AUDITING: A JOURNAL OF PRACTICE & THEORY pp. 117–142 ...(Geiger and Raghunandan 2002; Myers et al. 2003). ... fees, and the ratio of nonaudit fees to audit fees as the metrics. Consistent

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AUDITING: A JOURNAL OF PRACTICE & THEORYVol. 26, No. 2November 2007pp. 117–142

Auditor Independence: Evidence on theJoint Effects of Auditor Tenure and

Nonaudit FeesFerdinand A. Gul, Bikki L. Jaggi, and Gopal V. Krishnan

SUMMARY: This study examines whether the impact of nonaudit fees on auditor in-dependence is contingent on auditor tenure. The results, based on a sample of 4,720U.S. firms for the years 2000 and 2001, show that there is a positive association be-tween nonaudit fees and positive discretionary current accruals, a proxy for auditorindependence, for firms with short auditor tenure of not more than three years. Thesefindings suggest that nonaudit fees may impair auditor independence when auditortenure is short and not when auditor tenure is long. Furthermore, exploratory analysesshow that the positive association between nonaudit fees and earnings managementfor firms with short auditor tenure is significant for small clients but not for large clients.Taken together, these results suggest that the association between nonaudit fees andauditor independence is contingent upon auditor tenure, and that high nonaudit feeshave a negative impact on auditor independence when audit tenure is short and clientfirm size is small.

Keywords: auditor independence; nonaudit fees; discretionary accruals; auditor tenure.

Data Availability: Data are available from sources identified in the paper.

INTRODUCTION

Do nonaudit services impair auditors’ independence? This question has attracted at-tention from regulators, researchers, and the financial press. In response to theconcerns related to nonaudit services, the U.S. Congress passed the Sarbanes-Oxley

Act (SOX) in 2002, which prohibits auditors from providing to their clients certain typesof nonaudit services. To comply with SOX, the Securities and Exchange Commission (SEC)has revised the rules on auditor independence, which now limit the circumstances andremuneration for providing certain types of nonaudit services (SEC 2001). In addition, therevised rules require that the client firm shall disclose all fees paid to an audit firm by

Ferdinand A. Gul is a Professor at The Hong Kong Polytechnic University, Bikki L. Jaggiis a Professor at Rutgers, The State University of New Jersey, New Brunswick and a VisitingProfessor at The Hong Kong Polytechnic University, and Gopal V. Krishnan is an AssociateProfessor at George Mason University.

We gratefully acknowledge valuable comments from Yaw Mensah, Suresh Radhakrishnan, Lai Kam Wah, J. BKim, Bin Srinidhi, and workshop participants at The Hong Kong Polytechnic University. We also thank AnthonyNg and Angel Sung for their assistance in data collection and analyses.

Submitted: June 2005Accepted: March 2007

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separate categories, including services related to auditing, financial information system de-sign and implementation, and others, so that investors are fully informed about the typesand magnitudes of these fees. The SOX and the SEC’s regulations are apparently based onthe assumption that certain types of nonaudit services provided by audit firms are likely toimpair auditor independence, thereby, reducing audit quality.

Several studies have examined whether there is an association between nonaudit feespaid to audit firms and auditor independence.1 Of particular interest to us in this paper arethe studies that examine the impact of nonaudit fees on discretionary accruals that are usedas a proxy for earnings management (e.g., Francis and Ke 2002; Frankel et al. 2002; DeFondet al. 2002; Ashbaugh et al. 2003; Chung and Kallapur 2003; Larcker and Richardson2004). Findings of these studies are mixed. Frankel et al. (2002) (hereafter FJN) documentthat nonaudit fees are positively associated with the magnitude of discretionary accruals,suggesting that high nonaudit fees are likely to impair auditor independence. However,Ashbaugh et al. (2003) (hereafter ALM) use a more refined measure of discretionary ac-cruals and do not find a statistically significant association between nonaudit fees andpositive discretionary accruals. They conclude that there is no systematic evidence to sup-port FJN’s findings that higher nonaudit fees impair auditor independence. Chung andKallapur (2003) use a different nonaudit fees metric and also find no support for FJN’sfindings. Thus, despite concerns by regulators and the financial press, there is no clearevidence that higher nonaudit fees will negatively affect auditor independence.

Another stream of research in the auditing literature focuses on the association betweenauditor independence and auditor tenure (e.g., Dopuch et al. 2001; Geiger and Raghunandan2002; Johnson et al. 2002; Myers et al. 2003). The importance of auditor tenure is alsoreflected in Section 203 of the SOX, which requires a five-year rotation cycle for theexternal lead or reviewing audit partner. A recent report of the Commission on Public Trustand Private Enterprise appointed by the Conference Board also supports the idea of auditorrotation (Conference Board 2005). However, empirical evidence to date shows that longerauditor tenure rather than shorter auditor tenure is associated with higher-quality earnings(Geiger and Raghunandan 2002; Myers et al. 2003).

In this study, we integrate the research on auditor tenure with the research on nonauditfees/auditor independence and argue that an investigation of the relation between audit /nonaudit fees and auditor independence without consideration of auditor tenure is likely toprovide an incomplete picture. We, therefore, include auditor tenure in the analyses of theassociation between nonaudit fees and auditor independence and evaluate whether auditortenure affects this association.

We conjecture that nonaudit fees are likely to affect auditor independence for firmswith short auditor tenure, but not for firms with long auditor tenure. We argue that auditorswith short tenure are likely to place more emphasis on profits (quasi rents) than reputationprotection (Johnson et al. 2002). Furthermore, the competitive practice of low-balling couldcause the auditor to be more accommodating in the early years of the engagement (Geigerand Raghunandan 2002). Under these circumstances, higher nonaudit fees are likely to havean adverse effect on auditor independence for firms with short auditor tenure. We also arguethat auditors with short tenure are likely to be relatively unfamiliar with the clients’ ac-counting and control systems, which would make it easier for the clients to manage theirreported earnings. Thus, these two factors are likely to contribute to the negative association

1 Another stream of research evaluates the association between nonaudit services and auditor independence byexamining the impact of nonaudit fees on restatements (e.g., Raghunandan, et al. 2003) and the propensity toissue going-concern opinions (DeFond et al. 2002), etc.

Auditor Independence: Evidence on the Joint Effects of Auditor Tenure and Nonaudit Fees 119


between nonaudit fees and auditor independence for firms with short auditor tenure. Onthe other hand, auditors who have had a long relationship with their clients are likely tobe more concerned about auditor reputation protection and are less likely to be influencedby nonaudit fees. In addition, they are more likely to have client-specific knowledge thatwould allow them to deter earnings management more effectively.

Consistent with earlier studies, we use performance-adjusted discretionary accruals orREDCA (a term used by ALM)2 as a proxy for earnings management on the assumptionthat independent auditors should strictly monitor discretionary accruals that may be usedby the firm management to manipulate the reported earnings. As discussed by ALM, theuse of positive REDCA, i.e., income-increasing discretionary current accruals, is generallyof major concern to investors because managers are more likely to adjust earnings upwardsto meet market expectations or convert losses into small positive earnings (e.g., Burgstahlerand Dichev 1997). The use of negative REDCA (downward adjustment of reported earnings)is, however, considered to be conservative accounting, and investors are not likely to betoo concerned about its use (see also Butler et al. 2004). Thus, we focus on positive REDCA,but also conduct tests on the total sample as well as on the sub-sample of firms with negativediscretionary accruals.

Following ALM, we use the log of audit fees, the log of nonaudit fees, the log of totalfees, and the ratio of nonaudit fees to audit fees as the metrics. Consistent with the literature(e.g., Johnson et al. 2002), we use the cut-off point of three years for splitting the sampleinto short and long auditor tenure. In the sensitivity tests, we also use different cut-offpoints for splitting the sample into long and short auditor tenure.

