Independence in Appearance, Earnings Conservatism, and Prediction of Future Cash Flows

Abstract

We document that the provision of non-audit services to audit clients creates a lack of independence in appearance, resulting in heightened scrutiny of audit-client relationships with high ratios of non-audit fees to total fees. In some circumstances, this scrutiny can motivate managers and auditors of companies with high fee ratios to apply GAAP more conservatively to avoid costly regulation. Consistent with our predictions, we find evidence that earnings conservatism increases with the fee ratio only for politically visible companies in fiscal 2000 and no evidence that earnings conservatism increases with the fee ratio for any companies in fiscal 2001. We also investigate whether an unintended consequence of regulatory scrutiny related to independence in appearance is an attenuation of the usefulness of reported earnings for the purpose of predicting future cash flows. We find no evidence that impairment of this aspect of earnings quality is associated with high fee ratios.

JEL Classification: M41, M43, M44, M49, L84, G12