Auditor independence and non-audit services - ICAEW

an independent variable in the audit fee equation, either as the primary variable ofinterest or sometimes merely as a control variable. A related set of studies model feecutting on initial audit engagements (see section 8.6).8.4.2 US studiesSimon (1985) replicates Simunic’s (1984) study using more recent data for 1978-83.He relies on voluntary disclosures made in proxy statements. He finds similar results,i.e., a positive relationship between audit and NAS fees paid to the incumbent auditor.Thus, increasing NAS fees tend to be associated with increasing audit fees.Palmrose (1986a) also finds a positive relationship. She decomposes NAS into types,to investigate whether the proximity of the service to accounting influences theexistence and magnitude of any cost savings. It is found that the relationship isstrongest for accounting-related NAS, although it exists for tax and non-accountingservices too. However, she also finds a similar positive relationship between auditfees and the NAS fees paid to non-incumbent firms, a finding that weakens theargument for knowledge spillovers. She speculates that more audit effort could berequired to audit NAS purchasers if these have audit implications.The study by Abdel-Khalik (1990) uses more sophisticated statistical methods thanthe other studies to conduct a more direct test for spillovers. However, like Simunic’soriginal study, it is based (in this case for positive reasons) on the existence only ofNAS provision by the auditor. Abdel-Khalik argues that a client’s ability to capturethe benefits from knowledge spillovers depends on the evaluation of the cost of searchand displacement of the incumbent auditor, while the audit firm’s incentive to pass onthe economic benefits depends on their degree of monopoly power in the relevantsegment of the audit market. Both types of incentive are influenced by the client’sassessment of local audit market conditions.He points out that, because the degree of substitutability and complementarity ofpurchased NAS in relation the client’s own internal systems cannot be evaluated frompublic information, using NAS fees as an indicator of level of service is risky and mayresult in a spurious correlation between audit and NAS fees (p.319). Instead, hefocuses on the dichotomous decision to purchase (or not) NAS from the auditor.Abdel-Khalik tests for knowledge spillovers by evaluating the cost of the client’s selfselectinginto one regime or the other. Measures of self-selection bias are estimatedusing the Heckman-Lee two-stage method of switching regressions. Based on asample of 84 companies, he finds no significant link between audit and NAS fees.Solomon (1990) provides a discussion of this paper.Whisenant, Sankaraguruswamy and Raghunandan (2002) make use of recent SECmandatedNAS fee disclosures (SEC, 2000). The methodology used represents asignificant departure from previous single-equation models. 20 The authors show(using Hausman tests), that audit and non-audit fees are endogenous (i.e., determined20 Typically, studies of audit fee determinants relate audit fee to a range of independent (i.e.,exogenously determined) variables. The audit fee model is a single equation that is then estimatedusing regression analysis. NAS fees is often included as an independent variable. A positive coefficienton the NAS variable indicates a positive association between NAS fees and the dependent variable(audit fees) after controlling for the other independent variables in the model (such as company size,audit risk and audit complexity).48