Similar to ALM’s findings, the results using the total sample show that there is nosignificant association between nonaudit fees and REDCA. When we split the sample intopositive and negative discretionary accruals and include auditor tenure in the analyses, theassociation between nonaudit fees and earnings management becomes clearer. For example,when we include a dummy variable for auditor tenure (1 for short tenure � 3 years, 0otherwise) and interact this variable with nonaudit fees in the positive discretionary accrualssample, we obtain a significant positive coefficient for the interaction term. In other words,firms with high nonaudit fees and short tenure are associated with higher positive discre-tionary accruals. Similar results are obtained when separate tests are conducted for firmswith long and short auditor tenure. The results on the firms with negative discretionaryaccruals, however, show no significant association. These findings thus indicate that thereis an upward adjustment of reported earnings when nonaudit fees are high and auditortenure is short. On the other hand, the results for firms with long auditor tenure show thatthere is no significant association between positive discretionary accruals and nonaudit fees.These findings suggest that auditor independence may be compromised when nonaudit feesare high and auditor tenure is short. In other words, our results show that the relationbetween nonaudit fees and auditor independence is conditional on auditor tenure.

As an exploratory analysis, we examine whether the association between nonaudit feesand discretionary accruals for firms with short auditor tenure differs between large andsmall client firms. It has been argued in the literature that auditors of large firms are morelikely to remain independent because of client visibility and reputation protection (e.g.,Reynolds and Francis 2001; Larcker and Richardson 2004; Barton 2005). It is also possiblethat auditors may face bigger challenges early in their tenure when the client firm is smallbecause these firms may have weak accounting systems. Consequently, these small firms

2 See ALM (2003, 622) for a justification on using REDCA instead of other measures of discretionary currentaccruals.



may purchase more nonaudit services to improve their accounting systems. Thus, in ourexploratory analysis, we test whether there is comparatively higher earnings managementin small firms when auditor tenure is short and nonaudit fees are high. Our findings showthat there is a positive association between nonaudit fees and positive discretionary accrualsfor relatively small firms with shorter auditor tenure. Additional research, beyond the scopeof the present study, is warranted to establish whether higher discretionary accruals in smallfirms are caused by higher nonaudit fees or the weak accounting and internal control sys-tems within client firms.

This study makes the following contributions to the existing literature on auditor in-dependence. First, the findings provide evidence that the association between nonaudit feesand auditor independence depends on auditor tenure. Second, the findings show that theconcerns expressed by regulators and in the financial press regarding the role of nonauditfees on auditor independence are justified only when auditor tenure is short, but not whenauditor tenure is long. Third, the results support earlier findings that longer auditor tenuredoes not lead to reduced audit and financial reporting quality (e.g., Myers et al. 2003). Thisfinding thus suggests that the system of voluntary auditor rotation, which results in shorterauditor tenure, is linked to poorer audit quality when nonaudit fees are large. Fourth, theresults suggest that client size is also likely to play a role in the linkage between nonauditfees, auditor tenure, and auditor independence.

The remainder of the paper is organized as follows. In the second section, we developa hypothesis for the study, and the third section discusses the research methodology. Theresults are discussed in the fourth section, and conclusions are presented in the fifth section.

HYPOTHESISAuditor Tenure, Nonaudit Fees, and Auditor Independence

Auditor independence has been the subject of considerable debate for some time, andit has been examined from the perspectives of both nonaudit fees and auditor tenure. Theexisting studies on the association between nonaudit fees and auditor independence haveevaluated whether higher nonaudit fees create an economic bond between the auditor andthe client, which enables the client firm to exert influence over the auditors’ decisions andmake auditors less independent as nonaudit fees increase.3 However, as pointed out earlier,the findings of empirical studies using discretionary accruals as a proxy for auditor inde-pendence provide conflicting evidence.

The impact of auditor tenure on auditor independence has also attracted attention fromregulatory agencies, congressional bodies, the Conference Board, the popular press, as wellas academics (e.g., U.S. Senate 1977; AICPA 1978; Wall Street Journal 1991; SEC 1994;Conference Board 2005). A recent report of the Commission appointed by the ConferenceBoard states that ‘‘when there is confluence of circumstances that could put in question theaudit firm’s independence, the Commission believes that audit committees should carefullyconsider rotation of audit firm’’ (Conference Board 2005, 39). In addition, the report illus-trates the existence of certain circumstances that merit consideration of rotation and rec-ommends serious consideration of auditor rotation when the audit firm ‘‘has been employedfor a substantial period of time, e.g., over ten years’’ (Conference Board 2005). Auditorrotation is supported on the grounds that longer auditor tenure leads to economic bondingbetween the auditor and client firms, which may result in familiarity and personal connec-tions between the auditor and client firms. Hence, auditors are more likely to compromise

3 Some researchers, however, argue that the impact of nonaudit fees on auditor independence should be evaluatedin the context of total fees charged by audit firms.



their independence as auditor tenure increases. Auditor rotation is thus suggested as a wayto enhance auditor independence on the assumption that it would enable auditors to resistmanagement pressure and exercise greater objectivity (e.g., Brody and Moscove 1998).Similarly, Wolf et al. (1999) argue that auditor independence and objectivity will be en-hanced if audit firms relinquish their clients periodically. There is, however, no empiricalevidence to support the argument that longer auditor tenure is associated with lower auditorindependence.

In contrast to the argument supporting shorter auditor tenure, the other school ofthought suggests that threats to independence may be greatest during the first few years ofan auditor-client relationship because the ‘‘recently acquired quasi-rents of incumbency maymake new auditors more vulnerable to threats of dismissal in earlier years of auditor-clientrelationships’’ (Geiger and Raghunandan 2002, 68). Apart from the independence argument,it is also suggested that short tenure is associated with lower audit quality because theauditor is unfamiliar with the client’s accounting system and firm characteristics (e.g.,PricewaterhouseCoopers 2002).4 Similar arguments are also evident from the discussion inthe literature on audit failures, which suggest that audit failures occur almost three timesmore often when an audit firm performs its first or second audit of a given client (AICPA1992). The findings of a recent study also provide support for this argument by documentinglower earnings quality for clients with shorter auditor tenure (Myers et al. 2003). On bal-ance, the evidence suggests that short auditor tenure is associated with lower earningsquality because the auditor lacks independence or is unfamiliar with the client’s accountingsystem and firm characteristics, or perhaps both.5

Based on the evidence related to the impact of short auditor tenure on earnings man-agement, we conjecture that there will be a negative association between nonaudit fees andauditor independence for firms with short auditor tenure. The arguments below are presentedin support of our conjecture.

Prior research suggests that auditor incentives are traded off between the auditor’s desireto protect firm reputation (brand name) and to maintain profits (quasi rents) from theauditor-client relationship (Citron and Taffler 1992; Johnson et al. 2002). The desire tomaintain profits or quasi rents from an existing client relationship in the early years of theengagement could cause the auditor to be more accommodating to the client. Geiger andRaghunandan (2002) argue that auditors are willing to be more accommodating to the clientin the early years of an audit, because they are influenced by their desire to limit theirlosses on the current engagement as a result of the competitive practice of low-balling andto be able to ensure continuity of the engagement. Thus, it can be argued that a clientwould purchase nonaudit services in the early years of an engagement and persuade theauditor not to conduct in-depth analyses that may uncover earnings management. It is alsopossible that the auditor may face special audit problems earlier in the tenure because ofunfamiliarity with the client’s business, and thus may have difficulty in detecting earningsmanagement. Based on these arguments, we conjecture that large nonaudit fees combinedwith short auditor tenure are likely to be associated with higher earnings management. Onthe other hand, an auditor with a relatively longer tenure and an established relationshipwith the client over a period of time is likely to place more emphasis on reputation pro-tection than profit, and is less likely to be affected by high nonaudit fees. As a result ofthe long tenure, the auditor will have a better understanding of the client’s accountingsystem and be in a better position to detect earnings management. Consequently, we argue

4 See also Geiger and Raghunandan (2002) for arguments supporting this interpretation.5 It is beyond the scope of the present study to disentangle these explanations. This is left to future studies.



