2012 - Knechel - Non Audit Services and Knowledge Spillovers Evidence From New Zealand PDF

Journal of Business Finance & Accounting, 39(1) & (2), 60–81, January/March 2012, 0306-686X
doi: 10.1111/j.1468-5957.2011.02268.x
Non-Audit Services and Knowledge

Spillovers: Evidence from New Zealand
W. ROBERT KNECHEL, DIVESH S. SHARMA AND VINEETA D. SHARMA∗
Abstract: New Zealand provides a natural laboratory to test whether knowledge spillovers arise
from auditor-provided non-audit services. Unlike prior research, we do not assume constant
audit quality but first test whether audit quality varies with auditor-provided non-audit services
and audit efficiency. Results show that higher non-audit fees paid to the auditor in conjunction
with shorter audit lag does not reduce the quality of the audit. Results reveal a negative
association between non-audit fees and audit lag, thus suggesting the presence of knowledge
spillovers. However, the knowledge spillover effect is limited to the city office providing both
the audit and non-audit services.
Keywords: audit, audit quality, non-audit, fee, knowledge spillover
1. INTRODUCTION
Regulators and the corporate world have long debated the merits and costs of auditor
provided non-audit services. Anecdotal evidence supports the regulatory argument
that lucrative amounts of non-audit fees paid to the auditor may have been a factor
in some of the audit failures at the turn of the century such as Enron (US Senate,
2002). The US Congress passed the Sarbanes-Oxley Act of 2002 (SOX) in an attempt
to curb such behavior and restore confidence in the capital markets. One of the major
regulations of SOX was to ban the auditor from providing certain non-audit services to
an audit client. When debates about auditor-provided non-audit services were initiated,
Steven Wallman, former Commissioner of the Securities and Exchange Commission
(SEC), argued against the proposal because prohibiting auditors from providing non-
audit services ‘denies the benefits to the audit function of learning more about the
audit client and its business’ (Wallman, 1996 p. 92). The accounting profession has
strongly opposed such a ban since it was initially proposed by the SEC in 2000. Barry
Melancon, President of the AICPA, argued:
There will be a loss of synergies that exist when a firm provides a broad array of audit
and nonaudit services to its clients . . . In addition, the loss of nonaudit service lines
∗ The first author is from the University of Florida. The second and third authors are from Kennesaw
State University. They thank Andrew Stark (editor) and the anonymous referee for providing constructive
comments and suggestions. (Paper received November 2010, revised version accepted October 2011)
Address for correspondence: Divesh S. Sharma, School of Accountancy, Coles College of Business,
Kennesaw State University, 1000 Chastain Rd, MD 0402, Kennesaw, GA 30144, USA.
e-mail: dsharma2@kennesaw.edu

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NON-AUDIT SERVICES AND KNOWLEDGE SPILLOVERS 61
will reduce the scope of knowledge available at the accounting firms (Melancon, 2000,
p. 26).
The profession’s objection suggests that banning auditor-provided non-audit services

leads to a loss of audit effectiveness and efficiency.
Prior large sample empirical evidence has generally supported the argument that
auditor-provided non-audit services do not diminish the quality of the audit (e.g.,
Ashbaugh et al., 2003; DeFond et al., 2002; Kinney et al., 2004; and Raghunandan et al.,
2003). Knechel and Sharma (2010) add to this literature by examining the association
between auditor-provided non-audit services and both the effectiveness and efficiency
of audits. They argue that knowledge spillovers from non-audit services may result in
a more efficient audit but only as long as the services do not undermine the quality of
the audit.
In this study, we examine whether auditor-provided non-audit services generate
knowledge spillovers using a sample of audits from New Zealand. We believe New
Zealand provides an interesting context to study the merits and costs of the joint supply
of audit and non-audit services. In 2004, the New Zealand Securities Commission
(NZSEC, 2004) came to the conclusion that a ban on auditor-provided non-audit
services was not warranted after undertaking extensive consultations with many
stakeholders.1 At the same time, NZSEC (2004) acknowledged that:
audit firms should not undertake any work that could influence (or be seen to
influence) their ability to produce impartial and independent audit reports.
The effectiveness of NZSEC’s approach may be limited, however, because there is

no audit oversight body in New Zealand that issues independence rules such as the
PCAOB in the US or the FRC in Australia and the UK. As a result, the ‘rules’ in New
Zealand may be perceived as being more lax than in other developed countries since
the profession has not placed a ban on non-audit services despite NZSEC’s expressed
concerns. Self-regulation has also allowed the major audit firms to oppose the idea
of an independent audit regulatory body in spite of recent evidence of audit failures
(Chaplin, 2010).
Overall, New Zealand’s distinct audit and institutional environment provides a
natural setting to test issues related to non-audit services. In this self regulated
environment, clients are likely to purchase non-audit services when it is economical
to do so, unlike in other settings where such services are restricted by law (e.g., US). If
there are potential knowledge spillovers between audit and non-audit services then it
should be evident in a setting such as New Zealand. Further, NZSEC does not impose
a filing deadline as is done by regulators in the US (60 days for accelerated filers), UK
(180 days) and Australia (90 days). Reporting deadlines are likely to have an effect
on our measure of audit efficiency (audit lag) as auditors schedule and work towards
completing the audit in a timely manner. Without a mandated reporting deadline,
the audit lag is more likely to reflect the relative incentives and expectations facing
clients and auditors. These conditions allow for better empirical tests because the
timeliness of the audit is not affected by mandatory reporting deadlines. In such an
1 Participants in this process included audit firm personnel, fund managers, directors and senior executives
from listed, unlisted and government organizations, the New Zealand Stock Exchange, the Institute of
Chartered Accountants, and the Institute of Directors. A total of 169 written responses were received
including nine focus group meetings.

C 2012 Blackwell Publishing Ltd
62 KNECHEL, SHARMA AND SHARMA
environment, the auditor is likely to develop audit strategies that provide the desired
level of audit effectiveness while extracting efficiencies from the joint provision of non-
audit services.
Previous research in New Zealand has yielded inconsistent results on the costs
and benefits of auditor-provided non-audit services. Hay et al. (2006) show that non-
audit fees are not related to going concern opinions. Using a set of simultaneous fee
equations, Hay et al. (2006) report there are no knowledge spillovers between audit
and non-audit services in New Zealand.2 Further, Cahan et al. (2008) provide mixed
evidence on the association between non-audit fees and earnings management. Using
more recent data, Sharma et al. (2011) report that non-audit fees at the city office
level are adversely associated with earnings management and such an effect is more
pronounced for firms with weaker audit committees.
This study extends our understanding of the link between audit efficiency and non-
audit services in two important and novel ways by investigating: (1) whether joint
provision provides greater knowledge spillovers at the city office level or the national
level and (2) the degree of non-audit services that potentially triggers knowledge
spillovers. The first point is of interest because knowledge spillovers are only likely to
occur when auditors and consultants work in close enough proximity (i.e., a common
office) so as to actually share experiences and information. The second point raises
the issue of whether the benefits of non-audit services on the audit manifest from the
first dollar of non-audit services or after the auditor has provided a minimum amount
of non-audit service, and whether benefits of knowledge spillover continue to accrue
indefinitely with increasing provision of non-audit services.
In this study, we proxy audit efficiency using audit lag, i.e., the difference in days
between the balance sheet date and the audit report signature date. We estimate
an audit lag model based on 230 firm-years for fiscal 2004 and 2005 and find, after
controlling for various client and audit variables including the quality of the audit and
audit fees, that audit lag is decreasing in higher levels of non-audit fees. We find similar
results when we use the proportion of non-audit fees to total fees, high/low non-audit
fees, and various alternative measures of non-audit services. Importantly, we find that
the benefits of joint supply do not come at the loss of audit quality. The evidence
is consistent with Knechel and Sharma (2010) in that improved audit efficiency is
associated with the joint supply of audit and non-audit services. Interestingly, a new
finding is that the benefits of joint supply occur at the city office level and not at the
national office which is consistent with the view that information sharing and synergies
are more likely at the office providing both the audit and non-audit services than
between offices across the country. A second novel finding is that the benefits of the
joint supply of audit and non-audit services only begins to accrue once the level of
non-audit services approximately reaches the median level of all non-audit services;
at extreme levels of non-audit service provision there is less benefit from knowledge
spillovers. This finding suggests the benefits of joint supply accrue in a non-linear
fashion.
The remainder of the paper progresses as follows. In the next section we review the
literature on knowledge spillovers and develop our hypotheses. Section 3 describes
2 Knechel and Sharma (2010) contend that using audit fees as a proxy for audit production to test
knowledge spillover is subject to several assumptions that may not be valid. Furthermore, Larcker and
Rusticus (2010) argue that the use of simultaneous equations in accounting and audit research suffer
significant shortcomings that biases the results.

