gul et al - 2007 - auditor independence - evidence on the joint effects of auditor tenure and non-audit fees

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1

AUDITOR INDEPENDENCE : EVIDENCE ON THE JOINT EFFECTS OF
AUDITOR TENURE AND NON-AUDIT FEES





Ferdinand A Gul
The Hong Kong Polytechnic University
School of Accounting & Finance
Hung Hom
Hong Kong
Tel: 852 2766 7771
Fax: 852 2365 9303
Email:


&

Bikki Jaggi*
Rutgers University
School of Business
Levin Building
Piscataway-NJ 08850
Tel : 732-445-3539
Fax: 732-445-3201
Email:

&
The Hong Kong Polytechnic University
Hong Kong

&

Gopal Krishnan
George Mason University
School of Management, MSN 5F4
Fairfax, VA 22030


JANUARY, 2007



___________________
* Correspondence Author

Acknowledgement: We gratefully acknowledge valuable comments from Yaw Mensah,
Suresh Radhakrishnan, Lai Kam Wah, J.B Kim, Bin Srinidhi and workshop participants at
Hong Kong Polytechnic University. We also thank Anthony Ng and Angel Sung for their
assistance in data collection and analyses.
Auditing: A Journal of Practice and Theory
(Forthcoming, 2007)
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2
AUDITOR INDEPENDENCE: EVIDENCE ON THE JOINT EFFECTS OF
AUDITOR TENURE AND NON-AUDIT FEES

Abstract

This study examines whether the impact of non-audit fees on auditor independence is
contingent on auditor tenure. The results, based on a sample of 4,720 U.S. firms for the years
2000 and 2001, show that there is a positive association between non-audit fees and positive
discretionary current accruals, a proxy for auditor independence, for firms with short auditor
tenure of not more than three years. These findings suggest that non-audit fees may impair
auditor independence when auditor tenure is short and not when auditor tenure is long.
Furthermore, exploratory analyses show that the positive association between non-audit fees
and earnings management for firms with short auditor tenure is significant for small clients
but not for large clients. Taken together, these results suggest that the association between
non-audit fees and auditor independence is contingent upon auditor tenure, and that high non-
audit fees have a negative impact on auditor independence when audit tenure is short and
client firm size is small.

Keywords: Auditor independence, non-audit fees, discretionary accruals, auditor tenure.

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

3
AUDITOR INDEPENDENCE: EVIDENCE ON THE JOINT EFFECTS OF
AUDITOR TENURE AND NON-AUDIT FEES


I. INTRODUCTION

Do non-audit services impair auditors’ independence? This question has attracted
attention from regulators, researchers and the financial press. In response to the concerns
related to non-audit services, the U.S. Congress passed the Sarbanes-Oxley Act (SOX) in
2002, which prohibits auditors from providing to their clients certain types of non-audit
services. To comply with SOX, the Securities and Exchange Commission (SEC) has revised
the rules on auditor independence, which now limit the circumstances and remuneration for
providing certain types of non-audit services (SEC 2001). In addition, the revised rules
require that the client firm shall disclose all fees paid to an audit firm by separate categories,
including services related to auditing, financial information system design and
implementation, and others, so that investors are fully informed about the types and

magnitudes of these fees. The SOX and the SEC’s regulations are apparently based on the
assumption that certain types of non-audit services provided by audit firms are likely to
impair auditor independence, thereby reducing audit quality.
Several studies have examined whether there is an association between non-audit fees
paid to audit firms and auditor independence.
1
Of particular interest to us in this paper are the
studies that examine the impact of non-audit fees on discretionary accruals, which are used as
a proxy for earnings management (e.g., Francis and Ke 2002; Frankel et al. 2002; DeFond et
al. 2002; Ashbaugh et al. 2003; Chung and Kallapur 2003; Larcker and Richardson 2004).
Findings of these studies are mixed. Frankel et al. (2002) (hereafter FJN) document that non-
audit fees are positively associated with the magnitude of discretionary accruals, suggesting
that high non-audit fees are likely to impair auditor independence. However, Ashbaugh et al.
(2003) (hereafter ALM) use a more refined measure of discretionary accruals and do not find

