Does Client Importance Affect Auditor Independence at the Office Level?

Empirical Evidence from Going Concern Opinions

Chan Li Joseph Katz Graduate School of Business University of Pittsburgh, Pittsburgh, PA 15260 chanli@katz.pitt.edu 412-648-1723

I gratefully acknowledge the helpful comments and suggestions of Michael Willenborg (associate editor) and two anonymous reviewers. This paper is based on my dissertation, completed at the University of Kansas. I appreciate helpful suggestions and insights of my dissertation committee: James Heintz, Rajendra Srivastava, Todd Little, and especially Mike Ettredge (Chair) and Susan Scholz. I also thank Harry Evans, Mei Feng, Vicky Hoffman, Karla Johnstone, Kenneth Reynolds, Kathy Rupley and participants in the workshops at George Washington University, Georgia Institute of Technology, Miami University, Oregon State University, State University of New York at Buffalo, Temple University, University of Pittsburgh, University of Texas-San Antonio, and participants at the 2007 AAA midyear auditing conference.

Electronic copy available at: http://ssrn.com/abstract=1108189

Abstract This paper investigates whether client importance affects auditor independence within the local offices of audit firms. Client importance is measured as the proportion of audit fees, nonaudit service fees, or total fees that a distressed, public client contributes to the total public-client revenue earned by the individual audit offices. Auditor independence is measured as the auditors propensity to issue a going-concern opinion. The paper focuses on changes in the relation between fee ratios and auditor reporting decisions from the pre-SOX (2001) to post-SOX (2003) period. In the pre-SOX period, I do not find statistically significant association between any of the fee ratios and the auditors propensity to issue a going concern opinion. However, in the post-SOX period, I find evidence that higher audit fee and total fee ratios are positively associated with the auditors propensity to issue a going concern opinion. That is, post-SOX, relatively more important clients are more likely to receive a going concern opinion. These results allay concerns that auditor independence is compromised for significant clients. Key Words: auditor independence, going concern, audit fee, non-audit fee.

2
Electronic copy available at: http://ssrn.com/abstract=1108189

Does Client Importance Affect Auditor Independence at the Office Level? Empirical Evidence from Going Concern Opinions
1. Introduction This study addresses the question of whether auditors are less likely to act independently when dealing with larger, more economically significant clients. I examine whether the exercise of auditor independence, proxied by the auditors willingness to issue a going concern opinion, is associated with the proportion of audit fees, non-audit service fees, or total fees a distressed, public client contributes to the total public-client fees earned by an individual audit office. I also investigate the impact of the Sarbanes-Oxley Act (SOX) on auditor independence by comparing the effect of client importance on auditor reporting decisions during the pre-SOX (2001) versus post-SOX (2003) periods. Auditor independence has come under increased scrutiny over the past several years because of highly publicized accounting scandals, allegedly associated with audit failures and with the growing amount of non-audit service fees that audit firms receive from audit clients. Some observers contend that large non-audit service fees can cause auditors to become financially dependent on their clients (e.g., Levitt 2000). Several studies examining fees and investors perceptions of auditor independence document that when independence-in-appearance has been impaired (i.e., when auditors receive large non-audit fees from clients), the perception of auditor independence is damaged (Krishnan et al. 2005; Francis and Ke 2006; Krishnamurthy et al. 2006; Khurana and Raman 2006). To address the threat to auditor independence posed by non-audit fees, in 2001 the U.S. Securities and Exchange Commission (SEC) began to require public companies to disclose audit and non-audit service fees in their proxy statements. The SEC also limits the circumstances under which an audit firm can provide financial information system design and implementation (FISDI) services, and sets monetary limits on fees for internal audit services (SEC

2000). After the Enron and WorldCom scandals and the collapse of Arthur Andersen, Congress passed the Sarbanes-Oxley Act of 2002 (SOX), which banned audit firms from providing FISDI, internal audit, and certain other services to their audit clients. Recently, the Public Company Accounting Oversight Board issued guidance restricting the scope of acceptable tax planning services in response to alleged overly aggressive tax planning by several large accounting firms (PCAOB 2005). Collectively, these actions indicate a concern among regulators and investors that some auditors may compromise their audit independence in exchange for large amounts of non-audit services fees from their audit clients. However, previous empirical studies have generally failed to detect a negative association between non-audit or audit fees and proxies for auditor independence-in-fact (e.g. DeFond et al. 2002; Ashbaugh et al. 2003; Kinney et al. 2004; Larcker and Richardson 2004). Some studies have even reported a positive association (Reynolds and Francis 2001; Geiger and Rama 2003). Most prior studies on auditor independence focus on independence at the national audit firm level. However, recent research suggests that auditor incentives and economic dependence may be better captured at the local office level, because local offices contract with clients, administer audits, make audit decisions, and issue audit reports. Moreover, for an individual office of an audit firm, a single client can represent a large portion of office-level revenues, yet play a much smaller economic role at the national audit firm level (Francis et al. 1999). Thus, the economic impact of large clients is potentially more important to the engagement offices wellbeing than to the audit firm as a whole (Francis et al. 1999; Reynolds and Francis 2001). Several audit firm office-level studies have examined auditor independence using either client sales data (Reynolds and Francis 2001) or non-US fee data (Craswell et al. 2002; Ferguson et al. 2004) to proxy for client influence. Studies using non-US fee data have examined separately

the effects of audit fees and non-audit fees on auditor independence. However, if the overall auditor-client economic bond creates the primary threat to auditor independence, then total fees would seem an important measure. Both audit and non-audit fees can contribute to the economic bond as both are paid to the auditors (DeFond and Francis 2005; Francis 2006). Current data suggest that while non-audit fees have recently declined, audit fees have simultaneously increased dramatically (e.g. Asthana et al. 2004; Weil 2004; Gullapalli 2005). Thus, examining the combined effect of audit and non-audit fees effectively captures the overall potential threat to auditor independence. In addition, while previous studies have examined pre-SOX data, SOX specifically banned certain non-audit services to address regulators and investors concerns over auditor independence. Therefore, to the extent that auditor independence was compromised before SOX, it is important to examine whether the association between fees and auditor independence changes after SOX implementation. This study extends prior research by including post-SOX data at the local office level. Following prior research, I focus on distressed firms, because the going concern decision is more salient among this group (Hopwood et al. 1994; Mutchler et al. 1997; DeFond et al. 2002). I analyze 1,681 distressed firms in 2001, of which 126 receive first-time going concern audit reports; and 1,780 distressed firms in 2003, of which 108 receive first-time going concern audit reports. I focus on firms receiving first-time going concern opinions because previous studies suggest that rendering an initial going concern opinion to a client is a particularly difficult decision for the auditor (Kida 1980; Mutchler 1984). The ratios of client audit fees, non-audit fees, or total fees to total audit office fee revenue are included in logistic regressions that analyze the determinants of going concern opinions. Observing negative relations between fee ratios and going concern opinions is consistent with the concern that auditors receiving larger audit fees are less likely to act independently by issuing a going concern opinion.

Consistent with prior literature (e.g. DeFond et al. 2002; Craswell et al. 2002), I find no statistically significant associations between any of the fee ratios and the auditors propensity to issue a going concern opinion in the 2001 pre-SOX period. However, in the 2003 post-SOX period, I find that the audit fee ratio and the total fee ratio are positively associated with the auditors propensity to issue going concern opinions. That is, clients paying higher audit and total fees are more likely to receive a going concern report. Further, this relation is driven primarily by Big 4 auditors. None of these results support concerns that higher fees create problematic economic dependence for auditors with respect to their going concern decisions. Instead, they are consistent with market and regulatory incentives, such as firm reputation preservation and litigation risk avoidance, protecting auditor independence. The remainder of the paper is organized as follows. Section 2 provides a review of relevant prior research. Section 3 develops the research question and hypotheses. Section 4 describes the research methods and section 5 presents the results. Section 6 summarizes my findings. 2. Review of prior research Auditor independence can be defined as the joint probability that the auditor will detect and report a discovered breach in the financial reports (DeAngelo 1981; Watts and Zimmerman 1983). A large body of theoretical and empirical research suggests that because of reputation concerns and litigation costs, auditors have both market-based and institutional incentives to act independently (Watts and Zimmerman 1983; Palmrose 1988; Krishnan and Krishnan 1997). However, there are also forces that potentially threaten auditor independence (DeFond et al. 2002). DeAngelo (1981) develops a model where an auditor faces a conflict of interest. The incentives for

the auditor to compromise independence are related to client importance, the ratio of quasi rents specific to the client divided by all other quasi rents.1 Empirical research examining the relationship between fees (audit and non-audit) and proxy for impaired independence at the national level generally fails to find significant associations. The measures of impairment in these studies include earnings attributes, earnings restatements, and auditor reports (e.g. DeFond et al. 2002; Ashbaugh et al. 2003; Kinney et al. 2004). At the office level, Chung and Kallapur (2003) also find no relation between absolute discretionary accruals and non-audit fee and total fee ratios using a surrogate measure for audit practice office revenue. They estimate the surrogate measure by allocating an audit firms total revenue to its audit offices in proportion to the sum of log(sales) of each offices clients. Some studies do report significant associations, although the relations have differing interpretations. For example, Gaver and Paterson (2007) examine insurance firms and find that the tendency of financially weaker insurers to understate reserves is significantly reduced when they are economically important to the audit office. In contrast, using a sample of U.K. firms, Ferguson et al. (2004) find that the decile rank of a particular clients non-audit service fees is associated with more discretionary accruals and the likelihood of restatements. Similarly, Basioudis et al. (2006) find, after controlling for office-level influence of audit clients, that higher non-audit fees are associated with fewer going-concern reports for U.K. financially stressed companies. Table 1 summarizes the findings of prior literature on fee dependence and auditor independence. ------------- Insert Table 1 here --------------

