Do Mandatory Non-Audit Fee Disclosures Improve Audit Quality?

Evidence From Differential Disclosure Requirements

Hsihui Chang Drexel University

Jengfang Chen

National Cheng Kung University

Rong-Ruey Duh National Taiwan University

Christopher D. Ittner

University of Pennsylvania

March, 2013

The financial support of Ernst & Young is greatly appreciated.

Do Mandatory Non-Audit Fee Disclosures Improve Audit Quality? Evidence From Differential Disclosure Requirements

ABSTRACT

Economic and psychological theories provide conflicting predictions regarding

the influence of mandatory non-audit fee disclosure on audit quality. We investigate

these theories using both publicly disclosed and confidential, non-public fee data from

companies in Taiwan, a country that only requires firms meeting certain thresholds to

publicly disclose auditor fees. In the initial mandatory disclosure year, substantially

more firms fell just below the primary disclosure threshold than just above, consistent

with companies seeking to avoid disclosing auditor fees. We find significantly smaller

discretionary accruals and more frequent unfavorable audit opinions in the disclosing

firms, as well as significantly negative associations between non-audit (and total) fees

and audit quality in non-disclosers but not in disclosers. Moreover, disclosing firms

exhibited significantly improved audit quality from the year preceding mandatory

disclosure to the first disclosure year, while non-disclosers exhibited no significant

change. These results are consistent with mandatory fee disclosure enhancing auditor

independence and improving audit quality.

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1. Introduction

Over the past two decades, an increasing number of countries have issued

regulations requiring firms to disclose the level and composition of fees paid to

auditors. The primary impetus behind these regulations is the belief that larger

payments to auditors, particularly for non-audit services (NAS), create conflicts of

interest that compromise auditor objectivity, leading to lower quality accounting

statements. Regulators argue that mandatory disclosure of auditor fees allows

investors and other financial statement users to evaluate potential conflicts of interest

in the firms they are evaluating. The improved market monitoring possible with the

disclosure of non-audit fees is expected to mitigate the assumed biases in auditor

reports and certified financial statements.

An important question is whether mandatory fee disclosures lead to

improvements in audit quality, rather than simply providing information on potential

conflicts of interest to users. Although some theories contend that these disclosures

improve auditor independence (and therefore audit quality) by increasing legal

liability and reputation costs (e.g., Crawford and Sobel [1982], Church and Kuang

[2009]), others argue that these costs, together with the economies of scope from the

joint provision of audit and non-audit services, competitive pressures, audit firm

quality controls, and professional standards, already provide sufficient incentives to

minimize auditor conflicts of interest in the absence of fee disclosures (e.g., Arruñada

[1999]). Still other theories indicate that required disclosure of conflicts of interest

can actually reduce the quality of information provided by advisors such as auditors

(e.g., Cain, Lowenstein, and Moore [2005, 2011], Li and Madarasz [2008]).

Prior archival studies provide mixed evidence on the association between

non-audit or total auditor fees and audit quality proxies such as discretionary accruals

2

and audit opinions (see Habib [2012] for a meta-analysis of this literature). However,

these studies rely on fee data released in response to the disclosure requirements. As a

result, they provide joint tests of the effects of non-audit service provision and

mandatory fee disclosure, and are unable to shed light on whether fee disclosures

change the relation between NAS and audit quality or lead to improvements in audit

quality due to the lack of available fee data for non-disclosers.

We extend the auditor fee and mandatory disclosure literatures by examining the

effects of non-audit fee disclosure on audit quality using data from Taiwan, where

publicly-traded firms face differential fee disclosure requirements. Since 2002, all

listed firms in Taiwan are required to file audit and non-audit fee data with

government regulators, but are only required to publicly disclose the fee information

in a given year when one or more of the following thresholds is met: (1) non-audit

fees are either 25% or more of audit fees or are equal to or greater than New Taiwan

Dollar (NT$) 500,000;1 (2) a new auditor is appointed and receives lower audit fees

than the previous one; or (3) audit fees are less than 15% of those in the previous year.

We were granted unprecedented access to the 2002 fee data from firms that were

required to file this information with the government but were not required to publicly

disclose it.2 In contrast to studies using data from countries that require all listed

firms to disclose auditor fees, these confidential data (together with public fee data

from disclosing firms) allow us to take advantage of Taiwan’s differential disclosure

requirements to investigate whether the public disclosures moderate the relation

between non-audit fees and audit quality.

We begin by estimating the cross-sectional associations between NAS payments

1 The conversion rate is approximately US$1 = NT$31. 2 Due to the confidential nature of the data, we were only provided access to the non-public fee information for 2002, the first year of required disclosure.

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and two proxies for audit quality (discretionary accruals and unfavorable audit

opinions) in the initial disclosure year. We find consistent evidence that audit quality

is significantly higher in the disclosing firms, as well as evidence that the associations

between non-audit (and total) fees and fee ratios and both discretionary accruals and

unfavorable opinions are significantly different (often with different signs) in the

disclosers relative to the non-disclosers. We then take advantage of the disclosure

discontinuity at the 25% NAS to audit fee threshold (the reporting trigger for most of

the disclosing firms). The sample exhibits substantially more firms reporting NAS

percentages slightly below the 25% threshold than those reporting slightly above,

consistent with the notion that companies seek to avoid public disclosure of auditor

fees. Firms reporting NAS fee percentages slightly below the 25% threshold had

significantly poorer audit quality than firms just above the threshold (and therefore

being required to disclose auditor fees). Finally, we examine changes in the audit

quality measures from 2001 (the year prior to the fee disclosure requirements) to 2002

(the first year of mandatory disclosure). In 2001, the disclosing and non-disclosing

groups displayed no significant differences in accruals or audit opinions. With the

introduction of mandatory disclosure in 2002, the disclosing firms reported

significantly lower discretionary accruals and faced increased likelihood of receiving

an unfavorable opinion, while non-disclosers exhibited no significant changes in these

audit quality proxies, consistent with the fee disclosures enhancing auditor

independence.

Our study makes several contributions to the auditing and mandatory disclosure

literatures. We provide some of the first evidence that mandatory fee disclosures can

lead to improvements in audit quality. In particular, we find that disclosure eliminated

or reversed any negative associations between NAS and audit quality observed in the

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non-discloser group. The offsetting results in the two groups potentially explain the

insignificant cross-sectional associations between NAS and audit quality found in

many prior studies. If auditors improved audit quality in response to the disclosure

requirements, then any pre-disclosure relationships between conflicts of interest due

to NAS provision and lower audit quality would no longer be observed in the

post-disclosure data.

Our results also contribute to research examining the influence of mandatory

disclosure on accounting properties. Unlike the majority of mandatory disclosure

studies that are limited by changes in disclosure rules that affect all listed firms in a

country (Leuz and Wysocki [2006]), our unique access to the auditor fees paid by the

non-disclosing firms allow us to exploit the differential fee disclosure requirements in

Taiwan to provide more powerful tests of the influence of this widespread disclosure

requirement on accounting and audit quality.

More importantly, our study has implications for the theoretical debate over the

value of mandatory disclosure of conflicts of interests with advisors such as auditors.

Although the accounting literature generally assumes that fee disclosure will have an

insignificant or positive influence on audit quality, recent theoretical and experimental

studies suggest that mandatory disclosure of conflicts of interest can have perverse

effects that reduce the quality of information provided by auditors (e.g., Cain,

Lowenstein, and Moore [2005, 2011], Li and Madarasz [2008]). Contrary to these

studies’ predictions, we find no evidence that fee disclosure is associated with

reductions in audit quality.

Finally, our research responds to calls to investigate audit quality and mandatory

disclosure in different institutional settings (e.g., Francis [2011], Leuz and Wysocki

[2006]). The bulk of studies on NAS fees and auditor conflicts of interest focus on

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Anglo-Saxon countries (Habib [2012]) where financial transparency, auditor

reputation effects, and legal liability are quite high (potentially reducing the benefits

from fee disclosure). Our study is conducted using data from an ethnic Chinese, East

Asian country that is characterized by relation- versus rules-based governance, code

versus common law legal origin, more limited financial transparency, and lower

auditor legal liability (e.g., Claessens and Fan [2002], Leuz, Nanda, and Wysocki

[2003]). Research suggests that these differences can reduce auditor independence

and lead to lower accounting and audit quality in countries such as Taiwan (e.g., Au

and Wong [2000], Ball, Kothari, and Robin [2000], Chin, Tsao, and Chi [ 2007]),

potentially increasing the benefits from mandatory fee disclosures that are designed to

address these issues.

The remainder of the paper is organized as follows. Section 2 discusses the

institutional background for our study and develops our hypotheses. Section 3

describes our sample and variables. Section 4 presents empirical results. Section 5

concludes.

2. Institutional Background and Research Hypotheses

2.1 INSTITUTIONAL BACKGROUND

Prior to 2002, companies listed on the Taiwan Stock Exchange and GreTai

Securities Market were not required to disclose audit and non-audit fees.3 Following

several financial scandals in Taiwan and the U.S. that were blamed in part on auditor

conflicts of interests, the Financial Supervisory Commission (Taiwan’s securities

regulator) issued rules requiring companies listed on these exchanges to publicly

disclose audit and non-audit fee data beginning in 2002, if they meet any of the three

3 The Taiwan Stock Exchange is the main board and the GreTai Securities Market the secondary board in Taiwan.

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thresholds described earlier. Firms that do not meet any of these thresholds are not

required to publicly disclose fee data, but are required to file this information with the

regulator on a confidential basis. Like similar mandates in other countries, the

rationale behind the Taiwanese fee disclosure regulations is that the economic bond

between the auditor and its clients resulting from the joint provision of audit and

non-audit services can lead to substantial impairment in auditor independence, and

that investors benefit from being better informed of an auditor’s potential conflict of

interest.