4
a statistically significant association between non-audit fees and positive discretionary
accruals. They conclude that there is no systematic evidence to support FJN’s findings that
higher non-audit fees impair auditor independence. Chung and Kallapur (2003) use a
different non-audit fees metric and also find no support for FJN’s findings. Thus, despite
concerns by regulators and the financial press, there is no clear evidence that higher non-audit
fees will negatively affect auditor independence.
Another stream of research in the auditing literature focuses on the association
between auditor independence and auditor tenure (e.g., Dopuch et al. 2001; Geiger and
Raghunandan 2002; Johnson et al. 2002; Myers et al. 2003). The importance of auditor
tenure is also reflected in Section 203 of the SOX, which requires a five-year rotation cycle
for the external lead or reviewing audit partner. A recent report of the Commission on Public
Trust and Private Enterprise appointed by the Conference Board also supports the idea of
auditor rotation (Conference Board 2005). However, empirical evidence to date shows that
longer auditor 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 non-
audit fees/auditor independence and argue that an investigation of the relation between
audit/non-audit fees and auditor independence without consideration of auditor tenure is
likely to provide an incomplete picture. We, therefore, include auditor tenure in the analyses
of the association between non-audit fees and auditor independence and evaluate whether
auditor tenure affects this association.
We conjecture that non-audit fees are likely to affect auditor independence for firms
with short auditor tenure, but not for firms with long auditor tenure. We argue that auditors
with short tenure are likely to place more emphasis on profits (quasi rents) than reputation
protection (Johnson et al. 2002). Furthermore, the competitive practice of low-balling could

5
cause the auditor to be more accommodating in the early years of the engagement (Geiger
and Raghunandan 2002). Under these circumstances, higher non-audit fees are likely to have
an adverse effect on auditor independence for firms with short auditor tenure. We also argue
that auditors with short tenure are likely to be relatively unfamiliar with the clients’
accounting and control systems, which would make it easier for the clients to manage their
reported earnings. Thus, these two factors are likely to contribute to the negative association
between non-audit fees and auditor independence for firms with short auditor tenure. On the
other hand, auditors who have had a long relationship with their clients are likely to be more
concerned about auditor reputation protection and are less likely to be influenced by non-
audit fees. In addition, they are more likely to have client-specific knowledge, which would
allow them to deter earnings management more effectively.
Consistent with earlier studies, we use performance-adjusted discretionary accruals or
REDCA (a term used by ALM)
2
as a proxy for earnings management on the assumption that
independent auditors should strictly monitor discretionary accruals that may be used by the
firm management to manipulate the reported earnings. As discussed by ALM, the use of

positive REDCA, i.e., income-increasing discretionary current accruals, is generally of major
concern to investors because managers are more likely to adjust earnings upwards to meet
market expectations or convert losses into small positive earnings (e.g. Burgstahler and
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 be too
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 negative
discretionary accruals.
Following ALM, we use the log of audit fees, the log of non-audit fees, the log of
total fees and the ratio of non-audit fees to audit fees as the metrics. Consistent with the

6
literature (e.g., Johnson et al. 2002), we use the cut-off point of three years for splitting the
sample into short and long auditor tenure. In the sensitivity tests, we also use different cut-off
points 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 no
significant association between non-audit fees and REDCA. When we split the sample into
positive and negative discretionary accruals and include auditor tenure in the analyses, the
association between non-audit fees and earnings management becomes clearer. For example,
when we include a dummy variable for auditor tenure (1 for short tenure < =3years, 0
otherwise) and interact this variable with non-audit fees in the positive discretionary accruals
sample, we obtain a significant positive coefficient for the interaction term. In other words,
firms with high non-audit fees and short tenure are associated with higher positive
discretionary accruals. Similar results are obtained when separate tests are conducted for
firms with long and short auditor tenure. The results on the firms with negative discretionary
accruals, however, show no significant association. These findings thus indicate that there is
an upward adjustment of reported earnings when non-audit fees are high and auditor tenure is
short. On the other hand, the results for firms with long auditor tenure show that there is no
significant association between positive discretionary accruals and non-audit fees. These
findings suggest that auditor independence may be compromised when non-audit fees are

high and auditor tenure is short. In other words, our results show that the relation between
non-audit fees and auditor independence is conditional on auditor tenure.
As an exploratory analysis, we examine whether the association between non-audit
fees and discretionary accruals for firms with short auditor tenure differs between large and
small client firms. It has been argued in the literature that auditors of large firms are more
likely 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 possible

