Auditor Fees and Fraud Firms

Abstract

The issue of whether auditor fees affect auditor independence has been extensively debated by regulators, investors, investment professionals, auditors, and researchers. The revised SEC requirements that resulted from the implementation of the Sarbanes-Oxley Act (2002) limit non-audit services (NAS) and mandate NAS fee disclosure. The SEC’s requirements are based on the argument that auditor independence could be impairedand hence audit quality may be reducedwhen auditors audit their own work. Economic bonding leads to reduced independence, which may in turn lead to reduced audit quality. We study a sample of firms sanctioned by the SEC for fraudulent financial reporting in Accounting and Auditing Enforcement Releases (SEC-sanctioned fraud firms) and examine whether there is a relationship between auditor fee variables and the likelihood of being sanctioned by the SEC for fraud. We use SEC sanction as a measure of audit quality that has not previously been used in the literature and is more precise than some of the other proxies used for flawed financial/auditor reporting. We find, in univariate tests, that fraud firms paid significantly higher (total, audit, and NAS) fees. However, in multivariate tests, when controlling for other fraud determinants and endogeneity among the fraud, NAS, and audit fee variables, we find that, while NAS fees and total fees are positively and significantly related to the likelihood of being sanctioned by the SEC for fraud, audit fees are not. These findings suggest that higher NAS fees may cause economic bonding, leading to reduced audit quality, while higher audit fees do not appear to have the same effect. Our findings of significantly higher NAS fees in fraud firms hold after controlling for latent size effects and other rigorous testing. These results contribute to the literature that examines the SEC’s concerns about NAS, and can be used by policy makers for additional consideration.