An Empirical Analysis of Auditor Independence in The Banking Industry

An Empirical Analysis of Auditor Independence in the Banking Industry
Author(s): Kiridaran Kanagaretnam, Gopal V. Krishnan and Gerald J. Lobo

Source: The Accounting Review , NOVEMBER 2010, Vol. 85, No. 6 (NOVEMBER 2010), pp.
2011-2046
Published by: American Accounting Association
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THE ACCOUNTING REVIEW American Accounting Association
Vol. 85, No. 6 DOI: 10.2308/accr.2010.85.6.2011
2010
pp. 2011-2046
An Empirical Analysis of Auditor

Independence in the Banking Industry
Kiridaran Kanagaretnam
McMaster University
Gopal V. Krishnan
Lehigh University
Gerald J. Lobo
University of Houston
ABSTRACT: We examine auditor independence in the banking industry by analyzing
the relation between fees paid to auditors and the extent of earnings management
through loan loss provisions (LLP). We also examine whether this relation differs across
large banks whose managements are required under the Federal Deposit Insurance
Corporation Improvement Act to evaluate internal control over financial reporting and
whose auditors must attest to the effectiveness of such internal controls, and small
banks that are not subject to those requirements. We find that unexpected auditor fees
are unrelated to earnings management for large banks. For small banks, we find
greater earnings management via under-provisioning of LLP by banks that pay higher
unexpected total and nonaudit fees to the auditor. These results suggest that auditor
fee dependence on the audit client is associated with earnings management via abnor
mal LLP and is a potential threat to auditor independence for small banks. Our findings
are relevant to policymakers contemplating new regulations in light of the recent bank
ing crisis.
Keywords: auditor independence; earnings management; auditor fees; bank loan

loss provision; FDICIA.
Data Availability: All data presented in this paper are available from public sources.
We thank James Bierstaker, Jeff Chen, Chris Jones, Steven Kachelmeier (editor), Sok-Hyon Kang, Krishna Kumar, Ying
Li, Lihong Liang, Jim Largay III, Robert Mathieu, Erin Moore, Nandu Nayar, Dan Neeley, Mike Peters, H. Sami, Bin
Srinidhi, Mary Sullivan, Scott Whisenant, Bill Zhang, seminar participants at Brock University, The George Washington
University, Hong Kong Polytechnic University, Lehigh University, McMaster University, Nanyang Technological Univer
sity, University of Queensland, the 2007 American Accounting Association Annual Meeting, and the 2007 Annual Meeting
of the Canadian Academic Accounting Association, and two anonymous reviewers for their helpful suggestions. Professors
Kanagaretnam and Lobo thank the Social Sciences and Humanities Research Council of Canada (SSHRC) for its financial
support.
Editor's note: Accepted by Steven Kachelmeier, with thanks to John Core for serving as editor on a previous version.
Submitted: January 2007

Accepted: April 2010
Published Online: November 2010
2011

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2012 Kanagaretnam, Krishnan, and Lobo
I. INTRODUCTION
uditor independence is vital to maintaining public confidence in capital markets and to the
integrity of corporate financial statements. The objective of this study is to examine
-4. -âuditor independence in the banking industry. Banks represent a large percentage of the
total public equity market and are critical to the functioning of the economy as a whole. Never
theless, as noted by Fields et al. (2004), accounting researchers have done little to investigate the
various relationships that exist between banks and their auditors despite the economic importance
of the banking industry. Specifically, we provide empirical evidence on the relation between fees
paid to auditors of banks and the extent of earnings management via loan loss provisions (LLP).
Our study is timely and relevant given the recent banking crisis and that governments around the
world are contemplating new banking regulations. In particular, our research informs policymak
ers on the relationship that existed between fees paid to auditors and the extent of earnings
management in banks prior to the current banking crisis.
The banking industry offers a unique context to study auditor independence for a number of
reasons. First, banks are subject to the scrutiny of the Federal Deposit Insurance Corporation
(FDIC), the Federal Reserve Board, and other government agencies. Whether this intense regula
tory oversight enhances auditor independence is clearly an important and relevant question. Sec
ond, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) imposed new
auditing, corporate reporting, and governance reforms on depository institutions with assets ex
ceeding $500 million (increased to $1 billion in 2005) and on their auditors (Murphy 2004).
Section 36 of the Federal Deposit Insurance Act (FDI Act) and Part 363 of the FDIC's regulations
require the management of these institutions to evaluate internal control over financial reporting
and the auditor to attest to the effectiveness of internal controls over financial reporting.1 Given
these requirements, whether auditor independence is greater for larger banks that are subject to
greater regulatory oversight relative to smaller banks is an interesting and important question.
Third, bank LLP is well-suited to studying earnings management for the following reasons.
Bank managers have considerable discretion in estimating LLP. This discretion allows them flex
ibility in using LLP for income-increasing or income-decreasing earnings management, or for
smoothing earnings.3 LLP is also by far the largest and most important accrual for banks, thus
affording bank managers wide latitude in its use.4 Prior research indicates that banks use LLP to
manage earnings (Wahlen 1994; Kanagaretnam et al. 2003; Kanagaretnam et al. 2004). To the
extent that banks can leverage "fee dependence" to influence their auditors to accept abnormal
LLP, examining the relation between abnormal LLP and auditor fees is likely to reveal such a
linkage. We reason that abnormal LLP is a better proxy for earnings management than the abnor
1 There is some prior research on FDICIA. For example, Altamuro and Beatty (2010) examine several earnings quality
measures prior to and following FDICIA and find that the mandated internal control requirements increased the validity
of LLP, earnings persistence, and cash flow predictability, and reduced benchmark-beating and accounting conservatism
for affected versus unaffected banks.
2 In addition to bank asset size, we also take into consideration the banks that have to comply with Section 404 of the
Sarbanes-Oxley Act (SOX), which became effective in 2004, when classifying banks as large and small. We consider
small banks as banks that are exempted from both FDICIA and Section 404 of SOX. We use the terms small banks and
exempted banks interchangeably in our paper. Section II provides a more detailed description of the institutional details.
3 Prior research suggests several motives for bank managers' discretionary behavior with respect to LLP including,
signaling, capital management, management compensation, and income smoothing (Wahlen 1994; Collins et al. 1995;
Kanagaretnam et al. 2003; Kanagaretnam et al. 2004). Income-increasing abnormal LLP may be related to incentives
associated with meeting or just beating earnings benchmarks, management compensation, and income smoothing.
Income-decreasing abnormal LLP may be related to incentives associated with signaling, capital management, and
income smoothing.
4 The mean (median) ratio of LLP to earnings before LLP is 17 percent (14.6 percent) for our sample banks.
The Accounting Review November 2010

