Auditor Independence: Evidence on Non-audit fees, firm financial health and investors’ perceptions of earnings

Abstract

Motivated by the mixed results of prior research regarding the role of non-audit fees (NAFs) on auditor independence, this study examines the effect of NAFs on earnings response coefficients (ERCs) of healthy and financially distressed firms. We find that NAFs positively affect ERCs for healthy and marginal firms with little incentives to manage earnings while NAFs negatively affect ERCs for financially distressed firms with more incentives to manage earnings. We confirm our findings by showing that distressed firms are more likely to use accrual-based earnings management (AEM) as a channel to affect ERCs. These results hold after we control for various other determinants of audit quality and possible endogeneity. Results provide policy, research, and practical implications by advancing our understanding of the relationship between NAFs and investors’ perceptions of auditor independence.