the research method. Section 4 presents our results with the discussion in the final
section.
2. LITERATURE REVIEW AND HYPOTHESES

The literature remains inconsistent on whether the joint provision of audit and
non-audit services enhances the efficiency of the audit. There are two schools of
thought in this literature. Initial studies used audit and non-audit fees to determine
if there was evidence of knowledge spillovers. The underlying argument was that if a
client purchased both audit and non-audit services from the auditor, then assuming
the auditor passed cost efficiencies to the client, the client would then purchase
more audit services from the auditor (Simunic, 1980 and 1984).3 Simunic’s (1984)
results show that clients who purchase both audit and non-audit services from an
incumbent auditor pay significantly higher audit fees than those who do not purchase
both services from the incumbent suggesting the presence of knowledge spillovers.
Palmrose (1986) contradicts Simunic (1984) by observing a positive association
between audit and non-audit fees for clients purchasing non-audit services from a non-
incumbent also.
Abdel-khalik (1990, p. 296) argues that any efficiencies flowing from knowledge
spillovers should result in lower costs if a single auditor supplies both services than if
the two services are sourced from two different audit firms. Firth (1997a) concurs with
the nature of this association. Like Palmrose (1986), Abdel-khalik (1990) finds audit
fees do not differ significantly between clients purchasing audit services only and those
purchasing both audit and non-audit services. Firth (1997a) finds that audit and non-
audit fees are positively related and contends that there is no apparent reason why
this is so. His subsequent study (Firth, 2002) illustrates that the positive association
between audit and non-audit fees observed in the UK is primarily driven by company
specific events (e.g., mergers and acquisitions, restructuring, new finance, change in
management) that consequently results in the demand for more consultancy and audit
services. However, Clatworthy et al. (2002) observe a negative association between
audit and non-audit fees in the UK National Health Service sector and conclude
that this evidence is consistent with knowledge spillovers. More recent research
examining knowledge spillovers using a simultaneous system of fee equations also
provide inconsistent results. While Whisenant et al. (2003) and Hay et al. (2006) report
there are no knowledge spillovers, Antle et al. (2006) show the presence of knowledge
spillovers between audit and non-audit services.4
Other studies use more direct proxies for audit production to test the presence of
knowledge spillovers, i.e., audit hours or audit lag. Davis et al. (1993) and O’Keefe et al.
(1994) use audit hours regressed on various non-audit fees. Both studies fail to find
a negative association (evidence of knowledge spillover) between non-audit fees and
audit hours. Audit hours are proprietary data and the relatively small sample size could
explain their results. Using data envelope analysis (DEA), Knechel et al. (2009) do not
3 This conclusion is critically dependent on the assumption that the market for audit services is competitive.
Otherwise, an increase in audit fees could simply reflect rent seeking behavior by the auditor rather than
the ‘consumption’ of more auditing.
4 However, Larcker and Rusticus (2010) criticize the use of simultaneous equations in accounting research
because such models lack sufficient theoretical foundations and the arbitrary choice of variables tends to
bias the results.

find an association between engagement efficiency and the provision of management

advisory services; however, Gaeremynck et al. (2010) find that consulting services are
positively associated with efficiency for a sample of Belgium audits. Knechel and Payne
(2001) use data from an international accounting firm to examine if the provision
of tax or management advisory services (MAS) by the incumbent auditor is related to
audit lag . They posit that audit lag is a function of audit production and is a reasonable
proxy to detect evidence of knowledge spillovers. If there is evidence of knowledge
spillover, then Knechel and Payne (2001) expect a negative coefficient on the MAS
variables. They find that the joint provision of MAS reduces audit lag but the joint
provision of tax services increases audit lag.
Prior research on knowledge spillovers assumes that audit quality is constant but
few studies test the validity of this assumption. As a result, Knechel and Sharma (2010)
design their tests so that both audit quality and audit efficiency are considered. They
find that auditor-provided non-audit services do not compromise the quality of the
audit but enhances the efficiency of the audit (measured as audit report lag). In
addition, the evidence in Knechel and Sharma (2010) suggests that the SOX ban on
auditor-provided non-audit services diminished these efficiencies. Their results imply
that the SOX ban had the unintended effect of reducing audit efficiency at a time
when the SEC imposed rules for timelier filing of the financial statements.
Regarding audit quality, clients that pay significantly higher non-audit fees may be
economically bonded to the auditor and thus are more likely to receive the auditor’s
support for client-preferred financial reporting. Research evidence, however, is mixed
with some reporting evidence consistent with reduced auditor independence (e.g.,
Ferguson et al., 2004; Firth, 2002; Frankel et al., 2002; Gore et al., 2001; and Sharma
and Sidhu, 2001) while others find no significant evidence (e.g., Ashbaugh et al., 2003;
Craswell et al., 2002; DeFond et al., 2002; Ireland 2003; Kinney et al., 2004; Lennox,
1999; and Raghunandan et al., 2003). Clients that receive preferential treatment from
the auditor because they pay high non-audit fees could exhibit shorter audit lag as
the auditor decreases audit effort and quality. On the other hand, the joint provision
of audit and non-audit services may allow the auditor to quickly learn more about
such clients, thus increasing the opportunities for more timely detection of financial
misreporting. Given the inconsistent research evidence that non-audit services may or
may not undermine audit quality, we state our first hypothesis as follows:
H1 : Ceteris paribus, there is no association between auditor provided non-audit services

and audit quality when audit lag is short.
Turning to audit efficiency, Knechel and Sharma (2010) provide a detailed discus-
sion on how auditor provided non-audit services may lead to knowledge spillovers.
They posit that knowledge about a client, including its operating environment and
business processes, is an important common factor in achieving efficiencies in the
provision of audit and non-audit services (Carlton and Perloff, 2005). Such knowledge
may be enriched when the audit firm provides both audit and non-audit services.
Consequently, there can be a reduction in transaction costs and production factors
such as audit staff allocation, start-up time and learning effects, resulting in more
efficient audits. Drawing on Knechel and Sharma (2010), as well as the balance of
prior literature, we state our second hypothesis as follows:

H2 : Ceteris paribus, there is a negative association between auditor-provided non-audit

services and audit report lag consistent with improved efficiency in the audit.
A related question that has not been well examined in the existing literature is
how knowledge spillovers would actually occur when an auditor provides non-audit
services to a client. Some have argued that the size of accounting firms and the relative
separation of the consulting and audit staff (e.g., Chinese Walls) would make it difficult
for experience and knowledge to be shared across the firm (e.g., Whisenant et al.,
2003). Others argue that ‘Chinese Walls’ are paper thin and in many instances have
been breached (e.g., Rowan, 1987; and Gosling, 1999). Donohoe and Knechel (2010)
argue that, at least in the case of tax services, such sharing would naturally occur in
industries where an auditor is a specialist because the specialized knowledge bases and
training would be available to both the audit team and the tax staff servicing a client. In
New Zealand, the audit profession is self-regulated and audit firms appear to separate
the functions of audit and non-audit services, so the likelihood of cross-transfers of
knowledge or resources between the audit and non-audit functions may be reduced.
However, New Zealand is also a relatively small audit market, so to the extent such
transfers can occur, they are most likely to be observed in such a market. Ultimately,
the ability to share knowledge and experience between auditors and consultants will
somewhat depend on the proximity of the providers of different services. This suggests
that knowledge spillovers are more likely at the office level than the national level of
an audit firm, leading to our third hypothesis:
H3 : Knowledge spillovers between non-audit and audit staff are most likely to occur
within individual offices than across offices in the national practice of the firm.
In addition to examining the preceding hypotheses, we extend the literature by

raising an important empirical question regarding how knowledge spillovers manifest
through joint provision. Prior research assumes a linear knowledge spillover effect
that accrues from the first dollar of non-audit services. We posit that even when
knowledge spillovers may occur, it is not clear if there is a minimum level of non-
audit services that trigger shared knowledge, i.e., are knowledge spillovers a de minimus
phenomenon where a small amount of non-audit services can benefit the audit or is
there a maximum benefit that can accrue from knowledge spillovers? We examine this
question by considering whether the extent of knowledge spillovers is influenced by
the relative magnitude of the non-audit services provided to a client.
3. METHOD
(i) Sample
Our sample relates to fiscal years 2004 and 2005. This period is after SOX was enacted
in the US, and overlaps the period when NZSEC carried out its consultation on non-
audit services provided to audit clients. Therefore, our data provides potential insight
to the circumstances underlying the profession’s argument against any ban or limit
on auditor-provided non-audit services in New Zealand. Consideration of a post-SOX
effect is important because we minimize any turmoil in the New Zealand market and

actions taken by auditors in response to their international counterparts in the US.5

Our sample size is 230 firm-years and is derived as follows: The initial sample comprises
282 firm-years of New Zealand listed firms that are not foreign owned and trade on
the main board of the New Zealand Stock Exchange. We eliminate: (i) 16 and 10 firm-
years from the finance and utility industries, respectively, (ii) eight firm-years because
of dual listing, and (iii) 18 firm-years because of minimum data requirements (n = 5
per industry) to estimate discretionary accruals (our measure of audit quality).
(ii) Empirical Model
(a) Test of H1 : Audit Quality

We first test whether audit lag in conjunction with non-audit fees is related to audit
quality. An examination of audit efficiency is only meaningful after considering its
effect on audit quality because shorter audit lag could manifest as lower audit quality.
To test H1 , we regress the absolute value of discretionary accruals (ABSDACC) on high
non-audit fees conditional on short audit lag (SHORTLAG∗ HIGHNAS) as specified
in equation (1). We conduct a joint test of the coefficient on SHORTLAG and
SHORTLAG∗ HIGHNAS to test if clients with short audit lag (audit lag less than
or equal to the median) and high non-audit fees (non-audit fees greater than the
median) have lower audit quality. If audit quality is low for such clients, then any
efficiency in the audit process may simply come from reduced audit effort. The control
variables in equation (1) have been identified from prior research (e.g., Frankel et al.,
2002; Kinney et al., 2004; and Knechel and Sharma, 2010).6
ABSDACC = α + β1 HIGHNAS + β2 SHORTLAG + β3 HIGHNAS∗ SHORTLAG
+ β4 LN TA + β5 LEV + β6 LOSS + β7 OCF TA + β8 MKTBOOK
+ β9 ACQ FIN + β10 SQSUB + β11 LITI + β12 BIG4 + β13 LN AFEE
+ β14 YEAR + εi (1)
where:
ABSDACC Absolute value of discretionary accruals estimated

from the performance-adjusted modified Jones model
(Kothari et al. 2005).
HIGHNAS 1 if non-audit fees greater than the median, 0 otherwise.
SHORTLAG 1 if audit lag is less than or equal to the median, 0
otherwise.
HIGHNAS∗ SHORTLAG Interaction between HIGHNAS and SHORTLAG.
LN TA Natural logarithm of total assets.
LEV Total liabilities to total assets.
5 For example, the demise of Arthur Andersen also resulted in the Big 5 becoming the Big 4 in
New Zealand. We assume that the restructuring in the audit market at that time (2002) had settled by
2004.
6 For brevity and because this is not our main test, we do not discuss the control variables and their
directional association with the dependent variable, ABSDACC, but refer the reader to the cited literature.

LOSS 1 if a firm reports negative net income, 0 otherwise.

OCF TA Operating cash flow to average total assets.
MKTBOOK Market capitalization to book value of total assets.
ACQ FIN 1 if a firm is engaged in an acquisition or merger or
issues new debt or equity capital, 0 otherwise.
SQSUB Square-root of the number of subsidiaries.
LITI 1 if a firm operates in a risky industry, 0 otherwise.
BIG4 1 if the audit firm is a BIG4, 0 otherwise.
LN AFEE Natural logarithm of audit fees.
YEAR 1 if fiscal year is 2004, 0 otherwise.
(b) Test of H2 : Audit Efficiency

We test H2 by regressing audit lag on a number of control variables and our
experimental variable, non-audit fees. Audit lag as an audit effort or efficiency variable
is consistent with the notion of knowledge spillovers (Knechel and Payne, 2001; Payne
and Jensen, 2002; and Knechel and Sharma, 2010). These researchers contend that
the publicly available audit lag measure assumes that the time taken to complete
the audit is a proxy for audit effort. Since audit lag could be affected by client risk
factors that cause an auditor to expend greater effort on an audit, we control for such
effects through the inclusion of client (size, growth, complexity, financial health, risk
of misreporting, litigation risk, governance, ownership) and auditor factors (audit firm
size, audit fees, busy audit season). We posit that after controlling for such effects,
the association between audit lag and non-audit services would be negative if joint
provision generates audit efficiency.
We identify the auditor’s signature date from the audit report contained in the
annual report to determine the time it takes to complete the audit from year end.
Our regression model includes control variables used in prior audit lag research (e.g.,
Ashton et al., 1987 and 1989; Bamber et al., 1993; Knechel and Payne, 2001; and
Knechel and Sharma, 2010), and variables that are potentially correlated with non-
audit fees to control for any spurious effects on audit lag. The NASFEE variable in
equation (2) is measured in three ways: (i) the natural logarithm of total non-audit
fees paid by a client to its auditor (LN NASFEE), (ii) ratio of non-audit fees to total
fees (FEERATIO), and (iii) high versus low non-audit fees where HIGHNAS equals 1
if non-audit fees is greater than the median, and 0 otherwise. We focus on these three
measures because regulators are usually concerned that the amount of non-audit fees
and higher relative amounts of non-audit fees to total fees may impair the auditor’s
independence (Frankel et al., 2002; DeFond et al., 2002; and Kinney et al., 2004). Our
empirical model is specified as follows:
LN AULAG = α + β1 NASFEE + β2 LN TA + β3 LEV + β4 LIQ + β5 LOSS