American Accounting Association

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An Empirical Analysis of Auditor Independence in the Banking Industry 2013
mal accrual measures used in prior research.5 In particular, our study mitigates error in measuring
managerial discretion by focusing on a single accrual and a single industry. Focusing on a single
accrual facilitates a sharper separation into its normal (nondiscretionary) and abnormal (discre
tionary) components. We use a number of industry-specific variables to better isolate the normal
LLP from the abnormal LLP. Also, focusing on a single, relatively homogeneous industry provides
control over other determinants of cross-sectional differences in accruals, thus increasing the
reliability of the inferences from our empirical analysis.
Our main prediction is that, relative to large banks, small banks that pay higher fees to
auditors are likely to engage in higher levels of income-increasing earnings management?i.e.,
higher fees are likely to facilitate income-increasing LLP (under-provisioning of LLP). Income
increasing LLP is of particular importance in the context of auditor independence because auditors
are unlikely to be sued for income-decreasing accruals (St. Pierre and Anderson 1984). Addition
ally, we expect the magnitude of income-decreasing LLP to decrease for small banks as banks pay
higher fees.
A possible alternative hypothesis to the impairment of auditor independence through fees is
that audit fees may also reflect audit risk that is captured by the abnormal LLP. Auditors are likely
to charge higher audit fees to firms that are more difficult to audit and, if firms that are more
difficult to audit have higher incentives to manage earnings, this will be manifested in a positive
relationship between audit fees and abnormal LLP. We attempt to address this concern by includ
ing several variables that reflect differences in audit risk across banks as well as examining the
relationship using abnormal fees after explicitly taking account of possible factors driving the
normal fees.
Our sample consists of 1,740 bank-year observations over the years 2000-2006. Following
prior research, we estimate abnormal LLP as residuals from a regression of LLP on beginning loan
loss allowance, total loans outstanding, changes in total loans outstanding, net loan charge-offs,
beginning balance of non-performing loans, change in non-performing loans, loan mix, and con
trols for years (Wahlen 1994; Kanagaretnam et al. 2004). Next, we estimate a regression of
abnormal LLP on fee measures, an indicator variable for small banks (with total assets of less than
$500 million or less than $1 billion effective 2005 or non-accelerated filers under Section 404 of
Sarbanes-Oxley Act [SOX] effective 2004) that are exempt from internal control regulation, the
interaction of the fee measure and the indicator variable for small banks, auditor type (Big 5
versus non-Big 5 auditor), and several control variables. We use various measures of fees to
capture the auditor's economic dependence on the client, including total fees, nonaudit fees, audit
fees, ratio of nonaudit fees to total fees (fee ratio), abnormal (unexpected) total fees, abnormal
nonaudit fees, abnormal audit fees, and abnormal fee ratio. However, our main focus is on unex
pected total fees and unexpected nonaudit fees because these fee measures are based on control
ling for bank-level determinants of normal fees and prior research suggests that they are better
measures for examining fee dependence (Kinney and Libby 2002; Srinidhi and Gul 2007).
We report several key findings. First, for large banks, we document that both unexpected total
fees and unexpected nonaudit fees have no association with either income-increasing or income
decreasing abnormal LLP. Second, in contrast to the results for large banks, we find a strong
negative association between income-increasing (negative) abnormal LLP and both unexpected
total fees and unexpected nonaudit fees for small banks. In other words, higher auditor fees are
associated with higher income-increasing earnings management for small banks. We also docu
5 Prior research argues that proxies of abnormal accruals commonly used to detect earnings management are subject to
serious measurement error (Guay et al. 1996; McNichols 2000, 2002; Jones et al. 2008). For example, McNichols
(2002) questions the construct validity of a proxy based on aggregate accruals because of the complexity associated with
modeling the estimation errors in aggregate accruals.


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ment a negative association between unexpected nonaudit fees and income-decreasing (positive)
abnormal LLP for small banks. These results are consistent with greater earnings management by
small banks that pay higher abnormal fees to the auditor. Our results are robust to a variety of
sensitivity tests, including separate subsample analyses for small and large banks, deletion of
influential observations, and use of alternative models for estimating abnormal LLP.
Our findings are consistent with economic bonding between the auditor and the bank being
associated with income-increasing earnings management through LLP for small banks. In particu
lar, our results suggest that auditor fee dependence on the audit client can potentially threaten
auditor independence, particularly among banks that are not subject to the same level of regulatory
scrutiny as large banks.6
The next section describes the institutional background on FDICIA and SOX, particularly
how these regulations affect small and large banks. Section III describes our research design,
including the empirical models used to estimate abnormal LLP, unexpected fees paid to auditors,
and tests of the relation between these variables. We also discuss how the differences in regulation
of small and large banks could impact auditor independence. Section IV details the sample selec
tion, Section V discusses the results, and Section VI provides the conclusions of the study.
II. INSTITUTIONAL BACKGROUND

In response to the breakdown of thrifts and banks during the late 1980s and early 1990s, the
U.S. Congress enacted FDICIA in 1991 to strengthen the financial condition of the banking and
thrift industries. FDICIA, which created deposit insurance and the FDIC, is the most important
banking legislation in the U.S. since the Banking (Glass-Steagall) Act of 1933 (Benston and
Kaufman 1997). Further, a decade later, Congress passed another landmark legislation, the
Sarbanes-Oxley Act of 2002 (SOX) which, although modeled after FDICIA, is much broader in
scope.7 While FDICIA contains much more than deposit insurance reform, of particular interest
are the requirements for annual audit and reporting of management's assessment of the effective
ness of internal control that are intended to aid early detection of problems in the financial
management of insured banks. In June 1993, the FDIC enacted Part 363 titled, "Annual Indepen
dent Audits and Reporting Requirements," which requires each insured depository institution with
$500 million or more in total assets at the beginning of the year to prepare (see Sections 363.2 and
363.3 of FDIC 1993):8'9
1. Audited annual financial statements;
2. A management report signed by the CEO and the CFO that contains:
(a) a statement of management's responsibilities for:
i. preparing financial statements,
ii. establishing and maintaining an adequate internal control structure over finan
cial reporting, and
iii. complying with the laws and regulations that are designated by the FDIC and
other federal banking agencies;
6 Interestingly, over 85 percent of these small banks are audited by non-Big 5 auditors, suggesting that fee dependence
may be greater for the non-Big 5 auditors relative to the Big 5 auditors.
7 See Altamuro and Beatty (2010) for a mapping of sections of FDICIA with SOX.
8 Section 112 of FDICIA added Section 36, "Early Identification of Needed Improvements in Financial Management," to
the FDI Act. Section 36 gives the FDIC discretion to select an asset-size threshold of $150 million or more to exempt
smaller depository institutions from the above reporting requirements. This exemption was intended to ease compliance
cost for small and community banks.
9 In addition, Section 363.5 requires each depository institution to establish an independent audit committee, the members
of which shall be outside directors who are independent of the management.


