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Non-audit service and auditor independence: an examination of the Procomp effect

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Abstract

This paper examines whether non-audit service provision impairs auditor independence, and whether the degree of auditor independence in Taiwan changed in the wake of the 2004 Procomp scandal. The auditors involved in the Procomp affair were suspended from practice for 2 years and were sued, and we posit that these unprecedented sanctions and litigation affected subsequent auditor behavior. Considering the measurement errors involved in discretionary accruals, we propose an alternative analytic approach in which the dependent variable in the regression analysis is the difference between audited earnings and forecast earnings, scaled by total assets, and the primary independent variable is the non-audit fees ratio. After controlling for the effects of financial leverage, operating and market performance, industry, company size, audit firm size, management forecast error, and management attempts to manipulate earnings, regression analysis indicates that the coefficient for non-audit fees ratio is negative and significant in 2003 but not in 2004. Using non-audit fees instead of non-audit fees ratio to conduct the regression analysis yields similar results. This finding is consistent with the notion that auditors make a trade-off between gaining service fees and avoiding litigation and reputation loss. Limitations and policy implications are also offered.

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Notes

  1. See the Appendix for a description of the Procomp scandal.

  2. In an institutional situation unique to Taiwan, listed companies that have announced earnings forecast during a given year are required to announce their un-audited annual earnings by the end of January of the following year. Listed companies are required to announce their audited annual earnings by the end of April regardless of whether or not they have issued an earnings forecast.

  3. Shortly after the Procomp scandal emerged in June 2004, the FSC suspended the company’s auditors from practice for 2 years, and the Investor Protection Center filed a class action civil suit against those auditors. The Procomp scandal is not associated with provision of non-audit services to the audit client per se, but the severe and fast sanctions and legal action against auditors had never occurred in Taiwan before.

  4. According to SAS No. 39, Type I and Type II errors are the two types of decision errors that an auditor can make when deciding that sample evidence supports or does not support a test of controls or a substantive test based on a sampling procedure. These errors are sometimes referred to as alpha and beta risks. In relation to tests of controls, a type I error occurs when the assessed level of control risk based on the sample is greater than the true risk given the effectiveness of the control in practice, and a type II error occurs when the assessed level of control risk based on the sample is less than the true risk given the effectiveness of the control. In relation to substantive tests, a type I error is made when the sample supports the conclusion that the recorded account balance is materially misstated when it is not materially misstated, and a type II error is made when the sample supports the conclusion that the recorded account balance is not materially misstated when it is materially misstated. We applied the above concept in our study.

  5. The NT dollar to US dollar conversion rate used is 32.69:1. In the following, we use this conversion rate to express figures in US dollars.

  6. Although audit fees and non-audit fees are disclosed to the public, the public may not be able to discern the difference in these fees among companies. We thus use the mean of the fees (ratio) to split the sample. Companies with fees (ratio) higher than the mean are assigned 1; 0 otherwise. In the following, we use the dichotomized fee (ratio) for analysis. We also conduct a robustness check using continuous data (i.e., without dichotomization) in a subsequent section.

  7. According to regulations in Taiwan, within 4 months following the close of each fiscal year, a listed company should disclose to the public its audited financial reports, and within 1 month after the end of the first (and third) quarter of each fiscal year, it should disclose to the public its reviewed financial reports.

  8. The NT dollar to US dollar conversion rate used here is 32.69:1. In the following, we express amounts in US dollars.

  9. In Taiwan, two engagement partners must sign off on the audit report for an engagement.

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Acknowledgements

The authors would like to thank our anonymous referee, and Cheng-few Lee (the editor) for their helpful comments and suggestions. The editing assistance by Malcolm R. Mayfield is gratefully acknowledged.

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Correspondence to Rong-Ruey Duh.

