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Nonaudit Services and Earnings Management Case Study

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Updated: Jul 18th, 2020

Introduction

Frankel, Johnson, and Nelson attempted to provide not only the theoretical framework of how the non-audit services can be linked to the practices of corporate earnings management but also the empirical results incorporated in the authors’ study. There is a growing number of concerns about the degree to which practices of earnings management are related to fees auditors receive for the provision of non-audit services.

In particular, those concerns relate to the fact that such practices can limit the boundaries of the auditors’ independence and, as a result, increase the amount of earnings management. In the situation, where auditor’s fee depends on the company’s executives to whom an auditor provides his or her services, it is reasonable to assume that financial encouragement and an increase in fee creates an incentive for auditors to assist and participate in earnings management.

For that reason, there is several various initiatives from the governments and controlling bodies aimed at discoursing payments to the auditors for non-audit services. The objective of such initiatives is to regain the auditors’ independence and to increase monitoring and control of earnings management.

Background and hypothesis development

In terms of auditors’ independence, there is a rule issued by the SEC, concerning the requirements of the Commission to auditors and their practice, especially regarding non-audit services. The main requirement of the rule is the necessity of obligatory disclosure of the fees received by the auditors for such services in a form of proxy statements (Frankel, Johnson, and Nelson 73). It is also important to point out that based on such data, it became possible for the Commission to analyze the implications of different categories of auditors’ fees and their potential relation to earnings management practices.

As a result of disclosures, the experts’ assessment stated that the highest possibility of linkage to fees related to earnings management is associated with the category ‘All Other Fees’. Naturally, the presence of such a category is not a direct indication of an auditor’s bias. Moreover, considering all the facts, the hypothesis is that the very practice of providing both audit and non-audit services is not linked to earnings management. However, on the other hand, it is important to analyze the reasons why there are correlations between such services and earnings management, and whether the disclosure helped in any way to increase auditors’ independence in regard to these services.

Research design and empirical results

The results obtained by Frankel, Johnson, and Nelson took into consideration different earnings management variables, “including discretionary total accruals, discretionary working capital accruals, and performance-matched discretionary accruals” (Frankel, Johnson, and Nelson 73). It is imperative to underline that the study demonstrated different results not only in terms of different categories of fees but also in relation to the size of companies. Thus, according to Frankel, Johnson, and Nelson, there is no significant association between non-audit fees from larger companies and earnings management. Small increases in payment to auditors in the majority of cases were coincidental or not related to earnings management.

Conclusions

From a broader perspective, results obtained by Frankel, Johnson, and Nelson suggest that although companies who pay for non-audit services are more likely to be involved in earnings management practices, there is no direct linkage between non-audit services themselves and managing income. On a larger scale, small increases in auditors’ earnings do not appear to be directly related to managed earnings or limitations of auditors’ independence.

Works Cited

Frankel, Richard, Marilyn Johnson, and Karen Nelson. “The Relation between Auditors’ Fees for Nonaudit Services and Earnings Management.” The Accounting Review 77.1 (2002): 71-105. Print.

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IvyPanda. "Nonaudit Services and Earnings Management." July 18, 2020. https://ivypanda.com/essays/nonaudit-services-and-earnings-management/.

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IvyPanda. 2020. "Nonaudit Services and Earnings Management." July 18, 2020. https://ivypanda.com/essays/nonaudit-services-and-earnings-management/.

References

IvyPanda. (2020) 'Nonaudit Services and Earnings Management'. 18 July.

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