficient for 2003 is negative, it becomes positive and significant in 2004. Sensitivity analysis using only the companies whose earnings are adjusted downward by auditors as the sample suggests qualitatively the same results. Another sensitivity analysis with only companies in the electronics industry as the sample also indicates similar results.
This finding is consistent with the notion that auditors are faced with two types of incentives: gaining service fees and avoiding litigation and reputation loss. When the litigation and reputation loss is not severe, they will behave as if they were weighing more on service fees than on litigation and reputation loss. It is exactly the legal environment in Taiwan prior to the Procomp scandal. Prior to this event, regulatory sanctions against auditors are inefficient due to the prolonged procedures and no civil lawsuit against auditors is successful. The investor protection is not effective either. This legal environment provides auditors with little, if any, incentive to perform independently. However, immediately after the event broke out, SFC efficiently sanctions the involved auditors by suspending them from practice for two years. The Securities Investor and Futures Trader Protection Center also files lawsuit against auditors and audit firms. These unprecedented actions against auditors may have made auditors re-examine the balance between service fees and litigation risk when performing audit and non-audit services to the clients. In fact, there is some evidence that Big 4 firms are more careful and conservative in selecting audit clients as indicated by the percentage of Big 4 clients decreasing from 89.4% in 2003 to 85% in 2004. Because of the more selective practice, the coefficient for Big4 becomes even more negative in 2004. The differences in coefficients between 2003 and 2004 are significant, regardless of whether the independent variable is non-audit fees ratio or non-audit fees (p values are < 0.01).
Our study contributes to the literature by proposing an alternative surrogate for auditor independence. It captures the unique disclosure regulation in Taiwan that requires companies to officially and publicly disclose data on un-audited earnings, which is often difficult to obtain in other countries without such a requirement. Moreover, this measure directly observes the magnitude of aggregate audit adjustments made by auditors. In addition, to our knowledge, this study is the first to examine the impact of the Procomp scandal on auditor independence. Such an inquiry not only provides empirical evidence on how auditors balance different types of incentives, but it also has important implications for policy making. After the Enron scandal, auditors in the U.S. are barred from providing eight types of non-audit services to their audit clients. The Certified Public Accountants Law in Taiwan is currently under amendment. The draft proposes that auditors are proscribed from performing non-audit services to their audit clients whenever these non-audit services impair independence. Although the draft does not list specific non-audit services, as the U.S. does, the essence of the legislation is to prohibit non-audit service. Based on our findings, we believe that strengthening regulatory agency efficiency and law enforcement will be a better alternative. In fact, previous research indicates that jointly providing audit and non-audit services to the clients can increase audit efficiency via knowledge spillover (Simunic1984; Palmrose1986). As an economic agent, auditors will make a balance between service fees and litigation risk and loss.
The study has the following limitations. First, the sample in our study consists of companies paying non-audit fees to their auditors at least NTD 500,000 (about USD 15,295), or at least 25% as a percentage of non-audit fees to total fees. Whether the findings apply to other companies requires further study. Finally, our finding is based on the current institutional background; further research may examine auditors' behavior after the passage of the amended CPA Law.
Notes
According to China Times (2004/07/19), audit fees in Taiwan are lower than fees in the other Asian countries. It reports that audit fees in Taiwan are only one third as much as fess in Hong Kong.
It is a unique institutional setting in Taiwan that listed companies are required to announce their un-audited annual earnings by the end of the next year's January if companies have ever announced earnings forecast in a year. Listed companies are required to announce their audited annual earnings by the end of April regardless of whether or not they have announced earnings forecast.
Since the Procomp scandal took place in June, 2004, FSC immediately suspended auditors from practice for two years and Securities and Futures Investors Protection Center filed a class civil action against auditors. Procomp scandal is not associated with provision of non-audit services to the audit client, but these severe and fast sanctions and legal actions against auditors were never occurred in Taiwan before.
The NT dollar to US dollar conversion rate is 32.69:1. In the following, we use this conversion rate to express US dollars.