Studies suggest that auditors may be especially susceptible to conflicts of interest

in relationship-based cultures such as those found in Taiwan and other East Asian

countries. In particular, the concept of guanxi found in ethnic Chinese cultures such as

Taiwan emphasizes the importance of personal, reciprocal relationships between

parties. Guanxi manifests itself in business settings through governance that is more

relationship-based than rules-based, and in the importance placed on close reciprocal

ties between business people and their customers and suppliers (e.g., Kao [1996], Xin

and Pearce [1996]).

A number of researchers argue that in cultures characterized by guanxi, auditor

conflicts of interest tend to be greater, leading to lower quality accounting statements

(e.g., Au and Wong [2000], Liu, Wang, and Wu [2011]). Consistent with these

claims, surveys and experimental studies find that auditors in Chinese cultures,

relative to their Western counterparts, are far more likely to defer to their clients’

demands and are more inclined to believe that the provision of non-audit services

reduces auditor independence. Au and Wong [2000], for example, find that guanxi

has a significant, negative impact on Hong Kong auditors' ethical judgments in

auditor-client conflict situations. Tsui [1996] finds that, on average, Hong Kong

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auditors have lower ethical reasoning scores than U.S. auditors, and that lower ethical

reasoning scores within the Hong Kong sample are associated with greater likelihood

that auditors give in to client demands. Lin and Fraser's [2008] survey indicates that

Chinese auditors, relative to U.K. auditors, are more likely to believe that the

provision of non-audit services reduces auditor independence. Jeffrey, Dilla, and

Weatherholdt's [2004] experiment adds that Taiwanese auditors are more likely to

agree with client's accounting violations when the client is a close friend, but that the

auditor's acquiescence to the violations is moderated by larger threats of sanctions (as

may be the case if fee disclosures increase reputation and litigation costs). The guanxi

culture in Taiwan, combined with the country’s relatively low earnings quality and

financial transparency (e.g., Claessens and Fan [2002], Ball, Kothari, and Robin

[2000], Leuz, Nanda, and Wysocki [2003]), suggests that the increased visibility that

mandatory fee disclosures provide regarding potential conflicts of interest may have a

greater influence on audit quality in this environment than in the Western countries

typically examined in this literature.

2.2 THEORETICAL LINKS BETWEEN NAS DISCLOSURE AND AUDIT

QUALITY

Although a large number of countries now mandate disclosure of auditor fees,

the implications of these regulations for audit quality remain unclear. Many

accounting professionals argue that no conflicts of interest arise from larger payments

to auditors or from the joint provision of audit and non-audit services. According to

these commentators, professional standards, audit firm quality controls, legal

liabilities, and reputation concerns already limit conflicts of interest between auditors

and clients without the need for fee disclosures (Palmrose and Saul [2001]).

Consequently, the introduction of fee disclosure requirements is claimed to have little

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effect on audit quality.4

Some academic theories support the contention that fee disclosures will have

minimal impact on audit quality. Arruñada’s [1999] economic analysis argues that the

provision of non-audit services reduces total costs, increases technical competence,

and motivates more intense competition among audit firms. As a result, NAS

increases both client- and firm-specific assets, which has a positive effect on

independence as the auditor becomes more dependent on all its clients and therefore

more independent of any one client. The investment in reputational capital constrains

auditor bias because the gains from consenting to a given client’s demands are

outweighed by the reputational losses imposed by other clients who value a reputation

for independence. Since these market incentives already exist in the absence of fee

disclosures, Arruñada [1999] argues that the imposition of fee disclosure requirements

will have little beneficial impact on audit quality.

Moore, Tetlock, Tanlu, and Bazerman [2006] draw on psychological arguments

to develop an alternative theory of auditor bias. They contend that auditor conflicts of

interest are unavoidable, but that most auditor biases are unconscious. Their analysis

cites psychological studies showing that people do a poor job disregarding their own

self-interests and evaluating information impartially, even when they try to do so.

Since auditors tend to be unaware of their conflicts of interest and biases, mandatory

fee disclosures must inhibit auditor bias outright if they are to improve audit quality,

4 For example, in testimony on September 13, 2000 before the U.S. Securities and Exchange Commission regarding proposed changes in auditor independence rules, the President and CEO of the American Institute of Certified Public Accountants stated, “… there is no basis for the radical surgery the proposed rule would perform on the accounting profession. Given the severity of the treatment, one would expect to find a substantial record of empirical studies establishing the link between audit failure and non-audit services, findings to that effect in litigated cases, enforcement actions at least alleging such a connection or other evidence of harm. The fact is – there is no such record.” He added, “…the proposed disclosure requirements in public filings do not benefit shareholders and would send a message to audit committees that they should ban, rather than review, non-audit services from their auditors, regardless of the benefits to public companies” (http://www.sec.gov/rules/proposed/s71300/testimony/melanc1.htm, accessed December 1, 2012).

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which the authors believe to be unlikely (Bazerman, Loewenstein, and Moore [2002]).

Consequently, mandatory fee disclosures are predicted to have little influence on

auditor independence or audit quality.5

Other theories maintain that mandatory disclosure of conflicts of interest

improves audit quality. Economics-based research suggests that people lacking

information about the incentives of the other party trust that party’s report by default

(Gneezy [2005]). Therefore, investors are inclined to believe financial reports as long

as they are not aware of the high NAS fees the company paid its auditor. This gives

the auditor the ability to exploit the investors’ trust and gain benefits by vouching for

misleading reports in the non-disclosure condition (Sobel [1985]). However, once the

disclosure of audit and non-audit fees is mandatory, auditors have less incentive to

certify biased reports since they anticipate that investors will discount the value of the

audited financial statements (Crawford and Sobel [1982]).

When NAS fees are not disclosed, there may also be greater scope for implicit

collusion whereby managers provide auditors with financial incentives to give

favorable reports (Lennox [1999]). However, managers and auditors should find such

collusion more costly when NAS fees are disclosed since investors are able to make

more informed decisions when exercising their rights as owners of the company or

when deciding whether or not to sue auditors for breach of fiduciary duty.6

More recent theories contend that disclosure of conflicts of interest can actually

reduce the quality of information provided by auditors. Li and Madarasz’s [2008]

5 See Moore, Tanlu, and Bazerman [2010] for experimental evidence supporting these psychological arguments. 6 Schmidt’s [2012] analysis of U.S. data from 2001 to 2007 finds that disclosed NAS fee levels and NAS to total fee ratios are both positively associated with the likelihood that an accounting restatement results in audit litigation. Further, when plaintiff attorneys cite disclosed NAS fees when arguing that auditors are not independent, settlement frequencies and dollar amounts increase. Also see Church and Kuang [2009] for experimental evidence that the disclosure of conflicts of interest, in conjunction with costly sanctions such as litigation, improves audit quality.

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economic model demonstrates that mandatory disclosure can exacerbate conflict of

interest problems by providing incentives for less efficient communication between

the advisor and the external decision-maker. Experiments by Cain, Loewenstein, and

Moore [2005, 2011] and Koch and Schmidt [2010] show that disclosure can lead

advisors such as auditors to give even more biased advice. This is due to advisors

feeling “morally licensed” to provide biased advice once they have disclosed their

conflicts of interest, and to “strategic exaggeration” in which more biased advice is

given to offset the expectation of greater discounting of advice as a result of

disclosure. Disclosure also introduces a possible rationalization for unethical behavior

since the advisor can argue that the party receiving the disclosure should anticipate

bias (Loewenstein, Cain, and Sah [2011]).

2.3 HYPOTHESES

Despite the opposing theories on the association between mandatory disclosure

of conflicts of interest and the quality of information provided by advisors, archival

evidence on the impact of non-audit fee disclosure on audit quality is limited. Existing

archival studies on NAS and auditor independence typically examine the

cross-sectional associations between disclosed NAS fees or fee ratios and various

accounting and audit quality measures. Although auditor independence is not

observable, the assumption in these studies is that auditor conflicts of interest should

manifest themselves in lower audit quality. If higher non-audit fees reduce auditor

independence, then NAS fees or fee ratios are predicted to be negatively associated

with accounting and audit quality.7 The results are mixed, with some studies finding

7 Studies examining the association between NAS provision and audit quality focus on auditor “independence-in-fact,” which refers to the auditor possessing an independent mindset when planning and executing an audit, resulting in an audit report that is unbiased (Dopuch, King, and Schwartz [2003]). A related research stream examines “independence-in-appearance,” which relates to whether the auditor is perceived to be independent by clients and external parties (Dopuch, King, and Schwartz [2003]). Studies in this second research stream examine the stock market’s reaction to disclosed NAS

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greater NAS fees and/or NAS to total fee ratios associated with lower audit quality

(e.g., Frankel, Johnson, and Nelson [2002]), others finding greater provision of certain

types of NAS associated with higher audit quality (e.g., Kinney, Palmrose, and Scholz

[2004], Koh, Rajgopal, and Srinivasan [2012]), and a substantial number finding no

significant associations (e.g., Ashbaugh, Lafond, and Mayhew [2003], Chung and

Kallapur [2003], DeFond, Raghunandan, and Subramanyam [2002]).

