The Effects of Joint Provision and Disclosures of Non-Audit Services on Audit Committee
Decisions and Investor Preferences
Lisa Milici Gaynor
Georgetown University
Linda McDaniel*
University of Kentucky
Terry L. Neal
University of Tennessee
April 14, 2004
Preliminary and Incomplete
Please do not quote without permission
We appreciate the valuable assistance provided by Ron Goodstein, Scott Reed, Mark Terrell, and
the KPMG Audit Committee Institute for their assistance in recruiting participants for the
experiment. We also thank Joe Berandino, Jim LaTorre, and Ivo Jansen for their comments related
to instrument development, David Hulse for statistical advice, and Cam Cockrell and Dan
Hopkinson for research assistance. The paper has also benefited from comments of participants at
the University of Texas Interdisciplinary Corporate Governance Conference.
* Corresponding author
Data availability: contact corresponding author
1
The Effects of Joint Provision and Disclosures of Non-Audit Services on Audit Committee
Decisions and Investor Preferences
Abstract
We provide preliminary results on how recent SEC regulations that hold audit committees directly
accountable for auditor independence and audit quality influence whether committees are willing
to hire the auditor for non-audit services. We further examine whether new audit-committee and
non-audit service fee disclosure requirements that are designed to improve the transparency of the
relationships between the companies and auditors might also influence audit committees’
decisions. Thus, we examine whether audit committees' auditor independence / pre-approval
decisions take into consideration the likely effects of disclosures and whether these decisions are
consistent with investor preferences.
To address these questions, 100 experienced corporate directors, acting as either audit committee
members or investors, participated in an experiment in which we manipulated (1) the effect of
jointly provided audit and non-audit services on audit quality and (2) the requirement of non-audit
service disclosures. Our preliminary results suggest that while the majority of audit committee
members are reluctant to recommend the auditor for non-audit services, their recommendations
appear to consider whether the service improves audit quality. Also, when held accountable
through public disclosures, committees are less likely to approve joint provision even if audit
quality would improve. Finally, if investors are provided with information that joint provision
improves audit quality, they are more likely than audit committees to endorse the hiring of the
auditor.
2
The Effects of Joint Provision and Disclosures of Non-Audit Services on Audit Committee
Decisions and Investor Preferences
1.
Introduction
Outcries over the erosion of financial reporting quality have led to extensive efforts to
restore investor confidence in the capital markets. Among these efforts are regulatory reforms
aimed at improving the oversight effectiveness of audit committees and ensuring auditor
independence (Turner 2002). To this end, recent Securities and Exchange Commission (SEC)
regulations and Congressional legislation (through the Sarbanes-Oxley Act of 2002) hold audit
committees directly accountable for the objectivity of the auditor. To “promote effective corporate
governance,” audit committees are required to consider auditor independence by pre-approving
both audit and non-audit services (Unger 2001). In pre-approving, the audit committee evaluates
whether allowable non-audit services provided by the auditor (i.e., joint service provision)
compromise the auditor’s objectivity.1
Along with these rules, the SEC requires disclosures aimed at restoring investor confidence
(Turner 2001, Pitt 2002, Federal Register 2003). The first disclosure requirement relates to the
audit committee’s accountability for auditor independence. Specifically, the audit committee must
state that it pre-approved both audit and non-audit services provided by the auditor and considered
whether the joint provision of “non-audit services [was] compatible with maintaining the auditor’s
independence” (Unger 2001). The second required disclosure reports the total amount of audit and
non-audit service fees paid to the auditor. Together, these disclosures help investors assess auditor
independence and thus, financial reporting quality (SEC 2000).
1
The SEC prohibits certain non-audit services that, if provided to an audit client, would impair an auditor's
independence. The audit committee is charged with evaluating whether allowable non-audit services are compatible
with the auditor remaining objective.
3
Underlying an audit committee’s requirement to pre-approve non-audit services is the
SEC’s concern that certain non-audit services can negatively affect auditors’ objectivity.
However, the SEC acknowledges that certain non-audit services can improve audit quality and
supports the O’Malley Panel’s recommendation (see Public Oversight Board (POB) 2000)) that, in
the pre-approval process, audit committees consider the effects of non-audit services on audit
quality (Turner 2001). While the requirement to disclose audit and non-audit service fees is
expected to influence investor behavior, these disclosures may also affect audit committees’
decisions related to approving non-audit services (Unger 2001).
To investigate how these new regulations affect audit committees’ decisions, we design an
experiment that addresses three broad questions. First, to what extent do audit committees
consider the effects of the non-audit services on audit quality in deciding whether to approve the
purchase of non-audit services from the auditor? Second, do mandated disclosures, aimed at
influencing investors’ auditor independence perceptions, also affect audit committees’ decisions?
Finally, to what extent are audit committees’ decisions regarding the auditors’ joint service
provision consistent with those of investors’ preferences?
Participants in our experiment are 100 corporate directors who attended a KPMG Audit
Committee Institute Roundtable during 2003. Eighty-one of these directors assume roles of audit
committee members and recommend whether a non-audit service be jointly provided by the
auditor or provided by an unaffiliated audit firm. In a 2 x 2 between-subjects design, we
manipulate the effect of the non-audit service on audit quality via type of service (risk management
versus human resource management) and disclosure requirement via the type of company (public
versus private). We find that the relation between non-audit services and audit quality appears to
4
influence audit committees’ decisions to approve the joint provision of services.2 Further, audit
committees are less likely to approve joint service provision when public disclosures are required,
even if they believe joint provision results in a higher quality audit. Disclosure appears to increase
some audit committees’ concerns about auditor objectivity; other audit committees avoid joint
provision in order to evade disclosures that might raise investor concerns about auditor
independence.
The other 19 directors assume roles as investors in the public company and are asked which
firm they prefer provide the risk management services. In addition to public disclosures related to
audit and non-audit fees, investor participants received private information that the joint provision
of services would improve audit quality. Preliminary findings suggest that, relative to audit
committee members, investors are more likely to prefer the joint provision of non-audit services
that result in higher audit quality.
