An Empirical Analysis of Auditor Independence in the Banking Industry

Abstract

We examine auditor independence in the banking industry by analyzing the relation between fees paid to the auditors and the extent of earnings management through loan loss provisions (LLP). We also examine whether this relation differs across large banks whose managements are required under the FDIC Improvement Act to evaluate the internal control over financial reporting and whose auditors must attest to the report on the effectiveness of such internal controls, and small banks that are not subject to such controls. Our results indicate that unexpected auditor fees are unrelated to earnings management for large banks. For small banks, we find a strong negative association between income-increasing (negative) abnormal LLP and both unexpected total and nonaudit fees. These results suggest that auditor fee dependence on the audit client is associated with earnings management via abnormal LLP and may be a threat to auditor independence for small banks. Our findings are relevant to policymakers who are contemplating new regulations in light of the recent banking crisis.