Because all of these studies rely on mandated fee disclosures for their NAS data

(due to the lack of available auditor fee data in the absence of these disclosures), they

are unable to compare the associations between NAS and audit quality under

disclosure versus non-disclosure conditions.8 As a result, they shed little light on the

effects of the fee disclosure itself. Given this limitation and the contradictory theories

on the effects of mandatory disclosure of conflicts of interest, we extend the NAS and

mandatory disclosure literatures by examining whether the introduction of Taiwan’s

differential fee disclosure requirements had distinct effects on the audit quality of

disclosers and non-disclosers. If auditors with conflicts of interest are more likely to

overlook clients’ questionable accounting practices, then greater provision of

non-audit services is expected to be associated with lower audit quality. However, if

disclosure of NAS fees mitigates auditor conflicts of interest, then the introduction of

mandatory disclosure should lead to improvements in the quality of the disclosers’ fess or fee ratios. Relative to the mixed results in studies examining the association between NAS and proxies for audit quality, the market-based studies find much more consistent evidence that the stock market perceives greater provision of NAS to be associated with lower auditor independence (see Habib [2012] for a review). Although not the focus of our study, footnote 17 summarizes results from our tests examining the differential associations between NAS and earnings response coefficients in the disclosers and non-disclosers in our sample. 8 Francis and Ke [2006] examine whether the market’s assessment of earnings surprises for firms with high NAS changed following the introduction of mandatory fee disclosure. However, the authors do not have NAS fee data for the pre-disclosure period and must assume that firm-level NAS purchases were the same in the pre- and post-disclosure years. They do not examine audit quality. Koh, Rajgopal, and Srinivasan [2012] investigate whether earnings quality changed when the U.S. repealed earlier auditor fee disclosure requirements in 1981. They find no evidence that earnings quality declined following repeal of the disclosure requirement, but their analyses of fee disclosure’s impact on earnings quality are limited by the lack of fee data in the pre-disclosure and post-repeal periods.

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accounting information, and should reduce or eliminate any negative associations

between NAS and audit quality in these firms. In contrast, alternative theories contend

that the disclosure of auditor fees may have no effect on audit quality if existing

constraints already minimize auditor conflicts of interest, or may even lead to

reductions in audit quality. The conflicting theories lead us to examine the following

hypotheses:

H1: The disclosure of auditor fees moderates the association between NAS and

audit quality.

H2: The introduction of mandatory fee disclosure is associated with

improvements in audit quality in the disclosing firms but not in the

non-disclosing firms.

3. Sample and Variables

3.1 SAMPLE

Our analyses are conducted using data from publicly-traded firms listed on the

Taiwan Stock Exchange or GreTai Securities Market in 2002.9 This year represents

the first year of mandatory disclosure of audit and non-audit fees by Taiwanese firms

meeting any of the three disclosure thresholds.

Fee data for firms that were required to publicly disclose auditor payments are

gathered from published financial statements. For firms not meeting the disclosure

thresholds, we were provided unprecedented access to their confidential 2002 fee data.

Financial data for our tests are obtained from the Taiwan Economic Journal database.

Our initial sample consists of 1,022 firms. We delete 54 financial institutions

because discretionary accruals (one of our audit quality proxies) may not be a

meaningful measure for these firms. We also eliminate 170 firms with missing data

needed to compute our dependent and independent variables. Our final sample

9 Inclusion of an indicator for the firm’s stock market has no significant effect on our reported results.

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consists of 798 firms, of which 117 (14.7%) were required to disclose auditor fees in

2002. Of the disclosing firms, 97 were required to report auditor fees because they

met the 25% or greater non-audit to audit fee threshold or spent NT$500,000 or more

on non-audit services, 4 because the auditor was changed and the succeeding auditor

received lower audit fees, and 16 because audit fees were less than 15 percent of those

in 2001. We denote disclosing firms using the indicator variable DIS which equals 1 if

the firm was required to disclose auditor fees, and 0 otherwise.

3.2 NON-AUDIT FEE VARIABLES

Fee disclosure regulations have primarily been driven by concerns regarding the

magnitude of NAS fees relative to audit fees. The perception is that the higher the

ratio of NAS fees to total fees, the greater the auditor’s incentive to compromise audit

independence. However, as Ashbaugh, Lafond, and Mayhew [2003] point out, the

NAS to total fee ratio may not matter to the auditor if the client’s total fee is an

inconsequential part of the auditor’s client portfolio. Thus from an auditor

independence perspective, the level of NAS fees or total fees may be more important

(DeFond, Raghunandan, and Subramanyam [2002]). We therefore follow the auditor

fee literature by using multiple measures to capture NAS importance: (1) the NAS fee

ratio, which equals the ratio of non-audit fees to total fees (NASRATIO); (2) the

logarithm of NAS fees (NASFEE); and (3) the logarithm of total fees (TOTALFEE).

Table 1 reports the sample composition and mean 2002 NAS to total fee ratios by

industry. The sample exhibits some concentration of observations in the

Miscellaneous Industrial and Commercial Machinery and Equipment (SIC 35) and

Magnetic and Optical Recording Media (SIC 36) industries (20.4% and 26.4% of the

sample, respectively). Mean NAS fee ratios (NASRATIO) are below 15% in every

industry.

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3.3 AUDIT QUALITY PROXIES

Prior NAS research has used one of two primary proxies for audit quality:

discretionary accruals (e.g., Frankel, Johnson, and Nelson [2002], Ashbaugh, Lafond

and Mayhew [2003], Larcker and Richardson [2004]) or audit opinions (e.g., DeFond,

Raghunandan, and Subramanyam [2002]). Because each of these proxies has

strengths and weaknesses for studying conflicts of interest in auditing (Nelson [2012]),

we employ both measures in our tests. Consistent findings across these measures

should increase confidence in our results.

3.3.1 DISCRETIONARY ACCRUALS

If auditors with conflicts of interest give clients greater discretion in their accrual

choices, prior NAS research hypothesizes that greater provision of non-audit services

will be associated with larger discretionary accruals. Following Kothari, Leone, and

Wasley [2005], we use ordinary least-squares (OLS) to estimate the following

performance-adjusted Jones model by fiscal year and two-digit industry (SIC) code

(with a minimum of ten observations required for an industry to be included), and

controlling for concurrent firm performance using net income:

tNIPPESALESTA 3210 (1)

where TA is total accruals in year t; ΔSALES is sales in year t less sales in year t-1;

PPE is gross property, plant, and equipment in year t; and NI is operating income after

depreciation in year t. All variables are deflated by lagged total assets. The residuals

from equation (1) are used to measure discretionary accruals. Following Reynolds and

Francis [2000], Larcker and Richardson [2004], and others, the absolute value of

discretionary accruals serves as our measure of earnings management and audit

quality.

3.3.2 UNFAVORABLE AUDIT OPINIONS

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Our second audit quality proxy is audit opinions. If auditors are beholden to

clients due to relatively high NAS fees, the auditor fee literature predicts that

unfavorable audit opinions should be lower when NAS fees and fee ratios are larger.

DeFond, Raghunandan, and Subramanyam [2002], for example, argue that in issuing

an unfavorable opinion, the auditor must objectively evaluate client performance and

withstand client pressure to issue a clean opinion, suggesting the issuance of an

unfavorable opinion as a proxy of auditor independence and audit quality.

We code audit opinions (denoted UNFAVOR) 0 if the opinion is “clean” and 1 if

the opinion is “unfavorable.” Following Lennox [2005], we classify unmodified

opinions and modified opinions with harmless explanatory language as clean opinions.

We regard explanatory language as harmless if it includes one or more of the

following statements: (a) the financial statements comply with the applicable laws and

regulations; (b) the auditor’s opinion is shared with the report of another auditor; (c) a

change in accounting principles; or (d) certain events affect the comparability or

consistency of financial statements. An audit opinion is coded as unfavorable if it

discloses problems such as financial distress, lack of compliance with regulatory

requirements, civil or criminal investigations, significant accounting errors, or

significant related party transactions (Lennox [2005]).

3.4 CONTROL VARIABLES

3.4.1 DISCRETIONARY ACCRUALS MODELS

We include a number of variables in our discretionary accruals models to control

for factors that previous studies have found to affect the magnitude of discretionary

accruals. LAGTAC (lagged total accruals) controls for the reversal of accruals over

time (Ashbaugh, Lafond, and Mayhew [2003]). LEV (leverage) is included because

highly leveraged firms may have greater incentives for earnings management (Becker,

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DeFond, Jiambalvo, and Subramanyam [1998]; DeFond and Jiambalvo [1994]). LOSS

(an indicator variable for loss-reporting firms) controls for potential differences in

accruals between loss and profit firms (Choi and Wong [2007]). Following DeFond

and Subramanyam [1998], who find that the level of discretionary accruals is related

to auditor change, we include indicator variables for a firm’s first and last year with

the auditor (denoted FIRST and LAST, respectively). LAGROA (lagged return on

assets) controls for prior financial performance (Chung and Kallapur [2003]), SIZE

(the natural log of total assets) for the effect of client size on accruals quality

(Dechow and Dichev [2002]), and CFO (cash flow from operations deflated by

lagged total assets) for the potential correlation between accruals and cash flows

(Kothari, Leone, and Wasley [2005]). We include a BIG5 indicator because prior

literature suggests that Big 5 audit firms tend to be more conservative and tend to

constrain their clients’ extreme accruals reporting choices (Becker, DeFond,

Jiambalvo, and Subramanyam [1998]). We also control for the volatility of sales

(STDSALE), measured as the standard deviation of sales for the most recent three

fiscal years (Hribar and Nichols [2007]). Doyle, Weili, and McVay [2007] and Hribar

and Nichols [2007] report a positive association between cash flow volatility and

accruals, so we include cash flow volatility (STDCFO), measured as the standard

deviation of cash flows, for the most recent three fiscal years. Finally, because capital

market pressure can influence earnings management behavior (Matsumoto [2002],

Hribar and Nichols [2007]), we proxy for market uncertainty using stock return

volatility (STDRTN), measured using the standard deviation of monthly stock

returns for the current fiscal year.

