Managerial Auditing Journal

Non-audit service fees, auditor characteristics and earnings restatements

Deborah Bloomfield, Joshua Shackman,
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and earnings restatements", Managerial Auditing Journal, Vol. 23 Issue: 2, pp.125-141, https://
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Non-audit
Non-audit service fees, auditor service fees
characteristics and earnings
restatements
125
Deborah Bloomfield and Joshua Shackman
Touro University International, Cypress, California, USA
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Abstract
Purpose – The objective of the study is to provide empirical evidence of the impact of non-audit
services (NAS) as well as other auditor characteristics on auditor independence by testing the
relationship of NAS fees to the occurrence of financial statement restatements.
Design/methodology/approach – The authors tested whether firms that restate their financial
statements have higher levels of total service fees or higher levels of NAS fees than non-restatement
firms. The testing also includes an examination of the relationship between the audit firm size and the
audit firm industry specialization to financial statement restatements.
Findings – The study found only limited evidence to support the concept that firms with higher NAS
fees are more likely to restate earnings, thereby casting doubt on the public perception that NAS
impairs auditor independence and the legislative approval of Section 201 of the Sarbanes-Oxley Act
prohibiting external auditors from providing certain NAS to audit clients as necessary to preserve
auditor independence. The study did find stronger evidence that the level of total fees paid to the audit
firm is significant in the predictability of a restatement. In addition, the study also found stronger and
more conclusive evidence of a negative association to audit firm industry specialization and a strong
positive association to Big 5 audit firms.
Practical implications – Results demonstrate the necessity of regulations concerning NAS and
conflict of interest.
Originality/value – This paper is an original contribution that demonstrates the importance of
auditor characteristics over audit fees in predicting earnings management.
Keywords Auditor’s fees, Auditors, Earnings, Financial reporting
Paper type Research paper

1. Introduction
During the 1980s, the environment within many accounting firms focused on revenue
generation and firm growth as the primary criteria for auditors to become partners an
“up or out” or “whatever it takes” culture developed (Almer et al., 2000). The sale of
non-audit services (NAS) became a major strategy for achieving firm growth. This
strategy included linking a partner’s performance to the amount of NAS sold. In 1975,
NAS represented 11 percent of the Big 8’s (now Big 4) total revenues. By 1998, NAS
had grown to comprise 45 percent of the Big 5’s total revenues (GAO, 2003a, b). The
strategy was successful but with this new prosperity came criticism and concern about
the conflict of interest perceived by regulators and the public. Amid increasing
scrutiny and after independence violations were investigated by the SEC, the Big 5 Managerial Auditing Journal
Vol. 23 No. 2, 2008
firms began to spin-off their consulting arms in an attempt to appease the SEC (Gilbert pp. 125-141
et al., 2001). By 2000, the consulting divisions of the firms had been sold or divested, q Emerald Group Publishing Limited
0268-6902
resulting in NAS shrinking to approximately 30 percent of firm revenue (GAO, 2003). DOI 10.1108/02686900810839839
 MAJ The following year, the Enron and Arthur Andersen scandal would be exposed.
23,2 Other corporate accounting scandals followed resulting in increased scrutiny of the
accounting profession, particularly the incentive for auditors to continue the practice of
joint provision of services. The Enron debacle brought this debate to the forefront
when it was disclosed that Arthur Andersen received $25 million in audit fees and
$27 million in NAS (Beattie and Fearnley, 2002). In the Enron example, not just
126 non-audit fees but fees in general, exceeding $50 million, raised questions about the
economic dependence of the audit firm to its client and the conflict of interest fees
created. Arthur Andersen’s US Net Revenue was $3.6 billion for their fiscal year ended
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August 31, 2000. This meant Enron alone would constitute 1 percent of the firm’s
annual revenue. The number of firm partners for the same time period totaled 1,313
which would mean the average partner revenue stream to the firm would be
$2.7 million indicating that the partners on the engagement for Enron would have
placed a high value on retaining the client and its associated revenue stream.
At the same time, concerns over the quality of the financial information provided to
the public and regulators were on the rise. In October 2002, the United States General
Accounting Office (GAO, 2002) reported that although the number of companies
restating financial statements constitutes a small percentage of publicly listed
companies, the number of restatements related to accounting irregularities had
increased by a staggering 145 percent from January 1997 to June 2002.
In combination, the perceived conflict of interest resulting from the joint provision
of services and the increase in accounting irregularities, led to the passage of
legislation such as the Sarbanes-Oxley Act, Section 201 that restricted such fees. This
historic legislation has lead to a growing academic interest in the question as to
whether the payment of NAS fees impacts auditor independence.
This study adds to the small but growing literature that examines the relationship of
joint provision of NAS fees to earnings management using restatement data (Agrawal
and Chadha, 2005; Raghunandan et al., 2003; Kinney et al., 2004). These studies have
generally found little or no effect of NAS fees on auditor independence and leaves
researchers to question how important is the marketing pressure for NAS in comparison
to actual NAS fees or whether the accounting profession is in a no win battle with public
perception. SEC Chief Accountant Lynn Turner has stated that “When [audit partners]
are a marketing channel, they can’t piss off the client; otherwise, they can’t sell the other
services.” (Barr, 2000). This statement raises questions as to whether the actual
providing of NAS can lead to impairment of independence or whether the need to
market and sell these services leads to impairment.
This study directly compares auditor characteristics and auditor fees as
explanatory factors in restatement risk. The study did find evidence that the level of
total fees paid to the audit firm is significant in the predictability of a restatement. In
addition, the study also found a negative correlation to audit firm industry
specialization and a strong positive correlation to Big 5 audit firms. Overall, this study
finds that auditor characteristics have much stronger explanatory power than auditor
fees when it comes to predicting restatements.
This study adds to the existing research on restatements and auditor independence in
three important ways. First, this study uses a larger sample than previous studies (with
the exception of Kinney et al., 2004) and uses control variables and a randomly chosen
control sample rather than paired matching. It is one of a growing number of studies to
 use restatements as a proxy for earnings management rather than discretionary Non-audit
accruals or other methods. Second, this study is one of the first studies to use the GAO service fees
(2003) database of restatement firms as the test population source. The database has
been pre-scrubbed to include restatements limited to those arising from accounting
irregularities. The previous studies employed various internet search techniques to
create a population database. Third, this study includes the examination of additional
sources of conflict of interest. Specifically, this study takes a closer look at the impact of 127
auditor specialization and audit firm size and their relation to restatement risk.
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1.1 Restatements and NAS fees

