International Journal of Auditing doi:10.1111/ijau.12002 Int J Audit ••: ••–•• (2013) Effect of Regulatory Changes on Auditor Independence and Audit Quality Sarowar Hossain Australian School of Business, University of New South Wales, Australia This study investigates the impact of CLERP on auditor independence and audit quality Audit quality is measured by performance-adjusted discretionary accruals and the auditor’s propensity to issue a going-concern opinion for a financially distressed company The results show a significant and positive association between auditor-provided non-audit services (NAS) fees and the propensity to issue a going-concern opinion for a financially distressed company post-CLERP 9, but an insignificant association pre-CLERP The results show a significant and positive association between NAS fees and the performance-adjusted absolute value of discretionary accruals pre-CLERP 9, but this significant association was mitigated by the introduction of CLERP To address the potential impact of the level of abnormal NAS fees on auditor independence, the analysis is extended by incorporating predictions of abnormal NAS fees Abnormal NAS fees are significantly and negatively associated with the propensity to issue a going-concern opinion for a financially distressed company and positively associated with discretionary accruals pre-CLERP 9, but they are not significant post-CLERP The results provide evidence of improved audit quality after the implementation of CLERP The results will be useful to regulators for the justification of regulatory changes The findings provide evidence of the effectiveness of regulatory changes, specifically the CLERP 9, on the improvement of auditor independence and audit quality Key words: Going-concern, audit opinion, abnormal non-audit fees, audit quality, discretionary accruals, non-audit fees, CLERP 9, auditor independence, regulatory changes SUMMARY Correspondence to: Sarowar Hossain, Australian School of Business, University of New South Wales, NSW 2052, Australia Email: s.hossain@unsw.edu.au ISSN 1090-6738 © 2013 Blackwell Publishing Ltd This study investigates the effectiveness of regulatory changes, specifically the Corporate Law Economic Reform Program (CLERP) Act 2004 (Cth), on auditor independence and audit quality 2 The first measure of audit quality is the propensity of auditors to issue a going-concern opinion for a financially distressed company, and the second is the performance-adjusted absolute value of discretionary accruals Auditor independence is measured by the auditor-provided non-audit services (NAS) fees and abnormal NAS fees The study uses Australian company data for the period 2002-2007 The results show a significant and positive association between NAS fees and the propensity to issue a going-concern opinion for a financially distressed company post-CLERP 9, but this association is not significant pre-CLERP NAS fees are significantly and positively associated with the performance-adjusted absolute value of discretionary accruals pre-CLERP 9, but are not significant post-CLERP To address the potential impact of fee composition on auditor independence, the analysis is extended by incorporating predictions of abnormal NAS fees Abnormal NAS fees are derived from a fee estimation model drawn from prior research Abnormal NAS fees are significantly and negatively associated with the propensity to issue a going-concern opinion for a financially distressed company and positively associated with the absolute value of discretionary accruals pre-CLERP 9, but are not significant post-CLERP The findings provide evidence of improved audit quality after the implementation of CLERP The results will be useful to regulators for justifying regulatory changes The findings provide evidence of the effectiveness of regulatory changes, specifically the CLERP 9, on the improvement of auditor independence and audit quality INTRODUCTION This study examines the effectiveness of regulatory changes, specifically the Corporate Law Economic Reform Program Act 2004 (Cth) (hereafter CLERP 9) on auditor independence and audit quality Auditor-provided non-audit services have been one of the most debated issues for the last several decades, with arguments that abnormally high fees for auditor-provided non-audit services may compromise auditor independence (DeAngelo, 1981; Teng, 2006) Hoitash, Markelevich and Barragato (2007) argue that any association between the fees paid to auditors and audit quality is an important input to the ongoing debate on how the accounting profession should be organized © 2013 Blackwell Publishing Ltd S Hossain and monitored Following prior studies concerned with auditor independence, this study uses auditorprovided non-audit services (NAS) fees and abnormal NAS fees as measures