3.4.2 UNFAVORABLE OPINION MODELS

Control variables in our audit opinion models are drawn from prior studies (e.g.,

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DeFond, Raghunandan, and Subramanyam [2002], Craswell, Stokes, and Laughton

[2002], Lennox [2005]). While these studies differ in their objectives, they include

similar variables that are predicted to affect the likelihood of receiving an unfavorable

audit opinion. These include profitability (PROFIT), liquidity (LIQ), leverage (LEV),

company size (SIZE), default (DEFFAULT), and company growth (GROW). PROFIT

is the ratio of net income to total assets, LIQ is the ratio of current assets to current

liabilities, LEV is the ratio of total liabilities to total assets, SIZE is the natural log of

total assets, GROW is the annual percentage change in total assets, DEFAULT equals

1 if the company is in default, and BIG5 equals 1 if the firm has a Big 5 auditor. A

summary of variable definitions is presented in Table 2.

3.5 CORRELATIONS

Pearson correlations between the dependent and independent variables for each

audit quality proxy are provided in Table 3. The correlations between ACCUAL and

the three fee variables are extremely small (r < 0.05), as is the insignificant correlation

between ACCRUAL and the required disclosure indicator (DIS). Although UNFAVOR

is significantly correlated with all three of the NAS variables (p < 0.05) and with

disclosure (p < 0.10), the correlations are small in magnitude (r ≤ 0.11). Correlations

among the independent variables suggest no problems with multicollinearity.

4. Results

4.1 UNIVARIATE COMPARISONS OF DISCLOSERS AND NON-DISCLOSERS

Table 4 provides univariate tests comparing the disclosing and non-disclosing

firms. In 2001 (the year prior to the first mandated fee disclosures), the two

subsamples exhibit no mean or median differences in ACCRUAL or UNFAVOR. The

disclosing firms reported higher profits and cash flows than the non-disclosers in 2001,

18

but none of the other control variables is significantly different. However, in 2002 (the

first disclosure year) the disclosing firms reported significantly lower discretionary

accruals, though unfavorable opinions were not significantly different in the two

groups. NAS ratios and NAS fees were significantly higher in the disclosing firms,

reflecting the inclusion of these criteria in Taiwan’s fee disclosure thresholds. In

contrast, total fees paid to auditors were not significantly different in the two groups.

Profits and cash flows remained higher in the disclosing firms, with leverage also

becoming significantly lower in the disclosers.

When we conduct univariate tests of differences in the audit quality and control

variables in 2001 and 2002, we find significant mean and median reductions in

discretionary accruals and significant increases in unfavorable opinions in the

disclosing firms. In contrast, we find no significant changes in audit quality in the

non-disclosers. The differences in audit quality changes in the two groups are not

mirrored in differences in the control variables, which did not change significantly

from 2001 to 2002 in either group. These univariate tests provide preliminary

evidence that the mandated fee disclosure rules had differential effects on the audit

quality of disclosing and non-disclosing firms.

4.2 MULTIVARIATE DISCLOSURE TESTS

We next conduct multivariate tests to examine whether the relations between

non-audit and total fees and audit quality are influenced by the mandated disclosure

requirements. Similar to prior auditor fee studies, we estimate the cross-sectional

association between NAS and our two audit quality measures using data from the

initial disclosure year. However, in contrast to earlier studies that utilized data from

countries that require all public firms to disclose auditor fees, we take advantage of

Taiwan’s differential fee disclosure requirements to investigate whether the public fee

19

disclosures moderated the relation between non-audit fees and audit quality. In

particular, if auditors reacted to the new disclosure requirements by tightening audit

standards for disclosing firms with larger NAS fees, then we would expect firms that

publicly disclosed high NAS fees to report lower discretionary accruals and to be

more likely to receive unfavorable opinions.

4.2.1 DISCRETIONARY ACCRUALS TESTS

We use the following OLS regression model to examine the influence of NAS

fees and disclosure on discretionary accruals:

STDRTNSTDCFO

STDSALESBIGCFOSIZE

LAGROALASTFIRSTLOSSLEV

LAGTACDISNASDISNASACCRUAL

1514

13121110

98765

43210

5

*

(2)

where ACCRUAL is the absolute value of discretionary accruals, NAS is one of our

three auditor fee measures (i.e., NASRATIO, NASFEE, or TOTALFEE), and DIS is

an indicator variable that takes the value of 1 if a firm is required to publicly disclose

fee information and 0 otherwise. 10 If public fee disclosure improves auditor

independence (and therefore audit quality), we expect 02 and 03 .

The results are presented in Table 5. We find no evidence that NASRATIO,

NASFEE, or DIS has a significant main effect. This evidence suggests that non-audit

fees and fee disclosures in themselves did not directly affect discretionary accrual

levels. However, the interaction between NASRATIO and disclosure (but not between

NASFEE and disclosure) is negative and significant at the 5% level (two-tailed),

10 Although we combine the absolute values of both positive and negative discretionary accruals in our tests, it may also be the case that the provision of non-audit services has differential effects on positive and negative discretionary accruals (Ashbaugh, Lefond, and Mayhew [2003]). When we estimated separate models for positive and negative accruals, the NAS variables were only significant in the positive discretionary accruals models (i.e., higher than predicted accruals). We also estimated the models using audit fees in place of non-audit fees. The audit fee variable was not significant using either of our audit quality proxies, suggesting that audit fees are not driving the observed relation between fee disclosures and audit quality in our sample.

20

implying that discretionary accruals in disclosing firms (but not in non-disclosing

firms) are lower when the ratio of non-audit to total fees is higher.

In contrast to the insignificant main effects for the non-audit fee and disclosure

variables, the coefficient on the TOTALFEE main effect is positive and significant (p

< 0.05), consistent with larger payments to auditors impairing their independence. The

significant negative coefficient on the TOTALFEE*DIS interaction, on the other hand,

indicates that this relationship reverses when disclosure is required. Whereas the

estimated effect of TOTALFEE on ACCRUAL is 0.029 in the non-disclosing firm, its

effect in disclosing firms is -0.029 (i.e., 0.029 + (-0.058)) with the joint effect of α1 +

α3 significantly different from zero (F = 2.97, p = 0.08). As expected, discretionary

accruals are positively associated with LAGTAC, LOSS, FIRST, LAGROA, and

STDRTN, and negatively associated with SIZE and CFO.

4.2.2 UNFAVORABLE OPINION TESTS

Results for the audit opinion tests are provided in Table 6. We estimate the

following probit model to assess the auditor’s probability of issuing an unfavorable

opinion:

5

*

10

98765

43210

BIG

DEFAULTGROWSIZELEVLIQ

PROFITDISNASDISNASUNFAVOR

(3)

where UNFAVOR equals 1 if the firm received an unfavorable audit opinion, and 0

otherwise. The results are very similar to those in the discretionary accruals tests. We

continue to find no evidence that non-audit fees or disclosures in themselves have an

effect on audit quality, but significant evidence (p < 0.05, two-tailed) that the

probability of receiving an unfavorable opinion increases in disclosing firms when the

NAS ratio is higher. The coefficient on TOTALFEE is negative and significant,

indicating that in the absence of fee disclosures, higher payments to auditors reduce

21

the probability of receiving an unfavorable opinion. This result is consistent with the

earlier discretionary accrual evidence that in firms without disclosure requirements,

audit quality is lower when total fees are larger. However, the coefficient on the

TOTALFEE*DIS interaction is positive and significant at the 1% level, suggesting that

disclosure moderates the negative relation between total fees and unfavorable

opinions. A joint test of β1 + β3 (-0.201 + 0.224) in Model 3 is statistically

insignificant (χ2 = 0.65, p = 0.42), implying that the negative association between total

fees paid to auditors and unfavorable opinions disappears when fees are required to be

disclosed. Consistent with prior studies, the significant coefficients on the control

variables indicate that highly leveraged, less profitable, and smaller firms, and firms

in default, are more likely to receive unfavorable audit opinions.11

4.3 BEFORE-AND-AFTER TESTS OF AUDIT QUALITY

The preceding evidence is consistent with fee disclosure requirements improving

audit quality.12 However, an alternative explanation for the positive or insignificant

associations between NAS and the audit quality proxies in the disclosing firms but not

in the non-disclosers is that more extensive provision of non-audit services improves

the auditor’s knowledge of the client, leading to higher quality audits (e.g., Simunic

[1984]). Given Taiwan’s fee disclosure thresholds, the only firms purchasing

extensive non-audit services are disclosing firms, potentially explaining why audit

quality is higher in these firms. We investigate this possibility using multivariate tests

11 Following Lennox [2005], we repeated the opinion analyses using the subsample of companies that were more likely to deserve unfavorable opinions. We first estimated an audit opinion model using the following explanatory variables from prior studies: ROA, current assets to current liabilities, total liabilities to total assets, total assets, an indicator for firms default, and company growth. We then dropped 502 observations whose predicted probability of receiving an unfavorable opinion was less than 10%. The results were consistent with those using the full sample. 12Prior studies suggest that corporate governance can influence audit quality (e.g., Larcker and Richardson [2004]). To ensure that our results are not driven by governance differences, we re-estimated all of our models after including the percentage of inside ownership, the percentage of outside directors, board size, and CEO/Chairman duality as additional controls. Our results hold when we include these additional variables.

