Auditor Independence, Corporate Governance and Abnormal Accruals

Anwer S. Ahmed*
Texas A&M University

Scott Duellman and Ahmed Abdel-Meguid

Syracuse University

February 2006

Abstract

We predict that the more important a client is to an auditor’s office, the greater the
likelihood that auditor independence is compromised and the more aggressive is the
client’s accounting. We document a significant positive relation between an office-level
measure of client importance (based on relative magnitude of client fees) and abnormal
accruals over 2000-2001. Moreover, we find that this relation is extenuated by strong
governance. Furthermore, we find that after passing of the Sarbanes-Oxley Act, while
this relation is not significant for the overall sample, it continues to be significant for
weak governance firms.

JEL Classification: G3; M41; N22

Key words: Auditor Independence, Aggressive Accounting, Corporate Governance,

Sarbanes-Oxley.

*
Contact author; Tel.: (979) 845-1498; E-mail: aahmed@mays.tamu.edu
We are grateful to Dave Harris, James Myers, Linda Myers, Tom Omer, Anup Srivastava, Ed Swanson,
Senyo Tse, Charles Wasley, Mike Wilkins, Chris Wolfe, and workshop participants at Syracuse and Texas
A & M for helpful comments or discussions.
 Auditor Independence, Corporate Governance, and Abnormal Accruals

1. Introduction

The economic theory of auditor independence suggests that auditors trade off the

benefits of compromising their independence (e.g. client retention) against the potential

loss of reputation and litigation costs that might result from such a compromise (Watts

and Zimmerman, 1981; DeAngelo, 1981a, 1981b).1 Based on this theory, we predict and

find a positive relation between an office-level measure of client importance, and

abnormal accruals. Furthermore, in cross-sectional analysis, we find that the relation is

significant for firms with weak governance but not significant for firms with strong

governance. This result is consistent with strong governance alleviating the effects of

client influence. We also find that while, for the overall sample, the relation between

client influence and abnormal accruals has weakened in a post-Sarbanes-Oxley (SOX)

period relative to a pre-SOX period, the positive relation persists for firms with weak

governance in the post-SOX period.

Although the potentially adverse effects of economic dependence on auditor

independence have been recognized since more than four decades ago, for example in

Mautz and Sharaf (1961), to our knowledge, there are no prior archival studies that

document robust evidence of auditors compromising their independence due to the

economic influence of their clients. Building on Wallman’s (1996) insight that the

individual practice office is the appropriate unit of analysis for measuring economic

dependence, Reynolds and Francis (2001) find a negative relation between absolute

1
Watts and Zimmerman (1981) note that the first two references to auditor independence in The
Accountants Index, a publication of the AICPA, are to an August 7, 1909 Wall Street Journal Editorial that
uses the term “independent audit” to describe an audit conducted by an auditor who will not yield to
managerial pressure.

1
abnormal accruals and an office-level measure of client importance. They conclude that

existing incentives are sufficient to motivate auditors to be independent, despite the

presence of economic dependence inherent in auditor-client contracting. Chung and

Kallapur (2003) reach a similar conclusion in their examination of office-level client

importance and absolute abnormal accruals.2

We predict a positive relation between client importance (measured at the office-

level) and abnormal accruals because conflicts between auditors and their clients are

likely to arise when the client prefers to use aggressive accounting, which would

normally not be permitted by an independent auditor (Becker et al., 1998). However,

survey evidence suggests that if the auditor is economically dependent on the client, he or

she is likely to succumb to client pressure in such cases and not require a downward

adjustment (Trompeter, 1994; Nelson et al., 2002).

Our sample is based on firms in Audit Analytics and Compustat that are audited

by the Big 5 (or Big 4 after 2001) accounting firms over a pre-SOX period, 2000-2001,

and a post-SOX period, 2002-2004. We construct an office-level measure of client

importance, Influence, defined as the log of client total fees divided by the sum of log of

total fees of all public clients of the relevant office, similar to Reynolds and Francis

(2001) except that their measure is based on client sales rather than client fees.

We use two alternative abnormal accrual measures as our dependent variables.

The first measure is estimated using the advanced cross-sectional accrual model in

2
A related literature examines the effect of providing non-audit services on accrual-based measures of
earnings quality. Examples include Frankel et al. (2002), DeFond et al. (2002), and Ashbaugh et al. (2003).
Larcker and Richardson (2004) summarize the findings of this literature as follows: “… the literature
examining the relation between audit fees or non-audit services with accrual behavior finds virtually no
statistical evidence for a relation between measures of auditor independence and earnings quality.”

2
Larcker and Richardson (2004) and the second measure is performance-adjusted

abnormal accruals suggested by Kothari et al. (2005).

Consistent with the predictions of the economic theory of auditor independence,

we find a strong positive relation between both abnormal accrual measures and office-

level client importance after controlling for an extensive set of control variables. This is

in contrast with the negative relation between absolute abnormal accruals and client

importance in Reynolds and Francis (2001) and the insignificant relation between

absolute abnormal accruals and client importance in Chung and Kallapur (2003). The

difference in results is driven by our use of signed abnormal accruals versus their use of

(unsigned) absolute abnormal accruals as a dependent variable.3 The rationale for

unsigned abnormal accrual measures in the literature is that the direction of the earnings

management is not predicted. However, because we expect auditors to allow their more

important clients to engage in more aggressive accounting, the signed measure is more

appropriate for our tests.4

We also find that this relation holds for a subset of weak governance firms

(defined using the percentage of inside directors on the board and institutional

shareholdings) while it does not hold for strong governance firms. In other words, strong

governance appears to constrain income increasing abnormal accruals even when

auditors’ economic dependence on clients is high.

3
To reconcile our results with these studies we also repeat our tests with absolute abnormal accruals.
Consistent with their results, we generally find a negative coefficient on Influence.
4
Note that taking absolute values amounts to throwing away information. To see this, suppose abnormal
accruals are perfectly linearly related to Influence and we regress absolute abnormal accruals (instead of
signed abnormal accruals) on influence. In this case, using absolute values would show no relation when in
fact there is a significant relation.

3
 Finally, we find that while this relation has weakened in the post-SOX period

(2002-2004) for the overall sample, the relation persists for the sub-sample of firms with

weak governance even in the post-SOX period. Taken together the results are consistent

with the predictions of the economic theory of auditor independence.

To summarize, we contribute to the literature on the relation between auditor

independence (or quality) and clients’ accounting choices. First, using absolute abnormal

accruals as a dependent variable, prior studies find a negative relation between client

importance and absolute accruals. We find a significant positive relation between client

importance and signed abnormal accruals. Second, we find that this relation varies across

the strength of firms’ governance. Third, we provide evidence on how this relation has

changed in the post-SOX period relative to the pre-SOX period.

Section 2 presents our hypothesis development. The research design is presented

in section 3 and the evidence in section 4. The conclusion is presented in section 5.

2. Hypothesis Development

2.1. Auditor independence and abnormal accruals

Watts and Zimmerman (1981) define auditor independence as the likelihood the

auditor reports honestly if he observes a breach. A number of prior researchers have

recognized that the level of auditor independence is unlikely to be constant across clients.

For example, Mautz and Sharaf (1961) recognize the auditor’s financial dependence on

clients as a built-in anti-independence factor. DeAngelo (1981a) argues that future

economic interest in a client reduces the auditor’s independence vis-à-vis that client. In

4
other words, the greater the client-specific quasi-rent stream, the less likely the auditor is

to report a discovered breach.

Wallman (1996) argues that auditor independence should be examined at the

office level where the important audit decisions regarding individual clients are made.