Empirically, the quasi-rent ratio is unobservable (Chung and Kallapur 2003). Client importance generally is measured as the ratio of fees from a client divided by the audit firms total revenue (Chung and Kallapur 2003; Larcker and Richardson 2004)

Two prior studies are particularly relevant to this study because both examine the relation between client importance at the office level and auditor reporting decisions. Craswell et al. (2002) use Australian data in 1994 and 1996 to examine the association between audit fee dependence, measured as the ratio of client audit fees to total audit office fees, and the propensity to issue qualified audit opinions. They report no association between audit fee dependence and qualified audit opinions. Their study focuses on serious opinion qualifications, such as the auditors inability to form an opinion, inherent uncertainty underlying the accounting numbers, adverse opinions, or scope limitations. Reynolds and Francis (2001) use 1996 data to examine whether large clients influence office-level auditor reporting decisions by Big 5 auditors. Client influence is measured as the proportion of the clients net sales to the total net sales of all clients audited by the report-issuing office. They find client influence is negatively associated with discretionary accruals, and positively associated with auditor going-concern reports. Their results suggest that Big 5 auditors report more conservatively for their larger clients. This is consistent with the notion that, when making reporting judgments, auditors are more concerned with protecting their reputations (reputation protection theory), rather than influenced by important clients (economic dependence theory). This study extends these two studies in the following ways. First, I use the proportion of audit fees, non-audit fees, and total fees contributed by the specific client to the local offices total fees. Second, I use both pre- and post-SOX data to provide evidence on the efficacy of SOX in mitigating the potential auditor independence problems. 3. Hypothesis development Client importance and going concern opinions Prior research shows that clients receiving going concern opinions experience negative market reactions (Loudder et al. 1992; Blay and Geiger 2001) and increased risk of business

failure (Geiger et al. 1998). As a result, clients receiving going concern opinions are more likely to change auditors in hope of finding a more pliable auditor and receiving more favorable treatment (Mutchler 1984; Geiger et al. 1998). The impact of losing an important client is arguably more important to the engagement partner and the local offices well-being than to the audit firm as a whole (Reynolds and Francis 2001; DeFond and Francis 2005). Following this, local offices should have a greater economic dependence on a large client than the overall firm, and are thus more likely to treat such clients favorably. However, local offices also have incentives to protect their reputation and to reduce their litigation risk. Questionable audits can impair an offices reputation and adversely affect its ability to obtain and retain clients in its local market (Reynolds and Francis 2001). While economic dependence arguably exists for large clients, these clients also pose greater litigation risk (Stice 1991; Lys and Watts 1994). Carcello and Palmrose (1994) provide evidence that for bankrupt clients, prior modified audit reports could serve to weaken plaintiffs claims against auditors. Therefore, it is unclear whether the economic bond between auditors and important distressed clients will dominate the reputation and litigation effects for local offices, especially in the pre-SOX period, when the litigation risk was relatively lower. The above arguments lead to the first hypothesis (stated in the null form): H1: There is no association between auditors propensity to issue going concern opinions and the economic importance of distressed clients to their local office. Client importance is measured as the ratio of the individual clients audit fees, non-audit fees, and total fees to the total fee revenue of a local practice office. Observing a negative association between the fee ratios and going concern opinions would provide support for the economic dependence theory. Effects of SOX

After the events of 2002 (e.g. the collapse of Andersen, the passage of SOX, and the new oversight by PCAOB), the risk associated with auditing increased dramatically. For example, the change of regulatory authority for public company engagements from the private sector AICPA to the quasi-governmental PCAOB increased regulatory risk to audit firms, due to the likely advent of tougher standards and inspections (Johnstone and Bedard 2007).2 The insurance- and other liability-related costs also increased significantly in the post-SOX period (Rama and Read 2006). To mitigate the increased litigation risk and protect reputation capital in this era, auditors either resign from risky clients (Rama and Read 2006), require their clients to recognize bad news in a timely fashion (Krishnan 2007), or increase risk responsiveness in planning the extent of audit tests (Johnstone and Bedard 2007). Prior studies suggest that when clients pay large amounts of non-audit or total fees, investors react negatively (Krishnan et al. 2005; Francis and Ke 2006; Krishnamurthy et al. 2006; Khurana and Raman 2006). Thus, auditors may come under greater scrutiny when they conduct audits for important clients, which would lead auditors to focus more on maintaining independence-in-fact. This will be especially true in the post-SOX era because of the heightened litigation environment and the ban on certain non-audit services after the passage of SOX. Geiger et al. (2005) find that auditors in general are more likely to issue going-concern opinions after December 2001, consistent with the view that auditors report more conservatively in the post-SOX period. The response letters of the Big 4 accounting firms to the PCAOB Inspection Reports also indicate that they made organizational and structural changes after SOX.3 In fact, the U.S. Treasury Secretary expressed concern that auditors may have become overly strict with clients
2

The inspections from PCAOB are much more punitive in nature than the peer reviews that are primarily corrective in nature (Read et al. 2004; Rama and Read 2006). 3 For example, KPMG in the 2005 response letter states :we have further strengthened our commitment to quality, made fundamental changes to our business and landmark improvements to our risk management structure; and put cultural and governance reforms into effect that reflect the highest ethical standards. The PCAOBs inspection reports are available from the following website: http://www.pcaobus.org/Inspections/Public_Reports/index.aspx

after SOX (Solomon 2007). Therefore, I expect to find auditors less lenient towards influential clients in the post-SOX period. My hypothesis related to the SOX effect is (stated in the alternative form): H2: Auditors are more likely to issue going concern opinions to distressed clients that are of greater economic importance to their local office in the post-SOX period. 4. Research method Sample To calculate the proportion of audit fees, non-audit fees, and total fees of a specific client to a local offices total revenue, I obtain a sample of public companies having necessary office location and fee data in the Audit Analytics Database. This process results in a sample of 6,473 client companies in 2001 and 11,313 client companies in 2003. Sample companies must also have necessary financial information available from Compustat, which reduces the sample to 4,573 companies in 2001 and 5,844 companies in 2003.4 Following prior research (DeFond et al. 2002; Geiger and Rama 2003), I restrict my analyses to financially distressed companies and first-time going concern receivers. Financially distressed firms are defined as firms that report either negative net income or negative operating cash flows during the current fiscal year (Reynolds and Francis 2001; DeFond et al. 2002).5 Finally, I delete all financial institutions. These steps yield a final sample of 1,681 test companies in 2001, including 126 that receive first-time going concern

The sample difference between 2001 and 2003 is mainly due to missing fee data in 2001. I randomly check 50 companies proxy statements in 2001, and find that although the SEC requires companies to disclose fee information in their post-Feburary 5, 2001 proxy statements, some companies dont disclose, and most of the non -disclosure companies are small (with average revenue of $3.7 million compared to $635.1 million for companies that disclosed fee data in 2001). Similarly, the companies without financial information from Compustat are also likely to be small. Because small companies are less likely to be important, but are more likely to be distressed, missing small companies in the sample could potentially bias against finding a negative association between client importance and auditor going concern opinions. 5 I also define financially distressed companies as reporting both negative earnings and negative operating cash flows. Sample size decreases to 810 from 1,681 in 2001, including 97 companies receiving first-time going concern opinions, and decreases to 898 from 1,780 in 2003, including 80 first-time going concern companies. Results indicate that none of the fee ratios are significant in regressions for either 2001 or 2003.

opinions, and 1,780 test companies in 2003, including 108 that receive first-time going concern opinions. Research Model The following logistic model is used to test the hypotheses. All variables are measured in fiscal year 2001 or 2003, unless specified otherwise. GC = b0 + b1AUDFEE / NONAUDFEE / TOTALFEE + b2SALES + b3ROA + b4LEVERAGE + b5LIQUIDITY + b6CHGDT + b7PRLOSS + b8PRNOCF + b9BIG N + b10DELAY + b11NEWDEBT (1) where: GC = 1 for companies receiving first-time going concern opinions, 0 otherwise.

