Abnormal Audit Fee and Audit Quality

Auditing: A Journal of Practice & Theory
Vol. 31, No. 3

August 2012
pp. 122
American Accounting Association

DOI: 10.2308/ajpt-10294
Abnormal Audit Fee and Audit Quality

Sharad C. Asthana and Jeff P. Boone
SUMMARY: This study tests the hypotheses that below-normal audit fees signal
important nuances in the balance of bargaining power between the auditor and the client,
and that such power may ultimately influence audit quality. We find that audit quality,
proxied by absolute discretionary accruals and meeting or beating analysts earnings
forecasts, declines as negative abnormal audit fees increase in magnitude, with the
effect amplified as proxies for client bargaining power increase. We find that this effect is
dampened in years following the Sarbanes-Oxley Act (SOX), suggesting that SOX was
effective in enhancing auditor independence.
Keywords: abnormal audit fees; bargaining power; economic bonding.
INTRODUCTION
nderstanding the factors that lead auditors to compromise on audit quality is an important
issue of concern to scholars, investors, and regulators. One possible factor that has
received significant research attention is economic bonding between the auditor and
client. The basic idea in these studies is that positive abnormal audit fees reflect the extent of
economic bonding between the auditor and client, and greater economic bonding degrades audit
quality by impairing auditor independence. Based on this premise, studies have examined the
linkage between audit quality and positive abnormal audit fees, with such studies documenting a
negative association.
In this study, we reexamine the association between abnormal audit fees and audit quality, and
we do so in a way that allows our paper to offer two important contributions to the literature. First,
we incorporate into our conceptual framework insights about client bargaining power (Casterella et
al. 2004) in addition to the economic bonding story that forms the conceptual framework in prior
studies. Expanding the framework to consider both bargaining power and economic bonding allows
us to offer a novel prediction that would not be meaningful within a framework based exclusively
on economic bonding. That prediction is: audit quality will decline as negative abnormal audit fees
increase in magnitude, and the magnitude of the decline will increase as proxies for client
bargaining power increase. The economic bonding literature that informs prior studies places the
focus on positive abnormal audit fees, predicting no association between negative abnormal audit
Sharad C. Asthana and Jeff P. Boone are both Professors at The University of Texas at San Antonio.
Editors note: Accepted by Jean Bedard.
Submitted: December 2009

Accepted: March 2012
Published Online: August 2012
Asthana and Boone
fees and audit quality, and a negative association between positive abnormal audit fees and audit
quality.
Second, we include in our analysis data taken from the post-Sarbanes-Oxley (SOX) period
(i.e., years 20042009), in addition to data from the pre-SOX period (i.e., years 20002003). The
pre-SOX period has been the data source for virtually all of the prior studies. With data taken from
both the pre- and post-SOX periods, we are able to probe for a dampened association between
abnormal audit fees and audit quality that would be manifest if SOX reforms meaningfully
increased auditor independence or strengthened the auditors bargaining power, leading to higher
audit quality. To date, there is only limited empirical evidence that speaks to the issue of whether
SOX reforms increased audit quality.
Consistent with prior research (e.g., Choi et al. 2010; Hope et al. 2009; and Higgs and Skantz
2006), we decompose total audit fees into normal and abnormal components, and test for an
association between audit quality and abnormal audit fees, conditioning our tests on the sign of the
abnormal audit fee metric (i.e., above-normal audit fees and below-normal audit fees). Under the
bargaining power story, we expect to find that audit quality declines as negative abnormal fees
increase in magnitude, with the effect amplified as proxies for client bargaining power increase.
Under the economic bonding story (and consistent with prior studies), we expect to find that audit
quality declines as positive abnormal fees increase in magnitude. We also partition our analysis by
regulatory regime (i.e., a pre-SOX reporting period or a post-SOX reporting period) in order to
assess whether the sensitivity of audit quality to abnormal audit fees differs between these two
regimes. Our two proxies for audit quality are absolute discretionary accruals and meeting or
beating analysts earnings forecasts, and our two proxies for client bargaining power reflect the
importance of the client to the local practice office.
Our tests produce evidence consistent with both the economic bonding story and the bargaining
power story. As predicted by the economic bonding story, we find that absolute discretionary
accruals and the probability of meeting or beating earnings forecasts both increase as positive
abnormal audit fees increase. As predicted by the client bargaining power story, we find that
absolute discretionary accruals and the probability of meeting or beating earnings forecasts increase
with the magnitude of negative abnormal audit fees, with the effect amplified as client bargaining
power increases. With respect to the effects of SOX, we find that the effects of economic bonding
and client bargaining power are both dampened in the post-SOX regime, suggesting that SOX was
effective in enhancing auditor independence.
The evidence presented in our paper is important in at least two respects. First, our results
suggest that investors, regulators, and others interested in assessing the effects of auditor
remuneration on audit quality should be concerned with both above-normal and below-normal
auditor remuneration, but for different reasons. The potential effect of above-normal audit fees in
degrading audit quality by economically bonding the auditor with the client is well recognized and
extensively investigated. Less recognized is the possibility that below-normal audit fees signal
important nuances in the balance of power between the auditor and the client, and that such power
may ultimately influence audit quality. Thus, our study highlights the importance of considering the
bargaining power of the client when assessing audit quality. Second, our study presents the first
evidence (of which we are aware) to suggest that reforms introduced by the Sarbanes-Oxley Act
dampened the deleterious effects of economic bonding and client power on audit quality, and hence
increased audit quality. Both of these important insights from our study increase understanding of
the factors that may lead auditors to compromise on audit quality, and hence our paper should be of
interest to accounting scholars, investors, and regulators.
The remainder of the study is organized as follows. The second section develops our theoretical
framework and presents the hypotheses that we test. We present our research design in the third
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section, followed by a discussion of our sample in the fourth section and our results in the fifth
section. We offer concluding comments in the sixth section.
THEORETICAL FRAMEWORK AND HYPOTHESES
An audit firm is not a single person auditor; rather, it is a decentralized organization in which
individual audit partners act as agents for the audit firm (Liu and Simunic 2005). To the extent the
partnership profit-sharing plan does not effectively align the interests of the partner with that of the
audit firm partners as a whole, an uncontrolled moral hazard problem exists that might result in an
individual audit partner succumbing to client pressure for earnings management. This is because the
individual partner captures a significant portion of the expected benefit from acquiescing to client
demands, while passing to the partnership as a whole the expected cost (Trompeter 1994).
What factors might lead an audit partner to compromise on audit quality? As described below,
engagement profitability and client bargaining power are two possible explanations.
Engagement Profitability and Economic Bonding
Engagement profitability should influence audit quality for the following reason. Audit startup costs and client switching costs allow the auditor to price audit services at a price in excess of
the avoidable cost of producing the audit, and thus create for the incumbent auditor clientspecific quasi-rents (DeAngelo 1981a, 1981b). The client-specific quasi-rents economically bond
the auditor to the client, reduce auditor independence, and increase the likelihood that the
auditor will acquiescence to a clients demand for earnings management. However, succumbing
to client pressure risks audit firm forfeiture of some or all of the quasi-rents from the firms
entire client portfolio (if the earnings management is discovered), and additional economic loss
through litigation and government penalties (DeAngelo 1981a, 1981b). The auditor will
compromise audit integrity only if the expected gain (preserving the client-specific quasi-rent)
exceeds the expected loss (forfeited quasi-rents from the overall client portfolio, litigation costs,
and penalties), and thus the question of whether economic bonding undermines audit quality
depends upon the relative magnitude of expected costs and benefits, which is an empirical
question.1
Bargaining Power
Bargaining power should influence audit quality for the following reason. Audited financial
statements, and hence audit quality, are the joint effort of the auditor and the client (Antle and
Nalebuff 1991) that arise from a process of negotiation between the two (Gibbins et al. 2001). The
negotiation literature shows that when negotiators differ in bargaining power, the more powerful
party expects greater concessions (e.g., Pruitt and Carnevale 1993; Hornstein 1965; Michener et al.
1975), and Barnes (2004) shows that audit quality may decrease as client bargaining power
increases. In an experimental auditing setting, Hatfield et al. (2008) show that the effect of client
bargaining power on the audited financial statements depends upon the negotiation strategy
employed by the auditor, with a reciprocity negotiating strategy leading to more conservative
financial statements. Thus, the question of whether client bargaining power undermines audit
quality depends upon whether the auditor is able to employ a negotiating strategy that weakens the
advantage held by a client with strong bargaining power.
1
See Beck et al. (1988), Magee and Tseng (1990), and Zhang (1999) for extensions of DeAngelos (1981a,
1981b) idea that quasi-rents impair auditor independence.

