THE EFFECT OF ACCOUNTING REGULATION ON SECOND-TIER AUDIT FIRMS AND THEIR CLIENTS: AUDIT PRICING AND QUALITY, COST OF CAPITAL, AND BACKDATING OF STOCK OPTIONS A dissertation submitted to the Kent State University Graduate School of Management in partial fulfillment of the requirements for the degree of Doctor of Philosophy by Magdy Farag October 2007 UMI Number: 3286211 UMI Microform 3286211 Copyright 2008 by ProQuest Information and Learning Company All rights reserved This microform edition is protected against unauthorized copying under Title 17, United States Code ProQuest Information and Learning Company 300 North Zeeb Road P.O Box 1346 Ann Arbor, MI 48106-1346 Dissertation written by Magdy Farag B.S., Alexandria University, 1996 M.B.A., Arab Academy for Science and Technology, 2000 Ph.D., Kent State University, 2007 Approved by Dr Pervaiz Alam Chair, Doctoral Dissertation Committee Dr Michael Pearson Members, Doctoral Dissertation Committee Dr Richard Brown Dr David Booth Accepted by Dr James Boyed Doctoral Director, Graduate School of Management Dr Frederick Schroath Dean, Graduate School of Management ii ACKNOWLEDGMENT I would like to thank my dissertation chair, Dr Pervaiz Alam, for his valuable guidance and encouragement His support made this dissertation possible Special thanks also go to the members of my dissertation committee, Dr Michael Pearson, Dr Richard Brown, and Dr David Booth, for their support and advice I would like to acknowledge the support I received from my family I would like to thank my mother Maggy and my father Samir for their love and support with no limits throughout my life iii TABLE OF CONTENTS Page CHAPTER INTRODUCTION 1.1 1.2 1.3 1.4 1.5 1.6 Recent Regulatory Changes………………………………………… … Research Questions…………………………………………… ……… Research Hypotheses and Expectations……………………………… Summary of Results …………………………………………………… Research Contribution………………………………………… ……… 10 Summary………………………………………………….………… 11 CHAPTER BACKGROUND AND LITERATURE REVIEW 2.1 2.2 2.3 2.4 2.5 2.6 Agency Theory and the Audit Profession ……………………………… Supplier Concentration in the Market for Audit Services …………… Audit Quality …………………………………………………………… Cost of Capital ………………………………………………………… Backdating of Executive Stock Options ……………………………… Summary ……………………………………………………………… 13 15 20 25 28 31 CHAPTER HYPOTHESES AND METHODOLOGY 3.1 3.2 3.2.1 3.2.2 3.2.3 3.2.4 Hypotheses ……………………………………………………………… 33 Methodology …………………………………………………………… 39 Audit Fees of Second-Tier Audit Firms ………………………………… 39 Audit Quality and Cost of Capital …… ……………………………… 42 Cost of Capital Components …………………………………………… 47 Backdating of Stock Options …………………………………………… 51 CHAPTER RESULTS 4.1 4.2 4.2.1 4.2.2 4.2.3 4.2.4 4.3 4.3.1 4.3.2 4.3.3 4.4 Introduction ……………………………………………………………….53 Results for Audit Fees of Second-Tier Audit Firms …………………… 53 Sample …………………………………………………………………… 53 Descriptive Statistics …………………………………………………… 55 Non-Parametric Tests …………………………………………………… 64 Audit Pricing Model …………………………………………………… 66 Results for Audit Quality of Second-Tier Audit Firms …… ……… … 70 Sample …………………………………………………………………… 70 Descriptive Statistics …………………………………………………… 70 Audit Quality and Audit Firm …………………………………………….75 Results for Cost of Capital ……………………………………………… 81 iv 4.4.1 4.4.2 4.4.3 4.4.4 4.5 4.5.1 4.5.2 4.6 4.7 Sample …………………………………………………………………… 81 Descriptive Statistics …………………………………………………… 81 Results for Cost of Debt ………………………………………………… 84 Results for Cost of Equity ……………………………………………… 87 Backdating of Executive Stock Options ………………………………… 91 Sample ………………………….……………………………………… 91 Backdating Results ……………………………………………………… 92 Supplemental Tests……………………………………………………….103 Econometric Issues ………………………………………………………115 CHAPTER CONCLUSIONS, LIMITATIONS, AND FUTURE RESEARCH 5.1 5.2 5.3 5.4 Introduction ………………………………………………………………116 Summary and Conclusions ……………………….………………………116 Contributions…………………………………………………………… 123 Limitations and Future Research………………………………………….124 APPENDIX Alternative Measures of Cost of Equity……………………… 126 APPENDIX Converting the Natural Log Values of Audit Fees to their Original Dollar Values………………………………………… 130 REFERENCES ……………………………………………………….