Description
This study seeks to examine the relation between non-audit services provided by
incumbent auditors and an important aspect of earnings quality – conservatism, using New Zealand
data. Conservatism is defined as the adoption of accounting policies that accelerate expenses towards
the current period and/or defer revenues to later periods. If the provision of non-audit services
undermines auditor independence and encourages the condoning of clients’ aggressive accounting
practices, this will be revealed by a reduction in accounting conservatism.
Accounting Research Journal
The provision of non-audit services and earnings conservatism: Do New Zealand auditors
compromise their independence?
Beilei Zhang David Emanuel
Article information:
To cite this document:
Beilei Zhang David Emanuel, (2008),"The provision of non-audit services and earnings conservatism",
Accounting Research J ournal, Vol. 21 Iss 2 pp. 195 - 221
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Deborah Alexander, David Hay, (2013),"The effects of recurring and non-recurring non-audit
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Deborah Bloomfield, J oshua Shackman, (2008),"Non-audit service fees, auditor characteristics
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dx.doi.org/10.1108/02686900810839839
Mikko Zerni, (2012),"Do client firms manage the perception of auditor independence?: Evidence from
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The provision of non-audit
services and earnings
conservatism
Do New Zealand auditors compromise
their independence?
Beilei Zhang
BDO Spicers, Auckland, New Zealand, and
David Emanuel
Department of Accounting and Finance,
The University of Auckland Business School, Auckland, New Zealand
Abstract
Purpose – This study seeks to examine the relation between non-audit services provided by
incumbent auditors and an important aspect of earnings quality – conservatism, using New Zealand
data. Conservatism is de?ned as the adoption of accounting policies that accelerate expenses towards
the current period and/or defer revenues to later periods. If the provision of non-audit services
undermines auditor independence and encourages the condoning of clients’ aggressive accounting
practices, this will be revealed by a reduction in accounting conservatism.
Design/methodology/approach – The method aims to determine whether Basu’s conservatism is
affected by the level and proportion of non-audit services, where the dataset is partitioned into multiple
levels of these services.
Findings – Using 528 ?rm-year observations, evidence is presented for the existence of earnings
conservatism in New Zealand. However, no evidence of a negative association between non-audit
services and earnings conservatism is found.
Research limitations/implications – Although widely accepted in the conservatism literature, the
Basu model still suffers from some drawbacks. Issues of endogeneity may also contribute to the
insigni?cant results.
Practical implications – The results are consistent with factors such as reputational penalties and
litigation risk constraining auditor behaviour. Auditors in New Zealand may therefore still maintain
their independence “in fact”, irrespective of the level of non-audit fees (NAFs) purchased by clients.
Originality/value – This paper contains the ?rst tests of conservatism using New Zealand data. It
adds to the body of knowledge about the relationship, or the lack thereof, between NAF and desirable
attributes of accounting.
Keywords Auditors, Auditing, Earnings, New Zealand
Paper type Research paper
1. Introduction
The recent collapse of several major corporations in the USA and elsewhere has led to
the allegation that auditors of these companies failed to detect and/or persuade their
clients to recognise economic losses in a timely fashion (Wall Street Journal, 2002). In a
number of cases, the auditor provided substantial consulting services to the troubled
client. Given this, critics have been concerned that the ?nancial dependence and
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
Provision of
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Accounting Research Journal
Vol. 21 No. 2, 2008
pp. 195-221
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309610810905953
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responsibility that accompany the provision of non-audit services[1] may reduce the
ability of auditors to perform objective monitoring. As auditor independence is crucial
in maintaining the credibility of ?nancial reporting, recent research has examined the
relationship between non-audit services and clients’ earnings quality. However, the
evidence to date remains inconclusive. While, Frankel et al. (2002) and Dee et al. (2001)
suggest that the provision of non-audit services leads to more aggressive accounting
practices, other studies (Chung and Kallapur, 2003; Reynolds et al., 2004; DeFond et al.,
2002) contradict their ?ndings.
There are several motivations for this particular study. The ?rst is that issues
associated with the role of non-audit fees (NAFs) are only going to be resolved by the
weight of evidence, rather than by one study. The second is that there is, as far as we
are aware, only one prior study looking at this issue using New Zealand data (Cahan
et al., 2008). The third is that New Zealand data on audit and NAFs have been available
since the mid-1990s and therefore there is a panel of data available for analysis. The
last year of data is 2001, the year before Andersen was indicted over the Enron affair.
The fourth is that New Zealand’s small size can be an advantage if the argument is
advanced that this smallness and proximity could lead to closer interaction between
auditors and clients. For example, there is only one professional accounting body, and
there are only two major cities which are the sites for most audits. Finally, many prior
studies focus on attributes of accounting that are suggestive of earnings management,
but the methods used to identify earnings management have relatively
low-explanatory power. Rather than using earnings management proxies, this study
examines whether the provision of non-audit services by incumbent auditors is
associated with a reduction in one aspect of earnings quality – conservatism.
Conservatism is the application of a higher degree of veri?cation for favourable
information, via the adoption of accounting policies that accelerate expenses to the
current period, and/or defer revenues to later periods (Basu, 1997). Conservatism ?lls
an ex ante ef?cient role in contracting between the ?rm and its stakeholders. Basu
(1997) and Watts (2003a, b) argue that conservatism assists in monitoring important
contracts involving the entity and its stakeholders (for example debt contracts, and
contracts associated with remuneration), and is a central feature of corporate
governance (Ball et al., 2000). In the context of this paper, conservatism is a desirable
attribute of accounting information.
Financial statements are the result of both management’s representations and the
auditor’s assurance to outsiders about the validity of those representations (Krishnan,
2005). If non-audit services increase auditors’ economic dependence on clients and this
impairs independence, auditors will be less willing to challenge accounting that might
be “aggressive”. If so, then this will be observable through a reduction in conservatism.
Therefore, it is hypothesised that clients purchasing higher levels of non-audit services
will tend to report earnings of lower quality, which means lower levels of conservatism.
The empirical tests used to conduct this study require measurement of the economic
bond that non-audit services create, as well as measures that capture variation in
earnings conservatism. In regard to the former, we use two proxies that have been
commonly used in the literature. The ?rst is the ratio of NAFs to total fees (non-audit
fee ratio – NAFR), which captures the relative value of the audit versus non-audit
services provided by the auditor. Although this measure is of interest to investors and
regulators, it may not re?ect the economic importance of the client to the auditor
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(Frankel et al., 2002; Ashbaugh et al., 2003). A second measure, the dollar value of
NAFs, is also employed.
In regard to measures that capture variation in earnings conservatism, the Basu
(1997) model is adopted. This will provide some evidence on the existence of earnings
conservatism in New Zealand. Earnings are regressed on contemporaneous stock
returns. That is returns equals economic income, and this re?ects good (bad) news for
positive (negative) economic income. To test the main hypothesis, in a manner similar
to Ruddock et al. (2006), a modi?ed Basu (1997) model is then introduced to capture the
incremental effect of high NAFR (or NAF) on earnings conservatism. Using this model
as a base, later models include three control variables, Big N auditors, client size, and
leverage, to account for possible confounding effects on conservatism.
Based on 528 ?rm-year observations from 1995 to 2001, this study provides
evidence for the existence of earnings conservatism in New Zealand. This is consistent
with the ?ndings of Ball et al. (2000, 2003), which suggest that earnings in common law
countries display signi?cant conservatism. As far as we are aware this is the ?rst
evidence of Basu (1997) conservatism in New Zealand. The insigni?cance of key
coef?cients in the models when NAFR and NAFs are added does not support the idea
that NAFs affect the degree of accounting conservatism. Additional tests provide
qualitatively similar results to the main analyses. Overall, higher levels of non-audit
services are not found to be associated with reduced earnings conservatism.
One plausible explanation for this ?nding is that auditors in New Zealand have
market-based incentives to maintain their independence. Concerns about reputation
and litigation may serve to discipline auditors, preventing them from compromising
their independence to protect NAFs. Auditors providing high levels of non-audit
services may therefore still maintain their independence “in fact”, requiring the same
degree of conservatism from all clients regardless of the level of non-audit services
purchased. Of course, we acknowledge that a study that fails to reject the null
hypothesis is open to a number of alternative interpretations.
The remainder of the paper is organised as follows. Section 2 brie?y reviews prior
literature in the areas of non-audit services, auditor independence and earnings
conservatism, while Section 3 develops the study’s main hypothesis. Section 4
describes the sample selection and Section 5 provides descriptive statistics for the data.
Section 6 discusses the research design. Section 7 summarises the results of the main
analyses, while sensitivity analyses are presented in Section 8. Section 9 concludes.
2. Literature review
2.1 Auditor independence
Auditors aid investor-management contracting by attesting to the reliability of
management’s ?nancial reporting. An audit is an ef?cient monitoring device that
increases a ?rm’s value by mitigating agency problems that arise from these contracts
(Jensen and Meckling, 1976). However, this monitoring will only be valuable if the
auditor is independent (Watts and Zimmerman, 1986). According to Watts and
Zimmerman (1983, 1986), auditor independence is “the probability that the auditor will
report a discovered breach in the ?nancial reports”. An independent auditor will
therefore keep an objective perspective and be able to withstand clients’ pressure to
accept substandard reporting. As this is the foundation for trust in the attestation
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function, auditor independence is often considered to be the cornerstone of the auditing
profession.
However, recent accounting scandals such as at Enron, WorldCom, Adelphia, HIH,
and Global Crossing have put the issue of auditor independence in the newspaper
headlines. This has been particularly so as the ?rm of Arthur Andersen was auditor of
a disproportionately large number of failed ?rms, and it has been noted that Arthur
Andersen earned very large amounts from NAFs from at least some of these ?rms.
Since capital markets need to make investment decisions with the assumption of
auditor independence, the question that arises from these scandals is whether the
auditor is truly independent. In response to negative publicity surrounding major audit
failure, the Securities and Exchange Commission – SEC (2000) reinforced the
importance of independence by de?ning it as the absence of interests that may cause
bias in appearance[2] as well as in fact[3]. This was followed by the Sarbanes-Oxley
Act of 2002, which banned a wide range of services that historically auditors may have
provided. The New Zealand Institute of Chartered Accountants (NZICA) (2005) offers a
similar de?nition of auditor independence – independence in “mind” and in
“appearance”. Not only must auditors be independent in practice, but they should also
be seen to be independent[4].
Accounting scandals in the USA had an effect on several New Zealand listed
companies and their accounting service providers. In 2002, Telecom New Zealand
Limited announced the separation of its auditing and consulting work.
PricewaterhouseCoopers continued to consult on tax and ?nancial services, but
Telecom’s auditing contract was given to KPMG. As Edlin (2002) commented, “the
move has been made in response to con?dence-shaking concerns raised by an epidemic
of accounting scandals in the United States and other countries”.
This was also the case at The Warehouse Group Limited, where “global pressure”
led Ernst and Young to give up its external auditing contract with the group. The
New Zealand Shareholders’ Association had claimed that auditor independence was at
risk because external auditors were permitted to perform internal audit work (Chapple,
2003). Further, some New Zealand audits are now directly affected by the provisions of
the Sarbanes-Oxley Act. Others are affected through the development of new
independence policies within the global accounting ?rms. As well, in the light of these
events, some New Zealand companies have accepted the provisions of Sarbanes-Oxley
as re?ecting best practice.
Both the “mind” and “appearance” dimensions of independence can signi?cantly
affect the ability of an audit to mitigate agency costs. Users may place little value in the
audit opinion if they perceive low independence, even if independence has been
maintained “in fact” (Chan et al., 2002).
While independence in appearance is an important issue in its own right, most
research has addressed the determinants of independence impairment “in fact”.
Several researchers have examined the potential link between NAFs and auditor
independence, but the empirical evidence is mixed. Some researchers have examined
whether the provision of independent audit services creates an economic bond that
jeopardizes auditor independence. Others have taken this further by investigating the
relationship between non-audit services and clients’ earnings management using
different proxies. Each of these avenues of research is brie?y discussed below.
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2.1.1 Non-audit services and auditor independence. Both the agency and the
behavioural literature suggest that, intentionally or unconsciously, auditors are more
likely to accede to a client’s wishes, including pressure to consent to earnings
management, when the provision of non-audit services is substantial (Frankel et al.,
2002).
The original paper in this area is Simunic (1984). He ?nds that an increase in the
provision of non-audit services is associated with a signi?cant increase in audit fees.
He argues that the joint provision of audit and non-audit services creates “knowledge
spillovers[5]”, which may strengthen an auditor’s economic bond with the client. In
response to the view that the information gained from non-audit services complements
the audit function and hence improves ?nancial reporting quality, Simunic claims that
this information advantage would not enhance the quality of ?nancial reporting if the
economic bonding is signi?cant enough to compromise the auditor’s independence. He
argues that this will be especially the case when the performance of audit and
non-audit services is “tied” together and when the specialised resources from the
non-audit services cannot be transferred to an equally pro?table alternative use.
Regulators and standard-setters offer similar arguments. In particular, the SEC is
concerned about two effects that non-audit services may have in threatening auditor
independence and ?nancial reporting quality. It is argued that the provision of non-audit
services may make auditors more ?nancially dependent on their clients, and hence
increase the likelihood the auditor will not draw attention to earnings management,
fearing the loss of lucrative fees. The Public Oversight Board – POB(2000, p. 121) of the
American Institute of Certi?ed Public Accountants addressed this issue in its Report
and Recommendations from the Panel on Audit Effectiveness – “prospective revenues
from the provision of non-audit services, extending into the future, create precisely the
kind of ?nancial stake that produces a con?ict of interest capable of impairing
independence”. Second, dif?culties may arise if the auditor performs two roles that have
the potential to be in con?ict. It is argued that consulting services can put auditors in
managerial roles, potentially threatening their ability to monitor the client objectively.
While the agency literature views auditor bias as intentional, the behavioural
literature suggests that auditors unconsciously bias their judgements. Beeler and
Hunton (2001) investigate the effect of contingent economic rents on professional
judgement and impairment of auditor independence. Auditors appear motivated to
develop and maintain ongoing relationships with clients in order to realize future
economic rents, yet still believe that their professional judgement is objective and
unbiased. Beeler and Hunton conclude that independence impairment is typically the
result of subconscious biases that distort audit evidence and its interpretation, rather
than deliberate opportunistic behaviour.