Building on this notion, Reynolds and Francis (2001) extend DeAngelo’s (1981a) study

and examine auditor incentives within individual practice offices of the big five

accounting firms. They argue that although a single client is not economically significant

in a firm-wide portfolio, that client may be providing significant revenues to an

individual office. This creates incentives for the auditing office to be lenient and succumb

to client pressure from important or economically significant clients. Similarly,

Trompeter (1994) argues that at the individual partner level independence may be more

difficult to maintain because any one client may comprise a substantial share of the

revenues that the partner contributes to the firm.

On the other hand, auditors also have incentives to protect their reputation and

mitigate expected litigation costs arising from audit failures (Antle et al., 1997).

However, while the benefits of client retention accrue mainly to the local office, the costs

of any loss of reputation or litigation are borne by the entire firm (Reynolds and Francis,

2001). This constitutes a moral hazard problem (Narayanan, 1995). Thus, at the local

office level the incentives to retain large clients could dominate the incentives to protect

the firm’s reputation and avoid litigation.

The effect of these conflicting incentives is likely to be manifested in

confrontational situations between the auditor and the client. Given that Generally

Accepted Auditing Standards require the auditor to assess the appropriateness of the

5
accounting principles adopted by management, conflicts between auditors and their

clients are likely to arise when a client wants to use aggressive accounting that under

normal circumstances would not be approved by the auditor.5 In such situations, the

auditor will be forced to consider the costs of a biased judgment (e.g. loss of reputation or

litigation costs) and the benefits of appeasing the client (e.g. client retention).

The auditor is not likely to be concerned about use of conservative accounting as

much as about the use of aggressive accounting because the costs to auditors of income

overstatement by the client is likely to exceed the costs of understatement by the client.6

For example, evidence in St. Pierre and Anderson (1984), DeFond and Jiambalvo (1991,

1993) and Kinney and Martin (1994) suggests that auditors are much more likely to be

sued for allowing income overstatements than income understatements.

Furthermore, prior evidence suggests that in instances when auditor independence

is compromised, auditors are less likely to require downward adjustments for important

clients than for relatively unimportant clients. For example, Trompeter (1994) documents

that partners with compensation more closely tied to client retention are less likely to

require downward adjustments to income than partners with compensation less closely

tied to client retention. Similarly, based on a survey of 253 auditors from a Big 5 audit

firm, Nelson et al. (2002) document that auditors are more likely to oppose income-

increasing accruals for small clients than for large clients.

5
“An audit also includes assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall presentation of the statements" (Excerpt from the scope
paragraph in the Auditor's report).
6
While conservative accounting has been recently criticized by accounting regulators, there are economic
incentives for firms to choose conservative accounting. See Watts (2003) for a discussion of these
incentives and Ahmed et al. (2002) and Ahmed and Duellman (2005) for related evidence.

6
 Based on the above logic and evidence, we predict that the more important (or

economically significant) a particular client is to an office, the greater the likelihood that

auditor independence is compromised, ceteris paribus, and the more aggressive is the

client’s accounting.7 This prediction is consistent with Becker et al. (1998) who argue

that higher quality auditors will tend to reduce the incidence of income-increasing

earnings management.

2.2 Corporate governance and accounting choices

The above discussion assumes that other things, including the strength of

governance, across firms is held constant. This is unlikely to be the case because

governance mechanisms, such as the board of directors and institutional shareholders,

likely vary across firms and constrain managers’ accounting choices in at least two ways.

First, governance mechanisms reduce the likelihood of managerial malfeasance

directly through overseeing the financial reporting process. For example, Beasley (1996),

Dechow et al. (1996), and Farber (2005) find that board independence, in terms of the

percentage of outsiders is negatively related to the likelihood of financial statement fraud.

Peasnell et al. (2000) find that the percentage of outsiders on the board is negatively

related to income-increasing abnormal accruals for UK companies. Klein (2002b) finds

similar results for US firms using absolute abnormal accruals as a proxy for earnings

management. Koh (2003) finds that high levels of institutional ownership are negatively

related to income increasing discretionary accruals. Rajgopal et al. (1999) find a negative

relation between institutional ownership and the absolute value of discretionary accruals.

7
Evidence in Brown (2001), Bartov et al. (2002), and Matsumoto (2002) suggests that the propensity to
avoid negative surprises has increased over time up to 2001.

7
 Second, governance strength also affects accounting choices indirectly, as

governance mechanisms affect the extent to which the auditor can operate independently.

For example, McMullen (1996) finds that the likelihood of auditor turnover, following an

auditor-client disagreement, is negatively related to the presence of an audit committee.

Knapp (1987) finds that an audit committee comprised of members with corporate

expertise is more likely to support the auditor in the case of an auditor-client dispute than

an audit committee that comprises of members with other backgrounds. Carcello and

Neal (2003) find that the independence of the audit committee is negatively related to the

likelihood of auditor dismissal following a “going concern report”. Thus, an independent

audit committee shields the auditor from potential retaliation by management, alleviating

any pressure on the auditor’s opinion and thus enhancing the auditor’s independence.

Klein (2002a) finds a strong correspondence between audit committee independence and

overall board independence.

Thus, board independence and institutional ownership likely enhance governance

and mitigate aggressive accounting. Based on the above, we expect the effect of client

importance on accounting choices to be stronger for firms that have low board

independence and low institutional ownership. We discuss the precise measures of

governance that we use in section 3.

2.3. The impact of Sarbanes-Oxley

It is widely recognized that the fall of Enron and other firms reporting major

accounting problems together with the subsequent enactment of the Sarbanes-Oxley Act

in 2002 have radically altered the landscape of financial reporting. In particular, the

8
prosecution of Andersen and the monitoring of auditing firms by the PCAOB have

substantially raised the cost of audit failures. For example, in Business Week, April 25,

2005, Henry, France and Lavelle, (2005) state that “It used to be a cozy relationship:

Audit partners spent so much time on some accounts, they might as well have been on the

payroll. And with all the fat consulting contracts, they just about were. Not anymore.” 8

Barry C. Melancon, the president and CEO of the American Institute of CPAs

(AICPA), stated in a 2002 speech that SOX “Contains some of the most far-reaching

changes that congress has ever introduced to the business world. Its scope is large. It

contains fundamental reforms. Many of its standards are high. And its penalties are

stiff”. Consistent with the above, Cohen et al. (2005) provide systematic evidence of an

increase in the extent and frequency of earnings management up to 2001 and then a

subsequent reversal after Sarbanes-Oxley.9

Based on this significant change in the business environment of accounting firms,

we expect the management of accounting firms to exercise tighter control over individual

offices.10 Thus, auditors are less likely to be lenient towards influential clients after 2001.

We, therefore, predict that the relation between abnormal accruals and client importance

will weaken after Sarbanes-Oxley.11

8
Section 201 of the Sarbanes-Oxley Act prohibits accounting firms from jointly providing auditing and
nine non-audit services, including any type of services the PCAOB decides to prohibit.
9
Amir et al. (2005) also document evidence of a structural change in the relation between auditor
independence and cost of debt after 2001.
10
The major accounting firms’ response letters to the PCAOB Inspection Reports suggests that they made
organizational and structural changes after SOX.
11
Henry et al. (2005) also provide anecdotal evidence of changes in the auditor-client relationship

9
3. Research Design

We test our predictions using a regression of abnormal accruals on our measure of

client importance (Influence) and a set of control variables. We perform this regression

for the full sample as well as for sub-samples constructed on governance measures. We

also test for a change in this relation in a post-SOX period relative to a pre-SOX-period.

This section describes (i) the abnormal accrual measures, (ii) the measure of client

importance or influence, (iii) how we construct the governance partitions, and (iv) the

rationale for the control variables. We also perform additional robustness and sensitivity

tests that are described in section 4.5.

