An analysis of the impact of non-audit services on financial reporting quality: A test of two competing theories of auditor independence

Auditor independence has been a long-standing issue for regulators resulting in numerous studies on the subject on how to enhance it and numerous rules that attempt to ensure it (e.g. Cohen Report 1978; ASR 250 1978; SEC Rule 2-01 2000). One of regulators' most recent attempts to shore up auditor independence is evident in the provisions of the Sarbanes-Oxley Act of 2002 (SOX). As a test of two competing theories of auditor independence, and to determine whether SOX mandates have successfully enhanced financial reporting quality, I examine post-SOX changes in non-audit fees (as a proxy for changes in quasi-rents) and the extent of changes in two measures of financial reporting quality. Results suggest that SOX mandates have been effective, and that the proposition of DeAngelo (1981b) that non-audit services may impair auditor independence may more-closely describe the relationship between changes in quasi-rents and changes in financial reporting quality than does the theory of Lee and Gu (1998). Further, supplemental analyses suggest that, as proposed by the theories, the amount of low-balling is positively related to the amount of quasi-rents.