Description
The purpose of this paper is to study whether auditor independence reforms introduced in
2004 led to an enhancement in earnings quality in the post-reform era.
Accounting Research Journal
The impact of auditor independence regulations on established and emerging firms
Victoria J . Clout Larelle Chapple Nilan Gandhi
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Victoria J . Clout Larelle Chapple Nilan Gandhi , (2013),"The impact of auditor independence regulations on
established and emerging firms", Accounting Research J ournal, Vol. 26 Iss 2 pp. 88 - 108
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The impact of auditor
independence regulations on
established and emerging ?rms
Victoria J. Clout
Australian School of Business,
University of New South Wales, Sydney, Australia
Larelle Chapple
QUT Business School,
Queensland University of Technology, Brisbane, Australia, and
Nilan Gandhi
PricewaterhouseCoopers, Brisbane, Australia
Abstract
Purpose – The purpose of this paper is to study whether auditor independence reforms introduced in
2004 led to an enhancement in earnings quality in the post-reform era.
Design/methodology/approach – This study predicts that as the cost of compliance will vary
based on a ?rm’s existing corporate governance regime and the level of external scrutiny (monitoring)
it faces, we compare the earnings quality of a sample of “established” (S&P/ASX 100) to a sample of
“emerging” (S&P/ASX Small Ordinaries Index) ?rms. The paper examines the reporting behaviour of
the two groups of listed entities, covering the regulatory change period 2003-2006. The paper uses
regression modelling to test the associations between increased audit independence, earnings quality
and corporate governance mechanisms over the pre- and post-regulatory period.
Findings – The paper’s results con?rm that earnings quality for the established ?rms was enhanced
in the post-reform period; while this was not the case for emerging ?rms. The evidence also suggests
that corporate governance mechanisms of board independence and board ?nancial skill are associated
with higher earnings quality; while the higher the concentration of insider ?rm ownership is
associated with lower earnings quality.
Practical implications – This study provides policy makers with evidence as to changes in
reporting behaviour following law reform aimed at strengthening auditor independence.
Originality/value – The studies on earnings quality are informed by the US market practices.
Australia provides a unique setting through its auditor independence reforms to examine the impact of
reform choices. This study also investigates two speci?c subsets of the market: established ?rms and
emerging ?rms.
Keywords Corporate governance, Auditor independence, Earnings quality, Auditors
Paper type Research paper
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
The authors would like to thank Ann Tarca, Elisabeth Dedman, Tom Smith, Baljit Sidhu,
Neil Fargher, Marion Hutchinson, Gerry Gallery and John Watson for their comments on this
paper. The authors would also like to acknowledge the input of participants at the 2009
AFAANZ Conference, workshop participants at the School of Accountancy Queensland
University of Technology, University of Technology Sydney, and participants at the 2010
European Accounting Association’s 33rd Annual Congress.
Accounting Research Journal
Vol. 26 No. 2, 2013
pp. 88-108
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/ARJ-Dec-2011-0045
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1. Introduction
This paper examines the impact of the introduction of the auditor independence
regulations in 2004 in Australia[1]. The impact is observed through both the change in
audit fee ratio and earnings quality as two measures of the impact of the auditor
independence reforms. The study is in?uenced by prior literature that hypothesises the
association between earnings quality and auditor independence: auditor independence
improves earning quality by reducing the effectiveness of management attempts to
manipulate earnings (DeFond, 2010; Wilson, 2011). This investigation adopts a novel
approach by examining the earnings quality of two groups of listed entities,
established and emerging ?rms, pre- and post- the regulatory change period identi?ed
herein as 2003-2006.
The costs of compliance with the newauditor independence regulation should impact
market participants differently and comparing established and emerging ?rms is one
way of examining potential differences. The Corporate LawEconomic ReformProgram
(Audit Reform and Corporate Disclosure) Act 2004 (also known as CLERP 9) was
intended to enhance auditor independence through changes in the operations of auditors
and audit ?rms in Australia. Normative concepts either prescribed by legislation or set
up as best practice need to be validated by empirical testing within relevant institutional
settings (Hutchinson, 2009).
Earning quality is an observable form of reporting behaviour. There is question in
the literature whether low earnings quality is the result of governance failure (Xie et al.,
2003), which suggests that an examination of the association between auditor
independence and earnings quality pre- and post- the introduction of CLERP 9 is
warranted. Earnings management and earnings quality are typically measured using
manipulated discretionary accruals. Earnings management allows management to
distort the reporting of economic events. It should be noted that while it is the board that
presents the ?nancial statements, accountants and auditors are part of the governance
structure in bringing information to the market (Dellaportas et al., 2005). Reduced auditor
independence is linked to low earnings quality in the literature; therefore, intuition
suggests that regulation that enhances auditor independence should improve audit
quality. Afunction of the auditor is to constrain managers’ propensity to reduce earnings
quality and this function is enhanced when independence is increased. There has been
considerable research into other aspects of external auditor independence characteristics
and earning quality, including auditor size (Gul et al., 2001) and tenure (Carey and
Simnett, 2006; Jackson et al., 2008). We seek to provide evidence of the cost and impact of
auditor independence reforms by measuring audit fee changes and earning quality
changes, before and after the period of auditor independence reform.
The main research question this study seeks to address, therefore, is:
RQ1. How did the CLERP 9 auditor independence reforms impact on audit fees and
earnings quality?
The second research question is:
RQ2. Did the reforms have a differential impact on established and emerging ?rms?
In this study the pre-CLERP 9 period is 1 January 2003 to 30 June 2004 and the
post-CLERP 9 period is 1 July 2004 to 31 December 2006. The CLERP 9 legislation
became operational on 1 July 2004. The research design uses a narrow duration to
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capture pre- and post-regulatory effects. As discussed below, CLERP 9 introduced
several audit independence reforms, including mandatory auditor rotation. Australian
data showthat in the post-CLERP 9 period, the peak of audit partner rotation occurred in
the year 2007 (Chapple and Hossain, 2011). Accordingly, we have refrained from
examining earnings quality during the peak rotation impact period because of a
potentially abnormal impact rotation may have on fee ratio, used in the calculation of our
auditor independence measure.
We expect the earnings quality observed in the emerging ?rms to be different to the
established ?rms, and we would expect this reporting behaviour to vary across
regulatory reform periods. Earnings quality is priced by the market (Xie et al., 2003)
and the regulatory reform was aimed at enhancing transparency and accountability,
which should enhance earnings quality. Low transparency and reduced accountability
create an environment in which low earnings quality is produced. Enhancing earnings
quality is a bene?t of the legislation.
We expect to also see a difference in non-audit service fees, across the different time
periods and impacting our sample market segments differently, as this was a
matter speci?cally targeted by CLERP 9 as in?uencing auditor independence, or the
perception of auditor independence. The Ramsay Report (Ramsay, 2001) speci?cally
mentioned non-audit services in the context of auditor independence threats. Ultimately
CLERP 9 regulated the disclosure of non-audit service fees but did not recommend
banning of certain services, unlike the US in the Sarbanes-Oxley legislation (Chapple
and Koh, 2007).
The established ?rms were drawn from the S&P/ASX 100 and represent the “top”
end of the market as measured by market capitalisation. They have suf?cient
capitalisation to allowthemto be institutionally investable. For a ?rmto be classi?ed as
established it had to rank higher than any of the emerging ?rms on all of the following
criteria: market value; book value per share; and ?nancial year-end share price.
We contrast the reporting behaviour of the established ?rms with what we refer to as
emerging ?rms that are drawn from S&P/ASX Small Ordinaries Index. The emerging
?rms represent smaller market capitalisation ?rms. They rank below established
?rms on: market value; book value per share; and ?nancial year-end share price. The use
of book value per share is consistent with the speci?cation in Garner et al. (2002) that
emerging ?rms lack “bricks-and-mortar” assets. The creation of the S&P/ASX
Emerging Companies Index in 2009 suggests an interest in this group of ?rms by the
investment community (ASX, 2009). These two groups of ?rms represent the two
different ends of the spectrum of the burden of costs of compliance.
Our study differs from prior research in that it examines the impact of signi?cant
regulatory reforms in Australia, focussing on the impact differential between
established and emerging ?rms. The studies on earning quality are generally
informed by the US market practices. Australia provides a different setting to study
earnings quality through its corporate governance, market and regulatory structures,
particularly the auditor independence reforms, which differ fromthe US Sarbanes-Oxley
reforms (Chapple and Koh, 2007; Wilson, 2011). Our study makes a number of signi?cant
contributions to the existing literature. First, given the auditor independence regulatory
reforms in Australia were designed to strengthen ?nancial reporting; we link audit
fee ratio and earnings quality and examine their relation to the auditor independence
reforms. Second, the insights gained fromour study informvarious market participants,
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including institutional investors seeking portfolios that include both established
and emerging ?rms; regulators seeking to evaluate the impact of the past regulatory
reforms and/or assessing potential future regulatory reforms; and investors interested in
the reporting practices of these two groups of ?rms.
The remainder of this study is organised as follows. The next section contains a
discussion of the background to auditor independence reforms in CLERP 9 and reviews
the related literature. Section 3 describes the theory and hypotheses development.
Section 4 describes the research design and variables analysed. Section 5 reports the
results of our analysis and Section 6 concludes.
2. Background and related literature
2.1 Auditor independence regulatory reforms
A number of high pro?le Australian reporting scandals and corporate collapses earlier
last decade, including HIH and One.Tel, focussed attention on corporate governance
rules and practices including auditor independence. This attention has taken the
form of regulatory change in Australia and overseas. In Australia, CLERP 9 imposed
statutory changes to auditor independence requirements with the aim of: improving
auditor independence; delivering improved disclosures; and enhancing the
enforcement arrangements for corporate misbehaviour and at the same time
allowing for wealth creation and innovation (Australian Treasury, 2003).
CLERP 9 gained approval from the Australian Federal Parliament on 25 June 2004
and came into effect on 1 July 2004. CLERP 9 contains a number of schedules dealing
with: audit reform; ?nancial reporting; remuneration of directors and executives[2];
continuous disclosure[3]; auditor independence; expensing of options; compliance
controls; and the encouragement of greater shareholder participation at meetings
(Deloitte, 2005). Since the introduction of CLERP 9, auditing standards have become
statutory-based and not merely professional obligations. One of the most important
changes CLERP 9 brought about was the establishment of the Auditing and Assurance
Standards Board (AUASB) as a statutory body and the creation of the Financial
Reporting Council (FRC). The FRC is responsible for the oversight of the AUASB and
for approving its strategic decisions.
Under CLERP 9[4] auditors are required to provide clients with a written declaration
that the auditor has complied with the auditor independence requirements of the
Corporations Act and any applicable codes of professional conduct. The new liability
framework is designed to encourage a culture of compliance by making it an offence to
breach the independence requirements and placing liability on members of audit ?rms.
The structure of the reforms comprises mandates against certain con?ict of interest
relationships and situations, and requires individual auditors and audit ?rms to
continually monitor professional relationships and circumstances to identify con?icts.
As soon as they become aware of a con?ict of interest situation, the auditor and the
audit ?rm must take all reasonable steps to extinguish the con?ict of interest situation.
Such con?ict of interest situations must also be noti?ed to the corporate regulator,
the Australian Securities and Investments Commission. The introduction of CLERP 9
has strengthened the requirements for independence of auditors so that investors,
stakeholders and the general public can have greater con?dence in audit reports and
the long run performance of companies (Deloitte, 2005; Cooper and Deo, 2005). CLERP 9
also states that individuals (lead and review auditors) who play a signi?cant role in the
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audit of a listed company for ?ve successive years are ineligible to do so again for a
further two years. Restrictions on employment relationships between auditors and
audit clients were also introduced by CLERP 9 in the form of a two-year cooling off
period before a member of an audit ?rm can become a director or of?cer of an audit
client. Finally, CLERP 9 introduced a requirement that companies address the
self-review threat. The provision of non-audit services raises the possibility that an
individual auditor may be required to review the work of another member of the same
audit ?rm. The self-review threat requires:
.
the mandatory disclosure of fees paid for non-audit services in certain categories;
and
.
a statement from the audit committee to be included in the annual report that it is
satis?ed that the provision of those services is compatible with auditor
independence[5].
2.2 Earnings quality
Low earnings quality occurs when managers use judgment in ?nancial reporting and
in structuring transactions to alter ?nancial reports to either mislead stakeholders
about the underlying economic performance of the company or to in?uence contractual
outcomes that depend on reported accounting numbers (Trueman and Titman, 1988;
Giroux, 2003). Managers can reduce earnings quality by either manipulating accruals
or through real activities (earnings management). Accrual manipulation has no direct
cash ?ow effect and examples include under-provision for bad debts and delaying
asset write-offs to future periods (Roychowdhury, 2003).
The literature suggests that earnings quality is systematically related to the strength
of the corporate governance environment, including auditor independence and low
earnings quality is generally an outcome of weak governance and a lack in a culture of
compliance (Bhat et al., 2006; Dechow et al., 1996; Klein, 2002; Xie et al., 2003; Yu, 2006).
Reforms brought about by the introduction of CLERP 9 changed auditor independence
regulation and liability in Australia through mandatory independence requirements for
auditors. The expectation is that the implementation of increased independence
requirements for auditors prompts management of ?rms to act more diligently and
with due care in respect to shareholders’ interests when reporting ?nancial matters
(Deloitte, 2005). Observing earnings quality, and changes in earnings quality, is a useful
way to capture management’s propensity to act with diligence in ?nancial reporting.
