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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

MSc in Accountancy & Control 2009-2010

Deleted:

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

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Master of Science Accountancy and Control

2. Theoretical Framework...7
2.1

Introduction7

2.2

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

Thesis research model..13

3.2

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

Modified Jones model results...21

5.2

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

Conclusion....30

6.2

Implications..31

6.3

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],
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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:
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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.

Theoretical Framework

2.1

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
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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.
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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
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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.
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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

Non-audit
Services

(a) Thesis theoretical model.

Audit fees
Discretionary
accruals

Non-audit
fees

(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
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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
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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:
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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

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Minimum

Maximum

Mean

Std. Deviation

Master of Science Accountancy and Control


NARATIO

80

0%

80,12%

17,32%

0,1686045

NONAUDIT

80

5.000.000

509.934,51

992.375,182

AUDIT

80

42.000

23.000.000

2.195.707,76

4.426.665,309

TOTAL

80

52.000

28.000.000

2.705.629,78

5.206.332,231

Valid N (listwise)

80

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.

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
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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

Minimum

Maximum

Mean

Std. Deviation

NDA

81

-2,0979

4,0747

-,986515

,6280470

Valid N (listwise)

81

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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Master of Science Accountancy and Control

non-discretionary accruals. The non-discretionary accruals have the following


descriptive statistics:
Table 5.2
Descriptive statistics
N

Minimum

Maximum

Mean

Std. Deviation

NDA

81

-1,6697

,8293

,134774

,2764497

Valid N (listwise)

81

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

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R Square

Adjusted R

Std. Error of

Square

the Estimate

The relation between Auditors Fees and Earnings Management in Dutch firms

,976a

0,952

0,949

1,876E9

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

Table 5.4
ANOVAb
Model
1

Sum of Squares

df

Mean Square

Regression

5,147E21

8,578E20

Residual

2,569E20

73

3,519E18

Total

5,404E21

79

Sig.
,000a

243,784

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


b. Dependent Variable: Discretionary Accruals (DISACC)

Table 5.5
Coefficientsa
Model

Standard
Unstandardized Coefficients
B

Std. Error

Beta

Sig.

(Constant)

-5,508E8

1,008E9

-,546

,586

NARATIO

2,091E9

1,257E9

,043

1,663

,101

SIZE

-1,232

,033

-,979

-37,391

CFO

-1,538E9

1,671E9

-,026

-,920

LOSS

-1,350E9

5,209E8

-,073

-2,592

,012*

1,732E9

1,189E9

,039

1,457

,149

-1,068E8

7,605E8

-,004

-,140

,889

LEV
TYPE
a.

Coefficients

Dependent Variable: DISACC

** 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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,000**
,360

Master of Science Accountancy and Control

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

R
1

,982

R Square
a

0,965

Adjusted R

Std. Error of

Square

the Estimate

0,962

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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The relation between Auditors Fees and Earnings Management in Dutch firms

Model
1

Sum of Squares

df

Mean Square

Regression

5,215E21

8,691E20

Residual

1,888E20

73

2,587E18

Total

5,404E21

79

Sig.
,000a

336,019

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


b. Dependent Variable: Discretionary Accruals (DISACC)

Table 5.8
Coefficientsa
Model

Standard
Unstandardized Coefficients
B

Beta

Sig.

(Constant)

1,613E8

1,008E9

NONAUDIT

1585,909

289,214

,190

5,484

,000**
,000**

,190

,850

SIZE

-1,409

,043

-1,120

-32,917

CFO

-3,275E9

1,472E9

-,056

-2,225

,029*

LOSS

-1,389E9

4,465E8

-,075

-3,110

,003**

1,304E9

1,022E9

,029

1,276

,206

-3,644E8

6,522E8

-,0134

-,559

,578

LEV
TYPE
b.

Std. Error

Coefficients

Dependent Variable: DISACC

** 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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Master of Science Accountancy and Control

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

R
1

R Square

,982

Adjusted R

Std. Error of

Square

the Estimate

0,962

1,616E9

0,965

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


b. Dependent Variable: Discretionary Accruals (DISACC)

Table 5.10
ANOVAb
Model
1

Sum of Squares

df

Mean Square

Regression

5,213E21

8,688E20

Residual

1,907E20

73

2,613E18

Total

5,404E21

79

F
332,502

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


b. Dependent Variable: Discretionary Accruals (DISACC)

Table 5.11
Coefficientsa
Model

Standard
Unstandardized Coefficients

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Coefficients

Sig.
,000a

The relation between Auditors Fees and Earnings Management in Dutch firms

B
1

Beta

Sig.

(Constant)

-5,833E8

8.534E8

AUDIT

-932,075

172,999

-,499

-5,388

,000**

-,628

,116

-,499

-5,424

,000**

CFO

1,330E9

1,519E9

,023

,876

,384

LOSS

-7,704E8

4,600E8

-,042

-1,675

,098

LEV

1,884E9

1,023E9

,042

1,841

,070

TYPE

1,054E8

6,565E8

,004

,160

,873

SIZE

c.

