Dear Mr. Katz:

My colleague and I have attached a research paper entitled "Perceptions of the Relationship Between Nonaudit Services and Auditor Independence," which we hope will contribute in a meaningful way to the Commission's ongoing deliberations related to the impact of nonaudit services on auditor independence.

Our study examined how the performance of nonaudit services influences the perceptions of auditor independence held by three classes of financial statement users: the general public, non-Big 5 CPA firm professionals, and Big 5 CPA firm professionals. Four types of nonaudit services were studied: actuarial services, internal audit outsourcing, legal advisory services, and general management advisory services (information systems training). Our results indicated the following:

Nonaudit services appear to enhance auditor independence, as evidenced by their positive influence on user perceptions. Furthermore, this positive perception was evident across all four types of nonaudit services.

The positive influence of nonaudit services was also observed across all three classes of users. However, Big 5 CPA firm professionals rated auditor independence higher than either non-Big 5 CPA firm professionals or members of the general public.

The general public favored disclosure of the provision of nonaudit services, while CPA firm professionals favored disclosure of the amount of nonaudit services only if those services exceeded a specified dollar threshold.

We would be very pleased to discuss our research with you or any member of your staff. You may reach Dr. Greg Jenkins at (919) 513-2476 or me at (919) 515-4439.

Sincerely,

Dr. Kathy Krawczyk
Associate Professor of Accounting

PERCEPTIONS OF THE RELATIONSHIP
BETWEEN NONAUDIT SERVICES
AND AUDITOR INDEPENDENCE

J. Gregory Jenkins
Assistant Professor
Phone: (919) 513-2476
Email: greg_jenkins@ncsu.edu

Kathy Krawczyk
Associate Professor
Phone: (919) 515-4439
Email: katherine_krawczyk@ncsu.edu

North Carolina State University
Department of Accounting
Campus Box 8113
Raleigh, North Carolina 27695-8113

July 25, 2000

Data Availability: Data used in this study are available from the authors upon request.

Copyrighted. Not to be quoted or reproduced without the authors' permission.

PERCEPTIONS OF THE RELATIONSHIP
BETWEEN NONAUDIT SERVICES AND AUDITOR INDEPENDENCE

SYNOPSIS

Recent expansion of nonaudit services by public accounting firms has caused the Securities and Exchange Commission (SEC) to question whether auditors can remain independent of their clients to whom they provide both audit and nonaudit services. However, as evidenced by the debate surrounding the SEC's recently proposed restrictions on the provision of nonaudit services, some disagree, contending that nonaudit services strengthen the auditor's independence. This study examined how the performance of nonaudit services influenced the perceptions of auditor independence held by three groups of financial statement users: the general public, professionals from non-Big 5 CPA firms, and professionals from Big 5 CPA firms. The materiality of the nonaudit service fee and the type of nonaudit service performed were varied. Results indicated that nonaudit services had a positive influence on participants' perceptions of auditor independence, consistent with the contention that nonaudit services enhance auditor independence. Not surprisingly, Big 5 CPA firm professionals consistently rated auditor independence significantly higher than either non-Big 5 CPA firm professionals or members of the general public. Finally, the general public favored disclosure of the provision of nonaudit services, while CPA firm professionals favored disclosure of the amount of nonaudit services only if those services exceeded a specified threshold.

PERCEPTIONS OF THE RELATIONSHIP
BETWEEN NONAUDIT SERVICES AND AUDITOR INDEPENDENCE

INTRODUCTION

"Growing business ties between [public accounting] firms and their audit clients ... has raised new questions regarding the nature of the auditor-client relationship" (Jenkins and Lowe 1999, 74). Given the variety of nonaudit services currently offered by firms to their audit clients, one question is whether these services impair public perceptions of auditor independence. Recently, the Securities and Exchange Commission (SEC) proposed rules intended to strengthen auditor independence by significantly restricting the extent to which firms can provide consulting (i.e., nonaudit) services to their audit clients (Schroeder 2000). While the SEC's efforts have been supported by two of the Big 5 CPA firms (Ernst & Young and PricewaterhouseCoopers), the American Institute of Certified Public Accountants (AICPA) and the remaining Big 5 CPA firms have criticized the rules. The latter view consulting services as beneficial to the audit process and contend that there is no evidence of nonaudit services compromising audits (Schroeder 2000).

