Silicon Networks
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Marvin Tanner April 2006 Abstract Since the advent of Sarbanes-Oxley, there has been emphasis on financial information disclosure and a call for changes in the internal and external audit process. A call in the professional societies for the ban of non-audit functions by audit firms has been debated in conference sessions and professional society publications. The issues this paper addresses include: audit relationships between consultancy firms and clients; purchased influence in terms of audit firm retention or dismissal; Big 5 Audit firms retention as a form of insurance; is there a correlation between the audit process and what stocks are worth. This has led to concept that there is no correlation between audit consultancy fees and audit quality. The intent of the SEC regulations is to communicate the audit relationship to the board, stock holders, and interested parties. The system is working and would stronger SEC regulations provide more open communications between the board and the investment community? The literature does not support that contention, and suggests that the current system of checks and balances is finely tuned to produce accurate and detailed reporting. Correlation Between Audit Consultancy Fees and Audit Quality After the fall of Enron and the in the advent of Sarbanes-Oxley, there has been discourse on the internal and external audit process. There has been professional discussion on the need for a ban on audit firms generating income from non-audit engagements with audit clients. This has led to concept that there is no correlation between audit consultancy fees and audit quality. The intent of this discourse is to explore the relationship between audit consultancy fees and audit quality. Research methodology is based on Robert S. Kaplan and Anthony A. Atkinson's model of "Activity-Based Management" from Advanced Management Accounting, plus many professional journal articles and society conference proceedings. Historical accounts of audit impropriety and a call for reform by the Securities and Exchange Commission after the fall of Enron has been referred to as a crisis of confidence in the profession and the need for reforms (The Economist, March 9, 2002, p9). The Enron example not only demonstrates a lack of confidence, but also the issue of what stocks are worth. Arthur Levitt, former chairman of the Securities Exchange Commission (SEC), raised the issue if a company actually earns "what its stock are actually worth" (Business Week, January 28, 2002, p44). It has been suggested that these issues may not have occurred, based on higher quality of audits. There is an assumption that the Big 5 accounting firms provide a higher quality audit. According to Krishman and Gul the Big 5 audit more than eighty percent of publicly held corporations in the U.S. and Superior audit quality is generally associated with Big 5 Auditors (Has Audit Quality Declined? Evidence From The Pricing Of Discretionary Accruals, 2005). Audit firms have increased revenue streams by increasing non-audit consultancy engagements resulting in concern about audit quality when there are non-audit engagements. Krishman and Gul also claim that since the early 1990's accountants have become increasingly dependent on consulting services. For many large corporations and non-profits, an audit is a methodology to communicate between officers and the investment community. Hay and Davis suggest that an audit is signaling insider's knowledge of superior performance through selection of an auditor with a higher reputation. . . (The Voluntary Choice of an Audit of Any Level of Quality, p2). The perception of audit quality extends into the financial management of the firm in terms of rates paid for mortgage of commercial lines of credit. Hays goes on to say "previous studies provide evidence that auditing is associated with high agency costs, indicated by greater size, higher debt leverage, or lower managerial ownership. (Quoted by Hays,p2, attributed to Chow, 1982, Ettredge, Simon, Smith, and Stone, 1994). The quality of the audit effects perception by investors, customers, and suppliers on the confidence management has on financial reporting. In addition to effecting mortgage and capital costs, the quality of audit is a form of insurance. Hays in referring to Dye (1993) demonstrates that audit fees depend on the option value of the claim financial statement users have on the auditor's wealth in the event the audit is determined to have been substandard. Dye continues with the argument that insurance includes the 'deep pocket' attribute of a codefendant in the event of litigation by vested parties. Closely related to audit insurance is professional liability and the threat of litigation. Hays addresses the issue of audit quality in a reference to Palmrose(1988) also reports that audits by Big 8 (now big Big 5) firms are less likely to result in