of auditor independence (e.g., Craswell, 1999; DeFond, Raghunandan & Subramanyam, 2002; Frankel, Johnson & Nelson, 2002; Ashbaugh, LaFond & Mayhew, 2003; Chung & Kallapur, 2003; Kinney, Palmrose & Scholz, 2004; Cahan et al., 2008) and investigates the extent to which those fees are associated with audit quality in pre- and postCLERP periods Consistent with prior studies (e.g., Carey & Simnett, 2006; Choi, Kim & Zang, 2006; Chen, Sun & Wu, 2010; Chi, Douthett & Lei, 2010), this study uses the propensity to issue a going-concern opinion for financially distressed companies and the absolute value of discretionary accruals as proxies for audit quality Corporate governance failures have reduced investor confidence and raised questions regarding the integrity of the information provided to investors (Jain & Rezaee, 2003; Jain, Kim & Rezaee, 2003; Cohen, Dey & Lys, 2005) The highly publicized failures triggered the passage of the Sarbanes Oxley Act (SOX) on 30 July 2002 in the US and the CLERP Act (2004) on 25 June 2004 in Australia Although CLERP introduced sweeping changes, the implications of the reforms are yet to be ascertained Examination of the impact of the CLERP on NAS fees and their associations with audit quality will provide evidence of the effectiveness of regulatory changes Effective for the reporting period commencing on or after July 2004, the CLERP reforms require the mandatory disclosure of specific categories of NAS fees, although the NAS fees have been disclosed in the annual reports for a long period of time for Australian Securities Exchange (ASX) listed companies The Corporations Act 2001 (s300) requires that the audit committee or, in the absence of an audit committee, the board of directors is required to formally attest to their satisfaction that auditor independence was not compromised by the provision of NAS In annual reports, in accordance with the requirements of s307C of the Corporations Act 2001, the lead audit partner must state that there were: (a) no contraventions of the auditor independence requirements of the Corporations Act 2001; and (b) no contraventions of any applicable code of professional conduct in relation to the audit CLERP also mandated the rotation of both the lead and review audit partners every five years due to concerns about the familiarity Int J Audit ••: ••–•• (2013) Effect of Regulatory Changes on Auditor Independence and Audit Quality between the auditor and audit clients and their effects on auditor independence There is presently a lack of empirical evidence on the impact of CLERP on audit quality Therefore, this study seeks to provide such evidence The results show a significant and positive association between NAS fees and the propensity to issue a going-concern opinion for a financially distressed company post-CLERP 9, but this association is not significant pre-CLERP The results indicate that auditors are more likely to issue a going-concern opinion for a financially distressed company post-CLERP The results also show a significant and negative association between abnormal NAS fees and the propensity to issue a going-concern opinion for a financially distressed company pre-CLERP 9, but this association is not significant post-CLERP Further, the association between positive abnormal NAS fees and the propensity to issue a going-concern opinion for a financially distressed company is stronger preCLERP than post-CLERP The results indicate that auditors were less likely to issue a goingconcern opinion for a financially distressed company pre-CLERP than post-CLERP when auditors earn abnormally high NAS fees The association between NAS fees and the absolute value of performance-adjusted discretionary accruals is significant and positive pre-CLERP 9, but this relationship is not significant post-CLERP The results indicate that auditors tolerated a larger magnitude of accruals when they earned higher NAS fees pre-CLERP 9, but that significant association was mitigated by the introduction of CLERP Furthermore, abnormal NAS fees are significantly and positively associated with the absolute value of discretionary accruals pre-CLERP 9, but this association is not significant post-CLERP In addition, the association between positive abnormal NAS fees and the absolute value of discretionary accruals is stronger pre-CLERP as compared to post-CLERP Based on the results of multiple proxies of auditor independence and audit quality, the results provide evidence of improved audit quality after the implementation of CLERP The results documented in this study make significant contributions to the literature Similar studies have been conducted in the US; however, the US legislative response (i.e., SOX) is quite different from that in Australia Thus, the current paper address the question: Is the Australian