The relation between Auditors Fees and Earnings Management in Dutch firms

Student name: Manon Leeflang Student number: 5980798 Supervisor: Dr. G. Georgakopoulos 2nd Supervisor: Dr. V. Maas
Formatted: Superscript
Deleted: Deleted:

MSc in Accountancy & Control 2009-2010

Table of Contents
1. Introduction......4

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2. Theoretical Framework...7 2.1 2.2 Introduction7 Earnings management ...7 2.2.1 Management incentives to manage earnings8 2.2.2 Dicretionary accruals as a measure of earnings management.9 2.3 Auditors-client relation....10 2.3.1 Auditor independence.10 2.3.2 Threats to auditors independence...11

3. Hypotheses..13 3.1 3.2 Thesis research model..13 Hypothesis development..14

4. Research Design & Data description....16 4.1 Research design16 4.1.1 Modified Jones model.16 4.1.2 Dependent variable and audit fee model18 4.2 Data description19 4.2.1 Descriptive statistics20

5. Empirical analysis......21 5.1 5.2 Modified Jones model results...21 Auditors fee model results..22 5.2.1 Non-audit fee results...22 5.2.2 Audit fee results26 5.2.3 Total fee results28

6. Conclusion, Implications and future research.30 6.1 6.2 6.3 Conclusion....30 Implications..31 Suggestions for future research32

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The relation between Auditors Fees and Earnings Management in Dutch firms

References.........34

Appendix A...37

1.

Introduction

The purpose of this paper is to examine the relation between the fees paid to audit firms for audit and non-audit services and earnings management. The association between earnings management and auditors fees has been a research topic investigated in many papers (e.g. Larcker et al. [2003], Abbott et al. [2006], 3|Page

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Frankel et al. [2002], Ashbaugh et al [2003]). The relation between auditors fees and earnings management is an interesting topic to investigate because of the ongoing debate about the accounting profession and the appropriateness of providing audit and non-audit services. Auditor independence is seen as very important for the reliability and integrity of financial reporting (Wallman [1996]). Critics contend that the extensive fees paid to auditors, especially for non-audit services, increase the financial reliance if the auditor on the client (Becker et al. [1998]). As a result, independence of the audit firm may be in jeopardy. Although recent concerns about auditor independence have focused on the non-audit services to audit clients and the nonaudit fees, it is possible that audit fees create similar bonding or reputational incentives. This paper will thus try to find an association of audit fees and non-audit fees with earnings management. While there are a number of earnings management studies about this association for US and UK firms (e.g. Frankel et al. [2002]), I will focus on large Dutch firms. Due to recent developments under the Dutch law, Dutch firms are mandatory to disclose audit fee data. As of the 27th of June article 382a (BW 2, title 9) is developed which outlines the specific items of disclosure. Under this new article disclosure of the following items of audit fees is mandatory: audit services, other audit services, fiscal services and non-audit services. The disclosures are intended to provide information useful to investors in evaluating whether non-audit fees have impaired the auditors independence. It is an interesting topic to investigate because audit firms in the Netherlands initially sold their advisory branches, but have been starting to give advice again and this branch is growing as is indicated by the NIVRA in their comments on independence. Not only is this an interesting topic to research and discuss, it also contributes to existing research in a way that this research has never done before under Dutch firms, this because of the newly available information because of the mandatory disclosure of audit fees. Audit fees and non-audit-fees can now be examined and this study attempts to shed light on earnings management in Dutch firms, it also attempts to find a relation between audit fees and earnings management. Based on the above mentioned information I have developed the following research question for this thesis: 4|Page

The relation between Auditors Fees and Earnings Management in Dutch firms

To what extent is there an association between audit fees, non-audit fees and earnings management of Dutch firms, who classify as large under BW 2 title 9. To answer this research question, data was collected from the Datastream database. Data of the year 2008 was collected and this resulted in a sample size of 80 Dutch firm who classify as large and were listed on the Dutch exchange market. The data is used to test the three hypothesis identified in this study. Next to these hypotheses I have also identified four audit metric in determining the relationship between auditors fees and earnings management. The first hypothesis shows that there is a positive relationship between non-audit fees and discretionary earnings, which indicates that when non-audit fees increase and when the ratio of non-audit fee to total fees increases, earnings management also increases. In contrast with the results of non-audit fees, we found a significant negative relationship with earnings management and audit fees. The findings also suggest that if we combine both of the variables, there is no significant relationship with earnings management. This support the claim of Frankel et al. (2002) who suggest that audit fees and non-audit fees have both different incentives and combining the two will only masks their effects. This thesis started with an introductory paragraph which announces the subject, the purpose and the motivation of the study, followed with the research question and a summary of the findings. The following chapter of the thesis is the theoretical framework. This chapter is a review of literature to develop a theoretical framework on what is already known about the subject. In the third chapter the hypotheses are developed. The hypotheses are developed based on the research question and previous literature. In the fourth chapter of this thesis the research design is explained. In this chapter I will discuss the models that will be used to test the hypotheses. This chapter also revolves around the data sample used for the study. The fifth chapter outlines empirical analysis and findings of the research. The final chapter of this thesis includes the conclusion. This chapter will also outline implications for further studies and limitations of this research.

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2.
2.1

Theoretical Framework
Introduction

As of the 27th of June the Dutch law changed with regards to the disclosure of audit fee data. As of this date article 382a (BW 2, title 9) was developed which requires mandatory disclosure of audit fee for Dutch firms who classify as large. The 6|Page

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following items of audit fees needs to be disclosed: - audit services, - other audit services, - fiscal services and non-audit services. The disclosure of audit fee is intended to provide information useful to investors in evaluating whether non-audit fees have impaired auditor independence. It can also inform investors about financial reporting quality, including earnings management. Auditor independence is seen as very important for the reliability and integrity of financial reporting (Wallman, 1996). Auditor independence not only comprises independence of mind but also, and maybe more important in financial reporting, independence in appearance. In the theoretical framework I will perform a review of previous literature on the subject and includes an examination of relevant earnings management topics, audit services and non-audit services performed by the auditors and other matters that need to be reviewed to better understand the empirical search for the relation between earnings management and audit fees. The following subsection will discuss earnings management, the incentives of management to manage earnings and the different measures of earnings management, in this case the use of discretionary accruals. Subsection 2.3 will discuss audit fees and the possible threats and auditors incentive to allow earnings management.