TABLE 1Sample Firms by SIC Code for Years 2000 and 2001

n % Compustat (%)

Agriculture (0100–0999) 0 0.0 0.4Mining and Construction (1000–1999, excluding 1300–1399) 52 1.1 2.6Food (2000–2111) 105 2.2 2.3Textiles and print /publishing (2200–2799) 278 5.9 4.9Chemicals (2800–2824, 2840–2999) 117 2.5 2.5Pharmaceuticals (2830–2836) 364 7.7 6.0Extractive (1300–1399, 2900–2999) 187 4.0 4.4Durable manufactures (3000–3999, excluding 3570–3579

and 3670–3679)1248 26.4 22.6

Transportation (4000–4899) 261 5.5 7.2Utilities (4900–4999) 179 3.8 3.2Retail (5000–5999) 552 11.7 11.1Services (7000–8999, excluding 7370–7379) 460 9.8 11.9Computers (3570–3579, 3670–3679, 7370–7379) 894 18.9 19.8Others 23 0.5 1.0

Total 4720 100.0 100.0

that because of a combination of reputation protection and better understanding of theclient’s accounting system, high nonaudit fees are unlikely to be associated with earningsmanagement when auditor tenure is long. We develop the following hypothesis to test theimpact of auditor tenure on the association between auditor independence and nonauditfees:

H1: Higher nonaudit fees are associated with higher discretionary accruals whenauditor tenure is short.

RESEARCH METHODLOGYSample

Data on audit fees are obtained from the Standard and Poor’s database. Our analysesare based on all firms for which fee data are available for the years 2000 and 2001.6 Dataon auditor tenure and financial variables are extracted from the Compustat database. Thefinal sample consists of 4,720 observations; of which, 1,846 observations are from the year2000 and 2,874 observations are from the year 2001. The distribution of the sample firmsby industry is provided in Table 1.

The sample is widely distributed over different industry groups. Over 26 percent ofsample firms are from the manufacturing sector, followed by computer-related (18.9 per-cent) and retail-related (11.7 percent) businesses. This sample distribution by industry groupis consistent with the distribution of firms in the Compustat database, and in general issimilar to the sample used by ALM.

It needs to be pointed out, however, that some sample firms may be associated withspecial firm-specific events that may result in lower or higher discretionary accruals that

6 ALM based their analyses on firms for the year 2000 and obtained data from the EDGAR and Global Accessdatabases.



are used as a proxy for earnings management. Similarly, the sample may also include start-up firms that may behave differently with regard to earnings management. We expect thatthe use of a large sample will mitigate these problems to some extent.

Fee MetricsDescriptive statistics on the various fee metrics are provided in Table 2. The mean

(median) of audit fees is $0.59 ($0.22) million, whereas the mean (median) of nonauditfees is $1.34 ($0.23) million, respectively. These means (and medians) are generally similarto those reported by ALM. There are no significant differences in the fee metrics for theyears 2000 and 2001.

Additionally, we examine the fee metrics for firms audited by Big 5 and non-Big 5firms, where Big 5 audit firms refer to Arthur Andersen, Deloitte & Touche, Ernst andYoung, KPMG, and PricewaterhouseCoopers.7 The results (untabulated) show that the mean(median) of audit fees for clients of Big 5 is $0.62 ($0.24) million, and the mean (median)of nonaudit fees is $1.43 ($0.25) million, respectively. As for clients of non-Big 5, themean (median) of audit fees is $0.15 ($0.1) million, and the mean (median) of nonauditfees is $0.14 ($0.05) million, respectively. The means and medians suggest that audit aswell as nonaudit fees are significantly higher for Big 5 clients.

As pointed out earlier, we use the log of audit fees, the log of nonaudit fees, the logof total fees, and the ratio of nonaudit fees to total fees (FEERATIO) as fee metrics. Theuse of these metrics allows us to compare the results of our study with those obtained fromthe ALM study.

Validity of Audit Fee MetricsWe test the validity of audit fee data by evaluating the association between important

variables identified in the audit fee literature and audit fees (e.g., ALM). The model, basedon ALM, includes the variables of a client firm’s auditor choice, audit complexity, auditrisk, and demand for consulting services, as well as the variable of auditor tenure. Theaudit fee model is used for testing the validity of audit fee data:

FEE � � � � BIG5 � � LNMVE � � MERGEACQ � � FINANCING1 2 3 4

� � MVBV � � LEV � � ROA � � INVREC � � NEGATIVE ROA5 6 7 8 9

13

� � SPECIAL � � LOGTEN � � INDUSTRYDUMMIES � ε�10 11 i ii�1

(1)

where:

FEE � FEERATIO, AUDIT, NONAUDIT, or TOTAL fees. With theexception of FEERATIO, we take the natural log of each feevariable to normalize the distributions of these variables, allowingthe cross-sectional aggregation of observations;

BIG5 � 1 if the firm is audited by Big 5, and 0 otherwise;LNMVE � the natural log of the firm’s market value of equity;

MERGEACQ � 1 if the firm is engaged in a merger or acquisition during the studyperiod, and 0 otherwise;

7 The inverse Mill’s ratio (not tabulated) shows that the self-selection bias is not an issue in choosing Big 5 /non-Big 5 firms.

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TABLE 2Descriptive Statistics of Variables Used in Discretionary Accruals Analysis

Variable Mean Median Std Mean Median Std Mean Median Std

Panel A: Total Sample

Total sample (n � 4720) Tenure � 3 (n � 680) Tenure � 3 (n � 4040)REDCA �1.41% �0.86% 18.78% �1.19% �0.32% 26.48% �1.44% �0.94% 17.16%AUDFEE 0.59 0.22 1.54 0.51 0.19 1.48 0.61 0.23 1.55NONAUDFEE 1.34 0.23 4.75 1.17 0.20 4.50 1.37 0.23 4.79TOTALFEE 1.93 0.46 5.94 1.67 0.41 5.54 1.98 0.48 6.00FEERATIO 48.19% 49.37% 22.55% 48.39% 49.63% 23.50% 48.15% 49.36% 22.39%TENURE 8.61 7.00 5.10 2.63 3.00 0.64 9.62 8.00 4.82ASSETS 2595.83 289.56 14468.96 1758.86 230.91 7946.33 2736.71 304.11 15291.95BIG5 0.93 1.00 0.25 0.84 1.00 0.37 0.95 1.00 0.22PRECURRACCL �0.05 0.00 0.44 �0.17 �0.01 0.81 �0.03 0.00 0.34MVE 3318.52 286.71 18582.24 1973.49 210.07 10182.21 3544.91 299.14 19637.94MERGEACQ 0.36 0.00 0.48 0.35 0.00 0.48 0.36 0.00 0.48FINANCING 0.21 0.00 0.41 0.24 0.00 0.43 0.20 0.00 0.40LEV 0.49 0.47 0.35 0.51 0.44 0.52 0.49 0.48 0.31MVBV 2.98 1.90 33.59 4.14 1.92 30.66 2.79 1.90 34.06LITIGATION 0.29 0.00 0.45 0.29 0.00 0.46 0.28 0.00 0.45DLOSS 0.40 0.00 0.49 0.48 0.00 0.50 0.39 0.00 0.49CFO 0.03 0.08 0.31 �0.06 0.05 0.57 0.04 0.08 0.24INST HOLDING 41.91% 41.64% 26.21% 36.22% 33.19% 26.44% 42.87% 42.74% 26.06%YEARDUM 0.61 1.00 0.49 0.45 0.00 0.50 0.64 1.00 0.48

(continued on next page)

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TABLE 2 (continued)