22

of differences in the audit quality measures between 2001 (the year prior to the

disclosure requirements) and 2002 (the first disclosure year). We pool the two years

and include an indicator variable for 2002 (denoted AFTER). Separate models are

estimated for disclosers and non-disclosers, and standard errors are clustered by

company. If the disclosure requirements have differential effects on disclosers and

non-disclosers, then the coefficients on AFTER should be significantly different in the

two groups.

The results are presented in Table 7. In the disclosing firms, the coefficient on

AFTER is negative and highly significant in the ACRRUAL model (p < 0.01,

two-tailed), and positive but marginally insignificant (p < 0.12, two-tailed) in the

UNFAVOR model. In contrast, AFTER is insignificant for the non-disclosing firms

regardless of the audit quality measure. More importantly, F-tests for the equality of

coefficients on AFTER in the two groups indicate that the coefficients for the

disclosing firms are significantly different (p < 0.05) in both models. These results are

similar to the univariate tests in Table 4 which indicated that audit quality improved in

the mandatory disclosers in the first disclosure year, but did not change significantly

in the non-disclosers. Overall, the before-and-after test results are consistent with the

fee disclosure requirements having beneficial effects on auditor independence and

audit quality.

4.4 NAS RATIO DISCLOSURE THRESHOLD AND AUDIT QUALITY

We provide further evidence on the relation between fee disclosure requirements

and audit quality by taking advantage of Taiwan’s 25% non-audit to audit fee

disclosure threshold. The vast majority of mandatory fee disclosures were triggered

by this exogenously-imposed threshold, providing a natural opportunity to examine

23

discontinuities in audit quality around the 25% cutoff.13 If fee disclosures lead

auditors to increase independence from their clients, we expect the change in audit

quality to be most prominent around the 25% threshold.

We begin testing this prediction by incorporating the following indicator

variables in the 2002 audit quality models:

NAS05= 1 if a firm’s ratio of NAS fees to audit fees is between 0% and 5%

(inclusive), and 0 otherwise;

NAS15= 1 if a firm’s ratio of NAS fees to audit fees is between 5% (exclusive)

and 15% (inclusive), and 0 otherwise;

NAS25= 1 if a firm’s ratio of NAS fees to audit fees is between 15% (exclusive)

and 25% (inclusive), and 0 otherwise;

NAS35= 1 if a firm’s ratio of NAS fees to audit fees is between 25% (exclusive)

and 35% (inclusive), and 0 otherwise; and

NAS45= 1 if a firm’s ratio of NAS fees to audit fees is between 35% (exclusive)

and 45% (inclusive), and 0 otherwise.

The excluded category is firms with NAS to audit fee ratios greater than 45%. Table 8

presents regression results relating audit quality to the five categories of NAS to audit

fees. Audit quality is not significantly different in firms with very low NAS ratios

(NAS05) and very high ratios (the excluded category with NASRATIO > 0.45). As the

NAS ratio increases, audit quality becomes lower, with NAS15 significant in both the

ACCRUAL and UNFAVOR models. Audit quality becomes even lower in the NAS25

group where the indicators are significant in both models (p < 0.05, two-tailed), with

13 As noted earlier, 81.3% of the disclosers met the NAS ratio or magnitude threshold (with nearly all due to the ratio threshold). The disclosing firms meeting the other two thresholds made relatively little use of non-audit services. Our results are virtually unchanged when we exclude these observations. In addition, when we compare 2001 and 2002 audit quality in disclosers meeting the other two thresholds to the non-disclosers, we find no significant differences in audit quality. Thus, the observed audit quality differences appear to reflect the non-audit to audit fee ratio threshold.

24

the coefficient magnitudes significantly different than those on NAS15. When the

firms enter the NAS35 group and are required to disclose auditor fees, the coefficient

magnitudes become significantly smaller than those on the NAS25 indicator (p < 0.10).

Audit quality in the NAS45 group is not significantly different than that in firms with

NAS ratios greater than 45%. This evidence suggests that higher NAS ratios

compromise auditor independence in the absence of fee disclosure requirements, but

that the perceptual and reputational effects of mandated fee disclosures can prompt

greater auditor independence and higher audit quality.

Further evidence in support of this interpretation is found when we look more

closely at firms in close proximity to the 25% NAS to audit fee threshold. Figure 1

provides a histogram of the number of observations with NAS to audit fee ratios

within ±10% of this threshold (N = 120). The figure shows a distinct discontinuity

around the disclosure threshold. Whereas 32 firms reported NAS ratios of 22% to

24% (just below the threshold), only 6 reported NAS ratios of 25% to 27% (just

above). Similarly, 14 firms had NAS ratios of 24% and only 3 of 25%. These

distributions suggest that firms attempted to avoid this disclosure threshold, either by

reducing their purchases of non-audit services or by working with their auditors to

classify services as audit-related rather than non-audit-related.14

Table 9 reports univariate tests of changes in audit quality for the disclosers and

non-disclosers in this subsample. Once again, the two groups exhibit no significant

audit quality differences in the year prior to the disclosure requirements, while the

14 Taiwanese disclosure rules require fees for services to be classified as audit-related if those services are “normally provided” in connection with statutory and regulatory filings or if they are “reasonably related” to the performance of the audit. This vague wording suggests that fee disclosures may not be made in a consistent manner across companies. This situation may be exacerbated if an auditor agrees too readily with a client’s questionable reporting practices. Specifically, the auditor and its client might exploit the vague fee classification rules to avoid the fee disclosure threshold and hide their conflict of interest.

25

disclosers exhibit statistically higher audit quality in the first disclosure year. Mean

and median changes in discretionary accruals and unfavorable opinions between 2001

and 2002 are statistically significant for the disclosers, but neither changed

significantly in the non-disclosers. The differences in accruals and audit opinions

were not accompanied by differential mean or median changes in any of the control

variables (not tabulated), which remained statistically unchanged in both groups.15

The results in the univariate change tests are mirrored in the multivariate

before-and-after tests in Table 10. These regression models pool discloser and

non-discloser data from 2001 (the year prior to disclosure) and 2002 (the first

disclosure year). Indicator variables for disclosers (DIS) and the initial disclosure year

(AFTER) are included as additional predictors, along with the interaction between

these two indicators. Standard errors are clustered by company. If the disclosers’ audit

quality improved in response to the fee disclosure requirements, then the coefficients

on DIS*AFTER should be statistically negative in the ACCRUAL model and

statistically positive in the UNFAVOR model. The evidence supports these predictions,

with the interaction terms significant in the predicted directions. AFTER is not

significant in any of the models, but the disclosure firm indicator (DIS) is significantly

negative in the UNFAVOR model. The significant coefficient on DIS indicates that

prior to mandated disclosure, unfavorable opinions were less likely in the disclosing

firms after controlling for the other covariates. However, the opposite coefficient sign

on the significant interaction term implies that this relationship disappeared following

disclosure (with the joint effect of DIS and DIS*AFTER insignificant in the

UNFAVOR model). In sum, tests taking advantage of the exogenously imposed fee

disclosure threshold provide consistent evidence that the mandated disclosures led to 15 Results are similar when we restrict the sample to firms within ± 5% of the NAS to audit fee threshold.

26

significant improvements in the audit quality proxies in the disclosing firms.16 To the

extent that these changes were due (at least in part) to actions by or pressure from

auditors, these results support claims that fee disclosure enhances auditor

independence.17

5. Summary and Conclusions

This study takes advantage of Taiwan’s differential auditor fee disclosure

requirements to examine whether mandatory disclosure of non-audit fees: (1)

moderates the relation between NAS provision and audit quality, and (2) is associated

with improvements in audit quality. Economic and psychological theories provide

contradictory predictions regarding the benefits from mandatory disclosure of

conflicts of interest. Using either discretionary accruals or unfavorable audit opinions,

we find that audit quality is significantly higher in the disclosing firms. We also find

that disclosure eliminated or reversed any negative associations between NAS and

audit quality observed in the non-discloser group. In the year prior to the fee

disclosure requirements, the disclosing and non-disclosing groups displayed no

significant differences in audit quality. With the introduction of mandatory disclosure,

16 We also replicated the 2002 interaction tests in Tables 5 and 6 using the subsample of firms with NAS ratios within ± 10% of the 25% disclosure threshold. The results were nearly identical to those using the full sample, with all variables that were statistically significant remaining significant. 17 Although our evidence suggests that fee disclosures improved audit quality in our sample, it does not appear that this improvement was recognized by market participants. When we estimated the impact of fee disclosures on earnings response coefficients, we found that firms that publicly disclosed higher NAS fees ratios, NAS fees, and total fees tended to have lower ERCs than firms that disclosed lower values for these measures, and that auditor fees had no significant relation with ERCs in non-disclosers, despite our evidence that audit quality is no lower and sometimes higher in the disclosing firms. In addition, the ERC tests indicated that investors did not significantly discount the earnings quality of non-disclosing firms with higher NAS relative to non-disclosing firms with lower NAS, providing further evidence that auditor independence-in-appearance can vary from independence-in-fact. The negative relations between our NAS variables and ERCs in disclosing firms, and insignificant relations in non-disclosers, are consistent with the U.S. findings of Francis and Ke [2006]. These results are also consistent with experimental evidence that disclosure of NAS fees can reduce the efficiency of capital markets if such disclosures result in investors forming inaccurate beliefs of auditor independence-in-fact (Dopuch, King, and Schwartz [2003]). .

