Audit Fees
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Audit Fees

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Auditor Independence and Earnings’ Quality: Evidence for ∗Market Discipline vs. Proscriptive Regulation James Brown Montana State University Dino Falaschetti Montana State University Michael Orlando Federal Reserve Bank of Kansas City September 1, 2006 Abstract Received research largely argues against auditor independence influencing the quality of earnings’ reports, but encounters several difficulties in doing so. Addressing these difficulties, we build additional confidence that auditor independence improves earnings’ quality, though any such effect appears to be small. Moreover, our research facilitates a more careful inference from audit fee data about the efficacy of Sarbanes-Oxley’s restriction on consulting for audit clients. Here, we develop more defensible evidence that moving past the Securities and Exchange Commission’s (SEC’s) fee disclosure mandates to proscribe non-audit services diminished financial market opportunities. JEL: G14, G38, K22, M42 Keywords: Auditor Independence, Audit Fees, Non-Audit Services, Corporate Governance, Sarbanes-Oxley ∗ We thank Dan Covitz, Rob Fleck, Steven Hansen, Andy Hanssen, Mary Sullivan, Doug Young, participants at the 2006 meeting of the Washington Area Finance Association at George Washington stUniversity (WAFA) and the 81 Annual Conference of the Western Economic Association (WEA), and seminar audiences at Montana State University for helping us think about this ...

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Auditor Independence and Earnings’ Quality: Evidence for
∗Market Discipline vs. Proscriptive Regulation

James Brown
Montana State University

Dino Falaschetti
Montana State University

Michael Orlando
Federal Reserve Bank of Kansas City

September 1, 2006


Abstract

Received research largely argues against auditor independence influencing
the quality of earnings’ reports, but encounters several difficulties in doing
so. Addressing these difficulties, we build additional confidence that
auditor independence improves earnings’ quality, though any such effect
appears to be small. Moreover, our research facilitates a more careful
inference from audit fee data about the efficacy of Sarbanes-Oxley’s
restriction on consulting for audit clients. Here, we develop more
defensible evidence that moving past the Securities and Exchange
Commission’s (SEC’s) fee disclosure mandates to proscribe non-audit
services diminished financial market opportunities.



JEL: G14, G38, K22, M42

Keywords: Auditor Independence, Audit Fees, Non-Audit Services,
Corporate Governance, Sarbanes-Oxley

∗ We thank Dan Covitz, Rob Fleck, Steven Hansen, Andy Hanssen, Mary Sullivan, Doug Young,
participants at the 2006 meeting of the Washington Area Finance Association at George Washington
stUniversity (WAFA) and the 81 Annual Conference of the Western Economic Association (WEA), and
seminar audiences at Montana State University for helping us think about this research.
Auditor Independence and Earnings’ Quality: Evidence for
Market Discipline vs. Proscriptive Regulation

September 1, 2006


Abstract

Does auditor “independence” improve the quality of financial disclosures?
Popular characterizations of recent governance scandals strongly answer
“yes.” Scholarly evidence appears less decisive, however, in part because
it ignores several hypotheses about how independence can influence
earnings’ quality. We examine proxy data on fees for audit and non-audit
services (NAS) to address this issue as follows.

1. We relax a priori linear restrictions in the literature, which assume
that independence affects earnings’ quality in only one direction.

2. We offer a finer evaluation of how markets value independence by
better measuring unexpected disclosures and examining whether audit
fee disclosures improve the efficiency of market valuations; and

3. We look beyond internal effects of independence to consider the
potential for one firm’s governance choice to influence other firms’
financial market opportunities.

In each case, we find evidence that auditor independence does not, by
itself, materially degrade the quality of financial disclosures (either
internally or externally). To the extent that significant relationships appear
in our data, they are consistent with disclosure mandates exhausting
opportunities to enhance financial market performance, and thus with
proscriptive regulation (e.g., Sarbanes-Oxley’s restriction on NAS) having
foreclosed such opportunities.