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Abnormal Audit Fees

Simunic (1980) shows that the auditors expected fee charged to the client is driven by the units
of audit resources expended, the per-unit cost of those resources, and the auditors expected future
loss arising from the engagement (e.g., litigation losses, government penalties). Empirically, extant
research models the expected audit fee as a function of observable factors that proxy for the
auditors cost in performing the audit, including auditor effort (i.e., resources expended and their
cost), expected future litigation losses, and normal profit. If the audit fee model is well specified, the
residual audit fee reflects abnormal profits from the audit engagement. To the extent that some
factors are unobservable (and hence omitted from the audit fee model), the residual audit fee metric
measures abnormal audit profitability with error.
Abnormal audit profitability should be associated with both client bargaining power and
economic bonding. With respect to the former, Casterella et al. (2004) show a negative association
between proxies for client bargaining power and audit fees earned by industry specialists. Their
research suggests that, ceteris paribus, below-normal audit fees may reflect billing concessions
granted by the auditor due to client bargaining power. With respect to the later, Kinney and Libby
(2002) note that Unexpected fees may also better capture the profitability of the services provided
. . . more insidious effects on economic bond may result from unexpected nonaudit and audit fees
that may more accurately be likened to attempted bribes.
Although there is scant evidence on the association between abnormally low audit fees and
audit quality, a growing literature, described below, examines the association between abnormally
high audit fees (as a proxy for economic bond) and audit quality. DeFond et al. (2002), Krishnan et
al. (2005), Hoitash et al. (2007), and Hribar et al. (2010) test for a linear association between
abnormal audit and/or engagement fees and audit quality (i.e., the curve relating audit quality to
abnormal audit fees exhibits the same slope for both positive and negative abnormal audit fees).2
DeFond et al. (2002) find no association between abnormal engagement fees and auditors going
concern opinions during 20002001, while Krishnan et al. (2005) find that during year 2001,
earnings response coefficients (a direct indicator of audit quality) decline as abnormal engagement
fees increase. Hoitash et al. (2007) find during years 20002007 a positive association between
abnormal engagement fees and two (inverse) audit quality metricsthe Dechow and Dichev (2002)
accrual quality metric and the absolute value of performance-adjusted discretionary accruals. Hribar
et al. (2010) find during years 2000 to 2007 a positive association between abnormal audit fees and
accounting fraud, restatements, and SEC comment letters.3
Larcker and Richardson (2004), Higgs and Skantz (2006), Hope et al. (2009), Mitra et al.
(2009), and Choi et al. (2010) test for a nonlinear association between abnormal audit fees and audit
quality (i.e., the curve relating audit quality to abnormal audit fees exhibits different slope for
positive as compared to negative abnormal audit fees). Larcker and Richardson (2004) use data
from 2000 and 2001 to examine absolute discretionary accruals (an inverse indicator of audit
quality), and find that audit quality increases as abnormal engagement fees increase in absolute
magnitude. Higgs and Skantz (2006) find that during 20002002, earnings response coefficients (a
direct indicator of audit quality) are greater in firms with positive abnormal audit fees. Hope et al.
(2009) find that during 20002003, equity discount rates (an inverse indicator of audit quality)
increase as positive abnormal engagement fees increase, but find no association with negative
2
We refer to engagement fees when the test variable in the study was total fees (i.e., the sum of audit and
nonaudit fees).
In contemporaneous unpublished research, Hollingsworth and Li (2011) investigate the pre-SOX ( years 2000
2001) versus post-SOX ( years 20032004) linear association between audit fee ratios and ex ante cost of capital.
They find evidence of a positive association between total audit fees and ex ante cost of capital during 2003
2004, but no such association during 20002001.

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abnormal engagement fees. Mitra et al. (2009) find during years 20002005 a negative association
between positive abnormal audit fees, and both absolute discretionary accruals and incomeincreasing accruals, but find no association between negative abnormal audit fees and discretionary
accruals. Choi et al. (2010) find during 20002003 a positive association between positive
abnormal audit fees and absolute discretionary accruals, but no association when abnormal audit
fees are negative.
The weight of the preceding evidence suggests a negative association between audit quality
and positive abnormal audit fees, and no association between audit quality and negative abnormal
audit feesfindings consistent with the economic bonding hypothesis. However, as discussed
above, negative abnormal audit fees may reflect client bargaining power that could degrade audit
qualitywith the degrading being larger in magnitude the greater the bargaining power of the
client. Also as previously discussed, the question of whether client bargaining power undermines
audit quality ultimately depends upon whether the auditor is able to employ a negotiating strategy
that weakens the advantage held by a client with strong bargaining power. Thus, whether client
bargaining power affects audit quality remains an open empirical question, leading us to specify and
test the following client bargaining power hypotheses.
H1a: Audit quality will decline as below-normal audit fee increases in magnitude.
H1b: The association predicted in H1a will be amplified as proxies for client bargaining
power increase.
For completeness, we also specify and test the following economic bonding hypothesis:
H2: Audit quality will decline as above-normal audit fees increase in magnitude.
Post-Sox Abnormal Audit Fees
In addition to the question of client bargaining power, another as yet unanswered question is
whether the audit quality/abnormal audit fee association changed following SOX. Passed in 2002
following discovery of a series of high-profile financial reporting scandals, SOX seeks to improve
corporate governance and enhance auditor independence by mandating federal government
oversight of auditors, enhancing audit committee auditor oversight, and limiting the opportunity for
auditors to sell nonaudit services to clients (U.S. House of Representatives 2002). If these reforms
are sufficiently salient, they should manifest in a reduced association between abnormal audit fees
and audit quality post-SOX relative to pre-SOX. This leads to our final hypothesis:
H3: The association between audit quality and abnormal audit fees will be attenuated in the
post-SOX period as compared to the pre-SOX period.
RESEARCH DESIGN
To test our hypotheses, we need to measure abnormal audit fee and audit quality. We estimate
abnormal audit fee (ABNAFEE) as the actual audit fee paid by the client to its auditor minus the
predicted (normal) audit fee, with the difference deflated by the total audit fee revenue of the audit
office conducting the clients audit.
We deflate the abnormal audit fee by total audit fee revenues of the practice office conducting
the audit in order to capture the relative profitability of the engagement to the opining audit office.4
4
We do not deflate this measure by the total abnormal audit fee for the practice office since this results in nearzero denominator problem.