AUDFEE / NONAUDFEE / TOTALFEE = client audit fees / non-audit fees / or total fees, each divided by the total revenue of the local office that issues the audit report. SALES ROA = natural logarithm of clients total sales at the end of the year. = net income divided by total assets at the end of the year.

LEVERAGE = total liabilities divided by total assets at the end of the year. LIQUIDITY = total current assets divided by total current liabilities at the end of the year. CHGDT = the change in long-term debt divided by total assets, from year 2000 to 2001(or 2002 to 2003). = an indicator variable equal to 1 if the company reported negative net income in the prior year (2000 or 2002), 0 otherwise. = an indicator variable equal to 1 if the company reported negative operating cash flows in the prior year (2000 or 2002), 0 otherwise. = an indicator variable equal to 1 if the auditor is Big 4 (5), 0 otherwise. = number of days between fiscal year-end and the auditors report signing date. = 1 if the company issues new debt in the subsequent year (2002 or 2004), 0 otherwise.

PRLOSS

PRNOCF

BIG N DELAY

NEWDEBT

10

AUDFEE, NONAUDFEE and TOTALFEE are the test variables. AUDFEE and NONAUDFEE are used in one model, TOTALFEE in the other. If higher fees impair auditor independence, i.e., if the economic bond between auditors and important distressed clients dominates the reputation and litigation effects, their coefficients should be negative. The model controls for the effects of other factors that likely affect auditors probability of issuing going concern opinions: client size, extent of financial distress, audit firm size, audit reporting lag and client new financing. Prior research finds a negative relation between a companys size and its likelihood of receiving a going-concern opinion after controlling for the relation between size and bankruptcy (McKeown et al. 1991; Mutchler et al. 1997). This result could arise because auditors think large companies have more resources to avoid bankruptcy (Mutchler et al. 1997), or because large companies have more negotiation power with auditors in the opinion decision process (McKeown et al. 1991). I expect a negative association between SALES and GC. Financial distress factors include ROA, LEVERAGE, CHGDT, LIQUIDITY, PRLOSS and PRNOCF. I use net income divided by total assets (ROA) and total liabilities divided by total assets (LEVERAGE) to control for companies financial conditions. LIQUIDITY is measured as the current ratio and is used to control for companies liquidity risk. Mutchler et al. (1997) find that debt covenant violations are positively related to the probability of receiving a going concern opinion. I include CHGDT because increases in debt are likely to move companies closer to violations (Reynolds and Francis 2001). Alternatively, CHGDT can proxy for the ability to raise additional debt capital in the future, and hence funding viability. PRLOSS and PRNOCF are included because firms with multiple-year negative operating cash flows or negative net incomes are more likely to fail (Reynolds and Francis 2001; DeFond et al. 2002). I expect negative associations between ROA and GC, as well as between LIQUIDITY and GC. I expect positive

11

associations between LEVERAGE, PRLOSS, PRNOCF and GC. I do not have a directional prediction on the association between CHGDT and GC. Large auditors have more quasi-rents at stake if there is a questionable audit (DeAngelo 1981). They are also likely to suffer more reputation loss due to their larger investment in reputation capital. Thus large auditors may be more likely to issue going concern opinions, although prior studies find inconsistent results (e.g. Mutchler et al. 1997; Behn et al. 2001; DeFond et al. 2002; Geiger and Rama 2003). Auditor type is measured as a dichotomous variable: Big N versus non-Big N. I expect a positive association between BIG N and GC. I include audit report lag (DELAY) because prior research finds that going concern companies are associated with longer reporting lags (McKeown et al. 1991; Mutchler et al. 1997). I expect a positive relationship between DELAY and GC. In addition, I control for clients plans to issue new debt because Mutchler et al. (1997) find that new financing can reduce the probability of bankruptcy. Behn et al. (2001) also note that auditors may view clients new borrowing as evidence that the company has the capability to meet loan requirements in the near term. I expect a negative relationship between NEWDEBT and GC. 5. Results Descriptive statistics Table 2 presents descriptive statistics for financially distressed public companies in 2001 and 2003 (Panels A and B, respectively). In 2001, distressed clients total fees average 9.5 percent of all office-level revenue, audit fees contribute 5.2 percent, and non-audit fees contribute 4.3 percent. In 2003, the overall average contributed by distressed companies is similar, 9.7 percent, but audit fees now contribute 7.5 percent, while non-audit fees contribute only 2.2 percent. The change in both the audit and non-audit fee ratios is statistically significant (p-values are less than

12

0.001.) The increase in post-SOX audit fees is consistent with those noted in recent studies (Gullapalli 2005; Ettredge et al. 2007). Table 2 also compares fee ratios of clients receiving first-time going concern opinions to those receiving clean opinions. In 2001, the differences between the two groups are mainly insignificant for all three fee ratios. The one exception is the median test for the non-audit fee ratio, where non-audit fees are significantly higher for clients not receiving a going concern report. This result is consistent with concerns that clients contributing more non-audit fees receive more lenient treatment in the pre-SOX period. In contrast, in 2003, the difference between the non-audit fee ratios is not significant. However, the audit fee and total fee ratios are significantly higher for those receiving going concern opinions. This evidence is consistent with auditors in the post-SOX environment being more willing to issue unfavorable audit opinions to clients paying more fees, particularly audit fees. Thus, the 2003 univariate results do not support economic dependence concerns. Rather, this pattern is consistent with either increased conservatism in auditor going concern reporting postSOX, or with auditors performing more audit work for clients perceived to be more troubled. Of course, these possibilities are not mutually exclusive. Regarding control variables, in both years companies receiving going concern opinions are smaller, have lower ROA, are more highly leveraged, have higher liquidity risk, are more likely to report negative net incomes and negative operating cash flows in the prior year, and experience longer audit report lags. These results are consistent with prior studies (e.g. Mutchler et al. 1997; DeFond et al. 2002). However, the univariate results indicate that Big N auditors issue fewer going concern opinions. This result may be due to the clientele differences between auditor types. For instance, the average client revenue for Big N auditors is $996 and $792 million in 2001 and 2003, compared to $241 and $62 million for non-Big N auditors. The main difference between

13

2001 and 2003 is that in 2003 going concern companies are also less likely to issue new debt in the subsequent year. ------------ Insert Table 2 here ----------Table 3 presents the correlation tables for the dependent and independent variables. In both 2001 and 2003, the three fee ratios are highly correlated with each other. Although the correlations of several variables are above 0.35, the highest variance inflation factor (VIF) observed in regressions is 1.88 in 2001 and 2.12 in 2003, which is well below the suggested multicollinearity problem threshold of ten (Marquandt 1980; Gujarati 1995). Examination of standard errors and coefficient magnitude also indicates the regressions are not sensitive to inclusion or exclusion of the highly correlated variables. Thus, multicollinearity is unlikely to be a problem (Hosmer and Lemeshow 1989). ------------ Insert Table 3 here ----------Logistic regression results Table 4 presents logistic regression model results for 2001 (Panel A) and 2003 (Panel B). Two models are presented for each year. Model (1a) includes AUDFEE and NONAUDFEE as the test variables, and Model (1b) tests TOTALFEE. All four models are highly significant at the 0.001 level. Test variables In 2001, none of the fee ratio coefficients is significant. However, in 2003, both AUDFEE and TOTALFEE are positively associated with the presence of a going concern opinion (p-values < 0.05), while NONAUDFEE remains insignificant.6 Consistent with univariate results, these

I also examine the impact of each category of non-audit service fees: audit-related, FISDI, tax and other service fees. Results indicate none of these categories is associated with the auditors propensity to issue a going concern opinion in either 2001 or 2003. (The FISDI fee variable is not included in regressions for 2003, as SOX banned auditors from providing this type of service).