JEL: G14, G38, K22, M42

Keywords: Auditor Independence, Audit Fees, Non-Audit Services,
Corporate Governance, Sarbanes-Oxley 1. Introduction
High profile accounting scandals (e.g., Enron, WorldCom) squarely placed the topic
of corporate governance in front of popular and business media. A widely held belief
emerged that letting accountants consult for audit-clients compromises auditors’
independence and thus diminishes the quality of earnings’ reports (e.g., see Romano,
12004; Weil, 2004). Citing such conflicts of interest, US legislators built considerable
support for the Sarbanes-Oxley Act of 2002 (SOX, hereafter), part of which restricts
2accountants from producing non-audit services (NAS).
This support appears at odds, however, with scholarly examinations of disclosure
mandates that preceded SOX – i.e., previous Securities and Exchange Commission
(SEC) requirements that audit clients formally disclose fees paid for audit and non-
audit services. These studies offer limited evidence that markets value the
information that such disclosures make available (e.g., see Glezen and Millar, 1985;
Frankel et al., 2002; Ashbaugh et al., 2003), and employ such results to not only
argue against disclosure mandates, but also against proscriptive regulations like SOX
3(e.g., see DeFond et al., 2002).
We critically evaluate these results and find them wanting on several margins.
Received research ignores, for example, several channels through which information
about “fee dependence” can be influential. In addition, it leaves open the question of

1 Ezzamel, Gwilliam, and Holland (1996) document a similar perception for UK companies.
2 See “Title II – Auditor Independence” of the Sarbanes-Oxley Act of 2002 (HR 3763), summarized in our
Appendix A. The bill passed the House by a roll call vote of 423-3 and the Senate by a vote of 99-0 on
July 25, 2002 (Source: Thomas (a service of the Library of Congress), accessed April 12, 2005 at
http://thomas.loc.gov/home/thomas.html).
3 In addition, popular calls to loosen SOX and its regulatory constraint on producing NAS appear to be
growing. The US Chamber of Commerce (2006, p. 16), for example, argued that prohibiting “Big Four
firms” from “audit assignments when they have performed disqualifying services in prior years” unduly
restricts competition.
1how data from fee disclosures can inform regulations that would prescribe how
market participants organize their governance services. Addressing these issues, we
find more defensible evidence that mandating the disclosure of accounting fees can
productively strengthen market discipline, though any such effect appears to be small.
Moreover, to the extent that regulatory opportunities to enhance financial market
efficiency existed, our evidence is consistent with disclosure mandates having
exhausted them – i.e., any strengthening of market discipline that resulted from these
mandates may have fully internalized the costs and benefits of commingling audit and
non-audit services. Our research design thus offers more defensible evidence against
the efficacy of SOX in having moved past disclosure mandates to restrict auditors
from producing NAS.
These contributions come from a more firmly grounded empirical investigation of
how auditor independence relates to financial statement integrity. In the following
section, we review the literature to identify channels through which auditor
independence can plausibly influence earnings’ quality without being detected by
received research designs. This review highlights several channels as being worthy
of investigation.
1. In addition to threatening the integrity of financial disclosures, jointly
producing audit and non-audit services can leverage scope economies to
4improve disclosure-quality. But while such economies can offset associated
agency costs, and thus give rise to a non-monotonic relationship between

4 Banks, for example, exhibit qualitatively similar economies when jointly producing lending and
underwriting services (see, e.g., Drucker and Puri, forthcoming).
2audit quality and auditor “independence,” contributions to the literature have
a priori restricted this relationship to being linear.
2. If markets are efficient and auditor independence matters, then equity prices
should respond to disclosures about unexpected independence.
Contributions to the literature, however, examined how markets responded
to “gross” disclosures – i.e., disclosures that confound expected and
5unexpected independence. Even if auditor independence influences
earnings’ quality, the errors-in-variable problem that this treatment creates
can attenuate coefficient estimates of interest and thus hide evidence of an
effect.
3. Received research designs attempt to measure the own-firm effect of auditor
independence on the quality of earnings’ reports. They do not consider,
however, the potential for disclosures about auditor independence at one
firm to inform markets about others. Understanding the extent of such
informational externalities is important for evaluating the efficiency-
consequences of mandated disclosures and more proscriptive governance
regulations.
Each of these difficulties can bias inference toward rejecting the hypothesis that
separating the production of audit and non-audit services expands financial market
opportunities. After carefully addressing these issues in Section 3, however, we find