A competing viewpoint suggests that concerns about reputation and the threat of
lawsuits provide auditors with incentives to be independent. Therefore, the provision
of non-audit services will not compromise auditor independence; instead it may
strengthen audit quality and reduce clients’ earnings management. Arrun˜ada (1999)
claims that the provision of non-audit services increases auditors’ investment in
reputational capital. Using arguments similar to those of DeAngelo (1981), he shows
that concern about reputation constrains the behaviour of audit ?rms. This is because
the gains from agreeing to any one client’s demands are outweighed by the loss
of reputational capital that would be imposed by other clients who value a reputation
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for independence. Similarly, Dopuch et al. (2003) demonstrate that this increase in
reputational capital will increase auditor independence and audit quality, provided
that the probability of misstatement is low. Further, Palmrose (1988) ?nds that “Big 5”
auditors reduce litigation exposure by increasing their independence. This ?nding is
consistent with Francis et al. (1999) and Becker et al. (1998), who show that “Big 5”
auditors appear to constrain clients’ accounting discretion.
2.1.2 Auditor independence, NAF and earnings management. The above competing
arguments derive from a cost-bene?t trade-off – whether the economic rents generated
by retaining clients dominate the expected costs of sacri?cing auditor independence[6].
But it is not possible to quantify directly the bene?ts or costs. Therefore, it is ultimately
an empirical question whether auditors compromise their independence in order to
retain non-audit service clients, and to what extent the credibility of ?nancial reports is
eroded (DeFond et al., 2002). Over the last four or ?ve years an extremely large number
of papers have examined this issue. In this summary we brie?y mention some of them.
Frankel et al.’s (2002, henceforth FJN) analysis shows that the extent of NAF is
associated with several proxies for clients’ earnings management. In particular, they
?nd that ?rms purchasing higher levels of non-audit services are more likely to report
small earnings surprises and larger discretionary accruals and are better at meeting
analysts’ earnings forecasts. Because these clients appear to manage earnings to a
greater extent, FJN conclude that the provision of non-audit services adversely impacts
auditor independence.
However, subsequent studies have challenged their conclusions. The criticisms
include the failure of FJN to include a ?rm performance variable in the discretionary
accruals model (Ashbaugh et al., 2003), failure to account for the endogeneity of ?rm’s
reporting and their decisions to purchase services from auditors (Antle et al., 2006), and
failure to control for industry effects (Chung and Kallapur, 2003). Reynolds et al. (2004)
conclude that FJN’s results are primarily due to small to medium ?rms, ?rms having
initial public offerings, and ?rms in the e-commerce, biomedical, telecommunications
and pharmaceuticals industries. Larcker and Richardson (2004) attribute FJN’s results
to a small subset of their data.
The drawbacks of earnings management proxies are well documented in the
accounting choice literature. A popular proxy for earnings management is the level of
discretionary accruals, since it represents managers’ discretionary accounting policy
choices, which in turn could be motivated by self-interest. However, abnormal accruals
are a noisy proxy for earnings management (Healy and Wahlen, 1999; Dechow et al.,
1995). Studies that examine ?rms just beating (or meeting) earnings benchmarks also
face signi?cant problems. For example, ?rms may meet benchmarks through means
other than earnings management, such as improvements in operations (Dechow et al.,
2003).
Non-earnings management proxies also have limitations. Using auditors’
propensity to issue going concern opinions and restatements restricts samples to
distressed or restating ?rms, potentially reducing external validity.
2.2 Earnings conservatism
Conservatism has in?uenced accounting practice and theory for more than 500 years
(Basu, 1997). Recent research documents not only the existence of conservatism, but
also its rise in the last four decades (Watts, 2003a; Givoly and Hayn, 2000).
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Accounting conservatism has been traditionally expressed by the rule “anticipate
no pro?ts but anticipate all losses” (Bliss, 1924). Basu (1997) interprets this as
representing “the accountant’s tendency to require a higher degree of veri?cation to
recognize good news as gains than to recognize bad news as losses.” Differential
veri?cation produces earnings that re?ect bad news in a more timely fashion than good
news. It further implies that the effect of bad news on the earnings time-series will tend
to be transitory, whereas positive earnings changes will tend to persist.
The Framework for the Preparation and Presentation of Financial Statements
Section 37 (International Accounting Standards Board, 2005) provides an of?cial
de?nition of the concept – conservatism (prudence) requires preparers to exercise a
degree of caution when making estimations of uncertain transactions and events, “to
ensure that assets or revenues are not overstated and liabilities or expenses are not
understated.”
Explanations for the existence of conservatism point to the bene?ts it provides
users of ?nancial reports. As a desirable attribute of accounting earnings,
conservatism plays an ex ante ef?cient role in contracting between the ?rm and its
stakeholders (Basu, 1997; Watts, 2003a, b). They have limited horizons and limited
liability, and as a consequence asymmetric payoffs. Conservatism produces accounting
numbers that can be used in contracts among various parties to alleviate the con?icts
created by these asymmetries (Watts, 2003a).
Shareholder litigation is another explanation for conservatism. Overstatements of
earnings or assets are more likely to generate litigation costs for the ?rm than
understatements. Owing to this asymmetry, managers and auditors have incentives to
adopt conservative accounting so as to reduce the ?rm’s expected litigation costs. This
litigation explanation suggests that non-contracting parties in society also value
conservatism’s constraint on managers’ dysfunctional behaviour (Watts, 2003a). And
taxation and regulation are two additional explanations for conservatism (Shackelford
and Shevlin, 2001; Watts, 2003a).
The importance of accounting conservatism calls for empirical research on the topic.
In re-examining the conservatism principle, Basu (1997) develops a reverse regression
model that estimates earnings timeliness towards positive and negative stock returns.
Annual earnings are regressed on current stock returns, where positive (negative)
returns proxy for good (bad) news[7]. His results are consistent with the existence of
conservatism in US ?nancial reporting.
Basu’s model has been widely used by researchers in the area. As commented by
Ball et al. (2000), Basu’s reverse regression captures earnings’ timeliness in re?ecting
publicly available news, and hence has implications for earnings quality and reporting
transparency. In their study, they predict that Basu measures of conservatism vary
across common law countries (the USA, the UK, Australia and Canada) and code-law
countries (France, Germany and Japan) according to their different institutional
factors[8]. Consistent with this prediction, Ball et al. (2000) ?nd that accounting income
in common law countries is signi?cantly more conservative than in code law countries.
3. Hypothesis development
Critics of the profession have alleged that the high margin of NAFs increases the
auditor’s economic dependence on the client ?rm, which in turn increases the
auditor’s incentives to agree to clients’ wishes and condone aggressive accounting.
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Where there is an increase in the probability of an auditor not truthfully reporting the
results of the audit investigation, there is a threat to independence (Simunic, 1984).
Therefore, the provision of non-audit services may jeopardize auditors’ independence,
which could in turn reduce audit quality and ultimately result in reported earnings of
lower quality.
This study examines the impact of non-audit services on a speci?c attribute of
audited ?nancial statements – earnings conservatism. It is similar in motivation to
Ruddock et al. (2006), although it uses different proxies for economic bond and
economic income, and is applied to a different data set[9].
To the extent that non-audit services impair auditor independence, auditors are likely
to be less willing to challenge clients’ aggressive accounting. This will be revealed by a
reduction in accounting conservatism, as measured. Therefore, clients purchasing
higher levels of these services are expected to report earnings of lower quality, and in
particular earnings of lower conservatism. This reasoning leads to the main hypothesis:
H1. The higher the level of non-audit services provided by the incumbent auditor,
the less conservative the client’s accounting practices will be.
4. Sample selection and data
The basic data set is provided by the Department of Accounting and Finance at The
University of Auckland. The initial sample consists of 814 ?rm-year observations from
1995 to 2001, representing 176 New Zealand companies. For each ?rm-year, the data
?le provides information on the ?rm’s auditors, including fees paid for audit and
non-audit services, as well as key measures of ?nancial performance and position. In
order to calculate the market return of each ?rm, annual adjusted share prices[10] are
obtained from DataStream. Firm-years with insuf?cient data to estimate the empirical
models are eliminated. To remove the effect of outliers, observations are winsorized to
the 1 and 99 per cent levels. Financial institutions and regulated ?rms are also
excluded, as these ?rms may have different ?nancial reporting incentives (Burgstahler
and Dichev, 1997). The ?nal sample consists of 528 observations, representing 118 New
Zealand listed companies.
5. Research design
5.1 Economic dependence
This study uses two measures to proxy for the economic bond between a client and its
auditor. The ?rst is the ratio of NAF to total fees paid by the client (NAFR), as used by
FJN and several other researchers. This measure captures the relative value of the
audit versus non-audit services provided by the audit ?rm to the client, which may
affect investors’ and regulators’ perceptions of independence. To the extent that
non-audit services have a higher pro?t margin, it is alleged that auditors are more
concerned with avoiding the loss of audit clients that generate relatively large amounts
of NAF, and use audits as a platform from which they sell non-audit services[11].
This speci?cation is, however, subject to a number of criticisms. Speci?cally, this ratio
does not capture the ?nancial importance of the client to the audit ?rm (Frankel et al.,
2002; Ashbaugh et al., 2003). Although the Enron-Arthur Andersen scandal is a
frequently cited example of signi?cant client-auditor economic bonding, as pointed out
by Kinney and Libby (2002) and others, an analysis of Enron’s fee disclosures (audit
fees of $US 25 million and NAF of $US 27 million) would result in a NAFR of only 0.52,
ARJ
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which is close to the median (0.51) reported by FJN in Table II. Therefore, the second
measure for economic dependence is the dollar amount of NAF paid by each client to
its auditor[12]. This measure is speci?ed to incorporate the payment size, and thus
attempts to capture the clients’ ?nancial importance to the audit ?rm.
5.2 Measuring conservatism
5.2.1 Model 1: the Basu model, applied to pooled data and sub-samples. Following Basu
(1997), the ?rst test utilizes a “reverse” regression of annual earnings on
contemporaneous stock returns, which is stated as follows:
NI
it
¼ a
0
þ a
1
DRET
it
þb
0
RET
it
þb
1
RET
it
*
DRET
it
þ1
it
; ð1Þ
where, NI
it
– net income after tax for ?rm i in ?scal year t, de?ated by the market
capitalisation at the beginning of the ?scal year; RET
it
– annual stock return on ?rm i
for ?scal year t, that is ðP
t
2P
t21
Þ=P
t21
, where prices have already been adjusted for
dividends; DRET
it
– 1 if RET
it
# 0, and 0 otherwise.
Model 1 is ?rst estimated for the pooled sample, and then separately for ?rm-years
with high NAFRs (NAFR values in the top third[13] of the pooled sample) and low
NAFRs (NAFR values in the bottom third of the pooled sample). Using the Basu (1997)
model, both the pooled data, and sub-samples, can provide insight into the existence of
earnings conservatism in New Zealand.
Positive (negative) annual stock returns are used as a proxy for good (bad) news.
Assuming that news is uncorrelated through time, the intercept a
0
captures the
postponed recognition of news from previous periods. Conservative accounting implies
that a
0
is positive, as most unrealised losses are captured immediately. Little bad
news is postponed to future periods, while the recognition of gains is delayed. b
0
measures the responsiveness (sensitivity) of earnings to current good news. The
interactive slope coef?cient (b
1
), which is of interest here, represents the differential
sensitivity of earnings in recognising bad news over good news. Conservatism means
that earnings are more concurrently sensitive in incorporating economic losses relative
to economic gains, thus implying that b
1
is positive.
5.2.2 Model 2: modi?ed Basu model including the incremental effect of high NAFRs
on earnings conservatism, applied to sub-samples. To capture the incremental effect of
high NAFRs on earnings conservatism, additional intercept and slope coef?cients are
included. A dummy variable (DNAFR) is introduced, denoting the level of ?rm-years’
NAFRs in the pooled sample distribution. Based on the former classi?cation,
?rm-years with a NAFR in the top third of the pooled sample have a value of one for
DNAFR, while ?rm-years with a NAFR in the bottom third take a value of 0.
Firm-years in the middle third are excluded from the analysis. The following modi?ed
regression model is estimated:
NI
it
¼a
0
þa
1
DRET
it
þa
2
DNAFR
it
þa
3
DRET
it
*
DNAFR
it
þb
0
RET
it
þb
1
RET
it
*
DRET
it
þb
2
RET
it
*
DNAFR
it
þb
3
RET
it
*
DRET
it
*
DNAFR
it
þ1
it
;
ð2Þ
where, DNAFR
it
– 1 for ?rm-years with NAFR
it
in the top third of the pooled sample,
and 0 for ?rm-years with NAFR
it
in the bottom third.
The interactive coef?cients b
3
and b
2
, which are the focus here, measure the
incremental responsiveness of earnings to bad news and good news when NAFR is
Provision of
non-audit
services
203
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2
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(
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)
high. If conservatism is reduced when the ratio of NAF to total fees is high, b
3
is
expected to be signi?cantly negative. Also, if the responsiveness of earnings to good
news is increased when NAFR is high, consistent with reduced asymmetrical
timeliness, b
2
is expected to be signi?cantly positive.
5.2.3 Model 3: modi?ed Basu model including the incremental effect of high NAFRs
on earnings conservatism and control variables, applied to sub-samples. Prior literature
identi?es several factors that may in?uence a ?rm’s earnings conservatism. To
account for possible confounding effects on earnings conservatism, three control
variables are introduced.
First, Basu et al. (2001) document that Big 8 clients report earnings that are more
conservative than non-Big 8 clients, consistent with Big 8 auditors being more
conservative in order to protect their brand name reputations. Likewise, Becker et al.
(1998) ?nd that Big 6 auditors constrain accruals-based earnings management more
than non-Big 6 auditors. Therefore, Big N (now Big 4[14]) auditors are expected to
enhance earnings conservatism by constraining aggressive accruals and persuading
clients to report economic losses in a timely fashion. A dummy variable (BIGN) is
included to control for the impact that Big N auditors may have on the conservatism of
reported earnings. BIGN takes the value of 1 if the ?rm’s auditor is one of the Big N,
and 0 otherwise.
Second, the size hypothesis predicts that larger ?rms will tend to make
income-decreasing accounting choices, so as to reduce their political visibility
(Watts and Zimmerman, 1978)[15]. A control variable for client size, proxied by the
natural logarithm of ?rms’ total assets (in $’000), is employed to take account of this
effect.
Third, ?rms facing severe debtholder-shareholder con?icts over dividend policy are
inclined to adopt more conservative accounting (Ahmed et al., 2002). Following Ahmed
et al. (2002), leverage, measured as the ratio of long-term debt to total equity, is used as
a proxy for the severity of debtholder-shareholder con?icts. Firms with higher leverage
are expected to have greater earnings conservatism.