………… 133 v LIST OF FIGURES Page Figure 1: Cumulative Abnormal Returns around ESOs Grants for Clients of Second-Tier audit Firms…… 93 Figure 2: Cumulative Abnormal Returns around ESOs Grants for Clients of Big-Audit Firms…… 95 Figure 3: Cumulative Abnormal Returns around ESOs Grants for Clients of Second-Tier Audit Firms and Big-Audit Firms …………… … 96 Figure 4: Cumulative Abnormal Returns around ESOs Grants for Clients of Second-Tier Audit Firms in the Pre- and Post-SOX Periods… 101 vi LIST OF TABLES Page Table 1: Selection procedure and distribution of sample by audit firm size…… 54 Table 2: Descriptive statistics of audit fees and control variables …….……… 56 Table 3: Correlation coefficients for audit fees and control variables …… 62 Table 4: Change in audit fees of second-tier audit firms: Univariate tests …… 65 Table 5: The audit pricing model regression results ………………… …… 67 Table 6: Descriptive statistics of audit quality and control variables … …… 71 Table 7: Correlation coefficients for audit quality and control variables … …… 74 Table 8: Audit quality and audit firm regression results …………….… …… 76 Table 9: Audit quality and SOX period regression results….…… …….… … 78 Table 10: Audit quality and audit fees regression results….…………….… … 80 Table 11: Descriptive statistics of cost of capital and control variables …… … 82 Table 12: Correlation coefficients for cost of capital and control variables …… 83 Table 13: Cost of debt regression results……………………………………… 86 Table 14: Cost of equity regression results……………………………………… 88 Table 15: Cumulative abnormal returns around executive stock option grants 97 Table 16: Differences in cumulative abnormal returns around executive stock option grants between second-tier audit firms and big-audit firms ……………… 99 Table 17: Differences in cumulative abnormal returns around executive stock option grants for clients of second-tier audit firms in the pre- and post-SOX periods …………………………………………………………………………… 102 Table 18: Discretionary accruals and audit firm regression results ….… …… 106 Table 19: Discretionary accruals and SOX period regression results …… … 108 vii Table 20: Discretionary accruals and audit fees regression results….……… … 110 Table 21: Cost of debt sensitivity analysis regression results ……………… 111 Table 22: Cost of equity sensitivity analysis regression ………………………… 113 Table 23: Hypotheses results summary ……………….………………………… 122 viii CHAPTER INTRODUCTION 1.1 Recent Regulatory Changes The accounting profession has recently been affected by major financial reporting scandals and regulatory changes.1 Prior to November 2000, the U.S Securities and Exchange Commission (SEC) did not explicitly address many of the non-audit services auditors were performing In November 2000, the SEC amended its auditor independence rules and significantly revised the types of non-audit services that auditors could provide to their audit clients The SEC also required publicly traded firms to disclose fees from two categories of non-audit service: financial information systems design and implementation, and other fees (U.S SEC 2000) The Sarbanes-Oxley Act of 2002 (SOX) further addressed auditor independence Specifically, Section 201(a) of SOX expressly prohibits eight types of non-audit services,2 as well as any other service that the firms’ board of directors determines that the auditors are not permitted to provide to their public company audit clients SOX further provides that a registered public accounting firm may engage in non-audit services, including tax services, only if the activity is approved in advance by the audit committee of the board of directors Major scandals include the bankruptcy of Enron and WorldCom, the demise of Arthur Andersen, the major stock market crash in 2000, and the most comprehensive securities market reforms since the 1930s The eight specific prohibited services are: (1) bookkeeping or other services related to the accounting records or financial statements of the audit client, (2) financial information system design and implementation, (3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports, (4) actuarial services, (5) internal audit outsourcing services, (6) management function or human resources, (7) broker or dealer, investment advisor, or investment banking services, and (8) legal services and expert services unrelated to the audit 128 ˆ xt   Expected future earnings per share for