Audit Fees, Non-Audit Services and Auditor-Client Economic Bonding

Abstract

We investigate whether auditor independence is compromised by either the mix of audit and non audit services (NAS), or simply unusually large or audit fees. The results help reconcile apparently conflicting evidence in prior studies linking and indicators of earnings management, as well as providing new insights on the relation between the incentive structures faced by auditors and variation in audit quality. Using the unexpected accrual component of earnings as a proxy for the effect of impaired auditor independence, we initially find that client firms purchasing an unexpectedly large fee mix (i.e., relative to audit fees) display some evidence of aggressive accounting. However, when we explicitly allow for the possibly endogenous nature of unexpected accruals and unexpected NAS, this no longer holds. In contrast, similar evidence of a positive relation between the magnitude of unexpectedly large audit fees and positive unexpected accruals still occurs (albeit more weakly) after explicitly allowing for possible endogeneity. A significant positive association between unexpected total fees (audit plus NAS) and the magnitude of positive unexpected accruals is even more robust. However, further tests shows that these result are confined to clients of Non-Big 6 auditors. We therefore conclude that for large audit firms, the incentive to protect larger than expected fees is outweighed by the importance of their reputation for providing high quality audits relative to smaller audit firms. The results also highlight how sensitive conclusions about possible NAS effects are to the choice of proxy for economic bond as well as the precise experimental design.