Panel B: Positive REDCA Subsample

Positive REDCA (n � 2107) Tenure � 3 (n � 330) Tenure � 3 (n � 1777)PREDCA 8.92% 4.78% 13.16% 11.42% 5.90% 16.52% 8.46% 4.62% 12.39%AUDFEE 0.51 0.20 1.17 0.41 0.18 0.69 0.53 0.20 1.23NONAUDFEE 1.12 0.18 4.25 1.12 0.18 5.00 1.12 0.19 4.10TOTALFEE 1.63 0.40 5.17 1.53 0.39 5.47 1.65 0.41 5.12FEERATIO 46.82% 47.49% 22.72% 46.82% 46.82% 23.66% 46.82% 47.57% 22.55%TENURE 8.54 7.00 5.09 2.63 3.00 0.65 9.64 8.00 4.79ASSETS 2152.31 237.41 10498.52 1230.11 213.37 4179.66 2323.57 238.75 11281.63BIG5 0.93 1.00 0.26 0.85 1.00 0.36 0.94 1.00 0.24PRECURRACCL �0.08 0.00 0.58 �0.24 0.00 0.99 �0.05 0.00 0.46MVE 2604.68 244.15 14198.49 1262.39 210.50 4841.26 2853.95 252.33 15307.43MERGEACQ 0.34 0.00 0.47 0.36 0.00 0.48 0.34 0.00 0.47FINANCING 0.22 0.00 0.41 0.25 0.00 0.43 0.22 0.00 0.41LEV 0.47 0.44 0.35 0.49 0.42 0.48 0.47 0.44 0.32MVBV 3.3 2.00 21.12 5.63 2.04 43.62 2.87 1.98 13.23LITIGATION 0.3 0.00 0.46 0.31 0.00 0.46 0.30 0.00 0.46DLOSS 0.37 0.00 0.48 0.44 0.00 0.50 0.36 0.00 0.48CFO �0.03 0.04 0.34 �0.09 0.03 0.62 �0.01 0.04 0.26INST HOLDING 39.86% 37.78% 26.30% 34.71% 28.74% 26.20% 40.81% 38.53% 26.21%YEARDUM 0.55 1.00 0.50 0.42 0.00 0.49 0.57 1.00 0.49


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TABLE 2 (continued)

Variable Definitions:REDCA � the discretionary current accruals measure controlling for performance by including the prior years’ ROA in the estimation of expected accruals;

PREDCA � positive REDCA;AUDFEE � audit fee in millions of dollars;

NONAUDFEE � nonaudit fee in millions of dollars;TOTALFEE � sum of audit fee and nonaudit fee;FEERATIO � nonaudit fee divided by total fee;

TENURE � number of years the auditor has been auditing the client firm;ASSETS � total assets in millions of dollars;

BIG5 � 1 if the firm is audited by Big 5, and 0 otherwise;PRECURRACCL � last year’s total current accruals equal to net income before extraordinary items plus depreciation and amortization minus operating cash flows

scaled by beginning of year total assets;MVE � the firm’s market value of equity;

MERGEACQ � 1 if the firm is engaged in a merger or acquisition, and 0 otherwise;FINANCING � 1 if MERGEACQ is not equal to 1 and any of the following conditions apply: long-term debt increased by 20 percent or more, number of shares

outstanding increased by 10 percent or more after controlling for stock splits, and 0 otherwise;LEV � firm’s total assets less its book value divided by its total assets;

MVBV � firm’s market-to-book ratio defined as its market value of equity divided by book values;LITIGATION � 1 if the firm operates within a high-litigation industry, 0 otherwise, where high-litigation industries are industries with SIC codes of 2833–2836,

3570–3577, 3600–3674, 5200–5961, 7370–7374;DLOSS � 1 if the firm reports a negative net income for the year, and 0 otherwise;

CFO � firm’s cash flow from operations scaled by beginning of the year total assets;INST HOLDING � percentage of shares held by institutional owners; and

YEARDUM � 1 if fiscal year is 2001, 0 if fiscal year is 2000.



FINANCING � 1 if MERGEACQ is not equal to 1 and any of the followingconditions apply: long-term debt increased by 20 percent or more,number of shares outstanding increased by 10 percent or more aftercontrolling for stock splits, and 0 otherwise;

MVBV � the firm’s market-to-book ratio defined as its market value of equitydivided by book values;

LEV � a firm’s total assets less its book value divided by its total assets;ROA � the firm’s return-on-asset ratio calculated as net income before

extraordinary items divided by beginning of the year total assets;INVREC � the sum of the firm’s receivables and inventory divided by its total

assets;NEGATIVE ROA � 1 if the firm’s ROA is negative, and 0 otherwise;

SPECIAL � 1 if the firm reports special items, and 0 otherwise; andLOGTEN � the natural log of auditor tenure in years.

Industry dummies are included in the model to control for cross-industry differences infees.

The audit fee model results (untabulated) show that there is a positive associationbetween audit fees and BIG5, LNMVE,8 MERGERACQ, LEV, ROA, INVREC,NEGATIVE ROA, and SPECIAL, and a negative association between audit fees andFINANCING and MVBV, as expected. The adjusted R-squared values for audit fees, non-audit fees, and total audit fees are 62.74 percent, 52.87 percent, and 66.45 percent, respec-tively; whereas, it is only 26.50 percent for the fee ratio. These R-squared values are similarto those reported by ALM. These results thus suggest that our sample of audit fees isrepresentative of the population of publicly traded firms and the analyses on the associationbetween audit fees and earnings management should reflect reliable results.

Discretionary Accruals as a Proxy for Earnings ManagementDiscretionary accruals are commonly used as a proxy for earnings management, and

different models have been suggested in the literature to estimate discretionary accruals. Inthis paper, we use the performance-adjusted discretionary accruals (REDCA) measure. Themeasure has been considered a better proxy for earnings management because current itemsare subject to more manipulation in a short period than long-term items (see, for example,ALM; Klein 2002; Kothari et al. 2002). Moreover, the adjustment of discretionary currentaccruals with the performance factor makes them comparable across firms from differentindustry groups (e.g., Kothari et al. 2002; Klein 2002). While ALM also uses the PortfolioPerformance Adjusted Discretionary Current Accruals (PADCA) measure, we restrict ouranalyses to REDCA because the latter better reflects earnings management, as argued byALM.9

Long versus Short Auditor TenureGeiger and Raghunandan (2002) in their analyses show that auditors are likely to be

more accommodating in the initial three years of auditor tenure. This effect is mitigatedafter six or more years. They thus conclude that the threat to auditor independence is thegreatest during the first few years of the auditor/client relationship. Consistent with their

8 We use LNMVE as a proxy for size following ALM. When we use the log of total assets instead of LNMVE,our results are generally similar.

9 For calculation of REDCA, refer to ALM (2003, 622).



analyses, we set the cut-off point at three years for differentiating between short and longauditor tenure. We, however, also conduct analyses on different cut-off points.

Association between Discretionary Accruals and Nonaudit FeesWe evaluate the association between discretionary accruals and audit fee metrics using

an OLS regression model, similar to that used by ALM, except for the variables LOGTEN(tenure) and YEARDUM (year dummy).

LOGREDCA � � � � FEE � � BIG5 � � PRECURRACCL � � LNMVE1 2 3 4

� � MERGERACQ � � FINANCING � � LEV � � MVBV5 6 7 8

� � LITIGATION � � DLOSS � � CFO9 10 11

� � INST HOLDING � � LOGTEN � � YEARDUM � ε12 13 14 (2)

where:

LOGREDCA � log of REDCA;PRECURRACCL � last year’s total current accruals equal to net income before

extraordinary items plus depreciation and amortization minusoperating cash flows scaled by beginning of the year total assets;

LITIGATION � 1 if the firm operates within a high-litigation industry, 0 otherwise,where high-litigation industries are industries with SIC codes of2833–2836, 3570–3577, 3600–3674, 5200–5961, 7370–7374;

DLOSS � 1 if the firm reports a negative net income for the year, and 0otherwise;

CFO � the firm’s cash flow from operations scaled by beginning of the yeartotal assets;

INST HOLDING � the percentage of shares held by institutional owners; andYEARDUM � 1 if the fiscal year is 2001, and 0 if fiscal year is 2000.

Other variables have been defined earlier. We use the variable YEARDUM to control forthe effect of time period. Consistent with ALM and Warfield et al. (1995), the dependentvariable REDCA is transformed by taking the natural logarithm of absolute values to correctfor possible violations of normality.

We use the natural log of tenure in our analysis to overcome the problem that obser-vations are not normally distributed. We conduct tests on the total sample and also sepa-rately on the sub-samples of positive and negative discretionary accruals. The impact ofaudit tenure is evaluated by including an interaction term for audit fees and auditor tenurein the analyses, and also by conducting separate tests on firms with short and long auditortenure.

RESULTS AND DISCUSSIONCalculation and Descriptive Statistics of Auditor Tenure

Auditor tenure is calculated on the basis of information about the year when the auditfirm first started audit work with the client firm, as provided in the Compustat database.As the Compustat database used in this study dates back to 1984, there may be a mea-surement error for auditor tenure for some firms. This measurement error is, however,unlikely to seriously affect our results because tenure of nine years or more is considered



as long tenure. Furthermore, our sub-samples of short and long tenure are based on thethree-year cut-off point.

