1. College of Business Administration – Accounting Group Ronen Gal-Or Northeastern University College of Business Administration May 19, 2012 The Choice Between Audit and Consulting Services in the Post- SOX Environment 1

2. College of Business Administration – Accounting Group Research Questions  What factors influence the joint auditor/client decision to pursue an audit or consulting relationship?  What is the effect on audit efficiency and quality when auditors and their joint service clients choose consulting? 2

3. College of Business Administration – Accounting Group Setting Sarbanes Oxley Act of 2002 – Section 201 – Prohibited accounting firms from providing both audit and nine types of non-audit services (including most consulting services) to the same client KPMG, E&Y, and PWC had already spun off their consulting divisions and signed non-competition agreements. Deloitte retained its consulting division – Only Big 4 accounting firm required to make the choice between providing audit and consulting services to its joint service clients after the enactment of SOX. I examine differences in the types of auditor switches experienced by Deloitte and its Big 4 competitors. – Were Deloitte switches more likely to involve clients that were better candidates for consulting services? 3

4. College of Business Administration – Accounting Group Motivation European Commission Green Paper on Audit Policy (Oct 2010) – Proposed prohibition on jointly providing audit and consulting services. The non-competition agreements of KPMG, E&Y and PWC have expired and these Big-4 accounting firms are currently in the process of rebuilding their consulting practices. – This paper represents a baseline for future research examining current retention and switch decisions. The GAO (2003, 2008) has expressed concern about increased concentration in the audit market – “Audit market concentration may become problematic if it unduly affects audit fees or limits auditor choice by leaving a client with a very small set of auditor options, especially in the face of increasing restrictions about an auditor providing non-audit services to a client” Response to Consultation on EC Green Paper (Dec 2010) 4

5. College of Business Administration – Accounting Group Consulting Preference –The historical procurement of auditor provided consulting services –The historical procurement of auditor provided consulting services coupled with the likelihood that the client will require/desire consulting services in the future. –Free Cash Flow –Mergers and Acquisitions –New Issuances of Debt and Equity 5 Summary of Findings

6. College of Business Administration – Accounting Group Summary of Findings Loss of Audit Efficiency – Audit fees increased by a greater amount for joint service clients that discontinued the audit in order to continue the consulting relationship. No evidence of Loss in Audit Quality – Changes in Discretionary Accruals – Post-switch probability of restatements 6

7. College of Business Administration – Accounting Group Prior Literature Factors influencing auditor switches after the enactment of SOX – Influence of Andersen’s Demise on reshuffling of audit clients (Blouin et al, 2007; Kohlbeck et al, 2008; Ballas et al, 2008, Landsman et al, 2009) – Public companies increased use of lower tier auditors (Sullivan, 2006; Rama and Read, 2006; Ettredge et al, 2007; Hogan et al, 2007; Doogar et al, 2008; Krishnan et al, 2008; Landsman et al, 2009) – Other client and engagement factors influencing the decision to switch auditors after SOX (Nagy et al, 2008; Krishnan et al, 2010) Contribution… I introduce another factor influencing the types of auditor switches occurring post-SOX – Switches induced by the strategic joint auditor/client decision to continue providing consulting rather than audit services to existing clients. 7

8. College of Business Administration – Accounting Group Prior Literature Factors influencing the purchase of consulting services in an environment where audit and NAS were jointly provided (Pre-SOX) – Firth (2002), Lee (2002), Whisenant et al. (2003), Antle et al (2006) Contribution… I examine the factors influencing the choice of audit or consulting after their mandated separation (Post-SOX) 8

9. College of Business Administration – Accounting Group Hypothesis #1 Prior relationships influence future contracting (Neu, 1991, Burchell et al., 1997). The historical provision of consulting services should be positively associated with the decision to continue the consulting rather than the audit relationship. H1: Deloitte was more likely to experience auditor switches with clients that historically procured high levels of consulting services in comparison to its Big 4 competitors. 9

10. College of Business Administration – Accounting Group Hypothesis #2 10 The historical provision of consulting services COUPLED WITH future consulting requirements should be positively associated with the decision to continue the consulting rather than the audit relationship. H2: Deloitte was more likely to experience auditor switches with clients that historically procured high levels of consulting services and had increased likelihood of requiring consulting services in the future in comparison to its Big 4 competitors.