2.2

Earnings management

Before continuing to the examination it is important to settle on a definition of earnings management. The conclusion that a perfect definition of earnings management cannot be given is made very quickly. There are a of lot researchers who formulated a definition of earnings management [Davidson et al. (1987), Schipper (1989), Healy and Whalen (1999)]. In this research I will following Healy and Wahlen (1999) with their definition of earnings management, they defined earnings management as: the occurrence when managers use judgment in financial reporting and in structuring transaction to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers. In the next section I will discus the incentives of managers to manage earnings. 7|Page

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2.2.1 Management incentives to manage earnings Key in the earnings management definition is the intentional alteration of financial reporting to mislead stakeholder about the underlying economic performance or to influence contractual outcomes. Financial reports are used to provide stakeholders with information about the financial performance of the company. Financial reports are a way to reduce asymmetric information. The asymmetric information that exist between the stakeholders of a company and the manager is a classical case of the agency theory (the principal-agent problem). If both parties to the agency relationship are assumed to attempt to maximize their self-interests and if the monitoring of performance is not costless, then good reason exists to believe that the agent (manager) will not always act in the best interest of the principal (stakeholders) (Wanda Wallace, 1980). Asymmetric information thus exists because stakeholders do not have direct insight on the financial performance of a company, in contrast with managers who do have this insight. As discussed above financial reports can alter as a solution to this problem. If financial reports are to convey managers information on their firms performance, standards must permit managers to exercise judgment in financial reporting. Managers can then use their knowledge about the business and its opportunities to select reporting methods, estimates, and disclosures that match the firms business economics, potentially increasing the value of accounting as a form of communication. However, because auditing is imperfect, managements use of judgment also creates opportunities for earnings management, in which managers choose reporting methods and estimates that do not accurately reflect their firms underlying economics. There are several ways to manage earnings, abuses of big bath restructuring charges, premature revenue recognition, cookie jar reserves, etc (Healy and Wahlen [1999]). Researchers have examined many different incentives for earnings management, including:

Capital market expectations and valuation (capital market motivations): The widespread use of accounting information by investors and financial analysts to help value stocks can create an incentive for managers to manipulate earnings in an attempt to influence short-term stock price performance (e.g. unexpected accrual behavior);

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Contract written in term of accounting numbers (contracting motivations): Accounting data are used to help monitor and regulate the contracts between the firm and its many stakeholders. These contracts create incentives because it is likely to be costly for compensation committees and creditors to undo earnings management.

Antitrust or other government regulation (regulatory motivations): there are two forms of regulation, industry-specific regulation and anti-trust regulation. Accounting standard setters have demonstrated an interest in earnings management to circumvent industry regulation and also for anti-trust purposes.

As described above managers could have several incentives for earnings management, the scope of this study will be based on the capital market motivation in particular discretionary accruals. In the following subsection we will discuss the discretionary accruals as a way to manage earnings in further detail.

2.2.2 Discretionary earnings as a measure of earnings management The most commonly used approach to test for earnings management is using the total or aggregate accruals approach. This is achieved by dividing total accruals into two parts. The first is a non-discretionary or expected level that is assumed to be the normal level of accruals required for operations. The second part is an estimate or discretionary or unexpected accrual which proxies for the firms manipulation behavior. Thus non-discretionary accruals are accruals that normally cannot be influenced by a manager, on the other hand the discretionary part of the accruals can be influenced and managed by a manager. Many studies to date focuses on managements use of discretionary accruals in detecting earnings management (Healy and Wahlen [1999]; Dechow et al [1995]; Jones [1991]; Frankel et al [2002]). To estimate the discretionary accruals a model is required. In the paper of Dechow et al. several models to estimate the discretionary accruals are discussed. The models range from simple models in which discretionary accruals are measured as total accruals, to more sophisticated models that attempt to separate total accruals into discretionary and nondiscretionary components. In section 4 we will discuss the model used to calculate discretionary accruals in further detail.

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The focus of this research is to capture the auditors role in managing the earnings in Dutch firms. The scope of this research, with regards to managers incentives to managers earnings, will be limited on the capital market motivations and in particular discretionary accruals. In this type of earnings management auditors are expected to take steps in detecting earnings management and is thus relevant for this research.

2.3

Auditor-client relation

The question of whether an auditor should provide non-audit services to an audit client have been heavily debated in many papers and even in politics. There are several factors that could influence the auditor-client relation such a conflicts of interest, auditor bias and knowledge spillovers. Antle et al. (2006) even expand the set of factors that likely influences the auditor-client relation, with their research, by pricing games, productive effects and demand and supply of services. Another important issue to consider is the auditors independence in providing audit and nonaudit services and especially independence in appearance.

2.3.1. Auditor independence Auditor independence is seen as very important for the reliability and integrity of financial reporting (Wallman, 1996). Auditor independence not only comprises independence of mind but also, and maybe more important in financial reporting, independence in appearance. The Code of Ethics for professional accountants defines independence of mind as follows: The state of mind that permits the expression of a conclusion without being affected by influences that compromise professional judgment, thereby allowing an individual to act with integrity and exercise objectivity and professional skepticism. The Code of Ethics defines independence in appearance as follows: The avoidance of facts and circumstances that are so significant that a reasonable and informed third party would be likely to conclude, weighing all the specific facts and circumstances, that a firms, or a member of the audit teams, integrity, objectivity or professional skepticism has been compromised. Safeguarding auditor independence is essential for creditworthiness of the auditor and its reputation. Not only is the perceived independence of the auditor important for the 10 | P a g e

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auditor itself but also for the client and their audited figures. Beattie et al, 1999 argued that there are four factors that could influence the perceived auditors independence:

Regulatory framework laxness; Competition in the audit market; Economic dependence of the auditor on the client; Non-audit services.