In August 1999, the SEC called for academic research on a number of key accounting issues, including auditor independence. One of the specific topics they suggested for research is whether "users of financial statements consider nonaudit services provided by auditors to impair auditor independence" (Turner 1999). Kinney (1999) also called for an investigation into whether the public is concerned about financial statements when external auditors provide a substantial amount of nonaudit services to their audit clients. Furthermore, Goldwasser (1999, 52) called for regulators to "determine the extent to which various types of collateral services raise questions of impaired objectivity in the minds of financial statement users."

This study experimentally examined how the performance of nonaudit services influences the perceptions of auditor independence held by three groups of financial statement users: the general public, professionals from non-Big 5 CPA firms, and professionals from Big 5 CPA firms. Each participant reviewed two hypothetical situations: one in which an external audit firm provided audit services only and the second in which the firm additionally provided either a material or nominal level of one of four nonaudit services for an audit client. Three specific nonaudit services - actuarial services, outsourcing, and legal services - were studied because the Independence Standard Board (ISB) has specifically called for research on auditor independence as it relates to the performance of these services. Information systems consulting was added as a fourth nonaudit service as it is a commonly provided nonaudit service.

BACKGROUND

Nonaudit Services

Companies currently demand a broad set of nonaudit services from accounting firms (Wallman 1996). Accounting firms are responding by offering such varied services as investment banking, strategic management planning, human resource planning, computer hardware and software installation, and internal audit outsourcing services [AICPA 1997; Berton 1995]. The AICPA Special Committee on Assurance Services has identified new opportunities for auditors to expand traditional assurance service offerings. These opportunities include risk assessment, business performance management, electronic commerce, and healthcare performance measurement among others [Elliott and Pallais 1997; Telborg 1996].

Prior research suggests the impact of nonaudit services on auditor independence is uncertain. Indeed, no consensus exists within the profession about whether these services strengthen or hinder auditor independence (Schroeder 2000). Some believe that these collateral services create a working relationship between the auditor and the client that is too close (Goldwasser 1999, Sutton 1997). Others believe that the provision of nonaudit services enhances the auditor's knowledge of the client, thus increasing the auditor's objectivity (Goldwasser 1999, Wallman 1996). Finally, some studies indicate that the provision of nonaudit services has no effect on perceptions of auditor independence (Kinney 1999).

Auditor independence may be adversely affected by the provision of nonaudit services if shareholders perceive nonaudit services as creating an economic dependence of the auditor on firm management (Wallman 1996). Economic theory suggests that the separation of firm ownership from the control of decisions held by management leads to the presence of asymmetric information, creating the need for mechanisms to monitor a firm's financial reporting process. A commonly-used external monitoring mechanism is the firm's hiring of an independent auditor to opine on the firm's financial statements (cf., DeAngelo 1981). The value of this mechanism is dependent upon the auditor's perceived independence. As SEC Chairman Arthur Levitt stated "(W)ithout confidence in an auditor's objectivity and fairness, how can an investor know whether to trust the numbers?" (Schroeder 2000). Studies finding an adverse effect associated with the provision of nonaudit services include Shockley (1981) and Knapp (1985).

A second perspective suggests that the provision of nonaudit services strengthens the auditor's independence. DeAngelo (1981) argues that increased revenues generated by auditors from nonaudit services lead to greater reputational capital. The desire to maintain this reputational capital will lessen the auditors' willingness to acquiesce to their clients (cf., Haynes, Jenkins, and Nutt 1998). Goldman and Barlev (1974) also suggest that the provision of nonaudit services increases the auditor's independence because these services enhance the auditor's "uniqueness" to the client. This distinctiveness in turn increases the auditor's ability to resist management pressure. Studies finding this positive impact include Schulte (1965) and Hartley and Ross (1972).

Finally, a third perspective suggests no association between the provision of nonaudit services and auditor independence. In their reviews of prior studies, Kinney (1999) found no substantial evidence that investors are concerned about nonaudit services, while Wallman (1996) encountered little evidence that the performance of nonaudit services impairs independence in fact. Studies indicating no effect include McKinley, Pany, and Reckers (1985), Pany and Reckers (1988), and Knapp (1985).

