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Introduction
The relation between auditor independence and an auditor's ability to conduct high-quality audits has been widely debated by regulators, legislators, financial statement users and researchers. Much of this discussion has been fueled by dramatic changes in the market for accounting services during the 1990s, as well as concerns that auditors are less likely to enforce GAAP to the extent that they receive large fees from their audit clients.
Fees paid to auditors can affect audit quality in two ways: large fees paid to auditors may increase the effort exerted by auditors, hence, increasing audit quality. Alternatively, large fees paid to auditors, particularly those that are related to non-audit services, make auditors more economically dependent on their clients. Such financial reliance may induce a relationship whereby the auditor becomes reluctant to make appropriate inquiries during the audit for fear of losing highly profitable fees. Conversely, the potential for audit failure imposes significant economic costs on the auditor ([8] DeAngelo, 1981; [34] Simunic, 1984). Though a number of recent studies have examined the relationship between audit and non-audit fees and independence, they are ambiguous as to the relationship between audit fees and auditor behavior ([24] Larcker and Richardson, 2004). They also differ on how fee composition and client importance affect auditor independence.
We believe that examining fees paid by firms in the context of auditor profitability better captures the relation between audit quality and auditor independence. In this regard and consistent with the discussion in [21] Kinney and Libby (2002), we develop a methodology that is grounded in the notion that auditor independence is influenced by the amount of fees relative to their expected amounts; e.g. adjusted for auditor effort and risk, rather than the level of fees received from clients. We therefore examine effort and risk-adjusted fees rather than raw fees. Since, these attributes are unobservable, we develop two proxies, one based on client size and the other based on estimates of expected or normal fees paid to auditors. The former proxy assumes that a larger company will, on average, require the auditor to exert more effort and creates more reputation risk for the audit firm in the event of an audit failure. The latter proxy further refines the financial linkage between the auditor and...