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We do so since prior research (e.g., Reynolds and Francis 2001) suggests that economic incentives
impacting audit quality are best measured at the local office level rather than at the national firm
level. For example, the Enron audit failure largely stemmed from decisions made in the Houston
office of Arthur Andersen (Chaney and Philipich 2002). We define two separate variables from
ABNAFEE. If ABNAFEE . 0 then HIABNAFEE ABNAFEE, and 0 otherwise. If ABNAFEE 0
then LOABNAFEE jABNAFEEj, and 0 otherwise. This allows us to study the relationship of the
dependent variables with the positive and negative abnormal audit fee, separately. The predicted
audit fee is estimated from an audit fee model based on extant research.5 All the variables used in
various tests are summarized in Table 1.
Audit quality is unobservable. Consistent with prior research, we define audit quality as the
clients earnings quality (Higgs and Skantz 2006; Lim and Tan 2008; Davis et al. 2009; Francis and
Yu 2009; Reichelt and Wang 2010; Choi et al. 2010). Following this research, we use two
commonly used proxies for earnings quality: absolute discretionary accruals and propensity to meet
or beat earnings expectations. We also conduct additional tests using an earnings response
coefficient. The first two proxies are surrogates for actual earnings management, while the last one
is related to perceived earnings quality. However, for the sake of brevity, we only report results for
the first two, since the conclusions are similar. The tests for these proxies are discussed in more
detail below.
Discretionary Accruals Model
The level of discretionary accruals has commonly been used as a surrogate for managers
exercise of discretion provide by GAAP. To the extent the discretionary component of accruals is
used by managers to opportunistically manage earnings and auditors allow the manipulation to
remain uncorrected, discretionary accruals adversely reflect on the audit and earnings quality
(Schipper 1989; Jones 1991; Levitt 2000; DeFond and Park 2001). Discretionary accruals can be
used for increasing or decreasing earnings depending on the incentives of managers. Since we are
not looking at any specific managerial incentives, we have no directional predictions for accruals.
We therefore use the absolute value of discretionary accruals (jDACCj) as the independent variable
in our next test. Discretionary accruals (DACC) are calculated using the cross-sectional modified
version of the Jones model (Jones 1991; Dechow et al. 1995), deflated by total assets, and estimated
by year and for each industry. We adjust discretionary accruals for performance as suggested by
Kothari et al. (2005). Following Hribar and Collins (2002), we use the difference between net
income and cash from operations, deflated by lagged assets, as our measure of total accruals
(TACC). Thus:
TACC IBC OANCF=LagAT;
where IBC is the income before extraordinary items (Compustat cash flow item), OANCF is net
cash flow from operating activities, and AT is total assets. The model to estimate discretionary
accruals is:
TACC h1 h2 1=LagAT h3 fDSALE RECCH g=LagAT h4 PPEGT=LagAT
h5 ROA error:
1
Our audit fee model is based on models used in Ghosh and Lustgarten (2006), Craswell and Francis (1999),
Craswell et al. (1995), and Simon and Francis (1988). The adjusted-R2 of this model is over 81 percent.
However, we do not report details for the sake of brevity. Detailed specifications are available from the authors
on request.

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TABLE 1
Variable Definitions
(In Alphabetical Order)
Variable
ABNAFEE
ACQUIRED
B2M
BIG-N
BUSSEG
CFFO
CITYLEADER
jDACCj
DELAY
DISTRESS
DSOX
FINANCED
GEOSEG
HIABNAFEE
I_jDACCj
I_MBEX
ICOPINION
INFLUENCE
LAGROA
LARGEST
LDELAY
LEVERAGE
LNUMFOR
LOABNAFEE
LOFFICE
LOGMV
LOSS
MBEX
Definition
Actual audit fee minus predicted (normal) audit fee deflated by the total revenue of the
auditor office that audits the client.
A dichotomous variable with value of 1 if the firm indulged in acquisition activities, and
0 otherwise.
Book-to-market equity ratio.
A dichotomous variable with value of 1 if the auditor is one of the Big 4 (or Big 5), and
0 otherwise.
Number of business segments reported in Compustat segment file.
Cash flow from operations divided by total assets.
Following Francis and Yu (2009), a dichotomous variable with value of 1 if an audit
office has the highest total client audit fees in an industry within that city in a specific
year, and 0 otherwise.
Absolute discretionary accruals are calculated using the cross-sectional version of the
Jones (1991) model as in Dechow et al. (1995) with performance adjustment (Kothari
et al. 2005), deflated by total assets and estimated by year and for each two-digit SIC
code. We use the difference between net income and cash from operations as our
measure of total accruals (Hribar and Collins 2002).
Number of calendar days from fiscal year-end to date of auditors report.
Zmijewskis (1984) financial distress measure.
A dichotomous variable with value of 1 for fiscal years 200409, and 0 otherwise. We
choose 2004 as the cutoff since this was the implementation year for SOX 404(b).
A dichotomous variable with value of 1 if number of outstanding shares increased by at
least 10 percent or long-term debt increased by at least 20 percent during the year
(Geiger and North 2006).
Number of geographic segments reported in Compustat segment file.
Equal to ABNAFEE if ABNAFEE . 0, and 0 otherwise.
Implies the instrumented variable for jDACCj from Maddalas (1988) 2SLS estimation.
Implies the instrumented variable for MBEX from Maddalas (1988) 2SLS estimation.
Number of material internal control weaknesses reported in Audit Analytics.
Following Reynolds and Francis (2001), ratio of a clients total fee relative to the total
annual fee of the practice office that audits the client.
Lagged value of return on asset.
A dichotomous variable with value of 1 if the client pays the highest audit fee in the
practice office that audits the client.
Natural logarithm of DELAY variable plus one day.
Total debt deflated by total assets.
Natural logarithm of the number of analysts forecasts.
Equal to jABNAFEEj if ABNAFEE is less than or equal to 0, and 0 otherwise.
Following Francis and Yu (2009), the natural logarithm of total annual audit fee of the
practice office that audits the client.
Natural logarithm of the market value of equity (in $ million) at the end of the fiscal year.
A dichotomous variable with value of 1 if client has a negative net income before
extraordinary items, and 0 otherwise.
A dichotomous variable with value of 1 if the firm meets or beats the earnings
expectation (proxied by the most recent median consensus analyst forecast available on
I/B/E/S file) by two cents or less, and 0 otherwise.
(continued on next page)