approach effective? This is an important question for policy making to achieve an outcome with the © 2013 Blackwell Publishing Ltd least compliance cost This study provides evidence as to whether there is an observable impact from the CLERP reforms This has not been examined in prior Australian studies; therefore, the paper provides new evidence on the success of the CLERP approach to addressing problems with audit practice The remainder of the paper is organized as follows: The next section discusses the background of the regulatory changes, followed by presentation of the hypotheses The fourth section describes the research method and provides information about the sample The findings are reported in the fifth section, and this is followed by conclusions in the final section REGULATORY CHANGES During the last decade, corporate collapses throughout the world have received a great deal of media attention (Fargher & Jiang, 2006), questioning the adequacy of regulations to improve auditor independence and audit quality Following these corporate failures, the adequacy of the Australian regulations that aimed to ensure auditor independence were questioned, which resulted in a review of the independence of Australian company auditors (Fargher & Jiang, 2006) This review resulted in the publication of the Ramsay Report in October 2001 (Ramsay, 2001), and subsequently the CLERP draft was proposed in September 2002 In the US, corporate legislation, SOX (2002), was passed in response to a series of financial scandals (Chambers & Payne, 2008) The debates in the Ramsay Report (2001) and the CLERP proposal focused on the joint provision of audit and non-audit services (Fargher & Jiang, 2006) To improve auditor independence and audit quality in the joint provision of audit and non-audit services, the Joint Committee of Public Accounts and Audits (JCPAA, 2002) and the ASX Corporate Governance Council issued reports on best practice guidelines for listed companies (ASX, 2003) Australian reporting entities adopted Australian equivalents of International Financial Reporting Standards (IFRS) for the reporting period commencing on or after January 2005 In annual reports, in accordance with the requirements of s307C of the Corporations Act 2001, the lead audit partner has to declare whether there are: (a) any contraventions of the auditor independence requirements of the Corporations Act 2001; and (b) any contraventions Int J Audit ••: ••–•• (2013) of any applicable code of professional conduct in relation to the audit CLERP does not ban any particular NAS provided by the auditor However, this Act stresses that the auditor must identify and evaluate threats to independence and apply safeguards to reduce any threats to an acceptable level (Ramsay, 2001) Where the provision of NAS to a client poses a threat that cannot be reduced to an acceptable level, CLERP prohibits the provision of that service (Ramsay, 2001) As part of the CLERP reforms, the Corporation Act 2001 was amended to require the mandatory disclosure of fees paid for the specific categories of NAS provided in companies’ annual reports for the reporting period commencing on or after July 2004 Moreover, the reforms stipulated that the financial statements must include a statement by the audit committee (or board in its absence) that it is satisfied that the provision of NAS is compatible with auditor independence (Corporation Act 2001, s300) This disclosure should include an explanation of why certain problematic NAS, such as IT systems services and internal audit services, if contracted, did not compromise auditor independence (CLERP 9, 2004) Regulators and legislators throughout the world apparently presume that providing NAS impairs auditor independence, which may lead to lower audit quality (Kinney et al., 2004) After the implementation of SOX (2002), most NAS were banned in the US, and SOX also requires prior approval by a registrant’s independent audit committee of any NAS allowed by law (Kinney et al., 2004) Using pre- and-post SOX data, prior studies (e.g., Hoitash et al., 2007; Li, 2009) find a significant association between NAS fees and audit quality during the pre-SOX period and the association is not significant post-SOX In Australia, CLERP has not banned NAS; however, both the auditors and the audit committee (or board in its absence), must declare that the provision of NAS has not compromised auditor independence Therefore, the objective of the current study is to investigate whether the implementation of CLERP mitigates the association between NAS fees and audit quality DEVELOPMENT OF HYPOTHESES Association between auditor-provided NAS fees and audit quality The objective of passing CLERP was to improve auditor independence and audit quality CLERP © 2013 Blackwell Publishing Ltd S