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(b) assessments by management of:

i. the effectiveness of the internal control structure over financial reporting, and
ii. the institution's compliance with the designated laws and regulations during
the year;
3. The independent public accountant's report on the audited financial statements; and
4. The independent public accountant's attestation report on the assertion of management
concerning the institution's internal control structure and procedures for financial report
ing.
Effective 2005, the threshold for requirements 2(b)i and 4 was increased from $500 million to
$1 billion in total assets (FDIC 2005b).10 Although depository institutions with $500 million or
more but less than $1 billion in total assets are currently exempt from internal control assessments
by management and external auditors per Section 36, Section 404 of SOX mandates that all public
companies or subsidiaries of public companies must file a report on the auditor's attestation of the
effectiveness of internal control over financial reporting. Currently, Section 404 exempts non
accelerated filers?i.e., firms with public float less than $75 million.
In summary, publicly held banks with less than $500 million in total assets during the years
2000 through 2004 are exempt from Section 36 of the FDI Act. Effective 2004, publicly held
banks that are non-accelerated filers are exempt from Section 404 of SOX. Currently, publicly held
banks with less than $1 billion in total assets and with a public float less than $75 million are
exempt from both Section 36 as well as Section 404. Privately held banks are exempt from Section
404; further, effective 2005, privately held banks with $500 million or more but less than $1
billion in total assets (or less than $500 million in total assets during the years 2000 through 2004)
are exempt from Section 36 pertaining to management's and auditor's assessments of the effec
tiveness of internal control over financial reporting. We do not focus on privately held banks, as
information on fees paid to the auditor is not disclosed for these banks.
In addition to FDICIA and SOX, banks are expected to comply with guidance issued by the
SEC and the Federal Financial Institutions Examination Council (FFIEC) on LLP.11 Both SAB No.
102 and the policy statement emphasize the methodology used to measure LLP and the documen
tation, rather than external financial reporting (Phillips and Lierley 2001/2002).12
III. RESEARCH DESIGN

In this section, we first discuss our conceptual model, depicted in Figure 1, on the relation
between economic bonding and earnings management. Second, we describe the empirical model
used to estimate abnormal LLP. Third, we describe the empirical model used to estimate unex
pected (abnormal) measures of fees paid to the auditor. Fourth, we discuss the empirical model
used to test possible linkages between abnormal LLP and unexpected fees paid to auditors.
The model in Figure 1 is based on the predictive validity model of Kinney and Libby (2002)
that was developed by Runkel and McGrath (1972) and Libby (1981). As in prior research, the
economic bond to the audit client and earnings management by the client (link 1) are the two
theoretical constructs we examine. We identify proxies to measure the economic bond and earn
10 Note that the FDIC increased the asset size threshold for internal control assessments by management and external
auditors but retained the financial statement audit and other reporting requirements for all institutions with $500 million
or more in total assets to preserve safety and soundness in financial management (FDIC 2005a).
11 In July 2001, the SEC issued SAB No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues, and
the FFIEC issued, Policy Statement on Allowance for Loan and Lease Losses Methodologies and Documentation for
Banks and Savings Institutions.
12 Although this guidance applies equally to all institutions, the policy statement suggests that small banks may produce
' fewer supporting documents in support of their loan loss methodologies than large banks (FDIC 2001).


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ings management because these two constructs are unobservable. We use multiple fee measures to
capture the economic bond (link 2). Kinney and Libby (2002) reason that the economic bond is
likely to strengthen as unexpected nonaudit and audit fees increase because the abnormal rents
earned by the auditor increase. We use unexpected total fees and unexpected nonaudit fees as
primary measures of the economic bond (link 2) and the abnormal component of a bank's LLP as
the measure of earnings management (link 3). We examine banking firms because they provide a
setting with a stronger link 3 than that characterizing prior research. By using an industry-specific
measure of earnings management, we can also improve upon prior research in terms of a sharper
separation between abnormal and normal accruals. We control for several bank characteristics that
can also affect LLP (link 4). We then examine the relation between the various fee measures and
abnormal LLP (link 5) to draw inferences about link 1.
We expect banks that are exempt from assessments of the effectiveness of internal control
over financial reporting by managers and auditors to pose a greater risk to auditor independence
than banks that are not exempt. When bank managers and the auditor know that the bank will not
be subject to regulatory scrutiny, such a setting likely encourages earnings management by man
agers and could increase auditors' tolerance for earnings management relative to banks that are
expected to comply with the requirements of FDICIA and Section 404 of SOX.13
Estimation of Abnormal Loan Loss Provisions

In this section we describe our two-stage approach to examine link 5 (see Figure 1). We
estimate the normal or nondiscretionary component of LLP by regressing LLP on beginning loan
13 Prior research suggests that increased legal liability increases the auditor's effort and audit accuracy (Boritz and Zhang
1997; De and Sen 2002). Similarly, Kim et al. (2008) argue that legal environment plays an important role in deter
mining auditor effort.


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loss allowance, beginning non-performing loans, change in non-performing loans, net loan charge
offs, change in total loans outstanding, total loans outstanding, loan mix, and controls for period
effects using the following model (all variables are scaled by beginning total assets):14'15
LLP = a0 + axBEGLIA + a2BEGNPL + a3CHNPL + aALCO + a5CHLOANS + a^LOANS

+ LOANCATEGORIES + YEARCONTROLS +e ( 1 )
where:
LLP provision for loan losses;

BEGLLA = beginning loan loss allowance;
BEGNPL -- : beginning non-performing loans;
CHNPL = change in non-performing loans;
LCO net loan charge-off s ;
CHLOANS= : change in total loans outstanding;
LOANS = total loans outstanding; and
LOANCATEGORIES - amount of commercial loans (COMM), consumer loans (CON), real
estate loans (RESTATE), agriculture loans (AGRI), loans to foreign
banks and governments (FBG), and loans to other depository institutions
(DEPINS).
The residuals from model (1) are the abnormal component of LLP, referred to as ALLP. We
expect a negative coefficient on BEGLLA (i.e., accumulated LLP less write-offs at the beginning
of the year), as a higher initial loan loss allowance will require a lower LLP in the current period.
Consistent with prior research, we expect a2, a3, a4, and a6 to be positive. Higher levels of
non-performing loans indicate that problems with the loan portfolio will require higher loss pro
visions. Therefore, we expect the beginning balance of non-performing loans (BEGNPL) to be
positively related to LLP. We expect change in non-performing loans (CHNPL) to be positively
related to LLP because an increase in non-performing loans will require a higher loan loss provi
sion in the current period. We expect net loan charge-offs (LCO) to be positively related to LLP.
As explained by Beaver and Engel (1996), because current loan charge-offs can provide informa
tion about future loan charge-offs, they can influence expectations of the collectability of current
loans and hence current LLP. We expect the level of loans (LOANS) to be positively related to LLP
because a higher level of loans will also require higher provisions. We do not offer a prediction for
a5 because the effect of change in total loans (CHLOANS) on LLP depends on the quality of
incremental loans.16
Although non-performing loans and loan charge-offs serve as measures of risk, we include six
additional variables to control for differences in loan composition that also likely contribute to
differences in risk. For example, banks with a higher proportion of commercial and real estate
loans are likely to have higher loan loss provisions than banks with a higher proportion of
consumer loans. Failure to account for these differences makes the residuals from the loan loss
provision model a function of the bank type. This, in turn, could affect the inferences of our
auditor independence tests because both audit fees and ALLP may systematically vary across
banks based on their loan portfolio mix.
14 These variables have also been used in several prior studies (e.g., Wahlen 1994; Kanagaretnam et al. 2004) to estimate
the normal component of LLP.
15 We also use beginning total loans as an alternate deflator. Our results are not sensitive to this choice of deflator.
16 For convenience, we summarize the variable definitions in Table 1.