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TABLE 1 (continued)
Variable
Definition
QUALIFIED
A dichotomous variable with value of 1 if audit opinion is a qualified opinion, and 0

otherwise.
RESTATEMENT A dichotomous variable with value of 1 if the client issues a restatement in the current
fiscal year, and 0 otherwise.
SDCFFO
Standard deviation of cash flow from operations deflated by total assets, calculated over
the current and prior four years.
SDFOR
Standard deviation of analysts earnings forecasts.
SDSALES
Standard deviation of sales deflated by total assets, calculated over the current and prior
four years.
SGROWTH
Sales growth rate.
TENURE
A dichotomous variable with value of 1 if auditor has been with the client for three years
or less, and 0 otherwise.
TOP10%INFL A dichotomous variable with value of 1 if INFLUENCE is in the top 10 percent, and 0
otherwise.
USLEADER
Following Francis and Yu (2009), a dichotomous variable with value of 1 if an auditor
has the highest total client audit fees in an industry in the country in a specific year,
and 0 otherwise.
VOLATILITY
Standard deviation of daily returns for the past year obtained from CRSP.
where Lag(AT) is total assets of prior year; DSALE is change in revenue; RECCH is the decrease in
accounts receivables; PPEGT is property plant and equipment (gross total); and ROA is return on
assets, calculated as IBC deflated by AT. Equation (1) is estimated by year for each industry (twodigit SIC code). Then, TACC minus the predicted value from the above regression is our measure of
discretionary accruals.
Our test of jDACCj is based on the following model:
jDACCj a0 a1 LOABNAFEE a2 HIABNAFEE a3 LOFFICE a4 INFLUENCE
a5 TENURE a6 USLEADER a7 CITYLEADER a8 BUSSEG a9 GEOSEG
a10 LOGMV a11 SGROWTH a12 SDSALES a13 CFFO a14 SDCFFO
a15 ICOPINION a16 LEVERAGE a17 LOSS a18 DISTRESS a19 B2M
a20 VOLATILITY a21 FINANCED a22 ACQUIRED a23 LAGROA
a24 BIG-N a25 QUALIFIED a26 LDELAY a27 RESTATEMENT
a28 I MBEX error:
2
The control variables are from extant research. Francis and Yu (2009) show that larger offices of
Big 4 auditors have higher audit quality. The logarithm of total office-specific audit fee of all clients
in a given year (LOFFICE) is included to capture this effect. Reynolds and Francis (2001) provide
evidence that auditors report more conservatively for larger clients. Consistent with this research,
the variable INFLUENCE, defined as the ratio of a clients total fee relative to the total annual fee of
the practice office that audits the client, is included as an independent variable. TENURE (1/0
dummy variable for audit tenures of three years or less) controls for potential effect of short auditorclient association on audit quality (Johnson et al. 2002; Carey and Simnett 2006).
Balsam et al. (2003) argue that industry expertise increases audit quality. We include
USLEADER and CITYLEADER, consistent with Francis and Yu (2009), to control for national-level
and city-level auditor industry expertise. USLEADER is an indicator variable that is coded 1 if the
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auditor is the national audit fee leader in that industry. CITYLEADER is similarly defined at the city
level. BUSSEG (GEOSEG) is the number of business (geographic) segments reported in the
Compustat segment file. LOGMV is the natural logarithm of market value of equity at the end of the
fiscal year. This variable controls for any size-related effects. Prior research (Ashbaugh et al. 2003;
Butler et al. 2004; Menon and Williams 2004; Geiger and North 2006) finds LOGMV to be
negatively associated to discretionary accruals. SGROWTH is the annual growth in sales and has
been found to be positively related to discretionary accruals (Menon and Williams 2004).
CFFO is the cash flow from operations deflated by total assets. Previous researchers (Frankel et
al. 2002; Chung and Kallapur 2003) find a negative association between discretionary accruals and
CFFO. Hribar and Nichols (2007) find that accrual volatility may be related to firm-specific
operating characteristics as measured by the volatility of the firms cash flows and sales. Hence, we
include SDSALES and SDCFFO (calculated as the standard deviations over the current and past
four years of cash flow from operations and sales, respectively, deflated by the total assets) as
control variables. Doyle et al. (2007) suggest that earnings quality may be a function of the quality
of the firms internal control. ICOPINION (number of material internal control weaknesses reported
in Audit Analytics in the post-SOX period) is, therefore, included as a control variable.
Consistent with DeFond and Jiambalvo (1994), Reynolds and Francis (2001), and Francis and
Yu (2009), LEVERAGE, LOSS, and DISTRESS are included to control for the effects of debt and
financial distress. LEVERAGE is total debt deflated by total assets. LOSS is a dichotomous variable
with a value of 1 if client has a negative net income before extraordinary items, and 0 otherwise.
DISTRESS is Zmijewskis (1984) measure of financial distress. B2M is the book-to-market value
and captures the growth opportunities. Ashbaugh et al. (2003), Butler et al. (2004), Menon and
Williams (2004), and Geiger and North (2006) suggest B2M and DACC to be negatively
associated. Following Matsumoto (2002), Hribar and Nichols (2007), and Francis and Yu (2009),
we include stock-return volatility (VOLATILITY) to proxy for capital market pressures that can
result in increased earnings management. FINANCED and ACQUIRED are dichotomous variables
that have values of 1 if the company was involved in significant financing activities or acquisitions,
respectively, and 0 otherwise. Ashbaugh et al. (2003) and Chung and Kallapur (2003) find positive
coefficients on these two variables. LAGROA is the previous years return on assets and is included
to control for prior performance. BIG-N (a 0/1 dummy variable) and QUALIFIED (a 0/1 dummy
variable) capture the effect of auditor size and qualified opinions on earnings quality. Natural
logarithm of 1 number of calendar days from fiscal year-end to date of auditors report
(LDELAY) controls for the effect of extra effort by the auditor on earnings quality. Since
restatements can influence earnings management, the dichotomous variable RESTATEMENT is
added as a control variable. MBEX is a dichotomous variable with a value of 1 if the firm meets or
beats the earnings expectation (proxied by the most recent median consensus analysts forecast
available on I/B/E/S file) by two cents or less, and 0 otherwise. Since jDACCj and MBEX can be
jointly determined, we use Maddalas (1988) two-stage-least-squares estimation (2SLS) for
Equations (2) and (3) to avoid any endogeneity problems. I_MBEX denotes the instrumented
variable for MBEX from the 2SLS.6
Meet-or-Beat Earnings Expectation Model
There is evidence in extant literature that managers are rewarded (penalized) for meeting
(missing) earnings forecasts (Bartov et al. 2002; Kasznik and McNichols 2002; Lopez and Rees
2002) and this leads to incentives for managers to manage earnings. If auditors incentives to curtail
earnings management vary with abnormal audit fee, the propensity for meeting or beating analysts
6
See Rusticus and Larcker (2010) for a more detailed discussion of instrumental variable estimation.

