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Future Nonaudit Service Fees and Audit Quality


  • Accepted by Jeffrey Pittman. We are grateful for the constructive insights of the Editor and two anonymous reviewers. We also acknowledge the comments received from the workshop participants at the University of Auckland, Katholieke Universiteit Leuven, University of Kentucky, Kennesaw State University, Maastricht University, the University of Wisconsin and participants at the International Symposium on Auditing Research, Université Laval, Quebec City, Quebec, the American Accounting Association Mid-Year Auditing Meeting, Savannah, Georgia, the EAA Annual Congress, Ljubjana, Slovenia and the American Accounting Association Annual Meeting, Washington D.C. We thank Andrew Metrick for providing access to G-Score data on his website at Professors Causholli and Payne acknowledge the financial support from the Von Allmen Research Support Endowment at the University of Kentucky. Professor Chambers acknowledges the financial support of the Kennesaw State University School of Accountancy. Professor Payne acknowledges the financial support from the KPMG Professorship/Fellowship Endowment at the University of Kentucky.


Prior to the Sarbanes–Oxley Act of 2002, audit partners experienced economic pressure to grow revenue from the sale of nonaudit services to their audit clients. To an auditor who is highly rewarded for revenue generation and growth, nonaudit services may represent a particularly strengthened economic bond with the client. Prior research shows that, in general, nonaudit service fees received in the current period do not impair audit quality. We examine a different setting. We propose that auditor independence can become impaired, and audit quality compromised, when clients that currently purchase relatively low amounts of nonaudit services, increase their purchases of nonaudit services from the auditor in the subsequent period. We test our prediction in the context of earnings management as a proxy for audit quality, measured by (a) performance-adjusted discretionary accruals and (b) classification shifting of core expenses. Our results indicate that prior to the Sarbanes-Oxley Act, rewards to the auditor in the form of future additional nonaudit service fees from current-year high fee-growth-opportunity clients adversely affects audit quality. This effect is particularly strong among companies with powerful incentives to manage earnings. Our findings indicate that regulators should consider the multiperiod nature of the client–auditor relationship when contemplating policies that restrict nonaudit services, as well as the overall environment in which audit partners operate. This might include partner compensation arrangements that put pressure on audit partners to focus on increasing revenue at the expense of audit quality.

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