Including the above three control variables, the regression model is now estimated
as follows:
NI
it
¼ a
0
þ a
1
DRET
it
þa
2
DNAFR
it
þa
3
DRET
it
*
DNAFR
it
þ b
0
RET
it
þ b
1
RET
it
*
DRET
it
þ b
2
RET
it
*
DNAFR
it
þb
3
RET
it
*
DRET
it
*
DNAFR
it
þ g
0
BIGN
it
þ g
1
DRET
it
*
BIGN
it
þ g
2
RET
it
*
BIGN
it
þ g
3
RET
it
*
DRET
it
*
BIGN
it
þ d
0
SIZE
it
þd
1
DRET
it
*
SIZE
it
þ d
2
RET
it
*
SIZE
it
þ d
3
RET
it
*
DRET
it
*
SIZE
it
þ l
0
LEV
it
þ l
1
DRET
it
*
LEV
it
þ l
2
RET
it
*
LEV
it
þ l
3
RET
it
*
DRET
it
*
LEV
it
þ 1
it
;
ð3Þ
where, BIGN
it
– 1 if the ?rm i’s auditor is a Big N audit ?rm in year t; and 0 otherwise;
SIZE
it
– natural logarithm of ?rm i’s total assets in year t; LEV
it
– ratio of ?rm i’s
long-term debt to its total equity in year t.
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(
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All control variables are interacted with the test variables in Model 2. This not only
accounts for the effects those control variables may have on the intercept, but also
allows the slopes to vary. Consistent with prior literature that larger ?rms and higher
leveraged ?rms are predicted to have more conservative earnings, the interactive
coef?cients on these three control variables (g
3
, d
3
, l
3
, respectively) are expected to be
positive.
5.2.4 Models 4 and 5: replication of Models 2 and 3 using a different proxy for
economic bonding (NAF), applied to sub-samples. As previously mentioned, although
NAFR is of interest to investors and regulators, it may not capture the importance of
clients to the audit ?rm. Therefore, another measure of economic dependence (NAF) is
employed, and the above regressions (Models 2 and 3) are replicated using this new
measure. Firm-years are re-ranked according to the magnitude of NAF, and a dummy
variable (DNAF) takes a value of 1 if a ?rm-year’s NAF is in the top third of the pooled
sample, and 0 if it is in the bottom third. Firm-years in the middle third are excluded
from the analysis. With the variables de?ned as before, Model 1 is re-estimated using
this new classi?cation of sub-groups, and Models 2 and 3 are re-speci?ed as follows:
NI
it
¼ a
0
þ a
1
DRET
it
þa
2
DNAF
it
þa
3
DRET
it
*
DNAF
it
þ b
0
RET
it
þb
1
RET
it
*
DRET
it
þb
2
RET
it
*
DNAF
it
þb
3
RET
it
*
DRET
it
*
DNAF
it
þ1
it
;
ð4Þ
NI
it
¼ a
0
þ a
1
DRET
it
þa
2
DNAF
it
þ a
3
DRET
it
*
DNAF
it
þb
0
RET
it
þ b
1
RET
it
*
DRET
it
þ b
2
RET
it
*
DNAF
it
þ b
3
RET
it
*
DRET
it
*
DNAF
it
þ g
0
BIGN
it
þg
1
DRET
it
*
BIGN
it
þg
2
RET
it
*
BIGN
it
þ g
3
RET
it
*
DRET
it
*
BIGN
it
þd
0
SIZEit þ d
1
DRET
it
*
SIZE
it
þ d
2
RET
it
*
SIZE
it
þ d
3
RET
it
*
DRET
it
*
SIZE
it
þl
0
LEV
it
þ l
1
DRET
it
*
LEV
it
þ l
2
RET
it
*
LEV
it
þl
3
RET
it
*
DRET
it
*
LEV
it
þ 1
it
;
ð5Þ
where, DNAF
it
– 1 for ?rm-years with NAF
it
in the top third of the pooled sample, and
0 for ?rm-years with NAF
it
in the bottom third.
6. Descriptive statistics
Descriptive statistics for the pooled sample are reported in Table I. The median of the
dependent variable, net income de?ated by the beginning-of-the-year market
capitalization (NI), is 0.063. The ?rst quartile (0.014) of de?ated net income shows
that the large majority of the ?rm-years report a surplus. However, some ?rm-years
experienced severe losses, which reduces the mean to a value of 0.016. The median
annual stock return is 0, telling us that half of all ?rm-years encounter economic losses.
Table I also shows considerable variation in the consumption of non-audit services.
Eighteen percent of all ?rm-years have zero NAF, indicating that the auditor provided
no additional services[16], while the maximum fee is $5 million. On average, ?rm-year
NAF are $197,860, while the median fee is only $35,393. Some ?rm-years have
Provision of
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services
205
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d
a
s
t
h
e
r
a
t
i
o
o
f
l
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n
g
-
t
e
r
m
d
e
b
t
t
o
t
o
t
a
l
e
q
u
i
t
y
Table I.
Descriptive statistics
for pooled sample
ARJ
21,2
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A
t
2
1
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
substantial fee levels, which pushes the mean well above the third quartile ($135,000).
This variation makes the NAF proxy for economic dependence particularly interesting,
as the sub-sample design will capture the signi?cant differential between low and high
NAF levels. NAFR is fairly evenly distributed, with a mean of 0.331 and median of
0.310. Both the mean and median ratios are lower than those reported in FJN (0.331 vs
0.49 and 0.310 vs 0.51, respectively), suggesting that the provision of non-audit services
is less prevalent in New Zealand than in the USA.
Summary statistics for the three control variables are also presented in Table I. The
mean for BIGN is 0.887, showing that Big N auditors dominate New Zealand’s listed
?rm market. The mean for client size (SIZE) and leverage (LEV) are 11.713 and 0.477,
respectively.
Correlation coef?cients are presented in Table II, along with a x
2
statistic for the
two binary variables, DNAFR (or DNAF) and BIGN. Panel A contains the results for
the sub-samples when using NAFR as a proxy for economic dependence, while Panel B
reports the correlations for the sub-samples when using the alternative NAF proxy.
In Panel A, the point biserial correlation coef?cient shows that the dummy variable
for high and low NAFRs (DNAFR) is positively and signi?cantly correlated with RET
and SIZE. SIZE is positively correlated with BIGN and LEV, as expected. A similar
pattern of correlations is observed in Panel B. Despite many independent variables
being signi?cantly correlated, only the association between DNAF and SIZE is large in
economic terms (point biserial correlation of 0.60). Large ?rms use the consulting
services that the auditor has available more than small ?rms do, in part as non-BIGN
RET BIGN SIZE LEV
Panel A: correlations for NAFR sub-samples (n ¼ 352)
DNAFR 0.150
* *
(0.006) 40.55
* *
(0.000) 0.420
* *
(0.000) 0.090 (0.081)
RET 0.040 (0.407) 0.101 (0.059) 20.012 (0.818)
BIGN 0.380
* *
(0.000) 0.090 (0.106)
SIZE 0.131
*
(0.014) 0.405
* *
(0.000)
LEV 0.011 (0.835) 0.473
* *
(0.000)
Panel B: correlations for NAF sub-samples (n ¼ 352)
DNAF 0.120
*
(0.023) 35.46
* *
(0.000) 0.600
* *
(0.000) 0.080 (0.113)
RET 0.090 (0.104) 0.104 (0.051) 20.022 (0.683)
BIGN 0.360
* *
(0.000) 0.070 (0.171)
SIZE 0.130
*
(0.014) 0.367
* *
(0.000)
LEV 0.008 (0.887) 0.507
* *
(0.000)
Notes:
* *
and
*
indicate that the correlation is signi?cant at 1 and 5 per cent levels, respectively.
a
Firm-year observations are winsorized to the 1 and 99 per cent levels. Two-tailed p-values are
presented below the correlation coef?cients. Variable de?nitions: NI – net income after tax, de?ated by
the market capitalisation at the beginning of the ?scal year; RET – annual stock return, calculated as
ðP
t
2P
t21
Þ=P
t21
, where prices have been already adjusted for dividends; DNAFR – 1 for ?rm-years
with NAFR in the top third of the pooled sample, and 0 for ?rm-years with NAFR in the bottom third;
DNAF – 1 for ?rm-years with NAF in the top third of the pooled sample, and 0 for ?rm-years with
NAF in the bottom third; NAFR – non-audit service fee ratio, calculated as non-audit service fees over
total fees; NAF – non-audit service fees paid to holding company audit ?rm; BIGN – 1 if the ?rm’s
auditor is a Big N audit ?rm; and 0 otherwise; SIZE – natural logarithm of the ?rm’s total assets, $’000;
LEV – leverage, calculated as the ratio of the ?rm’s long-term debt to its total equity
Table II.
Pearson (Spearman)
correlation coef?cients
above (below) the
diagonal
a
point biserial
correlation coef?cient
where one variable is
binary x
2
statistic where
both variables are binary
Provision of
non-audit
services
207
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I
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A
t
2
1
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
auditors are more constrained in the range of services that they can provide. In this
setting, multicollinearity is unlikely to be a problem in the regression models.
7. Results
Table III reports the regression results for Model 1 (for both pooled and sub samples).
Table IV reports the results for Models 2 and 3 using NAFR to proxy for the economic
bond between an auditor and its client, while Table V presents the results for Models 4
and 5 using the alternative NAF proxy. Recall that Model 1 is a simple “reverse”
regression of earnings on contemporaneous stock returns, with a dummy variable that
equals one for negative returns. Model 2 (4) includes an additional dummy variable
DNAFR (DNAF) that accounts for those instances where NAFR (NAF) is relatively
high. Using Model 2 (4) as a base, Model 3 (5) includes three further variables to control
for possible confounding effects on earnings conservatism.
In Table III, regression results for Model 1 are presented initially for the pooled
sample, and then separately for ?rm-years with high and low values of NAFR (NAF).
Evidence from the full sample of ?rm-years is consistent with earnings conservatism.
The intercept (a
0
), and the incremental coef?cient on negative stock returns (b
1
) are
both positive and highly signi?cant. The signi?cantly positive intercept (a
0
) indicates
that the recognition of unrealized gains is postponed to future periods, and the
signi?cantly positive interactive slope coef?cient (b
1
) suggests a differential treatment
of economic losses. The magnitude of b
1
is far greater than b
0
(0.444 vs 0.093), showing
that earnings is about eight times ð7:7 ¼ ½0:444 þ 0:093?=0:093Þ as sensitive to
negative returns as it is to positive returns. Overall, these results suggest that, in New
Zealand, earnings are more responsive to contemporaneous bad news. This is
consistent with international studies which ?nd that earnings in common law countries
display signi?cant conservatism (Ball et al., 2000, 2003).
When Model 1 is estimated separately for ?rm-years with high and low NAFR
(NAF), conservatism is evident in both sub-samples. Under both economic bond
proxies, the coef?cient b
1
is positive and highly signi?cant, indicating that earnings is
more timely in recognising economic losses irrespective of the level of NAF.
Panel A of Tables IV and V summarises the regression results for Models 2 and 4.
As discussed earlier, if ?rms consuming higher values of NAFR (NAF) report less
conservative earnings, b
3
is expected to be signi?cantly negative and b
2
is expected to
be signi?cantly positive[17]. The signs of the interactive slope coef?cients b
3
and b
2
are mixed, and none of the estimates is signi?cantly different from zero. b
1
continues to
be positive and signi?cant, indicating an asymmetrically higher responsiveness to bad
news.
Panel B of Tables IV and V presents the regression results for Models 3 and 5. The
inclusion of control variables increases the explanatory power of the models, with
adjusted R
2
rising above 20 per cent. In both cases b
2
and b
3
are statistically
insigni?cantly different from 0. The interactive coef?cient for leverage (l
3
) is
signi?cantly positive, which is consistent with the prediction that highly leveraged
?rms may adopt more conservative accounting to reduce shareholder-debtholder
con?icts.
Overall, the insigni?cant results for b
3
and b
2
in Models 2 to 5 fail to support the
main hypothesis. No evidence is found for an incremental reduction in conservatism
where NAFR or NAF is relatively high. This ?nding is consistent with other recent
ARJ
21,2
208
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a
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q
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y
Table III.
Results from pooled
cross-sectional
regressions of de?ated
earnings on
contemporaneous stock
returns
Provision of
non-audit
services
209
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
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y
Table IV.
Results from pooled
cross-sectional
regressions of de?ated
earnings on
contemporaneous stock
returns (NAFR
sub-samples)
ARJ
21,2
210
D
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y
Table V.
Results from pooled
cross-sectional
regressions of de?ated
earnings on
contemporaneous stock
returns (NAF
sub-samples)
Provision of
non-audit
services
211
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
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U
N
I
V
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S
I
T
Y
A
t
2
1
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
research, such as Chung and Kallapur (2003), Reynolds et al. (2004), and Ruddock et al.
(2006) which fail to document a negative association between NAF and earnings
quality.
8. Sensitivity analyses
The primary tests are based on ?rm-years that include no purchase of non-audit
services from the incumbent auditor. With zero non-audit fee observations comprising
18 per cent of the pooled sample, most “low NAFR (NAF)” sub-sample ?rm-years are
more accurately described as “zero NAFR (NAF)”. To examine whether this
speci?cation drives the insigni?cant results of the main tests, additional analyses are
conducted. Regressions of Models 2 to 5 are re-run after the elimination of zero
non-audit fee observations. The results for the NAFR and NAF sub-samples are
presented in Tables VI and VII, respectively. The coef?cients of interest, b
3
and b
2
,
remain insigni?cant except for b
2
in Panel B of Table VI, but that estimate is negative.
Interestingly, b
3
in Table VII Panel B is even signi?cantly positive, which suggests
that auditors constrain clients’ aggressive accounting practice when the provision of
non-audit services is high. b
1
is still positive but is signi?cantly different from zero in
only two of the four regressions shown in these tables.
To further check the robustness of the primary results, the second sensitivity
analyses are conducted by changing the classi?cation of high/low NAFR/NAF. In the
primary tests, ?rm-years in the top (bottom) third of NAFR/NAF distribution are
compared to see if the high level of provision of non-audit services leads to clients’ less
conservative accounting practices. This comparison now becomes stricter by replacing
the classi?cation of high and low NAFR/NAF based on the upper and bottom quartile
and quintile of the NAFR/NAF distribution. These involve some extreme comparisons
and the effect of the level of the provision of non-audit services have on the
clients’ accounting practices might be observed. For example, ?rm-years in the lower
quintile are nearly “zero NAFR/NAF” observations. Models 2 to 5 are re-run based on
the new classi?cation of high/low NAFR/NAF and results are reported in Table VIII.
Nevertheless, b
3
and b
2
are still insigni?cant, except in one case, where b
2
is
signi?cantly positive using the Model 2 regression based on the observations in the
upper/lower quintile of the NAFR/NAF distribution.
Overall, the results of these additional analyses are qualitatively similar to the main
test results, suggesting that the primary analyses are not sensitive to the inclusion of
zero NAF observations[18].