3.1. Abnormal accrual measures

We use the following accrual model used by Larcker and Richardson (2004),

estimated by 2-digit industry every year, to measure abnormal accruals:

(1) Total Accruals = α +β1 (∆Sales-∆REC) + β2 PPE + β3 BTM + β4 CFO + ε

where, Total Accruals is the difference between operating cash flows (CFO) and income

before extraordinary items reported on the statement of cash flows (Compustat 123-

Compustat 308) deflated by average total assets (Compustat 6), Sales is the change in

sales for the year (Compustat 12) deflated by average total assets, ∆REC is the change in

receivables reported on the statement of cash flows (Compustat 302) deflated by average

total assets, PPE is the gross property plant and equipment (Compustat 7) deflated by

average total assets, BTM is the book-to-market ratio defined as the book value of

10
common equity outstanding (Compustat 60) divided by the market capitalization at the

end of the fiscal year (Compustat 25*Compustat 199). The residual of this model (ε) is

our measure of abnormal (or discretionary) accruals.

The above accrual model is an extension of the modified Jones (1991) model in

Dechow et al. (1995). It is based on the assumption that accruals are a function of sales

growth (∆Sales-∆REC) and capital intensity (PPE). Larcker and Richardson (2004) add

(i) the book-to-market ratio as a proxy for expected growth, and (ii) operating cash flows

because evidence in Dechow et al. (1995) suggests that the modified Jones model is mis-

specified for firms with extreme performance.

As an alternative measure of abnormal accruals we use a performance-matched

abnormal accrual measure suggested by Kothari et al. (2005). To obtain performance

matched discretionary accruals we match each firm-year with a firm-year from the same

two-digit SIC code with the closest ROA at time t-1.12 The performance-matched

abnormal accrual for a firm is the error term from equation (1) less the error term from

equation (1) of the matched firm. Kothari et al. (2005) suggest that when the hypothesis

being tested does not imply that earnings management varies with performance, using

performance-matched abnormal accruals enhances the reliability of the inferences.

3.2. Client importance measure

Our measure of client importance is defined as the log of total fees (audit plus

non-audit fees) paid to the auditor obtained from Audit Analytics divided by the

12
We define ROA t-1 as income before extraordinary items (Compustat 18) divided at time t-1 divided by
total assets at the end of year t-1. We do not deflate by average total assets, as deflating by average total
assets would cause us to lose observations. However, when deflating by average total assets at time t-1
results remain qualitatively unchanged.

11
summation of the log of total fees paid to the auditor of all public clients listed on

Compustat of the office issuing the opinion.13 We assign a client to the audit office

(associated with the auditor) closest to the client’s headquarters based on zip codes as in

Chung and Kallapur (2003). We obtain audit office zip codes from the lists of audit

offices reported in annual reports filed by auditors with the AICPA from 2001-2004.14

We assume that auditors’ office zip codes in 2000 are the same as in 2001. Any

mismatching, that occurs between audit client and audit office should bias against results,

as it will essentially add noise to our office-level influence measure. We obtain client zip

codes from Audit Analytics.

In our sample, the average (median) office audits 19.1 (15) firms, with a range of

1-64 clients per office. Although our average number of audits per office is higher than

that reported in Reynolds and Francis (2001), 13.5, our range is much lower (1-139).

3.3. Corporate governance partitions

As discussed in section 2, prior research suggests that governance mechanisms

(specifically board independence and institutional ownership) constrains managers’

accounting choices. Furthermore, Larcker and Richardson (2004) argue that the relation

between abnormal accruals and auditor independence measures (e.g. ratio of non-audit

fees to total fees) varies across firms with different governance structures. Given their

arguments and evidence, in addition to performing tests on the full sample, we perform

13
In additional testing (unreported) we use client sales, as in Reynolds and Francis (2001), instead of audit
fees to measure client importance and obtain qualitatively similar results.
14
We have a total of 303 audit offices for fiscal-year 2004 (Big 4) compared with 404 audit offices for
fiscal year 2001, the dramatic decrease is due to the closure of Arthur Anderson. The number of total
offices is comparable to Chung and Kallapur (2003) who find 412 audit office for fiscal year 2000. If a firm
has multiple offices in the same zip code, we treat these offices as one office.

12
tests on three partitions based on (i) the percentage of insiders on the board and (ii)

institutional shareholdings.

We define the weak (strong) governance partition as the set of firms with above

(below) median percentage of insiders on their boards and below (above) median

institutional shareholdings. The remaining firms are classified as moderate governance

firms.

3.4. Empirical model and control variables

The primary purpose of controls in our context is to mitigate measurement error

in abnormal accruals due to mis-specification in the accrual model. It is not appropriate in

our context to control for accrual choices that may be driven by earnings management

incentives because controlling for such behavior is likely to throw away the effect we are

investigating. We utilize the following empirical model to test our predictions:

(2) AA i,t = α0 + β1 Influence i,t + β2 Tenure i,t + β3 CFO i,t + β4 Asset Growth i,t +

β5 AA i,t-1 + ε i,t

where AA i,t is the abnormal accruals estimated in equation (1), Influence i,t is the log of

total fees paid to the auditor (Audit Analytics) divided by the summation of the log of

total fees paid to the auditor of all public clients listed on Compustat of the office issuing

in the opinion, Tenure i,t is the number of consecutive years the auditor has audited the

firm since 1990, CFO i,t is the operating cash flows of the client (Compustat 308) divided

by average total assets, Asset Growth i,t is the percentage change in total assets.

13
 We include Tenure as an explanatory variable because Myers et al. (2003) find

that auditor tenure is positively related to signed accruals and negatively related to

absolute abnormal accruals. If auditor tenure is correlated with Influence, omitting

auditor tenure could bias the coefficient on Influence. We define Tenure as the number of

consecutive years the client has been audited by the same audit firm.15 We control for

operating cash flows (CFO) because cash flows in equation (1) only control for

performance differences across firms within an industry whereas there could be important

performance differences across firms in different industries. We define operating cash

flows as cash flows from operations (Compustat 318) divided by average total assets. We

include Asset Growth as a control variable because the model for expected accruals could

be mis-specified for firms experiencing unusual growth or changes in assets. Finally, we

include the abnormal accruals estimated for the previous year to control for the potential

reversal of prior period abnormal accruals that is not captured in equation (1).

Prior studies examining the effects of client importance also include other factors

that affect abnormal accruals (e.g. leverage and size). We include some of these variables

as additional explanatory variables in our sensitivity tests.

4. Evidence

4.1. Sample selection and descriptive statistics

We estimate equation (1) annually for each 2-digit industry (with at least 8 firms

in the industry) using all firms with data available in Compustat between 1999 and 2004

15
We measure auditor tenure from 1990. If the firm’s auditor was not previously available in Compustat
we set Tenure equal to one.

14
and average total assets exceeding two million dollars.16 We exclude financial institutions

such as banks and insurance companies (SIC codes 6000-6999) similar to prior work. The

pooled sample contains 32,085 firm-years and is estimated using 366 industry-year

regressions. The mean coefficient estimates of our accrual model are similar to those

reported in Larcker and Richardson (2004) Table 3, Panel A, except that we find a

positive and significant coefficient on book-to-market. This difference is likely due to the

difference in time periods sampled. Additionally, in our sample the average adjusted R2 is

slightly higher (37.9%) than the average adjusted R2 in their study (30.1%).