While earnings quality has been studied extensively in both the USA and the UK,
there have been only several relevant Australian studies to date[6]. Holland and
Ramsay (2003) detected an unusually large number of Australian ?rms just achieving
small pro?ts or small increases in earnings and suggested this was evidence of low
earnings quality. Low earnings quality is also indicated in the literature as being
associated by CEO change (Godfrey et al., 2003; Wells, 2002; Wilson and Wang, 2010).
Australian ?rms under the greatest scrutiny during periods of price controls were
found to have signi?cantly lower earnings quality as opposed to the same ?rms
outside this period, and those ?rms not subject to price controls (Lim and Matolcsy,
1999). Evidence on the role of the ?rms’ internal governance structures suggests that it
is signi?cant in constraining earnings management (Davidson et al., 2005).
Of signi?cance to this study, Kent et al. (2010) ?nd in examining accruals quality,
that the presence of a quality (i.e. Big-4) auditor is one of the indicators of
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earnings quality. Accordingly, this study aims to contribute to the literature by
examining the impact of the introduction of CLERP 9 and auditor independence
changes on earnings quality in Australia.
Financial ratios and debt levels can affect earnings quality. Hutchinson et al. (2008)
provides a discussion of current mixed evidence on the relationship between leverage
andearnings quality. Theysuggest that additional scrutinyis placedonhighlyleveraged
?rms and this in turn acts as a discouragement of earnings management behaviour,
i.e. lower earnings quality. Other earnings management studies have indicated a
potential incentive for earnings management is created when a highly leveraged ?rm
approaches breaching a debt covenant (for evidence on distressed ?rms, see Saleh and
Ahmed, 2005).
2.3 Fee ratio
Our other variable of interest, fee ratio, will be affected by other attributes of the ?rm. For
example, growth opportunities of the ?rm provides mixed evidence on the relationship
between growth and earnings management indicating that the management of both high
and low growth ?rms have incentives to potentially engage in earnings management
(Hutchinson et al., 2008). Management of ?rms with low growth opportunities and
considerable cash available may use earnings management to conceal actions in their
own interests ( Jensen, 1986). On the other hand, high growth ?rms have potentially
weaker internal controls, thereby opening up the possibility for earnings management
(Kinney and MacDaniel, 1989).
Further, the literature suggests a higher quality audit will be demanded for ?rms
with greater agency costs (i.e. those with higher leverage) and this higher quality audit
requirement should, in turn, be associated with a reduction in non-audit services.
2.4 Earnings quality and corporate governance
The corporate governance literature suggests that agency problems are resolved
throughthe monitoringactivities of outside directors (Davidsonet al., 2005; Peasnell et al.,
2005). Outside directors have incentives to maintain their reputational capital, and as
such, will be effective monitors of management (Fama, 1980; Fama and Jensen, 1983).
The corporate governance mechanism, board independence, is associated with
enhanced earnings quality in the post-CLERP 9 period (earnings quality proxied by
performance adjusted current discretionary accruals) (Hutchinson et al., 2008). Xie et al.
(2003) and Klein (2002) suggest that earnings quality is likely to be higher where there is
greater independent outside board representation. The suggestion from prior literature
is that board independence is able to provide enhanced oversight of a ?rm’s ?nancial
reporting and, therefore, ensure that the accounting reports are reliable (Beasley, 1996;
Dechow et al., 1996; Yatim et al., 2006). The monitoring role of independent directors is
often cited as having the potential to curtail managers’ propensity to engage in
earnings management, resulting in higher earnings quality. Domestic and international
guidelines and regulations on corporate governance often emphasise the importance of
the role of non-executive directors (NEDs) (e.g. CLERP 9; see also ASX, 2004; Sir Adrian
Cadbury, Cadbury Committee, 1992; NYSE, 2002).
Evidence also suggests that post-CLERP 9 management incentives, proxied by
executive share ownership, is positively associated with low earnings quality
(Hutchinson et al., 2008). The study conducted by He et al. (2009) is speci?cally
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motivated by the introduction of the ASX Corporate Governance principles. They
examine earnings management and its relation to the NEDs’ management and
oversight. Using a data-set comprising 231 ?rms in 2005, they ?nd an association
between share ownership by NEDs and grey directors and more earnings
management.
We are in?uenced by these prior studies to include corporate governance measures
in our model including board structure: CEO compensation and CEO turnover. These
measures are suggested to in?uence earnings quality in addition to auditor
independence. Wells (2002) and Godfrey et al. (2003) indicate that new and incoming
CEOs tend to engage in earnings management in the form of an earnings bath; that is
by both heavy non-cash write-offs and unexpected accruals. Wells (2002) also suggests
that because accounting income is largely irrelevant to CEOs’ welfare during their ?rst
?nancial year of tenure (typically a partial year) incoming CEOs have a considerable
incentive to minimise reported income in the initial stage of their tenure.
Evidence in the literature suggests a positive relationship CEO share and option
based compensation and low earnings quality (Bergstresser and Philippon, 2006;
Burns and Kedia, 2005; Healy, 1985; Safdar, 2003; Xie et al., 2003). For example,
Bergstresser and Philippon (2006) provide evidence that lower earnings quality is more
pronounced for ?rms where the CEO’s total compensation is closely tied to the value of
stock and option holdings. Prior literature notes that the purchase of non-audit services
could be interpreted as a reduction in earnings quality (Iyengar and Zampelli, 2008). It
has also been suggested that a ?rm’s compensation committee will adjust a CEO’s
earnings-based (i.e. accounting numbers based) incentive compensation when there is
the perception (or reality) of impaired earnings credibility as signalled by the purchase
of non-audit services.
2.5 Earnings quality and established and emerging ?rms
As noted previously, the auditor independence regulatory effect is examined across
two separate market segments, namely: ?rms with a high market capitalisation
(established); and ?rms with a low market capitalisation (emerging). Such a distinction
has not generally been made in previous earnings quality studies. We suggest that
established and emerging ?rms are likely to behave differently because of differences
in their size, media coverage, analyst following, the presence of institutional investors,
culture of compliance and the degree of scrutiny they face by regulatory bodies. This
offers a novel approach to examining the reporting behaviour of ?rms during a period
of substantial change in corporate governance (i.e. auditor independence) regulation.
Based on the prior literature and theory (Watts and Zimmerman, 1986) it is expected
that, compared to emerging ?rms, established ?rms will generally: adopt early; comply
with corporate governance mandates; and make more conservative accounting choices,
as evidenced through higher earnings quality.
Political costs also play a role in in?uencing accounting choices. These costs:
[. . .] refer to the ability of the government and its regulatory agencies or other interest groups
to effect wealth redistributions between claimants in the ?rm or between the ?rm and other
sectors of its industry or the economy (Whittred and Zimmer, 1990, p. 32).
Watts and Zimmerman (1986) suggest that larger ?rms are more politically sensitive
and they are likely to make more conservative accounting choices. It has also been
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suggested that corporations are likely to make attempts at countering potential
government intrusions through strategies such as: social responsibility campaigns;
lobbying; and by making accounting choices that minimise reported earnings (Watts
and Zimmerman, 1978). Established ?rms are expected to adopt corporate governance
best practices and more conservative accounting choices than emerging ?rms because
of greater monitoring and political costs of established. Earnings quality is excepted to
be higher for the established ?rms than emerging ?rms.
The literature considers share analysts to be external monitors of the ?rm (Le et al.,
2006; Yu, 2008). It should also be noted that established ?rms tend to have a larger
analyst following than emerging ?rms, with this difference being particularly
noticeable in Australia. The average number of brokers following a stock on the
S&P/ASX Small Ordinaries Index was 5.13 in 2008 and small market capitalisation
stocks typically have less research analyst coverage than large market capitalisation
stocks (Comerton-Forde et al., 2011).
3. Theory and hypothesis development
It is expected that the established ?rms in this study respond earlier to auditor
independence reforms than the emerging ?rms. Established ?rms are anticipated to
already have an adequate internal governance structures in place to improve
transparency and to assure the market they are one step ahead in best practice. We
expect that the establishedgrouphave primarilyBig-4 auditors while the emerging?rms
are expected to have a mix of Big-4 and non-Big-4 auditors. Given the extensive
pre-publicity given to the CLEREP 9 reforms, it is reasonable to expect that established
?rms and their auditors have prepared for CLERP 9 prior to its introduction. Hence, the
impact of CLERP 9 on these ?rms is likely to be lower than for emerging ?rms.
Established ?rms are also likely to be under heavier scrutiny from external monitors,
including analysts, the media and other parties, than emerging ?rms. The overall
expectation is that the introduction of CLERP 9 has a greater impact on emerging
compared to established ?rms. The introduction of increased regulatory reforms that
enhance the corporate governance environment will serve to limit the abilityof managers
to acquire private control bene?ts through earnings management (Wright et al., 2006).
The provision of non-audit services increases auditors’ incentives to acquiesce to
client pressure, including pressure to allow earnings management (Firth, 1997).
Through the regulation of disclosure of non-audit services fees and the independence
requirements introduced by CLERP 9, the economic bond between auditors and clients
is likely to decrease, thus improving auditor independence. CLERP 9 proposed a
general statement of principle requiring the independence of auditors. Frankel et al.
(2002) found non-audit fees to be positively related to discretionary accruals, while
audit fees were negatively associated with discretionary accruals. Similarly, Xie et al.
(2003) found lower levels of earnings management when there is greater auditor
independence and the results of this study for the post-CLERP 9 period are expected to
con?rm these relationships. As with auditor independence, we expect the improvement
to be more notable for emerging compared to established ?rms.
The above discussion can be re?ned into the following hypotheses concerning
established and emerging ?rms:
H1a. The CLERP 9 auditor independence regulatory reforms are associated with
(i) lower non-audit services fees and (ii) improved earnings quality.
Auditor
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H1b. The CLERP 9 auditor independence regulatory reforms are associated with (i)
lower non-audit services fees and (ii) improved earnings quality for
established more than for emerging ?rms.
4. Research design and variable description
This study uses pooled ordinary least squares regressions to examine the hypotheses
across time. We use FEERATIO, measured as total non-audit fees divided by
total fees paid, to proxy for auditor independence (Ashbaugh et al., 2003; Frankel et al.,
2002; DeFond et al., 2002; Chung et al., 2005; Ferguson et al., 2004). To proxy
for earnings quality we use a measure of accruals (Dechow et al., 1995; Bartov et al.,
2000):
ACC
it
¼ a
0
þb
1
FEERATIO
it
þb
2
FEERATIO £ POSTCLERP9
it
þb
3
POSTCLERP9 þb
4
EST
i
þb
5
POSTCLERP9 £ EST
it
þb
6
FEERATIO £ POSTCLERP9 £ EST
it
þb
7
OWNERSHIP_CONTROLS
it
þb
8
BOARD_CONTROLS
it
þb
9
AUDIT_CONTROLS
it
þb
10
FIRM_FINANCIAL_CONTROLS
it
þb
11
INDUSTRY_CONTROLS
it
þb
12
YEAR_CONTROLS
it
þ1
it
ð1Þ
where ACC is accruals measured as:
ACC
it
¼ ðDCA
it
2DCASH
it
Þ 2ðDCL
it
2STD
it
2DTP
it
Þ 2DEP
it
ð2Þ
where:
DCA
it
change in total current assets.
DCASH
it
change in cash and cash equivalents.
DCL
it
change in total current liabilities.
DSTD
it
change in short-term debt (included in current liabilities).
DTP
it
change in income taxes payable.
DEP
it
depreciation and amortisation expense for ?rm i in year t.
As in Leuz et al. (2003), where ?rms do not report information on taxes payable or
short-term debt these variables are assumed to be 0.
FEERATIO is measured as the non-audit fees to total audit fees in the ?rm year.
POSTCLERP9 is an indictor variable which takes the value of 1 for years
post-CLERP 9 period (2005 and 2006), and 0 for the years pre-CLERP 9 period (2003
and 2004). We use the interaction variable FEERATIO £ POSTCLERP9 to examine for
an association post CLERP 9 of the fee ratio with earning quality, i.e. if CLERP 9 has
changed the fee ratio then this variable will be signi?cant. EST is an indictor variable
that takes the value of 1 for an established ?rmand 0 otherwise. To examine H1b we are
interested in the association between the interaction variable EST £ POSTCLERP 9 –
a signi?cant coef?cient on this variable will indicate a variance between the two ?rm
groups and in the pre- and post-CLERP9 periods. The interaction variable
FEERATIO £ POSTCLERP9 £ EST is used to determine if the fee ratio plays a role
in this change between periods and ?rm groups.
ARJ
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Shareholders with small, diversi?ed holdings have a limited ability to actively
monitor the activities of management. However, the literature suggests that concentrated
shareholding by investors is associated with improved external monitoring of
management; as the payoff to these substantial shareholders is expectedto offset the cost
of monitoring (Agrawal and Knoeber, 1996). Hence, this study includes ownership
controls including the variables that proxy for a block-holder ownership measured as the
number of shares held by the top 20 largest shareholders (LARGESHD), percentage of
insider ownership (CLOSELYHLD) and an indictor for whether the largest substantial
holders is an institutional owner (INSTITHOLD). This study predicts that the presence
of a large-shareholder may potentially decrease managers’ propensity to engage in
earnings management behaviour and result in higher earnings quality.