Finally, we also identi?ed all audit quali?cations in the dataset, as it could be
argued that large NAF revenues might induce a lower level of audit quali?cation
than might otherwise be the case. There are only three quali?cations in the “high”
NAF group and seven in the low-NAF group, so we are dealing with extremely
small numbers. Further, the high-NAF group of companies is signi?cantly more
pro?table and has signi?cantly higher returns on average than the low-NAF group.
Therefore, we cannot attribute the lower level of quali?cations in the high-NAF
group to the NAF.
9. Conclusion
This study examines the relation between non-audit services provided by incumbent
auditors and one important aspect of earnings quality – conservatism. Conservatism is
ARJ
21,2
212
D
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ð
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2
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1
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=
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Table VI.
Results of sensitivity
analyses (excluding zero
NAF observations)
(NAFR sub-samples)
Provision of
non-audit
services
213
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Table VII.
Results of sensitivity
analyses (excluding
zero non-audit fee
observations)
(NAF sub-samples)
ARJ
21,2
214
D
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Table VIII.
Results of sensitivity
analysis (changing the
classi?cation of high/low
NAFR/NAF)
Provision of
non-audit
services
215
D
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de?ned as the asymmetric recognition of economic losses. It plays an important role in
the ef?cient monitoring of contracts, and helps mitigate agency costs in organisations.
The provision of non-audit services by incumbent auditors has been subject to much
recent criticism. In particular, the economic bond created by these services is alleged to
compromise auditor independence, and hence lower the quality of clients’ reported
earnings. It is hypothesized that a negative relation exists between the provision of
non-audit services and clients’ earnings conservatism.
Two measures derived from the prior literature are employed to proxy for the
economic bond between auditors and their clients. The NAFR relates to the concerns of
investors and regulators, while the total of NAF captures the client’s economic
importance to the auditor.
Using the Basu (1997) model, evidence is presented for the existence of earnings
conservatism in New Zealand. This is consistent with international studies which
suggest that earnings in common law countries show signi?cant conservatism
(Ball et al., 2000, 2003). However, a modi?ed Basu (1997) model that includes the
incremental effect of high NAFR (NAF) on earnings conservatism fails to support the
main hypothesis. The further inclusion of three control variables, Big N auditors, client
size and leverage, also leads to insigni?cant results. The sensitivity analyses, which
eliminate zero NAF observations and change the classi?cation of high/low NAFR/NAF
provide results that are qualitatively similar to the main analyses. Overall, this study
provides no evidence that higher levels of non-audit services are associated with
reduced earnings conservatism.
One plausible explanation is that auditors in New Zealand have market-based
incentives to maintain their independence. Concerns about reputation and litigation
may dominate the economic dependence created by higher NAF. Auditors of clients
purchasing high levels of non-audit services may therefore still maintain their
independence “in fact”, requiring the same degree of conservatism from these clients as
for those purchasing low levels of non-audit services.
Although widely accepted in the conservatism literature, the Basu (1997) model still
suffers from some drawbacks. The ef?cient market hypothesis may not always hold,
and clear interpretations of the model are only possible if returns cause earnings and
not the reverse (Dietrich et al., 2002).
Finally, issues of endogeneity may also contribute to the insigni?cant results.
Accounting choices, including the level of conservatism exercised, may be associated
with the same factors that determine a ?rm’s demand for non-audit services. The
problem here is that it is not clear what those factors might be. Hence, this limitation is
inherent in all prior research examining the relation between non-audit services and
?rms’ accounting choices. It should also be noted that the inclusion of control variables
in Models 3 and 5 may mitigate this concern[19]. Nevertheless, there is scope for future
research to develop more sophisticated methods[20] to address the issue of endogeneity.
Notes
1. Non-audit services refer to fee based services performed by the auditing ?rm which are not
related to the audit engagement. They include tax services, management consulting, systems
planning, systems design and review, personnel services, risk management, actuarial
services, and acquisition services. (Chan et al., 2002).
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2. The SEC (2000, Section I) will not consider an auditor to be independent with respect to a
particular client “if a reasonable investor, with knowledge of all relevant facts and
circumstances, would conclude that the auditor is not capable of exercising objective and
impartial judgement”.
3. An auditor who is independent in fact has the ability to make independent audit decisions,
even if there is a perceived lack of independence.
4. New Zealand Financial Reporting Standards (FRS-9) clause 6.13(e) also mandates disclosure
of audit fees and NAF.
5. Knowledge spillovers refer to information generated while performing non-audit services
that can produce economic rents by reducing auditing costs.
6. As discussed above, the expected costs of sacri?ced independence include the loss of
reputation and litigation costs associated with audit failure.
7. This model relies on the “ef?cient market hypothesis”. Stock prices are assumed to
ef?ciently re?ect value-relevant information as it becomes public. When this condition holds,
stock prices will re?ect information received from sources other than current earnings, and
may lead accounting earnings.
8. Other studies using the Basu (1997) model to examine cross-country variation in
conservatism include Pope and Walker (1999), Giner and Rees (2001), GarciaLara and Mora
(2004) and GarciaLara et al. (2005).
9. In the review of Ruddock et al. (2006) by Francis (2006), three major comments are advanced.
Francis is critical of Ruddock et al.’s extrapolation of their Australian results to the US audit
market. The second is that he objects to Ruddock et al.’s use of “unexpected” NAF. The third
is that Francis is a “skeptic” when it comes to the Basu (1997) earnings conservatism story.
Only the third of those comments applies to this paper.
10. Prices are adjusted for subsequent capital actions, including dividend payouts. Share prices
at the end of ?scal year 1994 are also gathered to calculate annual stock returns for ?scal
year 1995.
11. As claimed by a former SEC chairman, “the auditing function is simply being used as a
springboard to more lucrative consulting services” (Levitt, 2000).
12. Several researchers use this proxy, including Antle et al. (2006), DeFond et al. (2002), Kinney
et al.(2004) and Reynolds et al. (2004). An alternative approach would be to examine the
client’s importance within the auditor’s portfolio of clients, by comparing the NAF paid by
the client with the audit ?rm’s total revenue in that year. However, data on the total fee
income of audit ?rms is not available; hence, this meaningful measure of individual client
signi?cance cannot be calculated.
13. This follows Ruddock et al. (2006).
14. Given the time period covered in this study, top tier auditors are hereafter referred to as the
“Big N”. N starts as 6 and ends at 5.
15. See, Zmijewski and Hagerman (1981) and Reynolds and Francis (2001) for evidence
supporting this position.
16. This issue will be addressed in the sensitivity analyses.
17. These regressions were replicated using total fees in place of NAF. While NAF are the focus
of our attention, the reason for this replication was to determine the similarity of the results
between total and NAF. The (unreported) results also have b
2
and b
3
estimates that are
insigni?cantly different from 0. The regressions were also replicated using a ratio of NAF to
the total of all fees for that auditor in each year with similar (insigni?cant) results.
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18. We also examined all auditor changes. There are 44 such changes in the (814 ?rm year)
database, and 25 are retained in the smaller (528 observations) dataset that is used for this
research. Only 20 make it through into the high- and low-NAF analysis, with ten in each
group. Of the ten high-NAF cases, eight show increases in NAFs in the year of the switch.
Nine of these ten changes are from one Big 5 to another Big 5 auditor. In all cases changes in
both audit and non-audit fees are small.
19. For example, larger ?rms may be both more likely to report conservative earnings and
purchase more non-audit services. The inclusion of client size as an exogenous variable in
Models 3 and 5 controls for this possibility.
20. For example, Antle et al. (2006) uses a simultaneous equations method to overcome
endogeneity problems.
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Accounting Research, Vol. 40, pp. 1221-45.
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pp. 3-26.
Corresponding author
David Emanuel can be contacted at: [email protected]
Provision of
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This article has been cited by:
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International Journal of Accounting & Information Management 23:1, 80-104. [Abstract] [Full Text] [PDF]
2. AHSAN HABIB. 2012. Non-Audit Service Fees and Financial Reporting Quality: A Meta-Analysis.
Abacus 48:10.1111/abac.2012.48.issue-2, 214-248. [CrossRef]
3. Vineeta D. Sharma, Divesh S. Sharma, Umapathy Ananthanarayanan. 2011. Client Importance and
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& Theory 30, 125-156. [CrossRef]
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doc_482429091.pdf
This study seeks to examine the relation between non-audit services provided by
incumbent auditors and an important aspect of earnings quality – conservatism, using New Zealand
data. Conservatism is defined as the adoption of accounting policies that accelerate expenses towards
the current period and/or defer revenues to later periods. If the provision of non-audit services
undermines auditor independence and encourages the condoning of clients’ aggressive accounting
practices, this will be revealed by a reduction in accounting conservatism.
Accounting Research Journal
The provision of non-audit services and earnings conservatism: Do New Zealand auditors
compromise their independence?
Beilei Zhang David Emanuel
Article information:
To cite this document:
Beilei Zhang David Emanuel, (2008),"The provision of non-audit services and earnings conservatism",
Accounting Research J ournal, Vol. 21 Iss 2 pp. 195 - 221
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Deborah Bloomfield, J oshua Shackman, (2008),"Non-audit service fees, auditor characteristics
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dx.doi.org/10.1108/02686900810839839
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The provision of non-audit
services and earnings
conservatism
Do New Zealand auditors compromise
their independence?
Beilei Zhang
BDO Spicers, Auckland, New Zealand, and
David Emanuel
Department of Accounting and Finance,
The University of Auckland Business School, Auckland, New Zealand
Abstract
Purpose – This study seeks to examine the relation between non-audit services provided by
incumbent auditors and an important aspect of earnings quality – conservatism, using New Zealand
data. Conservatism is de?ned as the adoption of accounting policies that accelerate expenses towards
the current period and/or defer revenues to later periods. If the provision of non-audit services
undermines auditor independence and encourages the condoning of clients’ aggressive accounting
practices, this will be revealed by a reduction in accounting conservatism.
Design/methodology/approach – The method aims to determine whether Basu’s conservatism is
affected by the level and proportion of non-audit services, where the dataset is partitioned into multiple
levels of these services.
Findings – Using 528 ?rm-year observations, evidence is presented for the existence of earnings
conservatism in New Zealand. However, no evidence of a negative association between non-audit
services and earnings conservatism is found.
Research limitations/implications – Although widely accepted in the conservatism literature, the
Basu model still suffers from some drawbacks. Issues of endogeneity may also contribute to the
insigni?cant results.
Practical implications – The results are consistent with factors such as reputational penalties and
litigation risk constraining auditor behaviour. Auditors in New Zealand may therefore still maintain
their independence “in fact”, irrespective of the level of non-audit fees (NAFs) purchased by clients.
Originality/value – This paper contains the ?rst tests of conservatism using New Zealand data. It
adds to the body of knowledge about the relationship, or the lack thereof, between NAF and desirable
attributes of accounting.
Keywords Auditors, Auditing, Earnings, New Zealand
Paper type Research paper
1. Introduction
The recent collapse of several major corporations in the USA and elsewhere has led to
the allegation that auditors of these companies failed to detect and/or persuade their
clients to recognise economic losses in a timely fashion (Wall Street Journal, 2002). In a
number of cases, the auditor provided substantial consulting services to the troubled
client. Given this, critics have been concerned that the ?nancial dependence and
The current issue and full text archive of this journal is available at
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Provision of
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Accounting Research Journal
Vol. 21 No. 2, 2008
pp. 195-221
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309610810905953
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responsibility that accompany the provision of non-audit services[1] may reduce the
ability of auditors to perform objective monitoring. As auditor independence is crucial
in maintaining the credibility of ?nancial reporting, recent research has examined the
relationship between non-audit services and clients’ earnings quality. However, the
evidence to date remains inconclusive. While, Frankel et al. (2002) and Dee et al. (2001)
suggest that the provision of non-audit services leads to more aggressive accounting
practices, other studies (Chung and Kallapur, 2003; Reynolds et al., 2004; DeFond et al.,
2002) contradict their ?ndings.
There are several motivations for this particular study. The ?rst is that issues
associated with the role of non-audit fees (NAFs) are only going to be resolved by the
weight of evidence, rather than by one study. The second is that there is, as far as we
are aware, only one prior study looking at this issue using New Zealand data (Cahan
et al., 2008). The third is that New Zealand data on audit and NAFs have been available
since the mid-1990s and therefore there is a panel of data available for analysis. The
last year of data is 2001, the year before Andersen was indicted over the Enron affair.
The fourth is that New Zealand’s small size can be an advantage if the argument is
advanced that this smallness and proximity could lead to closer interaction between
auditors and clients. For example, there is only one professional accounting body, and
there are only two major cities which are the sites for most audits. Finally, many prior
studies focus on attributes of accounting that are suggestive of earnings management,
but the methods used to identify earnings management have relatively
low-explanatory power. Rather than using earnings management proxies, this study
examines whether the provision of non-audit services by incumbent auditors is
associated with a reduction in one aspect of earnings quality – conservatism.
Conservatism is the application of a higher degree of veri?cation for favourable
information, via the adoption of accounting policies that accelerate expenses to the
current period, and/or defer revenues to later periods (Basu, 1997). Conservatism ?lls
an ex ante ef?cient role in contracting between the ?rm and its stakeholders. Basu
(1997) and Watts (2003a, b) argue that conservatism assists in monitoring important
contracts involving the entity and its stakeholders (for example debt contracts, and
contracts associated with remuneration), and is a central feature of corporate
governance (Ball et al., 2000). In the context of this paper, conservatism is a desirable
attribute of accounting information.
Financial statements are the result of both management’s representations and the
auditor’s assurance to outsiders about the validity of those representations (Krishnan,
2005). If non-audit services increase auditors’ economic dependence on clients and this
impairs independence, auditors will be less willing to challenge accounting that might
be “aggressive”. If so, then this will be observable through a reduction in conservatism.
Therefore, it is hypothesised that clients purchasing higher levels of non-audit services
will tend to report earnings of lower quality, which means lower levels of conservatism.
The empirical tests used to conduct this study require measurement of the economic
bond that non-audit services create, as well as measures that capture variation in
earnings conservatism. In regard to the former, we use two proxies that have been
commonly used in the literature. The ?rst is the ratio of NAFs to total fees (non-audit
fee ratio – NAFR), which captures the relative value of the audit versus non-audit
services provided by the auditor. Although this measure is of interest to investors and
regulators, it may not re?ect the economic importance of the client to the auditor
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(Frankel et al., 2002; Ashbaugh et al., 2003). A second measure, the dollar value of
NAFs, is also employed.