+ β6 OCF TA + β7 MKTBOOK + β8 ACQ FIN + β9 SQSUB
+ β10 XITEM + β11 FYE BUSY + β12 LITI + β13 RISK + β14 BIG4
+ β15 LN AFEE + β16 GOV + β17 INSIDE + β18 YEAR + εi (2)

where:
LN AULAG Natural logarithm of audit lag where audit lag is measured as the
number of days between the fiscal year-end date and audit report
date.
NASFEE Specific non-audit fee metric: LN NASFEE, FEERATIO, HIGHNAS.
LN TA Natural logarithm of total assets.
LEV Total liabilities to total assets.
LIQ Current assets to current liabilities.
LOSS 1 if a firm reports negative net income, 0 otherwise.
OCF TA Operating cash flow to average total assets.
MKTBOOK Market capitalization to book value of total assets.
ACQ FIN 1 if a firm is engaged in an acquisition or merger or issues new debt
or equity capital, 0 otherwise.
SQSUB Square-root of the number of subsidiaries.
XITEM 1 if a firm reports extraordinary items, 0 otherwise.
FYE BUSY 1 if a firm’s fiscal year ends between March and September, 0
otherwise.
LITI 1 if a firm operates in a risky industry, 0 otherwise.
RISK Risk of financial misreporting proxied by the absolute value of
discretionary accruals estimated from the performance-adjusted
modified Jones model (Kothari et al., 2005).
BIG4 1 if the audit firm is a BIG4, 0 otherwise.
LN AFEE Natural logarithm of audit fees.
GOV Governance index score derived based on three board and six audit
committee characteristics as described below in the text.
INSIDE Percentage of common shares owned by insiders.
YEAR 1 if fiscal year is 2004, 0 otherwise.
(c) Test of H3 : Office versus National Level Knowledge Spillovers

To test H3 , we derive city level (NAS CITY) and national level (NAS NAT) non-audit
fees paid by an audit client relative to total fees paid by other clients of the auditor
at the city office and national office levels, respectively. Our office and national level
fee estimates are similar to measures developed by Reynolds and Francis (2000) and
Chung and Kallapur (2003).7 To determine if knowledge spillovers occur at the city or
7 Reynolds and Francis (2000) and Chung and Kallapur (2003) use city office fee metrics to test for the
effects of economic bonding. Such metrics can also be used to test for knowledge spillovers at the city

national office levels, we estimate equation (2) by regressing LN AULAG on NAS NAT
or NAS CITY for a sample of firms whose auditor has offices in at least two cities. This
is an important criteria because knowledge spillover at the city level would be difficult
to isolate from the national level if an auditor only has one office.8 The sample size for
this test is 194.
(iii) Control Variables

We include the natural logarithm of total assets, LN TA, because prior studies show
larger companies have an inverse association with audit lag (Ashton et al., 1989;
and Bamber et al., 1993). LEV, LOSS, OCF TA and LIQ are included because these
represent various dimensions of financial risk and risk of misreporting or accounting
problems that affect audit lag (Knechel and Payne, 2001; and Knechel and Sharma,
2010). In addition, these financial risk variables are related to the risk of internal
control failures (Ashbaugh-Skaife et al., 2007; Doyle et al., 2007; and Naiker and
Sharma, 2009) that potentially can affect audit lag.9 We include MKTBOOK to
capture growth opportunities because firms with high growth have a greater risk of
financial misreporting, internal controls breaking down and thus the likelihood of
accounting errors, and longer audit lag (Knechel and Sharma, 2010). Prior going
concern research also suggests that the preceding financial variables are determinants
of potential going concern problems (e.g., DeFond et al., 2002; and Hay et al., 2006)
which have implications for audit lag (e.g., Ashton et al., 1987; and Bamber et al.,
1993). We include ACQ FIN since companies engaging in an acquisition/merger or
raising new capital may have longer audit lag because of related due diligence work
(Knechel and Sharma, 2010). Finally, we include SQSUB because the complexity of
the firm may increase the likelihood of internal control weaknesses (Ashbaugh-Skaife
et al., 2007; Doyle et al., 2007; and Naiker and Sharma, 2009) and delay the audit
(Ashton et al., 1987).
Prior research shows that the significant uncertainty about extraordinary items
(XITEMS) leads to greater audit effort and deliberations between auditors and
management (Ashton et al., 1989; and Bamber et al., 1993) which could increase audit
lag. FYE BUSY represents the busy audit season. Knechel and Payne (2001) report
that companies with fiscal year-end falling during the peak audit period experience
longer audit lag. To control for litigation risk, we define LITI to represent industries
with high litigation risk. Litigation risk may have the effect of increasing audit lag
due to heightened risk of financial misreporting and internal control failures (Frankel
et al., 2002; Doyle et al., 2007; and Naiker and Sharma, 2009).10 In our model, we also
control for the risk (RISK) of financial misreporting and audit quality directly. RISK is
office level because a client that purchases relatively more non-audit services from the auditor could create
opportunities for knowledge spillover to occur at the office that actually controls and performs the audit.
The prior literature makes similar propositions at the firm level (e.g., Simunic, 1980; O’Keefe et al., 1994;
Knechel and Payne, 2001; Donohoe and Knechel, 2009; Knechel et al., 2009; and Knechel and Sharma,
2010).
8 We are grateful to the anonymous referee for this suggestion.
9 The quality of internal control at a client can have an effect on how much interim work an auditor
will perform since much of that work concentrates on testing internal controls over financial reporting.
Consequently, audit report lag may be longer in a client with weak internal control because more substantive
testing will probably be performed after year end.
10 To determine an industry as risky in New Zealand, we identify the industry from the SIC codes used by
Frankel et al. (2002) and compare that to industry descriptions of the NZX. Accordingly, Food, Intermediate

the absolute value of discretionary accruals estimated from the performance-adjusted

modified Jones model (Kothari et al., 2005). We include an indicator for BIG4 because
larger audit firms presumably provide higher audit quality (Simunic, 1984). We control
for audit effort using the natural logarithm of audit fees (LN AFEE) because Knechel
and Sharma (2010) show that clients paying higher audit fees experience longer
audit lag.11
We also include a measure of a firm’s overall governance since the strength of a
client’s corporate governance at the board of director and audit committee levels can
influence the risk of financial misreporting (e.g., Beasley, 1996; Klein, 2002; Abbott
et al., 2004; and Sharma, 2004), the performance of the audit (e.g., Carcello et al.,
2002; and Sharma et al., 2008) and purchase of non-audit services (e.g., Causholli
et al., 2010). This body of literature suggests that stronger governance reduces the
risk of financial misreporting and extent of audit testing. To achieve a parsimonious
empirical model, we derive a governance index score (GOV) by first assigning a value
of 1 if a firm meets each of the three board of director and six audit committee
attributes that increase governance strength according to the NZSEC (2004) and
extant literature. Consistent with Causholli et al. (2010), we then sum the scores across
these nine attributes and use it as the GOV variable. The three board attributes scored
as 1 are: exceeding the median number of board meetings, exceeding the median
percentage of outside directors on the board, and the CEO is not the chairman
of the board. The six audit committee attributes scored as 1 are: exceeding the
median number of audit committee meetings, exceeding the median percentage of
independent directors on the audit committee, all audit committee members are non
executive directors, the chair of the audit committee is an independent director, there
is at least one financial expert on the audit committee and the committee has at least
three members.12
Finally, we include ownership by insiders (INSIDE) as a control variable because
prior research suggests inside ownership can either increase or decrease agency costs
such as the risk of financial misreporting and affect the quality of the audit (e.g.,
Prakash and Venable, 1993; Firth, 1997b; Sharma, 2004; and Sharma et al., 2009 and
2011). INSIDE is the cumulative percentage common stock owned by executives.13
4. RESULTS
(i) Descriptive Statistics