Board controls include a board independence variable (BRDIND), a measure of ?nancial
skill (BOARDSKILL), CEO change (CEOCHG) and CEO pay sensitivity to market
performance (PAYSENMRK). The BRDINDvariable is designedto capture the ASX(2004)
corporate governance recommendation that the majority of the board be independent.
Consistent with Firth (1997) and Abbott et al. (2003), this study’s expectation is that
the recruitment of a new CEO (CEOCHG) is positively associated with earnings
management, i.e. lower earnings quality (lower ACC). Similarly to do with the governance
role of the CEO, lower earnings quality is associated with equity-based compensation, this
studypredicts a positive relationshipbetweenACCandthe measure of CEOpaysensitivity
to market performance (PAYSENMRK). In this study PAYSENMRK is measured as
the sum of all directors of the ?rm equity-based pay for the ?nancial year valued at fair
value.
Audit controls includes a measure of whether the ?rm’s auditor is a Big-4 ?rm or
not (BIG4) and an indictor for change of audit ?rm (AUDFIRMCHG). The BIG4
variable is included as the literature suggests that the use of a Big-4 versus non-Big-4
variable is a proxy for audit quality (Baxter and Cotter, 2009).
Craswell et al. (2000) suggest that non-audit services are associated with the same
demands as audit fees (e.g. ?rm size), level of business activity and company age.
Whether evidence as to the perceived or real impairment of auditor independence can
be gained from this investigation is important, as regulators have indicated that the
provision of non-audit service fees can impair auditor independence. Legislative
interventions, such as Sarbanes Oxley Act targeting and reducing non-audit service
fees are likely to result in an appearance of enhanced auditor independence as opposed
to real enhancement (Ruddock et al., 2006). Hence, we include in this study ?rm
?nancial controls including log of total assets (SIZE) and a indicator for a year of loss
(LOSS). SIZE is indicated as being positively associated with the demand for non-audit
services (Firth, 1997; Frankel et al., 2002) and larger ?rms tend to have more stable
accruals (Dechow and Dichev, 2002).
5. Empirical analysis
5.1 Data and sample
The study period is 1 January 2003 to 31 December 2006. Data were collected for the
dependent and independent variables from Aspect Financial Database, Connect 4 and
company annual reports.
The sample consists of 1,004 ?rm-year observations; 518 for established ?rms and
486 for emerging ?rms. The starting point for selecting the established ?rms was the
Auditor
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S&P/ASX 200 All Australian. The ?rms from the S&P/ASX 200 were checked to
ensure all the ?rms selected ranked higher than the emerging ?rms in terms of: market
value; book value per share; and year-end share price. Firms in the ?nancial industry
were removed and ?rms were also required to have available data over the period
1 January 2003 to 31 December 2006. This ?ltering procedure resulted in a sample of
518 ?rm-year observations for 132 ?rms.
The starting point for selecting the emerging ?rms was the S&P/ASX Emerging
Firm Index. The ?rms were then examined to ensure they ranked lower than the
established ?rms on: market value; book value per share; and year-end share price; and
had available data for the period 1 January 2003 to 31 December 2006. This ?ltering
procedure produced a total of 486 ?rm-years observations for 123 ?rms.
Table I, Panel A presents an industry breakdown of the ?rm-year observations.
Firms are reported in Table I within industry groups based on their Global Industry
Classi?cation Standard (GICS) classi?cation. The highest number of ?rm-year
observations is from the materials sector for established ?rms (131 ?rms) and also the
materials sector for emerging ?rms (115 ?rms). Consistent with prior studies banks
and ?nancial institutions were excluded from the sample. Table I, Panel B contains the
variable names and descriptions.
Table II provides the descriptive statistics for the variables used in the model. From
Table II it appears for both the established and emerging ?rms mean accruals are
negative, i.e. decreasing rather than increasing accruals (2154.51 for established ?rms
and 28.036 for emerging ?rms). This suggests that on average established ?rms
engage in more decreasing accruals over the period than emerging ?rms. There are
similar means for the FEERATIO, CLOSELYHELD and BOARDSKILL variables
between both the established and emerging ?rm groups. The mean for LARGESHD is
over double that for established ?rms compared to emerging ?rms. BRDIND variable
mean and maximum are greater for established than emerging ?rms group,
i.e. suggesting a greater number of independent directors on established ?rm boards.
Established ?rm boards of directors appear to have greater sensitivity to ?rm share
price for their compensation as the PAYSENMRK variable mean is greater for
established ?rms. SIZE variable is consistent with a greater size of established ?rms
compared to emerging ?rms – based on the log book value of assets. Emerging ?rms
are considered in the literature to have less “bricks-and-mortar” assets than established
?rms.
In terms of the indicator variables, in Panel B, the levels of institutional
shareholdings are slightly higher for the established ?rms compared to the emerging
?rms. The established ?rms have a greater proportion with Big-4 auditors than
emerging ?rms during the period. Both the established and emerging ?rms had a
relatively small number of changes in CEO during the study period. A greater
proportion of emerging ?rms have the LOSS variable – indicating this group are
composed of a higher number of loss ?rms than the established ?rms. Established
?rms experienced greater audit ?rm change compared to emerging ?rms when
examining the AUDFIRMCHG variable.
The Pearson correlation coef?cients between ACC and LARGESHD, BRDIND,
BOARDSKILL, BIG4, SIZE and LOSS are signi?cant. All are negatively correlated
except for LOSS. The positive relationship between the LOSS variable and ACC is
consistent with the prior literature (Table III).
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Panel A: ?rm-year observations for established and emerging ?rms
GICS code Sector
Firm
years
Established
?rms
Emerging
?rms
Total
?rms
10 Energy 16 23 38
15 Materials 46 36 77
20 Industrials 25 15 38
25 Consumer discretionary 19 9 24
30 Consumer staples 8 5 13
35 Health care 7 12 19
45 Information technology 3 13 16
50 Telecommunications
services 4 2 6
55 Utilities 3 0 3
Total ?rms 131 115 234
2003 119 102 221
2004 131 115 246
2005 131 115 246
2006 131 115 246
Total ?rm-year
observations 512 447 959
Panel B: variable descriptions
Variable Description
ACC Total accruals measured as the change in current assets from last period to this
period – change in cash and cash equivalents – (change in current liabilities –
change in short-term debt – change in tax payable) – depreciation
FEERATIO Ratio of non-audit fees to total fees paid
POSTCLERP9 Takes a value of 1 for years post-CLERP 9 period (2005 and 2006), and 0 for the
years pre-CLERP 9 period (2003 and 2004)
EST Takes a value of 1 for an established ?rm and 0 otherwise
OWNERSHIP_CONTROLS
LARGESHD Number of shares held by the largest 20 shareholders
CLOSELYHLD The percentage of shares held by insiders in the ?rm – in year t
INSTITHOLD Takes a value of 1 if the largest substantial shareholder is an institutional
shareholder in year t, and 0 otherwise
BOARD_CONTROLS
BRDIND Number of independent directors on the board
BOARDSKILL A sum of scores for all directors where for each director a score is given of 1 for
each board director with ?nancial expertise and 0 otherwise (where expertise is
either quali?cation, membership of professional body or past experience)
CEOCHG Takes a value of 1 in the year of a CEO change, and 0 otherwise
PAYSENMRK The sum of all directors of the ?rm equity-based pay for the ?nancial year
valued at fair value
AUDIT_CONTROLS
BIG4 Takes a value of 1 when a ?rm has a Big-4 audit ?rm in year t, and 0 otherwise
AUDFIRMCHG Takes a value of 1 if there is a new audit ?rm for the ?nancial year, and 0
otherwise
FIRM FINANCIAL_CONTROLS
SIZE Log of total assets
LOSS Takes a value of 1 if there is a net loss reported in year t, and 0 otherwise
INDUSTRY
CONTROLS
Takes a value of 1 for the industry controlled and 0 otherwise
Table I.
Sample and variable
descriptions
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s
c
o
r
e
i
s
g
i
v
e
n
o
f
1
f
o
r
e
a
c
h
b
o
a
r
d
d
i
r
e
c
t
o
r
w
i
t
h
?
n
a
n
c
i
a
l
e
x
p
e
r
t
i
s
e
a
n
d
0
o
t
h
e
r
w
i
s
e
(
w
h
e
r
e
e
x
p
e
r
t
i
s
e
i
s
e
i
t
h
e
r
q
u
a
l
i
?
c
a
t
i
o
n
,
m
e
m
b
e
r
s
h
i
p
o
f
p
r
o
f
e
s
s
i
o
n
a
l
b
o
d
y
o
r
p
a
s
t
e
x
p
e
r
i
e
n
c
e
)
;
P
A
Y
S
E
N
M
R
K
–
s
u
m
o
f
a
l
l
d
i
r
e
c
t
o
r
s
o
f
t
h
e
?
r
m
e
q
u
i
t
y
-
b
a
s
e
d
p
a
y
f
o
r
t
h
e
?
n
a
n
c
i
a
l
y
e
a
r
v
a
l
u
e
d
a
t
f
a
i
r
v
a
l
u
e
(
i
n
m
i
l
l
i
o
n
s
)
;
S
I
Z
E
–
l
o
g
o
f
t
o
t
a
l
a
s
s
e
t
s
;
I
N
S
T
I
T
H
O
L
D
–
t
a
k
e
s
a
v
a
l
u
e
o
f
1
i
f
t
h
e
l
a
r
g
e
s
t
s
u
b
s
t
a
n
t
i
a
l
s
h
a
r
e
h
o
l
d
e
r
i
s
a
n
i
n
s
t
i
t
u
t
i
o
n
a
l
s
h
a
r
e
h
o
l
d
e
r
i
n
y
e
a
r
t
,
a
n
d
0
o
t
h
e
r
w
i
s
e
;
C
E
O
C
H
G
–
t
a
k
e
s
a
v
a
l
u
e
o
f
1
i
n
t
h
e
y
e
a
r
o
f
a
C
E
O
c
h
a
n
g
e
,
a
n
d
0
o
t
h
e
r
w
i
s
e
,
B
I
G
4
–
t
a
k
e
s
a
v
a
l
u
e
o
f
1
w
h
e
n
a
?
r
m
h
a
s
a
B
i
g
-
4
a
u
d
i
t
?
r
m
i
n
y
e
a
r
t
,
a
n
d
0
o
t
h
e
r
w
i
s
e
;
L
O
S
S
–
t
a
k
e
s
a
v
a
l
u
e
o
f
1
i
f
t
h
e
r
e
i
s
a
n
e
t
l
o
s
s
r
e
p
o
r
t
e
d
i
n
y
e
a
r
t
,
a
n
d
0
o
t
h
e
r
w
i
s
e
;
A
U
D
F
I
R
M
C
H
G
–
t
a
k
e
s
a
v
a
l
u
e
o
f
1
i
f
t
h
e
r
e
i
s
a
n
e
w
a
u
d
i
t
?
r
m
f
o
r
t
h
e
?
n
a
n
c
i
a
l
y
e
a
r
,
a
n
d
0
o
t
h
e
r
w
i
s
e
Table II.
Descriptive statistics
for established and
emerging ?rms
ARJ
26,2
100
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
1
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
A
C
C
F
E
E
R
A
T
I
O
F
E
E
R
A
T
I
O
£
P
O
S
T
C
L
E
R
P
9
F
E
E
R
A
T
I
O
£
E
S
T
£
P
O
S
T
C
L
E
R
P
9
P
O
S
T
C
L
E
R
P
9
F
E
E
R
A
T
I
O
£
E
S
T
P
O
S
T
C
L
E
R
P
9
£
E
S
T
L
A
R
G
E
S
H
D
C
L
O
S
E
L
Y
H
L
D
A
C
C
1
F
E
E
R
A
T
I
O
2
0
.
0
0
9
1
F
E
E
R
A
T
I
O
£
P
O
S
T
C
L
E
R
P
9
2
0
.
0
1
2
0
.
4
6
1
*
*
1
F
E
E
R
A
T
I
O
£
E
S
T
£
P
O
S
T
C
L
E
R
P
9
2
0
.
0
1
2
0
.
4
6
1
*
*
1
.
0
0
0
*
*
1
P
O
S
T
C
L
E
R
P
9
2
0
.
0
3
3
2
0
.
1
2
8
*
*
0
.
6
2
4
*
*
0
.
6
2
4
*
*
1
F
E
E
R
A
T
I
O
£
E
S
T
2
0
.
0
0
9
1
.
0
0
0
*
*
0
.
4
6
1
*
*
0
.
4
6
1
*
*
2
0
.
1
2
8
*
*
1
P
O
S
T
C
L
E
R
P
9
£
E
S
T
2
0
.
0
3
3
2
0
.
1
2
8
*
*
0
.
6
2
4
*
*
0
.
6
2
4
*
*
1
.
0
0
0
*
*
2
0
.
1
2
8
*
*
1
L
A
R
G
E
S
H
D
2
0
.
6
4
9
*
*
2
0
.
0
0
7
0
.
0
0
7
0
.
0
0
7
0
.
0
3
9
2
0
.
0
0
7
0
.
0
3
9
1
C
L
O
S
E
L
Y
H
L
D
0
.
0
9
3
0
.
0
3
2
0
.
0
0
7
2
0
.
0
0
7
2
0
.
0
7
0
.
0
3
2
0
.
0
7
0
.
0
4
4
1
B
R
D
I
N
D
2
0
.
3
8
2
*
*
0
.
1
0
9
*
0
.
0
6
0
.
0
6
0
.
0
2
1
0
.
1
0
9
*
0
.
0
2
1
0
.
4
2
5
*
*
2
0
.