11. College of Business Administration – Accounting Group Factors Influencing Future Consulting Needs 11 1.Free Cash Flow 2.M&A Activity 3.New Debt or Equity Issues 4.Growth Opportunities

12. College of Business Administration – Accounting Group Hypotheses #3 and #4 12 The audit switch mandated by SOX when choosing consulting over audit services may lead to the selection of an inferior successor auditor in terms of quality and efficiency. H3 (H4): In comparison to joint service switchers of its Big 4 competitors, Deloitte’s joint service switchers were more likely to experience a post- switch increase in audit fees (decrease in quality).

13. College of Business Administration – Accounting Group 13 Empirical Design – H1 Deloitte_Switch i,t = α + β 1 (OtherandIT_Fees_01 i ) + Control Variables (1) Dependent Variable – Deloitte_Switch - 1 if Deloitte switcher, 0 if Non-Deloitte Big 4 switcher Independent Variables of Interest – (1) Historical Other and IT Fees ( Prediction - β 1 > 0 )

14. College of Business Administration – Accounting Group 14 Empirical Design – H2 Deloitte_Switch i,t = α + β 1 (OtherandIT_Fees_2001 i ) + β 2 (Consult_Likelihood i,t-1 ) + β 3 (OtherandIT_Fees_2001 i * Consult_Likelihood i,t-1 ) + Control Variables Model (1) Augmented where Consult_Likelihood = Four proxies capture the likelihood of future consulting requirements (1) FCF, (2) M&A, (3) New_Issue, (4) MTB Prediction - β 3 > 0

15. College of Business Administration – Accounting Group 15 Model 1 - Variables of Interest

16. College of Business Administration – Accounting Group 16 Sample Selection Compustat/Audit Analytics non-financial audit-switching firms from July 31, 2002 to 2004 (1,586 firm-year observations) Eliminate non-Big 4 switchers (815 firm-year observations) Eliminate firms with missing 2001 Audit Analytics data (655 firm- year observations) Eliminate firms that did not retain the same auditor between 2001 and the year of the switch (459 firm-year observations) Eliminate firm-year observations with missing model (1) variable data (421 firm-year observations)

17. College of Business Administration – Accounting Group 17 Testing H1

18. College of Business Administration – Accounting Group 18 Testing H2 – Free Cash Flow

19. College of Business Administration – Accounting Group 19 Testing H2 – M&A

20. College of Business Administration – Accounting Group 20 Testing H2 – New Issuances

21. College of Business Administration – Accounting Group 21 Testing H2 – Growth Opportunities

22. College of Business Administration – Accounting Group 22 Empirical Design (H3) Chg_Log_Audit_Fees i,2004-2002 or t-(t-1) = α + β 1 (OtherandIT_Fees_01 i ) + β 2 (Deloitte_Switch i,t ) + β 3 (OtherandIT_Fees_01 i * Deloitte_Switch i,t ) + Control Variables (2) Dependent Variable – Chg_Log_Audit_Fees – Change in the log of audit fees Main Independent variable of interest – Interaction between OtherandIT_Fees_01 and Deloitte_Switch Prediction - β 3 > 0

23. College of Business Administration – Accounting Group 23 Empirical Design (H4) Chg_Disc_Accr i,2004-2002 or t-(t-1) OR Post_Switch_Restate = α + β 1 (OtherandIT_Fees_01 i ) + β 2 (Deloitte_Switch i,t ) + β 3 (OtherandIT_Fees_01 i * Deloitte_Switch i,t ) + Control Variables Dependent Variables – Chg_Disc_Accr – Change in discretionary accruals. – Post_Switch_Restate - 1 if the firm restated its financial statements post-auditor switch, 0 otherwise Main Independent variable of interest – Interaction between OtherandIT_Fees_01 and Deloitte_Switch Prediction - β 3 > 0

24. College of Business Administration – Accounting Group 24

25. College of Business Administration – Accounting Group 25 Robustness Tests Are differences in the full client composition of Deloitte vs. its competitors driving the results?

