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The Impact of Reputation, Audit Contract Type, Tenure, Audit Fees and Other Services on Auditors’ Perceptions of Audit Quality

Millicent Chang Department of Accounting and Finance

The University of Western Australia Nedlands, W.A 6907.

Gary S. Monroe

School of Accounting Edith Cowan University Churchlands, W.A 6018.

Abstract Audit quality is important in that a high quality audit results in reliable financial information for capital markets. This paper investigates auditors' perceptions of audit quality. Prior studies have tended to concentrate on the auditor’s independence, which is only one component of audit quality. It is important to understand the factors that auditors perceive as affecting audit quality since these are the factors that affect actual audit quality. This study investigates whether audit reputation, length of auditor-client relationship, audit contract type, provision of non-audit services and level of fee dependence affect auditors' perceptions of audit quality and independence. Data were obtained via auditors’ responses to a case study questionnaire. After reviewing the information in the case study, auditors made judgments about the quality of audit services likely to be provided, the risk of the auditor's independence becoming impaired, the likelihood of a material misstatement being discovered, and the likelihood of the auditor requiring management to adjust the financial statements or following management's refusal to adjust the financial statements, reporting the misstatement in the audit opinion. Auditor reputation, length of audit-client relationship, audit contract type, provision of non-audit services and level of fee dependence were manipulated in a 2 x (2x2x2x2) mixed design with auditor reputation being the between-subjects factor and the latter four variables being the repeated factors. The results indicate that auditors' perceptions of audit quality are affected by contract type and the risk of independence being impaired becomes a major concern when the auditor is economically dependent on a client for fee income. With respect to discovering material misstatements in the client's financial statements, the length of the auditor-client relationship, contract type and level of fee dependence influence the likelihood of discovering the material misstatement.

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1.0 INTRODUCTION There have been dramatic changes in the market for audit services during the 1980s and 1990s. One of the most significant changes was the revision of the rules pertaining to advertising and competition by the Institute of Chartered Accountants (ICA) and the Australian Society of Certified Practising Accountants (ASCPA). In addition, several mergers between large accounting firms took place. The Big Eight became the Big Six after the mergers between Arthur Young and Ernst & Whinney, and Touche Ross and Deloitte, Haskins and Sells. As a result, competition for clients is rife among auditing firms. In general, competition takes on two forms: price competition and product differentiation. Audit tendering has become a tool for price competition and audit firms engage in marketing strategies to differentiate themselves from the competition1. Recent corporate collapses and audit failures have threatened the credibility of auditors and affected the public’s perception of audit quality. Allegations of audit failure have resulted in the accounting profession undertaking several measures to strengthen the effectiveness of the independent audit, both in fact and in appearance. For example, Statement of Auditing Practice AUP 32 "Audit Independence" (1992) was issued by the Australian Accounting Research Foundation (AARF). Arond that time, the AARF also issued several exposure drafts on related issues (ED 43 "Knowledge of the Client's Business", ED 44 "Communication to Management on Matters Arising from the Audit" and ED 48 "The Auditor's Responsibility for Detecting Irregularities Including Fraud, Other Illegal Acts and Errors") that have since become AUPs. Audit quality is important in that a high quality audit results in reliable financial information for capital markets. Two important aspects of audit quality are perceived and actual audit quality. Whereas the former is audit quality as perceived by financial statement users, the latter is a function of the audit technology and resources directed to a particular audit engagement. Audit firms compete on the quality of audit services. However, product differentiation is a difficult dimension to compete on because auditing is a service, the quality of which cannot necessarily be observed. Due to the unobservable nature of audit services, only auditors have the opportunity to observe actual audit quality. Understanding the factors that affect actual audit quality and perceived audit quality are important research areas. This paper investigates auditors' perceptions of audit quality. Prior studies have tended to concentrate on the auditor’s independence, which is only one component of audit quality. It is important to understand the factors that auditors perceive as affecting audit quality since these are

1 As an example of the effects of this competition, Craswell [1992] reported a 40% drop in audit fees between

1980 and 1989 despite considerable inflation during that period. However, this could have resulted from cost savings due to increased efficiency and/or a reduction in audit quality.

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the factors that affect actual audit quality. This study investigates whether audit reputation, length of auditor-client relationship, audit contract type, provision of non-audit services and level of fee dependence affect auditors' perceptions of audit quality and independence. The effect of acculturation on auditors' percpetions are also studied 2.0 PRIOR RESEARCH Research into audit quality has taken a number of approaches. Simunic [1980], Simon [1985], Palmrose [1987], Francis and Simon [1988], Palmrose [1988] and Turpen [1990] examined audit quality from the differential pricing viewpoint, while other studies considered audit quality differences between auditing firms by using surrogates for audit quality (Palmrose [1982], Nichols and Smith [1983], Shockley and Holt [1983], Simunic and Stein [1987], Ettredge et al. [1988], Imhoff [1988], Palmrose [1988], Beatty [1989], Eichenseher et al. [1989], Wilson and Grimlund [1990] and DeFond [1992]). The third approach which is of direct relevance to this paper are studies that have examined audit quality from a behavioural perspective (e.g., Schroeder et al. [1986], Knapp [1991] and Carcello et al. [1992]). Several studies have examined the effects of a number of auditor characteristics on financial statement users’ and auditors’ perceptions of auditor independence, which is one of the components of audit quality. Shockley [1981] examined the effects of competition for clients, provision of management advisory services, size of audit firm and tenure on perceptions of independence. Financial statement users (financial analysts and commercial loan officers) and auditors participated in his study in a repeated measures design. Competition, size and the provision of management services significantly affected perceptions of independence. The judgments for the three subject groups were similar. Knapp [1985] investigated how contextual factors affected commercial loan officers’ perceptions of the ability of auditors to resist management pressure. His repeated measures design included the nature of conflict issue, client’s financial condition, provision of management advisory services and competition as independent variables. He found that the perceived ability of the client to influence the outcome of an auditor-client conflict increased as the subjectivity in technical standards increased and the client’s financial position improved. The effect of providing management advisory services and competition only weakly increased the likelihood of the conflict being resolved in the client’s favour. McKinley et al. [1985] reported that although bank loan officers believed that financial statements audited by Big Eight audit firms were more reliable than those audited by local firms, their confidence

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that the financial statements were free from fraud increased if the audit firm also provided management advisory services. Gul et al. [1990] examined the effect of audit tendering and audit committees on bankers’ perceptions of independence. He found a significant interaction between audit tendering and audit committees. The bankers perceived that auditors were more independent when the audit was obtained through tendering. Gul [1991] found that the size of the audit fee, the provision of management advisory services, audit firm size and competition affected bankers’ perceptions of the auditor’s ability to withstand management pressure although the portion of variance explained was low. Gul and Windsor [1991] reported that the financial condition of the client, and size of fees affected auditors’ perceptions of their independence. However, tendering had no effect. The more recent behavioural studies have extended previous work by incorporating the two aspects of audit quality, namely the auditor's ability to discover material misstatement and independence. These studies show that there are diverse and conflicting perceptions of the factors that affect audit quality and auditor independence. Individuals such as financial controllers and auditors who are directly involved in the audit process perceive audit quality differently to third parties such as audit committee members, bankers and fund managers. Even those parties actually involved in the audit process assess audit quality differently. Schroeder et al. [1986] evaluated the perceptions of audit committee chairpersons and audit partners on factors that affected external audit quality. Audit committee chairpersons were chosen because of their role in corporate governance. A questionnaire was used to obtain the participants’ perceptions of six audit team factors and nine firm wide factors on audit quality. The team factors included: level of partner/manager attention given to the audit, planning and conduct of audit team work, communication between audit team and management, independence exhibited by audit team members, mix of skills and depth of experience of team, and communication between audit team and audit committee. The firm wide factors were: provisions to keep auditors up to date technically, quality control procedures used by the firm, regulatory agency expertise, overall reputation, sizes and locations of offices, provision for team rotation, litigation experience, recency and outcome of peer review and the relative significance of total professional fees. The audit committee chairpersons judged audit team factors as more important to audit quality than firm wide factors. Generally, the audit partners’ perceptions were consistent with those of the audit committee chairpersons. Knapp [1991] investigated the effect that audit firm size, length of tenure and general audit strategy had on audit committee members' audit quality assessments. Being third parties to the audit process, audit committee members experience difficulty in observing variables such as audit team factors known to affect audit quality. Thus, they have to rely on observable auditor characteristics such as