1
1
9
*
I
N
S
T
I
T
H
O
L
D
2
0
.
0
3
8
0
.
0
3
5
0
.
0
2
0
.
0
2
0
.
0
8
6
0
.
0
3
5
0
.
0
8
6
2
0
.
0
0
9
2
0
.
1
5
9
*
*
B
O
A
R
D
S
K
I
L
L
2
0
.
3
2
8
*
*
0
.
1
4
3
*
*
0
.
1
4
6
*
*
0
.
1
4
6
*
*
0
.
0
8
6
0
.
1
4
3
*
*
0
.
0
8
6
0
.
2
9
8
*
*
2
0
.
0
8
3
P
A
Y
S
E
N
M
R
K
2
0
.
0
5
9
0
.
0
0
6
0
.
0
2
5
0
.
0
2
5
0
.
0
3
6
0
.
0
0
6
0
.
0
3
6
0
.
0
9
3
*
0
.
0
3
5
C
E
O
C
H
G
2
0
.
0
0
9
2
0
.
0
3
3
2
0
.
0
0
6
2
0
.
0
0
6
2
0
.
0
2
2
2
0
.
0
3
3
2
0
.
0
2
2
0
.
0
0
7
0
.
0
0
1
B
I
G
4
2
0
.
1
3
4
*
*
0
.
2
1
8
*
*
0
.
0
8
5
0
.
0
8
5
2
0
.
0
1
8
0
.
2
1
8
*
*
2
0
.
0
1
8
0
.
2
3
8
*
*
0
.
1
6
4
*
*
A
U
D
F
I
R
M
C
H
G
2
0
.
0
1
1
0
.
0
3
8
0
.
0
8
0
.
0
8
0
.
0
6
5
0
.
0
3
8
0
.
0
6
5
0
.
0
5
2
2
0
.
0
4
S
I
Z
E
2
0
.
3
8
7
*
*
0
.
1
4
9
*
*
0
.
1
2
8
*
*
0
.
1
2
8
*
*
0
.
0
8
9
*
0
.
1
4
9
*
*
0
.
0
8
9
*
0
.
5
4
1
*
*
2
0
.
0
0
3
L
O
S
S
0
.
1
4
1
*
*
2
0
.
1
1
1
*
2
0
.
0
4
8
2
0
.
0
4
8
2
0
.
0
2
7
2
0
.
1
1
1
*
2
0
.
0
2
7
2
0
.
1
8
4
*
*
2
0
.
0
3
6
B
R
D
I
N
D
I
N
S
T
I
T
H
O
L
D
B
O
A
R
D
S
K
I
L
L
P
A
Y
S
E
N
M
R
K
C
E
O
C
H
G
B
I
G
4
A
U
D
F
I
R
M
C
H
G
S
I
Z
E
L
O
S
S
B
R
D
I
N
D
1
I
N
S
T
I
T
H
O
L
D
0
.
0
9
9
*
1
B
O
A
R
D
S
K
I
L
L
0
.
5
0
1
*
*
0
.
0
4
1
1
P
A
Y
S
E
N
M
R
K
0
.
0
7
1
2
0
.
0
4
3
0
.
0
3
5
1
C
E
O
C
H
G
0
.
0
9
8
*
2
0
.
0
0
7
0
.
0
5
2
0
.
1
3
3
*
*
1
B
I
G
4
0
.
4
0
8
*
*
0
.
0
7
6
0
.
3
4
5
*
*
0
.
0
4
6
0
.
1
0
7
*
1
A
U
D
F
I
R
M
C
H
G
2
0
.
0
7
5
2
0
.
0
1
2
0
.
0
4
5
2
0
.
0
0
9
2
0
.
0
3
7
2
0
.
1
1
7
*
*
1
S
I
Z
E
0
.
6
9
6
*
*
0
.
0
7
2
0
.
5
1
0
*
*
0
.
1
0
5
*
0
.
1
3
1
*
*
0
.
6
0
8
*
*
2
0
.
0
8
1
1
L
O
S
S
2
0
.
3
9
6
*
*
2
0
.
1
0
4
*
2
0
.
3
8
8
*
*
2
0
.
0
6
2
2
0
.
0
7
8
2
0
.
4
6
3
*
*
0
.
0
4
8
2
0
.
6
3
6
*
*
1
N
o
t
e
s
:
S
i
g
n
i
?
c
a
n
t
a
t
:
*
0
.
0
5
a
n
d
*
*
0
.
0
1
l
e
v
e
l
s
;
B
I
G
4
–
e
q
u
a
l
t
o
1
f
o
r
a
l
l
?
r
m
s
a
n
d
i
s
t
h
e
r
e
f
o
r
e
,
a
c
o
n
s
t
a
n
t
;
A
C
C
–
a
c
c
r
u
a
l
s
m
e
a
s
u
r
e
d
a
s
p
e
r
D
e
c
h
o
w
e
t
a
l
.
(
1
9
9
5
)
a
n
d
L
e
u
z
e
t
a
l
.
(
2
0
0
3
)
(
i
n
m
i
l
l
i
o
n
s
)
;
F
E
E
R
A
T
I
O
–
r
a
t
i
o
o
f
n
o
n
-
a
u
d
i
t
f
e
e
s
t
o
t
o
t
a
l
f
e
e
s
p
a
i
d
t
o
t
h
e
e
x
t
e
r
n
a
l
a
u
d
i
t
o
r
;
L
A
R
G
E
S
H
D
–
n
u
m
b
e
r
o
f
s
h
a
r
e
s
h
e
l
d
b
y
t
h
e
l
a
r
g
e
s
t
2
0
s
h
a
r
e
h
o
l
d
e
r
s
r
e
p
o
r
t
e
d
(
i
n
m
i
l
l
i
o
n
s
)
;
C
L
O
S
E
L
Y
H
L
D
–
p
e
r
c
e
n
t
a
g
e
o
f
s
h
a
r
e
s
h
e
l
d
b
y
i
n
s
i
d
e
r
s
i
n
t
h
e
?
r
m
;
B
R
D
I
N
D
–
n
u
m
b
e
r
o
f
i
n
d
e
p
e
n
d
e
n
t
d
i
r
e
c
t
o
r
s
o
n
t
h
e
b
o
a
r
d
;
B
O
A
R
D
S
K
I
L
L
–
s
u
m
o
f
a
s
c
o
r
e
f
o
r
a
l
l
d
i
r
e
c
t
o
r
s
w
h
e
r
e
f
o
r
e
a
c
h
d
i
r
e
c
t
o
r
a
s
c
o
r
e
i
s
g
i
v
e
n
o
f
1
f
o
r
e
a
c
h
b
o
a
r
d
d
i
r
e
c
t
o
r
w
i
t
h
?
n
a
n
c
i
a
l
e
x
p
e
r
t
i
s
e
a
n
d
0
o
t
h
e
r
w
i
s
e
(
w
h
e
r
e
e
x
p
e
r
t
i
s
e
i
s
e
i
t
h
e
r
q
u
a
l
i
?
c
a
t
i
o
n
,
m
e
m
b
e
r
s
h
i
p
o
f
p
r
o
f
e
s
s
i
o
n
a
l
b
o
d
y
o
r
p
a
s
t
e
x
p
e
r
i
e
n
c
e
)
;
P
A
Y
S
E
N
M
R
K
–
s
u
m
o
f
a
l
l
d
i
r
e
c
t
o
r
s
o
f
t
h
e
?
r
m
e
q
u
i
t
y
-
b
a
s
e
d
p
a
y
f
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Table III.
Pearson corrections
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5.2 Regression analysis
Table IV presents the results of the pooled regression to test the hypothesised
relationship between earnings quality (ACC) and fee ratio (FEERATIO) for the
established and emerging groups.
The does not appear to be a signi?cant association the measure of earnings quality
and auditor independence. This is also the case partitioning for the two ?rmgroups and
for the pre- and post-CLERP 9 periods. The results do suggest for the sample that
post-CLERP 9 earnings quality has decreased, while this is not the case for established
Coef?cient p-value
FEERATIO 32.27 0.610
POSTCLERP9 696.67 0.085
*
EST 266.38 0.340
FEERATIO £ POSTCLERP9 234.06 0.575
FEERATIO £ EST £ POSTCLERP9 138.21 0.268
FEERATIO £ EST 2158.51 0.243
POSTCLERP9 £ EST 288.57 0.070
*
Ownership controls
LARGESHD 2851.67 0.000
* *
CLOSELYHLD 1.43 0.034
* *
INSTITHOLD 17.99 0.657
Board controls
BRDIND 218.35 0.119
BOARDSKILL 228.16 0.012
* *
CEOCHG 211.34 0.836
PAYSENMRK 0.002 0.994
Audit controls
BIG4 70.89 0.026
* *
AUDFIRMCHG 54.71 0.216
Firm ?nancial controls
SIZE 219.54 0.648
LOSS 25.51 0.443
INDUSTRY CONTROLS Yes
YEAR CONTROLS Yes
FIRM STANDARD CLUSTERED ERRORS Yes
R
2
52.43%
Notes: Signi?cant at:
*
0.05 and
* *
0.01 levels; the model was estimated using robust standard errors;
ACC – accruals measured as per Dechow et al. (1995) and Leuz et al. (2003) (in millions); FEERATIO –
ratio of non-audit fees to total fees paid to the external auditor; LARGESHD – number of shares held
by the largest 20 shareholders reported (in millions); CLOSELYHLD – percentage of shares held by
insiders in the ?rm; BRDIND – number of independent directors on the board; BOARDSKILL – sum
of a score for all directors where for each director a score is given of 1 for each board director with
?nancial expertise and 0 otherwise (where expertise is either quali?cation, membership of professional
body or past experience); PAYSENMRK – sum of all directors of the ?rm equity-based pay for the
?nancial year valued at fair value (in millions); SIZE – log of total assets; INSTITHOLD – takes a
value of 1 if the largest substantial shareholder is an institutional shareholder in year t, and 0
otherwise; CEOCHG – takes a value of 1 in the year of a CEO change, and 0 otherwise; BIG4 – takes a
value of 1 when a ?rm has a Big-4 audit ?rm in year t, and 0 otherwise; LOSS – takes a value of 1 if
there is a net loss reported in year t, and 0 otherwise; AUDFIRMCHG – takes a value of 1 if there is a
new audit ?rm for the ?nancial year, and 0 otherwise
Table IV.
Explaining ACC
for established
and emerging ?rms
(modelling
equation (1)) – pooled
sample
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?rms (with a negative and signi?cant sign on the coef?cient of POSTCLERP9 £ EST).
The corporate governance mechanisms that appear to be associated with higher
earnings quality are large-shareholder LARGESHD (i.e. block-holder) and
BOARDSKILL (both signi?cant and negatively associated with ACC). Where a ?rm
is closely held by insiders this appears to be associated with lower earnings quality
(a positive and signi?cant association between CLOSELYHLD and ACC).
6. Conclusion
The aim of this study was to investigate the contention that auditor independence
regulatory change (CLERP 9) led to a changes in company behaviour. Speci?cally we
address two related research questions on the association between earnings quality and
auditor independence. Given ?rms operate in different information environments, new
legislation impact is predicted to vary based on a ?rm’s existing corporate governance
regime and the level of external scrutiny (monitoring), therefore, we compare
“established” and “emerging” ?rms to examine this contention. The creation of
the S&P/ASX Emerging Companies Index in 2009 signals interest in the market in this
group of ?rms. The main ?ndings we report have implications for ?rms, accounting
standards setters and regulatory bodies.
Consistent with expectations, our results suggest for the established ?rms
post-CLERP 9 earnings quality has improved. Given that emerging ?rms face less
monitoring and lower political costs, the regulatory changes introduced in CLERP 9
appears that these ?rms have not experience an enhancement in earnings quality.
In terms of our stated research design, the intuition for H1a (earnings quality is
enhanced post-CLERP 9) is supported in the regression analysis, and hypothesis 1b
(the change in earnings quality is greater for emerging ?rms) is supported also.
Our results also suggest that of the corporate governance mechanisms of board
independence and board ?nancial skill are associated with higher earnings quality.
While the higher the concentration of insider ?rm ownership is associated with lower
earnings quality.
Notes
1. Regulatory change here means the effect of new legislation – the Corporate Law Economic
ReformProgram(Audit Reformand Corporate Disclosure) Act 2004 (referred to as CLERP 9).
2. CLERP 9 amended the Corporations Act 2001 and required companies to include a dedicated
Remuneration Report in the annual report. The Remuneration Report must set out the
remuneration details of all directors and top executives, and is subject to non-binding
approval by shareholders.
3. The introduction of CLERP 9 enhanced ASIC’s power to issue infringement notices and
impose penalties on companies contravening the continuous disclosure regime (Hsu, 2009).
4. All of these legislative requirements described below are contained in Division 3 Auditor
Independence of Part 2M.4 Corporations Act 2001.
5. In 2003 the categories were set out in Professional Statement FI (for further details, see
ICAA, 2004) and from 2006 onwards APES 110.
6. See Wilson (2011) for a comprehensive review of the Australian literature.
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Montgomery, C.A. and Hariharan, S. (1991), “Diversi?ed expansion by large established ?rms”,
Journal of Economic Behavior & Organization, Vol. 15, pp. 71-89.
Palmrose, Z.-V. (1986), “The effect of non-audit services on the pricing of audit services”, Journal
of Accounting Research, Vol. 24, pp. 405-411.
