Audit and Nonaudit Fees and the Market's Reaction to Earnings Announcements

Effective February 05, 2001, publicly traded companies are required to disclose audit and nonaudit fees paid to their external auditors. These fee data have been used to test whether auditor independence is impaired when the external auditor provides nonaudit services to a client, usually by examining whether certain earnings characteristics are related to nonaudit fees in ways that suggest impairment. This paper follows in that tradition by testing whether the earnings response coefficient (ERC), a proxy for earnings quality, is associated with engagement profitability. Residual fees derived from a two-stage regression model that prices audit and nonaudit services simultaneously are used to proxy for engagement profitability. If the market perceives abnormally profitable engagements as a threat to auditor independence, then we would expect the ERC to be lower for firms with positive fee residuals. The paper examines the residual fee-ERC relation for annual earnings announcements immediately before and after first-time fee disclosure. We report results for alternative measures of unexpected earnings (I/B/E/S forecast errors and deviations from a seasonal random walk), different formulations of residual fees (as a dichotomous and continuous variable) and different samples. For total fees and audit fees, there is a positive association between ERCs and the level of residual fees. For nonaudit fees, there is only one combination of unexpected earnings and residual fee formulation where we observe a significantly negative association between ERCs and residual fees. The findings for audit fees are consistent with a market that interprets abnormally high audit fees as a signal of a firm's commitment to high earnings quality. The restrictive conditions under which we find a negative association between nonaudit fees and ERCs provide limited support for the contention that perceived auditor independence is impaired by abnormally high nonaudit fees.