In the following subsection we will further discuss the influential factors economic dependence and non-audit services on auditors independence and their relation with earnings management.

2.3.2 Threats to auditors independence There are a lot of studies that examine whether there is a relation between non-audit fees, audit fees and earnings management [Cahan et al. (2008); Frankel et al. (2002); Antle et al. (2006), Simunic (1984)]. The study of Frankel et al. (2002) found a significant positive association between earnings management and the purchase of non-audit services. This suggests that the independence of auditors can be compromised by increasing the acquisition of nonaudit services, consistent with earlier research suggesting that providing non-audit services strengthens the auditors economic bond with the client and increases the auditors incentive to acquiesce to client pressure. Cahan et al. argue that the faster the growth in non-audit fees and the longer the client purchases non-audit services from its auditor, the more dependent the auditor becomes on that revenue stream, which in turn can reduce auditor independence. They also argue that the effect of the non-audit services fees depends on the importance of the client to the auditor. Their results support the results of Frankel et al., they found evidence of a positive and significant relation between discretionary accruals and the interaction of non-audit services fee and client importance. Simunic (1984) showed by his analysis that efficiencies of joint production, between non-audit services and audit services, may exist (such as knowledge spillover and cost savings) but that these efficiencies are not necessarily be desirable. They create a threat to auditor independence and auditors will be economically bonded to the client. Antle et al find evidence consistent with economies of scope (or knowledge spillovers) running in both directions between audit and non-audit services in the US and UK. 11 | P a g e

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3.

Hypotheses

The theoretical framework discussed prior research on the topics earnings management, audit- and non-audit fees.

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3.1

Thesis research model

Based on the prior research I have establish a theoretical model of this thesis, this model is illustrated in figure 3.1 (a). Based on this theoretical model I have developed a research model, see figure 3.1 (b). Audit services will be operationalized by audit fees while non-audit services will be operationalized by non-audit fees. Discretionary accruals will serve as a proxy for earnings management.

Figure 3.1 Thesis model illustrated Audit Services Earnings Management Discretionary accruals Audit fees

Non-audit Services

Non-audit fees

(a) Thesis theoretical model.

(b) Thesis research model

Earnings management and the relation with audit fees and non-audit fees havent yet been extensively researched in the Netherlands, in comparison with other notable countries such as the US and the UK. The economic environment in which Dutch firms operate could be compared with the economic environment of the UK and US. The characteristics of these economic environments are international orientated, open economy, strong equity market, investor protection, etc. The reason that this relation had not been researched yet, is the newly available data for Dutch companies. As of the 27th of June the Dutch law changed with regards to the disclosure of audit fee data. As of this date article 382a (BW 2, title 9) was developed which requires mandatory disclosure of audit fees of Dutch companies who classify as large. As discussed in the previous chapter and as shown in the above figure I will use discretionary accruals as a measure of earnings management. This measurement type of earnings management is the only one in which the auditors plays a significant role 13 | P a g e

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in detecting earnings management. The thesis research model will help to answer the research question and will help to develop the hypotheses of this research.

3.2

Hypothesis development

Empirical evidence on the relationship between non-audit fees and earnings management are mixed. Independence of auditors might be in jeopardy when providing non-audit services, also client importance, client pressure and economies of scope could be an incentive to accept earnings management. The study of Frankel et al (2002) provide evidence that suggest a loss of auditor independence due to a positive association between non-audit fees and discretionary accruals (earnings management). This result is in contrast with other studies. Cahan et al (2007) do not provide any support for a relation between non-audit fee growth rate or non-audit fee and discretionary accruals. Antle et al (2006) find a significant, negative effect of non-audit fees on abnormal accrual in the UK. The results of the study of Asbaugh together with results of other audit fee research (Defond et al. [2002]; Chung and Kallapur [2003]) do not support the conclusion that non-audit services are associated with earnings management. Because of this mixed empirical evidence we will test the following non-directional hypothesis, stated in the null form:

H1: Non-audit fees are not associated with earnings management. Prior literature also indentifies similar incentive effects for audit fees. For example, DeAngelo (1981) argue that economic rents associated with audit fees create an economic bond between auditor and client and therefore create incentives for auditors to permit earnings management. Frankel et al. (2002) find a negative association between audit fees and earnings management indicators. Asbaugh et al (2003) Cahan et al. (2007) even found no significant association at all between audit fees and abnormal accruals. Based on these findings we also test the non-directional hypothesis, stated in the null form:

H2: Audit fees are not associated with earnings management.

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As previously discussed audit fees and non-audit fees could give different incentives for earnings management. The results of Frankel et al (2002) and Ashbaugh et al (2003) support the claim that audit fees and non-audit fees in relation with earnings management give different incentives. Their results show that total audit fees are not significant and if audit and nonaudit fees are bonded it will masks their differential incentive effects. Other studies such as Simunic (1984) and Antle et al (2006) model the joint determination of audit- and non audit fees. When an auditor provides both services the auditor will be bonded economically to the client. Simunic (1984) demonstrates, an increase in non-audit fees might actually increase the audit fees as a result of spillover effects. To capture the explicit bond between the audit firm and the client we also test the following non-directional hypothesis, stated in the null form:

H3: Total fees are not associated with earnings management.

4.

Research design and Data description

The research will consist of an empirical analysis of the Dutch market data. The audit fee data of the year 2008 will be used because as of this year the disclosure of audit 15 | P a g e

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fee was made mandatory. This chapter will focus on the research design and will describe the research models. This chapter will also provide a description of the data that is used.