Descriptive statistics on auditor tenure are provided in Table 2. The results show thatmean (median) auditor tenure for the total sample is 8.6 (7) years. The mean and medianof the sub-samples of short and long auditor tenure are also provided in the table.

Descriptive Statistics on VariablesWe calculate REDCA based on all firms included in Compustat. Descriptive statistics

for different variables used in the analyses are also provided in Table 2 for the total sampleas well as for the sub-samples of short and long auditor tenure.10

In Panel A of Table 2, we provide statistics for the total sample. The mean and medianof REDCA deflated by total assets for the total sample are –1.41 percent and –0.86 percent,respectively. In Panel B, we provide descriptive statistics for the sub-sample of positivediscretionary accruals.

Regression ResultsFirst, we conduct an OLS regression test on the total sample using the log of absolute

value of REDCA as the dependent variable. The results are contained in Table 3.11 Theresults for the total sample show that the coefficients for LAF and LTOTALFEE are negativeand statistically significant, and similarly the coefficient for auditor tenure (LOGTEN) isalso significantly negative for all the four audit fee metrics. The coefficients for LNAF andFEERATIO are, however, insignificant. These results thus suggest that there is no associ-ation between discretionary accruals and nonaudit fees (LNAF). The negative coefficientfor LOGTEN indicates that longer auditor tenure is associated with lower discretionaryaccruals.

We also conduct separate regression tests, similar to the tests conducted by ALM, onthe sub-samples of firms with positive and negative discretionary accruals. A separate teston the use of positive discretionary accruals enables us to highlight the association betweennonaudit fees and an upward adjustment of reported earnings. In Table 4, we present theregression results on the sub-sample of firms with positive discretionary accruals.

The results reported in Panel A of Table 4 show that the coefficient for LNAF isnegative, but insignificant, and that the coefficient for LOGTEN is significantly negative forall models. The results on the tenure variable are consistent with the earlier findings (e.g.,Myers et al. 2003), showing that longer tenure is associated with lower earnings manage-ment.12 With the exception of the following control variable on the LNAF regression, theresults on other control variables are consistent with ALM’s results: BIG5, MERGEACQ,MVBV, and DLOSS. The coefficient for BIG5 is significantly negative in ALM’s results,whereas, it is insignificantly positive in our results. The variable MERGEACQ is positivein ALM’s as well as in our results, but the coefficient is insignificant in our results and itis significant in ALM’s results. The variables of MVBV and DLOSS are insignificantlynegative in our results, whereas, they are significantly positive in ALM’s results.

10 All variables are winsorized at the 1 and 99 percent levels at the bottom and top tail of the distribution,respectively.

11 The t-statistics presented in Tables 5, 6, and 7 and the t-statistics for all unreported results are corrected usingWhite (1980) standard errors.

12 Theoretical arguments suggest a nonlinear relation between audit firms’ tenure and audit quality, but priorempirical studies assume a linear relation (e.g., Myers et al. 2003). In this study, we also assume a linear relation,but we test whether the theoretical argument of a nonlinear relation is valid in this case. The results do notsupport the assumption of nonlinearity.



TABLE 3Regression Results on the Association between Audit Fee Metrics and Discretionary Accruals

(REDCA) on Total Sample for Years 2000 and 2001

LOGREDCA � � � � FEE � � BIG5 � � PRECURRACCL � � LNMVE1 2 3 4

� � MERGEACQ � � FINANCING � � LEV � � MVBE5 6 7 8

� � LITIGATION � � DLOSS � � CFO � � INST HOLDING9 10 11 12

� � LOGTEN � � YEARDUM � ε13 14

Fee Metric (n � 4720)

Variable LAF LNAF LTOTALFEE FEERATIO

INTERCEPT �3.26** �2.91** �3.09** �2.82**LAF �0.11**LNAF �0.02LTOTALFEE �0.07**FEERATIO 0.03BIG5 0.03 0.02 0.03 0.01PRECURRACCL �0.31** �0.32** �0.32** �0.32**LNMVE �0.01 �0.03* �0.01 �0.04**MERGEACQ 0.08 0.06 0.08 0.05FINANCING 0.13* 0.13** 0.10** 0.13**LEV 0.03 �0.03 0.01 �0.05MVBV 0.00 0.00 0.00 0.00LITIGATION 0.16** 0.19** 0.18** 0.19**DLOSS 0.41** 0.39** 0.41** 0.39**CFO �0.25** �0.27** �0.26** �0.28**INST HOLDING �0.35** �0.37** �0.35** �0.38**LOGTEN �0.09** �0.10** �0.10** �0.10**YEARDUM 0.04 0.04 0.03 0.04Adjusted R-sq 0.11 0.10 0.03 0.10

*, ** statistically significant at the �5%, �1% levels (two-tailed), respectively.Variable Definitions:

REDCA � discretionary current accruals measure controlling for performance by including the prioryears’ ROA in the estimation of expected accruals;

LOGREDCA � natural logarithm of the absolute value of REDCA;FEE � AUDIT, NONAUDIT, TOTAL fees, or FEERATIO. With the exception of FEERATIO, we

take the natural log of each fee variable to normalize these variables’ distributions, allowingthe cross-sectional aggregation of observations;

LAF � natural logarithm of audit fee;LNAF � natural logarithm of nonaudit fee;

LTOTALFEE � natural log of total fee (audit fee � nonaudit fee);FEERATIO � nonaudit fee divided by total fee;

BIG5 � 1 if the firm is audited by Big 5, and 0 otherwise;PRECURRACCL � last year’s total current accruals equal to net income before extraordinary items plus

depreciation and amortization minus operating cash flows scaled by beginning of year totalassets;

LNMVE � natural logarithm of firm’s market value of equity;MERGEACQ � 1 if the firm is engaged in a merger or acquisition, and 0 otherwise;FINANCING � 1 if MERGEACQ is not equal to 1 and any of the following conditions apply: long-term

debt increased by 20 percent or more, number of shares outstanding increased by 10percent or more after controlling for stock splits, and 0 otherwise;




TABLE 3 (continued)

LEV � firm’s total assets less its book value divided by its total assets;MVBV � firm’s market-to-book ratio defined as its market value of equity divided by book values;

LITIGATION � 1 if the firm operates within a high-litigation industry, 0 otherwise, where high-litigationindustries are industries with SIC codes of 2833–2836, 3570–3577, 3600–3674, 5200–5961,7370–7374;

DLOSS � 1 if the firm reports a negative net income for the year, and 0 otherwise;CFO � firm’s cash flow from operations scaled by beginning of the year total assets;

INST HOLDING � percentage of shares held by institutional owners;LOGTEN � natural logarithm of auditor tenure in years; and


In order to mitigate the econometric problems associated with the OLS regression teston the positive discretionary accruals, whose distribution is truncated at zero, we conducta Tobit test on this sub-sample by setting the lower bound to zero. Results of the Tobit test(untabulated) are similar to those of the OLS regression test, suggesting that the resultspresented in the table are robust.

We focus on the impact of auditor tenure on the association between nonaudit fees andauditor independence by including an interaction term for each fee metric and auditortenure. Consistent with the literature (e.g., Johnson et al. 2002), we split the sample intolong and short tenure based on the three-year cut-off point, and auditor tenure is coded as1 when it is three years or less. The results reported in Panel B of Table 4 show that thecoefficient for LNAF is negative and insignificant, whereas, the coefficient for the interactionterm between nonaudit fees and auditor tenure (LNAF*TENDUM) is positive and significant(p � 0.05, two-tailed).13 These results suggest that the association between nonaudit feesand positive discretionary accruals is positive and significant when auditor tenure is short,and there is no association between nonaudit fees and positive discretionary accruals whenauditor tenure is long.