This research reports on the judgments and decisions of experienced corporate directors as
they relate to new auditor independence regulations. In so doing, we hope to provide some
empirical evidence on the possible implications of the new pre-approval and disclosure
requirements – the latter targeted at investors – on audit committee decisions.
2. Background and Hypotheses Development
Audit committee responsibility for audit and financial reporting quality
The SEC has repeatedly espoused the importance of both the audit committee’s governance
role and the auditor’s independence in protecting investors and ensuring an efficient and reliable
capital market system (SEC 1983, Levitt 2000, Herdman 2002). As elected representatives of
investors, audit committee members’ role is to provide oversight of the reporting process (Blue
Ribbon Committee (BRC) 1999). That is, audit committees are “expected to serve as the guardian
2
Throughout the paper, we will use the term “audit committees” to mean audit committee members.
5
of investors’ interests and corporate accountability” (Zanni and Terrell 2002, p. 1). Auditor
independence is similarly critical: “[w]ithout independently audited financial statements, investors
would not be able to rely on financial statements” (CICA 2000).
Enron and other recent notable frauds highlighted the issue of audit committee
accountability to investors particularly as it relates to auditor independence and thus, audit quality.
This issue, in turn, rekindled a longstanding debate about the positive and negative effects of the
auditor’s provision of non-audit services on his or her independence, and the results on audit and
financial reporting quality.
While services that placed the auditor in a clearly compromised position (e.g., in the role of
management) previously were proscribed, compelling arguments were made in favor of an
“exclusionary rule” for all non-audit services due to the potential to compromise objectivity (SEC
2000). One argument was that the joint service provision required the auditor to serve two clients
– investors and managers. Others were that the auditor should not be in the position of evaluating
his or her own work and should not be allowed to assess his or her own independence (SEC 2000).
On the opposite end of the debate were those who believed that the joint provision of audit
and non-audit services could improve audit quality in a number of ways. One way is that certain
non-audit services provide the auditor with essential knowledge and familiarity with a client’s
business that is fundamental to the audit (Copeland 2002, Goldwasser 2002, Shedlarz 2002, Pletz
2002). For example, effective risk analysis is critical to audit quality and the auditor’s provision of
a non-audit, risk management service would aid in such expertise (Goldwasser 2002, Rice 2000).
Practitioners have also associated the ability to perform high quality audits with the breadth of
firm-level expertise of those outside the audit function who are brought in for consultation
6
(Copeland 2002, Berandino 2003, Plitch 2002).3 In addition, offering both audit and non-audit
services makes the firm more attractive to highly qualified and talented professionals, increasing
the firms’ intellectual capital and the overall quality of audits (Copeland 2002, Berandino 2003).
Congress and the SEC appeared to acknowledge a trade-off between the possible
impairment of auditor objectivity and the potential benefits to audit quality from the auditor’s
provision of non-audit services. Instead of banning auditors from providing all non-audit services
to clients, the SEC chose to exclude those services “that if provided to an audit client, would
impair an auditor's independence” (Levitt 2000, p. 5).4 For all allowable services, however, the
SEC requires the audit committee to pre-approve the auditor’s provision of non-audit services,
holding the committee directly responsible for their consideration of auditor independence and
audit quality (Federal Register 2003). The SEC further acknowledges that some non-audit services
may in fact improve audit quality (Federal Register 2003), and thus, believes the evaluation of
auditor independence is one that involves judgment (see, SEC 2000 and Unger 2001).
Given direct and legal responsibility for audit and financial reporting quality, all things
equal, it would seem reasonable for audit committees to consider the effect of an allowable nonaudit service on audit quality when deciding whether or not to approve joint provision. That is,
barring the belief that the joint service provision impairs auditor independence, audit committees
should be willing to approve those non-audit services that would result in higher audit quality. In
fact, we observe anecdotal support for this as we see audit committees supporting significant levels
of non-audit services (see Weil and Tannenbaum 2001, Frankel et al. 2002). However, there is no
direct evidence on the extent to which audit committees actually consider the effects on audit
The effects of such “knowledge spillovers” have been researched in accounting using analytical methods (e.g., see
Simunic 1984), experimental methods (e.g., see Flaming 2002) and archival methods (e.g., see Whisenant, et al. 2003).
4
These services include, for example, financial systems implementation, internal audit, etc.
3
7
quality in their non-audit service approval decisions as supported by the SEC. Thus, we propose
the following hypothesis5:
H1a:
Ceteris paribus, audit committees will be more likely to recommend the auditor
provide non-audit services when they believe the joint provision improves audit
quality relative to when they believe the service has no effect.
The effect of disclosures on audit committee decisions
Regulations that proscribe certain non-audit services and hold audit committees
accountable for auditor independence are steps toward assuring quality audits, and as a result,
more reliable financial reporting. However, the actual integrity of financial statements alone is
insufficient to restore investors’ confidence in the capital market system (see Turner 2002).
Investor confidence can be restored only if they believe the information can be trusted (Levitt
2000, p. 2).
The importance of instilling investor trust is evident from other recent regulatory actions
specifically targeted at investors’ perceptions. For example, the SEC requires disclosure of audit
and non-audit fees that the auditor provides (SEC 2000, Federal Register 2003).6 This rule arose
from concerns over the appearance of the auditor’s independence. Specifically, the SEC stated
that such disclosure has “the capacity to shape the behavior of investors, possibly decreasing
investors' confidence in the validity of their financial statements” (AIMR 2001, p. 1). That is,
knowledge about the type of the non-audit service and/or the size of the relative non-audit fee
provides information that allows investors to decide whether the auditor is in a position to give an
objective opinion on the financial statements (Unger 2001).
5
We present this research question as a hypothesis even though we present no underlying theory as policy and
practice seem to suggest a specific expected direction.