14

regression results suggest that in 2003, but not 2001, clients contributing relatively more audit fees to the local office are more likely to receive a going concern report. To assess the significance of the temporal switch from pre- to post-SOX, I use an analog of the Chow test for logistic regression (Allison 1999; DeMaris 2004).7 The Chi-square test results (untabulated) indicate that the change in audit and total fee coefficients between 2001 and 2003 is not statistically significant. Overall, this evidence does not support the concern that auditor independence is impaired for significant clients. Rather, results are consistent with the argument that reputation effects and potential litigation costs prevent leniency for such clients (e.g. Reynolds and Francis 2001; DeFond et al. 2002). In fact, 2003 results suggest that post-SOX, auditors may be more conservative when issuing going concern reports for important distressed public clients. This may be due to a perception of heightened audit risk in this post-scandal, post-SOX period, since larger clients tend to pose a greater litigation risk (Stice 1991; Lys and Watts 1994). An alternative explanation for this result is that post-SOX, auditors perform additional work for clients receiving first-time going concern reports, and this additional effort is reflected in audit fees, but not fully controlled by other model variables. Control variables Consistent with prior literature, going concern companies are smaller, have less liquidity, and experience longer audit report lags in both 2001 and 2003. Big N auditors tend to issue more going concern reports in 2001 than non-Big N auditors, although there is no such distinction in 2003. Similarly, LEVERAGE, CHGDT, and PRNOCF are significant in 2001, but not in 2003. In 2001, companies with higher leverage and prior year negative operating cash flows are more likely
7

The test statistic is Chi-square = -2lnLc [-2lnL1 + (-2lnL2)], where lnLc is the fitted log-likelihood for the combined sample, lnL1 is the fitted log-likelihood for group 1 (pre-SOX), and lnL2 is the fitted log-likelihood for group 2 (postSOX).

15

to receive a going concern opinion. However, going concern companies tend to report smaller increases in long-term debt (CHGDT), likely because lenders do not consider such companies to be acceptable credit risks. ROA, PRLOSS, and NEWDEBT are significant in 2003, but not in 2001. In 2003, companies with lower ROA and prior year negative net incomes are more likely to receive a going concern opinion. Companies that issued new debt in the subsequent year are less likely to receive a going concern opinion. ------------ Insert Table 4 here ----------Recapping test results, logistic regression results show no statistically significant association between going concern reports and the audit fees, non-audit fees or total fees contributed by a client to the total revenue of their auditors local office in 2001. However, in 2003, clients contributing a greater proportion of audit and total fees are more likely to receive a going concern report. One explanation for these results is that auditors may report more conservatively in 2003 on significant, distressed public clients. These results complement the findings of Geiger et al. (2005), who find evidence that auditors report more conservatively on all distressed public firms in the post-SOX period. However, as noted above, the change in audit and total fee coefficients between 2001 and 2003 is not statistically significant. The next section further investigates this finding and considers alternative explanations. Additional analyses This section further explores the role of auditor type in issuing going control reports.8 It also provides additional analyses to investigate the possibility that the positive association between fees and going concern reports in 2003 is attributable to additional audit effort expended on going concern clients. Auditor Type

I thank the associate editor for suggesting this analysis.

16

In regressions reported in Table 4, Big N auditors are more likely to issue going concern reports in 2001, but not in 2003. It is possible that this change is due to Big N auditors realigning their portfolios between 2001 and 2003 to reduce their exposure to risky clients. To assess any effects of such a selection bias, I use a treatment effects model.9 Results are similar to those shown in Table 4 for both 2001 and 2003 after considering the effects of selectivity. As an additional analysis of auditor type, I examine the model separately for Big N and non-Big N clients. (Big N auditor is not included as a control variable in these models.) If expected litigation risk and reputation loss are strong incentives for auditors to maintain their independence, I expect the association between fee ratios and going concern opinions to vary by auditor type, because expected litigation costs and reputation loss are greater for large auditors, especially in the post-SOX period (Rama and Read 2006; Ashbaugh-Skaife et al. 2007). Table 5, Panel A reports results for Big N and non-Big N clients separately in 2001, while Panel B shows results for 2003. In 2001, all fee ratios are insignificant for both Big N and non-Big N clients. In 2003, AUDFEE and TOTALFEE for Big N clients are significantly positive (pvalues < 0.05), and are marginally significant for non-Big N clients (p-values < 0.10). More importantly, the Chow test analog indicates significant changes in the association between fee ratios and going concern opinions from 2001 to 2003 for Big N clients, but not for non-Big N clients.10 Specifically, compared to 2001, Big N auditors in 2003 are three percent more likely to issue going concern opinions when audit fee ratios change by one standard deviation, and are one percent more likely to issue going concern opinions when total fee ratios change by one standard

Following Weber and Willenborg (2003), the first stage of the treatment effects analysis is to model auditor choice. The first stage model is BIG4 = b0 + b1SALES + b2ROA + b3LEVERAGE + b4LIQUIDITY + b5CHGDT + b6PRLOSS + b7PRNOCF + b8DELAY. The inverse Mills ratio generated by this step is added to the models presented in Table 4. 10 For the audit fee ratio, 2 = 6.607 and the one-tailed p-value is < 0.01. For the total fee ratio, 2 = 2.530 and the one-tailed p-value is <0.10.

17

deviation.11 Together with the results in Table 4, these results suggest that auditors, especially Big N auditors, tend to report more conservatively in the post-SOX period for distressed public companies contributing relatively more fees. Higher audit fees and audit effort Going concern companies likely require more audit work, and may be charged a risk premium, both resulting in higher audit fees (DeFond et al. 2002). Therefore, as mentioned previously, the positive association between audit fee ratios and first-time going concern reports in 2003 could be due to these factors rather than more conservative reporting.12 Although the model includes control variables for effort and risk, these effects may not be fully captured by the control variables. To assess this possibility, I conduct three additional tests. Results in this section are not tabulated. First, if auditors perform more work or charge higher risk premiums for first-time going concern companies in 2003, the increase in their audit fees from 2002 to 2003 should be greater than the increase for clean-opinion companies.13 To test this, I add the change in audit fees from 2002 to 2003, scaled by the average assets for 2002 and 2003, to models in Table 4. Results indicate the change in audit fees from 2002 to 2003 is not significantly associated with the likelihood of a 2003 going concern report. Further, results for AUDFEE and TOTFEE become stronger (both p-values < 0.01, rather than 0.05). Second, I substitute a lagged audit fee ratio for the current year audit fee ratio. The lagged audit fee ratio is the ratio of audit fees in 2002 to the total office revenue in 2002. The rationale for

11

Economic magnitude = coefficientp(1-p)one standard deviation of the variable. Where p = the probability that the dependent variable equals one. 12 Arguably, these clients are still relatively more important to the audit office, even if the greater fees arise from additional efforts and risk premiums. However, since these fees are intended to compensate for costs imposed on the auditor, they are less likely to represent profits. 13 I also compare the change in audit fees from 2002 to 2003 for first-time going concern companies to that for continuing going concern companies. The result shows there is no statistically significant difference for the change in audit fees between these two groups.

18

this substitution is that the clients importance to the audit offices in 2002 should be highly correlated with their importance in 2003. However, audit fees in 2002, when the client received a clean opinion, do not include extra work related to a going-concern client. Thus, if additional effort specific to first-time going-concern clients is mainly responsible for the higher fees in 2003, 2002 fee ratios should not be associated with 2003 going concern reports. The result indicates the coefficient for the lagged audit fee ratio is also positive and significant (p-value < 0.05). Third, I include clients unexpected fees, after controlling for client characteristics and audit risk factors, to models in Table 4. To measure unexpected fees, I regress the natural logarithm of audit fees, non-audit fees and total fees on variables drawn from prior research (Francis 1984; Craswell et al. 1995; Hay et al. 2006; Ettredge et al. 2007). These regressions are performed for both 2001 and 2003, resulting in six separate regressions.14 The residual from each OLS model is unexpected fees for a fee type and fee year. UAFEE, UNAFEE, and UTOTFEE denote unexpected audit fees, non-audit fees and total fees, respectively. Since these residuals represent determinants of fees not captured by the standard fee models, additional audit effort and risk premium effects may be captured here. Each of the fee models is highly significant and has good explanatory power, with adjusted R2s ranging from 0.642 to 0.809. Model variables results are consistent with prior studies, except for INVENTORY, which is significantly negative in 2003. I add UAFEE, UNAFEE, or UTOTFEE to models in Table 4. Results indicate none of the unexpected fee variables is significant and the results for the fee ratios remain unchanged in both

14

The OLS model is: Ln(audit fees) / Ln(non-audit fees) / Ln(total fees) = b0+ b1LnAT+ b2ADJREV +b3ROA+ b4LEVERAGE+ b5CHGDT+ b6LIQUIDITY + b7PRLOSS+ b8PRNOCF + b9BIG4+ b10DELAY + b11LOSS+ b12OCF+ b13RESTATE + b14BUSY + b15RECEIVABLE + b16INVENTORY+ b17SEGMENT+ b18FOREIGN + b19SPECIALITEM, where LnAT= natural log of assets; ADJREV = sales/assets; LOSS = 1 if the firm report negative net incomes in the current year, 0 otherwise; OCF = operating cash flows/assets; RESTATE = 1 if the firm restate their earnings in the current year, 0 otherwise; BUSY = 1 if the firms fiscal year -end is from December to March, 0 otherwise; RECEIVABLE = accounts receivable/assets; INVENTORY = inventory/assets; SEGMENT =natural log of number of reported segments; FOREIGN =1 if the firm has foreign operations, 0 otherwise; SPECIALITEM = special items/assets. All other variables are defined in conjunction with model (1).