Hossain and the Corporations Act 2001 require auditors to sign a declaration in the annual report stating that the independence of the auditor has not been compromised due to NAS The audit committee (or board in its absence) must also declare that the external auditor is working without impaired independence CLERP does not prohibit auditor-provided NAS However, CLERP mandates disclosure of the types of NAS fees in the annual report It is expected that non-audit fees will decrease due to the additional auditing pronouncements and disclosure of types of NAS and the prospect of greater regulatory reporting requirements by companies following those legislative reforms In addition, after the implementation of SOX in 2002, most NAS fees were banned in the US Big audit firms applying the international ruling can have the same effect in Australia because Big audit firms are international audit firms and may apply the same policy in auditing their Australian clients Auditor provided non-audit services have long been regarded as a threat to auditor independence by the regulators both in Australia and overseas (Craswell, 1999) Investigating the effect of the legal and regulatory changes in China, Chen et al (2010) find a negative association between client importance at the audit partner level and modified opinions during the pre-regulatory change period and a positive association during the postregulatory change period The findings of Chen et al (2010, p 127) suggest that ‘institutional improvements prompt auditors to prioritize the cost of compromising quality over economic benefits gained from important clients.’ Reynolds and Francis (2001) find that client importance is positively associated with the issuance of going concern reports for Big N clients Craswell, Stokes and Laughton (2002) argue that if fee dependence affects auditors’ independent judgements, then auditors are less likely to issue qualified audit opinions Using Australian data, Craswell (1999) reports that auditors’ decisions to qualify audit opinions are not affected by the provision of non-audit services Other Australian studies (e.g., Wines, 1994) find a significant and negative association between NAS and qualified opinions and argue that NAS creates perceptions of independence problems In contrast, Barkess and Simnett (1994) not find a significant association between NAS and qualified opinions Using US data, Li (2009) finds that client importance is not significantly associated with the issuance of Int J Audit ••: ••–•• (2013) Effect of Regulatory Changes on Auditor Independence and Audit Quality going-concern opinions during the pre-SOX period, but that there is a positive association post-SOX Based on the prior discussion, I expect a significant positive association between NAS fees and the propensity to issue going-concern opinions pre-CLERP and no or a significant negative association post-CLERP Thus, I propose the following hypothesis: H1a: There is a positive association between NAS fees and the propensity to issue a going-concern opinion for a financially distressed company post-CLERP but not pre-CLERP Regulators and legislators apparently presume that auditor-provided non-audit services impair auditor independence, which leads to lower quality audits (Kinney et al., 2004) The findings of prior studies regarding the associations between NAS fees and earnings management-based audit quality measures are mixed Frankel et al (2002) hypothesized that NAS increases the economic bonding between auditors and clients and therefore impairs auditor independence Cahan et al (2008) argue that faster growth and longer time period over which non-audit services are purchased from auditors may reduce auditor’s independence However, they did not find any support of a relationship between fee growth rates and length of purchasing non-audit services and discretionary accruals Studies by Krishnan, Sami and Zhang (2005) and Francis and Ke (2006) find lower earnings response coefficients for firms paying higher NAS fees Ferguson, Seow and Young (2004) find that client importance is positively associated with the absolute value of abnormal accruals Ghosh, Kallapur and Moon (2009) find that client importance is negatively associated with earnings response coefficients Using pre- and-post SOX data, Hoitash et al (2007) find a significant and positive association between NAS fees and discretionary accruals pre-SOX and no significant association post-SOX In contrast, Reynolds and Francis (2001) find that client importance is negatively associated with the absolute value of abnormal accruals The intention of regulatory changes is to improve the quality of financial statement audits and audit quality, which will also influence earnings reliability (Chambers & Payne, 2008) In Australia, effective after