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TABLE 1
Definitions of Variables
LAFEE = natural log of audit fees;

ETOFFEE = natural log of total fees;
LNAFEE = natural log of nonaudit fees;
FEERATIO = nonaudit fees divided by total fees;
UTOTFEE = unexpected total fees from model (2);
UN AFEE = unexpected nonaudit fees from model (2);
UAFEE = unexpected audit fees from model (2);
UFEERATIO = unexpected fee ratio from model (2);
LLP = provision for loan losses divided by beginning total assets;
ALLP = abnormal LLP (residual from model (1));
LOANS = total loans outstanding divided by beginning total assets;
BEGLLA = beginning loan loss allowance divided by beginning total assets;
CHLOANS = change in total loans outstanding divided by beginning total assets;
BEGNPL = beginning non-performing loans divided by beginning total assets;
CHNPL = change in non-performing loans divided by beginning total assets;
LCO = net loan charge-offs divided by beginning total assets;
COMM = commercial loans divided by beginning total assets;
CON = consumer loans divided by beginning total assets;
RESTATE = real estate loans divided by beginning total assets;
AGRI = agriculture loans divided by beginning total assets;
FBG = loans to foreign banks and governments divided by beginning total assets;
DEPINS = loans to other depository institutions divided by beginning total assets;
BIG5 = indicator variable that equals 1 if audited by a Big 5 firm, and 0 otherwise;
MB = market-to-book ratio at the end of the year;
LMVE = natural log of market value of common equity at the end of the year;
LOSS ? indicator variable that equals 1 if net income <0, and 0 otherwise;
PASTLLP = prior year's LLP divided by beginning total assets;
EBP = net income before extraordinary items and LLP divided by beginning total assets;
TIER1 = tier 1 risk-adjusted capital ratio at the beginning of the year;
TCAP = total risk-adjusted capital ratio at the beginning of the year;
LASSETS = natural log of total assets;
SECURITIES = [1 - (total securities/total assets)];
SNPL = non-performing loans divided by lagged total loans;
INTANG = intangible assets divided by total assets;
EFFICIENCY = total operating expenses divided by total revenues (measured as net interest income plus
non-interest income);
SLCO = net loan charge-offs divided by loan loss allowance;
S COMM = total commercial and agricultural loans divided by total loans;
SCON = total consumer loans divided by total loans;
SRESTATE = total real estate loans divided by total loans;
EXEMPT = banks exempted from internal control regulations. An indicator variable that equals 1 if
a bank has less than $500 million in total assets during the years 2000 through 2003 or
less than $500 million in total assets and public float less than $75 million for the year
2004 or less than $1 billion in total assets and public float less than $75 million for the
years 2005 and 2006, and 0 otherwise;
SMALL = indicator variable that equals 1 if a bank has less than $500 million in total assets during
the years 2000 through 2003; and
NF = indicator variable that equals 1 if a bank has less than $500 million in total assets and
public float less than $75 million for the year 2004 or less than $1 billion in total assets
and public float less than $75 million for the years 2005 and 2006, and 0 otherwise.


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The six loan portfolio composition variables included in the model are commercial loans
{COMM), consumer loans (CON), real estate loans (RESTATE), agriculture loans (AGRI), loans to
foreign banks and governments (FBG), and loans to other depository institutions (DEPINS). We
also include six year-indicator variables representing years 2000 through 2005 in model (1) to
control for period-specific effects.
Next, we describe the model for computing unexpected (abnormal) fees. Auditor fees are also
influenced by various economic determinants including size and complexity of audit task. There
fore, controlling for the economic determinants of auditor fees and using unexpected (abnormal)
auditor fees is likely a better measure of auditor fee dependence than using actual fees.
Estimation of Unexpected Fees

Kinney and Libby (2002) argue that unexpected fees are a better measure of the auditor-client
economic bond because they reflect the "excess" profit derived from an audit client. We estimate
unexpected fees as the difference between actual and expected (normal) fees, where expected fees
are the predicted values from a regression of auditor fees on a set of firm characteristics.
Prior research models auditor fees as a function of a firm's auditor choice, audit complexity,
and audit risk, in addition to other variables (Firth 1997; Ashbaugh et al. 2003). Fields et al.
(2004) examine the determinants of audit fees in the banking industry. We use the variables
identified in the Fields et al. (2004) study to estimate unexpected fees. Audit fees and other fees
are likely to be higher when the auditor is a Big 5 auditor. Auditor size also proxies for client size.
We measure firm size as the natural log of total assets. The normal audit fee is directly related to
a bank's credit risk, operating risk, liquidity risk, and capital risk. We include SNPL, SLCO,
SCOMM, SCON, and SRESTATE as proxies for a bank's credit risk and the efficiency ratio
(EFFICIENCY) as a proxy for operating risk. We measure the efficiency ratio as the ratio of total
operating expenses to total revenues. As in Fields et al. (2004), we use SECURITIES as a proxy for
liquidity risk, and intangible assets (INTANG) and total capital ratio (TCAP) to account for capital
risk. In addition, we include a control for exempted banks (EXEMPT), which are expected to pay
lower fees to auditors. We estimate the following model:17
FEE =S0+ 8XBIG5 + ?\LASSETS + ^SECURITIES + S4SNPL + S5LOSS + S6INTANG

+ ÊFFICIENCY + ?sSLCO + ?\SCOMM+ S?OSCON+ 8nSCESTATE+ 8nTCAP
+ ?i3EXEMPT + YEARCONTROLS + e (2)
where:
FEE fees paid to the auditor (LTOTFEE = In (audit fees + nonaudit fees); or
LNAFEE = In (nonaudit fees); or LAFEE = In (audit fees)); or FEERATIO
nonaudit fees/total fees);
BIG5 indicator variable that equals 1 if audited by a Big 5 firm, and 0 otherwise;
LASSETS natural log of total assets;
SECURITIES - [l-(total securities/total assets)];
SNPL non-performing loans divided by lagged total loans;
LOSS indicator variable that equals 1 if net income < 0, and 0 otherwise;
INTANG intangible assets divided by total assets;
17 As in Fields et al. (2004), this model includes three loan categories. We also estimate unexpected fees after including all
the six loan categories used in model (1). The relations between ALLP and UFEE are qualitatively the same when we
use all six loan categories to estimate abnormal fees.