5 To be sure, the literature does not completely ignore this issue. DeFond et al. (2002) and Frankel et al.
(2002), for example, evaluated how proxies for earnings’ quality relate to measures of “unexpected” non-
audit fees. These measures ignore, however, the potential for organizational features (e.g., audit committee
independence) to substitute for auditor independence in producing corporate governance services
(Falaschetti and Orlando, 2004). Moreover, while information sets must be available before they can
facilitate expectations, DeFond et al. (2002) and Frankel et al. (2002) estimate “expectations” from
contemporaneous information. Even received measures of unexpected non-audit fees thus appear prone to
the errors-in-variables problem that we attempt to address more carefully in the present paper.
3even stronger evidence against the efficacy of regulatory proscriptions on how
financial market participants produce governance services (e.g., the SOX restriction).
Indeed, to the extent that significant relationships appear in our data, they support the
hypothesis that mandated fee disclosures exhausted what was possible in expanding
financial market opportunities.
Corporate governance in general, and accounting systems in particular, play an
important role in defining an economy’s potential. For example, market discipline
can expand the set of feasible organizational opportunities, such as the ability to
separate ownership from control, and may itself benefit from informative financial
disclosures. Likewise, holding organizational opportunities constant, financial capital
can more easily find productive employment in rich informational environments.
However, our evidence that any responses to news about auditor independence are
“local” (i.e., they do not spillover to other firms) suggests that regulating how that
independence is established can compromise, rather than bolster, the integrity of
financial disclosures. We thus conclude in Section 4 by considering how political
forces may have pushed US governance regulations in a direction that works against
the public’s interest, and how future research might improve our understanding of this
important political dimension of economic performance.
2. Potential Difficulties with Received Research Designs
Even before legislators responded to recent governance scandals, the issue of
accountants producing NAS for audit clients received considerable regulatory
attention. The Securities and Exchange Commission’s (SEC) Accounting Series
Release (ASR) No. 250: Disclosure of Relationships with Independent Public
4Accountants, for example, required subject companies to disclose fees paid to
auditors for NAS (via proxy statements filed after September 30, 1978). Glezen and
Millar (1985) found, however, that shareholder voting on auditor-retention negligibly
responded to these disclosures. At least on its face, this evidence supports the
hypothesis that producing NAS for audit clients does not materially compromise an
accountant’s integrity (Glezen and Millar 1985, p. 859-60). It also appears to bolster
the SEC’s rationale for withdrawing ASR 250 in February of 1982 – i.e., shareholders
lack interest in fee disclosures.
2.1 Linear-restrictions can bias inference
But drawing such strong inference from Glezen and Millar’s (1985) evidence can be
problematic. For example, a negligible relationship between shareholder voting and
fee disclosures also supports the normatively opposing, but observationally
equivalent, hypothesis that auditor independence influences earnings’ quality in a
non-monotonic manner. The following figure illustrates one such possible
relationship.
5