To test for the effects of client importance on abnormal accruals we utilize a

sample of all Compustat firms audited by the Big 5 (or Big 4 after 2001) accounting firms

with available data from 2000-2004 with zip codes available on Audit Analytics. This

leaves us with a final sample of 11,061 firm-years. Our sample contains 3,578 firm-years

in the pre-SOX era (2000-2001) and 7,483 firm-years in the post-SOX era (2002-2004)

without requiring governance data. The sample size reduces to 1,373 firm-years and

3,054 firm-years respectively in the two periods when we require governance data. The

top and bottom 1% of all variables are winsorized to mitigate the potential effects of

outliers.17

Table 1, Panels A and B present descriptive statistics for our sample of firms in

the two sub-periods respectively. Panel A shows that the mean and median total accruals

are negative consistent with prior studies. The mean and median abnormal accruals (AA)

are 0.02 and 0.025 in the pre-SOX period whereas the mean and median AA are 0.011

16
We exclude these smaller firms as they often have extreme values for accruals that may bias the results.
Furthermore, we estimate the abnormal accruals for 1999 as equation (2) includes a control for prior
abnormal accruals.
17
Results remain qualitatively unchanged if we control for outliers by deleting observations with a Cook’s
D value greater than 4/n.

15
and 0.016 respectively in the post-SOX period. Note that these magnitudes are for our

sample firms (and not for all firms that are used to estimate the accrual model). These

magnitudes are slightly larger than magnitudes reported in Chung and Kallapur (2003)

and Larcker and Richardson (2004).

The mean and median values of Influence, based on office-level fees, are 0.135

and 0.089 respectively in the pre-SOX period and 0.089 and 0.056 in the post-SOX

period. The decline in these ratios is consistent with a reduction in non-audit work after

SOX as well as an increase in the number of clients per office due to Andersen ceasing

their auditing operations in 2002. With respect to other firm characteristics, the firms in

our sample are slightly larger, on average, than the firms in Reynolds and Francis (2001).

The mean log sales are 12.7 (unreported) for our sample versus 11.85 for their sample.

The mean and median CFO is 0.053 and 0.077 in the pre-SOX period compared to 0.04

and 0.07 in Larcker and Richardson (2004). The mean and median Inside Director % are

0.29 and 0.25 in the pre-SOX period and 0.32 and 0.29 in the post-SOX period. The

mean and median Institutional Ownership are 0.63 and 0.65 in the pre-SOX period and

0.68 and 0.70 in the post-SOX period. The mean (median) Inside Director % is 44.9%

(42.9%) for weak governance firms in the pre-SOX period (unreported) and 45.7%

(42.9%) in the post-SOX period (unreported). Thus, the structure of the board of directors

did not drastically change in regards to director composition for weak governance firms

post-SOX.

Table 1, Panels C and D present the Pearson and Spearman correlations between

our dependent and independent variables in the two sub-periods respectively. The

Pearson correlation between AA (P-AA) and Influence is insignificant at the 5% level of

16
significance in the pre-SOX period. However, the Spearman correlation is positive and

significant at the 5% level between AA (P-AA) and Influence. In the post-SOX era, the

Spearman correlation is significantly negative at the 5% level between AA (P-AA) and

Influence. The Pearson correlation is significantly negative between AA and Influence at

the 5% level of significance but the correlation between P-AA and Influence is

insignificant. Although the univariate correlations in the pre-SOX era are consistent with

the predicted relation, they do not control for firm characteristics that may be correlated

omitted variables.

4.2. Effect of Influence on abnormal accruals in the pre-SOX period

Table 2 presents the results of regressions of abnormal accruals and performance-

adjusted abnormal accruals on Influence and control variables over 2000-2001. All t-

statistics are based on the Newey-West standard errors corrected for serial correlation and

heteroskedasticity. If auditors allow their more influential clients to use relatively higher

income increasing abnormal accruals, we expect to observe a positive coefficient on

Influence. Table 2, Panel A shows that the coefficient on Influence is positive and

significant at conventional levels irrespective of whether we use abnormal accruals or

performance-adjusted abnormal accruals as our dependent variable.18 Interestingly, the

coefficient on Tenure is also positive and significant, consistent with the signed abnormal

accrual tests in Myers et al. (2003). The coefficient on CFO is negative and significant

consistent with the well-documented negative correlation between accruals and cash

18
Reynolds and Francis (2001) look at signed discretionary accruals for sub-samples of positive and
negative discretionary accruals. The problem with partitioning on the dependent variable is that one ends
up partitioning on the residual and so the OLS coefficients are likely to be biased. See Maddala (1983).
Furthermore, any difference between the two sub-samples is ignored.

17
flows. The coefficient on Asset Growth is positive and significant. The coefficient on

lagged abnormal accruals is positive and significant in column (i) but insignificant in

column (ii). Overall, the results are consistent with the notion that important clients tend

to use more aggressive accounting that boosts income compared to less influential clients.

Table 2, Panels B and C present the results of regressions similar to Table 2

except that we partition the sample into three sub-samples based on the strength of

governance as defined in section 3.3. We expect that firms with weak governance are

more likely to exert their economic influence over the auditor, as there are fewer

governance restraints to prevent them from doing so. This is based on prior studies, such

as Klein (2002b) and Peasnell et al. (2000), which suggest that stronger governance

constrains aggressive accounting. However, partitioning our sample and examining the

sub-samples separately also reduces the power of our tests because of loss of data due to

the additional data requirements as well as the smaller number of observations in each

partition. Table 2, Panel B shows that despite the lower power, the coefficient on

Influence is positive and significant for the weak governance firms but not significant for

the other two partitions. This result is consistent with strong governance mitigating the

impact of client influence.19 Panel C also shows a positive and significant coefficient on

Influence for the weak governance partition as well as a positive and marginally

significant coefficient for moderate governance firms. As expected, the coefficient on

Influence is not significant for the strong governance firms.

19
Please note we are not commenting on the relative size of the Influence coefficient relative to the other
partitions but only the significance.

18
4.3. Effect of Influence on abnormal accruals in the post-SOX period

As discussed in section 2, we expect the effect of Influence on abnormal accruals

to weaken in the post-SOX period given the heightened attention of regulators to

accounting and auditing such as the formation of the PCAOB. In Table 3, we present the

results of regressions similar to those in Table 2, Panel A except we now perform the

regression over both sub-periods and test for a change in the coefficient on Influence in

the post-SOX period. We also allow the coefficient on Tenure to change in the post-SOX

period.

Consistent with our predictions, we find that there is a statistically significant

decline in the coefficient on Influence in the post-SOX period. Moreover, it is no longer

significant for the full sample. There is a similar decline in the coefficient on Tenure in

the post-SOX period but the coefficient remains positive and significant at conventional

levels even after SOX.

We also test for differences in the size of coefficients across the governance

partitions using pooled data for the governance partitions in Table 3. We include dummy

variables for weak and moderate governance and interact these variables with both

Influence and Influence*SOX. We find (results not reported) that the Influence measure is

significantly positive in both the pre- and post-SOX period using both abnormal accruals

and performance adjusted abnormal accruals. Furthermore, Influence is not statistically

different from zero in the pre- and post-SOX period for any other governance partition.

Table 4, Panels A, B, and C, present the results of regressions for the full sample

and governance sub-samples in the post-SOX period. Panel A confirms the findings in

Table 3 that the coefficient on Influence is no longer significant but the coefficient on

19
Tenure remains positive and significant. Surprisingly, Panels B and C show that for the

weak governance firms the coefficient on Influence is positive and significant even after

SOX. Thus, SOX does not appear to have been successful in constraining aggressive

accounting choices by clients that are important to auditors for weak governance firms.

The coefficient on Tenure is not significant for any of the partitions, which could be due

to the lower power of the tests.

