Non-Audit Services and Earnings Conservatism: Is Auditor Independence Impaired?

Abstract:     
We examine whether the provision of non-audit services (NAS) by incumbent auditors is associated with a reduction in the extent of "news-based" earnings conservatism (i.e., the differential extent to which earnings reflect bad news on a timely basis). Reduced earnings conservatism is expected to occur if relatively high levels of NAS results in reduced auditor independence. Because the demand for NAS and the extent of earnings conservatism are potentially endogenous, our primary tests focus on the extent to which NAS purchases (relative to audit fees) are greater or less than expected. Using several different methods for identifying earnings conservatism, we consistently find that higher than expected levels of NAS are not associated with reduced conservatism. This result is also robust across alternative measures of the economic bond between auditors and their clients, and also holds for tests confined to either the Big 6 or non-Big 6 audit firms. Our results are consistent with factors such as market-based incentives, the threat of ligation and alternative governance mechanisms offsetting any expected benefits to the audit firm from reducing its independence. We therefore conclude that recent legislative intervention aimed at restricting the supply of NAS is unlikely to result in increased independence in fact, although independence in appearance may be improved.

Number of Pages in PDF File: 40

Keywords: Non audit services, auditor independence, conservatism, audit quality

JEL Classification: M00, G29, M41, M49

working papers series