July 2006, lead audit partner rotation was mandated (Fargher & Jiang, 2008), and this new mechanism of mandating audit partner rotation has given audit standards legislative backing (Carey & Simnett, © 2013 Blackwell Publishing Ltd 2006) The reforms also included proportionate liability for auditors and claims capping, which provided auditors with some certainty on liability claims (Fargher & Jiang, 2008) This could well affect auditor behaviour regarding earnings quality measures As reduced earnings management is used as one of the indicators of improved audit quality (Wong, Jubb & Chalmers, 2007) vis-à-vis financial reporting quality (see Becker et al., 1998) and audit quality is affected by independence, it follows that if the implementation of CLERP increased auditor independence, it may have consequently improved earnings managementbased measures of financial reporting quality Therefore, I expect a significant positive association between NAS fees and the absolute value of performance-adjusted discretionary accruals pre-CLERP and no or a significant negative association post-CLERP Thus, I propose the following hypothesis: H1b: There is a positive association between NAS fees and the absolute value of discretionary accruals pre-CLERP but not post-CLERP Association between abnormal NAS fees and audit quality The objectivity and independence of auditors is more likely to be influenced by the level of client fees in excess of the auditor’s expectation of normal fees, i.e., abnormal fees, rather than expected fees (Choi et al., 2006) Choi et al (2006) argue that when an auditor earns more than the expected level of NAS fees, the perceived net benefits become greater than the associated costs, which increases economic bonding and may decrease audit quality Kinney and Libby (2002) argue that strong economic bonding between the auditor and the client will reduce the quality of the reported earnings through the auditor’s reduced willingness to resist client-induced biases in reported accounting information Auditors may also be reluctant to issue a going-concern opinion due to the possibility of losing the client Using pre- and post-SOX data, Hoitash et al (2007) find a significant positive association between abnormal NAS fees and accruals pre-SOX and no significant association post-SOX Hoitash et al (2007) provide evidence consistent with the view that clients with higher abnormal NAS fees may have more influence on auditors’ decisions that lead to impaired auditor independence Choi et al (2006) Int J Audit ••: ••–•• (2013) S Hossain Control variables LnTA = natural log of total assets; BIG4 = if the audit firm is a Big firm, otherwise; EQUITY = if the company issued new shares in the current year, otherwise; MERGACQS = if the company has merger or acquisition activities during the current year, H2a: There is a negative association between otherwise; abnormal NAS fees and the propensity to issue a ROA = earnings before interest and taxes divided going-concern opinion for a financially distressed by total assets; company pre-CLERP but not post-CLERP LEVERAGE = total liabilities divided by total assets; H2b: There is a positive association between NEG_ROA = if the company reports a negative abnormal NAS fees and the absolute value of return on assets in the current year, otherwise; discretionary accruals pre-CLERP but not GROWTH = change of assets from prior year; post-CLERP MB = market-to-book value; LnSUBS = natural log of number of subsidiaries; FOROPS = if the company has any foreign RESEARCH METHOD subsidiaries, otherwise; USLIST = if the company is cross-listed in the US, Measurement of abnormal NAS fees otherwise; Following the procedures of Choi et al (2006) and ∑INDUSTRY = there are 10 indicator variables for 11 Global Industry Classification Standard Hoitash et al (2007) of decomposing fees into two (GICS) industry groups components, namely the expected component (normal fees) and the abnormal component Definitions of the variables are provided in the (abnormal fees), it is necessary to specify an Appendix for ease of reference The natural log of expectation model linking actual fees with their total assets (LnTA) is used as a proxy for client size determinants On the basis of economic bonds, Demand for non-audit services is likely to increase client size, client complexity and client-specific with firm size (Palmrose, 1986; Raghunandan et al., risk from prior studies (e.g Simunic, 1980; 2003) and, therefore, it is expected that NAS fees Francis & Stokes, 1986; Craswell et al., 1995; are positively associated with LnTA Non-audit DeFond et al., 2002; Frankel et al., 2002; Whisenant services fees are likely to be higher for clients with et al., 2003; Choi et al., 2006; Hay et al., 2006) and more complex business operations (Raghunandan