19

2001 and 2003. However, when controlling for unexpected fees, the change in coefficient of AUDFEE from 2001 to 2003 becomes marginally significant (the Chow test analog 2 = 2.202, one-tailed p-value < 0.10). Overall, these results do not support the alternate possibility that results in Table 4 are due to effects of increased audit effort on behalf of going concern clients, not otherwise captured by model variables. Sensitivity tests In this section I report results of a series of sensitivity tests. Again, results are not tabulated. Local audit office size effects Small audit firm offices usually have fewer publicly listed companies, and the public companies they do have are more likely to dominate in the audit firms portfolio (Craswell et al. 2002). To evaluate possible effects of this, I conduct two tests. First, I interact the fee ratios with a local office size indicator (= 1 if the total revenue of the local office is above the median for the sample; 0 otherwise). Results indicate that neither of the interaction terms is significant in any of the regressions, nor is the office size indicator. Second, I use only the smallest third of the local offices (based on office revenue) in the Table 4 models. Results are similar to those reported in Table 4. Each of these results suggests that the effect of client importance on auditors reporting decisions is not significantly influenced by the size of the local offices. Auditor switching effects Recent studies suggest that in the post-SOX period, there is an increased frequency of clients, particularly risky clients, shifting from Big 4 to non-Big 4 auditors (Cassell et al. 2006; Ettredge et al. 2007). This has two possible effects on the results presented above. First, if switching is associated with discounted fees in the early years of the new auditor-client

20

relationship (Simon and Francis 1988; Gregory and Collier 1996; Walker and Casterella 2000), then lower fees could bias against finding fee dependence for new engagements (Craswell et al. 2002). Second, non-Big 4 auditors are more likely to have smaller local offices, and thus might be dominated by the new, relatively large, but risky clients switching from the Big 4 in 2003. If so, the positive association between fee ratios and going concern reports may be due to the switching clients. To assess possible switching effects, I re-estimate all the models after removing companies that switched auditors in the year prior to each year studied. I also delete companies from each year studied if the reports are issued by the new auditors. Test results do not change except the result for TOTFEE in 2003 strengthens (p-value < 0.01, rather than 0.05). Comparison group The comparison group for all analyses to this point is based on distressed financial conditions. Here, I limit the observations to the third of the distressed sample with the longest audit report lags. This analysis is based on the assumption that the delay in reporting is most likely to be attributable to auditor-client negotiations over problematic issues that involve the exercise of independent audit judgment (Craswell et al. 2002). Here, none of the fee ratios is significant in either 2001 or 2003. Thus, even in cases where auditor-client negotiation may have been extensive, greater fees are not associated with a more lenient reporting. Power of the tests To assess whether insignificant results for all fee ratios in 2001 and non-audit fee ratios in 2003 are due to a lack of power in the analyses, I follow Craswell et al. (2002) by adding one standard deviation to each of the fee ratios. If the test lacks power, an increase of one standard deviation in the explanatory variable should affect the predicted choice probability (MacKieMason 1990). Results show that when fee ratios are increased by one standard deviation, the

21

proportion of correctly classified observations remains unchanged, which suggests that the auditors going concern report decision is not sensitive to the increase in fee dependence. Other specifications of client importance Finally, I focus on different measures of client importance. First I examine auditor reporting decisions for those public companies having the most potential influence, which is defined as having audit fee ratios greater than the sample median. Second, I re-define AUDFEE as the ratio of client audit fees to total local office audit fees, and NONAUDFEE as the ratio of client non-audit fees to total local office non-audit fees. Test results for both 2001 and 2003 remain the same when using either of these alternative specifications. 6. Conclusions This study investigates the effect of client importance on auditor independence. I measure client importance as the proportion of total local office revenue received from a client in audit fees, non-audit fees, or total fees. Auditor independence is measured by the auditors propensity to issue a going concern opinion to a distressed client. The analysis is based on samples of financially distressed public client firms in 2001 (pre-SOX) and 2003 (post-SOX). Results indicate no statistically significant association between the audit fees, non-audit fees, or total fees and going concern opinions in 2001. This is consistent with findings in prior studies using national-level firm analysis (DeFond et al. 2002). However, in 2003 results show a positive association between audit (and total) fees and going concern opinions. Non-audit fees continue to be unassociated with going concern opinions. These results are generally robust to a variety of alternative definitions and sensitivity tests. Additional analysis indicates that the association between distressed companies contributing more audit fees and receiving going concern reports is more pronounced for Big N clients.

22

The findings in this study do not support concerns that distressed companies contributing relatively more public-client fees receive more lenient treatment from their auditors. Rather, in 2003, companies contributing more fees are more likely to receive going concern reports. This is consistent with the view that auditors reporting more conservatively for larger clients to protect their reputations and to avoid litigation costs in the sensitive post-SOX period. However, the association is also consistent with firms performing more audit work or charging a higher risk premium for troubled clients in the latter period. A series of additional tests does not find evidence supporting this alternative explanation, but it cannot be ruled out definitively. Future researchers may be able to obtain information about hours charged to such engagements to better separate these effects. Another limitation of this study is the limited time period, including only one year pre- and one year post-SOX. Analysis of the pre-SOX era is limited by fee data availability. But the immediate post-SOX year studied here may not prove representative of an equilibrium of the post-SOX audit market. This is another avenue for future research.

23

References: Allison, P.D. 1999. Comparing logit and probit coefficients across groups. Sociological Methods & Research 28: 186-208. Ashbaugh, H., R. LaFond, and B. Mayhew. 2003. Do non-audit services compromise auditor independence? Further evidence. The Accounting Review 78: 611-639. Ashbaugh-Skaife, H., D. Collins, and W. Kinney. 2007. The discovery and reporting of internal control deficiencies prior to SOX-mandated audits. Journal of Accounting and Economics 44: 166192. Asthana, S., S. Balsam, and S. Kim. 2004. The effect of Enron, Andersen, and Sarbanes-Oxley on the market for audit services. Working paper. Temple University Basioudis, I.G, M.A. Geiger, and V. Papanastasiou. 2006 Audit fees, non-audit fees, and auditor going-concern reporting decisions in the United Kingdom. Working Paper. Aston University and University of Richmond. Behn, B.K., S.E. Kaplan, and K.R. Krumwiede. 2001. Further evidence on the auditors goingconcern report: the influence of management plans. Auditing: A Journal of Practice & Theory 20: 13-28. Blay, A.D., and M. Geiger. 2001. Market expectations for first-time going-concern recipients. Journal of Accounting, Auditing & Finance 17: 209-226. Cassell, C., G. Giroux, L. A. Myers, and T. C. Omer. 2006. Audit firms client portfolio decisions in the face of increased regulation and constrained resources. Working Paper Texas A&M. Carcello, J.V., D.R. Hermanson, and H.F. Huss.1995. Temporal changes in bankruptcy-related reporting. Auditing: A Journal of Practice & Theory 14: 133-143. Carcello, J.V. and Z. Palmrose 1994. Auditor litigation and modified reporting on bankrupt clients. Journal of Accounting Research Vol. 32 (Supplement): 1-30. Chung, H., and S. Kallapur. 2003. Client importance, non-audit fees, and abnormal accruals. The Accounting Review 78: 931-966. Craswell, A. T., J. R. Francis and S. L. Taylor. 1995. Auditor brand name reputation and industry specializations. Journal of Accounting and Economics 20 (3): 297-322. Craswell, A., D.J. Stokes, and J. Laughton. 2002. Auditor Independence and Fee Dependence. Journal of Accounting and Economics 33: 253-275. DeAngelo, L. 1981. Auditor size and audit quality. Journal of Accounting and Economics 3: 183199.