As previously stated, this study differs from many studies on earnings management
and non-auditor fees in that it uses financial restatements as a proxy for earnings
management. Other recent studies on NAS and earnings management have used
alternative proxies such analysis of discretionary or abnormal accruals (Frankel et al.,
2002; Antle et al., 2002; Ashbaugh et al., 2003). However, the findings from these studies
have been inconclusive. The use of discretionary accruals as a proxy for earnings
management has proven to be a difficult methodology to use effectively and may be the
reason for mixed study findings (Young, 1999). Beneish (2001) states the following with
regard to using discretionary accruals as a proxy for earnings management:
The difficulties faced by aggregate accrual models suggest that studies of specific accruals,
perhaps even case studies, are needed. One way in which one could assess the external
validity of aggregate accrual models and learn about the exercise of discretion in specific
industries is to study earnings restatements, the analysis of instances where firms restate
earnings, e.g. where actual earnings management is more likely.
Thus, restatements were used in this study as an alternative proxy for earnings
management.
Following Beneish’s recommendation for future research (2001), the use of
restatements as a proxy for earnings management has been established in recent
academic literature including Richardson et al. (2002), Raghunandan et al. (2003),
Agrawal and Chadha (2005) and Kinney et al. (2004). Financial statement restatements
are viewed as audit failures resulting from “the increasing reliance of audit firms on fees
from non-audit services” (Raghunandan et al., 2003). Restatements provide a means for a
direct test of the association between NAS and audit quality (Raghunandan et al., 2003).
Raghunandan et al. (2003) tested for an association between NAS and financial
restatements based on the following research question: “Are firms that pay higher fees
for NAS more likely to restate their financial statements?” The sample covered 110
firms drawn from SEC filings from 2000 to 2001 and compared the fees paid by the
restatement sample to fee data from 3,481 firms filing proxies with the SEC from
February 5, 2001 to August 31, 2002 (Raghunandan et al., 2003). The findings indicated
that firms with restatements are not more likely to have unexpectedly high NAS, fee
ratios or total fees. This study more than doubles the Raghunandan sample size to 250.
The Agrawal and Chadha (2005) study examined the effect of NAS fees on
restatement probability using a sample of 318 firms of which 159 were US public
companies that had restated earnings. The control firms were matched by industry and
size to the restatement firms. Fee measures included the proportion of NAS fees to total
fees and a dummy variable for NAS fees greater than $1 million. No strong association
between NAS and restatements were found.
 MAJ Kinney et al. (2004) examined the relationship between NAS fees and financial
23,2 restatements using a data set prior to the heightened concern over NAS fees and
financial reporting, covering 1995-2000. The sample included 617 restating SEC
registrants matched with a non-restating firm that has the same SIC code, the same
audit firm and similar size in total revenue. The study did not find a statistically
significant association between fees for financial information system services or internal
128 audit services, some association with unspecified NAS fees, and a negative association
with tax services.
Overall, research on the impact of auditor size and NAS fees has usually shown
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negative or inconclusive results. One reason for this may be related to the pair matching
methodologies used in some of these studies including Agrawal and Chadha (2005) and
Kinney et al. (2004). While Raghunandan et al. (2003) compares the mean characteristics
of restatement firms versus the mean characteristics of all non-restatement firms, the
regressions in their paper were done with matched paired sampling. While matched
paired sampling is common in auditing research methodologies, this approach has been
criticized. For example, Carson and Hoyt (2003) point out that “Correlation between the
matching variable (such as size) and the independent variable may produce coefficients
that are biased and inconsistent.” Of the three previous mentioned studies, only one of
them (Agrawal and Chadha, 2005) also used auditor characteristics as explanatory
variables. In fact, Kinney et al. (2004) employed matched pair by auditor so any conflict
of interest effects from having a large auditor that offers non-auditor services could not
be examined. The next section will review the literature on auditor characteristics and
earnings management.