Current independence standards and rules are based on the belief that nonaudit services create the potential for conflicts of interest. Dramatic changes in the profession, brought about by factors such as globalization and information technology, have created greater opportunities and incentives for audit firms to perform nonaudit services. Expansion in the performance of nonaudit services increases the need to update empirical evidence about the impact of nonaudit services on perceptions of auditor independence. Thus, the general research question examined in this study is whether the provision of nonaudit services differentially affects financial statement users' perceptions of auditor independence.

Users of Financial Statements

Kinney (1999) called for research examining the level of concern financial statement users have regarding auditor independence, or specifically, users' perceptions about "the appearance of lack of independence." Wallman (1996) stressed that the public's perception of auditor independence has been of highest importance to regulators and certain members of the profession for some time now. He stated that "... public perceptions about the integrity of financial reports are important to maintaining the health of our system of capital formation" (Wallman 1996, 95). Goldwasser (1999) calls for researchers to "poll" financial statement users to determine their perceptions related to auditor independence.

To address Kinney (1999) and Goldwasser's (1999) concerns, the current study examined the general public's perceptions of auditor independence. In addition, the perceptions of professional CPAs from both non-Big 5 firms and Big 5 firms were solicited to provide insight into the existence of any gap in perceptions between financial statement "preparers" and users. Moreover, the lack of consensus regarding independence regulations among the Big 5 firms and the AICPA, as described by Schroeder (2000), suggests that the opinions of professional CPAs may vary more than previously thought.

Materiality of Nonaudit Services

Wallman (1996, 85) indicated that "... independence issues are much more powerful in the context of a request from a client that generates a substantial amount of an office's or practice area's revenues." The AICPA and the SEC do not delineate "the circumstances under which the revenues from the client impair the auditor's independence" (Goldwasser 1999). Nonetheless, the SEC staff generally raises questions about independence when more than 15 percent of a firm's revenue is derived from one client (Wallman 1996).

The materiality of nonaudit services can also be measured by the relative magnitude of a client's fees that result from the provision of nonaudit services compared to all fees earned from the client. This study examines the effect of nonaudit services on perceptions of auditor independence using the latter "relative magnitude" measure of materiality and assuming that the client's total fees are material to the firm to further explore users' perceptions of materiality.

RESEARCH METHODOLOGY

The Study

This study examined how different groups of financial statement users ("users") assess auditor independence when a CPA firm provides nonaudit services to an audit client. To address this issue, users first read general instructions that defined auditor independence and then read two hypothetical cases concerning services provided to the CPA firm's clients.¹ At the end of each case, the users answered a series of questions related to their perceptions of auditor independence. Finally, the users were asked to complete a questionnaire regarding their backgrounds.

One of the hypothetical cases (hereafter referred to as the audit only case) described a scenario in which a CPA firm provided only audit services to a client.² The second case (hereafter referred to as the nonaudit service case) described a scenario in which a CPA firm provided one of four types of nonaudit services in addition to audit services. The nonaudit services were presented as representing either a material or nominal portion of the total client fees (40 percent compared to 3 percent). The four types of nonaudit services used included actuarial services, outsourced internal auditing, legal services, and information systems consulting (See the Appendix for descriptions of each nonaudit service).

Three distinct groups of financial statement users were represented: the general public, non-Big 5 CPA firms, and Big 5 CPA firms. A total of 289 users completed the study.³ The general public group consisted of 65 business professionals and graduate business students at a large public university. The average age of this group was 40.7 years, and the average number of years of education was 17.1 years. The non-Big 5 CPA firm group consisted of 141 practicing professionals, while the Big 5 CPA firm group consisted of 83 practicing professionals. The average age of each CPA firm group was 45.3 years and 30.7 years, respectively, and the average number of years of education were 17.5 and 17.2 years, respectively.

User Perceptions

Three questions were asked at the end of each case to assess the users' perceptions regarding auditor independence. These questions asked for perceptions regarding the degree of auditor independence, integrity, and objectivity. Users indicated their perceptions by drawing a slash mark (/) through a line with endpoints of "Complete lack of independence/ integrity/objectivity" and "Complete independence/integrity/ objectivity." To measure an individual's perceptions, each line was converted to a 100-point scale with 0 representing a "Complete lack of independence, etc." and 100 representing "Complete independence, etc." The difference between a user's perceptions in the audit only and the nonaudit service cases was used to measure the effect of nonaudit services.