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auditor size. The subjects were presented with a case study that described a client company. There was a material error in the accounts, which was known by management, but unknown to the auditors. Audit firm size, length of tenure and general audit strategy were manipulated in the case study in a full factorial 2x3x2 between-subjects design. Each subject estimated the likelihood of the auditor discovering the error and the conditional likelihood of the auditor requiring management to correct the error or, if management refused to correct the error, reporting the error in the audit opinion. The audit committee members’ audit quality assessments were significantly influenced by audit size class, length of tenure, but not by audit strategy. Carcello et al. [1992] endeavoured to identify the audit quality attributes perceived by participants in the financial reporting process. Questionnaires containing a list of 41 attributes identified by the literature as possibly influencing audit quality were sent to random samples of auditors, financial statement preparers and financial statement users. Consistent with Schroeder et al. [1986], the highest rated attributes were related to audit team rather than audit firm characteristics. Among the three groups of financial reporting participants, there were also significant differences in the importance assigned to each factor. Controllers and users placed more importance on adherence to the general auditing standards than auditors. Auditors believed that it was more important that the audit firm maintain a sceptical view than controllers, while controllers placed more importance on firm's responsiveness to client's needs. However, users found it more important that an auditor comply with general audit standards. Generally, audit partners differed with users in that they placed greater importance on the audit firm’s executive involvement. 3.0 RESEARCH METHOD This study extends the work of Knapp [1991] in an Australian environment by considering additional factors that may have an impact on audit quality and the impact of these factors on auditors’ assessments of audit quality. Data were obtained via auditors’ responses to a case study questionnaire. After reviewing the information in the case study, auditors made judgments about the quality of audit services likely to be provided, the risk of the auditor's independence becoming impaired, the credibility of the financial statements, the likelihood of a material misstatement being discovered, and the likelihood of the auditor requiring management to adjust the financial statements or following management's refusal to adjust the financial statements, reporting the misstatement in the audit opinion. Auditor reputation, length of audit-client relationship, audit contract type, provision of non-audit services and level of fee dependence were manipulated in a 2 x (2x2x2x2) mixed design with auditor reputation being the between-subjects factor and the latter four variables being the repeated factors.

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A mixed design was chosen primarily because of the length and repetitiveness of the task and potential problems of a low response rate. However, there is the possibility of bias associated with practice and order effects. That is, in addition to specific treatment effects, subjects’ responses will be affected by some previous learning experience with the test variables and the order in which they are presented. These effects were overcome in the experiment by randomising both the order of the 16 scenarios and the four auditor characteristics within the scenarios for each subject2. 3.1 Research Instrument The research instrument was based on the case study developed by Knapp [1991] with certain changes to suit the Australian environment. It involved a medium sized household electrical appliance company with the point of focus being a material misstatement in the current year's unaudited financial statements. The material misstatement was located in the inventory account and represented a portion of inventory that had become obsolete. The company’s directors were reluctant to write down the value of inventory to its market value due to its impact on the current year's profit. The directors wanted to delay the write down to the next financial year because of plans to issue shares to finance further acquisitions and repay outstanding bank loans. Given this hypothetical situation, it was interesting to examine subjects' judgments of how auditor reputation (firm size), length of auditor-client relationship, audit contract type, provision of non-audit services and level of fee dependence affected auditors’ perceptions of the likelihood of the auditor discovering the material misstatement and subsequently reporting the misstatement to management. The independent variables were selected because of their impact on auditor independence in prior studies and their inclusion in AUP 32. It is interesting to examine their impact on the overall audit quality and the individual components of audit quality. The five independent variables were dichotomously manipulated through the instructions as shown in Appendix 1. Two pretests of the research instrument were conducted. The first pretest involved 14 academic staff members to determine the face validity and realism of the auditor attributes and their various combinations in the case study. Revisions to the research instrument were made based on the first pretest. The second pretest consisted of administering the research instrument to 34 accountants undertaking the ICA’s Accounting 2 professional year module. Discussions held with pretest subjects provided feedback on the comprehensibility and clarity of expressions and terms used. The discussions revealed that instructions and wording of the questionnaire followed a logical sequence

2 There is also the potential for demand effects in a within-subjects experiment because multiple scenarios are

presented to each subject. This allows the subject to "guess" the hypothesis and therefore give responses that they think the researchers desire. Alternatively, given that the subjects know that they are involved in an experiment, they may respond differently to the way they would otherwise respond in a "real world' situation. This problem has been controlled for by making the case study as "real" as possible.

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and was easy to understand. The subjects also indicated that the presentation of that materials did not cause them to guess the hypotheses and unduly bias their responses. Two variations of the research instrument were used, one describing a "Big Six" auditor and the other a "non-Big Six" auditor. The research instrument contained background information about the company, its financial profile, two years audited financial statements and the current year unaudited balances, information about the incumbent auditor and the current year's audit, a practice session and 16 different scenarios based on the four auditor characteristics. A multiple stimulus approach was used, where all 16 scenarios were presented so that the complete set of stimuli was available and could directly influence each subject's assessment. Each scenario contained a combination of the four manipulated auditor characteristics. The practice session contained three cases, which were repeated later in the instrument. The practice scenarios were included to enable the subjects to familiarise themselves with the various terms used to describe the auditor characteristics. After reading each scenario, each subject answered five questions. These questions were measured using a nine point scale. Three of the questions (2, 4 and 5) related to auditor independence. The questions and their scales were: 1. What is your assessment of the quality of audit service likely to be provided3? A "1" on the scale

represented low quality while "9" represented high quality. 2. What is the risk of the auditor’s independence being impaired? A "1" on the scale represented

low risk while "9" represented high risk. 3. What is the likelihood that the auditors will discover the inventory overstatement? A "1" on the

scale represented very unlikely while "9" represented very likely. In answering the next two questions, please assume that the auditors discovered the inventory overstatement. 4. What is the likelihood that the auditors will request management to adjust the inventory balance?

A "1" on the scale represented very unlikely while "9" represented very likely. 5. What is the likelihood that the auditors will report the overstatement in the audit opinion if

management refuses to make the adjustment? A "1" on the scale represented very unlikely while "9" represented very likely.

To minimise the potential problem of order and practice effects, the order of the 16 scenarios was randomised and printed separately for each subject. In addition, the order of the four auditor characteristic variables was randomised for each scenario. Five different versions of the practice cases (e.g., five different combinations of three scenarios) were utilised to ensure that the practice

3 To minimise any potential misunderstandings about what “audit quality” means, the subjects were provided

with the following definition in the case instructions: audit quality is defined as the auditor's ability to discover and willingness to report material errors or misstatements in the client's financial statements.