In Panel C of Table 4, we present regression results of an additional test on the sub-sample of positive discretionary accruals by coding the long auditor tenure as 0 whenauditor tenure is nine years or more. This classification is similar to that used by Carcelloand Nagy (2004). As a result of this classification, firms with auditor tenure of four to eightyears are dropped from the analyses. The results of this test also suggest that the associationbetween discretionary accruals and nonaudit fees is positive and significant (p � 0.05,two-tailed), when auditor tenure is short.

As suggested in the literature, separate regression tests on the two groups may providebetter results when the association between the X variable (nonaudit fees) and Y variable(REDCA) is hypothesized to be contingent on the moderator variable Z (auditor tenure)which assumes two values (tenure less than and equal to three years or tenure more thanthree years) (e.g., Staw and Oldham 1978; Wright et al. 1996, 452). Therefore, we alsoconduct tests for firms with short and long tenure separately.14 The results are presented inTable 5.

The results on firms with short auditor tenure (Panel A) show that the coefficient fornonaudit fees (LNAF) is positive and significant (p � 0.05, two-tailed). These results thusindicate that higher nonaudit fees are associated with higher earnings management when

13 The sum of the coefficients for LNAF and the interaction term is 0.08 (�0.02 � 0.10), which is significantlydifferent from 0.

14 ALM also conduct tests on the role of size and split the sample into quintiles by total assets, as at the fiscalyear-end, and find no significant results. Our tests differ from ALM since we also consider auditor tenure. Asour sample size for short tenured auditors is small, we use the median split.



TABLE 4Regression Results on the Association between Positive Discretionary Accruals (PREDCA) andAudit Fee Metrics Using Interaction Term for Fee Metrics and Auditor Tenure for the Years

2000 and 2001

VariableFee Metric

LAF LNAF LTOTALFEE FEERATIO

Panel A: Positive Discretionary Accruals with LOGTEN (n � 2107)

LOGPREDCA � � � � FEE � � BIG5 � � PRECURRACCL � � LNMVE1 2 3 4



� � LOGTEN� � YEARDUM � ε13 14

INTERCEPT �2.85** �2.44** �2.597** �2.446**LAF �0.11*LNAF �0.00LTOTALFEE �0.04FEERATIO 0.19BIG5 0.05 0.03 0.04 0.02PRECURRACCL �0.33** �0.34** �0.34** �0.34**LNMVE �0.03 �0.06** �0.04 �0.07**MERGEACQ 0.16* 0.13 0.15* 0.12FINANCING 0.32** 0.33** 0.33** 0.33**LEV �0.17 �0.25* �0.22 �0.25*MVBV �0.00 �0.00 �0.00 �0.00LITIGATION 0.16* 0.18** 0.17** 0.18**DLOSS �0.07 �0.08 �0.07 �0.08CFO �0.73* �0.75* �0.74* �0.75*INST HOLDING �0.51** �0.53** �0.52** �0.55**LOGTEN �0.12** �0.13** �0.12** �0.12**YEARDUM �0.11 �0.12* �0.12* �0.11Adjusted R-sq 0.15 0.14 0.15 0.15

Panel B: TENDUM (1 for tenure � 3, 0 for tenure � 3) (n � 2107)

LOGPREDCA � � � � FEE � � FEE TENDUM � � TENDUM � � BIG5*1 2 3 4

� � PRECURACCL � � LNMVE � � MERGEACQ � � FINANCING5 6 7 8

� � LEV � � MVBE � � LITIGATION � � DLOSS � � CFO9 10 11 12 13

� � INST HOLDING � � YEARDUM � ε14 15

INTERCEPT �3.12** �2.68** �2.83** �2.63**LAF �0.14**LAF * TENDUM 0.08LNAF �0.02LNAF * TENDUM 0.10*




TABLE 4 (continued)

VariableFee Metric


LTOTALFEE �0.06LTOTALFEE * TENDUM 0.06FEERATIO 0.00FEERATIO * TENDUM �0.65*TENDUM 0.18 0.22* 0.12 0.36*BIG5 0.00 �0.02 �0.01 0.02PRECURRACCL �0.34** �0.35** �0.34** �0.33**LNMVE �0.02 �0.05* �0.03 �0.06**MERGEACQ 0.13 0.10 0.12 0.10FINANCING 0.16* 0.16* 0.16* 0.16*LEV �0.18 �0.26* �0.23 �0.28*MVBV 0.00 0.00 0.00 0.00LITIGATION 0.16* 0.19** 0.18** 0.19**DLOSS �0.03 �0.03 �0.03 �0.03CFO �0.77* �0.80* �0.79* �0.81*INST HOLDING �0.55** �0.57** �0.56** �0.58**YEARDUM �0.09 �0.09 �0.09 �0.10Adjusted R-sq 0.14 0.14 0.14 0.14

Panel C: TENDUM (1 for tenure � 3, 0 for tenure � 9) (n � 1199)

INTERCEPT �3.00** �2.46** �2.70** �2.52**LAF �0.12*LAF * TENDUM 0.10LNAF 0.01LNAF * TENDUM 0.04*LTOTALFEE �0.05LTOTALFEE * TENDUM 0.08FEERATIO �0.16FEERATIO * TENDUM �0.46TENDUM 0.29* 0.21** 0.21* 0.36BIG5 �0.16 �0.15 �0.17 �0.09PRECURRACCL �0.27** �0.26** �0.27** �0.24**LNMVE �0.01 �0.06 �0.03 �0.05*MERGEACQ 0.09 0.06 0.07 0.07FINANCING 0.12 0.12 0.12 0.13LEV �0.27 �0.38 �0.33 �0.36MVBV 0.00 0.00 0.00 0.00LITIGATION 0.25** 0.29** 0.27** 0.28**DLOSS 0.07 0.05 0.06 0.05CFO �0.62 �0.66* �0.64 �0.66*INST HOLDING �0.74** �0.79** �0.76** �0.76**YEARDUM �0.06 �0.07 �0.06 �0.08Adjusted R-sq 0.14 0.13 0.13 0.13




TABLE 4 (continued)

*, ** statistically significant at the �5%, �1% levels (two-taileded), respectively.Variable Definitions:

LOGPREDCA � the natural logarithm of the positive value of REDCA;FEE � AUDIT, NONAUDIT, TOTAL fees, or FEERATIO. With the exception of

FEERATIO, we take the natural log of each fee variable to normalize thesevariables’ distributions, allowing the cross-sectional aggregation of observations;

LAF � natural logarithm of audit fee;LAF * TENDUM � interaction term of LAF and TENDUM;

LNAF � natural logarithm of nonaudit fee;LNAF * TENDUM � interaction term of LNAF and TENDUM;

LTOTALFEE � natural logarithm of total fee (audit fee � nonaudit fee);LTOTALFEE * TENDUM � interaction term of LTOTALFEE and TENDUM;

FEERATIO � nonaudit fee divided by total fee;FEERATIO � interaction term of FEERATIO and TENDUM;


depreciation and amortization minus operating cash flows scaled by beginning ofyear total assets;

LNMVE � natural logarithm of the firm’s market value of equity;MERGEACQ � 1 if the firm is engaged in a merger or acquisition, and 0 otherwise;FINANCING � 1 if MERGEACQ is not equal to 1 and any of the following conditions apply: long-

term debt increased by 20 percent or more, number of shares outstanding increasedby 10 percent or more after controlling for stock splits, and 0 otherwise;

LEV � firm’s total assets less its book value divided by its total assets;MVBV � firm’s market-to-book ratio defined as its market value of equity divided by book

values;LITIGATION � 1 if the firm operates within a high-litigation industry, 0 otherwise, where high-

litigation industries are industries with SIC codes of 2833–2836, 3570–3577, 3600–3674, 5200–5961, 7370–7374;


INST HOLDING � percentage of shares held by institutional owners;LOGTEN � natural logarithm of auditor tenure in years; and


the auditor tenure is short. The coefficients of LTOTALFEE and FEERATIO are also pos-itive, but insignificant. On the other hand, the results for firms with long auditor tenure(Panel B) show that the coefficients are negative for LAF, LNAF, and LTOTALFEE butpositive for FEERATIO. Except for LAF, all coefficients are insignificant. These results thusindicate that there is a trend of lower discretionary accruals when nonaudit fees are highand auditor tenure is long. Overall, these results support our earlier findings that highernonaudit fees are significantly associated with higher positive discretionary accruals whenauditor tenure is short and there is no significant association between nonaudit fees andpositive discretionary accruals when auditor tenure is long.