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Asthana and Boone
10
earnings forecasts will be a function of the abnormal audit fee. We estimate the following logit
model to test this conjecture:
ProbMBEX 1
Fb0 b1 LOABNAFEE b2 HIABNAFEE b3 LOFFICE
b4 INFLUENCE b5 TENURE b6 USLEADER b7 CITYLEADER
b8 BUSSEG b9 GEOSEG b10 LOGMV b11 SGROWTH
b12 SDSALES b13 CFFO b14 SDCFFO b15 ICOPINION
b16 LEVERAGE b17 LOSS b18 DISTRESS b19 B2M
b20 VOLATILITY b21 FINANCED b22 ACQUIRED b23 LAGROA
b24 BIG-N b25 QUALIFIED b26 LDELAY b27 RESTATEMENT
b28 I jDACCj b29 SDFOR b30 LNUMFOR:
In Model (3), F() denotes the logistic cumulative probability distribution function. I_jDACCj
denotes the instrumented variable for jDACCj from the 2SLS. Following Reichelt and Wang
(2010), we include the standard deviation of analysts earnings forecasts (SDFOR) and natural
logarithm of number of analysts forecasts (LNUMFOR) to control for characteristics of the
forecasts.
Additional Tests
To test H1b, we further interact LOABNAFEE and HIABNAFEE with two measures of clients
bargaining powers in Models (2) and (3). LARGEST is a dichotomous variable with value of 1 if the
client pays the highest audit fee in the practice office that audits the client; TOP10%INFL is a
dichotomous variable with a value of 1 if INFLUENCE is in the top 10 percent, and 0 otherwise. To
make the interpretations of the interactions easier, we use the dichotomous versions of abnormal
audit fees, DLOABNAFEE and DHIABNAFEE, where DLOABNAFEE (DHIABNAFEE) is a
dichotomous variable with a value of one if LOABNAFEE (DHIABNAFEE) median value, and 0
otherwise.
To test our conjecture that SOX has dampened the association between abnormal audit fees and
earnings management (H3), we rerun Models (2) and (3) with an additional independent variable
DSOX and interaction terms, DLOABNAFEE DSOX and DHIABNAFEE DSOX, where DSOX is
a dichotomous variable with a value of 1 for the period 20042009, and 0 otherwise.7
Adjustment for Clustering
Since our data are pooled over time, the same firm may appear more than once in the sample,
resulting in clustering. Clustered samples can lead to underestimation of standard errors and
overestimation of significance levels (Cameron et al. 2011). We therefore estimate the t-statistics
adjusted for clustering using robust standard errors corrected for firm-level clustering and
heteroscedasticity, consistent with Petersen (2009) and Gow et al. (2010).
One of the SOX provisions to affect the audit relationship was the requirement that auditors evaluate and report on
managements assessment of the effectiveness of the firms internal controls (SOX Section 404(b) [U.S. House of
Representatives 2002]). Since SOX Section 404(b) was implemented for fiscal years ending on or after November 15,
2004 (per SEC Release No. 33-8392, issued February 24, 2004), we classify 20002003 as the pre-SOX period and
20042009 as the post-SOX period. However, using 2002 as the cutoff does not alter the conclusions.

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11
TABLE 2
Sample Selection
Observations
Remaining
Procedure
Data available on 2010 Audit Analytics database for non-Andersen clients
Firms also available on Compustat file
Firms not in financial or utility industry
Complete data available for jDACCj analysis
Complete data available for MBEX analysis on I/B/E/S and CRSP files
61,953
35,081
28,925
18,873
14,796
Sample 1
Sample 2
SAMPLE
The sample selection procedure is outlined in Table 2. We start with 61,953 firm-year
observations for the period 20002009 available in the Audit Analytics database for non-Andersen
clients. We exclude Andersen since the auditor-client relationship might be atypical, given the woes
of Andersen. After merging with Compustat we are left with 35,081 observations. We then exclude
the financial (SIC codes 60006900) and utility (SIC codes 44004900) industries, since the
incentives of managers from these regulated industries may be different. This leaves us with 28,925
observations. Missing data for estimating the variables in a modified Jones (1991) model and
Equation (2) further reduce our sample size to 18,873 observations (Sample 1). Finally, I/B/E/S and
CRSP data are needed for Equation (3), which results in Sample 2 with 14,796 observations.
Untabulated statistics show that the sample industry composition is very close to that of the
Compustat population. Across years, untabulated statistics generally show an even distribution of
observations. Sample characteristics, including measures of central tendency, are presented in Table
3. Mean (median) jDACCj and MBEX are 0.0655 (0.0418) and 0.2039 (0.0000), respectively. Mean
LOABNAFEE (HIABNAFEE) is 0.0259 (0.0267). Both variables have median values , 0.0001. A
typical client accounts for under 2 percent of the audit offices revenue (median value of
INFLUENCE). A mean value of over 10 percent for this variable suggests some large influential
clients. Over 23 percent of the clients have been with their auditors for three years or less. On
average, firms have between two and three business and geographic segments. Mean (median) log
of firm market value (in $ million) is 6.15 (6.14). Clients experienced a mean of 13 percent sales
growth during the sample period. The median firm had one internal control weakness reported in
Audit Analytics. On average, total debt was 19 percent of firm assets and 30 percent of the
firm-years reported losses. Book value was around 59 percent of market value of the firm. While 31
percent of the firms financed during the year, 19 percent were involved in acquisition activities. As
expected, a large proportion (80 percent) of the clients are audited by Big 4 auditors.
RESULTS
Results of estimation for Models (2) and (3) are presented in Panel A of Table 4. For the sake
of comparison, regressions are reported with and without control variables. The adjusted R2 of
models with controls range from 18.39 percent to 20.39 percent.8 For the jDACCj regression
(Equation (2)), 14 of the 26 control variables are significant (at 10 percent level or better).
8
Tests for outliers are conducted on all the regressions using Belsley et al.s (1980) procedure. Results (not
reported) do not change qualitatively when influential outliers are removed. Thus, our conclusions are not driven
by outliers.