7
that auditors may face bigger challenges early in their tenure when the client firm is small
because these firms may have weak accounting systems. Consequently, these small firms
may purchase more non-audit services to improve their accounting systems. Thus, in our
exploratory analysis, we test whether there is comparatively higher earnings management in
small firms when auditor tenure is short and non-audit fees are high. Our findings show that
there is a positive association between non-audit fees and positive discretionary accruals for
relatively small firms with shorter auditor tenure. Additional research, beyond the scope of
the present study, is warranted to establish whether higher discretionary accruals in small
firms are caused by higher non-audit fees or the weak accounting and internal control systems
within client firms.
This study makes the following contributions to the existing literature on auditor
independence. First, the findings provide evidence that the association between non-audit
fees and auditor independence depends on auditor tenure. Second, the findings show that the
concerns expressed by regulators and in the financial press regarding the role of non-audit
fees on auditor independence are justified only when auditor tenure is short, but not when
auditor tenure is long. Third, the results support earlier findings that longer auditor tenure
does not lead to reduced audit and financial reporting quality (e.g., Myers et al. 2003). This
finding thus suggests that the system of voluntary auditor rotation, which results in shorter
auditor tenure, is linked to poorer audit quality when non-audit fees are large. Fourth, the
results suggest that client size is also likely to play a role in the linkage between non-audit
fees, auditor tenure and auditor independence.

The remainder of the paper is organized as follows. In part two, we develop a
hypothesis for the study, and part three discusses the research methodology. The results are
discussed in part four, and conclusions are presented in part five.


8
II. HYPOTHESIS
Auditor Tenure, Non-Audit Fees and Auditor Independence

Auditor independence has been the subject of considerable debate for some time, and
it has been examined from the perspectives of both non-audit fees and auditor tenure. The
existing studies on the association between non-audit fees and auditor independence have
evaluated whether higher non-audit fees create an economic bond between the auditor and the
client, which enables the client firm to exert influence over the auditors’ decisions and make
auditors less independent as non-audit fees increase.
3
However, as pointed out earlier, the
findings of empirical studies using discretionary accruals as a proxy for auditor independence
provide conflicting evidence.
The impact of auditor tenure on auditor independence has also attracted attention from
regulatory agencies, congressional bodies, the Conference Board, the popular press as well as
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 Conference
Board states that “when there is confluence of circumstances that could put in question the
audit firm’s independence, the Commission believes that audit committees should carefully
consider rotation of audit firm (p. 39)”. In addition, the report illustrates the existence of
certain circumstances that merit consideration of rotation, and recommends serious
consideration of auditor rotation when the audit firm “has been employed for a substantial
period of time, e.g. over ten years”. Auditor rotation is supported on the ground that longer
auditor tenure leads to economic bonding between the auditor and client firms, which may

result in familiarity and personal connections between the auditor and client firms. Hence,
auditors are more likely to compromise their independence as auditor tenure increases.
Auditor rotation is thus suggested as a way to enhance auditor independence on the
assumption that it would enable auditors to resist management pressure and exercise greater

9
objectivity (e.g., Brody and Moscove 1998). Similarly, Wolf et al. (1999) argue that auditor
independence and objectivity will be enhanced if audit firms relinquish their clients
periodically. There is, however, no empirical evidence to support the argument that longer
auditor tenure is associated with lower auditor independence.
In contrast to the argument supporting shorter auditor tenure, the other school of
thought suggests that threats to independence may be greatest during the first few years of an
auditor-client relationship because the “recently acquired quasi-rents of incumbency may
make new auditors more vulnerable to threats of dismissal in earlier years of auditor-client
relationships” (Geiger and Raghunandan 2002, p.68). Apart from the independence argument,
it is also suggested that short tenure is associated with lower audit quality because the auditor
is unfamiliar with the client’s accounting system and firm characteristics (e.g.,
PriceWaterhouseCoopers 2002).
4
Similar arguments are also evident from the discussion in
the literature on audit failures, which suggest that audit failures occur almost three times
more often when an audit firm performs its first or second audit of a given client (AICPA
1992). The findings of a recent study also provide support for this argument by documenting
lower earnings quality for clients with shorter auditor tenure (Myers et al. 2003). On balance,
the evidence suggests that short auditor tenure is associated with lower earnings quality
because the auditor lacks independence or is unfamiliar with the client’s accounting system
and firm characteristics, or perhaps both.
5