1.2 Restatements and auditor characteristics

This study examines the auditor characteristics of size and industry specialization
which may be criteria reviewed by management in selecting an audit firm; thereby
playing a role in the economic bond between auditor and client. One of the few studies
to look at restatement risk and auditor size found no significant relationship (Agrawal
and Chadha, 2005). While the research on NAS fees and restatements has found little or
no evidence of conflict of interest, the largest auditor firms are the ones associated with
offering the broadest range of NAS. While previous researchers have suggested that
the largest auditor firms are chosen due to their high reputations of quality and
independence and are thus less prone to conflict of interest (Ruddock et al., 2002;
Francis et al., 1999), other research has produced contradictory results on auditor size
and earnings management (Kim et al., 2003). This study enhances existing research by
testing the auditor size variable in relation to financial statement restatements, finding
a strong correlation between Big 5 firms and restatements.
Again referring to the economic bond of the client firm to the independent auditor,
the concept that the firm paying for the audit has the ability to “hire and fire” the
auditor, leads to other questions regarding the selection of audit firms. While there are
many considerations in selecting a public accounting firm to conduct an independent
audit, one of the main criteria is that the auditor specializes in the client’s industry.
This is significant because it means that the audit firm is experienced in any unique
accounting practices or issues within the industry. The firm, based on knowledge
gained in the industry, should be better qualified than other firms, to design an audit
program that would incorporate industry specific items. If a firm chooses an audit firm
 that does not have expertise in their industry, a question is raised as to why. Therefore, Non-audit
this study examined the relationship of auditor specialization and restatements and service fees
found a negative correlation.

2. Hypotheses
Regulators, financial statement users, and researchers are all concerned that higher
total fees compromise auditor independence (Ashbaugh et al., 2003). Economic theory 129
of auditor independence suggests that when client fees are a larger component of total
firm fee revenue, there is an incentive for the auditor to compromise independence for
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important clients as measured by fee contribution (Chung and Kallapur, 2003). This
economic bond between clients and their auditors is the main threat to auditor
independence (Ashbaugh et al., 2003). Therefore, the first set of hypotheses tested was
structured to disprove that independent auditors, in cases involving restatements, have
compromised independence based on higher fee levels. The related hypotheses are:
H1(a). There is a positive relationship between higher total service fees paid to
auditors and restatements.
H1(b). There is a positive relationship between the ratio of higher total service fees
to total auditor revenue and restatements.
Second, the joint provision of NAS to audit clients has been considered an impairment of
auditor independence by legislators and the public (Raghunandan et al., 2003). These
fees were specifically targeted by the Sarbanes-Oxley Act as being particularly
dangerous in terms of a conflict of interest. If NAS are, in fact, a source of conflict of
interest and give the client additional bargaining power over the auditor, there should be
a positive relationship between NAS and restatement risk. The related hypotheses are:
H2(a). There is a positive relationship between the ratio of non-audit service fees to
total fees paid to auditors and restatements.
H2(b). There is a positive relationship between the ratio of non-audit service fees to
total auditor’s revenue and restatements.
H2(c). There is a positive relationship between NAS fees paid to auditors and
restatements.
As stated in Section 2, empirical evidence on auditor size and earnings management
has been inconsistent and contradictory. The Public Accounting Report’s (PAR) Top
100 for 2001 and 2002 data indicate that the Big 5/Big 4 firms provided $8.7 billion and
$5.9 billion in NAS in 2001 and 2002, respectively, compared to non-Big 5/Big 4 firms of
$850 and 800 million, respectively. According to the logic of H2(a),(b),(c), NAS leads to
conflict of interest problems. However, the level of NAS fees received might not
necessarily be the best indicator of conflict of interest. Simply offering NAS along with
the concurrent pressure to market such services to audit clients might be as big if not a
greater predictor of conflict of interest. Since, the Big 5 audit firms generally offer the
majority of NAS we expect them to face greater pressure to market NAS; hence, the
following hypothesis is proposed:
H3(a). Big 5 audit firms are associated with firms registered with the SEC that
restate their financial statements.
 MAJ Finally, again referring to the economic bond of the client firm to the independent
23,2 auditor, the concept that the firm paying for the audit has the ability to “hire and fire”
the auditor leads to other questions regarding the selection of audit firms. One
important criteria in selecting an audit firm that has received attention in the auditing
literature as a possible explanatory factor for disclosure or fraud, is auditor industry
specialization (AIS) (Carcello and Nagy, 2004, Dunn and Mayhew, 2004). This choice of
130 whether a firm selects an audit firm with industry specialization is significant. For
example, Carcello and Nagy (2004) find that firms who choose an auditor without
specialization in their industry are more likely to engage in fraud. Krishnan (2003),
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found that auditors with client industry expertise mitigate accruals-based earnings
management. To test the relationship between AIS and restatement risk, the following
hypothesis is proposed:

H3(b). There is a positive relationship between the choice of an auditor outside the
firm’s specialization and restatements.