August 2012
Asthana and Boone
12
TABLE 3
Sample Characteristics of Variables Used in Regression Analysis
Variable
jDACCj
MBEX
LOABNAFEE
HIABNAFEE
LOFFICE
INFLUENCE
TENURE
USLEADER
CITYLEADER
BUSSEG
GEOSEG
LOGMV
SGROWTH
SDSALES
CFFO
SDCFFO
ICOPINION
LEVERAGE
LOSS
DISTRESS
B2M
VOLATILITY
FINANCED
ACQUIRED
LAGROA
BIG-N
QUALIFIED
LDELAY
DSOX
SDFOR
LNUMFOR
Mean
Median
Std. Dev.
Quartile 1
Quartile 3
0.0655
0.2039
0.0259
0.0267
16.1265
0.1016
0.2307
0.2623
0.3014
2.5981
2.9799
6.1484
0.1306
0.1793
0.0601
0.0722
0.5573
0.1939
0.3007
0.0381
0.5862
0.0335
0.3081
0.1869
0.0105
0.7966
0.4698
4.0708
0.7003
0.0955
1.5177
0.0418
0.0000
, 0.0001
, 0.0001
16.4181
0.0187
0.0000
0.0000
0.0000
1.0000
2.0000
6.1383
0.0744
0.1261
0.0871
0.0489
1.0000
0.1548
0.0000
0.0001
0.4563
0.0293
0.0000
0.0000
0.0406
1.0000
0.0000
4.1271
1.0000
0.0400
1.6094
0.0854
0.4029
0.1049
0.0807
2.0009
0.2126
0.4213
0.4399
0.4589
2.1054
2.5588
2.1636
0.4473
0.1965
0.1737
0.0751
0.5783
0.1995
0.4586
0.1509
0.5143
0.0234
0.4617
0.3899
0.2066
0.4025
0.4991
0.3865
0.4582
0.1612
1.0241
0.0185
0.0000
0.0000
0.0000
14.9000
0.0000
0.0000
0.0000
0.0000
0.0000
1.0000
4.6300
0.0327
0.0725
0.0288
0.0289
0.0000
0.0088
0.0000
0.0000
0.2641
0.0203
0.0000
0.0000
0.0162
1.0000
0.0000
4.0000
0.0000
0.0100
0.6931
0.0795
0.0000
0.0064
0.0103
17.7000
0.0788
0.0000
1.0000
1.0000
4.0000
4.0000
7.5600
0.2009
0.2199
0.1407
0.0842
1.0000
0.3034
1.0000
0.0006
0.7387
0.0425
1.0000
0.0000
0.0834
1.0000
1.0000
4.3000
1.0000
0.1100
2.3026
See Table 1 for variable definitions. All values are for Sample 1 (n 18,873), except for MBEX, SDFOR, and
LNUMFOR that pertain to Sample 2 (n 14,796).
SGROWTH, SDSALES, CFFO, SDCFFO, LOSS, DISTRESS, VOLATILITY, FINANCED, and

MBEX are significantly positive; LOGMV, LEVERAGE, B2M, LAGROA, and BIG-N are
significantly negative. Thus, firms with more sales growth, sales volatility, cash from operations,
cash volatility, losses, distress, stock price volatility, and financing activities are more likely to have
higher jDACCj. There is also a positive association between jDACCj and MBEX. On the other hand,
firms with larger size, higher leverage, lower growth potential, profitability, and with BIG-N
auditors are more likely to have lower jDACCj.
Both LOABNAFEE and HIABNAFEE are significant and positive. This suggests that as the
magnitude of ABNAFEE increases on either side (positive or negative), the magnitude of jDACCj
increases. This supports H1a and H2.
August 2012
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TABLE 4
Multivariate Analysis
Panel A: Analysis of Earnings Quality and Abnormal Audit Fees
Dependent Variable
Variable
Intercept
LOABNAFEE
HIABNAFEE
LOFFICE
INFLUENCE
TENURE
USLEADER
CITYLEADER
BUSSEG
GEOSEG
LOGMV
SGROWTH
SDSALES
CFFO
SDCFFO
ICOPINION
LEVERAGE
LOSS
DISTRESS
B2M
VOLATILITY
FINANCED
ACQUIRED
LAGROA
BIG-N
QUALIFIED
LDELAY
RESTATEMENT
I_MBEX
I_jDACCj
SDFOR
LNUMFOR
Observations
Adjusted R2
F-value
Prob . F
Wald Chi-square
Prob . Chi-square
jDACCj
0.0515***
0.0234***
0.0257***
18,873
0.0042
21.14
, 0.0001
jDACCj
0.0463***
0.0117***
0.0165***
0.0004
0.0029
0.0014
0.0002
0.0004
0.0003
0.0002
0.0014***
0.0032***
0.0105***
0.0099*
0.2042***
0.0002
0.0171***
0.0067***
0.0421***
0.0023**
0.1552***
0.0044***
0.0007
0.0201***
0.0025*
0.0004
0.0008
0.0002
0.0025***
18,873
0.2039
71.44
, 0.0001
MBEX
MBEX
1.4078***
0.3262***
0.0558
14,796
0.0080
8.14
0.0171
3.1829***
1.6122***
0.6032**
0.2577***
0.8781**
0.1877
0.3684***
0.0379
0.1251***
0.0274
0.1955***
0.0404
0.0124
2.3532***
1.5347
2.0292***
4.0041***
1.2444***
0.9685
1.8771***
1.3174***
0.2481*
0.5510***
3.1752***
2.3783*
0.6233***
0.8180***
0.5414***
2.0837***
0.6618***
7.0523***
14,796
0.1839
762.62
, 0.0001
(continued on next page)

August 2012
Asthana and Boone
14
TABLE 4 (continued)
Panel B: Multivariate Analysis for Firms with Below-Normal Audit Fee
Dependent Variable
Variable
jDACCj
jDACCj
MBEX
Intercept
0.0275***
2.6509
DLOABNAFEE
0.0022**
2.4598**
DLOABNAFEE LARGEST
0.0048**
8.2166**
LARGEST
0.0031
1.8641***
DLOABNAFEE TOP10%INFL
TOP10%INFL
Control variables included but not reported for the sake of brevity.
Observations
9,545
7,352
Adjusted R2
0.2834
0.0618
p-value
, 0.0001
, 0.0001
0.0305***
0.0029***
0.0058**
0.0032
9,545
0.2404
, 0.0001
MBEX
3.8377
2.1974**
12.3241***
2.9667***
7,352
0.0630
, 0.0001
Panel C: Multivariate Analysis for Firms with Above-Normal Audit Fee

Dependent Variable
Variable
jDACCj
jDACCj
MBEX
Intercept
0.0331***
0.0193
DHIABNAFEE
0.0069**
0.1808**
DHIABNAFEE LARGEST
0.0050
0.0329
LARGEST
0.0039
0.0671
DHIABNAFEE TOP10%INFL
TOP10%INFL
Observations
9,328
7,444
Adjusted R2
0.2066
0.0510
p-value
, 0.0001
, 0.0001
0.0316**
0.0077***
MBEX
0.0202
0.1701***
0.0027
0.0022
0.0063
0.0440
9,328
0.2065
, 0.0001
7,444
0.0509
, 0.0001
Panel D: Comparison of Pre- and Post-SOX Period

Dependent Variable
jDACCj
MBEX
Intercept
0.0485***
DLOABNAFEE
0.0318***
DHIABNAFEE
0.0326***
DLOABNAFEE DSOX
0.0260***
DHIABNAFEE DSOX
0.0277**
DSOX
0.0011
Observations
18,873
Adjusted R2
0.1892
F-value
56.23
Prob . F
, 0.0001
Wald Chi-square
Prob . Chi-square
0.6885
1.5886***
0.8023**
0.6798
0.2735
2.5548***
14,796
0.1915
925.33
, 0.0001
*, **, *** Implies significance at 10, 5, and 1 percent levels (two-sided), respectively.
See Table 1 for variable definitions. DLOABNAFEE (DHIABNAFEE) is a dichotomous variable with value of 1 if
LOABNAFEE (DHIABNAFEE) median value, and 0 otherwise.