litigation. This supports Hays contention that the quality of the audit effects corporate perception on the quality of information. There has been concern expressed that large clients can influence auditor independence. Dee, Callaway, Lulseged, and Nowlin suggest that "auditors allow less discretion to their relatively large and influential clients (Earnings Quality and Auditor Independence: An Examination Using Non-Audit Fee Data, p1). There has been documented concerns identified in the literature about "influence shopping." It has been reported there is a tendency to select the audit firm according to the predicted outcome of the audit. If the internal audit committee is not convinced of the desired outcome, they will select another firm that will possibly deliver the desired results. Influence on auditors is not purchased as inferred. The calls for closer monitoring and disclosure rules regarding non-audit consulting revenue are the foundation for full disclosure in auditing. Kaplan addresses this issue in "Cost of Quality," the cost of quality (COQ) approach collects all costs currently being spent on preventing defects and fixing them after they have occurred (Advanced Management Accounting, p563). Kaplan does not infer that this approach be applied to audit consulting, however, internal audits by qualified auditors identifies defects in the accounting process. Clive S. Lennox addresses the concern that companies strategically dismiss incumbent auditors if they are more likely to issue unfavorable audit opinions compared to newly appointed auditors (Opinion Shipping, Audit Firm Dismissals, and Audit Committees, p1). Lennox sites "As a sub-committee of the board of directors, the audit committee is considered an important corporate governance mechanism for monitoring senior management and ensuring accountability and stakeholders (Cadbury Committee, 1992)." The literature suggests that the current mechanisms for internal audit are working as designed. Through disclosure when changing auditors and inclusion in the financial statement reporting the nature of non-audit consultancy revenue by the audit firm, there is clear signals to existing business partners and investors the relationship of potential undue influence. The intent of the SEC regulations is to communicate the audit relationship to the board, stock holders, and interested parties. The system is working and would stronger SEC regulations provide more open communications between the board and the investment community? The literature does not support that contention, and suggests that the current system of checks and balances is finely tuned to produce accurate and detailed reporting. Biography: Marvin Tanner is currently the vice president of operations, Silicon Networks Corporation, and professor of business, Graduate School of Business, University of Phoenix, San Jose. With more than twenty years of operations management experience, Mr. Tanner has been a developer of real-time accounting solutions for the Unix and Windows platforms. Currently, Mr. Tanner heads up the online accounting solutions group at Silicon Networks. He can be reached at (510) 463-8900 at the Jack London Square Executive Offices, Silicon Networks Corporation. References: Abardanell, Jeffery and Lehavy, Reuven, The Role of Reported Earnings? The Role of Reported Earnings in Explaining Apparent Bias and Over/Underreaction in Analysts' Earning Forecasts, April 1999. Dee, Carol Callaway, Lulseged, Ayalew, and Nowlin, Tanya S., "Earnings Quality and Auditor Independence", Workshop Presentation for the 2002 American Accounting Association Mid-Year Auditing Section Conference. Business Week, January 28, 2002. Economist, The, March 9, 2002 Gopal, Krishnan and Gul, Ferdinand, Has Audit Quality Declined? Evidence From The Pricing of Discretionary Accruals, City University of Hong Kong, Department of Accountancy, 2005. Hay, David and Davis, David, "The Voluntary Choice of an Audit of Any Level of Quality," Presentation at the 2001 Summer Workshop at the University of Technology, Sydney. Hudalb, Mohammand, and Cooke, T.E., The Impact of Managing Director Changes and Financial Distress on Audit Qualification and Auditor Switching, Journal of Business Finance and Accounting, Volume 32, Page 1703, November 2005. Kaplan, Robert S. and Atkinson, Anthony A., Advanced Management Accounting, Third Edition, Prentice Hall, New Jersey, 1998. Lennox, Clive S., "Opinion Shopping, Audit Firm Dismissals, and Audit Committees," Hong Kong University of Science and Technology, February 2002. Mohanram and Sunder, "How Has Regulation Fair Disclosure Affected the Functioning of Financial Analysis?" A Paper Presented at the 13th Annual Conference on Financial Economics and Accounting at the University of Maryland, December 2003. Weissenrieder, Fredrik, Value Based Management: Economic Value Added or Cash Value Added?, Study Number 1997:3, Department of Economics, Gothenburg University, 1997. |
