Audit Fees, Nonaudit Fees, and Auditor Reporting on Stressed Companies

Geiger, Marshall A., Rama, Dasaratha V., Auditing: A Journal of Practice & Theory

INTRODUCTION

This study examines the association between audit and nonaudit service (NAS) fees received by an auditor and the auditor's decision regarding the type of opinion to render to a financially stressed company. Motivation for this study comes from the interest of legislators and regulators about the impact of auditors' fees on audit judgments (SEC 2000a; U.S. GAO 2002; U.S. House of Representatives 2002), the continued interest regarding the importance and frequency of auditors issuing going-concern modified (GCM) opinions to stressed companies (U.S. House of Representatives 1985, 1990; Weil 2001; Dietz 2002; NASDAQ 2002), and the recent actions of the U.S. Congress and the Securities and Exchange Commission (SEC) to prohibit auditors from supplying certain types of nonaudit services to their audit clients and to require publicly traded companies in the U.S. to disclose the type and amounts of fees paid to the external auditor (Sarbanes-Oxley Act 2002; SEC 2000b). In this study, we examine audit reports for a sample of manufacturing companies in financial stress that filed their proxy statements after February 5, 2001, and test for the association between the type of audit opinion issued (going-concerned modified or not) and the level of audit and NAS fees.

The auditing profession has come under increased scrutiny over the past several years about the growing amount of nonaudit fees received from audit clients and the possible negative impact of such fees on auditor independence (Levitt 2000). The SEC and legislators (SEC 2000a, 2000b; U.S. House of Representatives 2002; U.S. Senate 2002) have asserted that significant nonaudit service fees can adversely impact auditor independence and impair auditor decision making, especially when those decisions involve a substantial amount of professional judgment. Such concerns over auditor independence and the level of NAS performed for audit clients led to the SEC's recent enactment of new rules related to nonaudit services supplied by auditors for SEC registrants. The new rules restrict certain types of nonaudit services and also include a fee disclosure requirement (SEC 2000b). Beginning February 5, 2001, SEC registrants must disclose the magnitude of audit fees, financial information systems fees, and all other NAS fees.

Subsequent to the Enron failure, legislative concerns related to nonaudit services led to the recently enacted Sarbanes-Oxley Act (2002). This Act seeks to prohibit certain types of nonaudit services, and also requires that a company's audit committee explicitly approve any other nonaudit service purchase from the incumbent auditor.

This study empirically examines assertions that auditors may act more favorably toward those clients from whom they receive higher NAS fees. We examine the audit reports rendered to financially stressed manufacturing companies and the relative magnitude of nonaudit fees paid by such companies to their auditors. If nonaudit fees can be argued to have an impact on audit judgments, then it is also plausible that the magnitude of audit fees could influence auditor judgments. Hence, we also examine if there is an association between the magnitude of audit fees and audit opinions.

Our analyses of stressed companies find no significant association between receiving a going-concern modified (GCM) audit report and the magnitude of NAS fees. However, we do find a positive association between audit fees and GCM opinions. While the small sample size in our study may limit the statistical power of our tests, our results are extremely robust across numerous alternative models and variable and sample specifications. In addition, as part of our "Further Analyses," we control for the possible endogeneity of audit opinions with audit fees and NAS fees and obtain the same results. The consistent findings obtained from numerous additional analyses give further credibility to our results.

Our findings are also consistent with contemporary research on NAS fees in the U.S. (DeFond et al. 2002) and lend additional evidence to prior research on NAS fees and auditor independence/ reporting decisions in other countries (Craswell 1999; Lennox 1999). Our results are also consistent with audit pricing studies that have found modified audit opinions require additional audit work and therefore are associated with increased audit fees (Simunic 1980; Palmrose 1986; Francis and Simon 1987; Barkess and Simnett 1994; Bell et al. 2001).

BACKGROUND AND RESEARCH QUESTIONS

Nonaudit Services and Auditor Judgments

The association between NAS fees and the possibility of impaired external auditor independence has been discussed in the literature for quite some time (c.f., Mautz and Sharaf 1961; Hylton 1964; U.S. Senate 1976). At issue is whether the revenues obtained from these additional services might create a situation where the external auditor becomes too closely aligned with the client and begins to lose a true sense of independence, which in turn affects the auditor's judgment. Auditors who perform significant NAS for audit clients have an additional economic incentive to retain the client, possibly at the risk of deciding difficult issues in the client's favor so as not to present a disagreement with the management that might ultimately lead to dismissal (Levitt 2000).