4.1

Research design

To test the previous formulated hypothesis, earnings management in Dutch firms must first be identified. As described in the theoretical framework I will use discretionary accruals as the measure of earnings management. The usual starting point for the measurement of discretionary accruals is total accruals. A particular model is then assumed for the process generating the nondiscretionary of total accruals. Dechow et al. (1994) considers five models of the process generating nondiscretionary accruals. This paper evaluates the ability of alternative models to detect earnings management. The following five models are described in the Dechow paper: the Healy model, the DeAngelo model, the Jones model, the modified Jones model and the Industry model. The results suggest that all the models considered appear to produce reasonably well specified tests. The power of the tests is low earnings management of economically plausible magnitudes. The paper finds that the modified version of the model developed by Jones (1991) provides the most powerful tests of earnings management. Based on the results of the Dechow et al. paper I will use the Modified Jones model to detect earnings management.

4.1.1. Modified Jones model The modification is designed to eliminate the conjectured tendency of the Jones model to measure discretionary accruals with error when discretion is exercised over revenues. If the adjustment is succesfull, the detection of earnings management should no longer be biased as it was in the original Jones model. To estimate the discretionary accruals with the modified Jones model the following steps need to be follow, these steps are based on the Dechow, Sloan and Sweeney study (1994). First we need to identify the total accruals. The total accruals are determined as follows: TAt = (CAt - CLt Casht + STDt - Dep) / (At-1),
where

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CAt = change in current assets; CLt = change in current liabilities; Casht = change in cash and cash equivalents; STDt = change in debt included in current liabilities; Dep = depreciation and amortization expense; A = total assets.

When the total accruals are indentified we need to determine the non-discretionary accruals. In the modified model, non-discretionary accruals are estimated during the event period as: NDAt = 1 (1/A-t) + 2 (REVt - RECt) + 3 (PPEt).
where NDA = estimated nondiscretionary accruals; REVt = revenues in year t less revenues in year t-1 scaled by the total assets at t-1; RECt = net receivables in year t less receivables in year t-1 scaled by the total assets at t-1; PPEt = gross property plant and equipment in year t scaled by the total assets at t-1; A-t = total assets at t-1; and 1, 2, 3 = firm-specific parameters. The OLS (Ordinary Least Squares) method can be used to obtain the estimates 1, 2, 3 of 1, 2, 3.

NDAt = 1 (1/A-t) + 2 (REVt - RECt) + 3 (PPEt) + t The discretionary accruals can now be determined for each firm using the error term t (residual) of the above model.

4.1.2. Dependent variable and audit fee model When the discretionary accruals per firms are determined we can develop the model to determine the relation between auditors fees and earnings management. The model that will be used to find the relation between auditors fees and earnings management is an extension of the Olson model. To test the hypotheses and to answer the research question, the following regression model can be used: 17 | P a g e

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DAC = + 1 FEE + 2 SIZE + 3 CFO + 4 LOSS + 5 LEV + 6 TYPE + t Consistent with Ashbaugh et al (2003) I will use four audit fee metrics to test if auditors fees are associated with earnings management. FEE indicates the alternative specifications of the fee variables, NARATIO, NONAUDIT, AUDIT and TOTAL. To measure the relation between non-audit fees and earnings management we will use the metrics NARATIO and NONAUDIT. These metrics will be used to determine any significant influence of high non-audit fees and other levels of non-audit compensation. NARATIO is the ratio of non-audit fee divided by total audit fees whereas NONAUDIT is the absolute value of audit fees. AUDIT will measure the relation between audit fees and earnings management. The fourth fee metric TOTAL captures the explicit bond between the audit firm and the client. There are also several control variables identified in previous research which I include in the regression model. I will control for operating cash flow scaled by average total assets (CFO) because firms with high cash flow can more easily have earnings management. Cahan et al (2008) also suggest to control for operating cash flow as the Jones model might not remove the impact of non-discretionary accruals that are related to firm performance. TYPE is a proxy for audit quality as prior literature suggests that Big-4 auditors are less likely to allow earnings management than non Big-4 auditors [Defond and Jambalvo (1991); Francis et al. (1999)]. TYPE is an indicator variable for Big-4 auditors. Leverage is also associated with discretionary accruals [Defond and Jambalvo (1991)] and will be measured as the ratio of total liabilities to total assets (LEV). I will include LOSS as indicator variable of loss, companies might generate larger discretionary accruals as a result of their financial situation. The last control variable is SIZE which is the absolute value of total assets. Size will be used as a control variable in the estimation of the effect of economic bonding.

4.2

Data description

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The data used in this study is from 80 organizations who were listed on the exchange market, all organizations are classified as large under BW 2 title 9 and are mandatory by law to disclose audit fee data. The data of the year 2008 will be used for examining earnings management and the relation of earnings management with auditors fees. Although all organizations are mandatory to disclose audit fee data the NIVRA has published a research on how well the auditors fees are disclosed in the annual reports of 2008 and indicates that the companies disclose the audit fees differently. Based on this research I will focus on organization who have disclosed the audit fee with the following items: audit services, other audit services, fiscal services and non-audit services. This way I will try to minimize errors in the results of this study. The financial data was conducted from Datastream for 119 firms, who were listed on the Dutch exchange market. Because of the recently changed law to disclose audit fee, the audit fee data was not yet available for the year 2008 in Datastream. The fee data was collected through manual inspection of the annual reports. The annual reports were collected from the companys websites. Some organizations were omitted from the data set for a number of reasons. The reasons to omit the organization include:

no financial data was found in Datastream; no audit fee data was found in the annual report of 2008; no financial data of the year 2007 was found (used in the Modified Jones model); no distinction between audit fee and non-audit fee in the disclosure of the 2008 annual reports; not all data was available for some variables used in our model.