3. Methodology
Using probit multiple regression analysis, this study tests the research questions by
using financial statement restatements as a proxy for earnings management. The
following defines and describes the variables, test population, data-gathering
technique and method of analysis.

3.1 Sample population

The test population was formed by selecting 250 of the 350 financial statement
restatements announced by public companies from January 1, 2001 to June 30, 2002 as
listed in the GAO database. While the GAO database does contain other years of data,
the population is limited to the years 2001 and 2002 since the SEC reporting
requirements for disclosing information regarding fees paid to independent auditors
were not in effect during 1997 through 2000. 2001 includes 225 restatements, and 2002
contains 125 restatements (the data ends in June of 2002). This gives a total population
of 350 restatements from which to draw 250 restatement firms. This population was
chosen for three reasons; the GAO database is readily available; information on the
public companies is available through the SEC Edgar database; and the population has
statistical strength due to its size and time duration. In addition, the database has
already been pre-scrubbed to only include financial restatements from accounting
irregularities.
An additional 250 public companies, non-restatement firms, were randomly chosen
from the SEC Edgar database. The firms were selected using Edgar’s historical
archives and a search string of 10-K with start and end dates for each year. The firms
were selected by year such that a proportional number of firms for each year will
be chosen to mirror the time characteristics of the 250 restatement firms. Therefore, the
total test population is N ¼ 500.
We chose to use a random sample rather than matched-paired because of possible
problems with the latter and to determine if different results from studies using
matched-pair sampling would be found. Carson and Hoyt (2003) found evidence that
matched-paired samples produce large biases and inconsistencies. In an experiment
 using data on insolvency in the insurance industry, they found large problems of Non-audit
biases used by matching by size: service fees
We find evidence that that this is an important concern: the financial matching criterion for
the matched-pairs samples in our study, log of assets, was significantly correlated (0.05 level)
with 14 of the 23 variables listed in Table III and nine of the 16 variables listed in Table IV.
Similar correlation exists between an alternative size measure, surplus, and the independent
variables (Carson and Hoyt, 2003). 131
If matching by even one variable leads to these biases, it is likely that matching by two
to four different variables (Agrawal and Chadha, 2005; Kinney et al., 2004) might
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introduce even more extreme biases and inconsistencies.

It should be noted that in using a control group the same size as the restatement
group, the sample size in relation to the population needs to be considered when
interpreting test results. This is also the case when using a matched-pairs design. Since,
the actual population of non-restatement firms is much larger than the restatement
population, the restatement group is overweighed in the regressions in the paper as well
as in the regressions in matched-pairs design. Thus, the coefficients in the regressions
should be interpreted with this in mind.

3.2 The variables

For the dependent variable we simply used a dummy variable, which carries a value of
1 if the firm is a restatement firm and a value of 0 for a non-restatement firm. This is
similar the approach used in Kinney et al. (2004).
In testing H1(a) we used total fees paid to the firm’s auditor as the independent
variable, which we obtained from SEC proxy filings. In testing H1(b), we used the ratio
of total fees paid to auditor as a percentage of total auditor revenue. This is an
approach which has been used by previous studies including, Chung et al (2003), Stice
(1991) and Thomas and Watts (1994). We obtained total auditor revenue data from the
PAR Top 100 for, 2002, America’s 100 Largest Public Accounting Firms (2002). Using
total fees as an explanatory variable addresses the broader question as to whether fees
in general impair auditor independence.
We also used SEC proxy filings to obtain data on the three NAS fee variables used
to test H2(a),(b),(c). Total NAS fees came from SEC proxy filings. Testing total NAS
fees is similar to the Kinney et al. (2004) approach of testing actual fees rather than the
use of unexpected NAS fees approach (Raghunandan et al., 2003). Unlike Kinney et al.
(2004), we include NAS fees as one variable rather than divide it into four different
types of NAS fees. We also calculated the ratio of NAS fees to total auditor revenues.
Finally, we calculated the ratio of NAS fees to total fees paid to auditors, a process also
used in Ashbaugh et al. (2003) and Frankel et al. (2002) studies.
Independent variables used to test H3(a),(b) include audit firm size and audit firm
specialization. Whether or not the audit firm is a Big 5 firm was defined as BIG 5 with
a one as a “yes, it is a Big 5 firm” or “no, it is not a Big 5 firm.” This designation was
also used by Carcello and Nagy (2004) for Big 6 firms. AIS was denoted as AIS. We
tested H3(b) by comparing the firm’s auditor and the firm’s industry to see if
the auditor specialized in their client’s industry. Specialization is determined from the
GAO study on Public Accounting Firms Mandated Study on Consolidation and
Competition (July 2003) that provides data on firm market share. If the audit firm
comprised at least 25 percent of the market share, the AIS variable carried a value of 1.
 MAJ If not, the value of the variable was 0. Both Carcello and Nagy (2004) and Dunn and
23,2 Mayhew (2004) use this designation for auditor specialization; however, specialization
is defined as firms with 20 percent of the market share rather than 25 percent. Carcello
and Nagy (2004) used a continuous measure of market share whereas Dunn and
Mayhew (2004) measured in the year the fraud began. In this research, industry
specialization data from the GAO study was limited to four firms, Deloitte & Touche,
132 Ernst & Young, KPMG, and Price Waterhouse Coopers; therefore, data analyzed for
industry specialization included a population of 353 limited to these Big 4 firms.
We used annual revenues as the primary control variable for size which is similar to
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Kinney et al. (2004). As tests for sensitivity of the results, we also used total assets and
total number of employees as alternative measures of size. The profitability of the
firms was measured as a return on assets in two ways. The primary way we measured
profitability was by using net cash flow from operations divided by total assets. This is
often considered a more reliable measure of the financial health of the firm than the
traditional measure of net income to total assets. Net income can be influenced by
many factors that do not relate to operations or that are subject to manipulation.
However, as a test of sensitivity, we used the ratio of net income to total assets as a
secondary measure of profitability.
The firm industry dummy variables were defined by the first digit in the SIC
number and were denoted as SIC. The categories ranged one through seven as follows:
(1) agriculture, mining, and construction;
(2) manufacturing;
(3) technology;
(4) transport, communications, and utilities;
(5) wholesale and retail;
(6) financial services; and
(7) services.