We provide descriptive statistics in Table 1. The average audit lag is about 60 days
(median 55 days). The average (median) fees paid to the auditor are approxi-
mately $185,400 ($66,500) and $101,400 ($22,000) for audit and non-audit services,
and Durables, Consumer, Media and Communication, Health Services, and Bio Technology industries are
considered to pose greater litigation risk in New Zealand.
11 Several of our control variables also control for potential spurious effects they may have on audit lag
through non-audit fees. These variables include LN TA, LEV, LIQ, LOSS, MKTBOOK, ACQ FIN, OCF TA
and SQSUB (Prakash and Venable, 1993; Firth, 1997b; Frankel et al., 2002; and Whisenant et al., 2003).
12 When we include the three board and six audit committee variables separately, we find that board
meetings, audit committee meetings and percentage outside directors on the board reduce audit lag while
the CEO also serving as the chair of the board increases audit lag.
13 If we include institutional ownership as an additional control variable, we find that it is not significant
and does not affect our test results.

Table 1
Descriptive Statistics (N = 230)
Variables a Mean SD 25 th Percentile 50 th Percentile 75 th Percentile
AULAG (days) 60.32 21.53 48.00 55.00 70.00

NASFEE ($000) 101.40 239.07 1.00 21.72 92.50
AFEE ($000) 185.40 387.97 33.00 66.50 154.00
TA ($m) 471.87 1,916.70 16.81 76.82 259.95
LEV 0.55 1.64 0.23 0.41 0.59
LIQ 3.42 10.84 0.95 1.54 2.76
LOSS 0.24 0.43 0.00 0.00 0.00
OCF TA 0.00 0.15 0.00 0.05 0.13
MKTBOOK 4.09 15.01 0.88 1.64 3.68
ACQ FIN 0.20 0.39 0.00 0.00 0.00
SQSUB 1.41 1.79 0.00 0.00 2.64
XITEM 0.14 0.35 0.00 0.00 0.00
FYE BUSY 0.75 0.43 0.00 1.00 1.00
LITI 0.60 0.49 0.00 1.00 1.00
RISK 0.26 0.89 0.01 0.04 0.13
BIG4 0.77 0.42 1.00 1.00 1.00
GOV 5.31 2.07 4.00 6.00 7.00
INSIDE 0.31 0.28 0.04 0.26 0.55
Notes:
a Variable Definitions:
AULAG = audit lag measured as the number of days between the fiscal year-end date and audit report date,
NASFEE = total non-audit fees paid to the audit firm, AFEE = audit fees paid to the audit firm, TA = total
assets, LEV = total liabilities to total assets, LIQ = current assets to current liabilities, LOSS = 1 if a firm re-
ports negative net income, 0 otherwise, OCF TA = operating cash flow to average total assets, MKTBOOK =
market capitalization to book value of total assets, ACQ FIN = 1 if a firm is engaged in an acquisition or
merger or issues new debt or equity capital, 0 otherwise, SQSUB = square-root of the number of subsidiaries,
XITEM = 1 if a firm reports extraordinary items, 0 otherwise, FYE BUSY = 1 if a firm’s fiscal year ends be-
tween March and September, 0 otherwise, LITI = 1 if a firm operates in a risky industry, 0 otherwise, RISK =
absolute value of discretionary accruals estimated from the performance-adjusted modified Jones model,
BIG4 = 1 if the audit firm is a BIG4, 0 otherwise, GOV = Governance index score is the sum across three
board and six audit committee characteristics. Each of the following three board attributes are scored 1 if
an observation exceeds the median number of board meetings, the median percentage of outside directors
on the board, and the CEO is not the chairman of the board. Each of the following six audit committee
attributes are scored 1 if an observation exceeds the median number of audit committee meetings, and the
median percentage of independent directors on the audit committee, all audit committee members are
non executive directors, the chair of the audit committee is an independent director, there is at least one
financial expert on the audit committee, and the audit committee has at least three members. INSIDE =
Percentage of common shares owned by insiders.
respectively.14 The average (median) firm size in terms of total assets is $472 million
($77m). Compared to Knechel and Sharma (2010): (i) audit lag is greater by 18 days,
(ii) audit and non-audit fees are significantly less, and (iii) firm size is considerably
smaller.15 The average leverage of our sample (0.55) is much larger than the 0.24 aver-
age in Knechel and Sharma (2010). We find that the incidence of acquisitions/merger
and issue of new debt or equity is lower in our sample (20% compared to 34%).
However, the average liquidity, operating cashflow, and busy financial year end are
similar. These descriptive results suggest firm characteristics are different between New
14 All values are presented in New Zealand dollars.

15 The New Zealand dollar equivalents (NZD) of the sample mean in Knechel and Sharma (2010) are:
audit fee = $1,263m, non-audit fee = $1,325m and total assets = $3,958m.

Zealand and the US which is not surprising because New Zealand is a small country
with a small and thinly traded capital market (Sharma et al., 2009).
For the 115 unique companies in our sample: 77 had auditors located in the city of
Auckland, 12 in Wellington, 11 in Christchurch, 7 in Dunedin and 8 in other cities. It
is clear that the audit market for listed companies is concentrated on the north island
of New Zealand. We further observe that all the Big 4 have offices across the four major
cities, as do the larger non-Big 4 such as Grant Thornton and BDO Spicers’. Of the
Big 4, only KPMG had offices in other cities.16
Pearson correlations are presented in Table 2. None of the correlations is greater
than 0.80 the threshold beyond which multicollinearity may pose statistical problems
(Gujarati, 2003). As expected, total assets is highly correlated with audit fees (r =
0.80) and non-audit fees (r = 0.51), as are audit and non-audit fees (r = 0.54) and
square-root subsidiaries and audit fees (r = 0.64). Variance-Inflation-Factors in all our
tests were less than 3.8, which is well below the threshold of 10 when multicollinerity
problems may occur (Gujarati, 2003).
(ii) Multivariate Results
(a) Test of H1 : Audit Quality

Table 3 presents the results of the test of audit quality for firms that have short lags
while also paying high non-audit fees. The coefficients on HIGHNAS, SHORTLAG and
the interaction term HIGHNAS∗ SHORTLAG are not significant. More importantly,
the joint coefficient (sum of SHORTLAG and HIGHNAS∗ SHORTLAG) is not signifi-
cant (p > 0.10). These results suggest that there is no significant loss of audit quality
for clients paying high non-audit fees with short audit lag.17 This result is consistent
with H1 .18
(b) Test of H2 : Audit Efficiency