Overall, our results are consistent with auditors allowing their importance clients

that have weak governance to engage in aggressive accounting relative to other clients.

4.4 Sensitivity analysis

4.4.1. Additional controls

In additional testing we include several other control variables consistent with

Reynolds and Francis (2001) and Chung and Kallapur (2003). We include additional

variables to control for firm size, profitability, leverage, and auditor switching. To control

for firm size we include the natural log of sales as larger firms are generally related to

absolute abnormal accruals in the previous literature. To control for profitability, we also

include income before extraordinary items divided by average total assets at time t-1. We

control for leverage as firms with different capital structures may have differing

incentives to use accruals. We define leverage as total long-term liabilities divided by

total assets. Finally, we control for auditor switching by including dummy terms for the

first year the client is with a given auditor and for the last year the client is with a given

auditor.20 DeFond and Subramanyam (1998) find that discretionary accruals are generally

20
As we are unable to document whether the firm switched auditors in 2005, we do not classify any firm-
year as being the last year with a particular auditor for observations with a 2004 fiscal year.

20
income decreasing during the firm’s last year with the auditor and indistinguishable from

zero in the first year with the new auditor. The inclusion of these additional control

variables do not qualitatively change our findings.

4.4.2. Constant auditor sample

Prior work documents that auditor changes are associated with unusual accruals.

We therefore repeat our tests for a subset of firms who have been with the same auditor

for five years or longer. Despite the smaller sample size, we find that the results are

qualitatively similar to those reported except that the variable Tenure loses significance is

some specifications.

4.4.3. Large firms and small audit offices

Extremely large clients may bias our results as the audit office to firm headquarter

matching may not reflect the true nature of the audit process as large firms may be

audited by teams from multiple offices. Thus, we eliminate the largest 10% of firms in

each year from our main tests. Despite the removal of these large firms we find

qualitatively similar results. We do not repeat these tests for the governance partitions as

we only have governance data for the largest firms in our sample. Thus, we do not have

enough power to effectively run the tests.

We also test whether our results are due to the audits provided by extremely small

audit offices. Small audit offices may be driving the result as they may only have one or

two public clients. To control for this possibility we eliminate observations that are

21
audited by an office with three or fewer public clients. After the elimination of small

audit office clients, results remain qualitatively unchanged.

4.4.4 Year-by-year regressions

As an additional robustness test we also run our influence tests by year. For the

1,346 firm-year observations in 2000 and the 2,240 firm-year observations in the year

2001 we find a positive and significant coefficient on Influence at conventional levels of

significance. Although the coefficient on Tenure is positive in the year 2000 it is not

significant at conventional levels. However, in the year 2001 Tenure is positive and

significant.

In the post-SOX period, we find a negative, and significant at the 10% level,

coefficient on Influence for the 2,657 firm-year observations from 2002. Thus, the

abnormal accruals from 2000 and 2001 seemed to reverse immediately post-SOX. The

coefficient on Tenure is also positive and significant for 2002. For the 2,518 firm year

observations in 2003 and the 2,300 observations in 2004 we find no significant relation

between Influence or Tenure and AA (P-AA).

5. Conclusion

DeAngelo (1981a) argues that future economic interest in a client reduces the

auditor’s independence vis-à-vis that client. In other words, the greater the ‘client-

specific quasi-rent stream’ the less likely the auditor is to report a discovered breach.

Using an office-level measure of client importance, as in Reynolds and Francis (2001),

we predict and find a significant positive relation between abnormal accruals and client

22
importance over the period 2000 to 2001. Furthermore, in view of the substantial changes

in the financial environment after 2001 (such as enactment of the Sarbanes-Oxley Act)

we predict and find that this relation has weakened in the post-SOX environment. In

additional cross-sectional analysis, we find that the positive relation between abnormal

accruals and client importance exists in both the pre- and post-SOX period for weak

governance firms. We do not find evidence of a relation between abnormal accruals and

client importance in strong governance firms in either period. This finding is consistent

with strong corporate governance mitigating the effect of client influence.

To our knowledge, this is the first study that documents auditors compromising

their independence based upon the economic influence of the client at the office level.

Further, it is the first study to document whether the relation between abnormal accruals

and client importance has changed in the post-SOX environment and whether strong

corporate governance mitigates these effects. Overall, the results are consistent with the

predictions of the economic theory of auditor independence.

23
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28
 Table 1, Panel A
Descriptive Statistics for the Sample Period 2000-2001

Mean Std. Dev. Min 25% Median 75% Max

Accrual Measures
AA 0.020 0.131 -0.473 -0.027 0.025 0.083 0.369
P-AA 0.000 0.204 -0.668 -0.080 -0.002 0.079 0.731
Total Accruals -0.088 0.132 -0.617 -0.123 -0.065 -0.023 0.193

Auditor & Firm Characteristics

Influence 0.135 0.129 0.016 0.049 0.089 0.172 0.568
Tenure 6.672 3.759 1.000 4.000 6.000 11.000 12.000
CFO 0.053 0.165 -0.679 0.013 0.077 0.136 0.375
Asset Growth 0.146 0.478 -0.568 -0.065 0.038 0.191 2.440
Inside Director % 0.294 0.164 0.000 0.167 0.250 0.400 0.750
Institutional Ownership 0.634 0.181 0.000 0.516 0.649 0.764 0.982
AA is the amount of abnormal accruals (ε) estimated from the following two-digit SIC-year regression:

Total Accruals = α +β1 (∆Sales-∆REC) + β2 PPE + β3 BTM + β4 CFO + ε.

Total Accruals is the difference between operating cash flows and income before extraordinary items
reported on the statement of cash flows (Compustat 123-Compustat 308) deflated by average total assets
(Compustat 6). ∆Sales is the change in sales for the year (Compustat 12) deflated by average total assets.
∆REC is the change in Receivables reported on the statement of cash flows (Compustat 302) deflated by
average total assets. PPE is the gross property plant and equipment (Compustat 7) deflated by average total
assets. BTM is the book-to-market ratio defined as the book value of common equity outstanding
(Compustat 60) divided by the market capitalization at the end of the fiscal year (Compustat 25*Compustat
199). P-AA is the performance adjusted abnormal accruals, calculated by subtracting the abnormal accrual
of a matched firm within the same two digit SIC code with the closest ROA at time t-1 from AA. Influence
is the log of total fees paid to the auditor (Audit Analytics) divided by the summation of the log of total fees
paid to the auditor of all public clients listed on Compustat of the office issuing in the opinion. Tenure is
the number of consecutive years the auditor has audited the firm since 1990. CFO is the operating cash
flows of the client (Compustat 308) divided by average total assets. Asset Growth is the percentage change
in total assets. Inside Director % is the percentage of directors who are currently employed by the firm.
Institutional Ownership is the total percentage of shares held by institutional investors.

29
 Table 1, Panel B
Descriptive Statistics for the Sample Period 2002-2004

Mean Std. Dev. Min 25% Median 75% Max

Accrual Measures
AA 0.011 0.110 -0.473 -0.029 0.016 0.061 0.369
P-AA 0.001 0.180 -0.668 -0.069 -0.000 0.067 0.731
Total Accruals -0.074 0.104 -0.617 -0.105 -0.05 -0.024 0.193

Auditor & Firm Characteristics

Influence 0.089 0.092 0.016 0.032 0.056 0.108 0.568
Tenure 6.465 4.514 1.000 3.000 5.000 10.000 15.000
CFO 0.056 0.156 -0.679 0.021 0.079 0.136 0.375
Asset Growth 0.114 0.375 -0.568 -0.043 0.053 0.172 2.440
Inside Director % 0.316 0.166 0.000 0.182 0.286 0.429 0.889
Institutional Ownership 0.683 0.204 0.001 0.564 0.705 0.814 0.982
AA is the amount of abnormal accruals (ε) estimated from the following two-digit SIC-year regression:

Total Accruals = α +β1 (∆Sales-∆REC) + β2 PPE + β3 BTM + β4 CFO + ε.