6
Section 10A(i)(2) of the Exchange Act entitled “Disclosure to Investors,” requires the company to disclose the
amount of fees billed for the two most recent years by the auditor in four categories: audit, audit-related, tax, and all
other. In addition, the company must disclose the types of services provided under all categories other than audit
services (Federal Register 2003).
8
SEC regulation further requires disclosure of the pre-approval process and that the audit
committee considered whether the provision of non-audit services is compatible with maintaining
the auditor's independence (Federal Register 2003). While the act of pre-approving holds audit
committees directly accountable for auditor independence (and thus, audit quality), its disclosure is
aimed at increasing investors’ confidence in the audit committee’s process of assessing auditor
independence (Raghunandan and Rama 2003, Federal Register 2003).
While the stated goal of these new fee and pre-approval disclosure requirements was to
help investors personally assess auditor independence, research in psychology and accounting
suggests how these disclosures may also affect audit committees’ behaviors. Because the rules
increase audit committee public accountability for actual as well as perceived independence, we
apply research in accountability to understand how audit committee decisions may be affected.
In both psychology and accounting research, accountability is defined as the implicit or
explicit expectation that one may be called upon to justify one’s beliefs, feelings, or actions
(Lerner and Tetlock 1999). The mandated disclosures hold audit committees accountable on two
dimensions. First, the act of disclosing the pre-approval process (i.e., the consideration of the
compatibility of the non-audit service with auditor independence) makes audit committees
accountable for the procedures underlying the decision (i.e., process accountability). Process
accountability focuses one on the quality of the judgment procedure and increases one’s feelings of
responsibility for the evaluation of alternatives (Lerner and Tetlock 1999). As a result, individuals
held accountable for their processes tend to engage in a more unbiased evaluation of decision
alternatives (Peecher and Kleinmuntz 1991; Lerner and Tetlock 1999).
Second, audit and non-audit fee disclosures hold audit committees accountable to investors
for the outcome of the pre-approval process (i.e., auditor independence). This is because investors
9
make inferences about auditor independence from the required disclosures, as intended by the
SEC. The nature of the required disclosures is a direct function of the audit committee’s ultimate
decision (i.e., whether or not to approve the joint provision of services). The accountability
literature shows that individuals held accountable for decision outcomes are more apt to expend
cognitive effort on self-justification and to arrive at outcomes that maximize their standing within
their social and/or organizational environment (Tetlock 1985; Peecher and Kleinmuntz 1991).
With either process or outcome accountability, individuals tend to select a course of action that
best conforms to a known audience’s views (Tetlock 1983; Tetlock et al. 1989).
Based on process accountability research, we expect audit committees to spend more time
evaluating whether the joint service provision is compatible with auditor independence. In
addition, outcome accountability findings would suggest that committees would place emphasis on
the potential negative impact of the service on investors’ perceptions of auditor independence. As
the SEC contends, “[c]ompanies may perceive disclosing the ratio of non-audit to audit service
fees will decrease investor confidence in the validity of their financial statements. In that case, we
can expect companies to take steps to improve the ratio…” (Unger 2001, p. 3).7
Given audit committees’ pre-approval decisions directly influence the nature of the
disclosures, committees may take action to evade disclosures, especially if these are seen as having
potentially negative implications. That is, if accountability leads committees to more closely
evaluate auditor independence and/or investor perception concerns, we expect audit committees
will be less likely to pre-approve the purchase of non-audit services from the auditor. Therefore,
we propose the following hypothesis.
Consistent with the SEC’s views and prior investor research (e.g., see Flaming 2002), we would expect audit
committees to view fee disclosures as having a negative effect on investors’ auditor independence perceptions.
7
10
H1b:
Ceteris paribus, audit committees will be less likely to recommend the auditor’s
joint provision of non-audit services when public disclosures are required relative to
when disclosures are not required.
Consistent with H1b that disclosures influence audit committees’ joint provision decisions,
is anecdotal evidence of some public boards’ reluctance or outward resistance to purchasing nonaudit services from their auditor. For example, many corporate audit committees (e.g.,
International Paper Co.) have established “bright lines” in which they will reject the purchase of
any non-audit service that brings the ratio of non-audit fees to audit fees over a specified threshold
(Goldwasser 2002, Plitch 2002, Bryan-Low 2003). Others (e.g., Johnson & Johnson) appear more
extreme in their behavior and simply refuse to purchase any additional services from their auditor
(Goldwasser 2002, Bryan-Low 2003).
These situations could be due to concerns over auditor objectivity, investors’ independence
perceptions, or the fact that there are no measurable benefits to hiring the auditor for the specific
non-audit service. However, as previously indicated, audit committees are accountable for audit
quality. Thus, absent the belief that a service is incompatible with auditor independence, if joint
provision provides synergies such that audit quality improves, it creates a situation in which the
audit committee must balance potential improvements to audit quality against the possibility that
investors will believe auditor independence is compromised. That is, if disclosures are required,
audit committees must choose between (1) joint service provision that results in higher audit
quality but may negatively affect investor perceptions, or (2) purchasing the services from an
unaffiliated firm and potentially sacrificing some audit quality yet avoiding the effects of
disclosures.
While the accountability literature suggests why audit committees may choose to avoid
disclosure, we have not considered this particular situation in which audit committees can avoid
11
disclosures only by sacrificing potential audit quality. We believe that an argument based on
disclosure transparency provides an additional reason why audit committees might be prone to
avoid disclosures even in this situation. Specifically, prior accounting research has demonstrated
that investors’ decisions are influenced by information transparency (c.f., Hirst and Hopkins 1998,
Maines and McDaniel 2000, Hodge et al. forthcoming). In this case, the mandated “disclosures
provide greater transparency to investors … [and allows them] to ask more direct and useful
questions of management and directors regarding their decisions to engage the accountants for
such service” (Federal Register 2003). Yet, the disclosures are not transparent with respect to the
positive effects of such services. Thus, audit committees are likely to view disclosures as having
an almost certain downside with no upside potential.