S&P (2010), S&P ASX Australian Indices: Methodology, Standard & Poors,
The McGraw-Hill Companies, Inc., April, available at: www.standardandpoors.com
(accessed 12 June 2010).
Simunic, D.A. (1984), “Auditing, consulting and auditor independence”, Journal of Accounting
Research, Vol. 22, pp. 679-702.
Corresponding author
Victoria J. Clout can be contacted at: [email protected]
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doc_553598754.pdf
The purpose of this paper is to study whether auditor independence reforms introduced in
2004 led to an enhancement in earnings quality in the post-reform era.
Accounting Research Journal
The impact of auditor independence regulations on established and emerging firms
Victoria J . Clout Larelle Chapple Nilan Gandhi
Article information:
To cite this document:
Victoria J . Clout Larelle Chapple Nilan Gandhi , (2013),"The impact of auditor independence regulations on
established and emerging firms", Accounting Research J ournal, Vol. 26 Iss 2 pp. 88 - 108
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The impact of auditor
independence regulations on
established and emerging ?rms
Victoria J. Clout
Australian School of Business,
University of New South Wales, Sydney, Australia
Larelle Chapple
QUT Business School,
Queensland University of Technology, Brisbane, Australia, and
Nilan Gandhi
PricewaterhouseCoopers, Brisbane, Australia
Abstract
Purpose – The purpose of this paper is to study whether auditor independence reforms introduced in
2004 led to an enhancement in earnings quality in the post-reform era.
Design/methodology/approach – This study predicts that as the cost of compliance will vary
based on a ?rm’s existing corporate governance regime and the level of external scrutiny (monitoring)
it faces, we compare the earnings quality of a sample of “established” (S&P/ASX 100) to a sample of
“emerging” (S&P/ASX Small Ordinaries Index) ?rms. The paper examines the reporting behaviour of
the two groups of listed entities, covering the regulatory change period 2003-2006. The paper uses
regression modelling to test the associations between increased audit independence, earnings quality
and corporate governance mechanisms over the pre- and post-regulatory period.
Findings – The paper’s results con?rm that earnings quality for the established ?rms was enhanced
in the post-reform period; while this was not the case for emerging ?rms. The evidence also suggests
that corporate governance mechanisms of board independence and board ?nancial skill are associated
with higher earnings quality; while the higher the concentration of insider ?rm ownership is
associated with lower earnings quality.
Practical implications – This study provides policy makers with evidence as to changes in
reporting behaviour following law reform aimed at strengthening auditor independence.
Originality/value – The studies on earnings quality are informed by the US market practices.
Australia provides a unique setting through its auditor independence reforms to examine the impact of
reform choices. This study also investigates two speci?c subsets of the market: established ?rms and
emerging ?rms.
Keywords Corporate governance, Auditor independence, Earnings quality, Auditors
Paper type Research paper
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
The authors would like to thank Ann Tarca, Elisabeth Dedman, Tom Smith, Baljit Sidhu,
Neil Fargher, Marion Hutchinson, Gerry Gallery and John Watson for their comments on this
paper. The authors would also like to acknowledge the input of participants at the 2009
AFAANZ Conference, workshop participants at the School of Accountancy Queensland
University of Technology, University of Technology Sydney, and participants at the 2010
European Accounting Association’s 33rd Annual Congress.
Accounting Research Journal
Vol. 26 No. 2, 2013
pp. 88-108
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/ARJ-Dec-2011-0045
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1. Introduction
This paper examines the impact of the introduction of the auditor independence
regulations in 2004 in Australia[1]. The impact is observed through both the change in
audit fee ratio and earnings quality as two measures of the impact of the auditor
independence reforms. The study is in?uenced by prior literature that hypothesises the
association between earnings quality and auditor independence: auditor independence
improves earning quality by reducing the effectiveness of management attempts to
manipulate earnings (DeFond, 2010; Wilson, 2011). This investigation adopts a novel
approach by examining the earnings quality of two groups of listed entities,
established and emerging ?rms, pre- and post- the regulatory change period identi?ed
herein as 2003-2006.
The costs of compliance with the newauditor independence regulation should impact
market participants differently and comparing established and emerging ?rms is one
way of examining potential differences. The Corporate LawEconomic ReformProgram
(Audit Reform and Corporate Disclosure) Act 2004 (also known as CLERP 9) was
intended to enhance auditor independence through changes in the operations of auditors
and audit ?rms in Australia. Normative concepts either prescribed by legislation or set
up as best practice need to be validated by empirical testing within relevant institutional
settings (Hutchinson, 2009).
Earning quality is an observable form of reporting behaviour. There is question in
the literature whether low earnings quality is the result of governance failure (Xie et al.,
2003), which suggests that an examination of the association between auditor
independence and earnings quality pre- and post- the introduction of CLERP 9 is
warranted. Earnings management and earnings quality are typically measured using
manipulated discretionary accruals. Earnings management allows management to
distort the reporting of economic events. It should be noted that while it is the board that
presents the ?nancial statements, accountants and auditors are part of the governance
structure in bringing information to the market (Dellaportas et al., 2005). Reduced auditor
independence is linked to low earnings quality in the literature; therefore, intuition
suggests that regulation that enhances auditor independence should improve audit
quality. Afunction of the auditor is to constrain managers’ propensity to reduce earnings
quality and this function is enhanced when independence is increased. There has been
considerable research into other aspects of external auditor independence characteristics
and earning quality, including auditor size (Gul et al., 2001) and tenure (Carey and
Simnett, 2006; Jackson et al., 2008). We seek to provide evidence of the cost and impact of
auditor independence reforms by measuring audit fee changes and earning quality
changes, before and after the period of auditor independence reform.
The main research question this study seeks to address, therefore, is:
RQ1. How did the CLERP 9 auditor independence reforms impact on audit fees and
earnings quality?
The second research question is:
RQ2. Did the reforms have a differential impact on established and emerging ?rms?
In this study the pre-CLERP 9 period is 1 January 2003 to 30 June 2004 and the
post-CLERP 9 period is 1 July 2004 to 31 December 2006. The CLERP 9 legislation
became operational on 1 July 2004. The research design uses a narrow duration to
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capture pre- and post-regulatory effects. As discussed below, CLERP 9 introduced
several audit independence reforms, including mandatory auditor rotation. Australian
data showthat in the post-CLERP 9 period, the peak of audit partner rotation occurred in
the year 2007 (Chapple and Hossain, 2011). Accordingly, we have refrained from
examining earnings quality during the peak rotation impact period because of a
potentially abnormal impact rotation may have on fee ratio, used in the calculation of our
auditor independence measure.
We expect the earnings quality observed in the emerging ?rms to be different to the
established ?rms, and we would expect this reporting behaviour to vary across
regulatory reform periods. Earnings quality is priced by the market (Xie et al., 2003)
and the regulatory reform was aimed at enhancing transparency and accountability,
which should enhance earnings quality. Low transparency and reduced accountability
create an environment in which low earnings quality is produced. Enhancing earnings
quality is a bene?t of the legislation.
We expect to also see a difference in non-audit service fees, across the different time
periods and impacting our sample market segments differently, as this was a
matter speci?cally targeted by CLERP 9 as in?uencing auditor independence, or the
perception of auditor independence. The Ramsay Report (Ramsay, 2001) speci?cally
mentioned non-audit services in the context of auditor independence threats. Ultimately
CLERP 9 regulated the disclosure of non-audit service fees but did not recommend
banning of certain services, unlike the US in the Sarbanes-Oxley legislation (Chapple
and Koh, 2007).
The established ?rms were drawn from the S&P/ASX 100 and represent the “top”
end of the market as measured by market capitalisation. They have suf?cient
capitalisation to allowthemto be institutionally investable. For a ?rmto be classi?ed as
established it had to rank higher than any of the emerging ?rms on all of the following
criteria: market value; book value per share; and ?nancial year-end share price.
We contrast the reporting behaviour of the established ?rms with what we refer to as
emerging ?rms that are drawn from S&P/ASX Small Ordinaries Index. The emerging
?rms represent smaller market capitalisation ?rms. They rank below established
?rms on: market value; book value per share; and ?nancial year-end share price. The use
of book value per share is consistent with the speci?cation in Garner et al. (2002) that
emerging ?rms lack “bricks-and-mortar” assets. The creation of the S&P/ASX
Emerging Companies Index in 2009 suggests an interest in this group of ?rms by the
investment community (ASX, 2009). These two groups of ?rms represent the two
different ends of the spectrum of the burden of costs of compliance.
Our study differs from prior research in that it examines the impact of signi?cant
regulatory reforms in Australia, focussing on the impact differential between
established and emerging ?rms. The studies on earning quality are generally
informed by the US market practices. Australia provides a different setting to study
earnings quality through its corporate governance, market and regulatory structures,
particularly the auditor independence reforms, which differ fromthe US Sarbanes-Oxley
reforms (Chapple and Koh, 2007; Wilson, 2011). Our study makes a number of signi?cant
contributions to the existing literature. First, given the auditor independence regulatory
reforms in Australia were designed to strengthen ?nancial reporting; we link audit
fee ratio and earnings quality and examine their relation to the auditor independence
reforms. Second, the insights gained fromour study informvarious market participants,
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including institutional investors seeking portfolios that include both established
and emerging ?rms; regulators seeking to evaluate the impact of the past regulatory
reforms and/or assessing potential future regulatory reforms; and investors interested in
the reporting practices of these two groups of ?rms.
The remainder of this study is organised as follows. The next section contains a
discussion of the background to auditor independence reforms in CLERP 9 and reviews
the related literature. Section 3 describes the theory and hypotheses development.
Section 4 describes the research design and variables analysed. Section 5 reports the
results of our analysis and Section 6 concludes.
2. Background and related literature
2.1 Auditor independence regulatory reforms
A number of high pro?le Australian reporting scandals and corporate collapses earlier
last decade, including HIH and One.Tel, focussed attention on corporate governance
rules and practices including auditor independence. This attention has taken the
form of regulatory change in Australia and overseas. In Australia, CLERP 9 imposed
statutory changes to auditor independence requirements with the aim of: improving
auditor independence; delivering improved disclosures; and enhancing the
enforcement arrangements for corporate misbehaviour and at the same time
allowing for wealth creation and innovation (Australian Treasury, 2003).
CLERP 9 gained approval from the Australian Federal Parliament on 25 June 2004
and came into effect on 1 July 2004. CLERP 9 contains a number of schedules dealing
with: audit reform; ?nancial reporting; remuneration of directors and executives[2];
continuous disclosure[3]; auditor independence; expensing of options; compliance
controls; and the encouragement of greater shareholder participation at meetings
(Deloitte, 2005). Since the introduction of CLERP 9, auditing standards have become
statutory-based and not merely professional obligations. One of the most important
changes CLERP 9 brought about was the establishment of the Auditing and Assurance
Standards Board (AUASB) as a statutory body and the creation of the Financial
Reporting Council (FRC). The FRC is responsible for the oversight of the AUASB and
for approving its strategic decisions.
Under CLERP 9[4] auditors are required to provide clients with a written declaration
that the auditor has complied with the auditor independence requirements of the
Corporations Act and any applicable codes of professional conduct. The new liability
framework is designed to encourage a culture of compliance by making it an offence to
breach the independence requirements and placing liability on members of audit ?rms.
The structure of the reforms comprises mandates against certain con?ict of interest
relationships and situations, and requires individual auditors and audit ?rms to
continually monitor professional relationships and circumstances to identify con?icts.
As soon as they become aware of a con?ict of interest situation, the auditor and the
audit ?rm must take all reasonable steps to extinguish the con?ict of interest situation.
Such con?ict of interest situations must also be noti?ed to the corporate regulator,
the Australian Securities and Investments Commission. The introduction of CLERP 9
has strengthened the requirements for independence of auditors so that investors,
stakeholders and the general public can have greater con?dence in audit reports and
the long run performance of companies (Deloitte, 2005; Cooper and Deo, 2005). CLERP 9
also states that individuals (lead and review auditors) who play a signi?cant role in the
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audit of a listed company for ?ve successive years are ineligible to do so again for a
further two years. Restrictions on employment relationships between auditors and
audit clients were also introduced by CLERP 9 in the form of a two-year cooling off
period before a member of an audit ?rm can become a director or of?cer of an audit
client. Finally, CLERP 9 introduced a requirement that companies address the
self-review threat. The provision of non-audit services raises the possibility that an
individual auditor may be required to review the work of another member of the same
audit ?rm. The self-review threat requires:
.
the mandatory disclosure of fees paid for non-audit services in certain categories;
and
.
a statement from the audit committee to be included in the annual report that it is
satis?ed that the provision of those services is compatible with auditor
independence[5].
2.2 Earnings quality
Low earnings quality occurs when managers use judgment in ?nancial reporting and
in structuring transactions to alter ?nancial reports to either mislead stakeholders
about the underlying economic performance of the company or to in?uence contractual
outcomes that depend on reported accounting numbers (Trueman and Titman, 1988;
Giroux, 2003). Managers can reduce earnings quality by either manipulating accruals
or through real activities (earnings management). Accrual manipulation has no direct
cash ?ow effect and examples include under-provision for bad debts and delaying
asset write-offs to future periods (Roychowdhury, 2003).
The literature suggests that earnings quality is systematically related to the strength
of the corporate governance environment, including auditor independence and low
earnings quality is generally an outcome of weak governance and a lack in a culture of
compliance (Bhat et al., 2006; Dechow et al., 1996; Klein, 2002; Xie et al., 2003; Yu, 2006).