27

the disclosing firms exhibited significantly improved audit quality while

non-disclosers exhibited no significant change. Taken together, our results are

consistent with mandatory fee disclosure enhancing auditor independence and

improving audit quality.

Our study has the following limitations. First, our sample comes from listed

firms in Taiwan, a country that is characterized by relation- versus rules-based

governance, code versus common law legal origin, more limited financial

transparency, and lower auditor legal liability. Although this setting limits the

generalizability of our results, these characteristics are common to many East Asian

countries that together represent a significant proportion of the world economy. In

addition, Taiwan’s differential fee disclosure requirements and our unique access to

the confidential fee data for the non-disclosers provide a unique setting for comparing

auditor independence and audit quality between the disclosing firms and the

non-disclosers. Second, our sample is limited to the first year of mandatory disclosure

due to constraints on our access to fees for the non-disclosers. This allows us to

examine the initial response to the new disclosure requirements, but potentially

restricts the generalizability of the findings to later years.

Despite these limitations, our study makes a number of contributions to the audit

and mandatory disclosure literatures. In particular, we provide the first evidence that

mandatory fee disclosures can lead to improvements in audit quality. In doing so, we

provide a potential explanation for the insignificant relations between NAS and audit

quality in many prior studies that rely on post-disclosure fee data, and contribute to

the theoretical debate over the value of mandatory disclosure of conflicts of interest.

28

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FIGURE 1

Distribution of Non-Audit to Audit Fees Surrounding the 25% Threshold Triggering

Mandatory Disclosure of Auditor Fees

33

TABLE 1

Sample Composition by Industry SIC Industry N % of Sample NASRATIO

10 Metal Mining 8 0.010 0.133

13 Oil and Gas Field Services, NEC 11 0.014 0.048

15 Building Construction General Contractors And Operative Builders

22 0.028 0.050

17 Electrical Work 24 0.030 0.099

20 Miscellaneous Food Preparations & Kindred Products

45 0.056 0.053

23 Miscellaneous Fabricated Textile Products

28 0.035 0.053

24 Prefabricated Wood Buildings and Components

7 0.009 0.066

26 Plastics, Foil, and Coated Paper Bags 7 0.009 0.053

29 Miscellaneous Products of Petroleum & Coal

9 0.011 0.113

30 Plastics Products, NEC 32 0.040 0.056

33 Miscellaneous Primary Metal Products

24 0.030 0.053

34 Miscellaneous Fabricated Metal Products

10 0.013 0.133

35 Misc. Industrial & Commercial Machinery & Equipment

163 0.204 0.128

36 Magnetic and Optical Recording Media

211 0.264 0.133

37 Miscellaneous Transportation Equipment

4 0.005 0.062

39 Miscellaneous Manufacturing Industries

33 0.041 0.127

44 Deep Sea Foreign Transportation of Freight

8 0.010 0.128

45 Airports, Flying Fields, and Airport Terminal Services

7 0.009 0.118

50 Durable Goods, NEC 40 0.050 0.147

59 Retail-Retail Stores, NEC 12 0.015 0.124

60 Functions Related to Deposit Banking, NEC

54 0.068 0.124

99 Non-Operating Establishments 39 0.049 0.101

N is the number of observations. NASRATIO = (Non-audit fees/Total fees).

34

TABLE 2

Variable Definitions Variable Name Description

ACCRUAL Absolute value of discretionary accruals

NASRATIO Proportion of NAS fees to total fees

NASFEE Logarithm of NAS fees

TOTALFEE Logarithm of total fees

DIS Indicator equal to 1 if a firm is required to publicly disclose fee information, and 0 otherwise

LAGTAC Lagged total accruals

LEV Financial leverage, defined as the ratio of total liabilities to total assets

LOSS Indicator equal to 1 if net income before extraordinary items is negative, and 0 otherwise

FIRST Indicator equal to 1 if the year is the first year with the auditor, and 0 otherwise

LAST Indicator equal to 1 if the year is the last year with the auditor, and 0 otherwise

LAGROA Lagged return on assets

SIZE Natural log of total assets

CFO Cash flow from operations deflated by lagged total assets

BIG5 Indicator equal to 1 if the auditor is from a Big 5 audit firm, and 0 otherwise

STDSALES Standard deviation of sales revenue; estimated using a rolling window and requiring three years of data

STDCFO Standard deviation of CFO; estimated using a rolling window and requiring three years of data

STDRTN Stock volatility, estimated using the standard deviation of monthly stock returns for the current fiscal year

UNFAVOR Indicator equal to 1 if the firm received an unfavorable audit opinion, and 0 otherwise

PROFIT Ratio of net income to total assets

LIQ Ratio of current assets to current liabilities

GROW Annual percentage change in total assets

DEFAULT Indicator equal to 1 if the company is in default, and 0 otherwise

35

TABLE 3

Correlations

Panel A: Correlations for discretionary accrual models

2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

1. ACCRUAL -0.04 * -0.03 -0.02 -0.02 0.32 ** 0.12 * 0.15 ** 0.23 ** 0.07 * 0.12 ** -0.13 ** -0.22 ** -0.07 * -0.08 * -0.18 ** 0.22 **

2. NASRATIO 0.71 ** 0.67 ** 0.60 ** -0.01 0.09 ** -0.03 0.02 -0.03 0.07 * 0.06 * 0.12 * 0.24 ** 0.09 ** 0.10 ** -0.04

3. NASFEE 0.50 ** 0.52 ** -0.02 0.08 ** 0.08 * 0.03 -0.02 0.11 ** 0.04 0.08 * 0.21 ** 0.06 * 0.07 * -0.03

4. TOTALFEE 0.32 ** -0.02 0.06 * 0.04 -0.01 -0.04 0.08 * 0.02 0.06 * 0.28 ** 0.07 * 0.06 * -0.02

5. DIS -0.10 ** -0.02 -0.13 ** 0.00 0.02 0.03 0.05 * 0.03 0.13 ** 0.03 0.04 -0.02

6. LAGTAC 0.13 ** 0.07 * 0.14 ** 0.08 * 0.14 ** -0.20 ** -0.24 ** -0.08 * 0.12 ** 0.13 ** -0.08 *

7. LEV 0.16 ** -0.03 -0.01 0.02 0.12 ** 0.11 ** 0.24 ** -0.02 -0.03 0.04

8. LOSS 0.07 * 0.02 0.04 -0.31 ** -0.36 ** -0.04 -0.03 0.01 0.02

9. FIRST 0.10 ** 0.03 -0.08 * 0.02 0.07 * 0.02 0.01 -0.01

10.LAST -0.02 -0.07 * 0.01 0.06 * 0.01 -0.02 0.03

11.LAGROA 0.02 0.22 ** 0.02 0.10 ** 0.08 * -0.07 *

12.SIZE 0.26 ** 0.23 ** 0.08 * 0.07 * -0.06 *

13.CFO 0.09 ** 0.23 ** 0.18 ** -0.09 *

14.BIG5 0.07 * 0.09 * -0.04

15.STDSALES 0.16 ** -0.08 *

16.STDCFO -0.11 **

17.STDRTN

36

TABLE 3 -Continued

Panel B: Correlations for unfavorable audit opinion models

2 3 4 5 6 7 8 9 10 11 12

1. UNFAVOR 0.11 ** 0.07 ** 0.09 ** 0.06 * -0.30 ** -0.04 0.13 ** -0.16 ** -0.06 * 0.48 ** -0.16 **

2. NASRATIO 0.71 ** 0.67 ** 0.63 ** 0.12 ** 0.03 0.09 ** 0.06 * 0.03 -0.09 ** 0.24 **

3. NASFEE 0.50 ** 0.50 ** 0.10 ** -0.01 0.08 ** 0.04 0.05 * -0.08 ** 0.21 **

4. TOTALFEE 0.30 ** 0.08 ** 0.03 0.06 * 0.02 0.01 -0.10 ** 0.28 **

5. DIS 0.03 -0.02 0.02 0.05 * -0.02 -0.07 * 0.13 **

6.PROFIT 0.01 -0.17 ** 0.08 * 0.08 * -0.47 ** 0.08 **

7.LIQ 0.04 0.12 ** 0.04 -0.16 ** 0.09 **

8.LEV 0.12 ** 0.07 * 0.68 ** 0.24 **

9.SIZE -0.24 ** -0.16 ** 0.23 **

10.GROW -0.24 ** 0.04

11.DEFAULT -0.07 *

12.BIG5

The table reports Pearson correlations. Spearman correlations yield similar results. ACCRUAL is the absolute value of discretionary accruals; UNFAVOR is an indicator variable coded 1 for an unfavorable audit opinion, else 0; NASRATIO is the proportion of non-audit fees to total fees; NASFEE is the logarithm of non-audit fees; and TOTALFEE is the logarithm of total fees paid to auditors. See Table 2 for other variable definitions .

