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Auditor Independence and Earnings Quality: Evidence for Market Discipline vs. Sarbanes-Oxley Proscriptions

43 Pages Posted: 2 Nov 2006 Last revised: 8 Oct 2008

James R. Brown

Iowa State University - Department of Finance

Dino Falaschetti

U.S. House of Representatives

Michael J. Orlando

Economic Advisors, Inc.; University of Colorado - Denver

Date Written: October 6, 2008

Abstract

Does auditor independence improve earnings quality and, if so, is regulation necessary to realize such improvements? Popular characterizations of recent governance scandals answer "yes!", but lack support from scholarly investigations. This disagreement motivates our investigation of whether auditor independence affects earnings quality 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 earnings quality.

2. We measure unexpected accounting fees in a more defensible 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 some support for auditor independence improving earnings quality. Importantly, however, they also suggest that mandated fee disclosures exhausted regulatory opportunities to improve this dimension of corporate governance, and thus speak more directly than does the literature against Sarbanes-Oxley's 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 Classification: G14, G38, K22, M41, M43, M49

Suggested Citation

Brown, James R. and Falaschetti, Dino and Orlando, Michael J., Auditor Independence and Earnings Quality: Evidence for Market Discipline vs. Sarbanes-Oxley Proscriptions (October 6, 2008). FSU College of Law, Law and Economics Paper No. 07-33; FSU College of Law, Public Law Research Paper No. 259; 2nd Annual Conference on Empirical Legal Studies Paper. Available at SSRN: https://ssrn.com/abstract=940847 or http://dx.doi.org/10.2139/ssrn.940847

James R. Brown

Iowa State University - Department of Finance ( email )

College of Business
Ames, IA 50011-2063
United States
5152944668 (Phone)

Dino Falaschetti (Contact Author)

U.S. House of Representatives ( email )

Committee on Financial Services
2129 Rayburn House Office Building
Washington, DC District of Columbia 20515
United States

Michael J. Orlando

Economic Advisors, Inc. ( email )

United States

HOME PAGE: http://home.comcast.net/~michael.j.orlando

University of Colorado - Denver ( email )

1475 Lawrence St.
Suite 4001
Denver, CO 80202
United States

HOME PAGE: http://www.ucdenver.edu/academics/colleges/business/degrees/ms/gem/Pages/faculty.aspx

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