For each firm, the firm industry variable carried a value of 1 with the other six
groupings carrying a 0 value.

3.3 Data gathering

The first step in data gathering was to utilize information from the GAO database to
construct a test database for the population. We retrieved each firm’s 10-K from Edgar
for the year in which the restatement was identified. From the 10-K and annual proxy
filing (DEF14A), we recorded the industry code (SIC), industry description, audit firm,
NAS fees, total fees, total revenue, total assets, and total employees in the test
population database. We obtained auditor revenue data from the PAR Top 100 for
2002, America’s 100 Largest Public Accounting Firms (2002).

3.4 Descriptive statistics

From a profitability standpoint, the restatement firms average a negative return on assets
from net income of 9.7 percent and a negative return on assets from cash flows of 6.3
percent. In contrast, the non-restatement firms averaged a negative return on assets from
net income of 0.8 percent and a positive return on assets from cash flows of 1.1 percent.
 This indicates that, the restatement firms are, on average, less profitable and produce Non-audit
significantly lower return on assets than the non-restatement group. service fees
When reviewing audit firm fee variables, the non-audit service fees and total service
fees for restatement firms are approximately 39.0-46.0 percent higher, respectively,
than the NAS fees and total service fees of the non-restatement firms. The ratio of
non-audit fees to total service fees is nearly the same for both groups; 48.4 percent for
the restatement firms and 46.0 percent for the non-restatement firms. 133
The industry demographics are similar between the two groups with the exception
of the financial services industry. There were 52 financial service firms in the
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non-restatement group while the restatement firm group was less than half that
number with 24 firms in the financial services industry (Figure 1).
In terms of the audit firms selected, 94.0 percent of the restatement firms selected
Big 5 audit firms versus 84.0 percent of the non-restatement firms. About 34 percent of
the restatement firms selected firms that specialized in their industry versus
40.0 percent of the non-restatement firms.
Finally, one of the most striking comparisons in the two groups is that the mean size
of the restatement group is roughly twice that of non-restatement group. This holds
true when size is measured by revenues, assets, or total number of employees.
The implications of this will be discussed later on in this paper.

3.5 Statistical methods and regression diagnostics

We performed the tests of the hypotheses using probit-multiple regression analysis
utilizing Stata software. While we used revenues as the main measure of firm size, to
test for robustness of results, we also used total employees and total assets as
alternative measures of size. We focused on the ratio of cash flow to total assets as the
main measure of firm profitability but also used the ratio of net income to total assets.
As an additional test for robustness, we used both the full sample of 500 firms as well
as the size corrected sample of 476 firms.
We prepared correlation matrices to identify highly correlated variables (Table I).
Highly correlated variables included within the same regression equations during

Services 53
58

Financial Services 52
24

Wholesale & Retail 27

26
10
Transport, Communications & Utilities 19
47
Technology 60

Manufacturing 49
52
12
Agriculture, Mining & Construction 11
0 10 20 30 40 50 60 70
# of firms Figure 1.
Restatement Non-restatement
Industry demographics
 MAJ Variable Restate Big5 NAS NASAR Feeratio Revenues Assets Employs Roani
23,2
Restate 1.0000
Big5 0.1163 1.0000
NAS 0.1093 0.0835 1.0000
NASAR 0.0978 0.0108 0.9522 1.0000
Feeratio 0.0373 0.2177 0.3184 0.3606 1.0000
134 Revenues 0.1230 0.0897 0.5492 0.5694 0.2123 1.0000
Assets 0.0630 0.0729 0.5380 0.5766 0.1807 0.6458 1.0000
Employs 0.1100 0.0791 0.4740 0.4466 0.1965 0.8223 0.4860 1.0000
Roani 2 0.0357 2 0.0088 0.0142 0.0184 2 0.0366 0.0051 0.0136 0.0193 1.0000
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Variable Restate AIS TOTALFEE TOTAR Revenues Assets Employs Feeratio Roacflow
Restate 1.0000
AIS 2 0.0732 1.0000
TOTALFEE 0.1352 0.1392 1.0000
TOTAR 0.1372 0.1004 0.9657 1.0000
Revenues 0.1307 0.0597 0.5459 0.5550 1.0000
Assets 0.0744 0.0272 0.5937 0.6009 0.6280 1.0000
Employs 0.1225 0.0799 0.4601 0.4478 0.8480 0.5405 1.0000
Table I. Feeratio 0.0392 0.0756 0.2504 0.2740 0.2070 0.1720 0.1994 1.0000
Correlation matrices Roacflow 2 0.0493 2 0.0484 0.0196 0.0240 0.0037 0.0191 0.0211 2 0.0346 1.0000