August 2012
15
In Model (3), since the dependent variable MBEX is a dichotomous variable, we use logistic
regression to estimate the propensity to meet or beat earnings expectations. The results for Model
(3) are exhibited in the last two columns of Panel A of Table 4. Twenty-one of the 28 control
variables are significant: CFFO, FINANCED, ACQUIRED, SDFOR, and jDACCj are significantly
positive; LOFFICE, INFLUENCE, USLEADER, BUSSEG, LOGMV, ICOPINION, LEVERAGE,
LOSS, B2M, VOLATILITY, LAGROA, BIG-N, QUALIFIED, LDELAY, RESTATEMENT, and
LNUMFOR are significantly negative. LOABNAFEE and HIABNAFEE are significantly positive.
Thus, this test also supports H1a and H2.
Tests for H1b are reported in Panels B and C of Table 4. DLOABNAFEE and DHIABNAFEE
are positive and significant as predicted by H1a and H2. DLOABNAFEE LARGEST and
DLOABNAFEE TOP10%INFL are both positive and significant at a 5 percent level or better for
jDACCj and MBEX. This suggests that highly influential firms with more bargaining power get
more freedom to manage their earnings, for a given level of LOABNAFEE. This supports H1b.
Moreover, DHIABNAFEE LARGEST and DHIABNAFEE TOP10%INFL are insignificant in
Panel C, as expected, since the bargaining effect is expected on the below-normal audit fee side
(firms getting discounts) and not on the above-normal audit fee side (firms paying premiums).
To test H3, we rerun Equations (2) and (3), with LOABNAFEE DSOX and HIABNAFEE
DSOX added as additional independent variables (see Panel D of Table 4). Both of these interaction
terms are significantly negative for Model (2), suggesting that the management of jDACCj postulated
in H1a and H2 has dampened post-SOX, supporting H3. However, the terms LOABNAFEE
LOABNAFEE DSOX and HIABNAFEE HIABNAFEE DSOX are both significantly positive at a
1 percent level, suggesting that the effects have not yet been completely erased as a result of SOX.
On the other hand, estimation of Model (3) with interactions yields insignificant interactions,
suggesting that the association of abnormal fees with MBEX is unaffected by SOX.
Additional Analyses with Earnings Response Coefficient
Lim and Tan (2008) use the ERC (earnings response coefficient) as a proxy for investors
perception of earnings quality and, in turn, audit quality. We run the ERC model with interactions of
unexpected earnings (UE) with LOABNAFEE and HIABNAFEE. The independent variables in this
model are based on Francis and Ke (2006), Lim and Tan (2008), Wilson (2008), and Ghosh et al. (2009).
We do not report detailed results for the sake of brevity. However, coefficients of UE LOABNAFEE
and UE HIABNAFEE are both negative, suggesting that the market perceives that audit quality
declines with LOABNAFEE and HIABNAFEE, consistent with results reported for jDACCj and MBEX.
Tests of Robustness
We conduct several tests of robustness discussed below to convince ourselves that our results
are not driven by any bias or model misspecification.
1. We first test for possible endogeneity bias in our audit fee model that potentially could
introduce error into our measurement of ABNAFEE. The concern arises because Whisenant
et al. (2003) suggest that audit and nonaudit fees are simultaneously determined, and thus
not exogenous. To rule out this possibility, we run Davidson and MacKinnons (1993)
endogeneity test. The null hypothesis of no endogeneity is not rejected.9
9
As an extra precaution, we reestimate the audit fee model using two-stage least squares as a control for potential
endogeneity bias. None of our conclusions are affected significantly. For Model (2), the coefficients of
LOABNAFEE and HIABNAFEE are 0.0238 ( p , 0.0001) and 0.0154 ( p 0.0138), respectively; for Model (3),
the coefficients of LOABNAFEE and HIABNAFEE are 1.3262 ( p , 0.0001) and 0.4209 ( p 0.0522),
respectively.

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16
Asthana and Boone
2. Unlike prior studies, we focus on audit fee revenue rather than nonaudit fee revenue as a
source of impaired audit quality. We do so for two reasons. First, audit fee revenue is a
recurring annuity whereas nonaudit fee revenue, with the exception of revenues from tax
services, is not. Recurring engagements (as compared to nonrecurring engagements) create
greater incentive for the auditor to compromise independence. Second, reforms enacted by
the Sarbanes-Oxley Act of 2002 have significantly reduced the scope of nonaudit services
that auditors can provide to their clients while also expanding the scope of work required
in the audit. Together, these two factors suggest that in the current milieu, audit fees
emerge as a potentially important determinant of audit quality.10 Recent research (Choi et
al. 2010) has, therefore, focused on audit fees. However, as a robustness check, we repeat
all of our tests with total engagement fee (i.e., the sum of audit and nonaudit fees) and
arrive at similar conclusions.
3. We try an alternate specification for our models. Instead of the split-linear regression, we
estimate the arctan regressions suggested by Freeman and Tse (1992) as below:
jDACCj g0 g1 arctang2 LOABNAFEE g3 g4 arctang5 LOABNAFEE g6
Controls error:
This specification yields interesting conclusions. The relationship of jDACCj with
HIABNAFEE (LOABNAFEE) is S-shaped (inverse S-shaped). The flat curve around
HIABNAFEE LOABNAFEE 0 suggests that the auditors do not impair their
independence until positive abnormal fee from a client exceeds what the auditor could earn
by simply resigning from this client and contracting with a new one.11 Similarly, on the
negative abnormal audit fee side, the auditor may have a pecking order. Initially they
would grant their influential clients (with bargaining powers) fee discounts, and as the
client gains more bargaining power, the auditor may also allow earnings management. The
flattening of the curve for extreme departures from normal fee suggests that the auditors
have a threshold or tolerance level for earnings management, and as the firm tries to report
extremely high levels of discretionary, accruals the auditors start resisting.
4. Since audit fee data became available on Audit Analytics in 2000, one could question how
the investors derive their normal audit fees to assess the audit quality in the year 2000.
We rerun our analyses without the year 2000 data and our conclusions do not change
qualitatively. For Model (2), the coefficients of LOABNAFEE and HIABNAFEE are
0.0251 (p 0.0049) and 0.0316 (p 0.0136), respectively; for Model (3), the coefficients
of LOABNAFEE and HIABNAFEE are 1.9900 (p , 0.0001) and 1.2004 (p 0.0004),
respectively.
5. Since quality of corporate governance may also affect earnings quality, as a sensitivity
analysis we add the Gompers et al. (2003) index of corporate governance to our
regressions and obtain similar results. We do not report these findings as our main results
since the sample size after merging with the Gompers database was considerably smaller.
6. To the extent that the first few years of the auditor-client relationship might be atypical, we run
our tests excluding the first three years of new clients. The results are not altered qualitatively.
For Model (2), the coefficients of LOABNAFEE and HIABNAFEE are 0.0153 (p 0.0016)
and 0.0233 (p 0.0011), respectively; for Model (3), the coefficients of LOABNAFEE and
HIABNAFEE are 1.3200 (p 0.0002) and 0.3991 (p 0.0813), respectively.
10
11
Findings of Hope et al. (2009) support this approach. They report that their results of positive association
between cost of equity capital and excess auditor remuneration only hold for audit fee and not for nonaudit fee.
We thank one of our reviewers for this insight.