Based on the above, we predict that when public disclosures are required, audit committees
will be more likely to purchase non-audit services from an unaffiliated firm even when they
believe joint provision results in higher audit quality. In other words, committees will be willing
to forego benefits to audit quality in order to avoid disclosure. To that end, we propose the
following hypothesis:
H1c:
Ceteris paribus, when joint service provision is believed to improve audit quality,
audit committees will be less likely to recommend the auditor provide non-audit
services when public disclosures are required.
3. Method
Design
To address the first set of research questions (H1a-H1c), we employ a 2 x 2 betweenparticipants design. The first factor relates to the effect of a proposed non-audit service on audit
quality. The factor is operationalized by varying the type of non-audit service: the joint provision
12
of the risk management and audit services is expected to result in higher audit quality; in contrast,
human resource services have no effect on the quality of the audit.8 The second factor is whether
or not the company is required to publicly disclose (1) audit and non-audit service fee data and (2)
the audit committee’s pre-approval of the services purchased from the auditor. This presence or
absence of a disclosure requirement is operationalized by the type of company, public or private,
respectively.
Participants
Participants included 81 corporate directors who were attending one of twelve different
corporate governance roundtables held around the country. On average, these directors are serving
or have served on 3.0 boards and have 5.4 years (3.3 years) experience as a public (private)
company audit committee member.9 Summary background information is presented in Table 1.
Insert Table 1 here
Procedure
We worked with a national coordinator of the governance seminars as well as the
individual administrators at each of the twelve locations to distribute and collect the instruments.10
We selected these two specific services based on reviews of auditing firms’ publications, statements from the NACD
web site, and conversations with affiliates from the KPMG Audit Committee Institute. While, in general, risk
management services are in a class that can easily improve audit quality and human resources are among those that
likely have little effect, it is possible for individual experiences to affect one’s views. To that end, we collect
information that allows us to assess the extent to which participants’ views matched the condition to which they were
assigned.
9
A total of 103 corporate directors participated; however, we dropped from the study two non-director (academic)
participants and one director who failed the manipulation check question. Of the 100, 81 participated as audit
committee members and the remaining 19 directors participated as investors, as subsequently discussed. We also
collected data on whether the audit committee experience was with small, mid, or large cap firms and also gathered the
number of years of audit experience. There were no significant differences in the nature of the experience across
experimental conditions.
10
The national coordinator assisted in drafting a uniform set of instructions to the administrators and attended six of
the nine seminars to ensure consistency in the distribution and request for participation. For those seminars for which
he was not in attendance, he assisted in the writing of the administrators’ announcement such that identical statements
would be made in the other three locations.
8
13
Each location distributed instruments for all experimental conditions, thus, participants were
randomly assigned to conditions at each location.
Upon arrival at the seminar, participants received a packet comprising (1) a short letter of
introduction asking for their voluntary participation in the study that would address an audit
committee’s approval for an accounting firm to provide non-audit services, (2) two pages of
background information on the company and decision, (3) a one-page question set related to the
primary decision, (4) a postage-paid, addressed return envelope, and (5) a two-page question set
containing manipulation check, explanatory, and demographic questions. Participants were
instructed to return the completed instrument to the administrator at the end of the seminar.11
Task and Instrument
Each of the 81 participants was instructed to assume the role of an audit committee member
for a growing small-cap company. They were told that at its upcoming meeting, the audit
committee would be recommending one of two Big 4 firms to provide some non-audit services to
the company. One of the two Big 4 firms (Firm A) was just hired to conduct the company’s
external audit; audit fees would be $1.3 million.
All participants were advised that Firm A (the external auditor) “has a well-established
reputation for providing these [non-audit] services to some of the leading firms in [the industry]”
and have “access to relevant best practices.” In contrast, participants were told that the second
firm, Firm B, had no present or prior association with the company, but did have experience in
providing these non-audit services. Both accounting firms bid $2 million for the 18-month nonaudit service project with $1.25 million expected to be billed this year.12 We wanted Firm A to
11
We also provided an option to return the instrument via mail if necessary. We received fewer than 15% of the 103
instruments in this fashion.
12
We reviewed audit fee and non-audit fee disclosures for a sample of 41 small-cap companies to determine a
reasonable amount for the non-audit service fees as well as the relative amount of the non-audit service to audit fees.
14
appear slightly more attractive in terms of the quality of the services and equivalent in costs such
that selecting Firm B would be for reasons other than service quality or cost savings.13
Each instrument comprised two pages of background information with page one describing
the nature of the allowable non-audit service and the relation of the non-audit services to audit
quality. In the risk management services cases, participants were instructed that if Firm A
provided joint services, a higher quality audit would result. In the human resource service cases,
participants were informed that purchasing joint services from Firm A would not lead to a higher
quality audit.
Page two of the background information varied depending on whether the company was
publicly or privately held. For those receiving the public company condition (company traded on
NASDAQ), the second page presented alternative sets of public disclosures: those the company
would be required to present in its public filings if the audit committee recommended the audit
firm (Firm A) for the non-audit services, and those required if the unaffiliated firm (Firm B)
provided the non-audit services.14 In either situation, the company would disclose $1.3 million in
audit fees. Should the external audit firm (unaffiliated firm) be selected to provide the non-audit
services, then the company would also disclose $1.25 million ($0) in other fees paid to the auditor.
In addition, if the audit committee recommended Firm B, there would be no mention of the preapproval of the non-audit services (or the fact that any were purchased).
We also had two partners from different Big 4 firms review the instruments for reasonableness and realism. We used
an approximate 1:1 ratio of audit to non-audit service fees in the case; this is considerably smaller than that reported by
Frankel et al. 2002 and Weil and Tannenbaum 2001 and used by Flaming (2002).
13
Based on pilot results and debriefing sessions, we believed it necessary to hold this factor constant and to eliminate
these reasons as alterative explanations.