Reforms brought about by the introduction of CLERP 9 changed auditor independence
regulation and liability in Australia through mandatory independence requirements for
auditors. The expectation is that the implementation of increased independence
requirements for auditors prompts management of ?rms to act more diligently and
with due care in respect to shareholders’ interests when reporting ?nancial matters
(Deloitte, 2005). Observing earnings quality, and changes in earnings quality, is a useful
way to capture management’s propensity to act with diligence in ?nancial reporting.
While earnings quality has been studied extensively in both the USA and the UK,
there have been only several relevant Australian studies to date[6]. Holland and
Ramsay (2003) detected an unusually large number of Australian ?rms just achieving
small pro?ts or small increases in earnings and suggested this was evidence of low
earnings quality. Low earnings quality is also indicated in the literature as being
associated by CEO change (Godfrey et al., 2003; Wells, 2002; Wilson and Wang, 2010).
Australian ?rms under the greatest scrutiny during periods of price controls were
found to have signi?cantly lower earnings quality as opposed to the same ?rms
outside this period, and those ?rms not subject to price controls (Lim and Matolcsy,
1999). Evidence on the role of the ?rms’ internal governance structures suggests that it
is signi?cant in constraining earnings management (Davidson et al., 2005).
Of signi?cance to this study, Kent et al. (2010) ?nd in examining accruals quality,
that the presence of a quality (i.e. Big-4) auditor is one of the indicators of
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earnings quality. Accordingly, this study aims to contribute to the literature by
examining the impact of the introduction of CLERP 9 and auditor independence
changes on earnings quality in Australia.
Financial ratios and debt levels can affect earnings quality. Hutchinson et al. (2008)
provides a discussion of current mixed evidence on the relationship between leverage
andearnings quality. Theysuggest that additional scrutinyis placedonhighlyleveraged
?rms and this in turn acts as a discouragement of earnings management behaviour,
i.e. lower earnings quality. Other earnings management studies have indicated a
potential incentive for earnings management is created when a highly leveraged ?rm
approaches breaching a debt covenant (for evidence on distressed ?rms, see Saleh and
Ahmed, 2005).
2.3 Fee ratio
Our other variable of interest, fee ratio, will be affected by other attributes of the ?rm. For
example, growth opportunities of the ?rm provides mixed evidence on the relationship
between growth and earnings management indicating that the management of both high
and low growth ?rms have incentives to potentially engage in earnings management
(Hutchinson et al., 2008). Management of ?rms with low growth opportunities and
considerable cash available may use earnings management to conceal actions in their
own interests ( Jensen, 1986). On the other hand, high growth ?rms have potentially
weaker internal controls, thereby opening up the possibility for earnings management
(Kinney and MacDaniel, 1989).
Further, the literature suggests a higher quality audit will be demanded for ?rms
with greater agency costs (i.e. those with higher leverage) and this higher quality audit
requirement should, in turn, be associated with a reduction in non-audit services.
2.4 Earnings quality and corporate governance
The corporate governance literature suggests that agency problems are resolved
throughthe monitoringactivities of outside directors (Davidsonet al., 2005; Peasnell et al.,
2005). Outside directors have incentives to maintain their reputational capital, and as
such, will be effective monitors of management (Fama, 1980; Fama and Jensen, 1983).
The corporate governance mechanism, board independence, is associated with
enhanced earnings quality in the post-CLERP 9 period (earnings quality proxied by
performance adjusted current discretionary accruals) (Hutchinson et al., 2008). Xie et al.
(2003) and Klein (2002) suggest that earnings quality is likely to be higher where there is
greater independent outside board representation. The suggestion from prior literature
is that board independence is able to provide enhanced oversight of a ?rm’s ?nancial
reporting and, therefore, ensure that the accounting reports are reliable (Beasley, 1996;
Dechow et al., 1996; Yatim et al., 2006). The monitoring role of independent directors is
often cited as having the potential to curtail managers’ propensity to engage in
earnings management, resulting in higher earnings quality. Domestic and international
guidelines and regulations on corporate governance often emphasise the importance of
the role of non-executive directors (NEDs) (e.g. CLERP 9; see also ASX, 2004; Sir Adrian
Cadbury, Cadbury Committee, 1992; NYSE, 2002).
Evidence also suggests that post-CLERP 9 management incentives, proxied by
executive share ownership, is positively associated with low earnings quality
(Hutchinson et al., 2008). The study conducted by He et al. (2009) is speci?cally
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motivated by the introduction of the ASX Corporate Governance principles. They
examine earnings management and its relation to the NEDs’ management and
oversight. Using a data-set comprising 231 ?rms in 2005, they ?nd an association
between share ownership by NEDs and grey directors and more earnings
management.
We are in?uenced by these prior studies to include corporate governance measures
in our model including board structure: CEO compensation and CEO turnover. These
measures are suggested to in?uence earnings quality in addition to auditor
independence. Wells (2002) and Godfrey et al. (2003) indicate that new and incoming
CEOs tend to engage in earnings management in the form of an earnings bath; that is
by both heavy non-cash write-offs and unexpected accruals. Wells (2002) also suggests
that because accounting income is largely irrelevant to CEOs’ welfare during their ?rst
?nancial year of tenure (typically a partial year) incoming CEOs have a considerable
incentive to minimise reported income in the initial stage of their tenure.
Evidence in the literature suggests a positive relationship CEO share and option
based compensation and low earnings quality (Bergstresser and Philippon, 2006;
Burns and Kedia, 2005; Healy, 1985; Safdar, 2003; Xie et al., 2003). For example,
Bergstresser and Philippon (2006) provide evidence that lower earnings quality is more
pronounced for ?rms where the CEO’s total compensation is closely tied to the value of
stock and option holdings. Prior literature notes that the purchase of non-audit services
could be interpreted as a reduction in earnings quality (Iyengar and Zampelli, 2008). It
has also been suggested that a ?rm’s compensation committee will adjust a CEO’s
earnings-based (i.e. accounting numbers based) incentive compensation when there is
the perception (or reality) of impaired earnings credibility as signalled by the purchase
of non-audit services.
2.5 Earnings quality and established and emerging ?rms
As noted previously, the auditor independence regulatory effect is examined across
two separate market segments, namely: ?rms with a high market capitalisation
(established); and ?rms with a low market capitalisation (emerging). Such a distinction
has not generally been made in previous earnings quality studies. We suggest that
established and emerging ?rms are likely to behave differently because of differences
in their size, media coverage, analyst following, the presence of institutional investors,
culture of compliance and the degree of scrutiny they face by regulatory bodies. This
offers a novel approach to examining the reporting behaviour of ?rms during a period
of substantial change in corporate governance (i.e. auditor independence) regulation.
Based on the prior literature and theory (Watts and Zimmerman, 1986) it is expected
that, compared to emerging ?rms, established ?rms will generally: adopt early; comply
with corporate governance mandates; and make more conservative accounting choices,
as evidenced through higher earnings quality.
Political costs also play a role in in?uencing accounting choices. These costs:
[. . .] refer to the ability of the government and its regulatory agencies or other interest groups
to effect wealth redistributions between claimants in the ?rm or between the ?rm and other
sectors of its industry or the economy (Whittred and Zimmer, 1990, p. 32).
Watts and Zimmerman (1986) suggest that larger ?rms are more politically sensitive
and they are likely to make more conservative accounting choices. It has also been
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suggested that corporations are likely to make attempts at countering potential
government intrusions through strategies such as: social responsibility campaigns;
lobbying; and by making accounting choices that minimise reported earnings (Watts
and Zimmerman, 1978). Established ?rms are expected to adopt corporate governance
best practices and more conservative accounting choices than emerging ?rms because
of greater monitoring and political costs of established. Earnings quality is excepted to
be higher for the established ?rms than emerging ?rms.
The literature considers share analysts to be external monitors of the ?rm (Le et al.,
2006; Yu, 2008). It should also be noted that established ?rms tend to have a larger
analyst following than emerging ?rms, with this difference being particularly
noticeable in Australia. The average number of brokers following a stock on the
S&P/ASX Small Ordinaries Index was 5.13 in 2008 and small market capitalisation
stocks typically have less research analyst coverage than large market capitalisation
stocks (Comerton-Forde et al., 2011).
3. Theory and hypothesis development
It is expected that the established ?rms in this study respond earlier to auditor
independence reforms than the emerging ?rms. Established ?rms are anticipated to
already have an adequate internal governance structures in place to improve
transparency and to assure the market they are one step ahead in best practice. We
expect that the establishedgrouphave primarilyBig-4 auditors while the emerging?rms
are expected to have a mix of Big-4 and non-Big-4 auditors. Given the extensive
pre-publicity given to the CLEREP 9 reforms, it is reasonable to expect that established
?rms and their auditors have prepared for CLERP 9 prior to its introduction. Hence, the
impact of CLERP 9 on these ?rms is likely to be lower than for emerging ?rms.
Established ?rms are also likely to be under heavier scrutiny from external monitors,
including analysts, the media and other parties, than emerging ?rms. The overall
expectation is that the introduction of CLERP 9 has a greater impact on emerging
compared to established ?rms. The introduction of increased regulatory reforms that
enhance the corporate governance environment will serve to limit the abilityof managers
to acquire private control bene?ts through earnings management (Wright et al., 2006).
The provision of non-audit services increases auditors’ incentives to acquiesce to
client pressure, including pressure to allow earnings management (Firth, 1997).
Through the regulation of disclosure of non-audit services fees and the independence
requirements introduced by CLERP 9, the economic bond between auditors and clients
is likely to decrease, thus improving auditor independence. CLERP 9 proposed a
general statement of principle requiring the independence of auditors. Frankel et al.
(2002) found non-audit fees to be positively related to discretionary accruals, while
audit fees were negatively associated with discretionary accruals. Similarly, Xie et al.
(2003) found lower levels of earnings management when there is greater auditor
independence and the results of this study for the post-CLERP 9 period are expected to
con?rm these relationships. As with auditor independence, we expect the improvement
to be more notable for emerging compared to established ?rms.
The above discussion can be re?ned into the following hypotheses concerning
established and emerging ?rms:
H1a. The CLERP 9 auditor independence regulatory reforms are associated with
(i) lower non-audit services fees and (ii) improved earnings quality.
Auditor
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H1b. The CLERP 9 auditor independence regulatory reforms are associated with (i)
lower non-audit services fees and (ii) improved earnings quality for
established more than for emerging ?rms.
4. Research design and variable description
This study uses pooled ordinary least squares regressions to examine the hypotheses
across time. We use FEERATIO, measured as total non-audit fees divided by
total fees paid, to proxy for auditor independence (Ashbaugh et al., 2003; Frankel et al.,
2002; DeFond et al., 2002; Chung et al., 2005; Ferguson et al., 2004). To proxy
for earnings quality we use a measure of accruals (Dechow et al., 1995; Bartov et al.,
2000):
ACC
it
¼ a
0
þb
1
FEERATIO
it
þb
2
FEERATIO £ POSTCLERP9
it
þb
3
POSTCLERP9 þb
4
EST
i
þb
5
POSTCLERP9 £ EST
it
þb
6
FEERATIO £ POSTCLERP9 £ EST
it
þb
7
OWNERSHIP_CONTROLS
it
þb
8
BOARD_CONTROLS
it
þb
9
AUDIT_CONTROLS
it
þb
10
FIRM_FINANCIAL_CONTROLS
it
þb
11
INDUSTRY_CONTROLS
it
þb
12
YEAR_CONTROLS
it
þ1
it
ð1Þ
where ACC is accruals measured as:
ACC
it
¼ ðDCA
it
2DCASH
it
Þ 2ðDCL
it
2STD
it
2DTP
it
Þ 2DEP
it
ð2Þ
where:
DCA
it
change in total current assets.
DCASH
it
change in cash and cash equivalents.
DCL
it
change in total current liabilities.
DSTD
it
change in short-term debt (included in current liabilities).
DTP
it
change in income taxes payable.
DEP
it
depreciation and amortisation expense for ?rm i in year t.
As in Leuz et al. (2003), where ?rms do not report information on taxes payable or
short-term debt these variables are assumed to be 0.
FEERATIO is measured as the non-audit fees to total audit fees in the ?rm year.
POSTCLERP9 is an indictor variable which takes the value of 1 for years
post-CLERP 9 period (2005 and 2006), and 0 for the years pre-CLERP 9 period (2003
and 2004). We use the interaction variable FEERATIO £ POSTCLERP9 to examine for
an association post CLERP 9 of the fee ratio with earning quality, i.e. if CLERP 9 has
changed the fee ratio then this variable will be signi?cant. EST is an indictor variable
that takes the value of 1 for an established ?rmand 0 otherwise. To examine H1b we are
interested in the association between the interaction variable EST £ POSTCLERP 9 –
a signi?cant coef?cient on this variable will indicate a variance between the two ?rm
groups and in the pre- and post-CLERP9 periods. The interaction variable
FEERATIO £ POSTCLERP9 £ EST is used to determine if the fee ratio plays a role
in this change between periods and ?rm groups.
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Shareholders with small, diversi?ed holdings have a limited ability to actively
monitor the activities of management. However, the literature suggests that concentrated
shareholding by investors is associated with improved external monitoring of
management; as the payoff to these substantial shareholders is expectedto offset the cost
of monitoring (Agrawal and Knoeber, 1996). Hence, this study includes ownership
controls including the variables that proxy for a block-holder ownership measured as the
number of shares held by the top 20 largest shareholders (LARGESHD), percentage of
insider ownership (CLOSELYHLD) and an indictor for whether the largest substantial
holders is an institutional owner (INSTITHOLD). This study predicts that the presence
of a large-shareholder may potentially decrease managers’ propensity to engage in
earnings management behaviour and result in higher earnings quality.