independence measures reported by Ashbaugh et al., 2003) LnSUBS, MERGACQS and FOROPS et al (2003) and Ruddock, Taylor and Taylor are used to proxy for client complexity, and it is (2006), this study uses the following ordinary expected that the variables representing client least squares (OLS) model to calculate abnormal complexity are positively associated with NAS NAS fees for each year separately The abnormal fees NEG_ROA, LEVERAGE and ROA are used to NAS fees are the residuals of the estimated proxy for a client’s risk characteristics Since an auditor charges higher fees for riskier clients model: (Simunic & Stein, 1996), the coefficients of NEG_ROA and LEVERAGE are expected to be LnNAS = β0 + β1LnTA + β BIG4 + β EQUITY positive and that of ROA to be negative The + β MERGACQS + β 5ROA + β6 LEVERAGE control variable, BIG4, is used to capture the capacity of providing non-audit services and a + β7 NEG_ROA + β8 GROWTH + β9 MB positive coefficient is expected with NAS fees The + β10LnSUBS + β11FOROPS + β12 USLIST demand for non-audit services is greater for + β13 ∑ INDUSTRY + ε (1) high-growth firms than low-growth firms (Choi & Wong, 2006) EQUITY, GROWTH and MB are used where to capture the effect of a client firm’s growth on LnNAS = natural log of auditor-provided non-audit NAS fees, and positive associations with fees for services fees;1 EQUITY, GROWTH and a negative association suggest that auditors’ incentives to compromise audit quality differ depending on whether the client pays more than or less than the normal level of fees, which, in turn, leads to the audit fee–audit quality association being based on the sign of abnormal audit fees Thus, I propose the following hypotheses: © 2013 Blackwell Publishing Ltd Int J Audit ••: ••–•• (2013) Effect of Regulatory Changes on Auditor Independence and Audit Quality with MB are expected A control variable for the US cross-listing (USLIST) is used owing to the additional requirements in US regulations Similar to Ashbaugh et al (2003) and Ruddock et al (2006), this study uses industry dummies to control for cross-industry differences in fees INDUSTRY is an indicator variable equal to if the company belongs to an appropriate industry group, otherwise Audit opinion model The following logistic regression model is estimated for the pre- and-post-CLERP periods to test the association between NAS fees, abnormal NAS fees and the propensity to issue a going-concern opinion for a financially distressed company after controlling for the variables used by Carey and Simnett (2006): OPINION = β0 + β1LnFEE + β 2PQUAL + β 3PBANK + β 4LnTA + β 5LnAGE + β 6LEVERAGE + β7 CLEVERAGE + β8ROA + β9LLOSS + β10INVESTMENTS + β11BIG + β12 CFO + β13 MINING + ε (2) where Dependent variable OPINION = OPINION is coded as if an auditor issues a going-concern opinion for a financially distressed company in the current year and as otherwise; Experimental variable FEE = alternative measures of fees, such as: LnNAS is the natural log of auditor-provided non-audit services fees;2 ABNAS fees are estimated from the residuals of the LnNAS fee model (Equation 1); Control variables PQUAL = if the auditor issued an opinion other than an unqualified one in the previous year, otherwise; PBANK = probability of bankruptcy, as measured by adjusted Zmijeswki score;3 LnAGE = natural log of number of years the company has been listed on the Australian Securities Exchange (ASX); CLEVERAGE = change in leverage during the year; LLOSS = if the client reported a loss in the previous year, otherwise; INVESTMENTS = short- and long-term investment securities (measured as current assets minus debtors and inventory) divided by total assets; CFO =operating cash flow deflated by total assets; © 2013 Blackwell Publishing Ltd MINING = if the company belongs to the mining industry, otherwise; e = error term All other variables are as defined in Equation (1) Prior year opinion (PQUAL) is a good predictor of the current year’s opinion because the going-concern problems may continue for a longer period (Monroe & Teh, 1993) Higher values of PBANK indicate a higher probability of bankruptcy (Carey & Simnett, 2006) LnTA is included because larger companies are less likely to end up in bankruptcy, due to their financial stability and greater negotiating power (Carey & Simnett, 2006) LnAGE is controlled because younger companies are more likely to encounter financial distress (Carey & Simnett, 2006) Similar to Carey and Simnett (2006), I use LEVERAGE and CLEVERAGE to control for the risk of insolvency ROA and LLOSS capture the profitability of the companies, as companies incurring a loss are more likely to receive a going-concern opinion (Carey & Simnett, 2006) CFO and INVESTMENTS proxy for the liquidity risk of a company, and a liquidity crisis may end in bankruptcy (Carey & Simnett, 2006) BIG4 is included in order to differentiate the propensity of issuing going-concern opinions by Big and non-Big audit firms MINING is controlled because the sample includes a large number of mining companies, which have different financial characteristics (Butterworth & Houghton, 1995; Carey & Simnett, 2006) Earnings management model Similar to Kothari, Leone and Wasley (2005), this study estimates non-discretionary accruals using the performance-adjusted modified Jones (1991) model, and estimates abnormal accruals as the residuals from the model Subject to a minimum of 10 observations (excluding financial sector 40) in each industry category for each year, this model is estimated cross-sectionally for each two-digit GICS (a six-digit for the Metals & Mining sector) industry group in each of the years 2002–2007 as follows: TACC = α + β1 ( ΔREV − ΔREC ) + β 2PPE + β 3LagROA + ε (3) where TACC = total accruals, being the difference between operating income (OI) and cash flow from operations; DREV = change in revenues from period t - to period t; Int J Audit ••: ••–•• (2013) S Hossain DREC = change in accounts receivables from period t - to period t; PPE = gross value of property, plants and equipment; LagROA = one-year lag of ROA; e = error terms All variables, including the intercept (other than LagROA), are scaled by the lagged total assets The model for examining the association between test variables and earnings management This study uses the following model to examine the association between NAS fees, abnormal NAS fees and the absolute value of performance-adjusted discretionary accruals for the pre- and post-CLERP periods after controlling for the variables used in Carey and Simnett (2006): DACC = α + β1LnFEE + β BIG + β 3PBANK + β OPINION + β 5LnTA + β6 LEVERAGE + β7 LLOSS + β8 ROA + β9LnAGE + β10 GROWTH + β11CFO + β12 MINING + ε (4) where Dependent variable DACC = discretionary accruals estimated from the residuals of Equation (3); Experimental variable FEE = alternative measures of fees, such as: LnNAS is the natural log of auditor-provided non-audit services fees; ABNAS fees is estimated from the residuals of the LnNAS fee model; Control variables OPINION = if the company has a modified opinion during the current year, otherwise; All other variables are defined in Equations (1) and (2) Consistent with the arguments of Carey and Simnett (2006), a number of variables (BIG4, PBANK, OPINION, LnTA, LEVERAGE, LLOSS, ROA, LnAGE, CFO, MINING) used in predicting the propensity to issue a going-concern opinion are expected to be associated with the level of discretionary accruals GROWTH is controlled for changes in a company’s financial position and their association with discretionary accruals Sample selection CLERP (2004) was enacted on 30 June 2004 Hence, the first reflection of CLERP is seen in © 2013 Blackwell Publishing Ltd Table 1: Sample selection (2002–2007) Firm-year observations OPINION Initial sample Financial (4010 to 4040) Missing data and data not available Non-distressed companies Final sample DACC 9,736 – 1,712 9,736 563 2,517 3,063 4,961 6,656 the annual reports prepared for the financial period 2004–05 Therefore, this study uses data from 2002, 2003, 2004 and balance dates between January and 29 June 2005 for the pre-CLERP and 2005 (balance date on 30 June), 2006 and 2007 for the post-CLERP Data were collected up to 2007 because of the Global Financial Crisis in 2008, which might affect the results The initial sample consists of 9,736 firm-year observations whose financial data were available in Aspect’s FinAnalysis database for fiscal years from 2002 to 2007 NAS fees and audit opinions data were hand-collected directly from the annual reports Consistent with Carey and Simnett (2006), the sample for the audit opinion model is restricted to financially distressed companies only I identified financially distressed companies based on either the company reporting a loss or a negative cash flow from operations during a given year The sample size is further reduced because of data requirements for predicting the type of audit opinions The final sample consists of 4,961 firm-year observations for the OPINION model The sample of discretionary accruals models was derived after excluding financial sector (GICS 40) and data requirements for estimating discretionary accruals The final sample is 6,656 firm-year observations for the DACC model Table shows how the sample sizes are derived for this study Table shows the industry representation of the sample companies The current study uses a twodigit GICS code (a six-digit code for Metals & Mining) There are 11 industry groups Similar to prior studies (e.g., Coulton, Taylor & Taylor, 2005), the current study also excludes industry groups for a particular year if