Auditor independence and accounting conservatism. Evidence from Australia following the corporate law economic reform program

• Date: 02 March 2015
• Published date: 02 March 2015
• Pages: 80-104
• DOI: https://doi.org/10.1108/IJAIM-02-2014-0008
• Author: Michael Crockett,Muhammad Jahangir Ali
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

Auditor independence and

accounting conservatism

Evidence from Australia following the

corporate law economic reform program

Michael Crockett and Muhammad Jahangir Ali

Department of Accounting, La Trobe University, Melbourne, Australia

Abstract

Purpose – The purpose of this paper is to examine the efcacy of the current legislative provisions

that protect auditor independence in Australia. The collapses of several high-prole companies (Enron

and WorldCom in the USA, HIH insurance and OneTel in Australia) in the early 2000s has raised

questions about audit quality and independence. In response, regulators have introduced new

regulations and guidance to improve audit quality. In Australia, the Corporations Act 2001 (2001) was

amended via the Corporate Law Economic Reform Program Act 2004. This study poses the question: do

non-audit service fees inuence the level of accounting conservatism?

Design/methodology/approach – The sample used in this analysis consists of all available

Australian listed companies from the years 2006 till 2010.

Findings – Using multiple measures of accounting conservatism and the auditor-client economic

bond, our results suggest that the level of the economic bond between the auditor and the client does not

signicantly inuence the level of accounting conservatism.

Originality/value – Our results demonstrate that the combination of intrinsic market mechanisms

and regulation in Australia sufciently protect auditor independence.

Keywords Australia, Accounting conservatism, Corporate law economic reform program,

Auditor independence, Audit fees, Non-audit service fees

Paper type Research paper

1. Introduction

The purpose of our study is to examine whether auditors’ independence proxied by

non-audit service fees inuences the level of accounting conservatism in Australia. The

independence of auditors is critically important to nancial systems around the world

and has an impact on auditors’ quality. Conducting an audit of nancial statements

should provide a safeguard against manipulation and misstatement. DeAngelo (1981,

p. 186) dened audit quality as “the market-assessed joint probability that a given

auditor will both (a) discover a breach in the client’s accounting system and (b) report the

breach” (DeAngelo, 1981). Stakeholders and investors rely on auditors to provide them

with the condence to invest their funds in a company. DeAngelo (1981) also argued that

if auditors are paid an inappropriate amount of audit fees, it is likely to be considered as

a lack of independence. Consequently, the independence of auditors is fundamental to

We greatly appreciate the helpful comments and suggestions received from the anonymous

referee, Darren Henry, Seema Miglani and the participants at the British Accounting and Finance

Conference, 2013 and the Department of Accounting seminar, La Trobe University.

The current issue and full text archive of this journal is available on Emerald Insight at:

www.emeraldinsight.com/1834-7649.htm

IJAIM

23,1

80

Received 12 February 2014

Revised 26 March 2014

Accepted 12 April 2014

InternationalJournal of

Accounting& Information

Management

Vol.23 No. 1, 2015

pp.80-104

©Emerald Group Publishing Limited

1834-7649

DOI 10.1108/IJAIM-02-2014-0008

this end. Law (2010) found that auditor independence decreases when auditors provide

accounting services, internal audit or corporate nance services to the rms. Ahadiat

(2011) demonstrates that the provision of non-audit services may indeed impair

independence.

Independent auditors should ensure a higher level of accounting conservatism

(proxy for nancial reporting quality) than less independent auditors (Amir et al., 2009).

The presence of accounting conservatism in nancial statements demonstrates a higher

level of nancial reporting quality (Lim, 2011). If an auditor loses independence, the

audit quality and nancial reporting quality declines. This in turn may result in

companies collapsing, investors losing their investments and the community losing

condence in the auditing profession, which happened in the early 2000s following a

string of business collapses.

The recent collapses of several high-prole companies has raised questions about

audit quality in nancial markets (Hakim and Omri, 2010) and auditors’ independence.

In response, regulators and accounting bodies alike have introduced new regulations

and guidelines to improve audit quality. The USA experienced a string of large

corporate collapses including Enron and WorldCom amidst much doubt concerning the

independence of these company’s external auditors. These collapses had a profound

effect on the public accounting profession in the USA, as shown by the enactment of the

Sarbanes-Oxley Act (2002). This statute made numerous changes to the legislation

governing the auditor-client relationship and corporate governance. Included in the

amendments was the prohibition of incumbent auditors providing their audit clients

most non-audit services (Sarbanes-Oxley Act, 2002). Though Australia experienced its

largest corporate collapse with the demise of HIH Insurance amidst similar concerns

regarding auditor independence, its legislative response was not as rigorous as that in

the USA.

Similar to the Sarbanes-Oxley Act, 2002, Australia modied the Corporations Act

2001 (2001) due to a perceived problem with auditor independence and corporate

governance. In response to recommendations from the Ramsay Report (2001) into the

independence of Australian company auditors and the ndings of the HIH Royal

Commission (2003), the Corporate Law Economic Reform Program (Audit Reform and

Corporate Disclosure) Act 2004 (henceforth CLERP 9) was enacted. This act revised the

Corporations Act 2001 (2001) to include new requirements regarding the independence

of auditors among a number of other changes.

The specic circumstances that cause auditors to lose their independence and

therefore jeopardize audit quality have yet to be determined. Researchers have

attempted to identify the factors that have a negative inuence on auditor independence

with mixed results. The varied ndings possibly result from the use of different proxy

measures for auditor independence, inaccurate or incomplete measures for auditor

independence and different institutional settings. Consequently, further analysis of the

auditor-client relationship is required to better understand what causes audit quality to

diminish.

Recent studies analyzing non-audit service fees as a proxy of auditor independence to

determine nancial reporting quality have considered accounting conservatism and

earnings management (Frankel et al., 2002;Ashbaugh et al., 2003;Chung and Kallapur,

2003;Ruddock et al., 2004;Larcker and Richardson, 2004). These studies have delivered

varied results. The relationship between non-audit service fees and auditor

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Auditor

independence