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cases did not lead the subjects to our hypothesised responses4. The instructions and wording of the questionnaire were expressed in a neutral tone to reduce the possibility of demand effects. Subjects were encouraged to go back and change their assessments if they felt that it was necessary. A biographical questionnaire was also included at the end of the case study. The subjects provided information such as their employer's name, current position, number of years in their current position, approximate time required to complete the questionnaire, the extensiveness of their auditing knowledge and prior experience with audit reports. Subjects were assured of the confidentiality of the information provided and were informed that the information volunteered would be used exclusively for research purposes. 4.0 HYPOTHESES This study investigates whether auditor reputation, length of auditor-client relationship, audit contract type, provision of non-audit services and level of fee dependence affect auditors' perceptions of audit quality. The hypotheses for each of these variables are discussed in turn. 4.1 Auditor Brand Name Reputation (audit firm size) The effect of the auditor's brand name on perceptions of auditor independence and audit quality has been well researched. Financial statement users differentiate between large and small auditors where the terms "Big Six" and "non-Big Six" have been used to describe these two types of auditors (e.g., Beatty [1990], DeFond [1992], Healy and Lys [1986], Balvers et al. [1988], Dopuch and Simunic [1980, 1982], Shockley and Holt [1983], Shockley [1981], Palmrose [1982], Simunic and Stein [1987], Palmrose [1987], Ettredge et al. [1988], McKinley et al. [1985], Deis and Giroux [1992]). Since brand name is one of the most visible, low cost and easily available information regarding an incumbent auditor, it should be included in any experimental study on the perceptions of auditor independence and audit quality because these assessments cannot be complete if the auditor's brand name is excluded or unknown. The brand name variable was operationalised at two levels, Big Six and non-Big Six auditors. Healy and Lys [1986] regard the auditor's investment in reputation capital as a bond, which guarantees audit clients that they will receive the audit quality that was contracted for and the brand name of the auditor signals to financial statement users the quality of the audit firm. High reputation auditors maintain a high level of audit quality by diligently detecting misstatements and disclosing

4 The practice cases did not have a significant impact on the subjects’ subsequent responses. The practice

cases were used as an alternative to repeating the first few cases later in the instrument and not informing the subjects of the repeated cases.

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them in the audit report. DeAngelo [1981b] argues that audits conducted by Big Eight firms were more likely to discover the presence of material errors in financial statements compared to smaller firms as they possess technological advantages over their competitors. This leads to the following hypotheses: H1a: Auditors’ assess audit quality as higher when the audit is conducted by a Big Six auditor

compared to when the audit is conducted by a non-Big Six auditor. H1b: Auditors’ assess the auditor to be more independent when the audit is conducted by a Big

Six auditor compared to when the audit is conducted by a non-Big Six auditor. H1c: Auditors’ assess the auditor to be more likely to discover the material misstatement when the

audit is conducted by a Big Six auditor compared to when the audit is conducted by a non-Big Six auditor.

It is expected that auditors from different size audit firms possess differing views of audit firm competence. It is hypothesised that Big Six auditors will impute a greater likelihood of discovering a material misstatement to Big Six auditors, while non-Big Six auditors will assess no difference in the discovery abilities of Big Six and non-Big Six auditors. H1d and H1e test these respective effects.

H1d: The Big Six auditor group's estimate of an auditor discovering a material misstatement is

higher for Big Six auditors than non-Big Six auditors. H1e: The non-Big Six auditor group's estimate of an auditor discovering a material misstatement is

not affected by auditor reputation. According to DeAngelo [1981b], in a situation where an auditor discovers a misstatement in the client's accounts and the client tries to influence the auditor not to report the misstatement, the auditor's incentive to "cheat" is measured by the loss of the present value of client specific quasi-rents if the engagement is discontinued. Alternatively, the countervailing disincentive to cheat is the present value of quasi-rents specific to the auditor's other current clients. If the auditor "fails to report" the misstatement and the "failure to report" is discovered, the auditor is in danger of losing these other clients and/or reduced fees from the clients that continue to retain the auditor. Therefore, it follows that auditors with a larger client base have more to lose, i.e. greater disincentive to cheat than smaller auditors. Shockley [1981] reported that Big Eight audit partners’, loan officers’ and financial analysts’ perceptions of independence were significantly influenced by audit firm size. The risk of independence becoming impaired was more likely for small auditors.

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Therefore, Big Six auditors and non-Big Six auditors are expected to respond differently to the effect of auditor brand name on independence. Based on Shockley’s [1981] results, it is expected that Big Six auditors’ perceptions of auditor independence will be influenced by audit brand name reputation while the non-Big Six auditors’ perceptions will not be affected. Big Six auditors will rate auditors in their same brand name class as more independent, i.e., more likely to report a discovered misstatement (H1f) and there will be no difference in perceived independence between the two types of auditors for non-Big Six auditors (H1g).

H1f: The Big Six auditor group's estimate of an auditor's independence is affected by auditor

reputation. H1g: The non-Big Six auditor group's estimate of an auditor's independence is not affected by

auditor reputation. 4.2 Length of Auditor-Client Relationship The length of the auditor-client relationship could affect an auditor’s perceptions of audit quality. In the earlier part of the relationship, the auditor is less familiar with the client's business environment and accounting system and will therefore have more difficulty discovering misstatements, especially if management is deliberately concealing them. As the relationship progresses, the auditor becomes more knowledgeable about the client's system such that his/her ability to discover misstatements increases. DeAngelo [1981a] and Williams [1988] discuss the auditor’s increasing effectiveness over the length of the client-auditor relationship where a better understanding the client's system leads to a greater likelihood of discovering material misstatements. It is expected that the length of an audit relationship is positively correlated to an auditor's likelihood of discovering a material misstatement. However, at some point in the relationship, due to complacency and a learned confidence in the client, the likelihood of discovering misstatements is reduced (Shockley [1981]). Mautz and Sharaf [1961, p. 208] described this as "…a slow, gradual, almost casual erosion of his 'honest disinterestedness'." Shockley [1981] used a less than five years and more than five year tenure dichotomy, while St Pierre and Anderson [1984] found that audit failures were more common when tenure was less than three years. It is hypothesised that auditors’ perceptions of audit quality and independence are affected by the length of auditor-client relationship. In this study, the length of audit relationship is manipulated at two levels. The first level represents the first year of the audit relationship, i.e., when a new auditor is appointed. The second level characterises the fifth year of the audit relationship where the auditor has previously performed four successive audit engagements.

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DeAngelo [1981a, 1981b] argues that the existence of client specific quasi-rents to incumbent auditors lead to a lower "perfectly accepted" level of auditor independence. Incumbent auditors make client specific investments on which the expected return is future quasi-rents. These future rents represent the excess of audit fees over the avoidable cost of production. Although both a newly appointed auditor and an auditor for five years are incumbent auditors, the newly appointed auditor has more to lose if the engagement is terminated because he/she has more future quasi-rents to recover and they may not have recover their start-up costs in the first year of the engagement5. The greater the future stream of client specific quasi-rents, the less likely an auditor is to report a material misstatement6. However, it should be recognised that the existence of future economic rents is necessary, but not sufficient, for selective disclosure. The auditor must believe the expected benefit of "cheating” to outweigh the expected costs, which includes the loss of future audit fees from other clients due to the loss of reputation should the selective disclosure be discovered. Empirical studies (Beck et al. [1988a] and Ragunathan [1987]) have shown that the length of an audit relationship is inversely related to the likelihood of an auditor reporting a discovered material breach. In light of the above, the following are hypothesised: H2a: Auditors’ perceptions of audit quality are higher for the auditors with a tenure of five years

than for the newly appointed auditors. H2b: Auditors’ assessments of independence are higher for the auditors with a tenure of five years

than for the newly appointed auditors. H2c: Auditors' estimates of the likelihood of discovering a material misstatement are higher for the

longer auditor-client relationship. 4.3 Audit Contract Type The type of audit contract was manipulated at two levels: fixed fee contract obtained through tendering and variable fee contract. According to Palmrose [1989] and McDonald and Monroe [1991], a fixed fee contract is one where the audit fees are determined before the performance of

5 This would be more likely if the auditor has “lowballed” to obtain the audit engagement. Under lowballing,

the auditor is counting on the client continuing the relationship so that the losses in the early year(s) of the engagement can be recovered in later years. In this situation, the auditor would be particularly sensitive to making decisions that could result in loss of the client, thus impairing his/her independence.