4.2.1 Descriptive statistics Table 4.1 reports the descriptive statistics for the four audit fees metrics that we have determined. Table 4.1
Descriptive Statistics of Audit and Non audit fees N Minimum Maximum Mean Std. Deviation

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NARATIO NONAUDIT AUDIT TOTAL Valid N (listwise) 80 80 80 80 80 0% 0 42.000 52.000 80,12% 5.000.000 23.000.000 28.000.000 17,32% 509.934,51 2.195.707,76 2.705.629,78 0,1686045 992.375,182 4.426.665,309 5.206.332,231

The sample consist of 80 firms in the year 2008. All variables are expressed in euros. NARATIO is the ratio of non-audit fees divided by total fees. The minimum of this ratio is 0% whereas the maximum is 80,12%. Because not all firm in our example have non-audit fees the minimum percentage is zero. There is a mean of 17,32%. The next fee metric that is identified is the absolute value of non-audit fees (NONAUDIT) again the minimum of this value is 0 as explained earlier. The maximum is non-audit fees 5.000.000 of Unilever N.V. The mean is 509.935. The absolute value of audit fees (AUDIT) has a minimum of 42.000 and a maximum of 23.000.000 (again Unilever N.V.). The value has a mean of 2.195.708. The last fee metric I have identified is the absolute value of total fees (TOTAL). The minimum is 52.000, the maximum 28.000.000 and the mean is 2.705.630.
Deleted:

5.

Empirical Analysis

The results of this research will consist of two parts. First we will determine the absolute amount of the discretionary accruals. This amount will be calculated by the modified Jones model. When the discretionary accruals are calculated we will show 20 | P a g e

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the results of the audit fee model and determine if audit-fees, non-audit fees and earnings management are related.

5.1 Modified Jones model results The modified Jones model is used to determine the absolute amount of the discretionary accruals. The following descriptive statistics are derived from the data set using SPSS: Table 5.1
Descriptive statistics N NDA Valid N (listwise) 81 81 Minimum -2,0979 Maximum 4,0747 Mean -,986515 Std. Deviation ,6280470

Because of some outliers/results the mean give some strange results. The mean should be zero when there is a normal-like distribution. To see if there is a normal-like distribution we have plotted the following histogram:

As we can see the centre of the histogram of the residual is around zero and thus normally distributed. After determining total accruals I will now determine the non-discretionary accruals to eventually determine the discretionary accruals. Based on the coefficients determined in calculating the total accruals I am able to determine the amount of the

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non-discretionary accruals. The non-discretionary accruals have the following descriptive statistics: Table 5.2
Descriptive statistics N NDA Valid N (listwise) 81 81 Minimum -1,6697 Maximum ,8293 Mean ,134774 Std. Deviation ,2764497

The next step in determining the discretionary accruals is the most easy step. I will now deduct the calculated non-discretionary accruals from the total accruals for each firm.

5.2. Auditors fee model results The discretionary accruals have been calculated and inserted for each firm determined in the data sample. I have excluded one outlier which reduces the sample size to 80. After the discretionary accruals have been calculated I can now investigate the association between audit- and non-audit fees through the, previously discussed, auditors fee model.

5.2.1 Non-audit fee results Table 5.3, 5.4 and 5.5 show the Model summary, ANOVA test and the coefficients of the regression model with the audit fee metric: NARATIO. The non-audit fee ratio (NARATIO) is one of the audit fee metrics to determine if there is an association between non-audit fees and earnings management. The tables will be used to show the correlation between the dependent variable and the independent variables and will be used to test our hypothesis.

Table 5.3
Model Summary Model R R Square Adjusted R Square Std. Error of the Estimate

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,976a

0,952

0,949

1,876E9

a. Predictors: (Constant), Accountant, CFO, NARATIO, Size, Loss, Leverage

Table 5.4
ANOVAb Model 1 Regression Residual Total Sum of Squares 5,147E21 2,569E20 5,404E21 df 6 73 79 Mean Square 8,578E20 3,519E18 F
243,784

Sig. ,000a

a. Predictors: (Constant), Accountant, CFO, NARATIO, Size, Loss, Leverage b. Dependent Variable: Discretionary Accruals (DISACC)

Table 5.5
Coefficientsa Model Unstandardized Coefficients B 1 (Constant) NARATIO SIZE CFO LOSS LEV TYPE
a. Dependent Variable: DISACC

Standard Coefficients Beta t -,546 ,043 -,979 -,026 -,073 ,039 -,004 1,663 -37,391 -,920 -2,592 1,457 -,140 Sig. ,586
,101 ,000** ,360 ,012* ,149 ,889

Std. Error 1,008E9 1,257E9 ,033 1,671E9 5,209E8 1,189E9 7,605E8

-5,508E8 2,091E9 -1,232 -1,538E9 -1,350E9 1,732E9 -1,068E8

** significance at the level 0,01 * significance at the level 0,05

Table 5.3 shows that the R square is 0,952. The coefficient of determination, R2, provides a measure of how well future outcome are likely to be predicted by the regression model. The explanatory power of the independent variables on the dependent variable discretionary accruals is thus 95,2%.

