Nonaudit Services and Earnings Conservatism: Is Auditor Independence Impaired?

We examine whether the provision of nonaudit services (NAS) by incumbent auditors is associated with a reduction in the extent to which earnings reflect bad news on a timely basis (that is, news†based conservatism). Reduced conservatism is expected to occur if relatively high levels of NAS result in reduced auditor independence and, ultimately, lower†quality auditing. Because client†specific demand for NAS is expected to vary, our proxy for the auditor†client economic bond is the extent to which NAS purchases (relative to audit fees) are greater or less than expected. Using several different methods for identifying news†based conservatism, we consistently find that higher than expected levels of NAS are not associated with reduced conservatism. This result is robust to allowing for endogenous NAS demand, as well as several explicit factors that may be associated with differences in conservatism. Similar conclusions arise from tests that use alternative measures of the economic bond between auditors and their clients, as well as in tests confined to either the Big 6 or non†Big 6 audit firms. Our results are consistent with factors such as market†based incentives, the threat of litigation, and alternative governance mechanisms offsetting any expected benefits to the audit firm from reducing its independence. We therefore conclude that recent legislative intervention aimed at restricting the supply of NAS is unlikely to result in increased independence in fact, although independence in appearance may be improved.