Our results relating to the test of hypothesis H2 are presented in columns two to six
of Table 4.19 We observe that larger firms have a significantly (p < 0.01) shorter audit
lag and loss making firms experience significantly (p < 0.01) longer audit lag. The
BIG4 coefficient has a significant negative coefficient (p < 0.01) suggesting that large
audit firms experience a shorter audit relative to non-BIG4 firms. The coefficient on
LN AFEE is positive and significant (p < 0.01) which is consistent with the notion
that higher audit fees represent increased audit effort and greater risks to the auditor,
16 These data should be interpreted with caution because they are based on a sample selected on a set of
criteria that may not be representative of the population.
17 Our results are similar if we use signed, positive or negative performance-adjusted discretionary accruals
and signed or negative performance-adjusted current accruals as proxies for audit quality (Kothari et al.,
2005). Our results show a significant negative (p < 0.05, two-tailed) effect of HIGHNAS∗ SHORTLAG on
audit quality when the proxy for audit quality is positive performance-adjusted current accruals. Such a
result suggests audit quality is higher for clients paying high non-audit fees and have shorter audit lag.
18 Some of the control variables in this model are not significant. This is not surprising for New Zealand
because of the small sample and stickiness of discretionary accruals (Cahan et al., 2008). One caveat we
recognize is that our test of non-audit services and audit quality involves a joint hypothesis of the underlying
research question plus the adequacy of the accrual model for identifying audit quality. See Dechow et al.
(2010) for a discussion of this joint hypothesis.
19 The regression models have explanatory power comparable to Knechel and Sharma (2010), which range
from 12% to 13%, whereas ours range from 15% to 19%.

C

Table 2
Pearson Correlation Coefficients (N = 230)
Variable a 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
1. LN AULAG −.25 −.27 .01 .06 .29 −.06 .14 −.01 −.02 −.01 −.01 .13 .06 −.27 −.08 −.21 −.08
2. LN NASFEE .51 −.08 −.14 −.27 .16 −.04 .12 .36 .17 −.03 −.06 −.11 .38 .54 .05 −.07
3. LN TA −.28 −.10 −.49 .24 −.22 .15 .47 .27 −.04 −.26 −.14 .40 .80 .42 −.10
4. LEV −.06 −.02 −.10 −.04 .15 −.04 −.02 .05 .06 −.03 −.13 −.07 .08 .09
2012 Blackwell Publishing Ltd

5. LIQ .09 −.00 .06 −.00 −.07 −.06 .00 −.00 −.00 −.10 −.14 −.02 .07
6. LOSS −.27 .12 .00 −.24 −.18 .07 .17 .18 −.21 −.36 −.31 .01
7. OCF TA .10 .05 .09 .06 .02 −.12 −.32 .10 .11 .14 −.04
8. MKTBOOK −.04 −.07 −.04 .02 .09 .01 −.15 −.11 −.08 .07
9. ACQ FIN .24 .11 .16 .09 −.10 .09 .26 .14 −.10
10. SQSUB .26 .04 .02 −.04 .13 .63 .23 −.05
11. XITEM .10 −.23 −.07 .05 .32 .01 −.04
12. FYE BUSY −.10 .02 .04 −.09 −.09 −.02
13. LITI .10 −.06 −.05 −.06 −.03
14. RISK −.01 −.08 −.20 .01
15. BIG4 .32 .08 −.06
16. LN AFEE .34 −.10
17. GOV .03
18. INSIDE
Notes:
Coefficients in bold are significant at p < 0.05 (two-tailed).
LN AULAG = natural logarithm of audit lag, LN NASFEE = natural logarithm of non-audit fees, LN TA = natural logarithm of total assets. LEV = total liabilities to
total assets, LIQ = current assets to current liabilities, LOSS = 1 if a firm reports negative net income, 0 otherwise, OCF TA = operating cash flow to average total
assets, MKTBOOK = market capitalization to book value of total assets, ACQ FIN = 1 if a firm is engaged in an acquisition or merger or issues new debt or equity
NON-AUDIT SERVICES AND KNOWLEDGE SPILLOVERS
capital, 0 otherwise, SQSUB = square-root of the number of subsidiaries, XITEM = 1 if a firm reports extraordinary items, 0 otherwise, FYE BUSY = 1 if a firm’s fiscal
year ends between March and September, 0 otherwise, LITI = 1 if a firm operates in a risky industry, 0 otherwise, RISK = absolute value of discretionary accruals
estimated from the performance-adjusted modified Jones model, BIG4 = 1 if the audit firm is a BIG4, 0 otherwise, GOV = Governance index score is the sum across
three board and six audit committee characteristics. Each of the following three board attributes are scored 1 if an observation exceeds the median number of board
meetings, the median percentage of outside directors on the board, and the CEO is not the chairman of the board. Each of the following six audit committee attributes
are scored 1 if an observation exceeds the median number of audit committee meetings, and the median percentage of independent directors on the audit committee,
all audit committee members are non-executive directors, the chair of the audit committee is an independent director, there is at least one financial expert on the
audit committee, and the audit committee has at least three members. INSIDE = Percentage of common shares owned by insiders.
73
Table 3
OLS Regression of Audit Quality Measured as Absolute Value of Discretionary
Accruals
ABSDACC = α + β1 HIGHNAS + β2 SHORTLAG + β3 HIGHNAS∗ SHORTLAG
+ β4 LN TA + β5 LEV + β6 LOSS + β7 OCF TA + β8 MKTBOOK
+ β9 ACQ FIN + β10 SQSUB + β11 LITI + β12 BIG4 + εi
Variables a Pred. Sign Estimate t-value §
Intercept ? 0.072 1.67∗

HIGHNAS ? −0.008 0.76
SHORTLAG ? 0.008 0.76
HIGHNAS∗ SHORTLAG ? 0.009 0.64
LN TA ? −0.003 1.14
LEV + 0.024 10.85∗∗∗
LOSS + −0.003 0.37
OCF TA + 0.011 4.93∗∗∗
MKTBOOK + 0.000 1.67∗∗
ACQ FIN + −0.011 1.27
SQSUB + 0.001 0.50
LITI ? 0.021 3.05∗∗∗
BIG4 − 0.002 0.22
Joint test: β 2 + β 3 ? 0.017 0.71
N 230
Adjusted R 2 /F -value 8.4% 2.72∗∗∗
Notes:
§ The reported t-values are based on White’s (1980) corrected standard errors and clustering by firm
(Petersen, 2009).
∗∗∗ , ∗∗ and ∗ represent significance at 0.01, 0.05 and 0.10 levels, respectively. The direction of the tests are
indicated by the predicted sign.
HIGHNAS = 1 if non-audit fees greater than the median, 0 otherwise, SHORTLAG = 1 if audit lag is less
than or equal to the median, 0 otherwise, HIGHNAS∗ SHORTLAG = interaction between HIGHNAS and
SHORTLAG, LN TA = natural logarithm of total assets, LEV = total liabilities to total assets, LOSS = 1
if a firm reports negative net income, 0 otherwise, OCF TA = operating cash flow to average total assets,
MKTBOOK = market capitalization to book value of total assets, ACQ FIN = 1 if a firm is engaged in an
acquisition or merger or issues new debt or equity capital, 0 otherwise, SQSUB = square-root of the number
of subsidiaries, LITI = 1 if a firm operates in a risky industry, 0 otherwise, BIG4 = 1 if the audit firm is a
BIG4, 0 otherwise.
thus increasing audit lag. The coefficient on our variable of interest, LN NASFEE,
is negative and significant (p < 0.01). Similarly, the coefficient on FEERATIO
(p < 0.10) and HIGHNAS (p < 0.10) are also negative and significant.20 The non-
audit fee results suggest that higher auditor-provided non-audit services shorten the
audit lag, which is consistent with the notion that knowledge spillovers occur when the
auditor provides both audit and non-audit services. Note that we control for the risk
of financial misreporting/audit quality in these tests. These results are consistent with
H2 .
20 Our results are robust to alternative proxies for non-audit fees such as the percentile rank of non-audit
fees and unexpected non-audit fees.