6 An alternative argument is that the auditor with more tenure is less likely to be independent. This is because the auditor has been making investments specific to that client over the past four years, e.g., tailoring computer-assisted audit programs to the client's system and unique needs such that termination will result in not only the loss of future audit fees but also the loss of the client specific expertise investment.

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audit work and the risk of task uncertainty is borne by the auditor. Fixed fee contracts provide incentives for a least cost audit effort since any excess of fees over costs will be retained by the auditor. In contrast, under a variable fee contract, audit fees are only determined after evidence acquisition so that auditors are more likely to expend more effort to discovering material misstatements. However, incentives for audit inefficiencies exist. Palmrose, however, found that audit contract type did not significantly influence audit hours and fixed contracts had significantly lower fees.7 When a fixed fee contract is obtained through tendering, the auditor has more incentive to expend less effort in evidence acquisition because the fee tendered may already have been "discounted" to bid competitively for the audit. It is proposed that a fixed fee contract coupled with the fact that the engagement was obtained through a tendering process aggravates the "lack of effort" problem with respect to evidence acquisition. This argument is supported by Anderson et al. [1987], who cautions the impairment of auditor independence as a result of auditor tendering because of the client's ability to threaten termination of the engagement. It is hypothesised that the audit contract type will affect auditors' perceptions of audit quality and independence. The issue as to whether an auditor under a variable contract is more likely to report a discovered breach in the client's financial statement is a complicated one and can take three possible directions. First, it is feasible that an auditor under either contract type is equally likely to disclose a discovered breach. This is because both auditors have performed the evidence acquisition process and both stand to lose future quasi-rents if terminated. The auditor under the fixed fee contract obtained through tendering will be paid the pre-determined fee regardless of any disputes with management. Even though the variable contract auditor's fees have not been previously determined, the auditor has to be paid for audit work done. A second possibility is that an auditor engaged under a fixed fee contract obtained through tendering is less likely to report the breach than the variable fee contract auditor. This is because the client has the power to exercise pressure on the auditor as a result of tendering, i.e., the client has more bargaining power. Anderson et al. [1987] found that clients use tendering to reduce audit fees and are willing to replace an auditor to reduce their audit fees. Therefore, an auditor under a fixed contract obtained through tendering might be less likely to report a discovered misstatement than an auditor with a variable contract because of client pressure.

7 Using Australian data, McDonald and Monroe reported that the lowest fees were associated with variable

contracts, the highest fees associated with fixed contracts with renegotiation. The audit fees for fixed fee contracts were higher than those for variable fee contracts, but less than those for fixed contracts with renegotiation.

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The third possibility of the variable contract auditor succumbing to management pressure should also be considered. Alexander [1984] and Kitchener [1983] argue that audit tendering actually reduces the risk of independence being impaired. This is because the audit tenderer actually speeds up the audit process by being more efficient and works better with the client's staff. Gul et al. [1990] examined bankers' perceptions of auditor independence and found that they placed more reliance on the financial statements when audit tendering had occurred. In a subsequent study, Gul and Windsor [1991] showed that auditors did not believe that audit tendering influenced their ability to resist management pressure. It is also predicted that an auditor engaged under a fixed fee contract obtained through tendering is less likely to discover a material misstatement than an auditor engaged under a variable fee contract. The following hypotheses are tested: H3a: Auditors’ perceptions of audit quality are lower for fixed fee contracts than for variable fee

contracts. H3b: Auditors’ assessments of independence are lower for fixed fee contracts than for variable

fee contracts. H3c: Auditors' estimates for an auditor discovering a material misstatement are lower for fixed fee

contracts than for variable fee contracts. 4.4 Provision of Non-audit Services Provision of non-audit services was operationalised as the provision of management consulting services, accounting services and tax services to an audit client. It was manipulated at two levels: (1) only audit services were provided and (2) both audit and non-audit services were provided to the client. Much of the controversy surrounding the "scope of services" issue has centred on auditor independence. This study differs from previous studies in two ways. First, it not only evaluates the effect of providing other services on auditor’s independence but also the auditor's ability to discover material misstatements. Second, it is not limited to management consulting services, but instead includes other services that can be provided by an accounting firm. As an auditor becomes more familiar with a client's business, it becomes increasingly difficult for the client to conceal problems from the auditor. Providing non-audit services could allow the auditor to gain additional insights into the client. The additional knowledge gained about the client could assist

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the auditor in performing the audit, thus increasing the likelihood of discovering material misstatements. However, it is difficult to predict the directional impact on quality due to the conflicting impact on the likelihood of discovering material misstatements and independence. Therefore, an auditor that provides both audit and non-audit services would be more likely to discover material misstatements than an auditor who only provides audit services. In large accounting firms, this "advantage" might be partially offset by the separation of audit and non-audit staff. However, there is still a sharing of knowledge to a large extent between audit and non-audit staff. Beck et al. [1988a] investigated the effect of management advisory services on economic bonding and found that knowledge spillovers actually increased the level of bonding in non-recurring engagements and decreased incremental bonding in recurring engagements. The auditor’s independence, however, might be impaired as a result of these other services because a decision to qualify the audit report on a client’s financial statements could be quite costly to the auditor if it could affect more than just the audit fee. In addition, the provision of other services could result in the situation where the auditor is providing an opinion on the financial statement consequences of their advice. If those services adversely affect the client and the financial statements do not adequately disclose that effect, the auditor may be reluctant to qualify his/her opinion on the accounts. Empirical evidence on the provision of other services on perceived auditor independence is conflicting. Schulte [1965] and Hartley and Ross [1972] provided evidence that auditor independence increased when management advisory services were provided since it increased the client's dependence on the auditor. Other studies (e.g., Briloff [1966], Titard [1971], Shockley [1981], Knapp [1985] and Gul [1991]) support the argument that with the provision of management advisory services, the auditor becomes in effect an employee of the client, is an advocate of the client, has financial interest in the success of the client and is in a position of auditing his own decision (Gul [1991]). Although Shockley [1981], Knapp [1985] and Gul [1991] found that the provision of management advisory services significantly affected bank loan officers' perceptions of the auditor's ability to resist management pressure, the variance explained by that factor was minimal. Carcello et al. [1992] found that the factor, "firm provides no consulting services to the client", was the second lowest rated attribute of audit quality, which implies that providing consulting services actually enhanced audit quality. Goldman and Barlev [1974] contend that when non-routine services such as management consulting were performed and the client benefited from the services, the balance of power actually tipped in favour of the auditor, thus increasing independence. Nichols and Price [1976] substituted these power relationships with dependency relationships. They argued that routineness actually increased the auditor's power. This is because it is very difficult to convince an auditor to deviate from established standards. If other sources of management advisory services are

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unavailable, the power imbalance between client and auditor is reduced. However, when substitutes exist, auditor independence becomes more problematic. In this study, the following hypotheses are tested: H4a: Auditors’ perceptions of audit quality are affected by the provision of non-audit services.

H4b: Auditors’ assessments of independence are lower when the auditor provides non-audit

services compared to when they provide only audit services. H4c: Auditors' estimates of the likelihood of an auditor discovering a material misstatement are

higher when the auditor provides non-audit services compared to when they provide only audit services.