Based on the evidence related to the impact of short auditor tenure on earnings

management, we conjecture that there will be a negative association between non-audit fees
and auditor independence for firms with short auditor tenure. The arguments below are
presented in support of our conjecture.
Prior research suggests that auditor incentives are traded off between the auditor’s
desire to protect firm reputation (brand name) and to maintain profits (quasi rents) from the

10
auditor-client relationship (Citron and Taffler 1992; Johnson et al. 2002). The desire to
maintain profits or quasi rents from an existing client relationship in the early years of the
engagement could cause the auditor to be more accommodating to the client. Geiger and
Raghunandan (2002) argue that auditors are willing to be more accommodating to the client
in the early years of an audit, because they are influenced by their desire to limit their losses
on the current engagement as a result of the competitive practice of low-balling and to be able
to ensure continuity of the engagement. Thus, it can be argued that a client would purchase
non-audit services in the early years of an engagement and persuade the auditor not to
conduct in-depth analyses which may uncover earnings management. It is also possible that
the auditor may face special audit problems earlier in the tenure because of unfamiliarity with
the client’s business, and thus may have difficulty in detecting earnings management. Based
on these arguments, we conjecture that large non-audit fees combined with short auditor
tenure are likely to be associated with higher earnings management. On the other hand, an
auditor with a relatively longer tenure and an established relationship with the client over a
period of time is likely to place more emphasis on reputation protection than profit, and is
less likely to be affected by high non-audit fees. As a result of the long tenure, the auditor
will have a better understanding of the client’s accounting system and be in a better position
to detect earnings management. Consequently, we argue that because of a combination of
reputation protection and better understanding of the client’s accounting system, high non-
audit fees are unlikely to be associated with earnings management when auditor tenure is
long. We develop the following hypothesis to test the impact of auditor tenure on the
association between auditor independence and non-audit fees:
H

1
: Higher non-audit fees are associated with higher discretionary accruals
when auditor tenure is short.


III. RESEARCH METHODLOGY

11
Sample
Data on audit fees are obtained from the Standard and Poor’s database. Our analyses
are based on all firms for which fee data are available for the years 2000 and 2001.
6
Data on
auditor tenure and financial variables are extracted from the Compustat database. The final
sample consists of 4,720 observations, of which 1,846 observations are from the year 2000
and 2,874 observations are from the year 2001. The distribution of the sample firms by
industry is provided in Table 1.
(Insert Table 1 here)
The sample is widely distributed over different industry groups. Over twenty-six
percent of sample firms are from the manufacturing sector, followed by computer-related
(18.9%) and retail-related (11.7%) businesses. This sample distribution by industry group is
consistent with the distribution of firms in the Compustat database, and in general is similar
to the sample used by ALM.
It needs to be pointed out, however, that some sample firms may be associated with
special firm-specific events that may result in lower or higher discretionary accruals, which
are used as a proxy for earnings management. Similarly, the sample may also include start-
up firms, which may behave differently with regard to earnings management. We expect that
the use of a large sample will mitigate these problems to some extent.
Fee Metrics
Descriptive statistics on the various fee metrics are provided in Table 2.