Figure 1
Possible Observed vs. Actual Relationship

An auditor’s dependence on non-audit fees can, in principle, improve or degrade
the quality of reported earnings. If, for example, informational inputs for producing
audit services intersect those for producing NAS, then jointly producing audit and
non-audit services can improve earnings quality by facilitating scope economies.
Joint production can, in addition, increase the cost of certifying misstated financial
statements – e.g., the reputational costs of any such certification might include
foregone profits from audit and non-audit services. On the other hand, by endowing
6managers with the capacity to threaten auditors with the loss of non-audit business,
jointly producing audit and non-audit services increases the pressure that managers
6can place on auditors to endorse compromised financial statements.
In this light, earnings’ quality appears capable of sharing a non-monotonic
relationship with fee dependence. Quality may, for example, first decrease with fee
dependence if marginal forces associated with managerial influence overwhelm those
associated with scope economies or reputational incentives. If these forces’ relative
magnitudes ultimately reverse, then earnings’ quality can also share a positive
relationship with fee dependence over domains where this dependency is more
considerable.
To the extent that such non-monotonicities characterize the relationship between
earnings quality and dependence on non-audit fees, research designs that a priori
restrict that relationship to being linear can spuriously produce evidence against the
hypothesis that NAS matters. For example, simple correlations between proxies for
quality and fee dependence, as well as corresponding coefficient estimates from linear
regressions, can appear negligible even if quality and fee dependence share an
important non-linear relationship. Glezen and Millar (1985) appear to have evaluated
simple hypotheses about how fee dependence relates to earnings’ quality, however,
instead of considering more flexible methods for evaluating joint hypotheses about
7this relationship and its functional form. Their reported results thus cannot dismiss

6 Arruñada (1999) offers a comprehensive evaluation of how the joint production of audit and non-audit
services enhances the quality of earnings reports. Frankel et al. (2002) do the same for how joint
production degrades earnings quality. Bratton (2003, pp. 12-13) reviews the conventional wisdom that
“nonaudit consulting rents, employment opportunities at clients, and audit industry concentration”
compromise the “professional relationship” between auditors and management.
7 Subsequent authors appear to have followed Glezen and Millar (1985) in this regard. We review some of
these contributions below.
7the normatively opposing hypothesis that dependence on non-audit fees significantly
8influences earnings’ quality, but in a non-monotonic manner.
In addition to being subject to the above criticisms, Glezen and Millar’s (1985)
evidence appears consistent with fee disclosures being important, but voting costs
discouraging even rational owners from collectively acting against compromised
auditors. More recent authors (e.g., Frankel et al., 2002; Ashbaugh et al., 2003) have
thus tended to look not at how approval voting responds to fee disclosures, but rather
at how market valuations respond. In doing so, however, they too ignored the
potentially confounding issue of functional form, and have thus done little to
9distinguish the observational equivalencies that Glezen and Millar (1985) left open.
Exploiting a more recent SEC reporting requirement, for example, Ashbaugh et
al., (2003) estimated that firm-level market valuations negligibly responded to
10disclosures about the proportion of fees paid to auditors for NAS (i.e., “fee ratios”).
On their face, these results largely support the hypothesis that having accountants
11produce NAS for audit clients does not degrade earnings’ quality. But while the

8 See, e.g., Glezen and Millar (1985, Tables 6 and 7).
9 Other widely cited contributions that we reviewed also encounter difficulty in making valid inference
available. Francis and Ke (2003), for example, examined whether the market valuation of earnings
surprises depends on auditor independence. In doing so, however, they not only omitted the reporting of
potentially important sensitivity analyses, they drew inference from an indicator of whether surprises
occurred after the SEC implemented its fee disclosure mandate (e.g., equation (5) formally characterizes
each firm as maintaining the same filing date). This methodology thus treats earnings surprises as having
occurred when audit-fee information was available, even for firms that file proxies in late quarters – i.e.,
firms for whom such information could not have been available. Such difficulties do not appear confined
to studies that report evidence that fee disclosures matter. DeFond et al. (2002), for example, reported that
the propensity for auditors to issue going concern opinions is unrelated to auditor independence. While
their evaluation restricts consideration to only distressed firms, however, it ignores the potential for bias to
emerge from non-random selection.
10 Ashbaugh et al. (2003) follow Frankel et al. (2002) in exploiting the SEC’s “Final Rule S7-13-00,
Revision of the Commission’s Auditor Independence Requirements,” which demands that companies
disclose, via proxy statements filed after February 5, 2001, information regarding fees that the auditor
billed to it during the previous year (Frankel et al., 2002, p. 4).
11 To be sure, Frankel et al. (2002) find evidence from accrual data that jointly producing audit and non-
audit services degrades earnings’ quality, but little in the way of an economically meaningful market
8