4.5 Fee Dependence Previous studies have recognised the effect of economic dependence on auditor independence. However, fee dependence has not been examined in the context of audit quality. DeAngelo [1981b] argued that fee dependence on a client can be seen as a surrogate for audit quality where it represents the relative magnitude of client specific quasi rents. The level of fee dependence was manipulated at two levels: (1) fees from the audit client represent approximately 18% of total gross fees; and (2) fees from the audit client represent approximately 5% of total gross fees. These levels of fee dependence test the effect of the "fees not exceeding 15% of the gross fees of the practice" rule in AUP 32 "Audit Independence". By fixing the cut off percentages at 18% and 5% on either side of the 15% mark, the effect of fee dependence on audit quality and auditor independence can be examined8. It is hypothesised that auditors’ perceptions of audit quality and independence will be affected by the level of fee dependence. Mautz and Sharaf [1961] were concerned that financial dependence on a client affected independence. That is, the more economically dependent an auditor becomes on an individual client, the more likely the auditor is to comply with the client's wishes. Gul [1991] showed that when the size of fees on an individual client was significant, bankers perceived auditor independence was impaired. Gul and Windsor [1991] found that auditors believed that their ability to resist

8 Unlike previous studies, which operationalised fee dependence as dependent or not dependent (e.g., Gul

[1991] and Gul and Windsor [1991]), we manipulate fee dependence through the percentage of fees derived from the client. This allows the subjects to make their own judgments about the effect of a percentage of fees on fee dependence.

16

management pressure was affected by the size of audit fees9. It is hypothesised that auditors will perceive a reduction in independence when an auditor is economically dependent on a client. The degree of economic dependence on a client should not affect an auditor's competence. That is, regardless of whether the total fees from any one client are a significant or insignificant proportion of gross total fees, the likelihood of the auditor discovering a material error or misstatement is the same. This assumes, of course, that the relative effort expended on the audit is the same across different levels of fee dependence. However, Watts and Zimmerman [1980] have cautioned that the amount of effort an auditor exerts when searching for breaches is dependent on his expectations of subsequent disclosure. Therefore, if an auditor knows that a dispute with management over material errors or misstatements will jeopardise the chances of the audit engagement being renewed, he/she will exercise less effort when gathering audit evidence. It is hypothesised that an auditor who is economically dependent on a client is less likely to discover a material misstatement in the client's financial statement compared to an auditor who is not economically dependent on that same client. H5a: Auditors' perceptions of audit quality are affected by the level of fee dependence.

H5b: Auditors' assessments of independence are higher when fees are 5% of total gross fees than

when fees are 18% of total gross fees. H5c: Auditors' estimates for an auditor discovering a material misstatement are higher when fees

are 5% of total gross fees than when fees are 18% of total gross fees. 4.6 Interaction Effects It is expected that the five auditor characteristics will interact with each other. Therefore, in addition to considering each attribute in isolation, the interaction between variables is considered. H6

represents the hypotheses that consider all the interactions between auditor reputation, length of audit relationship, contract type, provision of non-audit services and fee dependence for audit quality, independence and the likelihood of discovering a material misstatement respectively. H6a: Auditors' estimates of audit quality are affected by the interaction between auditor

reputation, length of the audit relationship, contract type, provision of other services and fee dependence.

9 An argument for mutual monitoring among partners in an accounting firm exists especially when a specific

partner is in charge of an audit engagement and the frim is perceived to be economically dependent on this enagagement.

17

H6b: Auditors' estimates of independence are affected by the interaction between auditor

reputation, length of the audit relationship, contract type, provision of other services and fee dependence.

H6c: Auditors' estimates of the likelihood of discovering a material misstatement are affected by

the interaction between auditor reputation, length of the audit relationship, contract type, provision of other services and fee dependence.

5.0 RESULTS 5.1 Subjects Auditors were utilised as subjects in this research study because it was interesting to examine their perceptions of the factors that affected audit quality and auditor independence. Given their actual involvement in the audit process, auditors' perceptions can act as surrogates for actual audit quality and independence. A total of 232 case studies with a covering letter outlining the importance of the research project and encouragement to participate were sent to audit partners of Big Six and non-Big Six firms in the six Australian capital cities. They then distributed the case studies to their staff. Follow up letters were mailed approximately two weeks after the original distribution of materials. Seventy case studies were returned, which represents a 30.2% response rate. The 70 participants had the following demographic characteristics: their average experience was 3.8 years with a range of 3 months to 23 years of audit experience; 52 auditors were from Big Six firms and 18 were from non-Big Six firms; and 40 were less experienced auditors (seniors and below) and 30 were more experienced auditors (supervisors, managers and partners). 5.2 Dependent Variables After reading each scenario, each subject answered five questions, which are repeated below. Three of the questions (2, 4 and 5) related to auditor independence. 1. What is your assessment of the quality of audit service likely to be provided? 2. What is the risk of the auditor’s independence being impaired? 3. What is the likelihood that the auditors will discover the inventory overstatement? 4. What is the likelihood that the auditors will request management to adjust the inventory balance? 5. What is the likelihood that the auditors will report the overstatement in the audit opinion if

management refuses to make the adjustment?

18

The three dependent variables, audit quality, independence and the likelihood of discovering a material misstatement, were measured on a nine point scale. DeAngelo [1981b]'s definition of audit quality as "the joint probability of discovering a material misstatement in the client's financial statements and reporting the discovered misstatement to client's management" was the measure of audit quality used. The responses to question 1 were used as a measure of audit quality, "1" represented low quality and "9" represented high quality The responses to question 2 were used to measure the risk of independence being impaired, "1 " indicated low risk while "9" indicated high risk. The likelihood of discovering a material misstatement was measured as “1” representing a low likelihood and “9” representing a high likelihood. 5.3 Descriptive Statistics Table 1 shows the means and standard deviations of audit quality estimates for each of the 32 situations presented to auditors.

[Insert Table 1 here] At an aggregate level, there appears to be some support for the hypotheses. Audit quality for the hypothesised "worst" case scenario where the auditor was from a non-Big Six firm, newly appointed under a fixed contract , other non-audit services were also provided and the auditor was fee dependent, the mean estimate was 6.32 (1.50) compared to the "best" case scenario where the mean estimate was 7.77 (1.16). The hypothesised "best" case scenario was when a Big Six auditor who had been performing the audit for five years, employed under a variable contract, was fee independent and only provided audit services.

[Insert Table 2 here] Table 2 exhibits the risk of auditor independence becoming impaired for each of the thirty two possible scenarios. Consistent with the estimates for audit quality, the mean estimates for the "best" case scenario was 2.33 (1.58). The "worst" case scenario estimate was 5.07 (2.02).Therefore, it seems to support the hypothesised relationships between the independent variables. The mean estimates also appear to congregate around the lower end of the scale indicating that are regardless of auditor characteristics, auditors perceive the risk of independence being impaired not to be a major problem.

[Insert Table 3 here]

19

The mean likelihood estimates of the auditor discovering the material misstatement are presented in Table 3. The mean estimate for the auditor hypothesised as "most" likely to discover the misstatement was 6.46 (1.92) while the estimate for the "least" likely was 5.39 (2.01). Therefore, in general, the mean estimates were in the expected directions.