We also conduct tests on the firms with negative discretionary accruals. The results(untabulated) for the total sample with an interaction variable as well as on the sub-samplesof firms with short and long tenure indicate significantly negative coefficient for LAF forlong tenure only, whereas, the coefficients for all other fee metrics are insignificant.

The above results support our hypothesis that higher nonaudit fees are associated withhigher discretionary accruals only when the auditor tenure is short. These results thusindicate that the association between nonaudit fees and auditor independence is contingentupon auditor tenure.



TABLE 5Regression Results on the Association between Audit Fee Metrics

and Positive Discretionary Accruals

LOGPREDCA � � � � FEE � � BIG5 � � PRECURRACCL � � LNMVE1 2 3 4



� � YEARDUM � ε13

VariablesFee Metric


Panel A: Positive Discretionary Accruals (PREDCA) and Short Tenure (Tenure � 3)(n � 330)

INTERCEPT �2.68** �2.07** �2.42** �2.63**LAF �0.03LNAF 0.12*LTOTALFEE 0.04FEERATIO 0.40BIG5 �0.10 �0.09 �0.12 �0.14PRECURRACCL �0.40** �0.40** �0.40** �0.40**LNMVE �0.08 �0.14** �0.11 �0.11*MERGEACQ �0.02 �0.13 �0.06 �0.07FINANCING 0.24 0.16 0.23 0.22LEV �0.16 �0.20 �0.19 �0.17MVBV �0.00 �0.00 �0.00 �0.00LITIGATION 0.24 0.27 0.25 0.23DLOSS 0.17 0.17 0.17 0.17CFO �0.29 �0.31 �0.31 �0.29INST HOLDING 0.03 �0.02 0.01 0.00YEARDUM �0.10 �0.09 �0.09 �0.08Adjusted R–sq 0.16 0.17 0.16 0.16

Panel B: Positive Discretionary Accruals (PREDCA) and Long Tenure (Tenure � 3)(n � 1777)

INTERCEPT �3.20** �2.81** �2.92** �2.70**LAF �0.13**LNAF �0.03LTOTALFEE �0.06FEERATIO 0.18BIG5 0.08 0.07 0.08 0.06PRECURRACCL �0.38** �0.39** �0.39** �0.39**LNMVE �0.01 �0.05* �0.03 �0.07*MERGEACQ 0.19* 0.17* 0.18* 0.15*FINANCING 0.28** 0.29** 0.29** 0.29**LEV �0.12 �0.21* �0.18 �0.23*MVBV 0.00 0.00 0.00 0.00LITIGATION 0.12 0.15* 0.14* 0.15*




TABLE 5 (continued)

VariablesFee Metric


DLOSS �0.20* �0.21* �0.20* �0.21**CFO �1.33** �1.34** �1.34** �1.35**INST HOLDING �0.56** �0.59** �0.58** �0.62**YEARDUM �0.10 �0.10* �0.11* �0.10Adjusted R–sq 0.15 0.15 0.15 0.15


LOGPREDCA � natural logarithm of the positive value of REDCA;FEE � AUDIT, NONAUDIT, TOTAL fees, or FEERATIO. With the exception of FEERATIO, we



LTOTALFEE � natural logarithm of total fee (audit fee � nonaudit fee);FEERATIO � nonaudit fee divided by total fee;



LNMVE � natural logarithm of the firm’s market value of equity;MERGEACQ � 1 if the firm is engaged in a merger or acquisition, and 0 otherwise;FINANCING � 1 if MERGEACQ is not equal to 1 and any of the following conditions apply: long-term





INST HOLDING � percentage of shares held by institutional owners; andYEARDUM � 1 if fiscal year is 2001, 0 if fiscal year is 2000.

Sensitivity Test Results Based on Different Tenure Cut-Off Points for Auditor TenureWe also use the cut-off points of two, four, and five years for identifying the firms with

short and long auditor tenure. The results of the tests (untabulated) on short and long auditortenure based on the cut-off point of two years are similar to the results for the three-yearcut-off. The coefficient of nonaudit fees for the short tenure sub-sample is positive andsignificant (p � 0.01, two-tailed). These results provide additional support for our findingsthat there is higher earnings management when nonaudit fees are high and auditor tenureis short. The test results on the sub-samples of short and long auditor tenure based on thecut-off points of four and five years show no significant results for the nonaudit fee coef-ficients. These findings thus indicate that short auditor tenure of up to three years is likelyto be associated with lower auditor independence.

Results on Individual YearsWe repeat all the tests on data for positive REDCA separately for the years 2000 and

2001 separately. The untabulated regression results for the years 2000 and 2001 indicatethat they are similar to the results for the pooled sample for two years; the significance



levels of the coefficients for nonaudit fees are similar to the significance levels for thepooled sample.

Exploratory Analysis on the Role of Client Firm SizeAdditionally, we explore whether the impact of auditor tenure on the association be-

tween auditor independence and nonaudit fees is different between large and small clientfirms. Motivation for this analysis is based on the findings of prior studies, which suggestthat firm size could be associated with the auditors’ propensity to be independent. Forexample, Larcker and Richardson (2004) show that nonaudit fees may be problematic interms of auditor independence for a small subset of firms that are small and are under thede facto control of the management,15 have low institutional holdings, and a low book-to-market ratio. Similarly, Reynolds and Francis (2001) find that the Big-5 auditors reportmore conservatively for large clients than for small clients. Their results are consistent withthe argument that the reputation protection motivation dominates economic dependence(measured as client’s size relative to the size of the office that contracts for the audit) sofar as auditor behavior for large clients is concerned. Though their results are specific toindividual practices of Big-5 accounting firms, they have general applicability with regardto the reputation protection motivation. Similarly, Barton’s (2005) arguments suggest thatthe client’s visibility is the most important concern with respect to an auditor’s reputation.Further, the likelihood of litigation, which is also expected to be higher for large clients,provides an additional incentive for auditors to be more independent (Lys and Watts 1994).

In contrast to the independence and reputation argument, it can also be argued that therelationship between nonaudit fees and discretionary accruals may be influenced by weakeraccounting systems and the rapid growth in small client firms. The development of ac-counting systems in smaller firms may not keep pace with the firm’s rapid growth or maybe slow because of costs involved. Consequently, the weaknesses in the accounting systemsof the smaller client firm may result in lower-quality financial information. This situationwill present a special challenge to auditors early in their tenure because they may not fullyunderstand the weaknesses in the client’s accounting system. Further, the client firm maypurchase more nonaudit services to improve their accounting system, which could meanhigher nonaudit fees for the auditor. The weaker accounting system may thus result inhigher discretionary accruals, and additional nonaudit services are likely to result in highernonaudit fees. This means that the positive association between discretionary accruals andhigher nonaudit fees for small clients may not necessarily reflect the lack of auditorindependence.

We evaluate whether there is a positive association between discretionary accruals andnonaudit fees for small client firms when auditor tenure is short. In order to explore therole of client size in the relationship between nonaudit fees and positive discretionaryaccruals, we conduct tests on the sub-samples of small and large clients firms separately.We use the median asset size to split the sample into subgroups of large and small clients.The results on the sub-samples of small and large clients with short auditor tenure areprovided in Table 6.16

The results on the sub-sample of large client firms (Panel B) show that the coefficientof LNAF is insignificant, whereas, the results on the small client firms (Panel A) show thatthe coefficient of LNAF is positive and significant (p � 0.05, two-tailed). These results thus

15 Evidence shows that small firms are associated with higher management ownership (see, for example, Warfieldet al. 1995).