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EFFICIENCY = total operating expenses divided by total revenues (measured as net interest
income plus non-interest income);
SLCO = net loan charge-offs divided by loan loss allowance;
SCOMM = total commercial and agricultural loans divided by total loans;
SCON = total consumer loans divided by total loans;
SRESTATE = total real estate loans divided by total loans;
TCAP = total risk-adjusted capital ratio; and
EXEMPT = indicator variable that equals 1 if a bank has less than $500 million in total
assets during the years 2000 through 2003 or less than $500 million in total
assets and public float less than $75 million for the year 2004 or less than $1
billion in total assets and public float less than $75 million for the years
2005 and 2006, and 0 otherwise.
We use the residuals from model (2) as the unexpected (abnormal) fees for our four fee
measures.
Main Tests
Our objective is to test whether the association between abnormal LLP (ALLP) and fees p
to the auditor is stronger for banks that are exempt from the annual auditing and reporti
internal control assessments under FDICIA and Section 404 of SOX. We create EXEM
indicator variable that equals 1 for banks that are exempt from FDICIA and Section 404 of
and 0 otherwise, and interact EXEMPT with fees paid to the auditor. This specification allo
to test whether the effect of fee dependence on earnings management is more pronounced
small banks that are subject to less scrutiny than large banks.
We estimate the model separately for negative (income-increasing) ALLP and pos
(income-decreasing) ALLP.iS Negative ALLP are of particular interest because of their
impact on reported earnings. We control for the following factors that prior research has
mented are associated with abnormal accruals (Ashbaugh et al. 2003): firm size, auditor
market-to-book ratio, level of accruals, and performance. We use log of market value of eq
measure size, and represent performance by two variables, existence of loss and earnings b
LLP, and growth by market-to-book ratio. We control for the reversal of accruals over tim
including past LLP, and for capital management incentives by including beginning of year
capital ratio and total capital ratio.19 We estimate the following model:
ALLP = 0 + yxEXEMPT+ y2UFEE + y3EXEMPT X UFEE + y4BIG5 + y5MB + y6LMV
+ y7LOSS+ ysPASTLLP+ y9EBP+ yXQTIERlt_x + ynTCAPt_x + YEARCONTRO

+ e (3)
where:
ALLP = abnormal loan loss provision (the residual from model (1));
We report the results of estimating model (3) using both positive and negative ALLP in Table 6.
Banks had incentives to influence regulatory capital through LLP prior to the change in bank capital adequacy require
ments in 1990. This change altered banks' incentives to manage capital through LLP as loan loss allowance is no longer
considered part of tier I or core capital. Therefore, we do not expect 10 to be significantly different from 0. Furthermore,
loan loss allowance is included in tier II or supplementary capital only up to 1.25 percent of risk-adjusted assets.
Therefore, we predict a negative coefficient on y10 as higher capital ratios would require lower LLP, ceteris paribus.


202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
EXEMPT= indicator variable that equals 1 if a bank has less than $500 million in total assets
during the years 2000 through 2003 or less than $500 million in total assets and
public float less than $75 million for the year 2004 or less than $1 billion in total assets
and public float less than $75 million for the years 2005 and 2006, and 0 otherwise;
UFEE = unexpected total fees or nonaudit fees or audit fees or fee ratio from model (2);
BIG5 = indicator variable that equals 1 if the bank is audited by a Big 5 firm, and 0
otherwise;
MB = market-to-book ratio at the end of the year;
LMVE = natural log of market value of common equity at the end of the year;
LOSS = indicator variable that equals 1 if net income < 0, and 0 otherwise;
PASTLLP= prior year's LLP divided by total assets at the beginning of the year;
EBP = net income before extraordinary items and loan loss provisions divided by total
assets at the beginning of the year;
TIERI = tier 1 risk-adjusted capital ratio at the beginning of the year; and
TCAP = total risk-adjusted capital ratio at the beginning of the year.
The coefficients of interest in model (3) are y2 and y3. For negative (income-increasing)
ALLP, a negative y2 is consistent with auditor fee dependence on the client, and indicates that
higher fees are associated with greater (more negative) income-increasing ALLP for large banks
that are not exempt from regulation. A negative y3 indicates greater fee dependence on clients that
are exempt from regulation relative to large banks that are not. For positive (income-decreasing)
ALLP, a negative y2 implies that higher auditor fees are associated with less conservative earnings
management (i.e., income-decreasing ALLP are less positive) for large banks that are not exempt
from regulation. Similarly, a negative y3 indicates greater fee dependence on clients that are
exempt from regulation relative to large banks that are not.
Kinney and Libby (2002) indicate that both audit fees and nonaudit fees are capable of
increasing the economic bond. They reason that the auditor might be willing to decrease audit fees
or nonaudit fees to maximize potential total fees. Therefore, it is the total fees derived from a
single client, rather than just audit fees, that best reflect the economic bond. Prior research also
employs nonaudit fees to measure auditor independence because lower regulation and the wide
variety of nonaudit services (from information technology to tax preparation) allow for inclusion
of rents in nonaudit fees (Srinidhi and Gul 2007). Kinney and Libby (2002, 109) state, "more
insidious effects on economic bond may result from unexpected nonaudit and audit fees that may
more accurately be likened to attempted bribes" (emphasis in the original). This suggests that
unexpected fees are a better measure of the auditor-client economic bond because they reflect the
"excess" profit derived from the audit client. Another benefit of using unexpected fees is that we
explicitly control for several risk-related variables that we include in the estimation of expected
fees. Therefore, we use unexpected total fees and unexpected nonaudit fees as our primary mea
sures of the economic bond. However, for consistency with prior research (e.g., Ashbaugh et al.
2003; Srinidhi and Gul 2007) we also conduct our analysis with unexpected audit fees and
unexpected fee ratio (nonaudit fees/total fees) as alternate measures of the economic bond. Al
though we use unexpected fees as our primary measure of economic bonding, we also estimate a
variation of model (3) where we replace UFEE with actual fees paid to the auditor. We discuss
sample selection in the next section.
IV. SAMPLE SELECTION

We select sample banks from banks listed in the 2007 Bank Compustat annual data files and
obtain auditor fees for the years 2000-2006 from Audit Analytics. The intersection of the Audit
Analytics with Bank Compustat data results in an initial sample of 2,044 bank-year observations.