August 2012
17
7. Firms that have consistent positive or negative abnormal fees across years might have
different motivations from firms that switch between the two categories. We split the
sample into firms that have five or more years with abnormal audit fees of the same sign
and those that do not. Our hypotheses hold for both subsets, suggesting that our results are
applicable to both categories of firms.
8. We try different cutoffs for the tenure variable to see if the results are sensitive to the
definition of tenure. We try five years and also two dummy variables for three years or
under and more than nine years. Our main conclusions are not affected.
9. The pricing of audit engagements for accelerated filers may be different from that of nonaccelerated filers, since accelerated filers could have a higher audit fee due to more internal
control work. The pricing of material weaknesses may also be different. If the size variable
in the audit fee model is unable to control for these effects, the conclusions might be
biased. To ascertain that the results are not different for accelerated/non-accelerated filers,
we run the tests separately for the two filing categories. We do not find any evidence of
any category leading the results. For example, in Model (2) for accelerated filers, the
coefficients of LOABNAFEE and HIABNAFEE are 0.0095 (significant at 1 percent) and
0.0054 (significant at 10 percent), respectively; for non-accelerated filers, the coefficients
of LOABNAFEE and HIABNAFEE are 0.0147 (significant at 10 percent) and 0.0202
(significant at 5 percent), respectively.
10. As with any ratio, the scaling of abnormal audit fee by the total revenue of the audit office
might introduce inflation (deflation) of the same numerator for smaller (larger) audit
offices. To ascertain if this scaling affects our results, we rerun all the tests with unscaled
abnormal audit fees. The coefficients of LOABNAFEE and HIABNAFEE continue to be
positive and significant at a 5 percent level or better for both Models (2) and (3).
11. Prior research (e.g., Bedard and Johnstone 2004; Johnstone and Bedard 2001, 2003)
suggests that proxies for audit risk used in extant research may be inadequate. There may
be above-normal effort in cases of earnings manipulation risk and corporate governance
risk (Bedard and Johnstone 2004) that are not captured by the audit fee model. This extra
effort may result in an abnormally high audit fee and lead to higher audit quality.
Extending this argument, below-normal audit fees may represent abbreviated audit efforts,
and not clients bargaining power, leading to poorer quality audits. In the absence of data
on engagement hours and staff mix, we utilize the number of days between fiscal year-end
and release of the audit report as a proxy for audit effort. We include this variable, square
of the variable, and natural logarithm of the variable in our audit fee model, in an effort to
control for auditor effort that is in response to missing audit risk factors. All of our
conclusions are supported as before. Additionally, unless the missing measures for audit
risk are correlated with bargaining power, the differential variation of audit quality with
clients bargaining power (documented in Panel C of Table 4) gives additional credibility
to our results. However, to the extent that we are unable to control for audit risks in our
model, the factors discussed above continue as limitations of our research.
12. In Panels B, C, and D of Table 4, we use logistic regressions for the dichotomous
dependent variable MBEX, along with interaction terms. Norton et al. (2004) caution that
since logistic regressions are nonlinear models, the interaction terms must be interpreted in
a different way. They show that the marginal effect of a change in both interacted variables
is not equal to the marginal effect of the change in just the interaction term. They suggest
applying the INTEFF function in Stata for estimating the correct marginal effect of the
interaction term. As a robustness check, we run the INTEFF function as detailed in Norton
et al. (2004). Our conclusions are unchanged, suggesting that the results reported in Panels
B, C, and D are robust. One constraint with the INTEFF procedure is that it works for only
August 2012
Asthana and Boone
18
one interaction term. In Panel D, for the SOX tests, we have two interaction terms. We
therefore run two separate tests with INTEFF for each interaction term.
In addition, to convince ourselves that our interpretation of the interaction effects is correct, we run
the above regressions with MBEX replaced with a continuous variable, excess earnings defined as
the reported earnings per share minus the analyst forecast. Since this dependent variable is not a
dichotomous variable, we no longer have to use the logistic regression. We are able to replicate all
the results reported before. This further provides assurance that our interpretation of the interaction
terms is reliable.
CONCLUSION
Auditors are hired and compensated by their clients, and this creates an economic bond
between the two. The question of whether this economic bond ultimately leads to reduced audit
quality remains an important public policy issue and has been the topic of prior research. We extend
this research by examining the role of client bargaining power in addition to economic bonding as a
determinant of audit quality. In our study, we examine the association between abnormal audit fees
and two audit quality proxies: (1) abnormal discretionary accruals and (2) the probability of meeting
or beating analysts consensus earnings forecasts.
Above-normal audit fees suggest quasi-rents arising from a highly profitable audit engagement,
while below-normal audit fees suggest the client has strong bargaining power (and hence is able to
negotiate billing concessions). Both factorsquasi-rents and client bargaining powermay lead the
auditor to succumb to client pressure for earnings management. Thus, absolute abnormal audit fees
reflect the presence of these independence-impairing underlying factors and is our variable of interest.
As hypothesized, we find that audit quality declines as actual audit fees depart from normal
fee levels. Our finding that audit quality declines as positive abnormal audit fees increase in
magnitude is consistent with prior research. New to the literature is our finding that audit quality
declines as negative abnormal audit fees increase in magnitude, with the decline increasing in
magnitude as proxies for client bargaining power increase.
We also examine whether the audit quality/abnormal audit fee association changed following
implementation of SOX, and use this examination as a means of testing whether SOX was effective
in increasing auditor independence. We find evidence that this association in the post-SOX era is
milder than in the pre-SOX era. Thus, SOX reforms increase the risk of and reduce the gain from
succumbing to client pressure and compromising audit quality.
It is important to note that our results regarding abnormally high or low audit fees could be
attributable not to economic bonding or client bargaining power, but rather to factors that are not
captured by our audit fee model. Alternative explanations that we cannot investigate due to data
limitations include such items as audit team composition (i.e., the relative allocation of audit hours
between partners, managers, and staff ), the audit work allocation between interim and year-end, the
influence of internal audit assistance, the relative quality of client financial reporting systems, and
individual differential audit firm production functions. Accordingly, the reader should remain
mindful of this limitation when interpreting our evidence.
Overall, our study increases understanding of the factors that may lead auditors to compromise
on audit quality, and hence our paper should be of interest to accounting scholars, investors, and
regulators.
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