Hypotheses for assessing the association between auditor‟s economic dependence

and FRQ

The following hypotheses predict that economic bonding between the auditor and the client, proxied by two fee constructs (the ratio of NAS fees to audit fees and the natural log of total fees) will lead to a decline in FRQ evidenced by clients paying higher total fees appearing to exercise greater discretion in managing accounting accruals.

3.2.1 Proportion of NAS fees to audit fees and FRQ

Building on prior studies such as DeFond and Park (1997), Jones (1991) and Healy (1985), it can be argued that the auditor may acquiesce to a client‟s influence due to fee

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dependence and consequently may allow that client greater discretion in its reported accruals. This greater latitude would make the client better able to manipulate earnings towards its desired earnings targets.

The sample period (2003-12) is characterised by a number of factors46_{, which could be}

expected to have an impact on the size of NAS purchased from the statutory auditors and the degree of discretionary accruals exercised. The widespread attention paid to the accounting scandals and financial crisis raised questions about the joint purchase of audit and NAS and could have influenced company management attitudes towards the purchase of these services. The reviews47 _{established by the UK government and the}

subsequent development of new ES for auditors (APB 2004) could also have heightened sensitivities on auditor independence and audit quality.

An audit firm‟s dependence on its clients increases as the economic bonding between

the firm and the client gets stronger (DeAngelo 1981). Simunic (1984) and Beck et al. (1988) assert that the NAS fee further strengthens the auditor-client bond as it increases the portion of audit firm wealth derived from a client. It can be argued that the client can use NAS fees as contingent fees to get the auditor to accept its opportunistic financial reporting (Beattie and Fearnley 2002). While the provision of contingent fees is explicitly prohibited by auditing standards in the UK and the US (for example, APB ES 4 and 5; and Section 302 of AICPA Code of Professional Conduct, respectively), Magee and Tseng (1990) note that clients can create contingent fees by withholding profitable NAS when the auditor does not allow the client to report its preferred financial condition.

Reynolds et al. (2004) argue that “audit fees are a stable, predictable stream of revenue”

for audit firms while NAS fees may differ significantly (p. 32). They observe that a

client “paying high NAS fees relative to audit fees still may pay relatively small total fees” against other clients (p. 32). Consequently, it is argued that “an economically

rational auditor would perceive greater fee pressure from a high-fee client receiving a relatively small proportion of non-audit services than from a low-fee client receiving a relatively high proportion of non-audit services” (Reynolds et al. 2004, p. 32). Finally,

46 _{For details, see Figure 4.1 in Chapter 4.}

47 _{Reviews include the Cadbury Committee Report (1992), the Smith Committee Report (2003), the EC}

Recommendations (2002), the CGAA Report (2003), the introduction of APB Ethical Standards (2004) and the changes in the Companies Act 2006.

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employing resource dependence theory (Pfeffer and Salancik 1978) from the perspective of auditors, it can be argued that auditors enter into relationships with their clients because they have to rely on clients‟ resources (audit and NAS fees received) for

their success. It can therefore be argued that auditors might tolerate more manipulation of accounting numbers where they receive higher NAS from a client.

Accordingly, the current study expects the association between the degree of auditor- auditee bonding and the level of reported discretionary accruals as a surrogate for FRQ is mediated by the enhanced regulatory regime, particularly after 2004 pronouncement of APB ES. Based on the above discussion, the first hypothesis can be stated as follows:

H1: The proportion of NAS fees to audit fees received from the audit client is positively related to the magnitude of discretionary accruals.

3.2.2 Total fees and FRQ

In assessing the impact of total fees on audit quality, Reynolds and Francis (2000) and Hansen and Watts (1997) argue that audit and NAS fees may create similar incentive effects for auditors. In line with this, Ashbaugh et al. (2003) argue that the sum of audit and NAS fees, i.e., the total fees to the auditor, best captures the explicit economic bond between the audit firm and the client.

However, Ashbaugh et al. (2003) observe that the fee ratio as a measure of auditor‟s

economic dependence may not capture the severity in cases where significantly higher fees are paid. They argue that the fee ratio can only capture the relative monetary value of the audit versus NAS provided by the audit firm to a client which may have an impact on the perception of independence (independence in appearance) held by regulators and the general public. Moreover, Reynolds et al. (2004), from the standpoint of an economic rationality, doubt the power of fee ratio (ratio of NAS fees to audit fees) in capturing economic dependence. They also note that the components of total fees

(audit and NAS) form the heart of an economic decision from the auditor‟s perspective.

Consequently, the second hypothesis is based on this clear and well-developed theoretical link between total fees and FRQ:

H2: The total fees received from the audit client are positively related to the magnitude of discretionary accruals.

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The level of economic dependence of the auditors for audit and NAS fees between 2003 and 2012 (i.e. two years before the ES were enforced and eight years into the APB ES regime) are examined through ordinary least square regressions. The chosen time period enables this study to examine the impact of the audit regulations in the UK both pre and post the focal point of the regulatory reforms that came in force in 2004 through the ES (APB 2004, 2010a). It is expected that the economic dependence of the auditors under the ES regime will be reflected in a change in discretionary accruals as a surrogate for FRQ for the sample period.

3.3 Hypotheses for assessing the impact of APB regulations in the form of restricted