***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively.

37

TABLE 4

Mean (Median) Comparisons of Independent and Dependent Variables in Disclosers

and Non-Disclosers

Year Prior to First Disclosure (2001)

First Disclosure Year (2002)

Test Statistics for Mean (Median) Differences Between Years

Discloser Non-Discloser Discloser Non-Discloser Discloser Non- Discloser

ACCRUAL 0.075 0.078 0.058+++ 0.072 -2.684*** -0.684 (0.064) (0.068) (0.046)+++ (0.061) (-2.438)*** (-0.882) UNFAVOR 0.068 0.078 0.094 0.085 1.747* 1.382 (0.000) (0.000) (0.000) (0.000) (1.732)* (1.013) NASRATIO 0.446+++ 0.053 (0.427)+++ (0.033) NASFEE 1263.239+++ 133.102 ($ thousands) (1000)+++ (66) TOTALFEE 2712.162 2422.287 ($ thousands) (2388) (2006) LAGTAC 0.202 0.221 0.190 0.218 -0.572 -0.221 (0.152) (0.176) (0.147) (0.168) (-0.431) (-0.467)LEV 0.342 0.403 0.349+ 0.408 0.215 0.202 (0.331) (0.392) (0.337)+ (0.396) (0.321) (0.309) LOSS 0.172 0.213 0.188 0.220 0.421 0.306 (0.000) (0.000) (0.000) (0.000) (0.521) (0.412) BIG5 0.793 0.776 0.803 0.780 0.278 0.168 (1.000) (1.000) (1.000) (1.000) (0.312) (0.286)FIRST 0.016 0.018 0.019 0.017 0.162 -0.102 (0.000) (0.000) (0.000) (0.000) (0.213) (-0.226) LAST 0.028 0.036 0.034 0.038 0.582 0.285 (0.000) (0.000) (0.000) (0.000) (0.325) (0.298) LAGROA 0.113 0.088 0.102 0.083 -0.321 -0.226 (0.108) (0.082) (0.968) (0.081) (-0.402) (-0.206)CFO 0.121+++ 0.072 0.113+++ 0.066 -0.398 -0.349 (0.116)+++ (0.068) (0.102)+++ (0.061) (-0.512) (-0.498) PROFIT 0.058+++ 0.042 0.053+++ 0.039 -0.365 -0.358 (0.050)+++ (0.038) (0.047)+++ (0.035) (-0.248) (-0.312) LIQ 2.426 2.216 2.431 2.230 0.132 0.206 (2.365) (2.165) (2.372) (2.169) (0.298) (0.326)GROW 1.257 1.158 1.246 1.161 -0.236 0.166 (1.136) (1.068) (1.125) (1.104) (-0.265) (0.298) SIZE 23.482 21.365 23.541 21.417 0.287 0.275 (23.254) (20.350) (23.383) (20.865) (0.321) (0.287) STDSALES 0.258 0.262 0.255 0.259 -0.287 -0.279 (0.201) (0.206) (0.196) (0.202) (-0.265) (-0.258)STDCFO 0.094 0.097 0.089 0.093 -0.412 -0.408 (0.073) (0.078) (0.068) (0.074) (-0.422) (-0.411) STDRTN 0.112 0.116 0.108 0.113 -0.365 -0.348 (0.106) (0.111) (0.105) (0.109) (-0.208) (-0.213) DEFAULT 0.008 0.010 0.017 0.012 0.576 0.623 (0.000) (0.000) (0.000) (0.000) (0.564) (0.598)

38

NOTES TO TABLE 4:

ACCRUAL is the absolute value of discretionary accruals; UNFAVOR is an indicator variable coded 1

for an unfavorable audit opinion, else 0; NASRATIO is the proportion of non-audit fees to total fees;

NASFEE is the logarithm of non-audit fees; and TOTALFEE is the logarithm of total fees paid to

auditors. See Table 2 for other variable definitions.

+++, ++, + indicate significantly different than non-disclosers in that year at the 1%, 5%, and 10%

levels, respectively. ***, **, * indicate that values in 2001 and 2002 were significantly different at the

1%, 5%, and 10% levels, respectively.

39

TABLE 5 OLS Models Examining the Effect of NAS Fee Disclosure on the Absolute Value of

Discretionary Accruals (N=798)

STDRTNSTDCFO

STDSALESBIGCFOSIZE

LAGROALASTFIRSTLOSSLEV

LAGTACDISNASDISNASACCRUAL

1514

13121110

98765

43210

5

*

(NAS = NASRATIO for Model 1, NASFEE for Model 2, and TOTALFEE for Model 3)

Model 1 Model 2 Model 3

Variable: Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.

NASRATIO 0.066 1.073

NASFEE 0.019 0.738

TOTALFEE 0.029 1.995 **

DIS -0.008 -0.765 -0.010 -0.836 -0.011 -0.852

NASRATIO*DIS -0.113 -1.995 **

NASFEE*DIS -0.043 -1.619

TOTALFEE*DIS -0.058 -2.799 ***

LAGTAC 0.059 2.903 *** 0.055 2.737 *** 0.056 2.782 ***

LEV 0.021 1.368 0.022 1.447 0.021 1.395

LOSS 0.018 2.516 ** 0.018 2.517 ** 0.019 2.619 ***

FIRST 0.044 2.507 ** 0.043 2.445 ** 0.047 2.636 ***

LAST 0.006 0.569 0.005 0.478 0.007 0.617

LAGROA 0.059 1.723 * 0.058 1.713 * 0.054 1.588

SIZE -0.007 -2.020 ** -0.006 -2.401 ** -0.009 -2.964 ***

CFO -0.046 -1.810 * -0.043 -1.701 * -0.044 -1.749 *

BIG5 -0.004 -0.879 -0.004 -0.871 -0.003 -0.862

STDSALES -0.032 -0.862 -0.046 -0.928 -0.035 -0.770

STDCFO -0.003 -0.945 -0.005 -1.045 -0.003 -0.939

STDRTN 0.247 2.962 *** 0.251 2.966 *** 0.243 2.891 ***

CONSTANT -0.032 -0.862 -0.036 -0.908 -0.035 -0.890

Adj. R2 0.092 0.090 0.094

N is the number of observations. ACCRUAL is the absolute value of discretionary accruals; NASRATIO is the proportion of non-audit fees to total fees; NASFEE is the logarithm of non-audit fees; TOTALFEE is the logarithm of total fees paid to auditors; and DIS is an indicator variable coded 1 for disclosing firms and 0 for non-disclosers. See Table 2 for other variable definitions. ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively.

40

TABLE 6

Probit Models Examining the Effect of NAS Fee Disclosure on Unfavorable Audit

Opinions (N=798)

5

*

10

98765

43210

BIG

DEFAULTGROWSIZELEVLIQ

PROFITDISNASDISNASUNFAVOR

(NAS = NASRATIO for Model 1, NASFEE for Model 2, and TOTALFEE for Model 3)

Model 1 Model 2 Model 3

Variable: Coeff. z-stat Coeff. z-stat Coeff. z-stat

NASRATIO -0.785 -1.017

NASFEE -0.232 -0.878

TOTALFEE -0.201 1.972 **

DIS 0.201. 0.687 0.203 0.691 0.205 0.672

NASRATIO*DIS 1.253 1.998 **

NASFEE*DIS 0.616 1.601

TOTALFEE*DIS 0.224 2.994 ***

PROFIT -1.033 -2.178 ** -1.195 -2.513 ** -1.280 -2.703 ***

LIQ -0.000 -0.038 0.001 0.042 0.001 0.077

LEV 0.951 3.002 *** 0.866 2.734 *** 0.837 2.634 ***

SIZE -0.000 -3.737 *** -0.000 -3.764 *** -0.000 -3.071 ***

GROW -0.026 -0.359 -0.030 -0.415 -0.038 -0.515

DEFAULT 7.144 5.150 *** 6.846 4.121 *** 6.609 4.006 ***

BIG5 0.041 0.823 0.042 0.831 0.040 0.817

CONSTANT -0.238 -1.379 -0.190 -1.036 -0.227 -1.256

Pseudo R2 0.104 0.102 0.107

N is the number of observations. UNFAVOR is an indicator variable coded 1 for an unfavorable audit opinion, else 0; NASRATIO is the proportion of non-audit fees to total fees; NASFEE is the logarithm of non-audit fees; TOTALFEE is the logarithm of total fees paid to auditors; and DIS is an indicator variable coded 1 for disclosing firms and 0 for non-disclosers. See Table 2 for other variable definitions.

***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively.

41

TABLE 7

Models Examining Audit quality in Disclosers and Non-Disclosers in the Years

Before and After the Introduction of Mandatory Disclosure

Discretionary accrual model (OLS):

STDRTNSTDCFOSTDSALESBIG

CFOSIZELAGROALASTFIRST

LOSSLEVLAGTACAFTERACCRUAL

13121110

98765

43210

5

Unfavorable audit opinion model (Probit):

58765

43210

BIGDEFAULTGROWSIZE

LEVLIQPROFITAFTERUNFAVOR

Panel A: Discretionary accruals

Discloser (N=234) Non-Discloser (N=1362)

Variable: Coeff. t-stat. Coeff. t-stat.