Std. Error

-,683

,496

Dependent Variable: DISACC

** 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

R
1

R Square

,976a

Adjusted R

Std. Error of

Square

the Estimate

0,948

1,879E9

0,952

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


b. Dependent Variable: Discretionary Accruals (DISACC)

Table 5.13
ANOVAb
Model
1

Sum of Squares

df

Mean Square

Regression

5,146E21

8,567E20

Residual

2,577E20

73

3,530E18

Total

5,404E21

79

Sig.
,000a

242,982

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


b. Dependent Variable: Discretionary Accruals (DISACC)

Table 5.14
Coefficientsa
Model

Standard
Unstandardized Coefficients
B

(Constant)

-3,872E8

9,948E8

TOTAL

Beta

Sig.

-,389

,698

-275,998

173,577

-,174

-1,590

,116

SIZE

-1,023

,136

-,813

-7,522

,000**

CFO

-2,087E9

1,813E9

-,004

-,115

LOSS

-1,144E9

5,328E8

-,062

-2,148

,035*

1,938E9

1,191E9

,044

1,627

,108

-5,321E8

7,642E8

-,002

-,070

,945

LEV
TYPE
d.

Std. Error

Coefficients

Dependent Variable: DISACC

** significance at the level 0,01


* significance at the level 0,05

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,909

The relation between Auditors Fees and Earnings Management in Dutch firms

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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Master of Science Accountancy and Control

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)

Positive

NO

Absolute value of non-audit fees (NONAUDIT)

Positive

YES (0,01)

Absolute value of audit fees (AUDIT)

Negative

YES (0,01)

Absolute value of total fees (TOTAL)

Negative

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
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The relation between Auditors Fees and Earnings Management in Dutch firms

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
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Master of Science Accountancy and Control

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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Antle, R., Gordon, E., Narayanamoorthy, G. and Zhou, L. (2006), The Joint
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DeFond, M., Raghunandan, K., & Subramanyam, K. (2002), Do Non-audit Service


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Formatted: Superscript

7th edition

APPENDIX A

Companies under study


Name Company

Name company

AALBERTS INDUSTRIES

KONINKLIJKE AHOLD NV

ACCELL GROUP NV

KONINKLIJKE BAM GRP

AFC AJAX NV

KONINKLIJKE BRILL NV

AKZO NOBEL N.V.

KONINKLIJKE DSM N.V

ALANHERI NV

KONINKLIJKE KPN NV

AMG ADVANCED METAL

KONINKLIJKE TEN CATE

AMSTERDAM MOLECULAR

KONINKLIJKE VOPAK NV

ARCADIS NV

LOGICA PLC

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The relation between Auditors Fees and Earnings Management in Dutch firms

ARSEUS NV

MACINTOSH RETAIL GRP

ASM INTERNATIONAL NV

MEDIQ NV

ASML HOLDING NV

N.V. PORCELEYNE FLES

BALLAST NEDAM NV

NED APPARATEN FABR.

BATENBURG BEHEER

NEDSENSE

BE SEMICONDUCTOR IND

NEWAYS ELECTRONICS

BETER BED HOLDING

NUTRECO HOLDING NV

BRUNEL INTERNATIONAL

OCTOPLUS

CROWN VAN GELDER

ORANJEWOUD NV

CRUCELL NV

ORDINA NV

CRYO-SAVE GROUP N.V.

PHARMING GROUP NV

CSM N.V.

PUNCH GRAPHIX

CTAC NV

QURIUS N.V.

DOCDATA NV

RANDSTAD HOLDING

DPA GROUP NV

REED ELSEVIER NV

DRAKA HOLDING NV

ROTO SMEETS GROUP NV

EXACT HOLDING NV

ROYAL DUTCH/SHELL GR

FORNIX BIOSCIENCES

SBM OFFSHORE NV

FUGRO NV

SIMAC TECHNIEK NV

GALAPAGOS

SLIGRO FOOD GROUP NV

GAMMA HOLDING NV

SPYKER CARS N.V.

GRONTMIJ

STERN GROEP NV

H.E.S. BEHEER N.V.

TELEGRAAF MEDIA

HEIJMANS NV

TIE HOLDING NV

HEINEKEN N.V.

TKH GROUP N.V.

HOLLAND COLOURS NV

TNT NV

ICT AUTOMATISERING

TOMTOM N.V.

IMTECH NV

UNILEVER N.V.

INNOCONCEPTS NV

UNIT4 NV

KENDRION NV

USG PEOPLE N.V.

KON. BOSKALIS WESTM.

WAVIN N.V.

KON. PHILIPS ELECTRO

WOLTERS KLUWER N.V.

KONINK. WESSANEN

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