(Insert Table 2 here)

The mean (median) of audit fees is $0.59 ($0.22) million, whereas the mean (median) of non-
audit fees is $1.34 ($0.23) million respectively. These means (and medians) are generally

12
similar to those reported by ALM. There are no significant differences in the fee metrics for
the years 2000 and 2001.
Additionally, we examine the fee metrics for firms audited by Big 5 and non-Big 5
firms, where Big 5 audit firms refer to Arthur Andersen, Deloitte & Touche, Ernst and Young,
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
non-audit fees is $1.43 ($0.25) million respectively. As for clients of non-Big 5, the mean
(median) of audit fees is $0.15 ($0.1) million, and the mean (median) of non-audit fees is
$0.14 ($0.05) million, respectively. The means and medians suggest that audit as well as
non-audit fees are significantly higher for Big 5 clients.
As pointed out earlier, we use the log of audit fees, the log of non-audit fees, the log
of total fees and the ratio of non-audit fees to total fees (FEERATIO) as fee metrics. The use
of these metrics allows us to compare the results of our study with those obtained from the
ALM study.
Validity of Audit Fee Metrics
We 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, based
on ALM, includes the variables of a client firm’s auditor choice, audit complexity, audit risk,
and demand for consulting services, as well as the variable of auditor tenure. The audit fee
model is used for testing the validity of audit fee data:
LEVMVBVFINANCINGMERGEACQLNMVEBIGFEE
654321

5
β
β
β
β
β
β
α
+
+
+
+++=


εγ
β
β
β
β
β
++
+
+
+++
∑
=
13
1
1110987
_

i
ii
MMIESINDUSTRYDU
LOGTENSPECIALROANEGATIVEINVRECROA
(1)
where,
FEE = FEERATIO, AUDIT, NON-AUDIT, or TOTAL fees. With the
exception of FEERATIO, we take the natural log of each fee
variable to normalize the distributions of these variables, allowing

13
the 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 study
period, 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
MVBV = the firm’s market-to-book ratio defined as its market value of equity
divided 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
LOGTEN = the natural log of auditor tenure in years

Industry dummies are included in the model to control for cross industry differences in fees.
The audit fee model results (untabulated) show that there is a positive association
between audit fees and BIG5, LNMVE
8
, MERGERACQ, LEV, ROA, INVREC,
NEGATIVE_ROA and SPECIAL, and a negative association between audit fees and
FINANCING 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 respectively,
whereas it is only 26.50 percent for the fee ratio. These R-squared values are similar to those
reported by ALM. These results thus suggest that our sample of audit fees is representative
of the population of publicly traded firms and the analyses on the association between audit
fees and earnings management should reflect reliable results.
Discretionary Accruals as a Proxy for Earnings Management
Discretionary accruals are commonly used as a proxy for earnings management, and
different models have been suggested in the literature to estimate discretionary accruals. In
this paper, we use the performance-adjusted discretionary accruals (REDCA) measure. The
measure has been considered a better proxy for earnings management because current items

14
are 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 current
accruals with the performance factor makes them comparable across firms from different
industry groups (e.g., Kothari et al. 2002; Klein 2002). While ALM also use the Portfolio
Performance Adjusted Discretionary Current Accruals (PADCA) measure, we restrict our
analyses to REDCA because the latter better reflects earnings management, as argued by
ALM.
9

Long versus Short Auditor Tenure
Geiger 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 mitigated after
six or more years. They thus conclude that the threat to auditor independence is the greatest
during the first few years of the auditor/client relationship. Consistent with their analyses, we
set the cut-off point at three years for differentiating between short and long auditor tenure.
We, however, also conduct analyses on different cut-off points.
Association between Discretionary Accruals and Non-audit Fees

We 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 = α + β
1
FEE+ β
2
BIG5+ β
3
PRECURRACCL+ β
4
LNMVE

εββ
ββββ
β
β
β
β

+++
++++
+
+
+
+
YEARDUMLOGTEN
HOLDINGINSTCFODLOSSLITIGATION
MVBVLEVFINANCINGMERGERACQ
1413
1211109
8765
_

(2)
where,
LOGREDCA = Log of REDCA
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 the year total assets

15
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 = the firm’s cash flow from operations scaled by beginning of the year
total assets
INST_HOLDING = the percentage of shares held by institutional owners

YEARDUM = 1 if the fiscal year is 2001, 0 if fiscal year is 2000


Other variables have been defined earlier. We use the variable YEARDUM to control for the
effect of time period. Consistent with ALM and Warfield et al. (1995), the dependent
variable REDCA is transformed by taking the natural logarithm of absolute values to correct
for possible violations of normality.
We use the natural log of tenure in our analysis to overcome the problem that
observations are not normally distributed. We conduct tests on the total sample and also
separately on the sub-samples of positive and negative discretionary accruals. The impact of
audit tenure is evaluated by including an interaction term for audit fees and auditor tenure in
the analyses, and also by conducting separate tests on firms with short and long auditor tenure.