AFTER (=1) -0.065 -2.752 *** -0.010 -0.429

LAGTAC 0.074 2.115 ** 0.063 2.007 **

LEV 0.033 1.455 0.029 1.389

LOSS 0.024 2.101 ** 0.019 1.956 **

FIRST 0.056 2.358 ** 0.037 2.006 **

LAST 0.008 0.580 0.007 0.509

LAGROA 0.063 1.738 * 0.048 1.554

SIZE -0.008 -1.761 * -0.007 -1.563

CFO -0.052 -1.977 ** -0.048 -1.734 *

BIG5 -0.006 -0.871 -0.005 -0.778

STDSALES -0.036 -0.774 -0.038 -0.913

STDCFO -0.003 -0.931 -0.006 -1.206

STDRTN 0.238 2.879 *** 0.247 2.816 ***

CONSTANT -0.036 -0.868 -0.041 -0.892

Adj. R2 0.076 0.072

F-test for equality of AFTER 5.81**

42

TABLE 7 -Continued

Panel B: Unfavorable audit opinion

Discloser (N=234) Non-Discloser (N=1362)

Variable: Coeff. z-stat Coeff. z-stat

AFTER (=1) 0.724 1.588 0.324 0.783

PROFIT -1.232 -2.319 ** -1.168 -2.113 **

LIQ -0.001 -0.043 0.001 0.036

LEV 0.861 2.968 *** 0.877 3.005 ***

SIZE -0.000 -3.446 *** -0.000 -3.547 ***

GROW -0.033 -0.406 -0.036 -0.513

DEFAULT 6.458 4.223 *** 6.056 4.042 ***

BIG5 0.035 0.786 0.053 0.935

CONSTANT -0.326 -1.546 -0.183 -1.013

Pseudo R2 0.113 0.106

F-test for equality of AFTER 4.50**

The models pool data from 2001 (the year prior to mandatory disclosure) and 2002 (the first disclosure year). N is

the number of observations. ACCRUAL is the absolute value of discretionary accruals; UNFAVOR is an

indicator variable coded 1 for an unfavorable audit opinion, else 0; NASRATIO is the proportion of

non-audit fees to total fees; NASFEE is the logarithm of non-audit fees; TOTALFEE is the logarithm

of total fees paid to auditors; and AFTER is an indicator variable coded 1 if year = 2002 , and 0 if year = 2001.

See Table 2 for other variable definitions.

***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively. Test statistics are computed using

robust standard errors adjusted for clustering by firm.

43

TABLE 8 Models Examining the Association Between of Non-Audit to Audit Fee Ratios and

Audit quality (N = 798)

Discretionary accruals model (OLS):

STDRTNSTDCFO

STDSALESBIGCFOSIZELAGROA

LASTFIRSTLOSSLEVLAGTAC

NASNASNASNASNASACCRUAL

1716

1514131211

109876

543210

5

4535251505

Unfavorable audit opinion model (Probit):

5

4535251505

12

11109876

543210

BIG

DEFAULTGROWSIZELEVLIQPROFIT

NASNASNASNASNASUNFAVOR

Discretionary Accruals Unfavorable Audit Opinion

Variables Coeff. (t-stat)

Variables Coeff. (z-stat)

NAS05

0.016 (1.632)

NAS05

-0.223 (-1.607)

NAS15

0.020* (1.852)

NAS15

-0.255* (-1.892)

NAS25

0.032*** (3.105)

NAS25

-0.383** (-2.210)

NAS35

0.018* (1.691)

NAS35 -0.231* (-1.678)

NAS45

0.006 (0.684)

NAS45 -0.162 (-1.041)

LAGTAC

0.062*** (2.973)

PROFIT -1.086** (-2.286)

LEV

0.022 (1.292)

LIQ -0.002 (-0.097)

LOSS

0.021*** (2.768)

LEV 0.960*** (3.023)

FIRST

0.047** (2.515)

SIZE -0.000*** (-3.651)

LAST

0.007 (0.624)

GROW -0.027 (-0.330)

LAGROA

0.059* (1.756)

DEFAULT 6.537*** (4.002)

SIZE

-0.006*** (-3.587)

BIG5 0.040 (0.859)

CFO

-0.044* (-1.730)

CONSTANT -0.160 (-0.863)

BIG5

-0.005 (-0.968)

STDSALES

0.012 * (1.770)

STDCFO

-0.006 (-0.970)

STDRTN

0.202*** (2.718)

44

CONSTANT Adj. R2

-0.045 (-0.930)

0.062

Pseudo R2

0.112

N is the number of observations. NAS05 is an indicator variable coded to 1 if a firm’s ratio of NAS fees to audit fees is between 0% and 5%, and 0 otherwise; NAS15 is an indicator variable coded 1 if a firm’s ratio of NAS fees to audit fees is between 5% and 15%, and 0 otherwise; NAS25 is an indicator variable coded 1 if a firm’s ratio of NAS fees to audit fees is between 15% and 25%, and 0 otherwise; ACCRUAL is the absolute value of discretionary accruals; UNFAVOR is an indicator variable coded 1 for an unfavorable audit opinion, and 0 otherwise; NASRATIO is the proportion of non-audit fees to total fees; and NASFEE is the logarithm of non-audit fees; TOTALFEE is the logarithm of total fees paid to auditors. See Table 2 for other variable definitions. ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively.

45

TABLE 9

Mean (Median) Comparisons of Audit quality and Auditor Fees in the Subset of

Disclosers and Non-Disclosers Within ±10% of the Non-Audit to Audit Fee Ratio

Threshold for Mandatory Disclosure

N is the number of observations. ACCRUAL is the absolute value of discretionary accruals; UNFAVOR is an indicator variable coded 1 for an unfavorable audit opinion, else 0; NASRATIO is the proportion of non-audit fees to total fees; NASFEE is the logarithm of non-audit fees;and TOTALFEE is the logarithm of total fees paid to auditors. See Table 2 for other variable definitions.

+++, ++, + indicate significantly different than non-disclosers in that year at the 1%, 5%, and 10%

levels, respectively. ***, **, * indicate that values in 2001 and 2002 were significantly different at the

1%, 5%, and 10% levels, respectively.

Year prior to first disclosure (2001)

First disclosure year (2002)

Test Statistics for Mean ( Median) Differences Between Years

Discloser (N = 35)

Non- Discloser (N = 85)

Discloser (N = 35)

Non- Discloser (N = 85)

Discloser (N=35)

Non- Discloser (N=85)

ACCRUAL 0.092 0.098 0.051+++ 0.129 -2.712*** 0.790 (0.084) (0.088) (0.043)+++ (0.098) (-2.650)*** (0.892) UNFAVOR 0.057 0.086 0.114+ 0.071 2.036** -0.882 (0.000) (0.000) (0.000)+ (0.000) (1.998)** (-0.967) NASRATIO 0.309 0.204 (0.313) (0.212) NASFEE 687.246 426.123 ($ thousands) (863) (402) TOTALFEE 2112.252 1763.252 ($ thousands) (2036) (1606)

46

TABLE 10 Multivariate Tests Examining Audit quality in the Pre- and Post-Disclosure Years;

Subsample of Firms With Non-Audit to Audit Fee Ratios Within ±10% of the Non-Audit to Audit Fee Ratio Threshold for Mandatory Disclosure (N = 240)

Discretionary accruals model (OLS):

STDRTNSTDCFO

STDSALESBIGCFOSIZE

LAGROALASTFIRSTLOSSLEV

LAGTACAFTERDISAFTERDISACCRUAL

1514

13121110

98765

43210

5

*

Unfavorable audit opinion model (Probit):

5

*

109876

543210

BIGDEFAULTGROWSIZELEV

LIQPROFITAFTERDISAFTERDISUNFAVOR

Discretionary Accruals Unfavorable Audit Opinion

Variables Coeff. (t-stat)

Variables Coeff. (z-stat)

DIS

0.025 (1.286)

DIS

-0.204** (-1.969)

AFTER

-0.014 (-0.855)

AFTER

0.101 (0.669)

DIS*AFTER

-0.038*** (3.105)

DIS*AFTER

0.220** (2.091)

LAGTAC

0.052*** (2.778)

PROFIT -1.283** (-2.286)

LEV

0.017 (1.391)

LIQ -0.002 (-0.074)

LOSS

0.015** (2.615)

LEV 0.833*** (2.631)

FIRST

0.043** (2.632)

SIZE -0.003*** (-3.073)

LAST

0.003 (0.613)

GROW -0.041 (-0.517)

LAGROA

0.050 (1.584)

DEFAULT 6.605*** (4.003)

SIZE

-0.012*** (-2.967)

BIG5 0.036 (0.814)

CFO

-0.047* (-1.752)

CONSTANT -0.230 (-1.258)

BIG5

-0.006 (-0.865)

STDSALES

-0.038 (-0.773)

STDCFO

-0.006 (-0.942)

STDRTN

0.239*** (2.887)

CONSTANT

-0.038 (-0.773)

Adj. R2 0.078 Pseudo R2 0.146

47

NOTES TO TABLE 10:

The models pool data from 2001 (the year prior to mandatory disclosure) and 2002 (the first disclosure year). N is

the number of observations. ACCRUAL is the absolute value of discretionary accruals; UNFAVOR is an

indicator variable coded 1 for an unfavorable audit opinion, else 0; NASRATIO is the proportion of

non-audit fees to total fees; NASFEE is the logarithm of non-audit fees; TOTALFEE is the logarithm

of total fees paid to auditors; and AFTER is an indicator variable coded 1 if year = 2002 , and 0 if year = 2001 .

See Table 2 for other variable definitions.

***, **, * indicate significantly different from zero at the 1%, 5%, and 10% levels, respectively.