In regard to measures that capture variation in earnings conservatism, the Basu
(1997) model is adopted. This will provide some evidence on the existence of earnings
conservatism in New Zealand. Earnings are regressed on contemporaneous stock
returns. That is returns equals economic income, and this re?ects good (bad) news for
positive (negative) economic income. To test the main hypothesis, in a manner similar
to Ruddock et al. (2006), a modi?ed Basu (1997) model is then introduced to capture the
incremental effect of high NAFR (or NAF) on earnings conservatism. Using this model
as a base, later models include three control variables, Big N auditors, client size, and
leverage, to account for possible confounding effects on conservatism.
Based on 528 ?rm-year observations from 1995 to 2001, this study provides
evidence for the existence of earnings conservatism in New Zealand. This is consistent
with the ?ndings of Ball et al. (2000, 2003), which suggest that earnings in common law
countries display signi?cant conservatism. As far as we are aware this is the ?rst
evidence of Basu (1997) conservatism in New Zealand. The insigni?cance of key
coef?cients in the models when NAFR and NAFs are added does not support the idea
that NAFs affect the degree of accounting conservatism. Additional tests provide
qualitatively similar results to the main analyses. Overall, higher levels of non-audit
services are not found to be associated with reduced earnings conservatism.
One plausible explanation for this ?nding is that auditors in New Zealand have
market-based incentives to maintain their independence. Concerns about reputation
and litigation may serve to discipline auditors, preventing them from compromising
their independence to protect NAFs. Auditors providing high levels of non-audit
services may therefore still maintain their independence “in fact”, requiring the same
degree of conservatism from all clients regardless of the level of non-audit services
purchased. Of course, we acknowledge that a study that fails to reject the null
hypothesis is open to a number of alternative interpretations.
The remainder of the paper is organised as follows. Section 2 brie?y reviews prior
literature in the areas of non-audit services, auditor independence and earnings
conservatism, while Section 3 develops the study’s main hypothesis. Section 4
describes the sample selection and Section 5 provides descriptive statistics for the data.
Section 6 discusses the research design. Section 7 summarises the results of the main
analyses, while sensitivity analyses are presented in Section 8. Section 9 concludes.
2. Literature review
2.1 Auditor independence
Auditors aid investor-management contracting by attesting to the reliability of
management’s ?nancial reporting. An audit is an ef?cient monitoring device that
increases a ?rm’s value by mitigating agency problems that arise from these contracts
(Jensen and Meckling, 1976). However, this monitoring will only be valuable if the
auditor is independent (Watts and Zimmerman, 1986). According to Watts and
Zimmerman (1983, 1986), auditor independence is “the probability that the auditor will
report a discovered breach in the ?nancial reports”. An independent auditor will
therefore keep an objective perspective and be able to withstand clients’ pressure to
accept substandard reporting. As this is the foundation for trust in the attestation
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function, auditor independence is often considered to be the cornerstone of the auditing
profession.
However, recent accounting scandals such as at Enron, WorldCom, Adelphia, HIH,
and Global Crossing have put the issue of auditor independence in the newspaper
headlines. This has been particularly so as the ?rm of Arthur Andersen was auditor of
a disproportionately large number of failed ?rms, and it has been noted that Arthur
Andersen earned very large amounts from NAFs from at least some of these ?rms.
Since capital markets need to make investment decisions with the assumption of
auditor independence, the question that arises from these scandals is whether the
auditor is truly independent. In response to negative publicity surrounding major audit
failure, the Securities and Exchange Commission – SEC (2000) reinforced the
importance of independence by de?ning it as the absence of interests that may cause
bias in appearance[2] as well as in fact[3]. This was followed by the Sarbanes-Oxley
Act of 2002, which banned a wide range of services that historically auditors may have
provided. The New Zealand Institute of Chartered Accountants (NZICA) (2005) offers a
similar de?nition of auditor independence – independence in “mind” and in
“appearance”. Not only must auditors be independent in practice, but they should also
be seen to be independent[4].
Accounting scandals in the USA had an effect on several New Zealand listed
companies and their accounting service providers. In 2002, Telecom New Zealand
Limited announced the separation of its auditing and consulting work.
PricewaterhouseCoopers continued to consult on tax and ?nancial services, but
Telecom’s auditing contract was given to KPMG. As Edlin (2002) commented, “the
move has been made in response to con?dence-shaking concerns raised by an epidemic
of accounting scandals in the United States and other countries”.
This was also the case at The Warehouse Group Limited, where “global pressure”
led Ernst and Young to give up its external auditing contract with the group. The
New Zealand Shareholders’ Association had claimed that auditor independence was at
risk because external auditors were permitted to perform internal audit work (Chapple,
2003). Further, some New Zealand audits are now directly affected by the provisions of
the Sarbanes-Oxley Act. Others are affected through the development of new
independence policies within the global accounting ?rms. As well, in the light of these
events, some New Zealand companies have accepted the provisions of Sarbanes-Oxley
as re?ecting best practice.
Both the “mind” and “appearance” dimensions of independence can signi?cantly
affect the ability of an audit to mitigate agency costs. Users may place little value in the
audit opinion if they perceive low independence, even if independence has been
maintained “in fact” (Chan et al., 2002).
While independence in appearance is an important issue in its own right, most
research has addressed the determinants of independence impairment “in fact”.
Several researchers have examined the potential link between NAFs and auditor
independence, but the empirical evidence is mixed. Some researchers have examined
whether the provision of independent audit services creates an economic bond that
jeopardizes auditor independence. Others have taken this further by investigating the
relationship between non-audit services and clients’ earnings management using
different proxies. Each of these avenues of research is brie?y discussed below.
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2.1.1 Non-audit services and auditor independence. Both the agency and the
behavioural literature suggest that, intentionally or unconsciously, auditors are more
likely to accede to a client’s wishes, including pressure to consent to earnings
management, when the provision of non-audit services is substantial (Frankel et al.,
2002).
The original paper in this area is Simunic (1984). He ?nds that an increase in the
provision of non-audit services is associated with a signi?cant increase in audit fees.
He argues that the joint provision of audit and non-audit services creates “knowledge
spillovers[5]”, which may strengthen an auditor’s economic bond with the client. In
response to the view that the information gained from non-audit services complements
the audit function and hence improves ?nancial reporting quality, Simunic claims that
this information advantage would not enhance the quality of ?nancial reporting if the
economic bonding is signi?cant enough to compromise the auditor’s independence. He
argues that this will be especially the case when the performance of audit and
non-audit services is “tied” together and when the specialised resources from the
non-audit services cannot be transferred to an equally pro?table alternative use.
Regulators and standard-setters offer similar arguments. In particular, the SEC is
concerned about two effects that non-audit services may have in threatening auditor
independence and ?nancial reporting quality. It is argued that the provision of non-audit
services may make auditors more ?nancially dependent on their clients, and hence
increase the likelihood the auditor will not draw attention to earnings management,
fearing the loss of lucrative fees. The Public Oversight Board – POB(2000, p. 121) of the
American Institute of Certi?ed Public Accountants addressed this issue in its Report
and Recommendations from the Panel on Audit Effectiveness – “prospective revenues
from the provision of non-audit services, extending into the future, create precisely the
kind of ?nancial stake that produces a con?ict of interest capable of impairing
independence”. Second, dif?culties may arise if the auditor performs two roles that have
the potential to be in con?ict. It is argued that consulting services can put auditors in
managerial roles, potentially threatening their ability to monitor the client objectively.
While the agency literature views auditor bias as intentional, the behavioural
literature suggests that auditors unconsciously bias their judgements. Beeler and
Hunton (2001) investigate the effect of contingent economic rents on professional
judgement and impairment of auditor independence. Auditors appear motivated to
develop and maintain ongoing relationships with clients in order to realize future
economic rents, yet still believe that their professional judgement is objective and
unbiased. Beeler and Hunton conclude that independence impairment is typically the
result of subconscious biases that distort audit evidence and its interpretation, rather
than deliberate opportunistic behaviour.
A competing viewpoint suggests that concerns about reputation and the threat of
lawsuits provide auditors with incentives to be independent. Therefore, the provision
of non-audit services will not compromise auditor independence; instead it may
strengthen audit quality and reduce clients’ earnings management. Arrun˜ada (1999)
claims that the provision of non-audit services increases auditors’ investment in
reputational capital. Using arguments similar to those of DeAngelo (1981), he shows
that concern about reputation constrains the behaviour of audit ?rms. This is because
the gains from agreeing to any one client’s demands are outweighed by the loss
of reputational capital that would be imposed by other clients who value a reputation
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for independence. Similarly, Dopuch et al. (2003) demonstrate that this increase in
reputational capital will increase auditor independence and audit quality, provided
that the probability of misstatement is low. Further, Palmrose (1988) ?nds that “Big 5”
auditors reduce litigation exposure by increasing their independence. This ?nding is
consistent with Francis et al. (1999) and Becker et al. (1998), who show that “Big 5”
auditors appear to constrain clients’ accounting discretion.
2.1.2 Auditor independence, NAF and earnings management. The above competing
arguments derive from a cost-bene?t trade-off – whether the economic rents generated
by retaining clients dominate the expected costs of sacri?cing auditor independence[6].
But it is not possible to quantify directly the bene?ts or costs. Therefore, it is ultimately
an empirical question whether auditors compromise their independence in order to
retain non-audit service clients, and to what extent the credibility of ?nancial reports is
eroded (DeFond et al., 2002). Over the last four or ?ve years an extremely large number
of papers have examined this issue. In this summary we brie?y mention some of them.
Frankel et al.’s (2002, henceforth FJN) analysis shows that the extent of NAF is
associated with several proxies for clients’ earnings management. In particular, they
?nd that ?rms purchasing higher levels of non-audit services are more likely to report
small earnings surprises and larger discretionary accruals and are better at meeting
analysts’ earnings forecasts. Because these clients appear to manage earnings to a
greater extent, FJN conclude that the provision of non-audit services adversely impacts
auditor independence.
However, subsequent studies have challenged their conclusions. The criticisms
include the failure of FJN to include a ?rm performance variable in the discretionary
accruals model (Ashbaugh et al., 2003), failure to account for the endogeneity of ?rm’s
reporting and their decisions to purchase services from auditors (Antle et al., 2006), and
failure to control for industry effects (Chung and Kallapur, 2003). Reynolds et al. (2004)
conclude that FJN’s results are primarily due to small to medium ?rms, ?rms having
initial public offerings, and ?rms in the e-commerce, biomedical, telecommunications
and pharmaceuticals industries. Larcker and Richardson (2004) attribute FJN’s results
to a small subset of their data.
The drawbacks of earnings management proxies are well documented in the
accounting choice literature. A popular proxy for earnings management is the level of
discretionary accruals, since it represents managers’ discretionary accounting policy
choices, which in turn could be motivated by self-interest. However, abnormal accruals
are a noisy proxy for earnings management (Healy and Wahlen, 1999; Dechow et al.,
1995). Studies that examine ?rms just beating (or meeting) earnings benchmarks also
face signi?cant problems. For example, ?rms may meet benchmarks through means
other than earnings management, such as improvements in operations (Dechow et al.,
2003).
Non-earnings management proxies also have limitations. Using auditors’
propensity to issue going concern opinions and restatements restricts samples to
distressed or restating ?rms, potentially reducing external validity.
2.2 Earnings conservatism
Conservatism has in?uenced accounting practice and theory for more than 500 years
(Basu, 1997). Recent research documents not only the existence of conservatism, but
also its rise in the last four decades (Watts, 2003a; Givoly and Hayn, 2000).
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Accounting conservatism has been traditionally expressed by the rule “anticipate
no pro?ts but anticipate all losses” (Bliss, 1924). Basu (1997) interprets this as
representing “the accountant’s tendency to require a higher degree of veri?cation to
recognize good news as gains than to recognize bad news as losses.” Differential
veri?cation produces earnings that re?ect bad news in a more timely fashion than good
news. It further implies that the effect of bad news on the earnings time-series will tend
to be transitory, whereas positive earnings changes will tend to persist.
The Framework for the Preparation and Presentation of Financial Statements
Section 37 (International Accounting Standards Board, 2005) provides an of?cial
de?nition of the concept – conservatism (prudence) requires preparers to exercise a
degree of caution when making estimations of uncertain transactions and events, “to
ensure that assets or revenues are not overstated and liabilities or expenses are not
understated.”
Explanations for the existence of conservatism point to the bene?ts it provides
users of ?nancial reports. As a desirable attribute of accounting earnings,
conservatism plays an ex ante ef?cient role in contracting between the ?rm and its
stakeholders (Basu, 1997; Watts, 2003a, b). They have limited horizons and limited
liability, and as a consequence asymmetric payoffs. Conservatism produces accounting
numbers that can be used in contracts among various parties to alleviate the con?icts
created by these asymmetries (Watts, 2003a).
Shareholder litigation is another explanation for conservatism. Overstatements of
earnings or assets are more likely to generate litigation costs for the ?rm than
understatements. Owing to this asymmetry, managers and auditors have incentives to
adopt conservative accounting so as to reduce the ?rm’s expected litigation costs. This
litigation explanation suggests that non-contracting parties in society also value
conservatism’s constraint on managers’ dysfunctional behaviour (Watts, 2003a). And
taxation and regulation are two additional explanations for conservatism (Shackelford
and Shevlin, 2001; Watts, 2003a).
The importance of accounting conservatism calls for empirical research on the topic.
In re-examining the conservatism principle, Basu (1997) develops a reverse regression
model that estimates earnings timeliness towards positive and negative stock returns.
Annual earnings are regressed on current stock returns, where positive (negative)
returns proxy for good (bad) news[7]. His results are consistent with the existence of
conservatism in US ?nancial reporting.
Basu’s model has been widely used by researchers in the area. As commented by
Ball et al. (2000), Basu’s reverse regression captures earnings’ timeliness in re?ecting
publicly available news, and hence has implications for earnings quality and reporting
transparency. In their study, they predict that Basu measures of conservatism vary
across common law countries (the USA, the UK, Australia and Canada) and code-law
countries (France, Germany and Japan) according to their different institutional
factors[8]. Consistent with this prediction, Ball et al. (2000) ?nd that accounting income
in common law countries is signi?cantly more conservative than in code law countries.
3. Hypothesis development
Critics of the profession have alleged that the high margin of NAFs increases the
auditor’s economic dependence on the client ?rm, which in turn increases the
auditor’s incentives to agree to clients’ wishes and condone aggressive accounting.
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Where there is an increase in the probability of an auditor not truthfully reporting the
results of the audit investigation, there is a threat to independence (Simunic, 1984).
Therefore, the provision of non-audit services may jeopardize auditors’ independence,
which could in turn reduce audit quality and ultimately result in reported earnings of
lower quality.