Total Accruals is the difference between operating cash flows and income before extraordinary items
reported on the statement of cash flows (Compustat 123-Compustat 308) deflated by average total assets
(Compustat 6). ∆Sales is the change in sales for the year (Compustat 12) deflated by average total assets.
∆REC is the change in Receivables reported on the statement of cash flows (Compustat 302) deflated by
average total assets. PPE is the gross property plant and equipment (Compustat 7) deflated by average total
assets. BTM is the book-to-market ratio defined as the book value of common equity outstanding
(Compustat 60) divided by the market capitalization at the end of the fiscal year (Compustat 25*Compustat
199). P-AA is the performance adjusted abnormal accruals, calculated by subtracting the abnormal accrual
of a matched firm within the same two digit SIC code with the closest ROA at time t-1 from AA. Influence
is the log of total fees paid to the auditor (Audit Analytics) divided by the summation of the log of total fees
paid to the auditor of all public clients listed on Compustat of the office issuing in the opinion. Tenure is
the number of consecutive years the auditor has audited the firm since 1990. CFO is the operating cash
flows of the client (Compustat 308) divided by average total assets. Asset Growth is the percentage change
in total assets. Inside Director % is the percentage of directors who are currently employed by the firm.
Institutional Ownership is the total percentage of shares held by institutional investors.

30
 Table 1, Panel C
Correlation Table 2000-2001
Pearson (Spearman) Correlations Above (Below) the Diagonal

1 2 3 4 5 6 7 8 9
1 AA 1 0.66 0.82 0.03 0.05 -0.20 0.08 0.04 0.06
2 P-AA 0.60 1 0.54 0.04 0.03 -0.21 0.08 -0.01 0.05
3 Total Accruals 0.67 0.48 1 0.10 0.15 0.01 0.16 -0.01 0.00
4 Influence 0.00 0.03 0.11 1 0.05 0.08 -0.02 -0.10 -0.07
5 Tenure 0.01 0.01 0.10 0.06 1 0.18 -0.08 -0.09 0.04
6 CFO -0.32 -0.26 -0.25 0.08 0.16 1 0.00 0.05 0.15
7 Asset Growth 0.11 0.09 0.26 0.05 -0.02 0.20 1 0.03 0.08
8 Inside Director % 0.04 -0.04 -0.05 -0.12 -0.10 0.06 0.06 1 -0.18
9 Institutional Ownership 0.07 0.05 -0.02 -0.07 0.03 0.12 0.11 -0.15 1

AA is the amount of abnormal accruals (ε) estimated from the following two-digit SIC-year regression:

Total Accruals = α +β1 (∆Sales-∆REC) + β2 PPE + β3 BTM + β4 CFO + ε.

Total Accruals is the difference between operating cash flows and income before extraordinary items reported on the statement of cash flows (Compustat 123-
Compustat 308) deflated by average total assets (Compustat 6). ∆Sales is the change in sales for the year (Compustat 12) deflated by average total assets. ∆REC
is the change in Receivables reported on the statement of cash flows (Compustat 302) deflated by average total assets. PPE is the gross property plant and
equipment (Compustat 7) deflated by average total assets. BTM is the book-to-market ratio defined as the book value of common equity outstanding (Compustat
60) divided by the market capitalization at the end of the fiscal year (Compustat 25*Compustat 199). P-AA is the performance adjusted abnormal accruals,
calculated by subtracting the abnormal accrual of a matched firm within the same two digit SIC code with the closest ROA at time t-1 from AA. Influence is the
log of total fees paid to the auditor (Audit Analytics) divided by the summation of the log of total fees paid to the auditor of all public clients listed on Compustat
of the office issuing in the opinion. Tenure is the number of consecutive years the auditor has audited the firm since 1990. CFO is the operating cash flows of the
client (Compustat 308) divided by average total assets. Asset Growth is the percentage change in total assets. Inside Director % is the percentage of directors
who are currently employed by the firm. Institutional Ownership is the total percentage of shares held by institutional investors.

31
 Table 1, Panel D
Correlation Table 2002-2004
Pearson (Spearman) Correlations Above (Below) the Diagonal

1 2 3 4 5 6 7 8 9
1 AA 1 0.61 0.78 -0.03 0.01 -0.31 0.05 -0.05 0.05
2 P-AA 0.60 1 0.48 -0.03 -0.01 -0.23 0.00 0.00 -0.02
3 Total Accruals 0.66 0.46 1 0.01 0.09 -0.07 0.16 -0.03 0.09
4 Influence -0.06 -0.03 0.03 1 0.09 0.09 -0.03 -0.03 -0.08
5 Tenure 0.01 0.01 0.09 0.11 1 0.09 -0.01 -0.01 0.03
6 CFO -0.38 -0.25 -0.30 0.11 0.06 1 0.14 -0.01 0.12
7 Asset Growth 0.04 0.03 0.21 0.02 0.05 0.34 1 0.03 0.15
8 Inside Director % -0.04 0.01 -0.02 -0.07 0.00 0.00 0.05 1 -0.10
9 Institutional Ownership 0.03 0.00 0.04 -0.10 0.02 0.11 0.17 -0.09 1

AA is the amount of abnormal accruals (ε) estimated from the following two-digit SIC-year regression:

Total Accruals = α +β1 (∆Sales-∆REC) + β2 PPE + β3 BTM + β4 CFO + ε.

Total Accruals is the difference between operating cash flows and income before extraordinary items reported on the statement of cash flows (Compustat 123-
Compustat 308) deflated by average total assets (Compustat 6). ∆Sales is the change in sales for the year (Compustat 12) deflated by average total assets. ∆REC
is the change in Receivables reported on the statement of cash flows (Compustat 302) deflated by average total assets. PPE is the gross property plant and
equipment (Compustat 7) deflated by average total assets. BTM is the book-to-market ratio defined as the book value of common equity outstanding (Compustat
60) divided by the market capitalization at the end of the fiscal year (Compustat 25*Compustat 199). P-AA is the performance adjusted abnormal accruals,
calculated by subtracting the abnormal accrual of a matched firm within the same two digit SIC code with the closest ROA at time t-1 from AA. Influence is the
log of total fees paid to the auditor (Audit Analytics) divided by the summation of the log of total fees paid to the auditor of all public clients listed on Compustat
of the office issuing in the opinion. Tenure is the number of consecutive years the auditor has audited the firm since 1990. CFO is the operating cash flows of the
client (Compustat 308) divided by average total assets. Asset Growth is the percentage change in total assets. Inside Director % is the percentage of directors
who are currently employed by the firm. Institutional Ownership is the total percentage of shares held by institutional investors.

32
 Table 2, Panel A
Regression of Abnormal Accruals on Influence, Tenure, and Controls
Sample Period: 2000-2001

Dependent Variable AA P-AA

(i) (ii)
β0 Intercept -0.005 -0.027
(-0.81) (-2.89)***
β1 Influence 0.045 0.081
(3.00)*** (3.91)***
β2 Tenure 0.003 0.004
(5.85)*** (4.40)***
β3 CFO -0.175 -0.276
(-7.96)*** (-7.87)***
β4 Asset Growth 0.023 0.038
(3.65)*** (3.86)***
β5 AA t-1 0.149 0.012
(4.94)*** (0.40)
Sample Period 2000-2001 2000-2001
N 3,578 3,578
Adjusted R-Square 0.0765 0.0561

All t-statistics are Newey-West corrected. */**/*** represents significance at the 10/5/1% levels
respectively.

