The association between audit fees and reported earnings quality in pre‐ and post‐Sarbanes‐Oxley regimes

The purpose of this paper is to examine the empirical association between expected and unexpected audit fees and reported earnings quality for a sample of Big 4(5) client companies over a period from 2000 to 2005.

The paper employs a cross‐sectional multiple regression model for a sample of 1,142 firms (6,852 firm‐years) covering a time period of six years comprising 2000 to 2005 to evaluate the relationship between both expected and unexpected audit fees and performance‐adjusted discretionary accruals that are estimated from the extended version of the modified Jones model.

The paper finds that both expected and unexpected audit fees are associated with an increase in earnings quality, as indicated by the reduction of both absolute and signed discretionary accrual adjustments. Furthermore, in some analyses these associations are found to persist into the post‐Sarbanes‐Oxley Act (SOX) period. The main results hold in sensitivity tests that involve using both the absolute and signed unexpected audit fees as independent variables and in tests that use both the absolute and signed current accruals as dependent variables of interest.

The results suggest that audit efforts consistent with client‐specific business attributes and reflected in expected audit fees mitigate financial reporting biases, the effect of which is incrementally observable to some extent in the post‐SOX period as well. Unexpected audit fees, a proxy for fee surprise arising out of auditor‐client‐specific contractual situations, are also associated with an increase in earnings quality. The association is, in some analyses, significant for the post‐SOX years. The test results do not exhibit any evidence of auditor independence problems associated with high expected and unexpected audit fees; a result that supports the “reputation protection” argument for auditors' reporting decisions.

In a time period surrounding the introduction of SOX when nonaudit consulting services have severely been restricted, and the audit fee growth for publicly traded companies have been dramatic, an analysis of this nature potentially produces valuable insights into the auditors' fee decision, audit efforts, and auditor independence issue. The study looks into a new perspective concerning the relationship between audit fees and financial reporting practice over the two regulatory regimes, pre‐ and post‐SOX.