[Insert Table 4 here] Table 4 shows the differences in estimates for each manipulated variable for auditor reputation, length of auditor-client relationship, contract type, provision of non-audit services and fee dependence. Subjects perceived significant differences between Big Six and non-Big Six auditors at the .05 level when assessing audit quality and independence. The length of audit relationship only affected the likelihood of discovery (p = .000) where the auditor of five years was more likely than the newly appointed auditor to discover the misstatement. There were also significant differences between fixed and variable contracts for estimates of audit quality, independence and the likelihood of discovery at p < .01. Only independence was affected by the provision of other services (p = .000) where auditors assessed a higher risk of independence being impaired when other non-audit services were provided. The degree of fee dependence also affected perceptions of independence (p = .000). 5.3 Multivariate Analysis of Variance Multivariate analysis of variance (MANOVA) was used to determine which, if any, of the main effects or interactions affected auditors' assessments of audit quality, independence, likelihood of discovery, likelihood of adjustment and likelihood of reporting. All main effects were significant at p < .01. Therefore, composite audit quality as measured by the five dependent variables is affected by auditor reputation, length of the audit relationship, contract type, provision of other services and the level of fee dependence.

[Insert Table 5 here] Univariate analyses was also conducted at the overall level, i.e., for all auditors, within each Big Six/non-Big Six auditor group and within the junior/senior audit group. This was done to determine if perceptual differences exist between groups. The omega-squared (? 2) statistic was also measured for all significant effects as it provided a measure of explained variance. It was necessary to measure ? 2 because the F statistic is dependent on sample size (Hays [1973], Shockley [1981]).

20

Univariate analysis of variance with audit quality as the dependent variable showed that the main effects, reputation and contract were significant at p = .002 and p = .000 respectively. The two-way interaction between contract and reputation was also significant (p = .032). Therefore, H1a and H3a

are supported as auditor reputation and contract type affect auditors' estimates of audit quality. Under a fixed contract, the audit quality estimates for a high reputation auditor was 7.08 (1.40) while for a low reputation auditor it was 6.56 (1.30). For the variable contract, audit quality estimates were 7.84 (1.21) and 6.90 (1.30) respectively for high reputation and low reputation auditors. Contract type explained 18.6% of the variance and therefore significantly affected perceptions of quality.

[Insert Table 6 here] To determine whether differences in perceptions exist between auditors in Big Six firms and those in non-Big Six firms, separate analyses were carried out. The results showed that auditor reputation (p = .000) and contract type (p = .000) affected Big Six auditors' audit quality perceptions while contract type (p = .002) and provision of non-audit services (p = .020) affected non-Big Six auditors' estimates. Therefore, as expected, while Big Six auditors considered reputation important for quality assessments, non-Big Six auditors did not. However, there is a consensus among the auditors that an auditor engaged under a variable contract will perform a higher quality audit compared to an audit with a fixed fee contract obtained by tender. Non-Big Six auditors found the provision of other-non-audit services to affect audit quality. A possible explanation for this effect is that since non-Big Six firms provide fewer non-audit services relative to their Big Six counter parts, their reservations about the effect of non-audit services on the quality of audit services is understandably related to diminished independence. Assessments of audit quality can also be affected by the everyday responsibilities and decisions made by auditors. It is argued that auditors in senior positions such as managers and partners make decisions which directly affect audit quality, especially with respect to independence issues. Therefore, it is expected that the audit quality estimates of senior and junior members of the audit team will be influenced by different factors. The MANOVA results showed that for junior auditors, contract type (p = .000), non-audit services (p = .023) and the interaction between non-audit services and fee dependence (p = .012) were significant. For the senior auditors, reputation (p = .000), contract type (p = .000) and the interaction between contract type, provision of non-audit services and fee dependence (p = .039) were significant. It is believed that the perceptions of junior auditors are more aligned with external financial statement users than senior auditors. It was expected that senior auditors' audit quality perceptions would not be affected by any of the factors presented because of their ability to judge each audit on its own merit and not be influenced by any

21

exogenous factor. However, the results do not indicate any significant perceptual differences between senior and junior auditors. For independence, univariate analysis indicated that contract type, provision of non-audit services, fee dependence, and the four-way interaction between length of auditor-client relationship, contract type, provision of non-audit services and reputation were significant at p < .05. Therefore, H1b, H2b, H3b, H4b and H5b are supported. This means that estimates of independence are affected by

all five variables. This finding is consistent with Knapp [1991], Shockley [1981] and Gul [1991]. When the auditor is economically dependent on a client, the risk of auditor independence being impaired was 4.75 (2.16) while for a fee independent auditor, the risk was 3.11 (1.75). Although the four-way interaction accounted for 2.6% of the variance, the ? ??for fee dependence was 46.4%. This means that auditors perceive fee dependence to be the most important factor affecting perceptions of independence.

[Insert Table 7 here] Separate analyses of Big Six and non-Big Six respondents revealed some interesting information. Contrary to predictions, Big Six and non-Big Six auditors' perceptions of independence were affected by the same factors. Contract type, provision of non-audit services and fee dependence were significant at the .05 level for both auditor groups. Auditor reputation did not affect the Big Six auditor group's perceptions of independence. Therefore, H1f is rejected and the results support H1g. This is contrary to Shockley’s [1981] findings with respect to Big Six auditors but consistent

for non Big-Six auditors. It would seem that other less observable characteristics play important parts in independence assessment. A possible explanation for this result is that auditors differ from general financial statement users and actually consider real as opposed to perceived independence. A counter-argument is that if each audit is evaluated on an individual basis, factors such as contract type and fee dependence should not affect independence. Analyses were carried out separately for junior and senior auditors. For the former, provision of non-audit services (p = .001), fee dependence (p = .000) and the interaction between length of audit relationship and contract type (p = .030) were significant. Senior auditors' assessments of independence were also affected by the same factors. Therefore, experience does not appear to play a part in the independence judgments of auditors. Table 8 shows the univariate analysis results of auditors assessments of the likelihood of discovering a material misstatement. Length of auditor-client relationship (p = .001), contract type (p = .000) and fee dependence (p = .010) significantly influenced the likelihood of discovery. However, contract type accounted for 23.8% of the explained variance.

22

[Insert Table 8 here]

The likelihood of a newly appointed auditor discovering a material misstatement was 5.61 (2.05), compared to 6.03 (1.99) for an auditor for five years. For a variable contract, the likelihood of discovery was 6.15 (1.97) while for a fixed contract, it was 5.50 (2.04). The assessments for fee dependent and fee independent auditors were 5.74 (2.07) and 5.91 (1.99) respectively. Auditor reputation does not seem to affect the probability of discovery, consistent with Knapp’s [1991] findings for audit committee members. The results support H2c, H3c, and H5c and reject H1c and H4c.

An analysis between Big Six and non-Big Six auditors for assessments of the likelihood of discovering a material misstatement was also carried out. For Big Six auditors, only contract type was significant at p < .05. However, for non-Big Six auditors, contract type (p = .008), provision of non audit services (p = .012), two-way interaction between provision of non-audit services and auditor reputation (p = .047), and the four-way interactions between contract type, provision of other non-audit services, fee dependence and auditor reputation (p = .021) and length of audit relationship, contract type, provision of other non-audit services and fee dependence (p = .010) were significant. Big Six auditors perceived contract type as the only variable affecting the likelihood of discovery while non-Big Six auditors were influenced by all five variables including auditor reputation. Therefore, both H1d and H1e are rejected.

Separate analysis between junior and senior auditors revealed interesting results. Junior auditors' assessments of the likelihood of the material misstatement being discovered were affected by auditor reputation (p = .017) and the interaction between tenure and contract type (p = .048). For senior auditors, contract type and fee dependence were significant at p < .05.