This study examines the impact of non-audit services on a speci?c attribute of
audited ?nancial statements – earnings conservatism. It is similar in motivation to
Ruddock et al. (2006), although it uses different proxies for economic bond and
economic income, and is applied to a different data set[9].
To the extent that non-audit services impair auditor independence, auditors are likely
to be less willing to challenge clients’ aggressive accounting. This will be revealed by a
reduction in accounting conservatism, as measured. Therefore, clients purchasing
higher levels of these services are expected to report earnings of lower quality, and in
particular earnings of lower conservatism. This reasoning leads to the main hypothesis:
H1. The higher the level of non-audit services provided by the incumbent auditor,
the less conservative the client’s accounting practices will be.
4. Sample selection and data
The basic data set is provided by the Department of Accounting and Finance at The
University of Auckland. The initial sample consists of 814 ?rm-year observations from
1995 to 2001, representing 176 New Zealand companies. For each ?rm-year, the data
?le provides information on the ?rm’s auditors, including fees paid for audit and
non-audit services, as well as key measures of ?nancial performance and position. In
order to calculate the market return of each ?rm, annual adjusted share prices[10] are
obtained from DataStream. Firm-years with insuf?cient data to estimate the empirical
models are eliminated. To remove the effect of outliers, observations are winsorized to
the 1 and 99 per cent levels. Financial institutions and regulated ?rms are also
excluded, as these ?rms may have different ?nancial reporting incentives (Burgstahler
and Dichev, 1997). The ?nal sample consists of 528 observations, representing 118 New
Zealand listed companies.
5. Research design
5.1 Economic dependence
This study uses two measures to proxy for the economic bond between a client and its
auditor. The ?rst is the ratio of NAF to total fees paid by the client (NAFR), as used by
FJN and several other researchers. This measure captures the relative value of the
audit versus non-audit services provided by the audit ?rm to the client, which may
affect investors’ and regulators’ perceptions of independence. To the extent that
non-audit services have a higher pro?t margin, it is alleged that auditors are more
concerned with avoiding the loss of audit clients that generate relatively large amounts
of NAF, and use audits as a platform from which they sell non-audit services[11].
This speci?cation is, however, subject to a number of criticisms. Speci?cally, this ratio
does not capture the ?nancial importance of the client to the audit ?rm (Frankel et al.,
2002; Ashbaugh et al., 2003). Although the Enron-Arthur Andersen scandal is a
frequently cited example of signi?cant client-auditor economic bonding, as pointed out
by Kinney and Libby (2002) and others, an analysis of Enron’s fee disclosures (audit
fees of $US 25 million and NAF of $US 27 million) would result in a NAFR of only 0.52,
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which is close to the median (0.51) reported by FJN in Table II. Therefore, the second
measure for economic dependence is the dollar amount of NAF paid by each client to
its auditor[12]. This measure is speci?ed to incorporate the payment size, and thus
attempts to capture the clients’ ?nancial importance to the audit ?rm.
5.2 Measuring conservatism
5.2.1 Model 1: the Basu model, applied to pooled data and sub-samples. Following Basu
(1997), the ?rst test utilizes a “reverse” regression of annual earnings on
contemporaneous stock returns, which is stated as follows:
NI
it
¼ a
0
þ a
1
DRET
it
þb
0
RET
it
þb
1
RET
it
*
DRET
it
þ1
it
; ð1Þ
where, NI
it
– net income after tax for ?rm i in ?scal year t, de?ated by the market
capitalisation at the beginning of the ?scal year; RET
it
– annual stock return on ?rm i
for ?scal year t, that is ðP
t
2P
t21
Þ=P
t21
, where prices have already been adjusted for
dividends; DRET
it
– 1 if RET
it
# 0, and 0 otherwise.
Model 1 is ?rst estimated for the pooled sample, and then separately for ?rm-years
with high NAFRs (NAFR values in the top third[13] of the pooled sample) and low
NAFRs (NAFR values in the bottom third of the pooled sample). Using the Basu (1997)
model, both the pooled data, and sub-samples, can provide insight into the existence of
earnings conservatism in New Zealand.
Positive (negative) annual stock returns are used as a proxy for good (bad) news.
Assuming that news is uncorrelated through time, the intercept a
0
captures the
postponed recognition of news from previous periods. Conservative accounting implies
that a
0
is positive, as most unrealised losses are captured immediately. Little bad
news is postponed to future periods, while the recognition of gains is delayed. b
0
measures the responsiveness (sensitivity) of earnings to current good news. The
interactive slope coef?cient (b
1
), which is of interest here, represents the differential
sensitivity of earnings in recognising bad news over good news. Conservatism means
that earnings are more concurrently sensitive in incorporating economic losses relative
to economic gains, thus implying that b
1
is positive.
5.2.2 Model 2: modi?ed Basu model including the incremental effect of high NAFRs
on earnings conservatism, applied to sub-samples. To capture the incremental effect of
high NAFRs on earnings conservatism, additional intercept and slope coef?cients are
included. A dummy variable (DNAFR) is introduced, denoting the level of ?rm-years’
NAFRs in the pooled sample distribution. Based on the former classi?cation,
?rm-years with a NAFR in the top third of the pooled sample have a value of one for
DNAFR, while ?rm-years with a NAFR in the bottom third take a value of 0.
Firm-years in the middle third are excluded from the analysis. The following modi?ed
regression model is estimated:
NI
it
¼a
0
þa
1
DRET
it
þa
2
DNAFR
it
þa
3
DRET
it
*
DNAFR
it
þb
0
RET
it
þb
1
RET
it
*
DRET
it
þb
2
RET
it
*
DNAFR
it
þb
3
RET
it
*
DRET
it
*
DNAFR
it
þ1
it
;
ð2Þ
where, DNAFR
it
– 1 for ?rm-years with NAFR
it
in the top third of the pooled sample,
and 0 for ?rm-years with NAFR
it
in the bottom third.
The interactive coef?cients b
3
and b
2
, which are the focus here, measure the
incremental responsiveness of earnings to bad news and good news when NAFR is
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high. If conservatism is reduced when the ratio of NAF to total fees is high, b
3
is
expected to be signi?cantly negative. Also, if the responsiveness of earnings to good
news is increased when NAFR is high, consistent with reduced asymmetrical
timeliness, b
2
is expected to be signi?cantly positive.
5.2.3 Model 3: modi?ed Basu model including the incremental effect of high NAFRs
on earnings conservatism and control variables, applied to sub-samples. Prior literature
identi?es several factors that may in?uence a ?rm’s earnings conservatism. To
account for possible confounding effects on earnings conservatism, three control
variables are introduced.
First, Basu et al. (2001) document that Big 8 clients report earnings that are more
conservative than non-Big 8 clients, consistent with Big 8 auditors being more
conservative in order to protect their brand name reputations. Likewise, Becker et al.
(1998) ?nd that Big 6 auditors constrain accruals-based earnings management more
than non-Big 6 auditors. Therefore, Big N (now Big 4[14]) auditors are expected to
enhance earnings conservatism by constraining aggressive accruals and persuading
clients to report economic losses in a timely fashion. A dummy variable (BIGN) is
included to control for the impact that Big N auditors may have on the conservatism of
reported earnings. BIGN takes the value of 1 if the ?rm’s auditor is one of the Big N,
and 0 otherwise.
Second, the size hypothesis predicts that larger ?rms will tend to make
income-decreasing accounting choices, so as to reduce their political visibility
(Watts and Zimmerman, 1978)[15]. A control variable for client size, proxied by the
natural logarithm of ?rms’ total assets (in $’000), is employed to take account of this
effect.
Third, ?rms facing severe debtholder-shareholder con?icts over dividend policy are
inclined to adopt more conservative accounting (Ahmed et al., 2002). Following Ahmed
et al. (2002), leverage, measured as the ratio of long-term debt to total equity, is used as
a proxy for the severity of debtholder-shareholder con?icts. Firms with higher leverage
are expected to have greater earnings conservatism.
Including the above three control variables, the regression model is now estimated
as follows:
NI
it
¼ a
0
þ a
1
DRET
it
þa
2
DNAFR
it
þa
3
DRET
it
*
DNAFR
it
þ b
0
RET
it
þ b
1
RET
it
*
DRET
it
þ b
2
RET
it
*
DNAFR
it
þb
3
RET
it
*
DRET
it
*
DNAFR
it
þ g
0
BIGN
it
þ g
1
DRET
it
*
BIGN
it
þ g
2
RET
it
*
BIGN
it
þ g
3
RET
it
*
DRET
it
*
BIGN
it
þ d
0
SIZE
it
þd
1
DRET
it
*
SIZE
it
þ d
2
RET
it
*
SIZE
it
þ d
3
RET
it
*
DRET
it
*
SIZE
it
þ l
0
LEV
it
þ l
1
DRET
it
*
LEV
it
þ l
2
RET
it
*
LEV
it
þ l
3
RET
it
*
DRET
it
*
LEV
it
þ 1
it
;
ð3Þ
where, BIGN
it
– 1 if the ?rm i’s auditor is a Big N audit ?rm in year t; and 0 otherwise;
SIZE
it
– natural logarithm of ?rm i’s total assets in year t; LEV
it
– ratio of ?rm i’s
long-term debt to its total equity in year t.
ARJ
21,2
204
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U
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I
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Y
A
t
2
1
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
All control variables are interacted with the test variables in Model 2. This not only
accounts for the effects those control variables may have on the intercept, but also
allows the slopes to vary. Consistent with prior literature that larger ?rms and higher
leveraged ?rms are predicted to have more conservative earnings, the interactive
coef?cients on these three control variables (g
3
, d
3
, l
3
, respectively) are expected to be
positive.
5.2.4 Models 4 and 5: replication of Models 2 and 3 using a different proxy for
economic bonding (NAF), applied to sub-samples. As previously mentioned, although
NAFR is of interest to investors and regulators, it may not capture the importance of
clients to the audit ?rm. Therefore, another measure of economic dependence (NAF) is
employed, and the above regressions (Models 2 and 3) are replicated using this new
measure. Firm-years are re-ranked according to the magnitude of NAF, and a dummy
variable (DNAF) takes a value of 1 if a ?rm-year’s NAF is in the top third of the pooled
sample, and 0 if it is in the bottom third. Firm-years in the middle third are excluded
from the analysis. With the variables de?ned as before, Model 1 is re-estimated using
this new classi?cation of sub-groups, and Models 2 and 3 are re-speci?ed as follows:
NI
it
¼ a
0
þ a
1
DRET
it
þa
2
DNAF
it
þa
3
DRET
it
*
DNAF
it
þ b
0
RET
it
þb
1
RET
it
*
DRET
it
þb
2
RET
it
*
DNAF
it
þb
3
RET
it
*
DRET
it
*
DNAF
it
þ1
it
;
ð4Þ
NI
it
¼ a
0
þ a
1
DRET
it
þa
2
DNAF
it
þ a
3
DRET
it
*
DNAF
it
þb
0
RET
it
þ b
1
RET
it
*
DRET
it
þ b
2
RET
it
*
DNAF
it
þ b
3
RET
it
*
DRET
it
*
DNAF
it
þ g
0
BIGN
it
þg
1
DRET
it
*
BIGN
it
þg
2
RET
it
*
BIGN
it
þ g
3
RET
it
*
DRET
it
*
BIGN
it
þd
0
SIZEit þ d
1
DRET
it
*
SIZE
it
þ d
2
RET
it
*
SIZE
it
þ d
3
RET
it
*
DRET
it
*
SIZE
it
þl
0
LEV
it
þ l
1
DRET
it
*
LEV
it
þ l
2
RET
it
*
LEV
it
þl
3
RET
it
*
DRET
it
*
LEV
it
þ 1
it
;
ð5Þ
where, DNAF
it
– 1 for ?rm-years with NAF
it
in the top third of the pooled sample, and
0 for ?rm-years with NAF
it
in the bottom third.
6. Descriptive statistics
Descriptive statistics for the pooled sample are reported in Table I. The median of the
dependent variable, net income de?ated by the beginning-of-the-year market
capitalization (NI), is 0.063. The ?rst quartile (0.014) of de?ated net income shows
that the large majority of the ?rm-years report a surplus. However, some ?rm-years
experienced severe losses, which reduces the mean to a value of 0.016. The median
annual stock return is 0, telling us that half of all ?rm-years encounter economic losses.
Table I also shows considerable variation in the consumption of non-audit services.
Eighteen percent of all ?rm-years have zero NAF, indicating that the auditor provided
no additional services[16], while the maximum fee is $5 million. On average, ?rm-year
NAF are $197,860, while the median fee is only $35,393. Some ?rm-years have
Provision of
non-audit
services
205
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
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
V
a
r
i
a
b
l
e
s
N
M
e
a
n
S
D
M
i
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i
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t
q
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5
2
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2
7
2
0
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3
6
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6
6
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2
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3
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6
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7
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3
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1
9
5
7
0
.
0
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0
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2
2
7
3
1
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2
6
0
9
N
A
F
5
2
8
1
9
7
,
8
6
0
5
4
8
,
9
2
1
0
4
,
0
0
0
3
5
,
3
9
3
1
3
5
,
0
0
0
5
,
0
0
0
,
0
0
0
T
O
T
F
E
E
5
2
8
3
6
6
,
4
5
1
7
6
9
,
5
3
1
4
,
5
0
0
4
8
,
0
0
0
1
3
0
,
0
0
0
3
2
0
,
0
0
0
6
,
0
0
0
,
0
0
0
N
A
F
R
5
2
8
0
.
3
3
0
8
0
.
2
5
7
4
0
.
0
0
0
0
0
.
0
9
0
9
0
.
3
1
0
3
0
.
5
1
6
5
0
.
8
8
7
3
B
I
G
N
5
2
8
0
.
8
8
7
3
0
.
3
2
2
2
0
.
0
0
0
0
1
.
0
0
0
0
1
.
0
0
0
0
1
.
0
0
0
0
1
.
0
0
0
0
S
I
Z
E
5
2
8
1
1
.
7
1
2
8
1
.
6
1
2
3
8
.
1
5
2
2
1
0
.
6
5
3
0
1
1
.
5
9
0
2
1
2
.
6
9
2
0
1
5
.
9
4
9
6
L
E
V
5
2
8
0
.
4
7
7
3
0
.
7
1
0
5
0
.
0
0
0
0
0
.
0
2
3
7
0
.
2
9
9
7
0
.
6
1
6
2
4
.
9
6
5
5
N
o
t
e
s
:
F
i
r
m
-
y
e
a
r
o
b
s
e
r
v
a
t
i
o
n
s
a
r
e
w
i
n
s
o
r
i
z
e
d
t
o
t
h
e
1
a
n
d
9
9
p
e
r
c
e
n
t
l
e
v
e
l
s
.