14
The SEC requires disclosure of amounts paid to the auditor for audit fees and for various categories of audit-related,
IT, tax, etc. In addition, if the company purchases non-audit services from the auditor, there is additional required
disclosure of the audit committee’s pre-approval of such services. The disclosures presented in the instrument were
patterned from actual 10-K filings for several small-cap firms who disclosed non-audit services. We presented two
categories – audit fees and “all other fees” as the company would have only the audit and non-audit fees to disclose.
15
For those receiving the private company condition, the second page of the background
information stated the total amount that the company would pay for audit and non-audit services,
emphasizing that the amount would not differ; the only difference is whether the company pays
$1.25 million for non-audit services to Firm A or Firm B. In addition, the instrument indicated
that because the company was privately held, it would not be required to make any public
disclosures regarding the amounts paid for audit or non-audit service fees nor would it be required
to disclose that the audit committee pre-approved such services.
After reading the background information, participants answered two sets of questions. The
first question set asked participants to indicate which firm they would recommend to provide the
non-audit service. They then were instructed that they might have to explain the reasoning behind
their recommendation and thus, were asked to list (1) the single most important factor in support of
the recommended firm, (2) other factors they considered that support their recommendation, and
(3) the single most important factor that argues against the recommended firm. After inserting this
question set into an envelope, participants responded to a second set of manipulation check,
control, and demographic questions.15
4. Audit Committee Results
Manipulation checks and control variables
Participants responded either “yes” or “no” to a manipulation check question that asked
whether the case materials indicated that the joint provision of the non-audit service and audit
would result in a higher quality audit. Those who received the risk management service cases
should have responded “yes,” whereas participants receiving the human resource service cases
15
Twelve accounting faculty, several accounting Ph.D. students, and 60 MBAs (with an average of 62 months of work
experience) pilot tested the instrument for clarity of the task and questions, completeness of information, and timing.
The revised instrument was reviewed for realism, reasonableness, and length by two former audit partners as well as
the national coordinator of the seminars. A few additional revisions were made based on these comments.
16
should have answered “no.” One participant responded incorrectly and, accordingly, was
eliminated from all analyses.16
Examination of how the relation between non-audit services and audit quality affects firm
recommendations requires that audit committees believe that the joint service provision either
improves or has no effect on audit quality. Given the backgrounds of the majority of our
participants, it is likely that their prior director experiences could influence the extent to which
they believe audit quality improves with any given non-audit service. Thus, we also ask “to what
extent do you believe the auditor’s provision of the risk management (human resource) services
would affect audit quality (AQ)?” Participants responded on an 11-point scale with 1 being “AQ
would be much lower,” 6 (the mid-point) being “no effect on AQ,” and 11 being “AQ would be
much higher.” Those assigned to the human resource conditions (n=40) reported a mean (standard
deviation) of 6.13 (1.18). This is not significantly different from the “no effect” of 6.0 (p=.507).
In comparison, mean response for participants in the risk management conditions (n=41) was 7.32
(1.84), which is significantly greater than the “no effect” of 6.0 (p<.0001). While the two means
also are significantly different (p<.001), the distributions for these responses suggest that some
participants believed that risk management (human resource) services had no measurable effect on
(improved) audit quality. Thus, to examine H1a and H1c, both of which address audit quality
effects, we use participants’ audit quality assessments as the independent variable instead of the
assigned service condition.17
16
We did not ask a question about the disclosure manipulation as the materials and questions referred to a public or
private situation throughout and the factor was completely between subjects.
17
A total of 9 of the 40 (14 of the 41) participants assigned to the human resource (risk management) condition
responded inconsistently with the intended service manipulation. While one might consider this a failed manipulation,
the construct we wished to examine is whether joint provision does or does not improve audit quality. We can
examine this by using the participants’ audit quality beliefs in our analyses. The inconsistency of our experimental
manipulation and the beliefs is not unexpected given these are experienced directors. By including them we believe
we have a more generalizable view of actual behaviors. We will, however, examine the results using a subset of
participants who responded consistently with the experimental as we had intended.
17
As part of their pre-approval decisions, audit committees must assess whether the non-audit
services are incompatible with auditor independence. If a service is viewed as incompatible, the
committee should not approve the auditor for such services. Thus, we ask participants to indicate
how the joint provision of risk management (human resource) services would affect the auditor’s
actual objectivity on an 11-point scale with 1 being “Objectivity not affected” and 11 as
“Objectivity significantly reduced.” Across all participants, the mean response (standard
deviation) was 4.96 (2.87) indicating that on average, participants view the joint provision of nonaudit services as slightly reducing auditor objectivity; the means for risk management and human
resource services, respectively, were 5.05 (2.92) and 4.86 (2.85). In addition, those in the public
and private company setting reported means of 5.12 (2.94) and 4.75 (2.81), respectively.
Differences across service type and company type were not significant (p=.77 and p=.60,
respectively).
Descriptive data for H1a, H1b, and H1c
H1a and H1b predict that audit committees will be more likely to approve the auditor’s
joint service provision if they believe the service will result in higher audit quality but less likely if
public disclosures are required. Further, H1c states that the effect of disclosures will hold even
when audit quality is expected to improve. As indicated previously, we will test H1a and H1c
using participants’ beliefs about the effect of non-audit services on audit quality rather than the
type of service. Therefore, panel A of Table 2 presents firm recommendations by type of company
and audit quality beliefs (instead of type of service) for the 81 participants. In spite of the audit
firm having a slight advantage in providing these non-audit services, audit committees seem
reluctant to hire an unaffiliated firm for non-audit services; the auditor is recommended only
37.0% of the time.
18
If, however, audit committees believe the non-audit service will improve audit quality, they
recommend joint service provision 52.8% of the time; in comparison, only 24.4% of the
committees recommend the auditor when the service is believed to have no effect on audit quality.
Thus, while audit committees prefer joint service provision less than 40% of the time on average,
they do so more often when they believe audit quality improves. This is consistent with H1a and
the Panel’s recommendation that audit committees consider audit quality in evaluating auditor
independence (POB 2000).