AA is the amount of abnormal accruals (ε) estimated from the following two-digit SIC-year regression:

Total Accruals = α +β1 (∆Sales-∆REC) + β2 PPE + β3 BTM + β4 CFO + ε.

Total Accruals is the difference between operating cash flows and income before extraordinary items
reported on the statement of cash flows (Compustat 123-Compustat 308) deflated by average total assets
(Compustat 6). ABS-AA is the absolute value of abnormal accruals (ε). P-AA is the performance adjusted
abnormal accruals, calculated by subtracting the abnormal accrual of a matched firm within the same two
digit SIC code with the closest ROA at time t-1 from AA. ABS-PAA is the absolute value of P-AA.
Influence is the log of total fees paid to the auditor (Audit Analytics) divided by the summation of the log
of total fees paid to the auditor of all public clients listed on Compustat of the office issuing in the opinion.
Tenure is the number of consecutive years the auditor has audited the firm since 1990. CFO is the operating
cash flows of the client (Compustat 308) divided by average total assets. Asset Growth is the percentage
change in total assets.

33
 Table 2, Panel B
Regression of Abnormal Accruals on Influence, Tenure, and Controls for
governance partitions
Sample Period: 2000-2001

Low Moderate High

Governance Governance Governance
(i) (ii) (iii)
β0 Intercept 0.048 0.006 0.139
(1.10) (0.12) (4.36)***
β1 Influence 0.058 0.001 -0.014
(1.73)* (0.04) (-0.81)
β2 Tenure 0.003 0.004 -0.002
(0.77) (1.31) (-0.96)
β3 CFO -0.540 -0.262 -0.529
(-6.34)*** (-2.63)*** (-12.24)***
β4 Asset Growth -0.068 -0.043 -0.078
(-2.36)** (-1.40) (-3.92)***
β5 AA t-1 -0.004 -0.008 -0.006
(-0.21) (-0.61) (-0.67)
Time Period 2000-2001 2000-2001 2000-2001
N 366 626 381
Adjusted R-Square 0.1871 0.0893 0.3769
All t-statistics are Newey-West corrected. */**/*** represents significance at the 10/5/1% levels
respectively.

AA is the amount of abnormal accruals (ε) estimated from the following two-digit SIC-year regression:

Total Accruals = α +β1 (∆Sales-∆REC) + β2 PPE + β3 BTM + β4 CFO + ε.

Total Accruals is the difference between operating cash flows and income before extraordinary items
reported on the statement of cash flows (Compustat 123-Compustat 308) deflated by average total assets
(Compustat 6). ABS-AA is the absolute value of abnormal accruals (ε). P-AA is the performance adjusted
abnormal accruals, calculated by subtracting the abnormal accrual of a matched firm within the same two
digit SIC code with the closest ROA at time t-1 from AA. ABS-PAA is the absolute value of P-AA.
Influence is the log of total fees paid to the auditor (Audit Analytics) divided by the summation of the log
of total fees paid to the auditor of all public clients listed on Compustat of the office issuing in the opinion.
Tenure is the number of consecutive years the auditor has audited the firm since 1990. CFO is the operating
cash flows of the client (Compustat 308) divided by average total assets. Asset Growth is the percentage
change in total assets. Firm-years are classified as high governance if they have both a higher percentage of
outside directors than the median firm and a higher percentage of institutional ownership than the median
firm. Firm-years are classified as moderate governance if they have either a higher percentage of outside
directors than the median firm or a higher percentage of institutional ownership than the median firm but
not both. Firm-years are classified as low governance if they have both a lower percentage of outside
directors than the median firm and a lower percentage of institutional ownership than the median.

34
 Table 2, Panel C
Regression of Performance Adjusted Abnormal Accruals
on Influence, Tenure, and Controls for governance partitions

Sample Period: 2000-2001

Low Moderate High

Governance Governance Governance
(i) (ii) (iii)
β0 Intercept 0.044 0.002 0.058
(1.69)* (0.07) (3.00)***
β1 Influence 0.089 0.063 0.023
(1.88)* (1.62) (0.68)
β2 Tenure -0.002 0.003 0.001
(-1.04) (2.05)** (0.44)
β3 CFO -0.550 -0.342 -0.507
(-4.65)*** (-2.76)*** (-7.90)***
β4 Asset Growth 0.036 0.002 -0.013
(0.96) (0.09) (-0.72)
β5 AA t-1 0.109 0.001 0.041
(1.39) (0.01) (0.61)
Time Period 2000-2001 2000-2001 2000-2001
N 366 626 381
Adjusted R-Square 0.1116 0.0594 0.1008
All t-statistics are Newey-West corrected. */**/*** represents significance at the 10/5/1% levels
respectively.

AA is the amount of abnormal accruals (ε) estimated from the following two-digit SIC-year regression:

Total Accruals = α +β1 (∆Sales-∆REC) + β2 PPE + β3 BTM + β4 CFO + ε.

Total Accruals is the difference between operating cash flows and income before extraordinary items
reported on the statement of cash flows (Compustat 123-Compustat 308) deflated by average total assets
(Compustat 6). ABS-AA is the absolute value of abnormal accruals (ε). P-AA is the performance adjusted
abnormal accruals, calculated by subtracting the abnormal accrual of a matched firm within the same two
digit SIC code with the closest ROA at time t-1 from AA. ABS-PAA is the absolute value of P-AA.
Influence is the log of total fees paid to the auditor (Audit Analytics) divided by the summation of the log
of total fees paid to the auditor of all public clients listed on Compustat of the office issuing in the opinion.
Tenure is the number of consecutive years the auditor has audited the firm since 1990. CFO is the operating
cash flows of the client (Compustat 308) divided by average total assets. Asset Growth is the percentage
change in total assets. Firm-years are classified as high governance if they have both a higher percentage of
outside directors than the median firm and a higher percentage of institutional ownership than the median
firm. Firm-years are classified as moderate governance if they have either a higher percentage of outside
directors than the median firm or a higher percentage of institutional ownership than the median firm but
not both. Firm-years are classified as low governance if they have both a lower percentage of outside
directors than the median firm and a lower percentage of institutional ownership than the median.

35
 Table 3
Regression of Abnormal Accruals on Influence, Tenure, and Controls
Sample Period: 2000-2004

Dependent Variable AA P-AA

(i) (ii)
β0 Intercept -0.005 -0.025
(-0.92) (-2.67)***
β1 Influence 0.048 0.080
(3.20)*** (3.77)***
β2 Tenure 0.004 0.004
(6.19)*** (4.41)***
β3 SOX 0.018 0.035
(2.80)*** (3.42)***
β4 SOX * Influence -0.051 -0.100
(-2.55)** (-3.51)**
β5 SOX * Tenure -0.003 -0.003
(-4.25)*** (-3.00)***
β6 CFO -0.207 -0.272
(-17.90)*** (-13.53)***
β7 Asset Growth 0.025 0.026
(5.79)*** (4.29)***
β8 AA t-1 0.131 0.027
(8.45)*** (1.67)*
Sample Period 2000-2004 2000-2004
N 11,061 11,061
Adjusted R-Square 0.1071 0.0551
Joint Test: β1 + β4 = 0 -0.003 -0.020
P-Value of Wald Chi-Square (0.844) (0.289)
Joint Test: β2 + β5 = 0 0.001 0.001
P-Value of Wald Chi-Square (0.001) (0.085)

All t-statistics are Newey-West corrected. */**/*** represents significance at the 10/5/1% levels
respectively. AA is the amount of abnormal accruals (ε) estimated from the following two-digit SIC-year
regression: Total Accruals = α +β1 (∆Sales-∆REC) + β2 PPE + β3 BTM + β4 CFO + ε. Influence is the log
of total fees paid to the auditor (Audit Analytics) divided by the summation of the log of total fees paid to
the auditor of all public clients listed on Compustat of the office issuing in the opinion. Tenure is the
number of consecutive years the auditor has audited the firm since 1990. CFO is the operating cash flows
of the client (Compustat 308) divided by average total assets. Asset Growth is the percentage change in
total assets.

