Is there a relation between audit fee cuts during the global financial crisis and banks’ financial reporting quality?

Abstract

As a result of the global financial crisis (GFC), several audit clients were able to negotiate lower audit fees for the years 2008 and 2009. However, the PCAOB has expressed concern that lower audit fees might lead to lower audit effort and lower audit quality and financial reporting quality. This study examines the relation between audit fee cuts and banks’ financial reporting quality. Specifically, we focus on earnings management via loan loss provisions (LLP), the relation between current period LLP and future loan charge-offs, i.e., LLP validity, and the timely recognition of loan losses. For banks audited by Big 4 auditors, we find that income-increasing abnormal LLP are decreasing in audit fee cuts and LLP validity is increasing in audit fee cuts. For banks audited by non-Big 4 auditors, LLP validity is higher for banks that received a fee cut of more than 25% relative to other banks audited by non-Big 4 auditors. We do not observe an association between timely loan loss recognition and cuts in audit fees except for banks audited by non-Big 4 auditors and exempt from internal control audits where a fee cut of more than 25% is associated with less timely loan loss recognition. Overall, the findings suggest that Big 4 auditors constrained earnings management via LLP in banks that received cuts in audit fees. Our findings have important implications for regulators, investors, and others.