Non-audit Services and Audit Quality: Evidence from Private Firms

Abstract

The purpose of this study is to examine the relationship between audit quality in private firms and the provision of non-audit services (NAS) – an issue that has rarely been considered in prior research. The threats to auditor independence are different in private firms compared to public firms. The same is true of the opportunities to use the same knowledge for audit and for NAS. Therefore, the effect of the provision of NAS on audit quality is also likely to be different. In this study, audit quality is measured by discretionary accruals, as well as by managers' perceptions of the extent to which the audit improves accounting quality. The regression analysis is based on 420 surveyed private firms in Sweden and suggests that audit quality is positively associated with NAS in general and accounting services in particular. The findings indicate that the joint provision of audit and NAS do not necessarily result in impaired auditor independence, but rather support the existence of knowledge spillover between the services.

Acknowledgements

The author gratefully acknowledges the help of Salvador Carmona (editor) and two anonymous reviewers. Earlier versions of the paper has benefited from comments and suggestions by seminar participants at the Workshop on Auditing and Financial Accounting Research (Vaasa 2008), 2nd Workshop on Audit Quality (Milan, 2008), and 32nd Annual Congress of the European Accounting Association (Tampere, 2009). The author also thanks Stefan Sundgren, John Christian Langli, Muhammad Abdolmohammadi, Jörgen Hellström and Christopher Nobes.

Notes

Information about client portfolios held by auditors-in-charge was acquired from the Credit Information Agency UC. The 839 auditors auditing these 1202 companies in 2008 and 2009 (several companies were audited by the same auditor) had on average 123 audit assignments. The median was 113.

Firm size is a good proxy for fee dependency, as size explains a large proportion of the variation in fees (Hay et al., 2006b).

Members of the EU may impose stricter rules. The regulation with respect to NAS also varies considerably between European countries (European Commission 2010/561/EC, p. 12).

SBPA is a governmental authority that investigates both on its own initiative and after having received complaints from clients, public authorities and individuals.

SBPA initiated a total of 431 investigations against auditors during 2003–2005. In 36% of the cases some type of disciplinary sanction was issued.

The tax authorities had reported to the SBPA on auditor misconduct on 126 (29%) of all 431 initiated investigations.

The included regions are Norrland (counties of Västerbotten, Västernorrland, Jämtland and Gävleborg), Småland (counties of Jönköping, Kalmar and Kronoberg) and Stockholm (county of Stockholm).

From 1 November 2010, firms not exceeding two out of the following size criteria were exempted from the audit requirement: three employees, a balance sheet total of 1.5 million SEK (approx. 164,294 euro) and a turnover of 3 million SEK (approx. 328,587 euro). 1 euro = 9.13 SEK as of 1 December 2011.

Nine firms were excluded due to bankruptcy, liquidation or merger. The questionnaire was sent to the CEO of the firm. In the covering letter, it was stipulated that if a CFO or similar was responsible for contact with the audit firm then he or she should respond. The CEO responded in 60% of the firms, the CFO in 31% and 9% of respondents had another position in the firm; 77% of the CEOs owned shares in the firm, while this proportion was 20% among CFOs and other respondents.

When estimating discretionary accruals, the 1% most extreme positive and negative values were eliminated for: (i) total accruals and (ii) change in net revenues divided by total assets. The 1% most extreme values for gross property, plant and equipment were also eliminated. In addition, I ran robustness checks on models using |DA| (models 1–3) as dependent variables, where up to 2% of the extreme values of |DA| were eliminated. The reason for being very observant about extreme values is that extreme discretionary accruals may be due to measurement errors (Kothari et al., 2005).

REGION1 consists of firms from the region of Småland. REGION 2 consists of firms from the region of Norrland. REGION3 is reference category and consists of firms from Stockholm. Emp50–249 is reference category and consists of firms with 50–249 employees.

NASRATIO has here been divided into three groups: (i) NAS fees exceeding 50% of total fees; (ii) NAS fees in the interval 1–50% of total fees and (iii) no NAS fees.

The same associations with quality measures are found when using an indicator variable for loss instead of ROA.

Tabulated results are available from the author upon request.

Additional information

Notes on contributors

Tobias Svanström

Paper accepted by Salvador Carmona.