Three other questions were used to measure the impact of nonaudit services on individuals' future actions and opinions. After each case, users were asked to indicate the degree of their reliance on the auditor's opinion using a 100-point scale with endpoints of 0 for "No reliance is possible" and 100 for "Complete reliance." The difference between users' perceptions in the audit only and the nonaudit service cases was used to measure the impact of nonaudit services on the users' reliance on the auditor's opinion. In addition, in the nonaudit service case, users were asked to indicate the relevance of the nonaudit service to their investment decisions on a 100-point scale with endpoints of 0 for "Not relevant" and 100 for "Very relevant." Finally, in the nonaudit service case, users were asked to indicate which of several statements agreed with their opinion regarding the need to disclose the performance of nonaudit services by the CPA firm.

RESULTS

Table 1 addresses the general research question of how the provision of nonaudit services affects perceptions of auditor independence. The table presents mean, or average, differences in perceptions of auditor independence, integrity, and objectivity between the audit only and nonaudit service cases. The differences are -7.54 for independence, -2.25 for integrity, and -6.70 for objectivity. These negative differences indicate that nonaudit services positively influenced users' perceptions of independence, integrity, and objectivity. To test whether these average differences are statistically less than zero, t-tests were conducted and are also reported in Table 1. The t-tests indicate that the differences for independence and objectivity are significantly less than zero at the 0.001 level. However, the average difference for integrity is not significantly less than zero.

Further analysis was conducted to determine whether perceptions of auditor independence, integrity, and objectivity differed across the three groups of financial statement users, the four types of nonaudit services, and the two levels of fee materiality. Since the three types of perceptions are related, one multiple analysis of variance (MANOVA) was conducted using the average differences in these three perceptions as the variables of interest. The results of this analysis indicated that perceptions did not significantly differ across groups of users, types of nonaudit service, and materiality levels.

Next, two separate MANOVAs were used to examine the average perceptions of auditor independence, integrity, and objectivity for the audit only case and the nonaudit service cases.⁴ For both cases, average perceptions significantly differed across the three user groups, at the .001 level. Average user group perceptions for the audit only case and the nonaudit service case, along with the corresponding F-statistics are reported in Panels A and B of Table 2, respectively. As shown in Panel A, Big 5 CPA firm professionals consistently perceived auditors as having significantly higher degrees of independence, integrity, and objectivity than either the non-Big 5 CPA firm professionals or the general public. For example, Big 5 CPA firm professionals' average rating of independence was 72.50 (on a 100-point scale) as compared to 55.69 for non-Big 5 CPA firm professionals and 50.53 for the general public.

Panel B of Table 2 provides similar data for the nonaudit service case. As shown in Panel B, Big 5 CPA firm professionals again perceived auditors as having significantly higher degrees of independence, integrity, and objectivity than either the non-Big 5 CPA firm professionals or the general public. Moreover, the non-Big 5 CPA firm professionals rated these same dimensions significantly higher than the general public. To illustrate, Big 5 CPA firm professionals' ratings of integrity were 79.58 as compared to 69.02 for non-Big 5 CPA firm professionals and 57.23 for the general public.

Table 3 presents the average differences between the two cases in users' degrees of reliance on the auditor's opinion. The average difference is -5.18, indicating users placed a higher degree of reliance on the auditor's opinion when nonaudit services were provided to the audit client. A t-test, also reported in Table 3, indicates that the average difference is significantly less than zero at the 0.001 level.

Table 3 also provides the average reliance ratings for the audit only case and the nonaudit service cases. Separate analyses of variance (ANOVAs) indicated that the average reliance ratings in both cases differed significantly across the three user groups, at the .001 level. As shown in Table 3 for both cases, Big 5 CPA firm professionals indicated that they would place a higher degree of reliance on the auditor's opinion than either the non-Big 5 CPA firm professionals or the general public. Moreover, in the nonaudit service case, the non-Big 5 CPA firm professionals indicated that they would place a higher degree of reliance on the auditor's opinion than the general public. Specifically, in the nonaudit service case, Big 5 CPA firm professionals' reliance ratings were 77.47 (on a 100-point scale) as compared to 67.10 for non-Big 5 CPA firm professionals and 54.18 for the general public.