6.0 IMPLICATIONS AND SUMMARY Perceptions of audit quality were affected by the two-way interaction between contract type and auditor reputation. Audit contract type also affected auditors' perceptions of independence and competence (probability of discovering the material misstatement). The results indicate that under a fixed contract obtained through tendering, an auditor believed that they were less likely to discover a material misstatement due to time constraints. In addition, if a material misstatement is discovered, an fixed contract auditor is less likely to report the misstatement. A possible explanation is client pressure on the auditor. As the audit engagement was obtained under a tendering process, the threat of termination gives the client bargaining power. Anderson et al [1987] found that clients utilised the

23

tendering process as a means of reducing fees and were willing to replace auditors to reduce their fees. The fact that audit contract type significantly influenced the perceptions of audit quality raises concerns about the effect of fixed fee contracts resulting from tenders on the auditing process in Australia. The effect of audit contract type on audit quality questions the quality of audits in this country in the face of rampant competition among auditing firms. It appears that some of the concerns expressed in the professional literature may have some justification. However, it should be noted that the manipulation of audit contract type where the fixed fee contract was combined with tendering did not allow us to separate the "lack of effort" effect, which was directly comparable with the variable fee contract, from the tendering effect. Thus it was not possible to determine the direct effect of the fixed contract on quality, independence and competence. Further research should address this issue. Perceptions of independence were affected by fee dependence where an auditor who was not dependent on the client for fee income was considered more independent than one who was economically dependent. This finding confirms the fee dependence test in AUP 32 where "fees not exceeding 15% of the gross fees of the practice" benchmark was used. However, we should bear in mind that even though fee dependence accounts for almost 50% of the variance explained in auditor independence, its effect should not be estimated in isolation. Case specific characteristics and circumstances, which could abate or exaggerate the independence problem, should also be considered. Auditors' perceptions of their ability to detect material misstatements were affected by the length of auditor-client relationship, contract type and fee dependence. Therefore, an auditor who was more familiar with the client's business environment, engaged under a variable contract and fee independent was more likely to discover material misstatements. This indicates that an auditor's competence is related to case specific circumstances rather than audit firm characteristics. In summary, the results indicate that auditors' perceptions of audit quality are affected by contract type and the risk of independence being impaired becomes a major concern when the auditor is economically dependent on a client for fee income. With respect to discovering material misstatements in the client's financial statements, the length of the auditor-client relationship, contract type and level of fee dependence influence the likelihood of discovery.

24

APPENDIX 1 Auditor Reputation (audit firm size) • ABC Ltd is presently audited by a "Big Six" auditor. The "Big Six" refers to the six largest

accounting firms in the world, each having offices in all major Australian cities and in many other cities throughout the world. They are Arthur Andersen, Ernst & Young, Coopers & Lybrand, Deloitte Ross Tohmatsu, KPMG Peat Marwick, and Price Waterhouse.

• ABC Ltd is presently being audited by a local accounting firm which has offices in Brisbane and Perth. It is also affiliated with other small public accounting firms.

Length of Auditor Relationship • “Newly appointed auditor” means that this is the first year of the audit relationship between the

client and accounting firm. • “Auditor for 5 years” means that the accounting firm has been engaged for a continuous period

of 5 years. Type of Audit Contract • “Fixed fee contract obtained through tendering” refers to a contract where fees were agreed

upon before audit work is carried out. Regardless of how long it takes the auditor to complete the audit, the client will be charged the fixed fee agreed at the start of the audit. The current audit engagement was obtained through a tendering process where 5 accounting firms submitted bids. The present auditor was appointed because the firm submitted the lowest bid.

• “Variable fee contract” refers to a contract where audit fees are agreed upon after conclusion of the audit. The audit fee is based on how many hours it takes the auditor to complete the audit.

Other Services • “Provides other services” means that the accounting firm provides management consulting

services, accounting services, and tax services in addition to audit services to ABC Ltd. • “Does not provide other services” means that the accounting firm provides only audit services to

ABC Ltd. Size of Audit Fees The contribution of ABC Ltd’s fees to total fees has been expressed as approximately 18% or 5% of the accounting firm's total fees. The accounting firm's total fees refers to the total revenues of the accounting firm from all professional activities, e.g., tax services, auditing services, consulting services, etc. • “Fees from ABC Ltd represent approximately 18% of total gross fees” indicates that fees from

ABC Ltd comprise 18% of the total fees of the accounting firm's Perth office. • “Fees from ABC Ltd represent approximately 5% of total gross fees” indicates that fees from

ABC Ltd comprise 5% of the total fees of the accounting firm's Perth office.

25

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Table 1 Mean Assessments (standard deviations) of Audit Quality for Each of the 32 Scenarios

Newly Appointed Auditor Auditor for five years

Fixed Variable Fixed Variable

18% 5% 18% 5% 18% 5% 18% 5%

Big

Other services

7.03 (1.74)

7.05 (1.12)

7.95 (1.26)

7.77 (1.09)

7.08 (1.44)

6.95 (1.23)

7.85 (1.39)

7.85 (1.09)

Six Only audit services

7.28 (1.61)

7.00 (1.41)

7.82 (1.32)

7.82 (1.05)

7.21 (1.44)

7.05 (1.17)

7.92 (1.37)

7.77 (1.16)

Non- Big

Other services

6.32 (1.50)

6.65 (1.20)

6.71 (1.58)

6.90 (1.11)

6.39 (1.38)

6.74 (1.09)

6.84 (1.39)

7.03 (1.43)

Six Only audit services

6.48 (1.53)

6.71 (1.04)

6.87 (1.31)

6.94 (1.06)

6.45 (1.41)

6.74 (1.26)

6.90 (1.19)

7.03 (1.35)

Table 2

Mean Likelihood Estimates of Independence for Each of the 32 Scenarios

Newly Appointed Auditor Auditor for five years

Fixed Variable Fixed Variable

18% 5% 18% 5% 18% 5% 18% 5%

Big

Other services

5.18 (2.33)

3.77 (2.15)

4.72 (2.24)

3.05 (1.89)

4.92 (2.41)

2.97 (1.63)

4.82 (2.41)

2.95 (1.89)

Six Only audit services

4.77 (2.28)

2.85 (1.69)

4.44 (2.01)

2.54 (1.71)

4.46 (2.33)

2.64 (1.53)

4.33 (2.25)

2.33 (1.58)

Non-

Big

Other services

5.07 (2.02)

3.61 (1.71)

4.87 (2.14)

3.61 (1.69)

5.39 (2.09)

3.87 (1.80)

4.87 (1.98)

3.58 (1.77)

Six Only audit services

4.84 (2.13)

3.19 (1.58)

4.23 (1.88)

2.74 (1.26)

4.81 (1.85)

3.36 (1.76)

4.45 (1.91)

3.07 (1.57)

31

Table 3

Mean Likelihood Estimates of Discovering a Material Misstatement for Each of the 32 Scenarios

Newly Appointed Auditor Auditor for five years

Fixed Variable Fixed Variable

18% 5% 18% 5% 18% 5% 18% 5%

Big

Other services

4.87 (2.15)

5.18 (1.97)

5.87 (2.03)

5.89 (2.08)

5.69 (2.00)

5.69 (1.97)

6.26 (1.98)

6.46 (1.86)

Six Only audit services

4.92 (2.02)

5.13 (2.05)

5.82 (1.93)

6.00 (2.15)

5.64 (2.06)

5.74 (1.97)

6.31 (2.02)

6.46 (1.92)

Non-

Big

Other services

5.39 (2.01)

5.71 (1.97)

6.00 (1.86)

6.03 (2.03)

5.61 (2.32)

5.97 (1.85)

6.19 (2.01)

6.39 (1.94)

Six Only audit services

5.39 (2.32)

5.74 (1.90)

6.03 (2.03)

6.16 (1.97)

5.81 (2.04)

5.87 (1.98)

6.23 (2.01)

6.23 (1.91)

32

Table 4

T Tests for Each Independent Variable

Audit Quality Independence Discovery Mean

(S.D.) prob

one-tailed Mean (S.D.)

prob one-tailed

Mean (S.D.)