16 No significant results are obtained for the long auditor tenure sub-sample.



TABLE 6Regression Results on the Association between Audit Fee Metrics

and Positive Discretionary Accruals

LOGPREDCA � � � � FEE � � BIG5 � � PRECURRACCL � � MERGEACQ1 2 3 4

� � FINANCING � � LEV � � MVBE � � LITIGATION � � DLOSS5 6 7 8 9

� � CFO � � INST HOLDING � � YEARDUM � ε10 11 12

VariablesFee Metric


Panel A: Positive Discretionary Accruals (PREDCA), Short Tenure (Tenure � 3), and SmallClients (n � 165)

INTERCEPT �3.29** �2.66** �3.13** �2.66**LAF �0.06LNAF 0.15*LTOTALFEE 0.00FEERATIO �1.02*BIG5 0.10 0.04 0.06 0.16PRECURRACCL �0.42** �0.42** �0.42** �0.38**MERGEACQ �0.38 �0.56* �0.41 �0.40FINANCING 0.30 0.16 0.28 0.31LEV �0.01 0.02 �0.01 0.02MVBV �0.00* �0.00* �0.00* �0.00LITIGATION 0.35 0.32 0.36 0.33DLOSS 0.22 0.23 0.23 0.23CFO �0.10 �0.10 �0.10 �0.13INST HOLDING �0.66 �0.75 �0.69 �0.70YEARDUM 0.14 0.13 0.15 �0.07Adjusted R-sq 0.20 0.22 0.20 0.22

Panel B: Positive Discretionary Accruals (PREDCA), Short Tenure (Tenure � 3), and LargeClients (n � 165)

INTERCEPT �2.47** �2.24** �2.41** �2.40**LAF �0.01LNAF 0.06LTOTALFEE 0.02FEERATIO �0.10BIG5 �0.45 �0.52 �0.47 �0.47PRECURRACCL �0.27** �0.25* �0.27** �0.27**MERGEACQ 0.20 0.13 0.19 0.19FINANCING �0.01 �0.05 �0.017 �0.02LEV �1.12* �1.24* �1.16* �1.14*MVBV 0.01 0.01 0.01 0.01LITIGATION 0.05 0.05 0.04 0.04DLOSS 0.02 0.05 0.03 0.03CFO �1.69** �1.71** �1.70** �1.69**INST HOLDING 0.47 0.41 0.45 0.47




TABLE 6 (continued)

VariablesFee Metric


YEARDUM �0.30 �0.27 �0.29 �0.29Adjusted R-sq 0.16 0.17 0.16 0.16


LOGPREDCA � natural logarithm of the positive value of REDCA;FEE � AUDIT, NONAUDIT, TOTAL fees, or FEERATIO. With the exception of FEERATIO, we



LTOTALFEE � natural logarithm of total fee (audit fee � nonaudit fee);FEERATIO � nonaudit fee divided by total fee;



MERGEACQ � 1 if the firm is engaged in a merger or acquisition, and 0 otherwise;FINANCING � 1 if MERGEACQ is not equal to 1 and any of the following conditions apply: long-term





INST HOLDING � percentage of shares held by institutional owners; andYEARDUM � 1 if fiscal year is 2001, 0 if fiscal year is 2000.

indicate that discretionary accruals are higher for small client firms when auditor tenure isshort and nonaudit fees are high.

We also conduct tests on the role client size separately for the years 2000 and 2001.The results (untabulated) for year 2000 indicate that the coefficient of nonaudit fees for theshort tenure sub-group is positive and significant (p � 0.01, two-tailed) for small firms (n� 95) but insignificant for large firms (n � 96). The results for the long tenure sub-groupfor large (n � 380) and small (n � 379) firms show that none of the nonaudit fee coefficientsare significant. The results on data for the year 2001 show that the coefficient of nonauditfees is positive and significant (p � 0.05, two-tailed) for small firms (n � 70) and insig-nificant for large firms (n � 70). These results are consistent with the results for the pooledsample for two years.

Overall, the results for the positive association between nonaudit fees and positivediscretionary accruals are consistently significant for relatively small firms with short au-ditor tenure. No significant results are obtained for large firms in both the short and longauditor tenure categories, suggesting that for large clients the reputation effect is likely tooutweigh economic dependence. These preliminary findings, however, do not establish acasual link between higher nonaudit fees and auditor independence in small client firms.Additional research is needed on the role of client size in the auditor independence/earningsmanagement linkage. Further research should also consider whether size could be a proxyfor other variables such as weak corporate governance, since Larcker and Richardson (2004)



find that nonaudit fees affect auditor independence for a small cluster of firms that has asmaller market capitalization, lower book-to-market ratio, lower institutional holdings, andhigher insider holdings.

Overall FindingsThe findings of this study suggest that higher audit fees decrease the likelihood of

biased financial reporting for the firms with long auditor tenure, and presumably, this isbecause the auditors are more independent. This result is consistent with the view that alonger auditor/client relationship facilitates a higher quality audit as auditors acquire an in-depth knowledge of the client’s business operations, processes, and systems (Petty andCuganesan 1996). The results also suggest that auditors with longer tenure provide moreeffective monitoring of earnings management. On the other hand, higher nonaudit feescharged by auditors with a shorter tenure may suggest that the monitoring effectiveness ofauditors is reduced to please their client firms. The results on other audit fee metrics donot show any significant association between these metrics and earnings management forshort or long tenure.

Limitations of the StudyLimitations of this study include issues related to the sample selection, and

measurement-related problems in estimating discretionary accruals and auditor tenure. Theresults of this study are based on data for two years, and thus, the findings may not begeneralizable to other years. Further, the study uses U.S. data and these results may notbe applicable in other countries where institutional settings and regulatory requirements aredifferent. It is possible that high positive discretionary accruals may be correlated with thefirm’s perceived riskiness or other underlying events that may have caused auditor changeduring the study. Because the Compustat database used in this study goes back to 1984only, our measurement of auditor tenure is constrained by this limitation. Additionally, aspointed out earlier, the findings may have been influenced by the start-up firms in thesample. Therefore, the findings need to be interpreted with caution.

It is widely recognized that there are measurement errors in calculating discretionaryaccruals. We have attempted to mitigate this problem by using REDCA, which is consideredto be a better proxy for earnings management. Additionally, we have focused on positivediscretionary accruals, which are considered to be a better proxy for earnings managementand auditor independence. It is possible that detailed analyses of negative discretionaryaccruals, which reflect the accounting ‘‘big-bath,’’ conservative accounting, and/or the cre-ation of ‘‘cookie jar’’ reserves, may provide some additional insight into the association ofnonaudit fees with auditor independence. Unraveling these issues in the context of thelinkage between nonaudit fees and earnings management is left for future research.

As discussed in the paper, we have used a log of fee metrics as the dependent variablein the analyses on the assumption that log transformation of fee metrics is more suitableto the focus of our study. The validity of our findings may, therefore, be influenced by theappropriateness of the fee metrics used in the study.

Finally, it is possible that the results may be interpreted without any reference to the‘‘independence story.’’17 The positive association between nonaudit fees and positive dis-cretionary accruals for firms with short auditor tenure may be driven by the lack of client-specific knowledge rather than lack of auditor independence. The significant results obtainedfor small clients may also be due to the fact that the most difficult clients to audit are the

17 We thank one of the reviewers for this interpretation.



ones with the weakest accounting system who are also small clients and purchase the mostnonaudit services.

CONCLUSIONIn this paper, we integrate two strands of the audit literature to examine whether the

linkage between nonaudit fees and auditor independence, measured in terms of positivediscretionary accruals, is contingent on auditor tenure. To test this proposition we extendthe Ashbaugh et al. (2003) (ALM) study by including auditor tenure in the analyses. Wedo this by running separate regressions on firms with short and long audit tenure. Ourresults show that auditor independence may be compromised when auditors with shorttenure receive high nonaudit fees. We do not find any significant association between non-audit fees and earnings management when auditor tenure is long. Further, our preliminaryresults suggest that the client size could moderate the linkages between nonaudit fees,auditor tenure, and auditor independence. More specifically, the size analyses suggest thatauditor independence may be compromised as a result of high nonaudit fees for smallerclients with short auditor tenure but not for larger clients. In other words, economic bondingoutweighs the reputation cost for relatively small firms with short auditor tenure. These andother related issues are clearly worth investigating in future studies.

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Documents

AUDITING: A JOURNAL OF PRACTICE & THEORY pp. 117–142 ...(Geiger and Raghunandan 2002; Myers et al. 2003). ... fees, and the ratio of nonaudit fees to audit fees as the metrics. Consistent