period (t   1, t   ) using either explicit analyst forecast or future earnings derived from growth forecasts g, r  Implied cost of equity estimates calculated as the internal rate of return solving the above equation They use actual book values per share and forecasted earnings per share up to three years ahead to impute future expected residual income for an initial three-year period They also assume clean surplus, that is, future book values are imputed from current book values, forecasted earnings and dividends Dividends are set equal to a constant fraction of forecasted earnings After the explicit forecast period of three years, the residual income series is derived by linearly fading the forecasted accounting return on equity to the sector-specific median return They compute the historic three-year average return on equity in a given country and year for the industrial, service, and financial sectors Negative sector-specific target returns are replaced by country-year medians From T = 12 on, residual income is assumed to remain constant Claus and Thomas (2001) Claus and Thomas (2001) apply a special case of the residual income valuation model in their evaluation of cost of equity Their model of cost of equity measurement is specified as follows: ˆ ˆ ( xt   rCT bvt  1 ) ( xt T  rCT bvt T 1 )(1  g ) ,   (1  rCT ) (rCT  g )(1  rCT )T  1 T Pt  bvt   129 where, Pt  Market price of a firm’s stock at date t; bvt  Book value per share at the beginning of the fiscal year; bvt   Expected future book value per share at date t   , where ˆ ˆ bvt   bvt  1  xt   d t  ; ˆ xt   Expected future earnings per share for period (t   1, t   ) using either explicit analyst forecast or future earnings derived from growth forecasts g, g = Expected future growth rate; r  Implied cost of equity estimates calculated as the internal rate of return solving the above equation They use actual book values per share and forecasted earnings per share up to five years ahead to derive the expected future residual income series They define residual income as forecasted earnings per share less a cost of equity charge for beginning of fiscal year book value of equity per share They assume clean surplus, that is, future book values are imputed from current book values, forecasted earnings, and dividends Dividends are set equal to a constant fraction of forecasted earnings At time T = 5, it is assumed that (nominal) residual income grows at rate g equal to the expected inflation As a proxy for g, they use the annualized median of country-specific, one-year-ahead realized monthly inflation rates g sets a lower bound to the cost of equity estimates Appendix B Converting the natural log values of audit fees to their original dollar values To find the amount of increase in audit fees paid by clients of Second-Tier audit firms between the pre- and post-SOX periods compared to the amount of increase in audit fees paid by clients of Big-audit firms, the log values of audit fees have to be converted to their original dollar values A confidence interval has to be constructed The following calculation is applied: ln(FEE) increases by 1 after SOX for both samples of Second-Tier audit firms and Big-audit firms Therefore, FEE increases by e  The amount of increase in FEE paid by clients of Second-Tier audit firms between the pre- and post-SOX periods = e0.372 = 1.45; and The amount of increase in FEE paid by clients of Big- audit firms between the pre- and post-SOX periods = e0.718 = 2.05 Therefore, the amount of increase in audit fees paid by clients of Second-Tier audit firms between the pre- and post-SOX periods compared to the amount of increase in audit fees paid by clients of Big-audit firms is on average equal to which is equal to 0.70 A confidence interval for this ratio is calculated as follows: A 95 percent confidence interval on 1 : 1  t  = (a,b) 130 1.45 , 2.05 131 a b Therefore, a 95 percent confidence interval on FEE: ( e , e ) A 95 percent confidence interval on 1 for Second-Tier audit firms: 1  t  = 1  1.96  = 0.372  1.96(0.02364) = 0.372  0.0463 (0.33, 0.42) Therefore, a 95 percent confidence interval on e  for Second-Tier audit firms: ( e0.33 , e0.42 ) = (1.39, 1.52) Similarly, a 95 percent confidence 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