Appendix

Appendix

1.1 Procomp scandal

Procomp Informatics Ltd. (Procomp), which was incorporated in Taiwan in February 1991, was a manufacturer of PC-related and compound semiconductor products. A winner of the National Prize for Small and Medium Enterprises in Taiwan, Procomp was audited by KPMG (Taiwan) prior to and subsequent to being listed on the Taiwan Stock Exchange (TSE) on December 18, 1999. On March 9, 2004, the company made an announcement that it had switched its auditor from KPMG (Taiwan) to DTTI (Taiwan). The claimed reason was that KPMG (Taiwan) had provided audit services for Procomp for five consecutive years, which would impair auditor independence. Newspapers reported that, in fact, KPMG (Taiwan) had disagreed with Procomp on the amount of allowance for doubtful accounts since 2002, although KPMG (Taiwan) had still issued an unqualified opinion. In addition, it was claimed, Procomp’s management “went opinion shopping” and selected DTTI (Taiwan) to replace KPMG (Taiwan) as the auditor for its financial statements of 2003 and the first quarter of 2004. DTTI (Taiwan) issued audit reports in 3 and 8 weeks, respectively, after accepting the engagement.Footnote 7

On June 14, 2004, Procomp filed for re-organization after failing to raise funds through issuing GDR (Global Depositary Receipts) to redeem outstanding bonds, which were due. The amount due was about USD 92 million.Footnote 8 A financial scandal broke out when it was revealed that the balance of cash and cash equivalents shown in the financial statements did not exist at all. The amounts were 162 million for the end of 2003 and 193 million for the first quarter of 2004, respectively. On the same day (i.e., June 14, 2004), its stock price closed at 26 cents, a 52% decline relative to 54 cents 1 year earlier. Trading in the shares was halted 11 days later. Tens of thousands of investors and creditors suffered huge losses. It was up to that point the biggest business scandal in Taiwan’s history. The company was de-listed from the TSE 3 months later due to insolvency.

The Financial Supervisory Commission (FSC) immediately started an investigation. According to the FSC report, Procomp inflated the company’s earnings by “making” falsified sales to paper companies in Hong Kong. Then, the company factored accounts receivables to banks in exchange for cash that was reported as cash and cash equivalent in the balance sheet, although the banks would restrict the use of cash if those accounts receivables were not collected. Therefore, the 193 million balance of cash and cash equivalents vanished. Additionally, the company did not really raise funds through the issuance of ECB in foreign countries. Instead, Procomp had its overseas companies subscribe to those bonds, convert them into the company’s stocks, and sell them on the TSE for cash, but the proceeds ultimately flowed into top management’s (the chairperson’s and CEO’s) personal pockets.

Shortly after the Procomp scandal emerged, a series of management fraud and accounting scandals were uncovered. For example, Infodisc Technology Co., Ltd, a CD and DVD manufacturer, failed to account for the whereabouts of 79 million of cash and cash equivalents. Summit Computer Technology Co., Ltd. was another case of the same nature. These companies were listed among electronics companies, as categorized by the TSE.

The FSC responded quickly by sanctioning both Procomp’s former and incumbent auditors with suspension from practice for 2 years for not following generally accepted auditing standards during the audit process.Footnote 9 The chairperson, president, CFO, and board of directors were all sued in accordance with the Securities and Exchange Law and Business Accounting Law. The chairperson was prosecuted and the prosecutor requested that she be sentenced to 20 years in jail and fined 15 million dollars. Meanwhile, the Investor Protection Center filed class action suits against the auditors, accounting firms and underwriters of the respective companies.

As of December 1, 2005, Procomp’s accounting firms had agreed to pay 1.8 million each to settle out of court. The underwriters also agreed to reimburse investors for losses of 2.4 million. Though the amount is not material relative to the losses of investors and creditors, it was unprecedented high for Taiwan at the time.

The SFC took many additional actions to mitigate the expectation gap between investors and auditors, including mandatory auditor rotation, inspection of audit working papers, amendment of the CPA Law in Taiwan to proscribe auditors from providing non-audit services that could impair independence, and asking accounting firms to purchase professional liability insurances. A series of reforms were enacted so as to deter accounting abuses and avoid more Procomp-like disasters in the future.

Procomp and similar scandals were not associated with provision of non-audit services to audit clients. However, whether the SFC’s sanctions and investors’ legal actions against auditors increase auditors’ litigation costs and hence incentives to maintain auditor independence is a critical issue, and we collectively refer to this possible effect on auditor behavior as the “Procomp effect”.

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Duh, RR., Lee, WC. & Hua, CY. Non-audit service and auditor independence: an examination of the Procomp effect. Rev Quant Finan Acc 32, 33–59 (2009). https://doi.org/10.1007/s11156-007-0080-5

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