202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
We hand-collect non-performing loans data for the period 1999-2006 from annual reports and
obtain data on loan portfolio composition from the Federal Reserve Bank Holding Company
Database (call reports). Our final sample with available data
20 for all variables and without outliers
comprises 1,740 bank-year observations for 301 banks. We have 1,618 observations with avail
able data for the models that use abnormal fee measures. The sample does not include any
privately held banks.
Table 2, Panel A reports descriptive statistics for the scaled variables used in the regressions.
On average, nonaudit fees as a proportion of total fees (FEERATIO) is about 0.32. The mean
values of UTOTFEE, UNAFEE, and ALLP are zero by construction. Note that UTOTFEE and
UN AFEE are estimated from 1,618 observations. More than 52 percent of the sample observations
are audited by Big 5 auditors. Turning to the bank loan variables, the ratios of average LLP, loan
charge-offs, and beginning non-performing loans to beginning total assets are 0.003, 0.002, and
0.004, respectively.21 About 19.2 percent of total observations are exempt from Section 36 of the
FDI Act and Section 404 of SOX.22
Table 2, Panel reports correlations for the scaled dependent and independent variables. As
expected, LLP is positively correlated with non-performing loans (BEGNPL), change in non
performing loans (CHNPL), and loan charge-offs (LCO). LLP is also positively correlated with
total loans (LOANS) and change in loans outstanding (CHLOANS). LLP is significantly (p < 0.05)
positively related to log of total fees and log of nonaudit fees, and ALLP is weakly negatively
correlated with nonaudit fees.
V. RESULTS
Estimation of Abnormal LLP
We report the estimation results of model (1) in Table 3, Panel A. The t-statistics reported in
Table 3 and in the other tables are based on standard errors adjusted for firm-level clustering. The
results in Table 3 show that the coefficients on the determinants of LLP have the expected signs
except for the coefficient on BEGNPL, which is not significant. The coefficients on BEGLLA,
CHNPL, LCO, and LOANS are significant at the 0.01 level. Of the variables that reflect loan type,
only the coefficients on commercial and consumer loans are statistically significant. The explana
tory power of the model is high (adjusted R2 = 66.32 percent), indicating that the model describes
the variation in LLP quite well.23
Estimation of Abnormal Fees

Table 3, Panel reports the results from estimating model (2). While we report results of
model (2) for four fee measures?total fees, nonaudit fees, audit fees, and fee ratio?our primary
focus is on total fees and nonaudit fees. As expected, we find a positive relation between the fee
20 We delete observations in the top 1 percent of scaled loan loss provisions, loan charge-offs, beginning non-performing
loans, total loans, and market-to-book ratios. The values of all variables in the reduced sample are generally within three
standard deviations from the mean.
21 These ratios are lower than the values reported in Wahlen (1994) and Kanagaretnam et al. (2004) due to increase in
overall quality of loans (Edwards and Mishkin 1995). Similarly, our sample data indicate that mean LLP equals 17
percent of earnings before provisions, considerably lower than the 148 percent for Wahlen's (1994) sample and lower
than the 31 percent for Kanagaretnam et al.'s (2004) sample.
22 We closely follow the approach of Gao et al. (2009) for identifying accelerated/non-accelerated filers under Section 404
of SOX. Our sample includes 14 bank-year observations that have assets less than $500 million in 2004 but were
accelerated filers. For 2005 and 2006, it includes 34 bank-year observations that had assets between $500 million and $1
billion that were non-accelerated filers.
23 Even without the year controls, the adjusted R2 is 56.55 percent, indicating that our model fit compares favorably with
the results of prior research. For example, McNichols (2002) reports that when change in working capital accruals is
regressed on changes in sales and property, plant, and equipment, the adjusted R2 for the pooled sample is 7.3 percent.
Ashbaugh et al. (2003) report mean R2 values of 11 percent and 18 percent for their models of abnormal accruals.


202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
Maximum 15.9673
16.4232 0.8413
15.7665 1.1758 0.0104
2.1350 0.0039 0.0179
1.2220 0.4166 0.0101
0.0080 9.9947
24.8273 0.0103
0.0279
20.1200
21.8600
0.129 0.001
LNAFEE
0.0144
1 1 1
(continued on next page)
LTOTFEE 0.059 0.013

75% 13.2761 0.3136
0.4414
12.8605
12.0438 0.6302
0.0033 0.8453
0.0001 0.0049
0.1338 0.0023 3.4230
20.5792 0.0030
0.0173 14.5450
12.9800
0.0122 0.0012 01 0
LCO
0.7380.001
12.5183
11.0895 0.2688
12.0857 -0.0027 0.0088 0.0028
0.0728 0.0013
0.0000 2.3690
19.5704 0.0144 12.8000
11.2150
Median
0.05330.0021 0.7285 01
0.0020
0
-0.0001
CHNPL 0.001
0.174
0.1605 0.0011 0.6382 0.0336

0.0074 0.0012 0.0005 1.8040 0.0012 9.9500
0.0118
25% 11.8373
10.3008
11.4081 -0.4973 -0.0006 18.7214 11.630
00 0
-0.3025 -0.0001 0.2300.001
TABLE 2
Descriptive Statistics and Correlations
Minimum 7.8478
10.5348 9.9034 -1.3148 -0.0009
-3.4709 -0.0029 0.0031 0.0000 0.9404
17.4361 -0.0005 9.780
7.1700
0.0105 0.3324 00 0 0.001

-0.0766 -0.0062-0.0003 -0.0565 0.125
1740)
ALLP LOANS BEGLLA CHLOANS BEGNPL
0.001
1.5040
1.1829 0.2037
1.1668 0.5142
1.0379 0.0012
0.0021 0.0030
0.1764 0.1101 0.0029
0.0032 0.3941
0.0017 0.4995 1.5186
1.7626 0.0024
0.0861 0.0053 3.3545
3.4947
0.172
Panel : Correlations between Dependent and Independent Variables (n = 1740)
0.2340.001
Variable Mean Std. Dev. 11.2298

12.6647 0.3151
12.2233 0.0000
0.0000
0.0025 0.7452
0.0000 0.0984
0.0090 0.0005
0.0035 0.0017 0.5247
0.1920 2.9110 0.0024
0.0075
19.7910 0.0146
11.9085
13.5740
Panel A: Main Variables Used in Regressions ( =
0.577 0.001
LTOTFEE UTOTFEE
FEERATIO CHLOANS
PASTLLP
LAFEE
LNAFEE UNAFEE BEGLLA
LOANS CHNPL
BEGNPL EXEMPT
LLPALLP LCO BIG5 LMVELOSS EBPTIER1TCAP LLP
MB
3 r?>
3. > 5ce O
crq ?
s-s