26. College of Business Administration – Accounting Group 26 Robustness Tests Auditor population-adjusted variables - All results consistent with tables 4 and 5 EXCEPT: – Table 5 – Panel D (MTB): The interaction variable becomes insignificant. Replace New_Issue with NewIssue_Futureyear - Results become more significant – Table 5 – Panel C (New_Issue): P-value < 0.05 for two-tailed test

27. College of Business Administration – Accounting Group 27 Current Work Alternate Control Groups – Including Switchers and Non-switchers – Deloitte switchers pre-SOX and post-SOX Examine other factors influencing the decision to choose auditing rather than consulting – Brand Recognition – Client importance in the particular office Examine audit quality changes for Deloitte’s joint service clients that choose auditing rather than consulting – Ambiguous effect on audit quality - Reduced likelihood of impaired independence vs. competitive internal pressures to produce profitable audit engagement

28. College of Business Administration – Accounting Group 28 Future Work As KPMG, E&Y and PWC expand their consulting capabilities, examine the factors that influence their audit vs. consulting decision. Have the factors influencing the choice between audit and consulting services changed in recent years? What additional factors beyond those examined in this study influence the audit vs. consulting decision? Does increased auditor concentration that is implied by the decision to exit the market for audit services influence audit quality? What is the influence of the audit committee on the firm’s decision to continue the audit or consulting relationship?

29. College of Business Administration – Accounting Group 29 Conclusion Preference for consulting – historical procurement of auditor-provided consulting services – Future consulting requirements Unintended consequence of government intervention – Loss of audit efficiency

30. College of Business Administration – Accounting Group 30 Thank You!

32. College of Business Administration – Accounting Group 32

34. College of Business Administration – Accounting Group 34 Timeline of Spinoffs Arthur Andersen Aug 7, 2000 - Andersen Consulting Goes Public Jan 1, 2001 - Andersen Consulting Changes Name to Accenture Ernst & Young Feb 29, 2000 - Cap Gemini Agrees to Merge with E&Y Consulting PricewaterhouseCoopers Sep 11, 2000 - HP Considers Acquiring PricewaterhouseCoopers' Consulting Biz Nov 14, 2000 - HP Drops Bid for PwC Consulting Jul 30, 2002 - PwC Sold its Consulting Unit to IBM KPMG Feb 8, 2001 - KPMG Consulting Goes Public Nov 1, 2002 – KPMG Consulting Changes Name to BearingPoint BDO Seidman May 10, 2000 - BDO Spins Off Consulting Division and Renamed Firm Wavebend Solutions, LLC Grant Thornton Oct 25, 2000 - Grant Thornton Sold Consulting Practice to Hitachi Ltd.

35. College of Business Administration – Accounting Group 35 Excerpts from the CLOROX Inc. Audit Committee Report The Audit Committee reported last year that, because of a consulting engagement between the Company and Deloitte Consulting, the engagement of Deloitte & Touche LLP as the Company’s auditors would be terminated unless Deloitte & Touche LLP and Deloitte Consulting separated from each other before December 31, 2002. The proposed split between the two Deloitte organizations did not occur. The Audit Committee, therefore, dismissed Deloitte & Touche LLP on February 15, 2003, after the review of the Company’s financial statements for the quarter ended December 31, 2002 had been completed.

36. College of Business Administration – Accounting Group 36 Excerpts from the AutoNation Inc. 8K Effective as of May 6, 2003, AutoNation, Inc. ("AutoNation") appointed KPMG LLP ("KPMG") as its new independent public accountant. Effective as of May 5, 2003, AutoNation dismissed Deloitte & Touche LLP ("D&T") as its independent public accountant. The change was made following the recent announcement by D&T that it had ended efforts to separate Deloitte Consulting, which provides certain non-audit consulting services to the Company that will become prohibited services for an audit firm to provide to its audit clients under the Sarbanes-Oxley Act of 2002 and the rules promulgated thereunder.