24

DeFond, M.L., and J.R. Francis. 2005. Audit research after Sarbanes-Oxley. Auditing: A Journal of Practice & Theory 24 (Supplement): 5-30. DeFond, M.L., K. Raghunandan, and K.R. Subramanyam. 2002. Do non-audit service fees impair auditor independence? Evidence from going concern audit opinions. Journal of Accounting Research 40: 1247-1274. DeMaris, A. 2004. Regression with social data: modeling continuous and limited response variables. Wiley Series in Probability and Statistics: Wiley-IEEE. Ettredge, M., C. Li and S. Scholz 2007. Audit fees and auditor dismissals in the Sarbanes-Oxley era. Accounting Horizons, forthcoming. Ferguson, A., J.R. Francis, and D.J. Stokes. 2003. The effects of firm-wide and office-level industry expertise on audit pricing. The Accounting Review 78: 429-448. Ferguson, A., G. Seow, and D. Young. 2004. Nonaudit services and earnings management: UK evidence. Contemporary Accounting Research 21: 813-841. Firth, M. 2002. Auditor-provided consultancy services and their associations with audit fees and audit opinions. Journal of Business Finance & Accounting 29: 661-693. Francis, J. R. 1984. The effect of audit firm size on audit prices: A study of the Australian market. Journal of Accounting and Economics 6 (2): 133-151. Francis, J.R. 2006. Are auditors compromised by nonaudit services? Assessing the evidence. Contemporary Accounting Research 23 (3): 747-760. Francis, J.R., and B. Ke. 2006. Disclosure of fees paid to auditors and the market valuation of earnings surprises. Review of Accounting Studies 11(4): 495-523. Francis, J.R., D. Stokes, and D. Anderson. 1999. City markets as a unit of analysis in audit research and the re-examination of big 6 market shares. Abacus 35: 185-206. Francis, J.R., K. Reichelt, and D. Wang. 2005. The pricing of national and city-specific reputations for industry expertise in the U.S. audit market. The Accounting Review 80: 113-136. Frankel, R., M. Johnson, and K. Nelson. 2002. Auditor independence and earning quality. The Accounting Review 77 (Supplement): 71-105. Geiger, M.A., K. Raghundandan, and D.V. Rama. 1998. Costs associated with going-concern modified audit opinions: an analysis of auditor changes, subsequent opinions, and client failures. Advances in Accounting 16: 117-139.

25

Geiger, M.A., K. Raghundandan, and D.V. Rama 2005. Recent changes in the association between bankruptcies and prior auditor opinions. Auditing: A Journal of Practice & Theory 24 (1): 21-35. Geiger, M.A., and D.V. Rama 2003. Audit fees, nonaudit fees, and auditor reporting on stressed companies. Auditing: A Journal of Practice & Theory 22 (1): 53-69. Gaver, J and Paterson, J. 2007. The influence of large clients on office-level auditor oversight: Evidence from the property-casualty insurance industry. Journal of Accounting and Economics 43: 299-320. Gregory, A and P. Collier. 1996. Audit fees and auditor change; an investigation of the persistence of fee reduction by type of change. Journal of Business Finance & Accounting 23: 13-28. Gujarati, D.N. 1995. Basic Econometrics. 3rd edition. New York, NY: McGraw-Hill. Gullapalli, D. 2005. Audit fees are on rise as companies pony up: Payments for consulting and other services shrink, in big change from 2000. Wall Street Journal, March 25, C3. Hay, D., C. R. Knechel, N. Wong. 2006. Audit fees: a meta-analysis of the effect of supply and demand attributes. Contemporary Accounting Research 23 (1): 141-191. Hopwood, W., J. McKeown, and J. Mutchler. 1994. Reexamination of auditor versus model accuracy within the context of the going concern opinion decision. Contemporary Accounting Research 11: 295-310. Hosmer, D, and S. Lemeshow. 1989. Applied Logistic Regression. New York, NY: John Wiley & Sons. Johnstone, K., and J. Bedard. 2007. Recent longitudinal evidence on risk management in auditing. Working Paper. University of Wisconsin-Madison. Khurana, I., and K. Raman. 2006. Do investors care about auditors economic dependence on the client? Contemporary Accounting Research 23 (4): 977-1016. Kida, T. 1980. An investigation into auditors continuity and related qualification judgments. Journal of Accounting Research 18: 506-523. Kinney, W.R., Z. Palmrose, and S. Scholz. 2004. Auditor independence, non-audit services, and restatements: was the U.S. government right? Journal of Accounting Research 42: 561-588. Krishnamurthy, S., J. Zhou, and N. Zhou. 2006. Auditor reputation, auditor independence, and the stock-market impact of Andersens indictment on its client firms. Contemporary Accounting Research 23 (2): 465-490. Krishnan, G.V. 2007. Did earnings conservatism increase for former Andersen clients? Journal of Accounting, Auditing and Finance 22 (2): 141-163 .

26

Krishnan, J. and J. Krishnan. 1997. Litigation risk and auditor resignations. The Accounting Review 72: 539-60. Krishnan, J., S.Heibatollah, and Y. Zhang. 2005. Does the provision of nonaudit services affect investor perceptions of auditor independence? Auditing: A Journal of Practice & Theory 24 (2): 111-135. Larker, D.F., and S.A. Richardson. 2004. Fees paid to audit firms, accrual choices, and corporate governance. Journal of Accounting Research 42: 625-658. Lennox, C.S. 1999. Non-audit fees, disclosure and audit quality. The European Accounting Review 8(2): 239-252. Levitt, A. 2000. Renewing the covenant with investors. Remarks delivered at the NYU Center for Law and Business, New York University, New York. Loudder, M.L., I. K. Khurana, R.B. Sawyers, C. Cordery, C. Johnson, J. Lowe, and R. Wunderle. 1992. The information content of audit qualifications. Auditing: A Journal of Practice & Theory 11: 69-82. Lys, T. and R.L. Watts. 1994. Lawsuits against auditors. Journal of Accounting Research Vol. 32 (Supplement): 65-93. MacKie-Mason, J. 1990. Do taxes affect corporate financing decisions? Journal of Finance 45: 1471-1493. Marquandt, D. 1980. You should standardize the predictor variables in your regression models. Discussion of: A critique of some ridge regression methods. Journal of the American Statistical Association: 87-91. McKeown, J., J.F. Mutchler, and W. Hopwood. 1991. Towards an explanation of auditor failure to modify the audit opinions of bankrupt companies. Auditing: A Journal of Practice & Theory 10: 1-13. Mutchler, J.F. 1984. Auditors perceptions of the going-concern opinion decision. Auditing: A Journal of Practice & Theory 3: 17-29. Mutchler, J.F., W. Hopwood, and J.C. McKeown. 1997. The influence of contrary information and mitigating factors on audit opinion decisions on bankrupt companies. Journal of Accounting Research 35: 295-310. Palmrose, Z. 1988. An analysis of auditor litigation and audit service quality. The Accounting Review 63: 55-73. Public Company Accounting Oversight Board 2005. PCAOB 19b-4 for ethics and independence rules concerning independence, tax services, and contingent fees.

27

Raguhunandan, K., W. Read, and S. Whisenant. 2003. Initial evidence on the association between non-audit fees and restated financial statements. Accounting Horizons 17: 223-234. Rama, D.V., W.J. Read. 2006. Resignations by the Big 4 and the market for audit services. Accounting Horizons 20(2): 97-109. Read, W., K. Raghunandan, and R. Rama. 2004. Local and regional audit firms and the market for SEC audits. Accounting Horizons 18(4): 241-254. Reynolds, J.K., and J.R. Francis. 2001. Does size matter? The influence of large clients on officelevel auditor reporting decisions. Journal of Accounting and Economics 30: 375-400. Reynolds, J.K., D.R. Deis, and J.R. Francis. 2004. Professional service fees and auditor objectivity. Auditing: A Journal of Practice & Theory 23: 29-52. Ruddock, C., S.J. Taylor, and S.L. Taylor. 2006. Nonaudit services and earnings conservatism: Is auditor independence impaired? Contemporary Accounting Research 23 (3): 701-746. Securities and Exchange Commission (SEC), 2000. Final rule: revision of commissions auditor independence requirements. Washington, DC. Simon, D. and J. Francis. 1988. The Effects of Auditor Change on Audit Fees: Tests of Price Cutting and Price Recovery. The Accounting Review 63 (2): 255-269. Solomon, D. 2007. Auditing the auditors after Sarbanes-Oxley. The Wall Street Journal. October 3, 2007: C2. Stice, J.D. 1991. Using financial and market information to identify pre-engagement factors associated with lawsuits against auditors. The Accounting Review 66 (3): 516-533. Walker, P. and J. Casterella. 2000. The Role of Auditee Profitability in Pricing New Audit Engagements. Auditing: A Journal of Practice & Theory 19 (1): 157-167. Watts, R., and J. Zimmerman. 1983. Agency problems, auditing, and the theory of the firm: some evidence. Journal of Law and Economics 26: 613-633. Weber, J. and Willenborg, M. 2003. Do expert informational intermediaries add value? Evidence from auditors in microcap IPOs. Journal of Accounting Research 41 (4): 681-720. Weil, J. 2004. Auditing firms get back to what they do best. Wall Street Journal, March 31, C3.