Users were also asked to rate the relevance of the performance of nonaudit services to their investment decisions, on a 100-point scale. These investment relevance ratings were significantly different for the three user groups based on the results of an ANOVA, at the 0.001 level. In particular, both the non-Big 5 CPA firm professionals and the general public considered the performance of nonaudit services to be more relevant to their decision to invest in the company than did the Big 5 CPA firm professionals (average ratings of 46.03 and 53.88, compared to 29.16). In addition, users who were given a material level of nonaudit services rated the performance of those services as more relevant to their investment decisions than those users who were given an immaterial level of nonaudit services (average rating of 51.55 compared to 34.34).

Finally, given the findings related to investment relevance, users' opinions as to the need for disclosure (or non-disclosure) of the performance of nonaudit services were examined. The initial analysis, presented in Panel A of Table 4, compared the percentage of users in each user group favoring disclosure of nonaudit services to the percentage of users favoring no disclosure. An overwhelming majority of the general public, 90.3 percent, favored disclosure, while only 49.6 percent of the non-Big 5 CPA firm professionals and 47.0 percent of the Big 5 CPA firm professionals favored disclosure.

As a follow-up, users were provided four forms of disclosure from which to select: disclosure of the amount of nonaudit services exceeding a specified threshold, disclosure of the amount of nonaudit services along with the amount of audit fees with the total fees exceeding a specified threshold, disclosure of the amount of nonaudit services regardless of the amount, and disclosure of the amount of nonaudit services along with the amount of audit fees regardless of the total amount. Panel B of Table 4 presents the percentage of users within each user group who favored each form of disclosure.⁵ Over 52 percent of the general public favored disclosure of the amount of nonaudit services along with the total audit fees, regardless of the amount. However, the non-Big 5 CPA firm professionals and the Big 5 CPA firm professionals favored disclosure of the amount of nonaudit services alone and only if those services exceeded a specified threshold (34.4 percent and 45.7 percent, respectively).

Summary and Future Research

This study's general research question was how the provision of nonaudit services affects financial statement users' perceptions of auditor independence. The results of prior studies of the impact of nonaudit services on auditor independence are equivocal, and even today, the profession continues to debate this fundamental issue (Schroeder 2000). The question was addressed by examining the difference between users' perceptions of auditor independence, integrity, and objectivity in an audit only case and a nonaudit service case. The results indicated that nonaudit services had an incremental or positive influence on users' perceptions of auditor independence and objectivity. Moreover, the auditor's provision of nonaudit services had a similarly positive influence on participants' willingness to rely on the auditor's opinion. Such findings support the contention that nonaudit services enhance auditor independence, thus strengthening the auditor's ability to resist management pressures.

A secondary question examined in this study addressed whether perceptions of auditor independence differ across members of the general public and the accounting profession. Not surprisingly, Big 5 CPA firm professionals consistently rated auditor independence, integrity, and objectivity and their reliance on the auditor's opinion significantly higher than either non-Big 5 CPA firm professionals or members of the general public in both an audit only case and a nonaudit service case. For the nonaudit service case, non-Big 5 CPA firm professionals also rated auditor independence, integrity, and objectivity and their reliance on the auditor's opinion significantly higher than the general public. These results suggest that the Big 5 CPA firm professionals may have a fundamentally different perception of "auditor independence" than either non-Big 5 CPA firm professionals or the general public. Given that an increasing proportion of the Big 5 CPA firms' revenues are derived from nonaudit services, such perceptions may be a consequence of the shifting focus of these large international firms. As a result, more attention may need to be given to understanding each group's perceptions of auditor independence and the implications of such differences.

User group differences also existed when the users' perceptions of investment relevance were examined. Interestingly, the non-Big 5 CPA firm professionals and the general public considered the performance of nonaudit services to be significantly more relevant to their investment decisions than did the Big 5 CPA firm professionals. The question specifically asked how relevant the public accounting firm's performance of the nonaudit service was to an investment decision, not how relevant the actual nonaudit service was to the investment decision. Big 5 CPA firm professionals may have read the question quite literally, and responded to the choice of CPA firm as opposed to the performance of the nonaudit service. As an alternative, Big 5 CPA firm professionals may believe that the performance of nonaudit services is irrelevant to an investment decision. Finally, their belief that the provision of nonaudit services is not relevant to an investment decision may result from their fundamentally different perceptions of "auditor independence."

