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The effects of board and auditor independence on earnings quality: evidence from Italy

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Abstract

Most regulations and corporate governance codes emphasize the adjective independent next to the words auditor and director because auditor and director independence is expected to result in better protection for shareholders and other stakeholders. In this study we use (1) the extent to which the auditor provides non-audit services (NAS) to clients as a possible factor influencing auditor independence and (2) the proportion of outside independent directors to the total number of directors as a proxy of board of directors’ independence (BODI). The two fundamental questions are the following: (1) Does the provision of NAS by auditors to audit clients impair auditor independence, thus reducing the quality of earnings? (2) Does BODI play a role in improving earnings quality? An empirical analysis is conducted on a sample of Italian listed companies during the period 2007–2010. Our evidence does not show an influence of BODI on our proxies of earnings management. Regarding the issue of auditor independence, the provision of NAS appears to be positively associated with the absolute abnormal working capital accruals, which is an indicator of a lower quality of earnings. We also show that board characteristics are not determinants in the choice of purchasing NAS and that the new Italian regulation on mandatory disclosure of audit and NAS fees appears to have had some influence on the behavior of companies in the 2007–2010 period in the form of a reduction in the relative magnitude of NAS compared to audit fees.

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Notes

  1. The list of banned non-audit services includes the following: (a) bookkeeping or other services related to accounting records or financial reports; (b) design and implementation of accounting information systems; (c) appraisal and valuation services or fairness opinions; (d) actuarial services; (e) internal audit outsourcing services; (f) advice and services in the field of company organization aimed at personnel selection, training and management; (g) broker or dealer, investment adviser, or investment banking services; (h) legal services; (i) other services and activities, including legal advice unrelated to the audit, identified by Consob (the Italian security and exchange commission) in the regulation adopted (for example, advisory services that involve the assignment of powers to represent the client, as well as legal services provided for disputes, Art. 149-decies of Consob Regulation No. 11971).

  2. It is worth noting that the independent requirements in the law are formulated in a way that differs from the corresponding provisions in BI (2006). This discrepancy provides an indication of the way the notion of independence in relation to corporate governance is open to different interpretations. To resolve any possible ambiguity, we interpreted the information provided by the company in a conservative way. This means that in any cases where the application of the TUF rules, as opposed to the corporate governance code rules, would show a different number of independent directors, we selected the smallest number.

  3. We also used a panel data structure; after performing the Hausman test, we used a random effects model, excluding the type of industry and year dummies. The results of this regression show the same evidence on H1 and H2: a positive and significant coefficient on NAS (coeff = 0.064, z = 3.12, p = 0.002), while the BODI is not significant.

  4. We use this model to incorporate the incremental effect on conservatism for companies in the sample we investigated that have high NAS. Following Ball and Shivakumar (2005) and Ruddock et al. (2006), the regression equation is as follows:

    \( \begin{aligned} {\text{ACC}} & = {\text{b}}0 + {\text{b1 DCFO}} + {\text{b2 DNAS}} + {\text{b3 DCFO}} \times {\text{DNAS}} + {\text{b4 CFO}} + {\text{b5 DCFO}} \times {\text{CFO}} \\ & \quad + {\text{b6 DNAS}} \times {\text{CFO}} + {\text{b7 DNAS}} \times {\text{DCFO}} \times {\text{CFO}} + {\text{e}} \\ \end{aligned} \)

    A corresponding analysis was conducted to test the notion of conservatism by adding the effect of BODI to the model. The equation for this model is as follows:

    \( \begin{aligned} {\text{ACC}} & = {\text{b}}0 + {\text{b1 DCFO}} + {\text{b2 CFO}} + {\text{b3 DCFO}} \times {\text{CFO}} + {\text{b4 BODI}} + {\text{b5 BODI}} \times {\text{DCFO}} \\ & \quad + {\text{b6 BODI}} \times {\text{CFO}} + {\text{b7 BODI}} \times {\text{DCFO}} \times {\text{CFO}} + {\text{e}} \\ \end{aligned} \)

    Definition of variables: ACC = total accruals scaled by average total assets; DCFO = (1) if CFO < 0, (0) otherwise; DNAS = (1) if NAS > 3rd quartile of NAS, (0) otherwise; NAS = non-audit services fee ratio [(further assurance services + tax consulting + other services) ÷ total remuneration]; CFO = cash flow from operations scaled by average total assets; BODI = number of independent board members over the total number of board members. The outcome of the OLS regression is available upon request.

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Acknowledgments

Part of this study has been conducted during a period of research at Rutgers Business School, Department of Accounting and Information Systems, Newark, NJ, USA. The author wishes to thank two anonymous referees, S. Govindaraj, D. Palmon, and participants to the research seminar at the University of Siena (Italy), SIDREA International Workshop at the University of Tuscia–Viterbo (Italy), for useful comments and suggestions.

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  1. Department of Economics and Management, University of Tuscia, Via del Paradiso, 47, 01100, Viterbo, Italy

    Giuseppe Ianniello

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Ianniello, G. The effects of board and auditor independence on earnings quality: evidence from Italy. J Manag Gov 19, 229–253 (2015). https://doi.org/10.1007/s10997-013-9285-2

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