Perceived auditor independence and audit firm fees

Holland, K. and Lane, J. (2008) Perceived auditor independence and audit firm fees (Discussion Papers in Centre for Research in Accounting, Accountability and Governance, CRAAG-08-11) Southampton. University of Southampton

Abstract

Regulation of provision of non-audit services (NAS) is premised on a belief that provision is potentially detrimental to auditors' actual or perceived independence. Simunic (1984) argues that such payments could lead to economic bonding between the audit firm and the auditee with a consequential impairment of independence. Although empirical studies have failed to produce unequivocal results of the effects of NAS on auditor independence (Schneider 2006), the actions of regulators, audit firms and auditees is consistent with the belief that economic bonding can at least impair perceived levels of auditor independence.

This study examines a sample of 1,273 UK company year ends over the six year period ending 2006. This data set allows the stability of any relationship to be analysed over a relatively long period of time and permits analysis both immediately prior to and post the collapse of Enron. This event is of interest as it represents a period where changes in investor concerns over auditor independence are likely to be at their greatest in recent history.

The paper's main contributions are the use of a valuation relevance approach to examine the relationship between total relative fees paid (audit fee and NAS) and auditee' market value. This approach is novel in this setting and avoids problematic measurement issues involved in using an event study methodology. A second contribution is to consider that any relationship between total fees and perceived auditor independence may not be linear as assumed in the previous studies.

The results can be summarised as follows. In general, increases in total relative fees are value enhancing, but only at relatively high level do the adverse affects on perceived independence outweigh these beneficial effects. Specifically we find a concave relationship between total relative fees and market values which is observed over the six year period as a whole and in the majority of the years when examined seperately. These results are robust to the exclusion of year ends audited by Andersons (Enron's auditor), and to alternative model and variable specifications. The results suggest that regulatory demands to disclosure fee levels are necessary to protect shareholders and could indicate that it is unnecessary to prohibit the provision of NAS given shareholders awareness of potential impairment. Whether the current disclosure requirements are sufficient for shareholders to assess the full potential impact is not considered in this study.

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