Finally, user group differences were found when the users' disclosure preferences were examined. A significantly larger percentage of the general public favored disclosure than did either the non-Big 5 CPA firm professionals or Big 5 CPA firm professionals. Specifically, the general public favored disclosure of the amount of nonaudit services along with the total audit fees, regardless of the amount. However, the non-Big 5 CPA firm professionals and Big 5 CPA firm professionals favored disclosure of the amount of nonaudit services only if those services exceeded a specified threshold. These findings suggest that the profession may need to revisit the issue of audit and nonaudit fee disclosure. Disclosure is already of concern to the SEC, which "wants public companies to disclose in annual proxy statements all nonaudit services provided by auditors" (Schroeder 2000).

Users indicated that the materiality of the nonaudit services was relevant only when making investment decisions. Specifically, users given a material level of nonaudit services rated the performance of those services as more relevant to their investment decisions than those users given an immaterial level of nonaudit services. The limited materiality results may be due to a control statement in both cases providing that the local office of the firm earned a material portion of its total revenues from the services provided to the company. This statement was included in an attempt to examine the materiality of the nonaudit service fee rather than the materiality of the aggregate fees. This statement may have forced users to consider any level of nonaudit services to be material, regardless of the study's manipulation of materiality level.

A number of avenues exist for the researchers to continue examining auditor independence. One interesting possibility centers on the focus of independence. That is, should auditors be independent of a client or of information prepared by the client as has been proposed by the AICPA (Kinney 1999)? Another issue of potential interest relates to who in the public accounting firm is most affected by a particular independence issue. As Wallman (1996) suggests, independence concerns may be most appropriately addressed by considering the potential influence of a particular set of circumstances on an individual auditor, a local office, a region, or the entire firm. Finally, the materiality results suggest the need for continued research on this important dimension of auditor independence.

Appendix

Nonaudit Services
(Assuming a material level of nonaudit service fees)

Legal Consulting Services

Given Haversham's prosperous past, management is considering changes to the company's executive compensation plans to protect its interest in certain key members of management, including the need for non-compete agreements. Prior to the current year's audit, Haversham engaged the public accounting firm which performs its audit to provide legal consulting services related to the changes in executive compensation plans. These services were provided by firm personnel not involved in the audit of the company. Of the total fees collected from Haversham for all services, a material portion is related to the provision of legal consulting services by the public accounting firm.

Information Systems Consulting Services

In the recent past, Haversham has experienced significant growth that has revealed inadequacies in its current accounting system. Consequently, the company has purchased a new accounting software package from a reputable software vendor. Prior to the current year's audit, Haversham engaged the public accounting firm which performs its audit to provide certain consulting services related to the initial training and instruction of Haversham employees on the new software. These services were provided by firm personnel not involved in the audit of the company. Of the total fees collected from Haversham for all services, a material portion is related to the provision of consulting services by the public accounting firm.

Outsourced Internal Auditing Services

While pleased with Haversham's rapid expansion, management is concerned about their ability to evaluate the operational effectiveness of company policies. Currently, the company has a limited internal audit function to assist management. Prior to the current year's audit, Haversham engaged the public accounting firm which performs its audit to provide internal auditing services aimed at evaluating operational effectiveness of company policies. These services were provided by firm personnel not involved in the audit of the company. Of the total fees collected from Haversham for all services, a material portion is related to the provision of internal auditing services by the public accounting firm.

Actuarial Services

To reward employees for its profitable past, Haversham recently adopted a stock option plan. Given its inexperience with such plans, management decided to seek outside advice and guidance. Prior to the current year's audit, Haversham engaged the public accounting firm which performs its audit to provide actuarial services - to be based upon certain assumptions made by company management - related to the adoption of the stock option plan. These services were provided by firm personnel not involved in the audit of the company. Of the total fees collected from Haversham for all services, a material portion is related to the provision of actuarial services by the public accounting firm.

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Endnotes