V
a
r
i
a
b
l
e
d
e
?
n
i
t
i
o
n
s
:
N
I
–
n
e
t
i
n
c
o
m
e
a
f
t
e
r
t
a
x
,
d
e
?
a
t
e
d
b
y
t
h
e
m
a
r
k
e
t
c
a
p
i
t
a
l
i
s
a
t
i
o
n
a
t
t
h
e
b
e
g
i
n
n
i
n
g
o
f
t
h
e
?
s
c
a
l
y
e
a
r
;
R
E
T
–
a
n
n
u
a
l
s
t
o
c
k
r
e
t
u
r
n
,
c
a
l
c
u
l
a
t
e
d
a
s
ð
P
t
2
P
t
2
1
Þ
=
P
t
2
1
,
w
h
e
r
e
p
r
i
c
e
s
h
a
v
e
b
e
e
n
a
l
r
e
a
d
y
a
d
j
u
s
t
e
d
f
o
r
d
i
v
i
d
e
n
d
s
;
N
A
F
–
n
o
n
-
a
u
d
i
t
s
e
r
v
i
c
e
f
e
e
s
p
a
i
d
t
o
h
o
l
d
i
n
g
c
o
m
p
a
n
y
a
u
d
i
t
?
r
m
;
T
O
T
F
E
E
–
t
o
t
a
l
o
f
a
u
d
i
t
a
n
d
n
o
n
-
a
u
d
i
t
s
e
r
v
i
c
e
f
e
e
s
p
a
i
d
t
o
h
o
l
d
i
n
g
c
o
m
p
a
n
y
a
u
d
i
t
?
r
m
;
N
A
F
R
–
n
o
n
-
a
u
d
i
t
s
e
r
v
i
c
e
f
e
e
r
a
t
i
o
,
c
a
l
c
u
l
a
t
e
d
a
s
n
o
n
-
a
u
d
i
t
s
e
r
v
i
c
e
f
e
e
s
o
v
e
r
t
o
t
a
l
f
e
e
s
;
B
I
G
N
–
1
i
f
t
h
e
?
r
m
’
s
a
u
d
i
t
o
r
i
s
a
B
i
g
N
a
u
d
i
t
?
r
m
;
a
n
d
0
o
t
h
e
r
w
i
s
e
;
S
I
Z
E
–
n
a
t
u
r
a
l
l
o
g
a
r
i
t
h
m
o
f
t
h
e
?
r
m
’
s
t
o
t
a
l
a
s
s
e
t
s
,
(
$
’
0
0
0
)
;
L
E
V
–
l
e
v
e
r
a
g
e
,
c
a
l
c
u
l
a
t
e
d
a
s
t
h
e
r
a
t
i
o
o
f
l
o
n
g
-
t
e
r
m
d
e
b
t
t
o
t
o
t
a
l
e
q
u
i
t
y
Table I.
Descriptive statistics
for pooled sample
ARJ
21,2
206
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Y
U
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Y
A
t
2
1
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
substantial fee levels, which pushes the mean well above the third quartile ($135,000).
This variation makes the NAF proxy for economic dependence particularly interesting,
as the sub-sample design will capture the signi?cant differential between low and high
NAF levels. NAFR is fairly evenly distributed, with a mean of 0.331 and median of
0.310. Both the mean and median ratios are lower than those reported in FJN (0.331 vs
0.49 and 0.310 vs 0.51, respectively), suggesting that the provision of non-audit services
is less prevalent in New Zealand than in the USA.
Summary statistics for the three control variables are also presented in Table I. The
mean for BIGN is 0.887, showing that Big N auditors dominate New Zealand’s listed
?rm market. The mean for client size (SIZE) and leverage (LEV) are 11.713 and 0.477,
respectively.
Correlation coef?cients are presented in Table II, along with a x
2
statistic for the
two binary variables, DNAFR (or DNAF) and BIGN. Panel A contains the results for
the sub-samples when using NAFR as a proxy for economic dependence, while Panel B
reports the correlations for the sub-samples when using the alternative NAF proxy.
In Panel A, the point biserial correlation coef?cient shows that the dummy variable
for high and low NAFRs (DNAFR) is positively and signi?cantly correlated with RET
and SIZE. SIZE is positively correlated with BIGN and LEV, as expected. A similar
pattern of correlations is observed in Panel B. Despite many independent variables
being signi?cantly correlated, only the association between DNAF and SIZE is large in
economic terms (point biserial correlation of 0.60). Large ?rms use the consulting
services that the auditor has available more than small ?rms do, in part as non-BIGN
RET BIGN SIZE LEV
Panel A: correlations for NAFR sub-samples (n ¼ 352)
DNAFR 0.150
* *
(0.006) 40.55
* *
(0.000) 0.420
* *
(0.000) 0.090 (0.081)
RET 0.040 (0.407) 0.101 (0.059) 20.012 (0.818)
BIGN 0.380
* *
(0.000) 0.090 (0.106)
SIZE 0.131
*
(0.014) 0.405
* *
(0.000)
LEV 0.011 (0.835) 0.473
* *
(0.000)
Panel B: correlations for NAF sub-samples (n ¼ 352)
DNAF 0.120
*
(0.023) 35.46
* *
(0.000) 0.600
* *
(0.000) 0.080 (0.113)
RET 0.090 (0.104) 0.104 (0.051) 20.022 (0.683)
BIGN 0.360
* *
(0.000) 0.070 (0.171)
SIZE 0.130
*
(0.014) 0.367
* *
(0.000)
LEV 0.008 (0.887) 0.507
* *
(0.000)
Notes:
* *
and
*
indicate that the correlation is signi?cant at 1 and 5 per cent levels, respectively.
a
Firm-year observations are winsorized to the 1 and 99 per cent levels. Two-tailed p-values are
presented below the correlation coef?cients. Variable de?nitions: NI – net income after tax, de?ated by
the market capitalisation at the beginning of the ?scal year; RET – annual stock return, calculated as
ðP
t
2P
t21
Þ=P
t21
, where prices have been already adjusted for dividends; DNAFR – 1 for ?rm-years
with NAFR in the top third of the pooled sample, and 0 for ?rm-years with NAFR in the bottom third;
DNAF – 1 for ?rm-years with NAF in the top third of the pooled sample, and 0 for ?rm-years with
NAF in the bottom third; NAFR – non-audit service fee ratio, calculated as non-audit service fees over
total fees; NAF – non-audit service fees paid to holding company audit ?rm; BIGN – 1 if the ?rm’s
auditor is a Big N audit ?rm; and 0 otherwise; SIZE – natural logarithm of the ?rm’s total assets, $’000;
LEV – leverage, calculated as the ratio of the ?rm’s long-term debt to its total equity
Table II.
Pearson (Spearman)
correlation coef?cients
above (below) the
diagonal
a
point biserial
correlation coef?cient
where one variable is
binary x
2
statistic where
both variables are binary
Provision of
non-audit
services
207
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O
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D
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C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
auditors are more constrained in the range of services that they can provide. In this
setting, multicollinearity is unlikely to be a problem in the regression models.
7. Results
Table III reports the regression results for Model 1 (for both pooled and sub samples).
Table IV reports the results for Models 2 and 3 using NAFR to proxy for the economic
bond between an auditor and its client, while Table V presents the results for Models 4
and 5 using the alternative NAF proxy. Recall that Model 1 is a simple “reverse”
regression of earnings on contemporaneous stock returns, with a dummy variable that
equals one for negative returns. Model 2 (4) includes an additional dummy variable
DNAFR (DNAF) that accounts for those instances where NAFR (NAF) is relatively
high. Using Model 2 (4) as a base, Model 3 (5) includes three further variables to control
for possible confounding effects on earnings conservatism.
In Table III, regression results for Model 1 are presented initially for the pooled
sample, and then separately for ?rm-years with high and low values of NAFR (NAF).
Evidence from the full sample of ?rm-years is consistent with earnings conservatism.
The intercept (a
0
), and the incremental coef?cient on negative stock returns (b
1
) are
both positive and highly signi?cant. The signi?cantly positive intercept (a
0
) indicates
that the recognition of unrealized gains is postponed to future periods, and the
signi?cantly positive interactive slope coef?cient (b
1
) suggests a differential treatment
of economic losses. The magnitude of b
1
is far greater than b
0
(0.444 vs 0.093), showing
that earnings is about eight times ð7:7 ¼ ½0:444 þ 0:093?=0:093Þ as sensitive to
negative returns as it is to positive returns. Overall, these results suggest that, in New
Zealand, earnings are more responsive to contemporaneous bad news. This is
consistent with international studies which ?nd that earnings in common law countries
display signi?cant conservatism (Ball et al., 2000, 2003).
When Model 1 is estimated separately for ?rm-years with high and low NAFR
(NAF), conservatism is evident in both sub-samples. Under both economic bond
proxies, the coef?cient b
1
is positive and highly signi?cant, indicating that earnings is
more timely in recognising economic losses irrespective of the level of NAF.
Panel A of Tables IV and V summarises the regression results for Models 2 and 4.
As discussed earlier, if ?rms consuming higher values of NAFR (NAF) report less
conservative earnings, b
3
is expected to be signi?cantly negative and b
2
is expected to
be signi?cantly positive[17]. The signs of the interactive slope coef?cients b
3
and b
2
are mixed, and none of the estimates is signi?cantly different from zero. b
1
continues to
be positive and signi?cant, indicating an asymmetrically higher responsiveness to bad
news.
Panel B of Tables IV and V presents the regression results for Models 3 and 5. The
inclusion of control variables increases the explanatory power of the models, with
adjusted R
2
rising above 20 per cent. In both cases b
2
and b
3
are statistically
insigni?cantly different from 0. The interactive coef?cient for leverage (l
3
) is
signi?cantly positive, which is consistent with the prediction that highly leveraged
?rms may adopt more conservative accounting to reduce shareholder-debtholder
con?icts.
Overall, the insigni?cant results for b
3
and b
2
in Models 2 to 5 fail to support the
main hypothesis. No evidence is found for an incremental reduction in conservatism
where NAFR or NAF is relatively high. This ?nding is consistent with other recent
ARJ
21,2
208
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Table III.
Results from pooled
cross-sectional
regressions of de?ated
earnings on
contemporaneous stock
returns
Provision of
non-audit
services
209
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Table IV.
Results from pooled
cross-sectional
regressions of de?ated
earnings on
contemporaneous stock
returns (NAFR
sub-samples)
ARJ
21,2
210
D
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=
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r
a
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q
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i
t
y
Table V.
Results from pooled
cross-sectional
regressions of de?ated
earnings on
contemporaneous stock
returns (NAF
sub-samples)
Provision of
non-audit
services
211
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
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
research, such as Chung and Kallapur (2003), Reynolds et al. (2004), and Ruddock et al.
(2006) which fail to document a negative association between NAF and earnings
quality.
8. Sensitivity analyses
The primary tests are based on ?rm-years that include no purchase of non-audit
services from the incumbent auditor. With zero non-audit fee observations comprising
18 per cent of the pooled sample, most “low NAFR (NAF)” sub-sample ?rm-years are
more accurately described as “zero NAFR (NAF)”. To examine whether this
speci?cation drives the insigni?cant results of the main tests, additional analyses are
conducted. Regressions of Models 2 to 5 are re-run after the elimination of zero
non-audit fee observations. The results for the NAFR and NAF sub-samples are
presented in Tables VI and VII, respectively. The coef?cients of interest, b
3
and b
2
,
remain insigni?cant except for b
2
in Panel B of Table VI, but that estimate is negative.
Interestingly, b
3
in Table VII Panel B is even signi?cantly positive, which suggests
that auditors constrain clients’ aggressive accounting practice when the provision of
non-audit services is high. b
1
is still positive but is signi?cantly different from zero in
only two of the four regressions shown in these tables.
To further check the robustness of the primary results, the second sensitivity
analyses are conducted by changing the classi?cation of high/low NAFR/NAF. In the
primary tests, ?rm-years in the top (bottom) third of NAFR/NAF distribution are
compared to see if the high level of provision of non-audit services leads to clients’ less
conservative accounting practices. This comparison now becomes stricter by replacing
the classi?cation of high and low NAFR/NAF based on the upper and bottom quartile
and quintile of the NAFR/NAF distribution. These involve some extreme comparisons
and the effect of the level of the provision of non-audit services have on the
clients’ accounting practices might be observed. For example, ?rm-years in the lower
quintile are nearly “zero NAFR/NAF” observations. Models 2 to 5 are re-run based on
the new classi?cation of high/low NAFR/NAF and results are reported in Table VIII.
Nevertheless, b
3
and b
2
are still insigni?cant, except in one case, where b
2
is
signi?cantly positive using the Model 2 regression based on the observations in the
upper/lower quintile of the NAFR/NAF distribution.
Overall, the results of these additional analyses are qualitatively similar to the main
test results, suggesting that the primary analyses are not sensitive to the inclusion of
zero NAF observations[18].
Finally, we also identi?ed all audit quali?cations in the dataset, as it could be
argued that large NAF revenues might induce a lower level of audit quali?cation
than might otherwise be the case. There are only three quali?cations in the “high”
NAF group and seven in the low-NAF group, so we are dealing with extremely
small numbers. Further, the high-NAF group of companies is signi?cantly more
pro?table and has signi?cantly higher returns on average than the low-NAF group.
Therefore, we cannot attribute the lower level of quali?cations in the high-NAF
group to the NAF.
9. Conclusion
This study examines the relation between non-audit services provided by incumbent
auditors and one important aspect of earnings quality – conservatism. Conservatism is
ARJ
21,2
212
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Table VI.
Results of sensitivity
analyses (excluding zero
NAF observations)
(NAFR sub-samples)
Provision of
non-audit
services
213
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t
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d
3
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t
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t
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l
0
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1
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R
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t
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þ
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)
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2
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?
)
a
3
(
?
)
b
0
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þ
)
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1
(
þ
)
b
2
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þ
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b
3
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)
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d
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3
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0
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3
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3
3
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2
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9
0
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1
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2
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4
3
3
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0
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9
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2
2
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2
2
)
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r
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)
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1
(
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2
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)
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3
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0
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0
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0
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2
0
.
5
1
5
)
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0
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7
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2
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6
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5
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1
9
(
0
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1
0
9
)
0
.
8
1
8
*
*
*
(
3
.
3
3
8
)
N
o
t
e
s
:
*
,
*
*
a
n
d
*
*
*
i
n
d
i
c
a
t
e
s
i
g
n
i
?
c
a
n
c
e
a
t
t
h
e
1
0
,
5
a
n
d
1
p
e
r
c
e
n
t
l
e
v
e
l
s
,
r
e
s
p
e
c
t
i
v
e
l
y
.
