Fees Paid to Audit Firms, Accrual Choices, and Corporate Governance

TLDR

The study investigates how audit and non‑audit fees relate to firms’ accrual choices. The authors analyze fee ratios and accrual measures across a large pooled sample of firms, using latent class mixture models to identify homogeneous clusters. The analysis finds that a higher non‑audit fee ratio is positively associated with larger absolute accruals only for a small minority of firms, while higher overall fees are linked to smaller accruals—especially in firms with weak governance—suggesting auditors are constrained by reputation effects.

Abstract

We examine the relation between the fees paid to auditors for audit and non‐audit services, and the choice of accrual measures for a large sample of firms. Using our pooled sample, we find that the ratio of non‐audit fees to total fees has a positive relation with the absolute value of accruals similar to Frankel, Johnson, and Nelson [2002]. However, using latent class mixture models to identify clusters of firms with a homogenous regression structure reveals that this positive association only occurs for about 8.5% of the sample. In contrast to the fee ratio results, we find consistent evidence of a negative relation between the level of fees (both audit and non‐audit) paid to auditors and accruals (i.e., higher fees are associated with smaller accruals). The latent class analysis also indicates that this negative relation is strongest for client firms with weak governance. Overall, our results are most consistent with auditor behavior being constrained by the reputation effects associated with allowing clients to engage in unusual accrual choices.