Insert table 2 here
Panel A further indicates that 41.7% of audit committees recommended joint service
provision when the company is private and faces no disclosure requirements. In contrast, only
33.3% recommended the auditor when public disclosures are required. This pattern holds even for
the situation in which the service is expected to improve audit quality. In the private company,
72.7% of the audit committees recommend the auditor for the non-audit services. When the
company is public, only 44.0% of the committees recommend the auditor. These results are
directionally consistent with H1b and H1c.18
Tests of H1a and H1b
We use logistical regression to test the effects of the relations between non-audit service
and audit quality (H1a) and public disclosures (H1b) on audit committees’ firm recommendations
(FIRMREC). The independent variables include AQBELIEF, the participant’s assessment of the
effect of the non-audit service on audit quality, and PUBLIC, an indicator variable to test the
18
We present firm recommendations by type of service and company in panel B of table 2 as a comparison. As
expected, the differences are not as great as those reported in panel A; however, the frequencies are in the predicted
direction.
19
effects of required disclosures. We also include as a control variable the participant’s belief of the
effect of joint provision on auditor’s objectivity (OBJBELIEF).
We predict a positive relation between AQBELIEF and FIRMREC – that is, when joint
provision is expected to improve audit quality, the audit committee is more likely to recommend
the auditor. We expect the coefficients on PUBLIC and OBJBELIEF to be negative: audit
committees will be more likely to recommend the unaffiliated firm when non-audit service
disclosures are required and when they believe joint provision impairs auditor objectivity.
As shown in table 3, the overall model is significant at a p<.001. The coefficient on
OBJBELIEF is significantly negative (p<.01, one-tailed) suggesting that when audit committees
believe joint provision to impair auditor objectivity, they do not recommend the auditor for nonaudit services. This is consistent with the SEC’s requirement holding audit committees
responsible for auditor independence. The AQBELIEF and PUBLIC coefficients are both in the
direction hypothesized by H1a and H1b, respectively. Audit committees are significantly more
likely to recommend joint service provision when they believe audit quality will improve,
supporting H1a (p<.01, one-tailed). They also are less likely to recommend the auditor when
public disclosures are required (p<.10, one-tailed). Thus, these combined results provide support
for both H1a and H1b.
Insert table 3 here
We wish to examine if disclosures influence firm recommendations for the expected
reason. Specifically, we asked participants in the public conditions whether or not required nonaudit service disclosures would affect investors’ perceptions of auditor independent. Thirty-nine
of the 45 participants responded “yes”; these participants further evaluated whether investors
20
would perceive the auditor as “slightly less independent” or “not independent,” on an 11-point
scale of 1 to 11, respectively. The mean response (standard deviation) was 6.05 (2.56) suggesting
that, on average, audit committees believe disclosures negatively influence investors’ perceptions
of auditor independence as purported by the SEC.19
Test of H1c
H1c, a specific case of H1b, predicts that the effect of disclosure will hold even when audit
committees believe joint service provision improves audit quality. That is, we hypothesize that
committees will be willing to even forego benefits to audit quality in order to avoid disclosures.
We find that 56.0% of those participants in the public condition who believed joint service
provision improves audit quality chose Firm B, as compared to 27.3% in the private condition.
This difference is significant at p=.06.
To assess why these participants were willing to forego audit quality, we model their
FIRMRECs with logistical regression including the independent variables of AQBELIEF,
PUBLIC, and OBJBELIEF. The results are presented in table 4. Similar to that reported in table
3, we find that participants’ beliefs that joint service provision may compromise auditors’
objectivity is a significant determinant of their recommendations (p < .01). Yet, after controlling
for this, PUBLIC still has a marginally significant effect in the hypothesized direction (p < .10).
This result is consistent with H1c and indicates that in spite of potential benefits to the audit, the
negative effect of disclosures on investors’ perceptions leads some participants to take actions that
will avoid disclosures.
Insert table 4 here
19
These responses differed between non-audit service types with audit committees expressing more concern about
how investors would view disclosures for human resources (mean=7.31) relative to risk management (mean=5.17).
These means are significantly difference at p < .009. We plan to examine this further including possible interactive
effects.
21
5. Investor Preferences
Hypothesis development
One motivation in adopting the non-audit service disclosure rules was the need to provide
greater transparency to investors (Turner 2001, Pitt 2002). Specifically, the SEC’s original
proposal defended such disclosures as a way to provide “sunlight to the auditor independence
area” (SEC 2000) so investors can “determine for themselves whether there are concerns related to
the independence area” (Federal Register 2003). While providing “sunlight,” these disclosures are
likely to have a negative, or at best, neutral effect on investors’ perceptions of auditor
independence (e.g., see Flaming 2002). This may be due in part to the exact nature of these public
disclosures. Specifically, if the auditor provides joint services, investors have only information
related to the amounts paid to the auditor. While they also know that the audit committee
approved the services, they do not learn why the auditor was hired. For example, was the auditor
the most qualified and/or the cheapest provider of the service, or did the company benefit in ways
beyond that associated with the service per se, e.g., audit quality improvements?
Investors rely on audit committees to take actions that will enhance audit quality, in part,
because committees do have private information that, presently, is not reported in required
disclosures. So an interesting question is whether audit committees, with this private information,
are protecting investors’ interests. That is, if investors had the same information that audit
committees have, would the committees’ recommendations be consistent with investors’
preferences?
Related to our prior arguments, we expect audit committees will recommend joint service
provision less than what investors would prefer if investors had full information. Specifically, we
believe that the direct link between audit committees’ pre-approval decisions and resulting
disclosures creates incentives for audit committees to avoid disclosures. For example, if audit
22
committees approve an unaffiliated firm for non-audit services, they avoid the possibility of
investors’ “more direct and useful questions” due the increased transparency that disclosures bring
(Federal Register 2003). Committees may also avoid possible regulatory scrutiny when the auditor
provides no non-audit services, as the disclosures would signal the existence of no service-related
conflicts of interest. In contrast, investors have no accountability incentives with respect to
disclosures and thus, would be more likely to prefer joint service provision if audit quality
improved. Thus, we investigate the possible effects of additional disclosures on investors’
preferences, and propose the following hypothesis (research question):
H2:
Ceteris paribus, compared to investors’ preferences when investors believe joint
service provision improves audit quality, audit committees will be less willing to
recommend the auditors’ provision of non-audit services.