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The ANOVA test is shown in Table 5.4, this table contains a variance analysis. The variance analysis is useful for testing the entire models significance and will test its reliability. The model is significant (Sig. 0,01). The beta coefficient of the non-audit fee ratio (NARATIO) is 0,043 with a significance level of 0,101. The coefficient in for non-audit fees is positive but not significant. The sign of the coefficient is consistent with prior research such as Frankel et al. (2002) and Ashbaugh et al. (2003) but they also report a significant coefficient which is in contrast with the results of this research. Of the control variables, SIZE and LOSS are significant. Both control variables are negatively associated with discretionary accruals indicating that companies who report a loss are less likely to contract for more non-audit services and that smaller companies have a higher non-audit fee ratio. Table 5.6, 5.7 and 5.8 show the Model summary, ANOVA test and the coefficients of the regression model with the audit fee metric: NONAUDIT. The absolute value of the non-audit fee (NONAUDIT) is the other audit fee metric to determine if there is an association between non-audit fees and earnings management. Table 5.6
Model Summaryb Model 1 R ,982
a

R Square 0,965

Adjusted R Square 0,962

Std. Error of the Estimate 1,608E9

a. Predictors: (Constant), Accountant, CFO, NONAUDIT, Size, Loss, Leverage

b. Dependent Variable: Discretionary Accruals (DISACC)

Table 5.7
ANOVAb

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Model 1 Regression Residual Total

Sum of Squares 5,215E21 1,888E20 5,404E21

df 6 73 79

Mean Square 8,691E20 2,587E18

F
336,019

Sig. ,000a

a. Predictors: (Constant), Accountant, CFO, NONAUDIT, Size, Loss, Leverage b. Dependent Variable: Discretionary Accruals (DISACC)

Table 5.8
Coefficientsa Model Unstandardized Coefficients B 1 (Constant) NONAUDIT SIZE CFO LOSS LEV TYPE
b. Dependent Variable: DISACC

Standard Coefficients Beta t ,190 ,190 -1,120 -,056 -,075 ,029 -,0134 5,484 -32,917 -2,225 -3,110 1,276 -,559 Sig. ,850
,000** ,000** ,029* ,003** ,206 ,578

Std. Error 1,008E9 289,214 ,043 1,472E9 4,465E8 1,022E9 6,522E8

1,613E8 1585,909 -1,409 -3,275E9 -1,389E9 1,304E9 -3,644E8

** significance at the level 0,01 * significance at the level 0,05

Table 5.6 shows that the R square of this model is 0,965. The explanatory power of this model is slightly higher than the model previously discussed. Table 5.7 shows the ANOVA model which is significant at a level of 0,01. The coefficient of the absolute value of the non-audit fee is positive (0,190) and significant (significance 0,01). This suggest relation suggest that when non-audit fees increase the possibility of earnings management also increases. This is consistent empirical evidence such as the results of the article of Frankel et al. (2002). Consistent with the results of non-audit fee ratio the relation of LOSS and SIZE are negative and significant. In addition, the control variable CFO in this model is significant at a level of 0,05 and there is a negative relation. This result suggest that companies with high cash flow have increased non-audit services.

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The result of both fee metric suggest that they are positively related with discretionary accruals, the indicator of earnings management. Although the fee metric of the nonaudit fee ratio is insignificant, absolute value of non-audit fees is significant. Following the results H1 is rejected, non-audit fees seem to have a positive association with earnings management.

5.2.2 Audit fee results The absolute value of the audit fee (AUDIT) is the fee metric to determine if there is an association between audit fees and earnings management. Table 5.9, 5.10 and 5.12 show the Model summary, ANOVA test and the coefficients of the regression model with the audit fee metric: AUDIT. Table 5.9
Model Summaryb Model 1 R ,982
a

R Square 0,965

Adjusted R Square 0,962

Std. Error of the Estimate 1,616E9

a. Predictors: (Constant), Accountant, CFO, AUDIT, Size, Loss, Leverage

b. Dependent Variable: Discretionary Accruals (DISACC)

Table 5.10
ANOVAb Model 1 Regression Residual Total Sum of Squares 5,213E21 1,907E20 5,404E21 df 6 73 79 Mean Square 8,688E20 2,613E18 F
332,502

Sig. ,000a

a. Predictors: (Constant), Accountant, CFO, AUDIT, Size, Loss, Leverage b. Dependent Variable: Discretionary Accruals (DISACC)

Table 5.11
Coefficientsa Model Unstandardized Coefficients Standard Coefficients

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B 1 (Constant) AUDIT SIZE CFO LOSS LEV TYPE

c. Dependent Variable: DISACC

Std. Error 8.534E8 172,999 ,116 1,519E9 4,600E8 1,023E9 6,565E8

Beta

t -,683

Sig. ,496
,000** ,000** ,384 ,098 ,070 ,873

-5,833E8 -932,075 -,628 1,330E9 -7,704E8 1,884E9 1,054E8

-,499 -,499 ,023 -,042 ,042 ,004

-5,388 -5,424 ,876 -1,675 1,841 ,160

** significance at the level 0,01

Table 5.9 shows that the R square of this model is 0,965. The explanatory power of this model is as high as our previously discussed model with the fee metric NONAUDIT and it slightly higher than the model with the fee metric NARATIO. Again the ANOVA model is significant at a level of 0,01 (Table 5.10). The coefficient of the absolute value of audit fees (AUDIT) is -,499 and is significant at a level of <0,01 (Table 5.11). This indicates that there is a significant negative relationship between audit fees and discretionary accruals, the measure for earnings management. In contrary to the previous results of the fee metric NONAUDIT and NARATIO, the only control variable that is significant is SIZE. The size of the company is negatively related to discretionary accruals. The audit fee results show that there is a significant negative relation between the absolute value of audit fees and discretionary accruals. We therefore can reject the null hypothesis H2.