IV. RESULTS AND DISCUSSION
Calculation and Descriptive Statistics of Auditor Tenure
Auditor tenure is calculated on the basis of information about the year when the audit
firm 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 measurement
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 the three year cut-off
point.

16
Descriptive statistics on auditor tenure are provided in Table 2. The results show that
mean (median) auditor tenure for the total sample is 8.6 (7) years. The mean and median of
the sub-samples of short and long auditor tenure are also provided in the table.
Descriptive Statistics on Variables
We 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 sample as

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
median of 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
positive discretionary accruals.

Regression Results
First, 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

(Insert Table 3 here)

The results for the total sample show that the coefficients for LAF and LTOTALFEE
are negative and statistically significant, and similarly the coefficient for auditor tenure
(LOGTEN) is also significantly negative for all the four audit fee metrics. The coefficients
for LNAF and FEERATIO are, however, insignificant. These results thus suggest that there
is no association between discretionary accruals and non-audit fees (LNAF). The negative
coefficient for LOGTEN indicates that longer auditor tenure is associated with lower
discretionary accruals.
We also conduct separate regression tests, similar to the tests conducted by ALM, on
the sub-samples of firms with positive and negative discretionary accruals. A separate test on

17
the use of positive discretionary accruals enables us to highlight the association between non-
audit fees and an upward adjustment of reported earnings. In Table 4, we present the
regression results on the sub-sample of firms with positive discretionary accruals.
(Insert Table 4 here)

The results reported in Panel A of Table 4 show that the coefficient for LNAF is
negative, but insignificant, and that the coefficient for LOGTEN is significantly negative for
all 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
management.
12
With the exception of the following control variable on the LNAF regression,
the results 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 positive in
ALM’s as well as in our results, but the coefficient is insignificant in our results and it is
significant in ALM’s results. The variables of MVBV and DLOSS are insignificantly
negative in our results, whereas they are significantly positive in ALM’s results.
In order to mitigate the econometric problems associated with the OLS regression test
on the positive discretionary accruals, whose distribution is truncated at zero, we conduct a
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 results
presented in the table are robust.
We focus on the impact of auditor tenure on the association between non-audit fees
and auditor independence by including an interaction term for each fee metric and auditor
tenure. Consistent with the literature (e.g., Johnson et al. 2002), we split the sample into long
and short tenure based on the three-year cut-off point and auditor tenure is coded as 1 when it

18
is three years or less. The results reported in Panel B of Table 4 show that the coefficient for
LNAF is negative and insignificant, whereas the coefficient for the interaction term between
non-audit fees and auditor tenure (LNAF*TENDUM) is positive and significant (p<0.05, 2-
tailed).
13

These results suggest that the association between non-audit fees and positive
discretionary accruals is positive and significant when auditor tenure is short, and there is no
association between non-audit fees and positive discretionary accruals when auditor 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 when auditor
tenure is nine years or more. This classification is similar to that used by Carcello and Nagy
(2004). As a result of this classification, firms with auditor tenure of four to eight years are
dropped from the analyses. The results of this test also suggest that the association between
discretionary accruals and non-audit fees is positive and significant (p<0.05, 2-tailed), when
auditor tenure is short.
As suggested in the literature, separate regression tests on the two groups may provide
better results when the association between the X variable (non-audit 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 than three
years) (e.g., Staw and Oldham 1978; Wright et al. 1996, 452). Therefore, we also conduct
tests for firms with short and long tenure separately.
14
The results are presented in Table 5.
(Insert Table 5 here)

The results on firms with short auditor tenure (Panel A) show that the coefficient for
non-audit fees (LNAF) is positive and significant (p<0.05, 2-tailed). These results thus
indicate that higher non-audit fees are associated with higher earnings management when the