Participants and Method
To examine H2, we created a fifth experimental condition whereby 19 of the director
participants assumed the role of an investor in a public company. On average, these participants
served on approximately 3.7 boards and on audit committees of 3.2 (4.9) private (public)
companies. Summary background information is presented in panel B of table 1.
The 19 participants received packets very similar to the pubic company, risk management
services, audit committee condition.20 The information about the audit firms and the risk
management service remained identical to that in the public-audit committee condition. After
reading the background information, participants indicated the firm (Firm A or B) that they would
prefer the audit committee recommend provide the non-audit services; they also listed reasons for
and against their selections. After inserting this question set into an envelope, participants
20
Because we were interested investor perceptions, there was no private company condition. In addition, as we
wanted to see if investors’ preferences changed when they were told that the service improved audit quality, we used
only risk management services.
23
proceeded to a second set of manipulation check, clarification, control, and demographic
questions. These questions were nearly identical to those assigned to the audit committee role yet
modified for the investor role.
Results
We asked participants how difficult it was for them to respond as an investor rather than an
audit committee member. The mean response (standard deviation) was 3.68 (2.95) on an 11-point
scale with 1 and 11 being “not at all” and “extremely” difficult, respectively, suggesting
participants had no difficulty responding as investors.
Second, participants responded to the manipulation check question, “to what extent do you
believe the auditor’s provision of the risk management services would affect audit quality (AQ)?”
On an 11-point scale (1 is “AQ would be much lower” and 11 is “AQ would be much higher”),
these participants reported a mean of 6.68 (1.92), which was significantly different than “no effect”
of 6.0 (p=.068), suggesting investor participants believe audit quality improved with the auditor’s
joint provision of risk management services.
Underlying the SEC’s mandated disclosures is that it allows investors to evaluate auditor
independence. Parallel to the audit committee question, we ask to what extent the joint provision
of services affects investors’ perceptions of auditors’ objectivity. Investor participants reported a
mean (standard deviation) of 4.26 (2.47) suggesting that investors believe auditor objectivity is
slightly reduced by the joint provision, consistent with the SEC’s contention. It further suggests
that audit committees’ concerns over investors’ perceptions of auditor objectivity may not be
unfounded.
Table 5 reports shows that, on average, 68.4% of investors prefer the auditor provide risk
management services in contrast to audit committees’ recommendations of only 41.7% of the time.
24
This difference is significant at p < .05, consistent with H2. Interestingly, investors prefer more
joint service provision relative to investors even though audit committees see greater
improvements to audit quality compared to investors (mean AQBELIEF for investors is 6.68
compared to 7.83 for audit committees).21
Insert table 5 here
6.
Discussion
One problem repeatedly cited in regulatory debates over rules restricting auditor provision
of non-audit services is the lack of empirical evidence indicating that non-audit services in fact
leads to actual and/or perceived auditor independence impairments (e.g., POB 2000, Turner 2001).
Also questioned is the effectiveness of SEC required disclosures in meeting the objectives of
increased financial reporting quality. Former SEC Chairman Pitt (2002), in discussions of the
then-impending adoption of the Sarbanes-Oxley Act, expressed his concern over the lack of
empirical evidence supporting the new disclosure requirements. Further, he stated that if and when
problems are empirically shown to exist, reforms should be tailored to fit those specific problems
(Pitt 2002). There have been other calls for research that addresses such issues. For example, the
POB (2000) called for the continuous evaluation of the effectiveness of new SEC disclosure
requirements as well as future rule-making initiatives. Former Acting SEC Chairman Unger
(2001) stated that the non-audit service disclosure requirements “lay the groundwork for future
study of the effect of non-audit services on auditor independence” and expressed a need for “better
empirical information on the effect of various non-audit services in the future.”
21
In this setting, audit committees made recommendations based on current disclosure rules, i.e., they know that
investors have no additional information on audit quality per se. Thus, we do not know whether audit committees’
recommendations would change to be more consistent with those of investors if audit quality related disclosures were
also required. We made this design choice knowing that access to director participants was limited.
25
This study addresses such regulator concerns and appeals for empirical evidence by
examining the effects of joint service provision and disclosures on investor perceptions and audit
committee decisions. By using experienced corporate directors as participants, we hope to provide
evidence that will aid regulators in better understanding the potential consequences of new rules
and assessing whether these are meeting the intended goals of increasing audit and financial
reporting quality.
Our findings suggest that fewer than 40% of audit committees, on average, are willing to
recommend the auditor for allowable non-audit services. While some committees view these joint
services as incompatible with auditor objectivity, it appears that committees view the disclosure
effects on investors’ perceptions as negative and thus, some committees hesitate to approve joint
provision in order to avoid these public disclosures. There is even a willingness to forego audit
quality improvements in order to do so. Given investors provided with information available to
audit committees would appear to prefer less of this trade off, it is possible that mandated
disclosures may lead to behaviors that would not be consistent with improved audit quality. The
SEC contends that information that affects behaviors is material and thus important for investors.
Thus, our findings also suggest there may be a need to consider expanding disclosures.
This study suffers from all of the usual and expected limitations of experimental work as
well as limitations due to its very preliminary stage. However, upon completion, we hope the
paper will contribute to the corporate governance literature in a number of ways. First, by
examining decisions of actual corporate directors, we provide insight on the extent to which audit
committee members believe that the joint provision of audit and non-audit services negatively
impacts actual auditor objectivity as well as investors’ perceptions of auditor independence, issues
of importance to regulators. While several archival studies explore these effects by looking at
26
proxies of audit quality such as their relationship with financial restatements (e.g., Kinney, et al.