C

Table 4
OLS Regression of Audit Lag on Non-Audit Fees and Control Variables
LN AULAG = α + β1 NASFEE + β2 LN TA + β3 LEV + β4 LIQ + β5 LOSS + β6 OCF TA + β7 MKTBOOK + β8 ACQ FIN

+ β9 SQSUB + β10 XITEM + β11 FYE BUSY + β12 LITI + β13 RISK + β14 BIG4 + β15 LN AFEE + β16 GOV
+ β17 INSIDE + β18 YEAR + εi
LN NASFEE FEERATIO HIGHNAS NAS NAT NAS CITY
Variables a (Pred. Sign) Estimate t-value § Estimate t-value § Estimate t-value § Estimate t-value § Estimate t-value §
Intercept (?) 4.236 16.93∗∗∗ 4.737 20.25∗∗∗ 4.278 16.39∗∗∗ 4.330 16.06∗∗∗ 4.318 16.32∗∗∗
NASFEE (?) −0.016 3.55∗∗∗ −0.162 1.77∗ −0.086 1.94∗ −0.176 0.84 −0.327 2.01∗∗
LN TA (−) −0.068 3.74∗∗∗ −0.030 2.18∗∗ −0.069 3.70∗∗∗ −0.070 3.52∗∗∗ −0.067 3.39∗∗∗
LEV (?) −0.023 1.93∗ −0.013 1.10 −0.023 1.86∗ 0.080 6.24∗∗∗ 0.097 7.73∗∗∗
LIQ (−) 0.000 0.14 0.000 0.01 0.000 0.25 0.001 0.50 0.001 0.45
LOSS (+) 0.123 2.54∗∗∗ 0.148 2.93∗∗∗ 0.131 2.62∗∗∗ 0.157 2.67∗∗∗ 0.147 2.55∗∗∗
OCF TA (+) 0.021 1.64∗ 0.015 1.15 0.019 1.51∗ 0.045 1.96∗∗ 0.045 1.99∗∗
MKTBOOK (+) 0.000 0.25 0.000 0.02 −0.001 0.45 −0.001 1.00 −0.001 0.88
ACQ FIN (+) −0.041 0.83 −0.038 0.75 −0.040 0.79 −0.070 1.32 −0.060 1.16
SQSUB (+) −0.011 0.85 0.006 0.50 −0.013 1.02 −0.020 1.50 −0.019 1.47
XITEM (+) 0.041 0.77 0.080 1.45∗ 0.042 0.77 −0.036 0.60 −0.039 0.66
FYE BUSY (+) 0.013 0.33 −0.007 0.17 0.014 0.33 0.017 0.37 0.011 0.25
LITI (+) −0.013 0.33 0.018 0.45 −0.017 0.42 −0.024 0.55 −0.029 0.68
RISK (+) −0.009 0.44 −0.005 0.25 −0.006 0.28 −0.009 0.40 −0.007 0.33
BIG4 (−) −0.124 2.70∗∗∗ −0.141 2.98∗∗∗ −0.161 3.49∗∗∗ −0.159 2.39∗∗∗ −0.151 2.30∗∗
LN AFEE (?) 0.119 3.96∗∗∗ 0.110 3.61∗∗∗ 0.111 3.43∗∗∗ 0.107 3.38∗∗∗
GOV (−) −0.016 1.59∗ −0.013 1.26 −0.013 1.30∗ −0.029 2.59∗∗∗ −0.031 2.83∗∗∗
INSIDE (?) 0.003 1.31 0.003 1.20 0.003 1.41 0.004 1.79∗ 0.005 2.24∗∗
NON-AUDIT SERVICES AND KNOWLEDGE SPILLOVERS
YEAR (?) 0.040 1.08 0.034 0.88 0.037 0.98 0.008 0.19 0.017 0.43
N 230 230 230 194 194
Adjusted R 2 /F −value 19% 3.94∗∗∗ 15% 2.98∗∗∗ 18% 3.71∗∗∗ 15% 2.95∗∗∗ 16% 3.20∗∗∗
75
76
Table 4 (Continued)
Notes:
§ The reported t-values are based on White’s (1980) corrected standard errors and clustering by firm (Petersen, 2009).
∗∗∗ , ∗∗ and ∗ represent significance at 0.01, 0.05 and 0.10 levels, respectively. The direction of the tests are indicated by the predicted sign.
LN AULAG = natural logarithm of audit lag, LN NASFEE = natural logarithm of non-audit fees, FEERATIO = ratio of non-audit fees to total fees, HIGHNAS = 1 if
non-audit fee is greater than the median, 0 otherwise, NAS NAT = non-audit fees paid by a client relative to total fees of the auditor at the national level, NAS CITY =
non-audit fees paid by a client relative to total fees of the auditor at the city office level, LN TA = natural logarithm of total assets, LEV = total liabilities to total
assets, LIQ = current assets to current liabilities, LOSS = 1 if a firm reports negative net income, 0 otherwise, OCF TA = operating cash flow to average total assets,
MKTBOOK = market capitalization to book value of total assets, ACQ FIN = 1 if a firm is engaged in an acquisition or merger or issues new debt or equity capital,
0 otherwise, SQSUB = square-root of the number of subsidiaries, XITEM = 1 if a firm reports extraordinary items, 0 otherwise, FYE BUSY = 1 if a firm’s fiscal year ends
between March and September, 0 otherwise, LITI = 1 if a firm operates in a risky industry, 0 otherwise, RISK = absolute value of discretionary accruals estimated from
the performance-adjusted modified Jones model, BIG4 = 1 if the audit firm is a BIG4, 0 otherwise, LN AFEE = natural logarithm of audit fees, GOV = Governance
index score is the sum across three board and six audit committee characteristics. Each of the following three board attributes are scored 1 if an observation exceeds
the median number of board meetings, the median percentage of outside directors on the board, and the CEO is not the chairman of the board. Each of the following
six audit committee attributes are scored 1 if an observation exceeds the median number of audit committee meetings, and the median percentage of independent
KNECHEL, SHARMA AND SHARMA
directors on the audit committee, all audit committee members are non-executive directors, the chair of the audit committee is an independent director, there is at
least one financial expert on the audit committee, and the audit committee has at least three members. INSIDE = Percentage of common shares owned by insiders,
C

YEAR = year dummy.