19
auditor tenure is short. The coefficients of LTOTALFEE and FEERATIO are also positive,
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 but positive for
FEERATIO. Except for LAF, all coefficients are insignificant. These results thus indicate

that there is a trend of lower discretionary accruals when non-audit fees are high and auditor
tenure is long. Overall, these results support our earlier findings that higher non-audit fees
are significantly associated with higher positive discretionary accruals when auditor tenure is
short and there is no significant association between non-audit fees and positive 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-samples
of firms with short and long tenure indicate significantly negative coefficient for LAF for
long tenure only, whereas the coefficients for all other fee metrics are insignificant.
The above results support our hypothesis that higher non-audit fees are associated
with higher discretionary accruals only when the auditor tenure is short. These results thus
indicate that the association between non-audit fees and auditor independence is contingent
upon auditor tenure.
Sensitivity Test Results Based on Different Tenure Cut-off Points for Auditor Tenure
We 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
auditor tenure based on the cut-off point of two years are similar to the results for the three-
year cut- off. The coefficient of non-audit fees for the short tenure sub-sample is positive and
significant (p < 0.01, 2-tailed). These results provide additional support for our findings that
there is higher earnings management when non-audit fees are high and auditor tenure is short.
The test results on the sub-samples of short and long auditor tenure based on the cut-off

20
points of four and five years show no significant results for the non-audit fee coefficients.
These findings thus indicate that short auditor tenure of up to three years is likely to be
associated with lower auditor independence.
Results on Individual Years
We 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 indicate that
they are similar to the results for the pooled sample for two years; the significance levels of

the coefficients for non-audit fees are similar to the significance levels for the pooled sample.
Exploratory Analysis on the Role of Client Firm Size
Additionally, we explore whether the impact of auditor tenure on the association
between auditor independence and non-audit fees is different between large and small client
firms. Motivation for this analysis is based on the findings of prior studies, which suggest
that firm size could be associated with the auditors’ propensity to be independent. For
example, Larcker and Richardson (2004) show that non-audit fees may be problematic in
terms of auditor independence for a small subset of firms that are small and are under the de
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 report more
conservatively for large clients than for small clients. Their results are consistent with the
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) so far as
auditor behavior for large clients is concerned. Though their results are specific to individual
practices of Big-5 accounting firms, they have general applicability with regard to the
reputation protection motivation. Similarly, Barton’s (2005) arguments suggest that the
client’s visibility is the most important concern with respect to an auditor’s reputation.

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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 the
relationship between non-audit fees and discretionary accruals may be influenced by weaker
accounting systems and the rapid growth in small client firms. The development of
accounting systems in smaller firms may not keep pace with the firm’s rapid growth or may
be slow because of costs involved. Consequently, the weaknesses in the accounting systems
of the smaller client firm may result in lower quality financial information. This situation
will present a special challenge to auditors early in their tenure because they may not fully

understand the weaknesses in the client’s accounting system. Further, the client firm may
purchase more non-audit services to improve their accounting system, which could mean
higher non-audit fees for the auditor. The weaker accounting system may thus result in
higher discretionary accruals and additional non-audit services are likely to result in higher
non-audit fees. This means that the positive association between discretionary accruals and
higher non-audit fees for small clients may not necessarily reflect the lack of auditor
independence.
We evaluate whether there is a positive association between discretionary accruals
and non-audit fees for small client firms when auditor tenure is short. In order to explore the
role of client size in the relationship between non-audit fees and positive discretionary
accruals, 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 are provided in
Table 6.
16

(Insert Table 6 here)