the group has fewer than 10 companies when estimating discretionary accruals Int J Audit ••: ••–•• (2013) Effect of Regulatory Changes on Auditor Independence and Audit Quality Table 2: Industry representation of the sample companies (2002–2007) Industry Group (GICS code) OPINION DACC Firm-year observations 10 11 Total Per cent 491 57 384 332 138 581 563 474 120 60 1,761 4,961 9.90 1.15 7.74 6.69 2.78 11.71 11.35 9.55 2.42 1.21 35.50 100.00 Energy (10) Materials (15) Industrial (20) Consumer Discretionary (25) Consumer Staples (30) Healthcare (35) Financials (40) Information Technology (45) Telecommunication Services (50) Utilities (55) Metals and Mining (151040) Firm-year observations Per cent 628 180 946 876 290 723 9.42 2.70 14.19 13.14 4.35 10.85 695 163 106 2058 6,656 10.43 2.45 1.59 30.88 100.00 Two-digit GICS industry classification (6-digit for Metals & Mining) DATA ANALYSIS AND DISCUSSION OPINION Descriptive statistics Table shows the descriptive statistics for the sample The average size of the sample companies pre-CLERP was $610.464 million and post-CLERP the average size was $1,142.609 million and the difference is significant The average NAS fees are higher pre-CLERP ($128,812.616) than post-CLERP ($67,502.291) and the difference is significant Other than LLOSS and PQAUL, mean differences for all the control variables are significantly different between the pre-CLERP and the post-CLERP periods The maximum VIF value is 2.708, indicating that multicollinearity is not a significant concern Association between NAS fees and OPINION Table provides the logistic regression results for the association between NAS fees and the propensity to issue a going-concern opinion for a financially distressed company during the pre- and post-CLERP Consistent with Carey and Simnett (2006), the sample is restricted to financially distressed companies The model is well-fitted with pseudo R2s ranging from 0.239 to 0.252 The results (Table 4, columns and 3) show that the association between the LnNAS fees and the propensity to issue a going-concern opinion for a financially distressed company is significant and positive post-CLERP (coefficient = 0.049, p = 0.006) © 2013 Blackwell Publishing Ltd (one-tailed) and is not significant pre-CLERP (coefficient = -0.021, p = 0.104) The findings indicate that auditors are more likely to issue a going-concern opinion for a financially distressed company post-CLERP when providing NAS fees This finding is consistent with the US study by Li (2009), who finds that client importance is not significantly associated with the issuance of going-concern opinions pre-SOX, but that association is significant and positive post-SOX The significant association between LnNAS fees indicates the improvement of auditor independence and audit quality post-CLERP Auditors earning more than the expected level of NAS fees may compromise audit quality To test whether the association between abnormal NAS fees and the propensity to issue going-concern opinions remained the same before and after the implementation of CLERP 9, this study estimated abnormal NAS fees based on the NAS fee model (Equation 1) Table (columns and 5) shows that the association between the signed abnormal NAS fees is significantly and negatively associated (coefficient = -0.036, p = 0.005) with OPINION pre-CLERP 9, but is not significant (coefficient = 0.017, p = 0.196) postCLERP A separate analysis (not tabulated) shows that the association between positive abnormal NAS fees and OPINION is significant and negative (coefficient = -0.090, p = 0.003) and stronger pre-CLERP than post-CLERP (coefficient = -0.173, p = 0.040) These findings also indicate that auditor independence and audit Int J Audit ãã: ãããã (2013) â 2013 Blackwell Publishing Ltd 610.464 128,812.616 12.002 7.212 0.261 0.201 0.261 -1.157 16.145 2.208 0.613 1.384 -0.468 0.874 0.309 0.536 -0.261 0.329 Mean 9,388 9,000.000 10.000 9.105 0.000 0.000 0.000 -2.612 16.055 2.303 0.236 0.036 -0.163 1.000 0.204 1.000 -0.113 0.000 Median Pre-CLERP (n = 2,192) 12,340.889 2,136,337.525 8.689 4.561 0.439 0.401 0.439 11.917 1.843 0.785 2.739 2.689 1.741 0.332 0.301 0.499 0.740 0.470 Std deviation 1,142.609 67,502.291 12.116 6.420 0.225 0.195 0.225 -2.284 16.473 2.174 0.360 1.420 -0.389 0.788 0.372 0.415 -0.257 0.374 Mean 11.879 5,159.500 9.000 8.618 0.000 0.000 0.000 -3.128 16.290 2.197 0.436 0.235 -0.153 1.000 0.282 0.000 -0.104 0.000 Median 19,778.128 406,373.659 9.735 4.836 0.418 0.396 0.418 5.825 1.877 0.835 0.922 3.941 0.723 0.409 0.304 0.493 0.476 0.484 Std deviation Post-CLERP (n = 2,769) 5.870 18.452 2.911 4.362 -6.167 0.535 1.442 -17.168 -2.962 -2.161 7.952 -7.385 8.484 -0.190 -3.264 5.870 18.452 2.911 t-statistics VIF 2.450 1.825 – 1.211 2.590 2.613 1.052 1.035 1.004 2.708 1.643 1.335 1.225 1.291 1.169 p-value