28

Table 1 Summary of Prior Studies on Fee Dependence and Auditor Independence Country Craswell et al. (2002) Sample Year Australia 1994, 1996 Level of analysis National Office Proxy for impairment of auditor independence Qualified audit reports Qualified audit reports Audit Fees ns ns na na ns na na na na + na na na + ns Non-audit Fees ns na ns + + + + + na na na + + + ns Total Client Fees Sales na na na na na na na na na na na na na na ns + ns ns ns na na na na na na na na + na na na na na

Ruddock et al. (2006) Lennox (1999) Firth (2002) Ferguson et al. (2004)

Australia 1993-2000 UK UK UK 1988-1994 1996 1996-1998

National Earnings conservatism National Qualified audit reports National Qualified audit reports National Absolute discretionary accruals Restatements Office Absolute discretionary accruals Restatements National Going concern reports Office Absolute total accruals Absolute discretionary accruals Going concern reports

Basioudis et al. (2006) Reynolds & Francis (2001)

UK US

2003 1996

Frankel et al. (2002)

US

2001

National Absolute discretionary accruals Income-increasing discretionary accruals Income-decreasing discretionary accruals Just meet analysts' expectations National Going concern reports National Absolute discretionary accruals Income-increasing discretionary accruals Income-decreasing discretionary accruals Just meet analysts' expectations

DeFond et al. (2002) Ashbaugh et al. (2003)

US US

2001 2000

ns + ns na ns ns ns na ns ns na ns ns ns na (The table is continued on the next page.)

29

Table 1 (Continued) Country Chung & Kallapur (2003) US Sample Year 2001 Level of analysis National Office National National Proxy for impairment of auditor independence Absolute discretionary accruals Absolute discretionary accruals Going concern reports Restatements Audit Fees na na + na Non-audit Fees ns ns ns ns Total Client Fees Sales ns na ns na na ns na na

Geiger & Rama (2003) Raghunandan et al. (2003)

US US

2001 2001 19952000 20002001

Kinney et al. (2004) Larcker & Richardson (2004)

US

National

Restatements

ns

na

na

US

National

Directional discretionary accurals Absolute discretionary accruals Income-increasing discretionary accruals Income-decreasing discretionary accruals Absolute discretionary accruals

na na na na na

ns + ns

ns + ns

na na na na na

Reynolds et al. (2004) Gaver and Paterson (2007)

US

2001

National

US

1993

Office

Under-reserve for financially weak insurers

na

na

Abbreviations for fees and sales coefficients: na = not applicable (not tested). ns = tested but not significant. + = positive, significant coefficient. - = negative, significant coefficient.

30

Table 2 Descriptive Statistics for Financial Distressed Companies Panel A: Descriptive Statistics for 2001 Full Sample ( n = 1,681) Median Std. Dev. 0.009 0.121 0.007 0.099 0.018 0.193 18.065 2.363 -0.128 0.816 0.442 0.388 2.105 4.014 0.000 0.158 1.000 0.490 1.000 0.499 1.000 0.347 51.000 25.619 0.000 0.491 GC Sample ( n = 126) Mean Median 0.068 0.011 0.041 0.004 0.109 0.019 16.564 16.481 -1.007 -0.653 0.788 0.694 1.323 0.745 -0.008 0.000 0.794 1.000 0.754 1.000 0.778 1.000 75.111 80.500 0.365 0.000 NO GC Sample ( n = 1,555) Mean Median 0.051 0.009 0.043 0.007 0.094 0.018 18.174 18.152 -0.333 -0.113 0.478 0.430 3.672 2.231 0.013 0.000 0.585 1.000 0.501 1.000 0.866 1.000 53.594 50.000 0.408 0.000

Variables AUDFEE NONAUDFEE TOTALFEE SALES ROA LEVERAGE LIQUIDITY CHGDT PRLOSS PRNOCF BIG N DELAY NEWDEBT

Mean 0.052 0.043 0.095 18.054 -0.383 0.502 3.496 0.012 0.601 0.520 0.860 55.207 0.405

t-statistic 1.531 -0.254 0.834 -7.475* -9.142* 8.813* -6.392* -1.481 4.622* 5.513* -2.754* 9.295* -0.938

Z-statistic 1.154 -2.196 0.082 -7.407* -9.921* 6.451* -10.940* -2.395 4.594* 5.466* -2.748* 8.597* -0.938

Panel B: Descriptive Statistics for 2003 Full Sample ( n = 1,780) Median Std. Dev. 0.015 0.162 0.004 0.053 0.021 0.194 17.765 2.526 -0.108 0.949 0.517 0.984 1.918 3.537 0.000 0.814 1.000 0.442 1.000 0.500 1.000 0.453 63.000 38.005 0.000 0.485 GC Sample ( n = 108) Mean Median 0.160 0.043 0.024 0.003 0.184 0.054 15.980 16.044 -1.489 -0.394 1.744 0.862 1.066 0.480 -0.091 0.000 0.852 1.000 0.685 1.000 0.435 0.000 85.000 80.500 0.213 0.000 NO GC Sample ( n = 1,672) Mean Median 0.069 0.014 0.022 0.004 0.092 0.020 17.784 17.844 -0.231 -0.099 0.585 0.501 3.307 2.009 0.003 0.000 0.725 1.000 0.498 0.000 0.730 1.000 64.318 61.000 0.387 0.000

Variables AUDFEE NONAUDFEE TOTALFEE SALES ROA LEVERAGE LIQUIDITY CHGDT PRLOSS PRNOCF BIG N DELAY NEWDEBT

Mean 0.075 0.022 0.097 17.675 -0.307 0.656 3.171 -0.003 0.733 0.509 0.712 65.572 0.376

t-statistic 5.678* 0.432 4.846* -7.299* -14.078* 12.349* -6.452* -1.165 2.883* 3.792* -6.643* 5.527* -3.629*

Z-statistic 4.381* -0.875 3.948* -6.364* -8.743* 8.184* -11.116* -2.181 2.877* 3.778* -6.564* 7.305* -3.616*

31

Notes: Fee information is obtained from Audit Analytics and financial information is obtained from Compustat. The sample is restricted to financially distressed firms, defined as those that report either negative net income or negative operating cash flows. * Significant at the 0.01 level (two-tailed). Significant at the 0.05 level (two-tailed).

Variables definition: GC NO GC AUDFEE = going concern company. = clean opinion company. = client audit fees divided by the total revenue of the auditor local office that issues the audit report.

NONAUDFEE = client non-audit fees divided by the total revenue of the auditor local office that issues the audit report. TOTALFEE SALES ROA LEVERAGE LIQUIDITY CHGDT PRLOSS PRNOCF BIG N DELAY NEWDEBT = client total fees divided by the total revenue of the auditor local office that issues the audit report. = natural logarithms of clients total revenue at the end of the year. = net income divided by total assets at the end of the year. = total liabilities divided by total assets at the end of the year. =total current assets divided by total current liabilities at the end of the year. = the change of long-term debt divided by assets from year 2000 (2002) to 2001 (2003). = an indicator variable equal to 1 when the firm reported negative net income in year 2000 (2002); 0 otherwise. = an indicator variable equal to 1 when the firm reported negative operating cash flows in year 2000 (2002); 0 otherwise. = an indicator variable equal to 1 when the auditor is Big 4 (5); 0 otherwise. = number of days between fiscal year-end and the auditors sign date. = an indicator variable equal to 1 when the firm issues new debt in the subsequent year; 0 otherwise.

