Auditor Independence and the Quality of Information in Financial Disclosures: Evidence for Market Discipline vs. Sarbanes-Oxley Proscriptions

Abstract:     
Does auditor independence improve the quality of financial disclosures, and if it does, is regulation necessary to realize such improvements? Popular characterizations of governance scandals from the early 2000s answer, “Yes!” but lack support from scholarly investigations. This disagreement motivates our investigation of whether auditor independence matters in ways that prior research would have missed, and what any such effect means for the efficiency-consequences of related governance regulations.

1. We relax a priori data-restrictions that ignore the potential for auditors’ dependence on consulting fees to enhance the quality of earnings reports;

2. We measure unexpected accounting fees in a more firmly grounded manner, and develop a matching estimator to examine whether fee disclosures improve asset-pricing efficiency; and

3. We empirically evaluate the potential for governance externalities to rationalize proscriptive regulations.

Our results offer stronger support that auditor independence increases earnings quality on historically observable margins. More importantly, they also imply that an SEC requirement to disclose audit and consulting fees may have exhausted regulatory opportunities to improve this dimension of corporate governance, and thus speak more directly than does the literature against Sarbanes-Oxley’s subsequent proscription on jointly producing audit and non-audit services.

Keywords: Auditor independence, earnings quality, corporate governance, externalities, disclosure mandates, Sarbanes-Oxley Act of 2002

JEL Classifications: G14, G38, K22, M42

Accepted Paper Series