The growth in NAS and the resultant independence-related concerns have been instrumental in the SEC's recent action to limit or prohibit certain types of NAS and to require disclosure of nonaudit and audit fees paid by registrants to their external auditors. The former Chairman of the SEC criticized audit firms for using auditing as "a loss-leader retained as a foot in the door for higher-fee consulting services" (Levitt 1996). He also noted that consulting and other services may "shorten the distance between the auditor and management" and that "independence--if not in fact, then certainly in appearance--becomes a more elusive proposition."

In its rule proposal, the SEC (2000a) stated:

   Our concern is ... as auditors become involved in a broad array of
   business arrangements with their clients, they come to be seen by
   themselves, their firms, their clients, and investors less as
   exacting, skeptical professionals who must be satisfied before
   signing off on the financial statements, and more like any other
   service vendor who must satisfy the client to make the sale.

In the final rules, the SEC (2000b) expressed its concern that "the rapid rise in the growth of nonaudit services has increased the economic incentives for the auditor to preserve a relationship with the audit client, thereby increasing the risk that the auditor will be less inclined to be objective." The Commission suggested that significant NAS fees could increase the pressure on auditors to "see it the way the client does" (SEC 2000b). The SEC also noted that such pressures on auditor independence may be greatest in the gray areas, where the rules may not be very clear or when a considerable amount of the auditor's professional judgment must be applied. Along these lines, Chairman Levitt (2000) noted:

   It is not the bright line of right and wrong that the lack of
   auditor independence often implicates as much as it is that gray
   area where the answers aren't so clear; where the temptation to "see
   it the way your client does" is subtle, yet real.

Auditor Reporting Independence and NAS Fees

DeAngelo (1981) and Watts and Zimmerman (1986) have defined auditor independence as the joint probability of detecting and reporting errors. DeAngelo (1981) and Craswell (1999) note that the first element of the definition relates more to auditor technical competence or capability, and the second relates more directly to the issue of auditor independence. Thus, auditor independence depends not only on the ability of the auditor to identify problems, but also to report those problems appropriately. Since prior research has indicated that auditors typically do not have difficulty identifying cases involving going-concern issues for financially stressed clients (Kida 1980; Mutchler 1984, 1986; Simnett and Trotman 1989), the independence issue lies more directly with auditor reporting of these difficulties. Thus, Firth (1997), Craswell (1999), and Lennox (1999) have argued that a direct test of the effects of NAS fees on auditor independence is the examination of auditor reporting decisions, particularly on stressed companies.

The decision on what type of opinion to render on the client's financial statements is the final, cumulative audit decision and is subject to a considerable amount of professional judgment and negotiation with client management. SAS No. 59 (AICPA 1988) requires auditors to assess the continued viability of their clients in each audit engagement, and if there is substantial doubt about the ability of the entity to continue as a going concern, then the auditor must evaluate management's plans and mitigating circumstances. Both the initial going-concern assessment and the evaluation of the appropriateness and probability of success of management's plans involve highly subjective judgments. (1)

Negotiations about the type of audit opinion to be issued are particularly sensitive in the case of a financially stressed client. If auditors defer to the wishes of client management, they would be less likely to issue going-concern modified audit opinions, since audit clients do not welcome the receipt of a going-concern modified audit opinion (Kida 1980; Mutchler 1984). Further, the issuance of a going-concern modified audit opinion involves costs to both the auditor and the client (Kida 1980; Mutchler 1984; Geiger et al. 1998; Blay and Geiger 2001 ; Weil 2001). …

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Publication information: Article title: Audit Fees, Nonaudit Fees, and Auditor Reporting on Stressed Companies. Contributors: Geiger, Marshall A. - Author, Rama, Dasaratha V. - Author. Journal title: Auditing: A Journal of Practice & Theory. Volume: 22. Issue: 2 Publication date: September 2003. Page number: 53+. © Not available. COPYRIGHT 2003 Gale Group.

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