32

Table 3 Pearson Correlation Tables Panel A: Correlation Table for Year 2001
Variables
GC AUDFEE NONAUDFEE TOTALFEE SALES ROA LEVERAGE LIQUIDITY CHGDT PRLOSS PRNOCF BIG N DELAY AUDFEE 0.04 NONAUDFEE -0.01 0.52 TOTALFEE 0.02 0.90 0.84 SALES -0.18 -0.01 0.25 0.12 ROA -0.22 0.03 0.08 0.06 0.27 LEVERAGE 0.21 0.11 0.10 0.12 0.22 -0.18 LIQUIDITY -0.15 -0.08 -0.10 -0.10 -0.32 0.07 -0.46 CHGDT -0.03 0.01 0.01 0.01 0.00 -0.15 0.19 -0.02 PRLOSS 0.11 -0.05 -0.12 -0.09 -0.34 -0.26 0.00 0.09 0.05 PRNOCF 0.13 -0.07 -0.14 -0.12 -0.43 -0.25 -0.07 0.17 0.04 0.47 BIG N -0.07 -0.53 -0.20 -0.44 0.25 0.08 -0.13 0.08 -0.04 -0.01 -0.06 DELAY 0.22 0.10 0.01 0.07 -0.12 -0.09 0.26 -0.22 0.00 0.10 0.08 -0.13 NEWDEBT -0.02 0.02 0.08 0.06 0.24 0.08 0.27 -0.21 0.10 -0.10 -0.15 -0.02 0.10

Panel B: Correlation Table for Year 2003

Variables
GC AUDFEE NONAUDFEE TOTALFEE SALES ROA LEVERAGE LIQUIDITY CHGDT PRLOSS PRNOCF BIG N DELAY AUDFEE 0.13 NONAUDFEE 0.01 0.49 TOTALFEE 0.11 0.97 0.68 SALES -0.17 -0.11 0.10 -0.07 ROA -0.32 -0.03 0.05 -0.01 0.36 LEVERAGE 0.28 0.09 0.01 0.08 -0.04 -0.57 LIQUIDITY -0.15 -0.10 -0.05 -0.10 -0.29 0.07 -0.26 CHGDT -0.03 -0.11 0.00 -0.09 0.08 0.04 0.21 0.01 PRLOSS 0.07 -0.09 -0.07 -0.09 -0.17 -0.17 0.06 0.08 -0.01 PRNOCF 0.09 -0.03 -0.11 -0.06 -0.46 -0.23 0.03 0.16 -0.02 0.38 BIG N -0.16 -0.45 -0.20 -0.43 0.42 0.14 -0.13 0.11 0.03 0.05 -0.08 DELAY 0.13 0.08 0.03 0.08 -0.02 -0.07 0.14 -0.20 0.00 0.00 -0.02 -0.09 NEWDEBT -0.09 0.00 0.09 0.02 0.24 0.11 0.06 -0.15 0.04 -0.06 -0.13 0.08 0.04

Notes: All correlations with absolute value of 0.04 and above are statistically significant at the 0.10 level.

33

Table 4 Logistic Regressions for the Relations between Client Importance and Going Concern Opinions in 2001 and 2003 Panel A: Year =2001 Expected Sign Model 1a Coefficient (Wald 2) 1.774 (3.061) 0.766 (0.532) 0.730 (0.317) Model 1b Coefficient (Wald 2) 1.776 (3.121) Panel B: Year = 2003 Model 1a Coefficient (Wald 2) 0.879 (0.644) 1.326 (5.274) 0.186 (0.007) Model 1b Coefficient (Wald 2) 0.933 (0.736)

Variables Intercept AUDFEE NONAUDFEE TOTALFEE SALES ROA LEVERAGE LIQUIDITY CHGDT PRLOSS PRNOCF BIG N DELAY NEWDEBT N= Chi-Square Pseudo R2 Notes:

? ? ? + ? + + + + -

-0.346 (39.154)* -0.157 (2.363) 0.616 (6.007) -0.514 (33.568)* -1.279 (7.994)* 0.233 (0.706) 0.845 (9.955)* 0.672 (3.937) 0.018 (17.891)* -0.189 (0.699) 1681 248.138* 0.332

0.750 (1.549) -0.346 (39.345)* -0.157 (2.363) 0.616 (6.009) -0.514 (33.578)* -1.279 (8.022)* 0.233 (0.708) 0.845 (9.991)* 0.670 (4.105) 0.018 (17.904)* -0.189 (0.702) 1681 248.138* 0.332

-0.198 (10.566)* -0.180 (2.836) 0.096 (0.879) -0.678 (32.205)* 0.051 (0.419) 0.518 (2.742) 0.082 (0.092) 0.152 (0.266) 0.005 (5.247) -0.745 (7.835)* 1780 208.108* 0.300

1.166 (6.248) -0.201 (11.017)* -0.179 (2.816) 0.096 (0.875) -0.680 (32.397)* 0.048 (0.376) 0.519 (2.754) 0.083 (0.094) 0.146 (0.248) 0.005 (5.259) -0.761 (8.285)* 1780 207.888* 0.300

Fee information is obtained from Audit Analytics and financial information is obtained from Compustat. The sample is restricted to financially distressed firms, defined as those that report either negative net income or negative operating cash flows. * Significant at the 0.01 level (two-tailed). Significant at the 0.05 level (two-tailed). Significant at the 0.10 level (two-tailed).

34

Table 5 Logistic Regressions for the Relations between Client Importance and Going Concern Opinions in 2001 and 2003 for Big N and Non-Big N Auditors Panel A: Year = 2001 Clients of Big N Auditors Model 1a Coefficient (Wald 2) 2.119 (3.312) -3.131 (1.251) 2.811 (1.434) Model 1b Coefficient (Wald 2) 1.890 (2.683) Clients of non-Big N Auditors Model 1a Coefficient (Wald 2) 4.228 (1.911) 1.915 (2.292) -0.388 (0.054) Model 1b Coefficient (Wald 2) 4.015 (1.773)

Variables Intercept AUDFEE NONAUDFEE TOTALFEE SALES ROA LEVERAGE LIQUIDITY CHGDT PRLOSS PRNOCF DELAY NEWDEBT N= Chi-Square Pseudo R2

Expected Sign

? ? ? + ? + + + -

-0.354 (34.224)* -0.270 (6.088) 0.860 (7.643)* -0.438 (24.245)* -1.483 (9.804)* 0.368 (1.303) 0.677 (5.148) 0.020 (18.168)* -0.205 (0.638) 1445 197.483* 0.327

-0.056 (0.003) -0.340 (32.616)* -0.269 (6.066) 0.841 (7.367)* -0.425 (22.722)* -1.465 (9.579)* 0.349 (1.179) 0.661 (4.938) 0.020 (17.567)* -0.202 (0.623) 1445 196.013* 0.324

-0.411 (4.875) 0.069 (0.116) 0.096 (0.048) -1.356 (11.777)* 0.484 (0.123) -0.281 (0.196) 1.668 (5.503) 0.014 (2.299) -0.505 (0.907) 236 58.454* 0.424

0.967 (1.364) -0.388 (4.562) 0.048 (0.057) 0.111 (0.063) -1.319 (11.342)* 0.300 (0.046) -0.291 (0.213) 1.508 (4.927) 0.014 (2.205) -0.489 (0.863) 236 57.520* 0.418

(The table is continued on the next page)

35

Table 5 (Continued) Panel B: Year = 2003 Clients of Big N Auditors Expected Sign Model 1a Coefficient (Wald 2) 1.152 (0.358) 7.212 (6.226) -8.286 (1.450) Model 1b Coefficient (Wald 2) 1.471 (0.587) Clients of non-Big N Auditors Model 1a Coefficient (Wald 2) 0.299 (0.041) 1.111 (3.715) -0.887 (0.094) Model 1b Coefficient (Wald 2) 0.370 (0.064)

Variables Intercept AUDFEE NONAUDFEE TOTALFEE SALES ROA LEVERAGE LIQUIDITY CHGDT PRLOSS PRNOCF DELAY NEWDEBT N= Chi-Square Pseudo R2 Notes:

? ? ? + ? + + + -

-0.221 (5.194) -0.238 (0.918) 0.733 (5.754) -0.866 (17.690)* -2.776 (11.939)* 0.461 (0.972) 0.192 (0.245) 0.005 (2.864) -1.317 (9.556)* 1268 118.594* 0.329

2.316 (4.881) -0.233 (5.830) -0.232 (0.898) 0.649 (4.685) -0.874 (18.170)* -2.873 (12.812)* 0.485 (1.074) 0.134 (0.120) 0.005 (2.499) -1.232 (8.785)* 1268 114.967* 0.319

-0.175 (4.577) -0.214 (2.864) 0.067 (0.415) -0.400 (8.879)* 0.061 (0.679) 0.538 (1.564) -0.037 (0.009) 0.005 (2.798) -0.569 (2.266) 512 79.826* 0.279

0.918 (0.350) -0.181 (4.944) -0.213 (2.847) 0.067 (0.418) -0.407 (9.239)* 0.059 (0.623) 0.538 (1.573) -0.027 (0.005) 0.006 (3.043) -0.615 (2.730) 512 79.388* 0.277

Fee information is obtained from Audit Analytics and financial information is obtained from Compustat. The sample is restricted to financially distressed firms, defined as those that report either negative net income or negative operating cash flows. * Significant at the 0.01 level (two-tailed). Significant at the 0.05 level (two-tailed). Significant at the 0.10 level (two-tailed).

36