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Abstract

The framers of the Sarbanes–Oxley Act (SOX) presume that nonaudit services (NASs) lower the quality of financial statements, so they have prohibited auditors from offering most NASs. In addition, regulators believe that NASs may cause the auditor to be perceived as “dependent” in appearance, thus increasing information risk, even if they have no impact on the quality of financial statements. The authors investigate two hypotheses using pre-SOX data. First, they ask whether the proportion of NASs fees to total fees has a positive or negative association with the ability of financial statements to predict a firm’s future cash flows, which can be considered a measure of the quality of the statements. Second, they ask whether the proportion has a negative or positive association with the cost of capital (COC) and the bid/ask spread, controlling for the predictability. The COC and the bid/ask spread serve as proxies for information risk. Contrary to the proponents of prohibiting NAS, the authors find that the proportion of NASs fees to total fees has a positive association with predictability. Controlling for the quality of financial statements, NASs still have a negative association with the COC and the bid/ask spread as proxies for information risk. These findings suggest that NASs improve the quality of financial statements and reduce information risk.

Keywords

nonaudit services quality of financial statements capital markets

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The Impact of Nonaudit Services on Capital Markets

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