prob one-tailed

Auditor Reputation Big Six

7.46

(1.36)

3.79

(2.24)

5.75

(2.05)

Non-Big Six

6.76

(1.38)

.000

4.11

(1.98)

.007

5.92

(2.01)

.073

Relationship Length

Newly appointed auditor

7.13

(1.40)

3.96

(2.12)

5.61

(2.05)

5 years as auditor

7.15

(1.37)

.373

3.90

(2.14)

.312

6.03

(1.99)

.000

Contract Type

Fixed

6.85

(1.38)

4.09

(2.16)

5.50

(2.04)

Variable

7.43

(1.33)

.000

3.77

(2.09)

.007

6.15

(1.97)

.000

Non-audit services

Yes

7.11

(1.40)

4.19

(2.18)

5.82

(2.02)

No

7.17

(1.37)

.252

3.67

(2.05)

.000

5.83

(2.04)

.448

Fee Dependence

18%

7.12

(1.52)

4.75

(2.16)

5.74

(2.07)

5%

7.16

(1.24)

.326

3.11

(1.75)

.000

5.91

(1.99)

.090

33

34

Table 5 Multivariate Analysis of Variance for Auditors' Assessments of Audit Quality,

Independence, Probability of Discovery, Probability of Adjustment and Probability of Reporting

Effect DF Pillai-

Bartlett's trace

Hotelling-Lawley's

trace

Wilks's lambda

F-value

Main Effects

Reputation (A) 5,64 .241 .317 .759 4.054** Tenure (B) 5,64 .233 .303 .767 3.883** Contract (C) 5,64 .476 .910 .524 11.650** Services (D) 5,64 .235 .307 .765 3.929** Fee (E) 5,64 .682 2.141 .318 27.403**

Two-way Interactions

AB 5,64 .146 .171 .854 2.193 AC 5,64 .107 .119 .893 1.526 AD 5,64 .025 .026 .975 .328 AE 5,64 .113 .128 .887 1.635 BC 5,64 .089 .097 .911 1.244 BD 5,64 .067 .072 .933 .921 BE 5,64 .022 .023 .978 .291 CD 5,64 .046 .048 .954 .611 CE 5,64 .084 .092 .916 1.176 DE 5,64 .110 .123 .890 1.575

Three-way Interactions

ABC 5,64 .072 .077 .928 .990 ABD 5,64 .024 .024 .976 .310 ABE 5,64 .042 .044 .958 .564 ACD 5,64 .111 .124 .890 1.590 ACE 5,64 .065 .069 .935 .883 ADE 5,64 .015 .015 .985 .197 BCD 5,64 .018 .019 .982 .241 BCE 5,64 .036 .037 .964 .477 BDE 5,64 .033 .034 .967 .441 CDE 5,64 .012 .012 .988 .155

Four-way Interactions

ABCD 5,64 .081 .088 .919 1.123 ABCE 5,64 .004 .004 .996 .055 ABDE 5,64 .054 .057 .946 .732 ACDE 5,64 .046 .048 .954 .613 BCDE 5,64 .074 .080 .926 1.025

35

Five-way Interaction

ABCDE 5,64 .080 .087 .920 1.112

* p<.05 ** p<.01

36

Table 6 Univariate Analysis of Variance for Auditors' Assessment of Audit Quality

Source of Variation SS df MS F

Reputation (A) 147.135 1,68 147.135 10.247** Tenure (B) .267 1,68 .267 .077 Contract (C) 84.441 1,68 84.441 33.077** Services (D) .889 1,68 .889 1.306 Fee (E) 0.879 1,68 0.879 .320 AB .388 1,68 .388 .112 AC 12.191 1,68 12.191 4.776* AD .039 1,68 .039 .057 AE 7.558 1,68 7.558 2.748 BC .116 1,68 .116 .275 BD .038 1,68 .038 .083 BE .028 1,68 .028 .101 CD .321 1,68 .321 .614 CE .179 1,68 .179 .528 DE .474 1,68 .474 2.190 ABC .016 1,68 .016 .039 ABD .024 1,68 .024 .366 ABE .028 1,68 .028 .101 ACD .249 1,68 .249 .477 ACE .722 1,68 .722 2.126 ADE .002 1,68 .002 .011 BCD .008 1,68 .008 .029 BCE .000 1,68 .000 .001 BDE .002 1,68 .002 .007 CDE .115 1,68 .115 .262 ABCD .000 1,68 .000 .002 ABCE .008 1,68 .008 .025 ABDE .024 1,68 .024 .074 ACDE .165 1,68 .165 .376 BCDE .367 1,68 .367 1,174 ABCDE .453 1,68 .453 1.448

* p<.05 ** p<.01

37

Table 7 Univariate Analysis of Variance for Auditors' Assessment of the Risk of

Independence being Impaired

Source of Variation SS df MS F

Reputation (A) 24.920 1,68 24.920 .704 Tenure (B) .450 1,68 .450 .134 Contract (C) 28.014 1,68 28.014 10.175** Services (D) 72.923 1,68 72.923 15.050** Fee (E) 730.972 1,68 730.972 122.251** AB 10.358 1,68 10.358 3.071 AC .114 1,68 .114 .041 AD .030 1,68 .030 .006 AE 10.072 1,68 10.072 1.684 BC 1.219 1,68 1.219 1.318 BD .140 1,68 .140 .173 BE .327 1,68 .327 .394 CD .248 1,68 .248 .272 CE .105 1,68 .105 .173 DE 1.542 1,68 1.542 2.170 ABC 2.269 1,68 2.269 2.454 ABD .011 1,68 .011 .014 ABE .948 1,68 .948 1.143 ACD .955 1,68 .955 1.048 ACE 1.034 1,68 1.034 1.704 ADE .092 1,68 .092 .130 BCD .037 1,68 .037 .047 BCE .004 1,68 .004 .005 BDE 1.380 1,68 1.380 1.579 CDE .030 1,68 .030 .035 ABCD 3.809 1,68 3.809 4.774* ABCE .040 1,68 .040 .047 ABDE .137 1,68 .137 .157 ACDE .052 1,68 .052 .060 BCDE .481 1,68 .481 .900 ABCDE .181 1,68 .181 .339

* p<.05 ** p<.01

38

Table 8 Univariate Analysis of Variance for Auditors' Assessment of the Probability of

Discovery

Source of Variation SS df MS F

Reputation (A) 8.422 1,68 8.422 .161 Tenure (B) 44.254 1,68 44.254 12.678** Contract (C) 107.500 1,68 107.500 44.782** Services (D) .075 1,68 .075 .071 Fee (E) 7.473 1,68 7.473 6.941* AB 8.018 1,68 8.018 2.297 AC 6.379 1,68 6.379 2.657 AD .004 1,68 .004 .004 AE .080 1,68 .080 .074 BC 1.069 1,68 1.069 1.970 BD .055 1,68 .055 .141 BE .251 1,68 .251 .652 CD .000 1,68 .000 .000 CE .679 1,68 .679 1.719 DE .069 1,68 .069 .154 ABC .319 1,68 .319 .588 ABD .055 1,68 .055 .141 ABE .001 1,68 .001 .003 ACD .043 1,68 .043 .118 ACE .515 1,68 .515 1.303 ADE .226 1,68 .226 .505 BCD .136 1,68 .136 .482 BCE .788 1,68 .788 1.801 BDE .406 1,68 .406 .870 CDE .075 1,68 .075 .183 ABCD .136 1,68 .136 .482 ABCE .081 1,68 .081 .185 ABDE .406 1,68 .406 .870 ACDE .004 1,68 .004 .009 BCDE .154 1,68 .154 .471 ABCDE .211 1,68 .211 .645

* p<.05 ** p<.01