testing with a correlation over 0.50 include (highlighted in italic font in the table): NAS
fees and revenues at 0.54, the ratio of NAS fees to auditor revenue and revenues at 0.57,
and total auditor fees and revenues at 0.55. To address the issue of multi-collinearity of
these variables, we ran these regressions with standard ordinary least squares and
found the variance inflation factors to be quite low (all below 6.3) in spite of the
relatively high-correlation coefficients. Therefore, the results of the testing were not
impacted by this issue.
We did find significant heteroscedasticity for most of the regression specifications.
The test we used was a likelihood ratio test with revenues and employees used as the
independent variables in the variance function. The results presented in Tables II-V are
from the probit model using White heteroscedasticity-corrected standard errors.

3.6 Regression results: total auditor fees versus auditor size

Table II presents the results of the regressions comparing the explanatory power of
total fees paid to auditors to the choice of a BIG 5 auditor. Both total fee variables have

Independent variable Heteroscedasticity-corrected probit

Dependent variable: restatement probability

Total audit fees 0.0300 * (0.0161)
Total audit fees/total auditor revenue 1.5517 * * (0.6896)
BIG5 dummy 0.4406 (0.1993) 0.5215 * * (0.2519)
No. of employees 0.0040 (0.0027) 0.0045 * (0.0026)
Cash flow/total assets 2 0.0020 (0.0019) 2 0.0014 * * * (0.0004)
Industry dummies Yes Yes
Constant 2 0.3930 * (0.2180) 2 0.4626 * (0.2735)
Pseudo R 2 0.0494 0.0415
Table II. Observations 500 479
Total audit fees versus
auditor size Notes: *Significant at 10 percent; * * – 5 percent; * * * – 1 percent
 Non-audit
Independent variable Heteroscedasticity-corrected Probit
service fees
Dependent variable: restatement probability
Non-audit fees 0.0279 (0.0170)
Non-audit fees/total auditor
revenue 1.5041 (0.9472)
Non-audit fees/total audit fees 2 0.0014 (0.0025) 135
BIG5 dummy 0.4580 * * (0.1986) 0.4236 * (0.2422) 0.5098 * * (0.2049)
Number of employees 0.0049 * (0.0028) 0.0051 * (0.0028) 0.0079 * * (0.0031)
Cash flow/total assets 20.0019 (0.0017) 20.0014 * * * (0.0004) 2 0.0018 (0.0013)
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Industry dummies Yes Yes Yes

Constant 20.3956 * (0.2181) 20.3553 (0.2616) 2 0.3672 (0.2292)
2
Pseudo R 0.0470 0.0386 0.0447
Observations 500 479 500 Table III.
Non-audit fees versus
Notes: *Significant at 10 percent; * * – 5 percent; * * * – 1 percent auditor size

Independent variable Probit results

Dependent variable: restatement probability

Total audit fees 0.0348 * * (0.0176)
Total audit fees/total auditor revenue 1.8979 * * (0.8538)
Auditor industry specialist dummy 20.2798 * * (0.1349) 2 0.2627 * (0.1348)
Number of employees 0.0050 * (0.0028) 0.0056 * * (0.0027)
Cash flow/total assets 20.0014 * * * (0.0004) 2 0.0014 * * * (0.0004)
Industry dummies Yes Yes
Constant 0.1078 (0.1485) 0.1000 (0.1485)
Pseudo R 2 0.0479 0.0469
Observations 370 370 Table IV.
Total audit fees versus
Notes: *Significant 10 percent; * * – 5 percent; * * * – 1 percent auditor specialization