202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
0.018 0.001
0.230 0.8070.0011.000
0.098 0.0010.0680.005 0.008 0.442 0.335 EBP TCAP

0.298 -0.167 0.141 -0.021 0.193 -0.282 0.115 -0.125 0.158 -0.040
-0.040 -0.115 -0.064 -0.023

0.001 0.001 0.001 0.001 0.001 0.094 0.757 0.004
-0.007 -0.070
0.001 0.386
0.001 0.001
0.167 0.001 0.167 0.001 0.057 0.0011.000
0.033 0.0140.560 0.206
-0.173 -0.046
-0.033 -0.081
LOSS PASTLLP
BEGNPL CHNPL LCO LTOTFEE LNAFEE

0.327 0.0010.074
0.0001.000 0.104 0.001 0.0010.379 0.0021.000
-0.039 -0.159 0.013 0.121
0.935 0.001 0.577 0.001 0.169 0.301 0.001 0.001
0.119 0.471
-0.038 -0.092
0.051 0.001
0.047 0.297
-0.002 0.461 -0.033 0.025 0.112 0.001
0.0001.000 1.000
0.1090.001 0.0100.0950.001 0.001
-0.062 -0.203
MB LMVE
0.067 -0.035 0.167 -0.161 0.204 -0.051
0.0001.0000.0160.497 0.0011.000 0.001 0.030 0.001 0.001 0.001 0.033
0.3120.001
-0.125
0.132 0.052 0.324 0.854 0.029 0.047
-0.052 -0.048
1740)
0.005 0.141 0.024 0.004
0.070 0.277 0.001 0.0010.008

0.697 0.725
BIG5
0.044
-0.009
0.549
-0.026 -0.211 -0.121
0.728
0.100 0.0580.1000.001 0.4020.1500.001
-0.039 -0.020
EXEMPT
-0.054 -0.008
1.000 1.000 1.000 BEGLLA 1.000 -0.014
ALLP 0.000 0.000 0.000

0.001 0.001
ALLP LOANS BEGLLA CHLOANS
0.001 0.911 0.0790.001 0.0180.465

0.187
Panel : Correlations between Dependent and Independent Variables ( -0.003 -0.004
LOANS 1.000 0.256 0.759

FEERATIO
0.0340.154 0.852
0.001 0.697 0.001 0.729

0.874 0.112
LAFEE
LLP -0.004
ALLP -0.038 LOANS -0.187
CHLOANS -0.081
CHLOANS 1.000 BEGLLA 0.009 BEGNPL 0.008
LTOTFEE
BEGNPL CHNPL LNAFEE
LCO

202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
TCAP
0.002
0.009 0.001
1.000 0.074
055 0.066 -0.026

0.022 0.006 0.285 0.001 0.001 0.001 0.107 0.119 -0.188
0.001 0.0010.038
0.0010.061 0.117
-0.1750.011 0.001 0.000-0.170 0.205 0.005 0.001 0.001
0.001 0.001 -0.067 0.061 0.001 0.001 0.009 0.001 0.033
0.0010.288 -0.207
0.172 0.001 0.001 0.001 0.001 1.000
0.929 0.062 -0.119
0.573 0.193 -0.122 0.068 0.094 -0.0.020504 0.001 0.001 0.101 0.104 -0.086 0.045 0.082 -0.149 0.062 0.184 -0.205
0.113 -0.415 0.002
LMVE LOSS PASTLLP EBP
1.000
1.000 -0.060
0.012
0.001 0.036
0.014
0.0220.829 0.020
0.152 0.218
-0.084
0.025
0.000 0.168
0.777 0.006 0.115
0.019
0.001
0.5020.441
0.001
0.686 0.020 0.078 0.354 0.001 0.289 0.554 0.0010.097
0.4160.690 0.001
0.005 0.001 0.839 0.001 0.001 0.790 0.0290.0011.000
0.167 0.5320.001 0.2250.268 0.050
0.016 -0.487 0.038
-0.010 -0.056 -0.042
MB
0.531 0.001 0.001 1.000

0.1220.1310.001 0.0010.418 0.4980.0010.098 0.001
-0.367
BIG5
-0.037
0.031 0.001 0.001 1.000

0.576
0.192 0.001 0.001
-0.442 -0.312 -0.437
EXEMPT
-0.108 -0.013
0.074 0.001 0.001

0.635
FEERATIO
0.043 0.154 0.166 0.001 0.0011.000
-0.158
0.011 0.001 0.0010.613 1.000 Numbers below the correlation coefficient are p-valu
LAFEE
0.157 0.944 0.001
Please see Table 1 for variable definitions.
= 1618 for UTOTFEE and UNAFEE.
-0.061
LTOTFEE FEERATIO PASTLLP

CHNPL LNAFEE LAFEE EXEMPT
LCO BIG5 LMVE LOSS
MB EBP
I >3 O Ci
>O > ?
C/O 3
CTQ ? 3o

202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
TABLE 3
Regressions for Computing ALLP and Abnormal Fees
Panel A: Results of Regression of LLP on Determinants of Normal LLP3
Expected
Variable Sign Coefficient t-statistic
Intercept -0.0012*** -5.87

BEGLLA -0.1148*** -4.66
BEGNPL + -0.0072 -0.43
CHNPL + 0.0406*** 2.69
LCO + 0.9559*** 25.88
CHLOANS ? 0.0006 0.69
LOANS + 0.0034*** 7.66
COMM ? 0.0004*** 2.89
CON ? -0.0014*** -2.76
RESTATE ? 0.0000 0.10
AGRI ? 0.0007 0.34
FBG ? -0.0209 -1.39
DEPINS ? 0.0072 0.73
Year Controls Yes
1740
Adjusted R 66.32%
Panel B: Results of Regressions of Fee Measures on Determinants of Fees