Board controls include a board independence variable (BRDIND), a measure of ?nancial
skill (BOARDSKILL), CEO change (CEOCHG) and CEO pay sensitivity to market
performance (PAYSENMRK). The BRDINDvariable is designedto capture the ASX(2004)
corporate governance recommendation that the majority of the board be independent.
Consistent with Firth (1997) and Abbott et al. (2003), this study’s expectation is that
the recruitment of a new CEO (CEOCHG) is positively associated with earnings
management, i.e. lower earnings quality (lower ACC). Similarly to do with the governance
role of the CEO, lower earnings quality is associated with equity-based compensation, this
studypredicts a positive relationshipbetweenACCandthe measure of CEOpaysensitivity
to market performance (PAYSENMRK). In this study PAYSENMRK is measured as
the sum of all directors of the ?rm equity-based pay for the ?nancial year valued at fair
value.
Audit controls includes a measure of whether the ?rm’s auditor is a Big-4 ?rm or
not (BIG4) and an indictor for change of audit ?rm (AUDFIRMCHG). The BIG4
variable is included as the literature suggests that the use of a Big-4 versus non-Big-4
variable is a proxy for audit quality (Baxter and Cotter, 2009).
Craswell et al. (2000) suggest that non-audit services are associated with the same
demands as audit fees (e.g. ?rm size), level of business activity and company age.
Whether evidence as to the perceived or real impairment of auditor independence can
be gained from this investigation is important, as regulators have indicated that the
provision of non-audit service fees can impair auditor independence. Legislative
interventions, such as Sarbanes Oxley Act targeting and reducing non-audit service
fees are likely to result in an appearance of enhanced auditor independence as opposed
to real enhancement (Ruddock et al., 2006). Hence, we include in this study ?rm
?nancial controls including log of total assets (SIZE) and a indicator for a year of loss
(LOSS). SIZE is indicated as being positively associated with the demand for non-audit
services (Firth, 1997; Frankel et al., 2002) and larger ?rms tend to have more stable
accruals (Dechow and Dichev, 2002).
5. Empirical analysis
5.1 Data and sample
The study period is 1 January 2003 to 31 December 2006. Data were collected for the
dependent and independent variables from Aspect Financial Database, Connect 4 and
company annual reports.
The sample consists of 1,004 ?rm-year observations; 518 for established ?rms and
486 for emerging ?rms. The starting point for selecting the established ?rms was the
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S&P/ASX 200 All Australian. The ?rms from the S&P/ASX 200 were checked to
ensure all the ?rms selected ranked higher than the emerging ?rms in terms of: market
value; book value per share; and year-end share price. Firms in the ?nancial industry
were removed and ?rms were also required to have available data over the period
1 January 2003 to 31 December 2006. This ?ltering procedure resulted in a sample of
518 ?rm-year observations for 132 ?rms.
The starting point for selecting the emerging ?rms was the S&P/ASX Emerging
Firm Index. The ?rms were then examined to ensure they ranked lower than the
established ?rms on: market value; book value per share; and year-end share price; and
had available data for the period 1 January 2003 to 31 December 2006. This ?ltering
procedure produced a total of 486 ?rm-years observations for 123 ?rms.
Table I, Panel A presents an industry breakdown of the ?rm-year observations.
Firms are reported in Table I within industry groups based on their Global Industry
Classi?cation Standard (GICS) classi?cation. The highest number of ?rm-year
observations is from the materials sector for established ?rms (131 ?rms) and also the
materials sector for emerging ?rms (115 ?rms). Consistent with prior studies banks
and ?nancial institutions were excluded from the sample. Table I, Panel B contains the
variable names and descriptions.
Table II provides the descriptive statistics for the variables used in the model. From
Table II it appears for both the established and emerging ?rms mean accruals are
negative, i.e. decreasing rather than increasing accruals (2154.51 for established ?rms
and 28.036 for emerging ?rms). This suggests that on average established ?rms
engage in more decreasing accruals over the period than emerging ?rms. There are
similar means for the FEERATIO, CLOSELYHELD and BOARDSKILL variables
between both the established and emerging ?rm groups. The mean for LARGESHD is
over double that for established ?rms compared to emerging ?rms. BRDIND variable
mean and maximum are greater for established than emerging ?rms group,
i.e. suggesting a greater number of independent directors on established ?rm boards.
Established ?rm boards of directors appear to have greater sensitivity to ?rm share
price for their compensation as the PAYSENMRK variable mean is greater for
established ?rms. SIZE variable is consistent with a greater size of established ?rms
compared to emerging ?rms – based on the log book value of assets. Emerging ?rms
are considered in the literature to have less “bricks-and-mortar” assets than established
?rms.
In terms of the indicator variables, in Panel B, the levels of institutional
shareholdings are slightly higher for the established ?rms compared to the emerging
?rms. The established ?rms have a greater proportion with Big-4 auditors than
emerging ?rms during the period. Both the established and emerging ?rms had a
relatively small number of changes in CEO during the study period. A greater
proportion of emerging ?rms have the LOSS variable – indicating this group are
composed of a higher number of loss ?rms than the established ?rms. Established
?rms experienced greater audit ?rm change compared to emerging ?rms when
examining the AUDFIRMCHG variable.
The Pearson correlation coef?cients between ACC and LARGESHD, BRDIND,
BOARDSKILL, BIG4, SIZE and LOSS are signi?cant. All are negatively correlated
except for LOSS. The positive relationship between the LOSS variable and ACC is
consistent with the prior literature (Table III).
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Panel A: ?rm-year observations for established and emerging ?rms
GICS code Sector
Firm
years
Established
?rms
Emerging
?rms
Total
?rms
10 Energy 16 23 38
15 Materials 46 36 77
20 Industrials 25 15 38
25 Consumer discretionary 19 9 24
30 Consumer staples 8 5 13
35 Health care 7 12 19
45 Information technology 3 13 16
50 Telecommunications
services 4 2 6
55 Utilities 3 0 3
Total ?rms 131 115 234
2003 119 102 221
2004 131 115 246
2005 131 115 246
2006 131 115 246
Total ?rm-year
observations 512 447 959
Panel B: variable descriptions
Variable Description
ACC Total accruals measured as the change in current assets from last period to this
period – change in cash and cash equivalents – (change in current liabilities –
change in short-term debt – change in tax payable) – depreciation
FEERATIO Ratio of non-audit fees to total fees paid
POSTCLERP9 Takes a value of 1 for years post-CLERP 9 period (2005 and 2006), and 0 for the
years pre-CLERP 9 period (2003 and 2004)
EST Takes a value of 1 for an established ?rm and 0 otherwise
OWNERSHIP_CONTROLS
LARGESHD Number of shares held by the largest 20 shareholders
CLOSELYHLD The percentage of shares held by insiders in the ?rm – in year t
INSTITHOLD Takes a value of 1 if the largest substantial shareholder is an institutional
shareholder in year t, and 0 otherwise
BOARD_CONTROLS
BRDIND Number of independent directors on the board
BOARDSKILL A sum of scores for all directors where for each director a score is given of 1 for
each board director with ?nancial expertise and 0 otherwise (where expertise is
either quali?cation, membership of professional body or past experience)
CEOCHG Takes a value of 1 in the year of a CEO change, and 0 otherwise
PAYSENMRK The sum of all directors of the ?rm equity-based pay for the ?nancial year
valued at fair value
AUDIT_CONTROLS
BIG4 Takes a value of 1 when a ?rm has a Big-4 audit ?rm in year t, and 0 otherwise
AUDFIRMCHG Takes a value of 1 if there is a new audit ?rm for the ?nancial year, and 0
otherwise
FIRM FINANCIAL_CONTROLS
SIZE Log of total assets
LOSS Takes a value of 1 if there is a net loss reported in year t, and 0 otherwise
INDUSTRY
CONTROLS
Takes a value of 1 for the industry controlled and 0 otherwise
Table I.
Sample and variable
descriptions
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h
e
e
x
t
e
r
n
a
l
a
u
d
i
t
o
r
;
L
A
R
G
E
S
H
D
–
n
u
m
b
e
r
o
f
s
h
a
r
e
s
h
e
l
d
b
y
t
h
e
l
a
r
g
e
s
t
2
0
s
h
a
r
e
h
o
l
d
e
r
s
r
e
p
o
r
t
e
d
(
i
n
m
i
l
l
i
o
n
s
)
;
C
L
O
S
E
L
Y
H
L
D
–
p
e
r
c
e
n
t
a
g
e
o
f
s
h
a
r
e
s
h
e
l
d
b
y
i
n
s
i
d
e
r
s
i
n
t
h
e
?
r
m
;
B
R
D
I
N
D
–
n
u
m
b
e
r
o
f
i
n
d
e
p
e
n
d
e
n
t
d
i
r
e
c
t
o
r
s
o
n
t
h
e
b
o
a
r
d
;
B
O
A
R
D
S
K
I
L
L
–
s
u
m
o
f
a
s
c
o
r
e
f
o
r
a
l
l
d
i
r
e
c
t
o
r
s
w
h
e
r
e
f
o
r
e
a
c
h
d
i
r
e
c
t
o
r
a
s
c
o
r
e
i
s
g
i
v
e
n
o
f
1
f
o
r
e
a
c
h
b
o
a
r
d
d
i
r
e
c
t
o
r
w
i
t
h
?
n
a
n
c
i
a
l
e
x
p
e
r
t
i
s
e
a
n
d
0
o
t
h
e
r
w
i
s
e
(
w
h
e
r
e
e
x
p
e
r
t
i
s
e
i
s
e
i
t
h
e
r
q
u
a
l
i
?
c
a
t
i
o
n
,
m
e
m
b
e
r
s
h
i
p
o
f
p
r
o
f
e
s
s
i
o
n
a
l
b
o
d
y
o
r
p
a
s
t
e
x
p
e
r
i
e
n
c
e
)
;
P
A
Y
S
E
N
M
R
K
–
s
u
m
o
f
a
l
l
d
i
r
e
c
t
o
r
s
o
f
t
h
e
?
r
m
e
q
u
i
t
y
-
b
a
s
e
d
p
a
y
f
o
r
t
h
e
?
n
a
n
c
i
a
l
y
e
a
r
v
a
l
u
e
d
a
t
f
a
i
r
v
a
l
u
e
(
i
n
m
i
l
l
i
o
n
s
)
;
S
I
Z
E
–
l
o
g
o
f
t
o
t
a
l
a
s
s
e
t
s
;
I
N
S
T
I
T
H
O
L
D
–
t
a
k
e
s
a
v
a
l
u
e
o
f
1
i
f
t
h
e
l
a
r
g
e
s
t
s
u
b
s
t
a
n
t
i
a
l
s
h
a
r
e
h
o
l
d
e
r
i
s
a
n
i
n
s
t
i
t
u
t
i
o
n
a
l
s
h
a
r
e
h
o
l
d
e
r
i
n
y
e
a
r
t
,
a
n
d
0
o
t
h
e
r
w
i
s
e
;
C
E
O
C
H
G
–
t
a
k
e
s
a
v
a
l
u
e
o
f
1
i
n
t
h
e
y
e
a
r
o
f
a
C
E
O
c
h
a
n
g
e
,
a
n
d
0
o
t
h
e
r
w
i
s
e
,
B
I
G
4
–
t
a
k
e
s
a
v
a
l
u
e
o
f
1
w
h
e
n
a
?
r
m
h
a
s
a
B
i
g
-
4
a
u
d
i
t
?
r
m
i
n
y
e
a
r
t
,
a
n
d
0
o
t
h
e
r
w
i
s
e
;
L
O
S
S
–
t
a
k
e
s
a
v
a
l
u
e
o
f
1
i
f
t
h
e
r
e
i
s
a
n
e
t
l
o
s
s
r
e
p
o
r
t
e
d
i
n
y
e
a
r
t
,
a
n
d
0
o
t
h
e
r
w
i
s
e
;
A
U
D
F
I
R
M
C
H
G
–
t
a
k
e
s
a
v
a
l
u
e
o
f
1
i
f
t
h
e
r
e
i
s
a
n
e
w
a
u
d
i
t
?
r
m
f
o
r
t
h
e
?
n
a
n
c
i
a
l
y
e
a
r
,
a
n
d
0
o
t
h
e
r
w
i
s
e
Table II.
Descriptive statistics
for established and
emerging ?rms
ARJ
26,2
100
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
1
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
A
C
C
F
E
E
R
A
T
I
O
F
E
E
R
A
T
I
O
£
P
O
S
T
C
L
E
R
P
9
F
E
E
R
A
T
I
O
£
E
S
T
£
P
O
S
T
C
L
E
R
P
9
P
O
S
T
C
L
E
R
P
9
F
E
E
R
A
T
I
O
£
E
S
T
P
O
S
T
C
L
E
R
P
9
£
E
S
T
L
A
R
G
E
S
H
D
C
L
O
S
E
L
Y
H
L
D
A
C
C
1
F
E
E
R
A
T
I
O
2
0
.
0
0
9
1
F
E
E
R
A
T
I
O
£
P
O
S
T
C
L
E
R
P
9
2
0
.
0
1
2
0
.
4
6
1
*
*
1
F
E
E
R
A
T
I
O
£
E
S
T
£
P
O
S
T
C
L
E
R
P
9
2
0
.