(c) Test of H3 : Local versus National Level of Knowledge Spillovers

The last four columns of Table 4 show the results for the national and city level
tests. The operational definition of NAS NAT (national level non-audit fees) indicates
this variable captures non-audit services provided at the national office level and the
NAS CITY variable captures non-audit services provided by the city office conducting
the audit. Our hypothesis predicts that the association between audit lag and non-
audit fees will be more pronounced at the city level than at the national level because
staff providing audit and non-audit services are more likely to share knowledge when
they are in close proximity. The results in Table 4 show that the coefficient on non-
audit fees at the national office level (NAS NAT) is not significant (b = −0.176, p >
0.10) but the coefficient at the city office level (NAS CITY) is negative and significant
(b = −0.327, p < 0.05). A test of differences between these two coefficients shows
that the NAS CITY coefficient is significantly larger than the NAS NAT coefficient
(t = 1.838, p < 0.05). These results suggest that knowledge spillover benefits from the
joint provision is limited to the office providing the services.21 This result is consistent
with H3 .22
(d) Tipping-Point for Knowledge Spillovers

To explore the level of non-audit fees at which knowledge spillovers begin to manifest
in shorter audit lag, we derive quartile and decile categories of non-audit fees. We
then regress audit lag on three and nine dummy variables for quartiles and deciles,
respectively, and the control variables in equation (2). Our results show that the
coefficient on the non-audit fee variable is negative and significant for the third
(p < 0.01) and fourth (p < 0.05) quartiles and from decile five onwards. Specifically,
we find that as we move up the deciles (higher non-audit fees), the significance of
the negative coefficients improves (from p < 0.10 to p < 0.01) with the 10th decile
being insignificant. While we would not generalize the exact cutoff to markets other
than New Zealand, these results suggest that the benefits of joint provision do not
begin to manifest in shorter audit lag at the first dollar of auditor-provided non-
audit services but begin to occur when a moderate amount of non-audit services is
provided. Further, our decile findings suggest that the effect of non-audit services fees
on audit lag is non-linear. Audit lag begins to significantly decline after the median
level of non-audit services fees but substantially increases at the highest level. Such
findings suggest that the mechanism through which joint provision of audit and non-
audit services may create knowledge spillovers is much more complex than assumed
in the prior literature. Our results suggest there is room for further research to
21 When we perform audit quality tests at the city office level, we find that the interaction term, NAS CITY∗
SHORTLAG is negative and significant suggesting that clients consuming high levels of NAS at the city office
do not experience low audit quality; rather these clients experience higher audit quality. Such findings are
more consistent with knowledge spillover than economic bonding.
22 Our results are consistent if we estimate the regressions for a sample comprising only (i) audit offices
in the four major cities; Auckland, Christchurch, Dunedin and Wellington and (ii) audit offices on the
North Island. In both these samples, the coefficient on NAS CITY is significantly greater (p < 0.05) than
the coefficient on NAS NAT. We perform several other tests such as excluding non-Big 4 firms and find
our results remain the same. Our results are not sensitive to a particular Big 4 auditor that was tested by
removing one Big 4 auditor at a time. Our results are qualitatively similar if we partition the sample into
large and small firms split at the median of total assets.

advance our understanding of the association between joint provision and knowledge
spillovers.
5. DISCUSSION
In this study we examine whether the purchase of auditor-provided non-audit services
is related to audit lag to infer the presence of knowledge spillovers between the
audit and non-audit functions. New Zealand provides a natural laboratory to test such
associations because there is no mandatory annual report filing deadline, there are
no restrictions on the joint provision of audit and non-audit services, and there is no
regulation of audit firms. Additionally, prior research shows that auditor-provided non-
audit services do not undermine the quality of the audit opinion in New Zealand (Hay
et al., 2006) but may affect the quality of financial information (Cahan et al., 2008; and
Sharma et al., 2011). Therefore, it is not clear whether auditor provided non-audit
services are costly from the capital markets’ point of view. The results of our study
suggest that the joint supply of audit and non-audit services results in shorter audit lag
without a significant loss in audit quality. Such results are consistent with the notion
that knowledge spillovers occur as a result of the auditor providing both audit and non-
audit services to a client. Our results are consistent with Knechel and Sharma (2010)
suggesting that joint supply benefits may also occur in other international settings
where there is no ban on non-audit services.
We extend the literature by providing some novel insights to the knowledge
spillover debate. First, we document that the benefits of knowledge spillover mostly
accrues to the office jointly providing audit and non-audit services to a client. Future
research could investigate the mixed results in prior knowledge spillover studies by
considering the level (city or national office level) at which knowledge spillover is more
likely to occur. Second, we observe that knowledge spillovers, and thus audit efficiency,
occur after a moderate amount of non-audit services has been provided and appears to
manifest in a non-linear fashion. Future studies could investigate this further because
the linear relationship between joint provision and knowledge spillovers assumed
in prior research may have suppressed the sensitivity to detect the benefits of joint
provision. Our findings have important implications for policy makers in New Zealand
in that they support the NZSEC’s decision to not limit or ban the joint supply of audit
and non-audit services.
Our study is subject to the following limitations which open up avenues for further
research. First, we acknowledge that our publicly available proxy for audit production,
audit lag, may not be the best measure to capture the manifestation of knowledge
spillovers and audit efficiency. Auditors usually perform the audit in three phases
which includes scheduling, fieldwork and reporting (Knechel and Payne, 2001). We do
not know how these vary across our sample or how they affect our measure of audit lag
because such data is not publicly available. Access to more reliable proxies for auditor
effort is a limitation of all audit lag studies and is an issue that is insurmountable unless
audit firms provide proprietary data. Second, our results suggest that longer audit lag
may imply inefficiency on the part of the auditor if the auditor does not provide more
than moderate amounts of non-audit services. However, longer audit lag could be due
to other issues such as underlying going concern problems and financial misreporting
that our control variables may not adequately capture. Our results are limited to the
extent the empirical analyses do not adequately control for such effects. Finally, we do

not examine the type of non-audit services because separate categories of non-audit
fees are not consistently reported by our sample of listed companies in New Zealand.
Future studies can pursue such investigations conditional upon reliable data being
available.
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Journal of Business Finance & Accounting, 39(1) & (2), 60–81, January/March 2012, 0306-686X

Non-Audit Services and Knowledge

W. ROBERT KNECHEL, DIVESH S. SHARMA AND VINEETA D. SHARMA∗

The profession’s objection suggests that banning auditor-provided non-audit services

The effectiveness of NZSEC’s approach may be limited, however, because there is

2. LITERATURE REVIEW AND HYPOTHESES

find an association between engagement efficiency and the provision of management

H1 : Ceteris paribus, there is no association between auditor provided non-audit services

H2 : Ceteris paribus, there is a negative association between auditor-provided non-audit

In addition to examining the preceding hypotheses, we extend the literature by

actions taken by auditors in response to their international counterparts in the US.5

(ii) Empirical Model

(a) Test of H1 : Audit Quality

ABSDACC Absolute value of discretionary accruals estimated

LOSS 1 if a firm reports negative net income, 0 otherwise.

(b) Test of H2 : Audit Efficiency

LN AULAG = α + β1 NASFEE + β2 LN TA + β3 LEV + β4 LIQ + β5 LOSS

(c) Test of H3 : Office versus National Level Knowledge Spillovers

(iii) Control Variables

the absolute value of discretionary accruals estimated from the performance-adjusted

(i) Descriptive Statistics

AULAG (days) 60.32 21.53 48.00 55.00 70.00

14 All values are presented in New Zealand dollars.

(ii) Multivariate Results

(a) Test of H1 : Audit Quality

(b) Test of H2 : Audit Efficiency

2012 Blackwell Publishing Ltd

Intercept ? 0.072 1.67∗

2012 Blackwell Publishing Ltd

2012 Blackwell Publishing Ltd

(c) Test of H3 : Local versus National Level of Knowledge Spillovers

(d) Tipping-Point for Knowledge Spillovers

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