The Effect of Nonaudit Fees on Accounting Practices

Accounting watchdogs have long warned that providing nonaudit services can compromise an auditor’s independence. Now they have some numbers to support their case. In a new study, researchers at MIT, Michigan State University and Stanford conclude that auditors are more likely to condone earnings management when audit clients pay large nonaudit fees.

The relationship between earnings quality and nonaudit services has generated concern since the 1970s, when the U.S. Congress first considered limiting the services that auditors could provide. Since then, interest in the issue has intensified in response to two trends: the rapid growth of auditors providing nonaudit services and the emergence of shareholder value as the dominant yardstick by which companies are judged. Between 1993 and 1999, the use of nonaudit services, such as management and information systems consulting, increased at an annual rate of 26%, compared to 9% for audits. During that same period, the growing obsession with stock market performance — initially applauded for increasing CEO accountability —began to show its flaws. Critics worried that unscrupulous executives would do whatever it took to drive up their company’s share price, just as auditors’ incentives were becoming increasingly stacked in favor of turning a blind eye.

In response to these concerns, the U.S. Securities and Exchange Commission revised its guidelines for determining auditor independence in November 2000. Among other provisions, the new framework prohibited auditors from providing certain nonaudit services, such as bookkeeping, that inherently create conflicts of interest, and it required public companies to begin disclosing the audit and nonaudit fees they pay each year.

The study’s authors took advantage of this ruling to construct a sample of 3,074 nonfinancial firms that filed proxy statements between February 5, 2001, when the new requirement went into effect, and June 15, 2001. Simply tabulating the fees disclosed in these statements revealed that nonaudit services were much more prevalent than previously believed. In formulating its new rules, the SEC relied on data suggesting that only a minority of audit clients — a little over one-fourth — purchased nonaudit services and that these transactions amounted to only 10% of revenues for the Big Five (Arthur Andersen, Deloitte & Touche, Ernst & Young, KPMG and PricewaterhouseCoopers). However, the first wave of disclosures painted a very different picture.