0
1
2
0
.
4
6
1
*
*
1
.
0
0
0
*
*
1
P
O
S
T
C
L
E
R
P
9
2
0
.
0
3
3
2
0
.
1
2
8
*
*
0
.
6
2
4
*
*
0
.
6
2
4
*
*
1
F
E
E
R
A
T
I
O
£
E
S
T
2
0
.
0
0
9
1
.
0
0
0
*
*
0
.
4
6
1
*
*
0
.
4
6
1
*
*
2
0
.
1
2
8
*
*
1
P
O
S
T
C
L
E
R
P
9
£
E
S
T
2
0
.
0
3
3
2
0
.
1
2
8
*
*
0
.
6
2
4
*
*
0
.
6
2
4
*
*
1
.
0
0
0
*
*
2
0
.
1
2
8
*
*
1
L
A
R
G
E
S
H
D
2
0
.
6
4
9
*
*
2
0
.
0
0
7
0
.
0
0
7
0
.
0
0
7
0
.
0
3
9
2
0
.
0
0
7
0
.
0
3
9
1
C
L
O
S
E
L
Y
H
L
D
0
.
0
9
3
0
.
0
3
2
0
.
0
0
7
2
0
.
0
0
7
2
0
.
0
7
0
.
0
3
2
0
.
0
7
0
.
0
4
4
1
B
R
D
I
N
D
2
0
.
3
8
2
*
*
0
.
1
0
9
*
0
.
0
6
0
.
0
6
0
.
0
2
1
0
.
1
0
9
*
0
.
0
2
1
0
.
4
2
5
*
*
2
0
.
1
1
9
*
I
N
S
T
I
T
H
O
L
D
2
0
.
0
3
8
0
.
0
3
5
0
.
0
2
0
.
0
2
0
.
0
8
6
0
.
0
3
5
0
.
0
8
6
2
0
.
0
0
9
2
0
.
1
5
9
*
*
B
O
A
R
D
S
K
I
L
L
2
0
.
3
2
8
*
*
0
.
1
4
3
*
*
0
.
1
4
6
*
*
0
.
1
4
6
*
*
0
.
0
8
6
0
.
1
4
3
*
*
0
.
0
8
6
0
.
2
9
8
*
*
2
0
.
0
8
3
P
A
Y
S
E
N
M
R
K
2
0
.
0
5
9
0
.
0
0
6
0
.
0
2
5
0
.
0
2
5
0
.
0
3
6
0
.
0
0
6
0
.
0
3
6
0
.
0
9
3
*
0
.
0
3
5
C
E
O
C
H
G
2
0
.
0
0
9
2
0
.
0
3
3
2
0
.
0
0
6
2
0
.
0
0
6
2
0
.
0
2
2
2
0
.
0
3
3
2
0
.
0
2
2
0
.
0
0
7
0
.
0
0
1
B
I
G
4
2
0
.
1
3
4
*
*
0
.
2
1
8
*
*
0
.
0
8
5
0
.
0
8
5
2
0
.
0
1
8
0
.
2
1
8
*
*
2
0
.
0
1
8
0
.
2
3
8
*
*
0
.
1
6
4
*
*
A
U
D
F
I
R
M
C
H
G
2
0
.
0
1
1
0
.
0
3
8
0
.
0
8
0
.
0
8
0
.
0
6
5
0
.
0
3
8
0
.
0
6
5
0
.
0
5
2
2
0
.
0
4
S
I
Z
E
2
0
.
3
8
7
*
*
0
.
1
4
9
*
*
0
.
1
2
8
*
*
0
.
1
2
8
*
*
0
.
0
8
9
*
0
.
1
4
9
*
*
0
.
0
8
9
*
0
.
5
4
1
*
*
2
0
.
0
0
3
L
O
S
S
0
.
1
4
1
*
*
2
0
.
1
1
1
*
2
0
.
0
4
8
2
0
.
0
4
8
2
0
.
0
2
7
2
0
.
1
1
1
*
2
0
.
0
2
7
2
0
.
1
8
4
*
*
2
0
.
0
3
6
B
R
D
I
N
D
I
N
S
T
I
T
H
O
L
D
B
O
A
R
D
S
K
I
L
L
P
A
Y
S
E
N
M
R
K
C
E
O
C
H
G
B
I
G
4
A
U
D
F
I
R
M
C
H
G
S
I
Z
E
L
O
S
S
B
R
D
I
N
D
1
I
N
S
T
I
T
H
O
L
D
0
.
0
9
9
*
1
B
O
A
R
D
S
K
I
L
L
0
.
5
0
1
*
*
0
.
0
4
1
1
P
A
Y
S
E
N
M
R
K
0
.
0
7
1
2
0
.
0
4
3
0
.
0
3
5
1
C
E
O
C
H
G
0
.
0
9
8
*
2
0
.
0
0
7
0
.
0
5
2
0
.
1
3
3
*
*
1
B
I
G
4
0
.
4
0
8
*
*
0
.
0
7
6
0
.
3
4
5
*
*
0
.
0
4
6
0
.
1
0
7
*
1
A
U
D
F
I
R
M
C
H
G
2
0
.
0
7
5
2
0
.
0
1
2
0
.
0
4
5
2
0
.
0
0
9
2
0
.
0
3
7
2
0
.
1
1
7
*
*
1
S
I
Z
E
0
.
6
9
6
*
*
0
.
0
7
2
0
.
5
1
0
*
*
0
.
1
0
5
*
0
.
1
3
1
*
*
0
.
6
0
8
*
*
2
0
.
0
8
1
1
L
O
S
S
2
0
.
3
9
6
*
*
2
0
.
1
0
4
*
2
0
.
3
8
8
*
*
2
0
.
0
6
2
2
0
.
0
7
8
2
0
.
4
6
3
*
*
0
.
0
4
8
2
0
.
6
3
6
*
*
1
N
o
t
e
s
:
S
i
g
n
i
?
c
a
n
t
a
t
:
*
0
.
0
5
a
n
d
*
*
0
.
0
1
l
e
v
e
l
s
;
B
I
G
4
–
e
q
u
a
l
t
o
1
f
o
r
a
l
l
?
r
m
s
a
n
d
i
s
t
h
e
r
e
f
o
r
e
,
a
c
o
n
s
t
a
n
t
;
A
C
C
–
a
c
c
r
u
a
l
s
m
e
a
s
u
r
e
d
a
s
p
e
r
D
e
c
h
o
w
e
t
a
l
.
(
1
9
9
5
)
a
n
d
L
e
u
z
e
t
a
l
.
(
2
0
0
3
)
(
i
n
m
i
l
l
i
o
n
s
)
;
F
E
E
R
A
T
I
O
–
r
a
t
i
o
o
f
n
o
n
-
a
u
d
i
t
f
e
e
s
t
o
t
o
t
a
l
f
e
e
s
p
a
i
d
t
o
t
h
e
e
x
t
e
r
n
a
l
a
u
d
i
t
o
r
;
L
A
R
G
E
S
H
D
–
n
u
m
b
e
r
o
f
s
h
a
r
e
s
h
e
l
d
b
y
t
h
e
l
a
r
g
e
s
t
2
0
s
h
a
r
e
h
o
l
d
e
r
s
r
e
p
o
r
t
e
d
(
i
n
m
i
l
l
i
o
n
s
)
;
C
L
O
S
E
L
Y
H
L
D
–
p
e
r
c
e
n
t
a
g
e
o
f
s
h
a
r
e
s
h
e
l
d
b
y
i
n
s
i
d
e
r
s
i
n
t
h
e
?
r
m
;
B
R
D
I
N
D
–
n
u
m
b
e
r
o
f
i
n
d
e
p
e
n
d
e
n
t
d
i
r
e
c
t
o
r
s
o
n
t
h
e
b
o
a
r
d
;
B
O
A
R
D
S
K
I
L
L
–
s
u
m
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Table III.
Pearson corrections
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5.2 Regression analysis
Table IV presents the results of the pooled regression to test the hypothesised
relationship between earnings quality (ACC) and fee ratio (FEERATIO) for the
established and emerging groups.
The does not appear to be a signi?cant association the measure of earnings quality
and auditor independence. This is also the case partitioning for the two ?rmgroups and
for the pre- and post-CLERP 9 periods. The results do suggest for the sample that
post-CLERP 9 earnings quality has decreased, while this is not the case for established
Coef?cient p-value
FEERATIO 32.27 0.610
POSTCLERP9 696.67 0.085
*
EST 266.38 0.340
FEERATIO £ POSTCLERP9 234.06 0.575
FEERATIO £ EST £ POSTCLERP9 138.21 0.268
FEERATIO £ EST 2158.51 0.243
POSTCLERP9 £ EST 288.57 0.070
*
Ownership controls
LARGESHD 2851.67 0.000
* *
CLOSELYHLD 1.43 0.034
* *
INSTITHOLD 17.99 0.657
Board controls
BRDIND 218.35 0.119
BOARDSKILL 228.16 0.012
* *
CEOCHG 211.34 0.836
PAYSENMRK 0.002 0.994
Audit controls
BIG4 70.89 0.026
* *
AUDFIRMCHG 54.71 0.216
Firm ?nancial controls
SIZE 219.54 0.648
LOSS 25.51 0.443
INDUSTRY CONTROLS Yes
YEAR CONTROLS Yes
FIRM STANDARD CLUSTERED ERRORS Yes
R
2
52.43%
Notes: Signi?cant at:
*
0.05 and
* *
0.01 levels; the model was estimated using robust standard errors;
ACC – accruals measured as per Dechow et al. (1995) and Leuz et al. (2003) (in millions); FEERATIO –
ratio of non-audit fees to total fees paid to the external auditor; LARGESHD – number of shares held
by the largest 20 shareholders reported (in millions); CLOSELYHLD – percentage of shares held by
insiders in the ?rm; BRDIND – number of independent directors on the board; BOARDSKILL – sum
of a score for all directors where for each director a score is given of 1 for each board director with
?nancial expertise and 0 otherwise (where expertise is either quali?cation, membership of professional
body or past experience); PAYSENMRK – sum of all directors of the ?rm equity-based pay for the
?nancial year valued at fair value (in millions); SIZE – log of total assets; INSTITHOLD – takes a
value of 1 if the largest substantial shareholder is an institutional shareholder in year t, and 0
otherwise; CEOCHG – takes a value of 1 in the year of a CEO change, and 0 otherwise; BIG4 – takes a
value of 1 when a ?rm has a Big-4 audit ?rm in year t, and 0 otherwise; LOSS – takes a value of 1 if
there is a net loss reported in year t, and 0 otherwise; AUDFIRMCHG – takes a value of 1 if there is a
new audit ?rm for the ?nancial year, and 0 otherwise
Table IV.
Explaining ACC
for established
and emerging ?rms
(modelling
equation (1)) – pooled
sample
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?rms (with a negative and signi?cant sign on the coef?cient of POSTCLERP9 £ EST).
The corporate governance mechanisms that appear to be associated with higher
earnings quality are large-shareholder LARGESHD (i.e. block-holder) and
BOARDSKILL (both signi?cant and negatively associated with ACC). Where a ?rm
is closely held by insiders this appears to be associated with lower earnings quality
(a positive and signi?cant association between CLOSELYHLD and ACC).
6. Conclusion
The aim of this study was to investigate the contention that auditor independence
regulatory change (CLERP 9) led to a changes in company behaviour. Speci?cally we
address two related research questions on the association between earnings quality and
auditor independence. Given ?rms operate in different information environments, new
legislation impact is predicted to vary based on a ?rm’s existing corporate governance
regime and the level of external scrutiny (monitoring), therefore, we compare
“established” and “emerging” ?rms to examine this contention. The creation of
the S&P/ASX Emerging Companies Index in 2009 signals interest in the market in this
group of ?rms. The main ?ndings we report have implications for ?rms, accounting
standards setters and regulatory bodies.
Consistent with expectations, our results suggest for the established ?rms
post-CLERP 9 earnings quality has improved. Given that emerging ?rms face less
monitoring and lower political costs, the regulatory changes introduced in CLERP 9
appears that these ?rms have not experience an enhancement in earnings quality.
In terms of our stated research design, the intuition for H1a (earnings quality is
enhanced post-CLERP 9) is supported in the regression analysis, and hypothesis 1b
(the change in earnings quality is greater for emerging ?rms) is supported also.
Our results also suggest that of the corporate governance mechanisms of board
independence and board ?nancial skill are associated with higher earnings quality.
While the higher the concentration of insider ?rm ownership is associated with lower
earnings quality.
Notes
1. Regulatory change here means the effect of new legislation – the Corporate Law Economic
ReformProgram(Audit Reformand Corporate Disclosure) Act 2004 (referred to as CLERP 9).
2. CLERP 9 amended the Corporations Act 2001 and required companies to include a dedicated
Remuneration Report in the annual report. The Remuneration Report must set out the
remuneration details of all directors and top executives, and is subject to non-binding
approval by shareholders.
3. The introduction of CLERP 9 enhanced ASIC’s power to issue infringement notices and
impose penalties on companies contravening the continuous disclosure regime (Hsu, 2009).
4. All of these legislative requirements described below are contained in Division 3 Auditor
Independence of Part 2M.4 Corporations Act 2001.
5. In 2003 the categories were set out in Professional Statement FI (for further details, see
ICAA, 2004) and from 2006 onwards APES 110.
6. See Wilson (2011) for a comprehensive review of the Australian literature.
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Corresponding author
Victoria J. Clout can be contacted at: [email protected]
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