36
 Table 4, Panel A
Regression of Abnormal Accruals on Influence, Tenure, and Controls
Sample Period: 2002-2004

Dependent Variable AA P-AA

(i) (ii)
β0 Intercept 0.012 0.012
(4.33)*** (2.38)**
β1 Influence 0.000 -0.022
(0.01) (-1.14)
β2 Tenure 0.001 0.001
(3.93)*** (1.74)*
β3 CFO -0.226 -0.267
(-17.32)*** (-10.92)***
β4 Asset Growth 0.028 0.017
(4.98)*** (2.23)**
β5 AA t-1 0.121 0.034
(7.10)*** (1.88)*
Sample Period 2002-2004 2002-2004
N 7,483 7,483
Adjusted R-Square 0.1277 0.0552

All t-statistics are Newey-West corrected. */**/*** represents significance at the 10/5/1% levels
respectively.

AA is the amount of abnormal accruals (ε) estimated from the following two-digit SIC-year regression:

Total Accruals = α +β1 (∆Sales-∆REC) + β2 PPE + β3 BTM + β4 CFO + ε.

Total Accruals is the difference between operating cash flows and income before extraordinary items
reported on the statement of cash flows (Compustat 123-Compustat 308) deflated by average total assets
(Compustat 6). ABS-AA is the absolute value of abnormal accruals (ε). P-AA is the performance adjusted
abnormal accruals, calculated by subtracting the abnormal accrual of a matched firm within the same two
digit SIC code with the closest ROA at time t-1 from AA. ABS-PAA is the absolute value of P-AA.
Influence is the log of total fees paid to the auditor (Audit Analytics) divided by the summation of the log
of total fees paid to the auditor of all public clients listed on Compustat of the office issuing in the opinion.
Tenure is the number of consecutive years the auditor has audited the firm since 1990. CFO is the operating
cash flows of the client (Compustat 308) divided by average total assets. Asset Growth is the percentage
change in total assets.

37
 Table 4, Panel B
Regression of Abnormal Accruals on Influence, Tenure, and Controls for
governance partitions

Sample Period: 2002-2004

Low Moderate High

Governance Governance Governance
(i) (ii) (iii)
β0 Intercept 0.010 0.023 0.049
(1.24) (3.96)*** (6.56)***
β1 Influence 0.051 -0.002 0.003
(2.56)** (-0.09) (0.10)
β2 Tenure 0.000 0.000 -0.000
(0.44) (1.13) (-0.81)
β3 CFO -0.259 -0.288 -0.333
(-4.81)*** (-8.60)*** (-7.56)***
β4 Asset Growth 0.073 0.047 0.021
(2.97)*** (2.41)** (1.53)
β5 AA t-1 0.259 0.119 0.132
(4.69)*** (2.40)*** (2.65)***
Time Period 2002-2004 2002-2004 2002-2004
N 827 1,396 831
Adjusted R-Square 0.1712 0.1165 0.1851
All t-statistics are Newey-West corrected. */**/*** represents significance at the 10/5/1% levels
respectively.

AA is the amount of abnormal accruals (ε) estimated from the following two-digit SIC-year regression:

Total Accruals = α +β1 (∆Sales-∆REC) + β2 PPE + β3 BTM + β4 CFO + ε.

Total Accruals is the difference between operating cash flows and income before extraordinary items
reported on the statement of cash flows (Compustat 123-Compustat 308) deflated by average total assets
(Compustat 6). ABS-AA is the absolute value of abnormal accruals (ε). P-AA is the performance adjusted
abnormal accruals, calculated by subtracting the abnormal accrual of a matched firm within the same two
digit SIC code with the closest ROA at time t-1 from AA. ABS-PAA is the absolute value of P-AA.
Influence is the log of total fees paid to the auditor (Audit Analytics) divided by the summation of the log
of total fees paid to the auditor of all public clients listed on Compustat of the office issuing in the opinion.
Tenure is the number of consecutive years the auditor has audited the firm since 1990. CFO is the operating
cash flows of the client (Compustat 308) divided by average total assets. Asset Growth is the percentage
change in total assets. Firm-years are classified as high governance if they have both a higher percentage of
outside directors than the median firm and a higher percentage of institutional ownership than the median
firm. Firm-years are classified as moderate governance if they have either a higher percentage of outside
directors than the median firm or a higher percentage of institutional ownership than the median firm but
not both. Firm-years are classified as low governance if they have both a lower percentage of outside
directors than the median firm and a lower percentage of institutional ownership than the median.

38
 Table 4, Panel C
Regression of Performance Adjusted Abnormal Accruals
on Influence, Tenure, and Controls for governance partitions

Sample Period: 2002-2004

Low Moderate High

Governance Governance Governance
(i) (ii) (iii)
β0 Intercept 0.006 0.029 0.048
(0.39) (2.69)*** (2.74)***
β1 Influence 0.085 -0.019 0.019
(2.39)** (-0.52) (0.35)
β2 Tenure 0.001 -0.000 -0.001
(0.53) (-0.45) (-1.14)
β3 CFO -0.359 -0.333 -0.391
(-3.92)*** (-5.91)*** (-4.28)***
β4 Asset Growth 0.083 0.046 -0.004
(2.34)** (2.03)** (-0.13)
β5 AA t-1 0.101 0.008 0.029
(1.56) (0.16) (0.41)
Time Period 2002-2004 2002-2004 2002-2004
N 827 1,396 831
Adjusted R-Square 0.0677 0.0418 0.0645
All t-statistics are Newey-West corrected. */**/*** represents significance at the 10/5/1% levels
respectively.

AA is the amount of abnormal accruals (ε) estimated from the following two-digit SIC-year regression:

Total Accruals = α +β1 (∆Sales-∆REC) + β2 PPE + β3 BTM + β4 CFO + ε.

Total Accruals is the difference between operating cash flows and income before extraordinary items
reported on the statement of cash flows (Compustat 123-Compustat 308) deflated by average total assets
(Compustat 6). ABS-AA is the absolute value of abnormal accruals (ε). P-AA is the performance adjusted
abnormal accruals, calculated by subtracting the abnormal accrual of a matched firm within the same two
digit SIC code with the closest ROA at time t-1 from AA. ABS-PAA is the absolute value of P-AA.
Influence is the log of total fees paid to the auditor (Audit Analytics) divided by the summation of the log
of total fees paid to the auditor of all public clients listed on Compustat of the office issuing in the opinion.
Tenure is the number of consecutive years the auditor has audited the firm since 1990. CFO is the operating
cash flows of the client (Compustat 308) divided by average total assets. Asset Growth is the percentage
change in total assets. Firm-years are classified as high governance if they have both a higher percentage of
outside directors than the median firm and a higher percentage of institutional ownership than the median
firm. Firm-years are classified as moderate governance if they have either a higher percentage of outside
directors than the median firm or a higher percentage of institutional ownership than the median firm but
not both. Firm-years are classified as low governance if they have both a lower percentage of outside
directors than the median firm and a lower percentage of institutional ownership than the median.

39