5.2.2 Results of joint determination of audit and non-audit fees Table 5.12, 5.13 and 5.14 show the Model summary, ANOVA test and the coefficients of the regression model with the audit fee metric: TOTAL. In previous research such as Simunic (1984) a joint determination is shown between audit and

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nonaudit fees, we therefore test the variable TOTAL to capture the explicit economic bond between auditors and their clients. Table 5.12
Model Summaryb Model 1 R ,976a R Square 0,952 Adjusted R Square 0,948 Std. Error of the Estimate 1,879E9

a. Predictors: (Constant), Accountant, CFO, TOTAL, Size, Loss, Leverage

b. Dependent Variable: Discretionary Accruals (DISACC)

Table 5.13
ANOVAb Model 1 Regression Residual Total Sum of Squares 5,146E21 2,577E20 5,404E21 df 6 73 79 Mean Square 8,567E20 3,530E18 F
242,982

Sig. ,000a

a. Predictors: (Constant), Accountant, CFO, AUDIT, Size, Loss, Leverage b. Dependent Variable: Discretionary Accruals (DISACC)

Table 5.14
Coefficientsa Model Unstandardized Coefficients B 1 (Constant) TOTAL SIZE CFO LOSS LEV TYPE
d. Dependent Variable: DISACC

Standard Coefficients Beta t -,389 -,174 -,813 -,004 -,062 ,044 -,002 -1,590 -7,522 -,115 -2,148 1,627 -,070 Sig. ,698
,116 ,000** ,909 ,035* ,108 ,945

Std. Error 9,948E8 173,577 ,136 1,813E9 5,328E8 1,191E9 7,642E8

-3,872E8 -275,998 -1,023 -2,087E9 -1,144E9 1,938E9 -5,321E8

** significance at the level 0,01 * significance at the level 0,05

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Table 5.12 shows that the R square of this model is 0,976. The explanatory power of this model is highest compared to the previous results. Again the ANOVA model is significant at a level of 0,01 (Table 5.13). The results of the absolute value of total fees (Table 5.14) shows that there is no significant relation with discretionary accruals. The null hypothesis H3 can be accepted, the significance of the model is 0,116. The results suggest that combining the variables audit- and non-audit fees mask the effects of the different incentives.

6.

Conclusion, Implications and future research

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This research investigates the relationship between auditors fees and earnings management in Dutch listed firms. The following research question is introduced in the introduction paragraph:

To what extent is there an association between audit fees, non-audit fees and earnings management of Dutch firms, who classify as large under BW 2 title 9. To answer this question we developed three hypothesis and determined four audit fee metrics. The following table shows a summary of the results of the audit fee metrics: Table 6.1
Summary results audit fee metrics Fee metric Demonstrated sign Significance

Non-audit fee ratio (NARATIO) Absolute value of non-audit fees (NONAUDIT) Absolute value of audit fees (AUDIT) Absolute value of total fees (TOTAL)

Positive Positive Negative Negative

NO YES (0,01) YES (0,01) NO

6.1 Conclusions Research about the relationship between auditors fees and earnings management has received a lot of attention is countries such as the UK or the US. Due to a recently changed law, regarding the disclosure of audit fees, it was made possible to conduct such a research in the Netherlands as well. The results of previous research regarding the relationship between non-audit, audit and earnings management has been mixed. The results of this thesis are congruent with the results of the research of Frankel et al (2002). The research identifies different incentives of audit fees and non-audit fees with regards to discretionary accruals. The findings suggests that there is a positive relationship between non-audit fees and discretionary accruals. Discretionary accruals are used in this thesis as the measure of earnings management. The positive relationship with non-audit fees is both found in the non-audit fee ratio and the 30 | P a g e

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absolute value of non-audit fees, whereby only the absolute value of non-audit fees is found to be significant. The findings regards the relationship between audit fees and earnings management suggests that there is a significant negative relationship. These results suggest that when an organization has an increase in audit fees it results in a decrease of earnings management. Many research have also focused of the joint determination of audit fees and nonaudit fees and their measure to capture the explicit economic bond between the auditor and its client. The joint determination in this research is the audit fee metric total audit fees, which is the sum of audit- and non-audit fees. The findings suggest that there is no significant relation between totals fees and earnings management. This findings is congruent with the results of the research of Frankel et al. (2002) who suggest that combining the two variables will masks the effects of the different incentives. The research question can now be answered. There is a positive relationship between non-audit fees and earnings management, whereby there is a negative relationship between audit fees and earnings management. If we will combine both of the variables I have found that there is no relationship with earnings management which support the claim of Frankel et al. (2002) who suggest that audit fees and non-audit fees have both different incentives and combining the two will only masks their effects.

6.2 Implications The conclusion as mentioned above is subject to several implications. The first implications of this research is the sample size limitation of this study. Because of the newly available data, data of the year 2008 was only available. Not all annual reports of 2009 were available at the time of this research which could have give different results if this year was also included. Because the year 2008 was the first year in the Netherlands to disclose audit fee data not all data was disclosed in the same way. NIVRA has published a research on how well the auditors fees are disclosed in the annual reports of 2008 and indicates that 31 | P a g e

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the companies disclose the audit fees differently. Some companies disclosed the audit fee data of all their auditors/advisers of the year 2008, whereas others only disclosed the audit fee data of their auditor. Some companies didnt disclose their audit fee data at all, I excluded them from the research. Because the disclosure of the audit fee was differently for practically each firm our results could be biased. Another limitation of this study is the fact that earnings management is difficult to detect as it takes many form. We have only used one form of earnings management is this study which is discretionary accruals. Thereby it could be possible that the modified Jones model isnt the best model to detect earnings management in companies in the Netherlands. This research does not test branch-specifics. This causes a general conclusion, which may not apply for each specific branch. It is possible the results of this study would be different in specific branches and that there will be different relations between auditors fees and earnings management due to the different environment.

6.3 Suggestions for further research The result of this study and the limitations previously discussed suggest a number of opportunities for further research. A suggestion for a repeat study is recommended when more audit fee data is available and a larger sample size can be used. It could also mitigate the different ways of disclosure because it would be the second year of disclosure. In fact, all of the limitations of this research could be seen as opportunities for further research. Given the mixed results of previous research and the fact that earnings management is difficult to detect, a qualitative study could be a solution to further increase the understanding of the relation between auditors fees and earnings management.