2004), abnormal accruals (e.g., Frankel, et al. 2002), and going-concern opinions (e.g., DeFond, et
al. 2002), no prior studies have looked at the possible direct effects on audit committees’ decisions.
Finally, this paper can contribute to existing literature on disclosure and financial reporting
transparency. Research argues that managers sometimes make decisions to avoid increasing
financial reporting transparency (e.g., see Healy and Palepu 2001, Hodge et al forthcoming). This
study provides evidence on the extent to which disclosures may also influence audit committees in
a situation in which the committee and its decision directly influences the mandatory disclosures.
27
Table 1
Sample Size and Demographic Data for Corporate Director Participants
Panel A: Sample Size
Total number of corporate director participants
Less: Participants with an academic versus director background
Participant who failed the manipulation check
Final sample
103
(2)
(1)
100
Participants assigned the role of an audit committee member
Participants assigned the role of an investor
Total number of participants
81
19
100
Panel B: Experience Data for All Corporate Director Participants
All
Participants
(n = 100)
Audit
Committee
Members
(n = 81)
Investors
(n = 19)
Average years on private company audit committees
3.2
3.3
3.2
Average years on public company audit committees
5.3
5.4
4.9
Average years as an independent auditor
6.3
5.9
7.8
Average number of directorships in other companies
3.2
3.0
3.7
28
Table 2
Percentage of Audit Committees Who Recommend the External Auditor (Firm A) Provide the
Non-Audit Service
Panel A: Audit Committee Participants’ Recommendations by Audit Quality Belief and Type of Company
Non-Audit Service Effects on Audit Quality Belief
Service has No Effect on
Audit Quality
Service Improves Audit
Quality
Overall
Private
(no disclosure)
28.0%
(7 out of 25)
72.7%
(8 out of 11)
41.7%
(15 out of 36)
Public
(required disclosures)
20.0%
(4 out of 20)
44.0%
(11 out of 25)
33.3%
(15 out of 45)
Overall
24.4%
(11 out of 45)
52.8%
(19 out of 36)
37.0%
(30 out of 81)
Type of Company
Panel B: Audit Committee Participant Recommendations by Type of Service and Type of Company
Type of Non-Audit Service
Human Resource
(no effect on audit quality)
Risk Management
(improves audit quality)
Overall
Private
(no disclosure)
36.8%
(7 out of 19)
47.1%
(8 out of 17)
41.7%
(15 out of 36)
Public
(required disclosures)
23.8%
(5 out of 21)
41.7%
(10 out of 24)
33.3%
(15 out of 45)
Overall
30.0%
(12 out of 40)
43.9%
(18 out of 41)
37.0%
(30 out of 81)
Type of Company
29
Table 3
Logistic Regression of Audit Firm Recommendation on Audit Quality Belief, Type of Company,
and Auditor Objectivity Belief
Tests of H1a and H1b
FIRMREC = b0 + b1 AQBELIEF + b2 PUBLIC + b3 OBJBELIEF + 
Variable
Predicted
Relation
Estimated
Coefficients
Standard
Errors
Wald
Chi-Square
3.938**
INTERCEPT
none
-3.112
1.568
AQBELIEF
+
0.711
0.232
9.422***
PUBLIC
-
-0.844
0.609
1.922*
OBJBELIEF
-
-0.427
0.117
13.420***
Number of Observations
81
Chi-Square for Model
(3 degrees of freedom)
33.476
p-value
0.0001
Pseudo R2 =
0.31
Concordant Pairs
84.2%
AQBELIEF
= extent to which the participant believes the joint provision of the non-audit service
would affect audit quality, based on an 11-point scale (1 = AQ would be much lower,
11 = AQ would be much higher)
PUBLIC
= 1 if participant is assigned to the public company condition (disclosures required),
else 0
OBJBELIEF = extent to which the participant believes the joint provision of the non-audit service
would affect the auditor’s actual objectivity, based on an 11-point scale (1 = objectivity
not affected, 11 = objectivity significantly reduced)
*, **, ***
Statistically significant at less than the .10, .05, and .01 level, based on one-tailed (twotailed) tests for variables whose relation to the dependent variable is (is not) predicted.
30
Table 4
Logistic Regression of Audit Firm Recommendation on Audit Quality Belief, Type of Company,
and Auditor Objectivity Belief: An Analysis of Tradeoff of Audit Quality
Test of H1c
FIRMREC = b0 + b1 AQBELIEF + b2 PUBLIC + b3 OBJBELIEF + 
Variable
INTERCEPT
Predicted
Relation
none
Estimated
Coefficients
-3.541
Standard
Errors
3.586
Wald
Chi-Square
0.975
AQBELIEF
+
0.791
0.456
3.010**
PUBLIC
-
-1.190
0.901
1.745*
OBJBELIEF
-
-0.438
0.175
6.261***
Number of Observations
36
Chi-Square for Model
(3 degrees of freedom)
13.333
p-value
0.0040
2
Pseudo R =
0.27
Concordant Pairs
81.7%
AQBELIEF
= extent to which the participant believes the joint provision of the non-audit service
would affect audit quality, based on an 11-point scale (1 = AQ would be much lower,
11 = AQ would be much higher)
PUBLIC
= 1 if participant is assigned to the public company condition (disclosures required),
else 0
OBJBELIEF = extent to which the participant believes the joint provision of the non-audit service
would affect the auditor’s actual objectivity, based on an 11-point scale (1 = objectivity
not affected, 11 = objectivity significantly reduced)
*, **, ***
Statistically significant at less than the .10, .05, and .01 level, based on one-tailed (twotailed) tests for variables whose relation to the dependent variable is (is not) predicted.
31
Table 5
Percentage of Audit Committee Members and Investors Who Recommend the External Auditor
(Firm A) Provide the Risk Management Non-Audit Service for the Public Company
Public Condition for Risk Management Non-audit Services
Participant Type
Percentage Who Prefer Joint Provision
Audit Committee Members – Public
41.7%
(10 out of 24)
Investor – Additional private information
68.4%
(13 out of 19)
Difference
p = 0.04
32
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