Leeflang.M. MSc

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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

MSc in Accountancy & Control 2009-2010

Table of Contents

1. Introduction......4

Formatted:Superscript

Deleted:

Deleted:


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Master of Science Accountancy and Control

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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.92.3 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

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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 theextensive 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 non-

audit 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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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 asvery 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 stakeholderswith 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 non-

audit 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 non-

audit 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 auditfees 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

(a) Thesis theoretical model. (b)Thesis research model

Earnings management and the relation with audit fees and non-audit fees havent yet

been extensively researched in the Netherlands, in comparison with other notable

countries such as the US and the UK. The economic environment in which Dutch

firms operate could be compared with the economic environment of the UK and US.

The characteristics of these economic environments are international orientated, open

economy, strong equity market, investor protection, etc.

The reason that this relation had not been researched yet, is the newly available data

for Dutch companies. As of the 27th of June the Dutch law changed with regards to

the disclosure of audit fee data. As of this date article 382a (BW 2, title 9) was

developed which requires mandatory disclosure of audit fees of Dutch companies who

classify as large.

As discussed in the previous chapter and as shown in the above figure I will use

discretionary accruals as a measure of earnings management. This measurement type

of earnings management is the only one in which the auditors plays a significant role

Earnings

Management

Non-auditfees

Audit fees

Non-auditServices

Audit Services

Discretionary

accruals


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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 differentialincentive 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 modelto 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 = + 1FEE + 2SIZE + 3CFO + 4LOSS + 5LEV + 6TYPE + 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 alternativespecifications 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 haspublished a research on how well the auditors fees are disclosed in the annual reports

of 2008 and indicates that the companies disclose the audit fees differently. Based on

this research I will focus on organization who have disclosed the audit fee with the

following items: audit services, other audit services, fiscal services and non-audit

services. This way I will try to minimize errors in the results of this study.

The financial data was conducted from Datastream for 119 firms, who were listed on

the Dutch exchange market. Because of the recently changed law to disclose audit fee,

the audit fee data was not yet available for the year 2008 in Datastream. The fee data

was collected through manual inspection of the annual reports. The annual reports

were collected from the companys websites. Some organizations were omitted from

the data set for a number of reasons. The reasons to omit the organization include:

no financial data was found in Datastream;

no audit fee data was found in the annual report of 2008;

no financial data of the year 2007 was found (used in the Modified Jones model);

no distinction between audit fee and non-audit fee in the disclosure of the 2008

annual reports;

not all data was available for some variables used in our model.

4.2.1 Descriptive statistics

Table 4.1 reports the descriptive statistics for the four audit fees metrics that we have

determined.

Table 4.1

Descriptive Statistics of Audit and Non audit fees

N Minimum Maximum Mean Std. Deviation


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NARATIO 80 0% 80,12% 17,32% 0,1686045

NONAUDIT 80 0 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

Deleted:


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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 thediscretionary 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

Valid N (listwise)

81

81

-2,0979 4,0747 -,986515 ,6280470

Because of some outliers/results the mean give some strange results. The mean should

be zero when there is a normal-like distribution. To see if there is a normal-like

distribution we have plotted the following histogram:

As we can see the centre of the histogram of the residual is around zero and thus

normally distributed.

After determining total accruals I will now determine the non-discretionary accruals

to eventually determine the discretionary accruals. Based on the coefficients

determined in calculating the total accruals I am able to determine the amount of the


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

descriptive statistics:

Table 5.2

Descriptive statisticsN Minimum Maximum Mean Std. Deviation

NDA

Valid N (listwise)

81

81

-1,6697 ,8293 ,134774 ,2764497

The next step in determining the discretionary accruals is the most easy step. I will

now deduct the calculated non-discretionary accruals from the total accruals for each

firm.

5.2. Auditors fee model results

The discretionary accruals have been calculated and inserted for each firm determined

in the data sample. I have excluded one outlier which reduces the sample size to 80.

After the discretionary accruals have been calculated I can now investigate the

association between audit- and non-audit fees through the, previously discussed,

auditors fee model.

5.2.1 Non-audit fee results

Table 5.3, 5.4 and 5.5 show the Model summary, ANOVA test and the coefficients of

the regression model with the audit fee metric: NARATIO. The non-audit fee ratio

(NARATIO) is one of the audit fee metrics to determine if there is an association

between non-audit fees and earnings management. The tables will be used to show the

correlation between the dependent variable and the independent variables and will be

used to test our hypothesis.

Table 5.3

Model Summary

Model R R Square Adjus ted R

Square

Std. Error of

the Estimate


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1 ,976a

0,952 0,949 1,876E9

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

Table 5.4

ANOVAb

Model Sum of Squares df Mean Square F Sig.

1 Regression

Residual

Total

5,147E21

2,569E20

5,404E21

6

73

79

8,578E20

3,519E18

243,784 ,000a

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

b. Dependent Variable: Discretionary Accruals (DISACC)

Table 5.5

Coefficientsa

Unstandardized Coefficients

Standard

Coefficients

Model

B Std. Error Beta t Sig.