Independent variable Probit results

Dependent variable: restatement probability

Non-audit service fees 0.0333 * (0.0179)
Non-audit service fees/total
auditor revenue 1.7617 * (1.0289)
Non-audit service fees/total audit
fees 0.0029 (0.0030)
Auditor industry specialist
dummy 20.2664 * * (0.1346) 20.2547 * (0.1346) 2 0.2511 * (0.1344)
Number of employees 0.0060 * * (0.0029) 0.0065 * * (0.0029) 0.0088 * * *(0.0032)
Cash flow/total assets 20.0014 * * * (0.0004) 20.0014 * * * (0.0004) 2 0.0013 * * * (0.0004)
Industry dummies Yes Yes Yes
Constant 0.1202 (0.1479) 0.1153 (0.1479) 0.1166 (0.2034)
2
Pseudo R 0.0445 0.0433 0.0397
Observations 370 370 370 Table V.
Non-audit fees versus
Notes: *Significant at 10 percent; * * – 5 percent; * * * – 1 percent auditor specialization
 MAJ positive coefficients and reach statistical significance. The BIG 5 variable also has a
23,2 positive and statistically significant coefficient in both specifications.
While the results in Table II are evidence in favor of H1(a, b), and H3(a), the size of
the coefficient on BIG 5 suggests that, this is a much more important variable in
predicting restatements than the total fee variables. With regard to the restatement
sample and the control sample, having a BIG 5 auditor increases the chances of being
136 in the restatement group 44-50 percent.
In comparison, the coefficients for the total fee variables suggest that these
variables are not as important as the BIG 5 variable. For example, the coefficient on the
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total audit fees variable is roughly 0.03. If a firm were to go from a median value of
total audit fees (approximately $0.6 million) to being in the top quartile of this variable,
it would need an increase total audit fees by approximately $3.5 million. This would
increase the probability of being in the restatement group by approximately
11.0 percent. The same is suggested by the small coefficient for the ratio of total audit
fees to total auditor revenue variable – a very large increase from a median value to an
upper quartile value leads only to a small increase in the probability of being in the
restatement group.
It should be noted, that since the control group does not represent the entire
population of non-restatement firms, these probabilities should not be interpreted as
absolute probabilities of a restatement. However, comparing such probabilities do shed
light on the importance of these variables beyond just statistical significance. In
summary, while both the total fees variables and BIG 5 reach statistical significance,
the economic significance of BIG 5 appears to be much greater.
Other variables that reach statistical significance include number of employees and
the ratio cash flow to total assets. Low-cash flow has long been associated with
earnings management (AICPA, 1997: “inability to generate cash flow while reporting
earnings and earnings growth”) but the negative coefficient on revenue is somewhat
surprising and will be discussed more in Section 5.3. Of the dummy variables, only the
financial services industry dummy reached significance (it had a negative sign not
shown in the table).
In Table III, BIG 5 still reached statistical significance with a relatively large
coefficient. However, none of the three NAS fee variables reached significance. Overall,
the results shown in Tables II and III suggest that, the choice of a BIG 5 auditor is the
more important explanatory variable than the total fee variables. These results also
suggest that total fees are a more important explanatory factor than NAS fees. This is
additional evidence in support of H3(a), but not in favor of H1(a)-(c).

3.7 Regression results: total auditor fees versus AIS

In Table IV, the total audit fee variables reach statistical significance along with the
AIS, which is consistent with H1(a, b) and H3(b). The coefficient on the AIS variable is
negative, which is also consistent with H3(b). The size of the coefficient suggests
that the probability of being in the restatement group is reduced by roughly 25 percent
when the auditor specializes in the firm’s industry. While this suggests, that AIS might
not be as important as the BIG 5 variable, its coefficient does suggest that it is more
important than the total fees variables. It should be noted that this is only in a
sub-sample of firms using four of the BIG 5 auditors, but it does appear that industry
 specialization reduces or even reverses the positive effect of BIG 5 on the probability of Non-audit
a restatement. service fees
In Table V, AIS remains statistically significant in all three specifications. Also, two
of the three non-audit fee variables reach statistical significance. However, coefficient
sizes, once again, suggests that AIS has much more economic significance than the
audit fee variables. Increases from the median to the fourth quartile for total non-audit
fees or non-audit fees/total auditor revenue would both lead to only a 2.0-3.0 percent 137
increase in the probability of a restatement. This is quite small compared to the more
than 25 percentage point decrease in probability associated with AIS.
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Overall, the results in Tables II-V present evidence in favor of the total fee H1(a, b)
and of the auditor characteristics H3(a, b) and H3(b). These tables also demonstrate
mixed evidence for the NAS H2(a, b) and. H2(c) does not test positive in any of the
regressions. The size of the coefficient also suggests that the auditor characteristic
variables are more important than the total fee variables.

3.8 Regression results: sensitivity tests

Initially from the 500 sample of firms, the restatement group had a mean total revenue
nearly twice that of the control group. While other studies have suggested that
restatement firms tend to be larger than non-restatement firms (Kinney et al., 2004;
Agrawal and Chadha, 2005), our initial result might have been due to a large firm bias
in the GAO database population. Reporting in the database is voluntary, so perhaps
larger firms are more likely to report a restatement than a smaller firm. To correct for
this possible bias, we removed the largest firm in the restatement sample and smallest
firm in the control sample until the restatement group had a slightly lower mean total
revenues than the control group for a total of 238 firms in each group (Table VI) We
removed the 12 largest firms from the restatement group and the 12 smallest firms
from the control group.
This correction does not change the results for any of the hypotheses. The only
substantial change in results is that number of employees no longer has a positive and
statistically significant coefficient, and becomes negative and insignificant. Thus, the
results of the hypotheses hold up even when correcting for possible size bias in the
GAO database population. It should be noted that the fact that firms are larger on
average in the restatement sample might not be due to GAO bias but rather due to bias
by regulators who are more likely to pay attention to larger firms.
The results for the hypotheses also hold up when revenues or assets are used in the
regressions as the measure of firm size. The only difference is that revenue fails to
reach statistical significance in all regressions, and assets only reach significance in a
few of the regressions. The use of net income/assets as the measure of profitability
instead of cash flow did not affect the results of any the hypotheses. This measure of
profitability failed to reach significance unlike the cash flow ratio.