37. College of Business Administration – Accounting Group 37 Alternate Empirical Design (H1 & H2) Switch i,t = α + β 1 (Deloitte i ) + β 2 (OtherandIT_Fees_01 i ) + β 3 (Deloitte i *OtherandIT_Fees_01 i ) + Control Variables Dependent Variable – Switch - 1 if Big 4 switcher, 0 if Big 4 non-switcher (same firm from 2001 – 2004) – Deloitte – 1 if Deloitte switcher or remained with Deloitte from 2001-2004, 0 if Non-Deloitte switcher or remained with Non-Deloitte firm from 2001-2004 Independent Variables of Interest – (1) Historical Other and IT Fees ( Prediction - β 3 > 0 ) – Results Consistent

38. College of Business Administration – Accounting Group 38 Alternate Empirical Design (H3) Switch i,t = α + β 1 (Deloitte i ) + β 2 (OtherandIT_Fees_01 i ) + β 3 (Consult_Likelihood i ) + β 4 (Deloitte i *OtherandIT_Fees_01 i *Consult_Likelihood i )+ Control Variables Dependent Variable – Consult_Likelihood FCF (MTB) – If switcher, then FCF (MTB) = Average of Current and prior three year FCF (MTB) before auditor switch. If non-switcher, then FCF (MTB) = Average of FCF (MTB) from 2001-2004. M&A (New_Issues) – If switcher, then M&A (New_Issues) = 1 if client had M&A (New Issue) activity in the year of or the year prior to the switch, 0 otherwise. If non-switcher, then M&A (New_Issues) = 1 if client had M&A (New Issue) activity from 2001-2004, 0 otherwise. Independent Variable of Interest – Prediction - β 4 > 0 – VIF > 10 in some cases, Results generally inconsistent, Three way interaction difficult to interpret.

39. College of Business Administration – Accounting Group 39 Alternate Empirical Design (H4) Chg_Log_Audit_Fees i,2004-2002 = α + β 1 (OtherandIT_Fees_01 i ) + β 2 (Deloitte i ) + β 3 (Switch i ) + β 4 (OtherandIT_Fees_01 i *Deloitte i *Switch i ) + Control Variables Independent Variable of Interest – Prediction - β 4 > 0 VIF > 10 Results insignificant – may be influenced by DeAngelo (1981) low-balling phenomenon. Three way interaction difficult to interpret.

40. College of Business Administration – Accounting Group 40 Economic Significance of Fee Increase Table 7 – Panel A – Column 1 e (β2 + β3(Median(Deloitte(Log_Fees_01)) = e (-0.558 + 0.054(10.943)) = 1.03347 – The two year change (increase) in audit fees (2002 to 2004) is 3.35% larger for Deloitte joint service switchers compared to Non-Deloitte joint service switchers.

41. College of Business Administration – Accounting Group 41 Economic Significance of Fee Increase Table 7 – Panel A – Column 3 e (β2 + β3(Median(Deloitte(Dummy_Fees_01)) = e (-0.584 + 0.649(1)) = 1.0672 – The two year change (increase) in audit fees (2002 to 2004) is 6.72% larger for Deloitte joint service switchers compared to Non-Deloitte joint service switchers.

42. College of Business Administration – Accounting Group 42 Economic Significance of Fee Increase Table 7 – Panel B – Column 1 e (β2 + β3(Median(Deloitte(Log_Fees_01)) = e (-0.349 + 0.036(10.955)) = 1.046425 – The one year change (increase) in audit fees (t-1 to t) is 4.64% larger for Deloitte joint service switchers compared to Non-Deloitte joint service switchers.

43. College of Business Administration – Accounting Group 43 Economic Significance of Fee Increase Table 7 – Panel B – Column 3 e (β2 + β3(Median(Deloitte(Dummy_Fees_01)) = e (-0.401 + 0.475(1)) = 1.0768 – The one year change (increase) in audit fees (t-1 to t) is 7.68% larger for Deloitte joint service switchers compared to Non-Deloitte joint service switchers.