F
i
r
m
-
y
e
a
r
o
b
s
e
r
v
a
t
i
o
n
s
a
r
e
w
i
n
s
o
r
i
z
e
d
t
o
t
h
e
1
a
n
d
9
9
p
e
r
c
e
n
t
l
e
v
e
l
s
.
T
w
o
-
t
a
i
l
e
d
t
-
s
t
a
t
i
s
t
i
c
s
a
r
e
p
r
o
v
i
d
e
d
b
e
l
o
w
t
h
e
c
o
e
f
?
c
i
e
n
t
s
.
V
a
r
i
a
b
l
e
d
e
?
n
i
t
i
o
n
s
:
N
I
–
n
e
t
i
n
c
o
m
e
a
f
t
e
r
t
a
x
,
d
e
?
a
t
e
d
b
y
t
h
e
m
a
r
k
e
t
c
a
p
i
t
a
l
i
s
a
t
i
o
n
a
t
t
h
e
b
e
g
i
n
n
i
n
g
o
f
t
h
e
?
s
c
a
l
y
e
a
r
;
R
E
T
–
a
n
n
u
a
l
s
t
o
c
k
r
e
t
u
r
n
,
c
a
l
c
u
l
a
t
e
d
a
s
ð
P
t
2
P
t
2
1
Þ
=
P
t
2
1
,
w
h
e
r
e
p
r
i
c
e
s
h
a
v
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b
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n
a
l
r
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a
d
y
a
d
j
u
s
t
e
d
f
o
r
d
i
v
i
d
e
n
d
s
;
D
N
A
F
–
1
f
o
r
?
r
m
-
y
e
a
r
s
w
i
t
h
N
A
F
i
n
t
h
e
t
o
p
t
h
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r
d
o
f
t
h
e
p
o
o
l
e
d
s
a
m
p
l
e
,
a
n
d
0
f
o
r
?
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m
-
y
e
a
r
s
w
i
t
h
N
A
F
i
n
t
h
e
b
o
t
t
o
m
t
h
i
r
d
;
N
A
F
–
n
o
n
-
a
u
d
i
t
s
e
r
v
i
c
e
f
e
e
s
p
a
i
d
t
o
h
o
l
d
i
n
g
c
o
m
p
a
n
y
a
u
d
i
t
?
r
m
;
B
I
G
N
–
1
i
f
t
h
e
?
r
m
’
s
a
u
d
i
t
o
r
i
s
a
B
i
g
N
a
u
d
i
t
?
r
m
;
a
n
d
0
o
t
h
e
r
w
i
s
e
;
S
I
Z
E
–
n
a
t
u
r
a
l
l
o
g
a
r
i
t
h
m
o
f
t
h
e
?
r
m
’
s
t
o
t
a
l
a
s
s
e
t
s
,
$
’
0
0
0
;
L
E
V
–
l
e
v
e
r
a
g
e
,
c
a
l
c
u
l
a
t
e
d
a
s
t
h
e
r
a
t
i
o
o
f
t
h
e
?
r
m
’
s
l
o
n
g
-
t
e
r
m
d
e
b
t
t
o
i
t
s
t
o
t
a
l
e
q
u
i
t
y
Table VII.
Results of sensitivity
analyses (excluding
zero non-audit fee
observations)
(NAF sub-samples)
ARJ
21,2
214
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
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
U
p
p
e
r
/
l
o
w
e
r
q
u
a
r
t
i
l
e
o
f
N
A
F
R
/
N
A
F
d
i
s
t
r
i
b
u
t
i
o
n
(
n
¼
2
6
8
)
U
p
p
e
r
/
l
o
w
e
r
q
u
a
r
t
i
l
e
o
f
N
A
F
R
/
N
A
F
d
i
s
t
r
i
b
u
t
i
o
n
(
n
¼
2
1
4
)
M
o
d
e
l
2
(
N
A
F
)
M
o
d
e
l
3
(
N
A
F
)
M
o
d
e
l
4
(
N
A
F
R
)
M
o
d
e
l
5
(
N
A
F
R
)
M
o
d
e
l
2
(
N
A
F
)
M
o
d
e
l
3
(
N
A
F
)
M
o
d
e
l
4
(
N
A
F
R
)
M
o
d
e
l
5
(
N
A
F
R
)
a
0
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þ
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0
9
0
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1
.
8
4
0
)
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1
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0
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3
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6
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1
)
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2
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5
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2
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7
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2
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2
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4
)
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7
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0
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)
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0
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2
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3
4
6
)
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2
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5
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6
7
0
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2
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9
1
6
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2
0
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3
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2
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2
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2
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2
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5
8
8
)
2
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1
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2
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1
3
)
a
3
(
?
)
0
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0
2
0
(
0
.
1
9
3
)
2
0
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1
1
4
(
2
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6
3
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1
2
1
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0
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0
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2
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2
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7
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3
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0
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4
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3
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4
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2
0
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5
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8
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8
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5
9
7
)
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0
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1
1
4
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2
1
.
9
4
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0
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4
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1
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4
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2
1
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7
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9
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5
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2
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3
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1
8
3
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2
3
.
0
7
0
)
2
0
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5
5
2
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2
1
.
4
6
8
)
2
0
.
1
4
6
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(
2
2
.
1
1
2
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5
1
3
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2
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8
)
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1
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0
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9
1
8
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(
5
.
0
8
2
)
1
.
1
4
7
(
1
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1
1
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6
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3
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0
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7
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8
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(
4
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2
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6
)
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9
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1
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)
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4
5
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(
3
.
5
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)
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3
7
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5
4
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2
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0
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5
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0
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6
5
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2
0
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2
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3
)
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5
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0
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(
1
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7
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1
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0
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4
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0
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2
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1
8
9
(
1
.
1
6
8
)
2
0
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1
1
3
(
2
0
.
6
5
5
)
b
3
(
2
)
2
0
.
4
0
7
(
2
1
.
4
0
9
)
2
0
.
4
0
6
(
2
1
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1
5
5
)
2
0
.
0
1
0
(
2
0
.
0
2
6
)
2
0
.
1
6
7
(
2
0
.
3
6
4
)
2
0
.
1
3
5
(
2
0
.
4
3
4
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2
0
.
4
6
6
(
2
0
.
9
5
4
)
0
.
0
7
5
(
2
0
.
2
0
8
)
2
0
.
3
6
9
(
2
0
.
6
5
5
)
C
o
n
t
r
o
l
v
a
r
i
a
b
l
e
g
3
(
þ
)
0
.
4
0
3
(
1
.
1
8
3
)
1
.
6
4
3
(
1
.
4
7
8
)
0
.
3
3
7
(
2
0
.
9
5
3
)
0
.
4
5
4
(
1
.
1
1
3
)
d
3
(
þ
)
2
0
.
1
0
6
(
2
1
.
0
2
5
)
2
0
.
0
7
6
(
2
0
.
5
7
3
)
2
0
.
1
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6
(
2
0
.
9
6
2
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2
0
.
0
7
9
(
0
.
6
9
7
)
l
3
(
þ
)
0
.
4
7
5
(
1
.
4
2
0
)
0
.
4
2
8
(
1
.
0
5
1
)
0
.
8
9
5
*
*
*
(
3
.
2
1
4
)
0
.
7
7
8
*
*
*
(
3
.
0
2
5
)
A
d
j
u
s
t
e
d
R
2
(
p
e
r
c
e
n
t
)
1
4
.
3
0
1
8
.
5
0
1
2
.
0
0
1
5
.
9
0
1
7
.
9
0
2
6
.
7
0
1
5
.
2
0
2
7
.
9
0
N
o
t
e
s
:
*
,
*
*
a
n
d
*
*
*
i
n
d
i
c
a
t
e
s
i
g
n
i
?
c
a
n
c
e
a
t
t
h
e
1
0
,
5
a
n
d
1
p
e
r
c
e
n
t
l
e
v
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Table VIII.
Results of sensitivity
analysis (changing the
classi?cation of high/low
NAFR/NAF)
Provision of
non-audit
services
215
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
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
de?ned as the asymmetric recognition of economic losses. It plays an important role in
the ef?cient monitoring of contracts, and helps mitigate agency costs in organisations.
The provision of non-audit services by incumbent auditors has been subject to much
recent criticism. In particular, the economic bond created by these services is alleged to
compromise auditor independence, and hence lower the quality of clients’ reported
earnings. It is hypothesized that a negative relation exists between the provision of
non-audit services and clients’ earnings conservatism.
Two measures derived from the prior literature are employed to proxy for the
economic bond between auditors and their clients. The NAFR relates to the concerns of
investors and regulators, while the total of NAF captures the client’s economic
importance to the auditor.
Using the Basu (1997) model, evidence is presented for the existence of earnings
conservatism in New Zealand. This is consistent with international studies which
suggest that earnings in common law countries show signi?cant conservatism
(Ball et al., 2000, 2003). However, a modi?ed Basu (1997) model that includes the
incremental effect of high NAFR (NAF) on earnings conservatism fails to support the
main hypothesis. The further inclusion of three control variables, Big N auditors, client
size and leverage, also leads to insigni?cant results. The sensitivity analyses, which
eliminate zero NAF observations and change the classi?cation of high/low NAFR/NAF
provide results that are qualitatively similar to the main analyses. Overall, this study
provides no evidence that higher levels of non-audit services are associated with
reduced earnings conservatism.
One plausible explanation is that auditors in New Zealand have market-based
incentives to maintain their independence. Concerns about reputation and litigation
may dominate the economic dependence created by higher NAF. Auditors of clients
purchasing high levels of non-audit services may therefore still maintain their
independence “in fact”, requiring the same degree of conservatism from these clients as
for those purchasing low levels of non-audit services.
Although widely accepted in the conservatism literature, the Basu (1997) model still
suffers from some drawbacks. The ef?cient market hypothesis may not always hold,
and clear interpretations of the model are only possible if returns cause earnings and
not the reverse (Dietrich et al., 2002).
Finally, issues of endogeneity may also contribute to the insigni?cant results.
Accounting choices, including the level of conservatism exercised, may be associated
with the same factors that determine a ?rm’s demand for non-audit services. The
problem here is that it is not clear what those factors might be. Hence, this limitation is
inherent in all prior research examining the relation between non-audit services and
?rms’ accounting choices. It should also be noted that the inclusion of control variables
in Models 3 and 5 may mitigate this concern[19]. Nevertheless, there is scope for future
research to develop more sophisticated methods[20] to address the issue of endogeneity.
Notes
1. Non-audit services refer to fee based services performed by the auditing ?rm which are not
related to the audit engagement. They include tax services, management consulting, systems
planning, systems design and review, personnel services, risk management, actuarial
services, and acquisition services. (Chan et al., 2002).
ARJ
21,2
216
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
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
2. The SEC (2000, Section I) will not consider an auditor to be independent with respect to a
particular client “if a reasonable investor, with knowledge of all relevant facts and
circumstances, would conclude that the auditor is not capable of exercising objective and
impartial judgement”.
3. An auditor who is independent in fact has the ability to make independent audit decisions,
even if there is a perceived lack of independence.
4. New Zealand Financial Reporting Standards (FRS-9) clause 6.13(e) also mandates disclosure
of audit fees and NAF.
5. Knowledge spillovers refer to information generated while performing non-audit services
that can produce economic rents by reducing auditing costs.
6. As discussed above, the expected costs of sacri?ced independence include the loss of
reputation and litigation costs associated with audit failure.
7. This model relies on the “ef?cient market hypothesis”. Stock prices are assumed to
ef?ciently re?ect value-relevant information as it becomes public. When this condition holds,
stock prices will re?ect information received from sources other than current earnings, and
may lead accounting earnings.
8. Other studies using the Basu (1997) model to examine cross-country variation in
conservatism include Pope and Walker (1999), Giner and Rees (2001), GarciaLara and Mora
(2004) and GarciaLara et al. (2005).
9. In the review of Ruddock et al. (2006) by Francis (2006), three major comments are advanced.
Francis is critical of Ruddock et al.’s extrapolation of their Australian results to the US audit
market. The second is that he objects to Ruddock et al.’s use of “unexpected” NAF. The third
is that Francis is a “skeptic” when it comes to the Basu (1997) earnings conservatism story.
Only the third of those comments applies to this paper.
10. Prices are adjusted for subsequent capital actions, including dividend payouts. Share prices
at the end of ?scal year 1994 are also gathered to calculate annual stock returns for ?scal
year 1995.
11. As claimed by a former SEC chairman, “the auditing function is simply being used as a
springboard to more lucrative consulting services” (Levitt, 2000).
12. Several researchers use this proxy, including Antle et al. (2006), DeFond et al. (2002), Kinney
et al.(2004) and Reynolds et al. (2004). An alternative approach would be to examine the
client’s importance within the auditor’s portfolio of clients, by comparing the NAF paid by
the client with the audit ?rm’s total revenue in that year. However, data on the total fee
income of audit ?rms is not available; hence, this meaningful measure of individual client
signi?cance cannot be calculated.
13. This follows Ruddock et al. (2006).
14. Given the time period covered in this study, top tier auditors are hereafter referred to as the
“Big N”. N starts as 6 and ends at 5.
15. See, Zmijewski and Hagerman (1981) and Reynolds and Francis (2001) for evidence
supporting this position.
16. This issue will be addressed in the sensitivity analyses.
17. These regressions were replicated using total fees in place of NAF. While NAF are the focus
of our attention, the reason for this replication was to determine the similarity of the results
between total and NAF. The (unreported) results also have b
2
and b
3
estimates that are
insigni?cantly different from 0. The regressions were also replicated using a ratio of NAF to
the total of all fees for that auditor in each year with similar (insigni?cant) results.
Provision of
non-audit
services
217
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
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
18. We also examined all auditor changes. There are 44 such changes in the (814 ?rm year)
database, and 25 are retained in the smaller (528 observations) dataset that is used for this
research. Only 20 make it through into the high- and low-NAF analysis, with ten in each
group. Of the ten high-NAF cases, eight show increases in NAFs in the year of the switch.
Nine of these ten changes are from one Big 5 to another Big 5 auditor. In all cases changes in
both audit and non-audit fees are small.
19. For example, larger ?rms may be both more likely to report conservative earnings and
purchase more non-audit services. The inclusion of client size as an exogenous variable in
Models 3 and 5 controls for this possibility.
20. For example, Antle et al. (2006) uses a simultaneous equations method to overcome
endogeneity problems.
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Further reading
Chaney, P. and Philipich, K. (2002), “Shredded reputation: the cost of audit failure”, Journal of
Accounting Research, Vol. 40, pp. 1221-45.
Healy, P. and Palepu, K. (2003), “The fall of Enron”, Journal of Economic Perspectives, Vol. 17,
pp. 3-26.
Corresponding author
David Emanuel can be contacted at: [email protected]
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