4. Conclusions and implications

The results of this paper show that characteristics of the auditor rather than fees paid
to auditors are more important predictors of earnings management as measured by
restatements. The result that NAS fees do not have strong explanatory power is
consistent with previous studies. We do find that total fees paid to auditors have
some mild but significant explanatory power. The variable that appears to have
 MAJ
Restatement Non-restatement
23,2
Sample size 250 250
Fee Variables
Mean NAS in 000s $1,990 $917
Mean NAS as a percent of audit firm revenue 0.03 percent 0.02 percent
138 Mean total service fees (TOTALFEE) in 000s $3,076 $1,464
Mean TOTALFEE as a percent of audit firm revenue 0.06 percent 0.04 percent
Mean ratio of NAS to TOTALFEE 48.40 percent 46.00 percent
Size variables
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Mean revenue in 000s $2,783,039 $1,264,002

Mean assets in 000s $4,111,309 $2,575,482
Mean no of employees 10,619 4,990
Profitability variables
Mean net income in 000s 2$264,172 2$179,194
Mean Cash from Ops in 000s $158,580 $118,443
Mean ROA based on net income 29.70 percent 20.80 percent
Mean ROA based on cash flows 26.30 percent 1.10 percent
Audit firm characteristics
Table VI. Auditor specialty 85 100
Descriptive statistics Big 5 auditor 235 211

the strongest explanatory power is the BIG 5 auditor variable. The study findings,
while not supportive of the need to limit NAS through regulation, does highlight the
need for regulation and supports the spirit of Title II of the act which includes among
other components, the establishment of the Public Company Accounting Oversight
Board, audit partner rotation, conflict of interest policies and requiring auditors to
report to the audit committee. In addition, the study results related to large audit firms
highlights the concerns explored by the US GAO with regard to mandatory audit firm
rotation and the impact of consolidation and competition on the public accounting
industry. Finally, the study results raise additional questions for academic researchers
to pursue – to add to the knowledge on audit quality, auditor independence, and
earnings management.
Throughout history as large profile public companies announce financial statement
restatements the question “where were the independent auditors?” arises. From the
crash of 1929, to the savings and loans crises of the 1980s, to the large fraud cases of the
turn of the millennium, the government and the public have turned to the accounting
profession for answers. While the SEC has the primary regulatory responsibility over
the accounting profession, the US Congress has the ability to legislate and thereby
regulate the profession as well (Chenok, 2000). During 1976-1977 a Senate Subcommittee
of the Government Affairs Committee held hearings to investigate publicly owned
company failures and wrongdoings that had not been reported by independent auditors
(Chenok, 2000). The committee was concerned with the quality of audits and auditor
independence. The resulting staff report made recommendations for reform that boiled
down to taking away the ability of the accounting profession to self-regulate and
transferring the responsibility to the federal government (Chenok, 2000). The AICPA
formed a response and lobbied congress to stall the legislation. In spite of almost three
decades of effort to preserve the right to self-regulate the accounting profession, the
 battle was lost when the Sarbanes-Oxley Act created the Public Company Accounting Non-audit
Oversight Board. service fees
Respondents to the GAO study on Accounting Firm Consolidation (2003), required
as a part of the Sarbanes-Oxley Act, commented that new regulations deriving from
the Sarbanes-Oxley Act and changing auditing standards have had an impact on audit
quality and independence. Another GAO study on mandatory audit firm rotation
(2004) concluded that mandatory rotation should not be regulated until the 139
effectiveness of the act for enhancing auditor independence and audit quality could
be monitored and evaluated.
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Future academic research will need to examine the effectiveness of this increased
oversight and regulation on reducing the number of audit failures and financial
statement restatements. These studies should include pre and post Sarbanes-Oxley Act
testing to determine if the increased regulation has had an impact on audit quality and
the number of financial statement restatements. An examination of the effectiveness or
correlation of the regulatory variables should be conducted as well as impact studies of
moving from self-regulation to external oversight of the accounting industry.
Additional root cause and systemic research should be conducted to determine what
audit firm characteristics, including firm size, industry specialization, audit processes
and quality controls, are factors impacting audit quality and audit failure.
The independent audit is a crucial component of the US capital market system, as
evidenced by the market’s reaction to stock prices of companies that announce an
accounting restatement. It is imperative that regulators, audit committees, corporate
management, the accounting profession and academic researchers continue to work
collaboratively to mitigate the risk of audit failures.

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Corresponding author
Deborah Bloomfield can be contacted at: dbloomfield@tourou.edu

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