22
The results on the sub-sample of large client firms (Panel B) show that the coefficient
of LNAF is insignificant, whereas the results on the small client firms (Panel A) show that
the coefficient of LNAF is positive and significant (p<0.05, 2-tailed). These results thus
indicate that discretionary accruals are higher for small client firms when auditor tenure is
short and non-audit 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 non-audit fees for the
short tenure sub-group is positive and significant (p<0.01, 2-tailed) for small firms (N=95)
but insignificant for large firms (N=96). The results for the long tenure sub-group for large
(N=380) and small (N=379) firms show that none of the non-audit fee coefficients are

significant. The results on data for the year 2001 show that the coefficient of non-audit fees
is positive and significant (p<0.05, 2-tailed) for small firms (N=70) and insignificant for large
firms (N=70). These results are consistent with the results for the pooled sample for two years.
Overall, the results for the positive association between non-audit fees and positive
discretionary accruals are consistently significant for relatively small firms with short auditor
tenure. No significant results are obtained for large firms in both the short and long auditor
tenure categories, suggesting that for large clients the reputation effect is likely to outweigh
economic dependence. These preliminary findings, however, do not establish a casual link
between higher non-audit fees and auditor independence in small client firms. Additional
research is needed on the role of client size in the auditor independence/earnings management
linkage. Further research should also consider whether size could be a proxy for other
variables such as weak corporate governance since Larcker and Richardson (2004) find that
non-audit fees affects auditor independence for a small cluster of firms which has a smaller
market capitalization, lower book-to-market ratio, lower institutional holdings, and higher
insider holdings.

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Overall Findings
The 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 is
because the auditors are more independent. This result is consistent with the view that a
longer 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 and
Cuganesan 1996). The results also suggest that auditors with longer tenure provide more
effective monitoring of earnings management. On the other hand, higher non-audit fees
charged by auditors with a shorter tenure may suggest that the monitoring effectiveness of
auditors is reduced to please their client firms. The results on other audit fee metrics do not
show any significant association between these metrics and earnings management for short or
long tenure.
Limitations of the Study

Limitations of this study include issues related to the sample selection, and
measurement-related problems in estimating discretionary accruals and auditor tenure. The
results of this study are based on data for two years, and thus the findings may not be
generalizable to other years. Further, the study uses US data and these results may not be
applicable in other countries where institutional settings and regulatory requirements are
different. It is possible that high positive discretionary accruals may be correlated with the
firm’s perceived riskiness or other underlying events that may have caused auditor change
during the study. Because the Compustat data base used in this study goes back to 1984 only,
our measurement of auditor tenure is constrained by this limitation. Additionally, as pointed
out earlier, the findings may have been influenced by the start-up firms in the sample.
Therefore, the findings need to be interpreted with caution.

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It is widely recognized that there are measurement errors in calculating discretionary
accruals. We have attempted to mitigate this problem by using REDCA, which is considered
to be a better proxy for earnings management. Additionally, we have focused on positive
discretionary accruals, which are considered to be a better proxy for earnings management
and auditor independence. It is possible that detailed analyses of negative discretionary
accruals, which reflect the accounting “big-bath”, conservative accounting and/or the creation
of “cookie jar” reserves, may provide some additional insight into the association of non-
audit fees with auditor independence. Unraveling these issues in the context of the linkage
between non-audit 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 variable
in the analyses on the assumption that log transformation of fee metrics is more suitable to
the focus of our study. The validity of our findings may, therefore, be influenced by the
appropriateness 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 non-audit fees and positive

discretionary 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 obtained
for small clients may also be due to the fact that the most difficult clients to audit are the ones
with the weakest accounting system who are also small clients and purchase the most non-
audit services.
V. CONCLUSION
In this paper we integrate two strands of the audit literature to examine whether the
linkage between non-audit fees and auditor independence, measured in terms of positive
discretionary accruals, is contingent on auditor tenure. To test this proposition we extend the
ALM study by including auditor tenure in the analyses. We do this by running separate

25
regressions on firms with short and long audit tenure. Our results show that auditor
independence may be compromised when auditors with short tenure receive high non-audit
fees. We do not find any significant association between non-audit fees and earnings
management when auditor tenure is long. Further, our preliminary results suggest that the
client size could moderate the linkages between non-audit fees, auditor tenure and auditor
independence. More specifically, the size analyses suggest that auditor independence may be
compromised as a result of high non-audit fees for smaller clients with short auditor tenure
but not for larger clients. In other words, economic bonding outweighs the reputation cost for
relatively small firms with short auditor tenure. These and other related issues are clearly
worth investigating in future studies.