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References
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Antle, R., Gordon, E., Narayanamoorthy, G. and Zhou, L. (2006), The Joint Determination of Audit Fees, Non-Audit Fees, and Abnormal Accruals. Review of Quantitative Finance and Accounting, 27(3), 235-266. Ashbaugh, H., LaFond, R. and Mayhew, B. (2003), Do Nonaudit Services Compromise Auditor Independence? Further Evidence. The Accounting Review, 78(3), 611-639. Beattie, V., Brandt, R., & Fearnley, S. (1999), Perceptions of Auditor Independence: UK Evidence. Journal of International Accounting, Auditing and Taxation, 8(1), 67107. Cahan, S., Emanuel D., Hay D., & Wong N. (2008), Non-audit fees, Long-term Auditor-client Relationships and Earnings Management. Accounting and Finance, 48 (2008) 181-207. Caramanis, C., & Lennox, C. (2008), Audit Effort and Earnings Management. Journal of Accounting and Economics, 45(1), 116138. Chung, H. and Kallapur, S. (2003), Client Importance, Non-audit Services and Abnormal Accruals. Working Paper, Purdue university. DeAngelo L., (1981), Auditor Independence, Low balling and disclosure regulation. Journal of Accounting and Economics, Augustus, 113-127
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Dechow, P., Sloan, R. & Sweeney, P. (1994), Detecting Earnings Management. The Accounting Review, 70(2), 193-225. Defond M., & Jiambalvo J. (1994), Debt covenants effects and the manipulation of accruals. Journal of Accounting and Economics, 17, 145-176

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DeFond, M., Raghunandan, K., & Subramanyam, K. (2002), Do Non-audit Service Fees Impair Auditor Independence? Evidence From Going Concern Audit Opinions. Journal of Accounting Research, 40(4), 12471274. DeFond, M., & Subramanyam, K. (1998), Auditor Changes and Discretionary Accruals. Journal of Accounting and Economics, 25(1), 3567. Francis, J., Maydew, E. & Sparks, H. (1999), The role of the Bug 6 auditors in the credible reporting of accruals. Auditing: A Journal of Practice & Theory, 18, 17-34 Frankel, R., Johnson, M., & Nelson, K. (2002), The Relation Between Auditors Fees For Nonaudit Services and Earnings Management. The Accounting Review, 77(Supplement: Quality of Earnings Conference), 71105. Healy, P. & Wahlen, J, (1999), A review of the Earnings Management literature and Its implications For Standard Setting. Accounting Horizons, 13(4), 365-383. Jones J.J. (1991), Earnings Management during Import Relief Investigations. Journal Accounting Research 29, 193-228. Larcker, D., & Richardson, S. (2004), Fees Paid to Audit Firms, Accrual Choices, and Corporate Governance. Journal of Accounting Research, 42(3), 625658. McVay, S. (2006), Earnings Management Using Classification Shifting: An Examination of Core Earnings and Special Items. The Accounting Review, 81(3), 501531. Nelson M., Elliot J. & Tarpley R. (2002), Evidence from Auditors about Managers and Auditors Earnings Management Decisions. The Accounting Review, 77, 175-202. Roychowdhury, S. (2006), Earnings Management Through Real Activities Manipulation. Journal of Accounting and Economics, 42(3), 335370. 35 | P a g e

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Schipper K. (1989), Commentary: Earnings Management. Accounting Horizons (December), 91-102. Simunic D. (1984), Auditing, Consulting, and Auditor Independence. Journal of Accounting Research, 22(2), 679-702. Wallman, S. (1996), The Future of Accounting, Part III: Reliability and Auditor Independence. Accounting Horizons, 10, 7697. Books Davidson S., Stickney C. & Weil R. (1987), Accounting: The language business. 7th edition

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APPENDIX A

Companies under study

Name Company AALBERTS INDUSTRIES ACCELL GROUP NV AFC AJAX NV AKZO NOBEL N.V. ALANHERI NV AMG ADVANCED METAL AMSTERDAM MOLECULAR ARCADIS NV Name company KONINKLIJKE AHOLD NV KONINKLIJKE BAM GRP KONINKLIJKE BRILL NV KONINKLIJKE DSM N.V KONINKLIJKE KPN NV KONINKLIJKE TEN CATE KONINKLIJKE VOPAK NV LOGICA PLC

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ARSEUS NV ASM INTERNATIONAL NV ASML HOLDING NV BALLAST NEDAM NV BATENBURG BEHEER BE SEMICONDUCTOR IND BETER BED HOLDING BRUNEL INTERNATIONAL CROWN VAN GELDER CRUCELL NV CRYO-SAVE GROUP N.V. CSM N.V. CTAC NV DOCDATA NV DPA GROUP NV DRAKA HOLDING NV EXACT HOLDING NV FORNIX BIOSCIENCES FUGRO NV GALAPAGOS GAMMA HOLDING NV GRONTMIJ H.E.S. BEHEER N.V. HEIJMANS NV

MACINTOSH RETAIL GRP MEDIQ NV N.V. PORCELEYNE FLES NED APPARATEN FABR. NEDSENSE NEWAYS ELECTRONICS NUTRECO HOLDING NV OCTOPLUS ORANJEWOUD NV ORDINA NV PHARMING GROUP NV PUNCH GRAPHIX QURIUS N.V. RANDSTAD HOLDING REED ELSEVIER NV ROTO SMEETS GROUP NV ROYAL DUTCH/SHELL GR SBM OFFSHORE NV SIMAC TECHNIEK NV SLIGRO FOOD GROUP NV SPYKER CARS N.V. STERN GROEP NV TELEGRAAF MEDIA TIE HOLDING NV

HEINEKEN N.V. HOLLAND COLOURS NV ICT AUTOMATISERING IMTECH NV INNOCONCEPTS NV KENDRION NV KON. BOSKALIS WESTM. KON. PHILIPS ELECTRO KONINK. WESSANEN

TKH GROUP N.V. TNT NV TOMTOM N.V. UNILEVER N.V. UNIT4 NV USG PEOPLE N.V. WAVIN N.V. WOLTERS KLUWER N.V.

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