1 (Constant)

NARATIO

SIZE

CFO

LOSS

LEV

TYPE

-5,508E8

2,091E9

-1,232

-1,538E9

-1,350E9

1,732E9

-1,068E8

1,008E9

1,257E9

,033

1,671E9

5,209E8

1,189E9

7,605E8

,043

-,979

-,026

-,073

,039

-,004

-,546

1,663

-37,391

-,920

-2,592

1,457

-,140

,586

,101

,000**

,360

,012*

,149

,889

a. 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 theregression model. The explanatory power of the independent variables on the

dependent variable discretionary accruals is thus 95,2%.


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The ANOVA test is shown in Table 5.4, this table contains a variance analysis. The

variance analysis is useful for testing the entire models significance and will test its

reliability. The model is significant (Sig. 0,01).

The beta coefficient of the non-audit fee ratio (NARATIO) is 0,043 with asignificance 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


Square

Std. Error of

the Estimate

1 ,982a

0,965 0,962 1,608E9

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


Table 5.7

ANOVAb


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1 Regression

Residual

Total

5,215E21

1,888E20

5,404E21

6

73

79

8,691E20

2,587E18

336,019 ,000a

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


Table 5.8

Coefficientsa


Standard

Coefficients

Model


1 (Constant)

NONAUDIT

SIZE

CFO

LOSS

LEV

TYPE

1,613E8

1585,909

-1,409

-3,275E9

-1,389E9

1,304E9

-3,644E8

1,008E9

289,214

,043

1,472E9

4,465E8

1,022E9

6,522E8

,190

-1,120

-,056

-,075

,029

-,0134

,190

5,484

-32,917

-2,225

-3,110

1,276

-,559

,850

,000**

,000**

,029*

,003**

,206

,578

b. Dependent Variable: DISACC



Table 5.6 shows that the R square of this model is 0,965. The explanatory power of

this model is slightly higher than the model previously discussed. Table 5.7 shows the

ANOVA model which is significant at a level of 0,01.

The coefficient of the absolute value of the non-audit fee is positive (0,190) and

significant (significance 0,01). This suggest relation suggest that when non-audit

fees increase the possibility of earnings management also increases. This is consistent

empirical evidence such as the results of the article of Frankel et al. (2002).

Consistent with the results of non-audit fee ratio the relation of LOSS and SIZE are

negative and significant. In addition, the control variable CFO in this model is

significant at a level of 0,05 and there is a negative relation. This result suggest that

companies with high cash flow have increased non-audit services.


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The result of both fee metric suggest that they are positively related with discretionary

accruals, the indicator of earnings management. Although the fee metric of the non-

audit 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


Square

Std. Error of

the Estimate

1 ,982a

0,965 0,962 1,616E9

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


Table 5.10

ANOVAb


1 Regression

Residual

Total

5,213E21

1,907E20

5,404E21

6

73

79

8,688E20

2,613E18

332,502 ,000a



Table 5.11

Coefficientsa

Model


Standard

Coefficients


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1 (Constant)

AUDIT

SIZE

CFO

LOSS

LEV

TYPE

-5,833E8

-932,075

-,628

1,330E9

-7,704E81,884E9

1,054E8

8.534E8

172,999

,116

1,519E9

4,600E81,023E9

6,565E8

-,499

-,499

,023

-,042,042

,004

-,683

-5,388

-5,424

,876

-1,6751,841

,160

,496

,000**

,000**

,384

,098

,070

,873

c. Dependent Variable: DISACC



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


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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 Summary

b


Square

Std. Error of

the Estimate

1 ,976a

0,952 0,948 1,879E9

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


Table 5.13

ANOVAb


1 Regression

Residual

Total

5,146E21

2,577E20

5,404E21

6

73

79

8,567E20

3,530E18

242,982 ,000a



Table 5.14

Coefficientsa


Standard

Coefficients

Model


1 (Constant)

TOTAL

SIZE

CFO

LOSS

LEV

TYPE

-3,872E8

-275,998

-1,023

-2,087E9

-1,144E9

1,938E9

-5,321E8

9,948E8

173,577

,136

1,813E9

5,328E8

1,191E9

7,642E8

-,174

-,813

-,004

-,062

,044

-,002

-,389

-1,590

-7,522

-,115

-2,148

1,627

-,070

,698

,116

,000**

,909

,035*

,108

,945

d. Dependent Variable: DISACC




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this model is highest compared to the previous results. Again the ANOVA model is

significant at a level of 0,01 (Table 5.13).

The results of the absolute value of total fees (Table 5.14) shows that there is no

significant relation with discretionary accruals. The null hypothesis H3 can be

accepted, the significance of the model is 0,116. The results suggest that combining

the variables audit- and non-audit fees mask the effects of the different incentives.

6. Conclusion, Implications and future research


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This research investigates the relationship between auditors fees and earnings

management in Dutch listed firms. The following research question is introduced in

the introduction paragraph:

To what extent is there an association between audit fees, non-audit fees and earningsmanagement 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 Signifi cance

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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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 non-

audit 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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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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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

Formatted:Superscript

Deleted:

Deleted:


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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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