Variable Total Fee Nonaudit Fee Audit Fee Fee Ratio
(1) (2) (3) (4) (5)
Intercept 5.4366*** 2.7859*** 5.7552*** -0.0626
(12.58) (3.34) (12.47) (-0.44)
BIG5 0.2908*** 0.2693*** 0.2508*** 0.0193
(5.63) (2.77) (4.87) (1.13)
LASSETS 0.6714*** 0.7136*** 0.6292*** 0.0188**
(22.53) (13.71) (21.50) (2.44)
SECURITIES 0.8548*** 1.1918*** 0.7794*** 0.0678
(4.00) (3.49) (3.10) (1.11)
SNPL 13.9441*** 41.8254*** 1.5396 6.6917***
(2.61) (4.56) (0.35) (4.76)
LOSS 0.2522 -0.3621 0.4643* -0.0950*
(1.08) (-0.79) (1.90) (-1.35)
INTANG 5.4330*** -1.0942 8.4852*** -1.5201***
(3.92) (-0.38) (4.83) (-3.43)
EFFICIENCY 1.1689*** 1.7519*** 0.7808*** 0.1665*
(3.92) (2.94) (2.76) (1.80)
SLCO -0.0863 -0.3179 0.0303 -0.0718*
(-0.85) (-1.46) (0.24) (-1.68)
SCOMM 0.2634*** 0.2556 0.2497** 0.0021
(2.68) (1.55) (2.22) (0.06)
SCON -0.4945** -0.2637 -0.5205** 0.0339
(-2.15) (-0.60) (-2.06) (0.39)


202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
Panel B: Results of Regressions of Fee Measures on Determinants of Feesb

Variable Total Fee Nonaudit Fee Audit Fee Fee Ratio
0)_ (2) (3) (4) (5)

SRESTATE -0.0812 -0.1646 -0.0511 -0.0181
(-1.20) (-1.20) (-0.80) (-0.68)
TCAP 0.0159*** 0.0061 0.0223*** -0.0027
(2.77) (0.35) (3.19) (-0.74)
EXEMPT -0.0167 -0.1237 -0.0589 0.0281
(-0.28) (-1.26) (-0.94) (1.57)
Year controls Yes Yes Yes Yes
1618 1618 1618 1618
Adj. R2 80.38% 51.11% 74.44% 6.53%
*, **, *** Indicate 0.10, 0.05, and 0.01 significance levels, respectively, for a two-tailed test.
a Panel A: The regression model is:
LLP =a0+ axBEGLLA + a2BEGNPL + a3CHNPL + a4LCO + a5CHLOANS + a6LOANS + LOAN CAT
+ YEARCONTROLS + e.
t-statistics are based on standard errors adjusted for firm-level clustering.

b Panel B: The regression model is:
FEE = 4 + 8XBIG5 + ?\LASSETS + ^SECURITIES + ?4SNPL + ?5LOSS + ?6INTANG + ÊFFICIENC

+ ^5COMM+ ?l0SCON+ ?nSCESTATE+ ?nTCAP+ 3E E + YEARCONTROLS + e.
t-statistics, in parentheses, are based on standard errors adjusted for firm-level clustering.
measures, total fees and nonaudit fees, and BIG5, LASSETS, SECURITIES, NPL, E
and SCOMM. The signs of the coefficients are generally consistent with Fields et al. (2
the total fees model, the adjusted R2 is 80.38 percent, indicating a good fit. For the n
model, the adjusted R2 is 51.11 percent. These values are higher than the adjuste
reported in Ashbaugh et al. (2003) for industrial firms and consistent with the R2 val
in Fields et al. (2004). We use the residuals from model (2) as the unexpected (abnorma
our fee measures.24
Association between Income-increasing (Negative) Abnormal LLP and Abnormal

Fee Measures
We present the results of model (3) relating abnormal LLP to fee measures (total fees, non
audit fees, audit fees, and fee ratio) in Tables 4 and 5. Although we report estimation results for all
four fee measures for completeness, we only discuss the results for unexpected total and nonaudit
fees, the measures of particular interest.25 Table 4 reports the results for negative (income
increasing) ALLP, and Table 5 reports the results for positive (income-decreasing) ALLP. In each
table, Panel A presents the results using abnormal (unexpected) fee measures, and Panel presents
the results using actual fee measures.
The correlations between our proxies for abnormal LLP and abnormal fee measures and size are very low, confirming
that our subsequent analysis for large and small banks does not suffer from latent size issues.
The results for audit fees and fee ratio are discussed in the section on sensitivity analysis.


202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
(9) (-2.64) (-2.33) 0.00000.0000
(0.26) (0.70)
(1.41)
-0.0002** 0.0000
(-0.75) (-2.81)
Abnormal Fee Ratio
-0.0018*** -0.0002 -0.0014*** (continued on next page)
(8)
-0.0017**
(-2.51) (-2.43) 0.0001 0.0000
(0.63)
0.0001
(0.63) (1.39)
-0.0002** (-1.78)
-0.0003*
(7)
-0.0016**
0.0000
(0.19) (0.40)
0.0000 0.0000
(0.35) (0.68)
0.0000(1.27)
(-2.39)
-0.0002**(-2.36) 0.0001
Abnormal Audit Fee
(6) -0.0016**
-0.0002**
0.0000
(-2.36) (0.29) 0.0001
(0.70)
0.0000 0.0000
(1.25)
(-2.35) (0.36)
(5)
-0.0017**
(-2.21)
-0.0000
(-0.88) 0.0000 0.0000
(0.39) 0.0000
(0.76) (1.25)
(-2.45)-0.0001** -0.0003**(-2.42)
Abnormal Nonaudit Fee
TABLE 4
Relation Between Income-Increasing (Negative) ALLP and Fee Measures
(4)
-0.0016** -0.0002**
(-2.39) -0.0001* 0.0000 0.0000
(0.25)
0.0000
(0.65) (1.30)
(-2.40) (-1.74)
(3)
-0.0015**
0.0000 0.0000
0.0000 0.0000(1.05)
(0.09) (-2.67) (0.51)
(0.89)
Panel A: Results of Regressions of Income-Increasing (Negative) ALLP on Abnormal Fee Measures3
(-2.20)-0.0002**(-2.27) -0.0006***
Abnormal Total Fee
(2) (-2.28) (-2.36)
(-0.74)
0.0000 0.0000
(0.41) 0.0000
(0.70) (1.17)
-0.0015** -0.0002** -0.0001
EXEMPT X UFEERATIO
EXEMPT X UTOTFEE EXEMPT X UNAFEE
EXEMPT X UAFEE
UFEERATIO
UTOTFEE
Variable Intercept
EXEMPT UNAFEE UAFEE
(1) BIG5
MB
LMVE

202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
(9) -0.0004
(-2.77) (-1.00)
(9) (-2.00)
0.0000
(-1.29)
(0.81)
Yes
-0.0016*
-0.0024** (-1.70) (-0.08) 6.70%
-0.0291* -0.0124 -0.0000 882 Fee Ratio (continued on next page)
Abnormal Fee Ratio
-0.0016***
(8) -0.0003
(-2.79)
(8) (-2.17)
-0.0142
(-1.79)
0.0000
(-1.47)
(0.85) Yes 5.97% (-1.04)
(-0.22) 882
-0.0024** -0.0306* -0.0000
(7)
-0.0023***
(7) -0.0024**(-2.19)
(-2.94)
-0.0140 (0.90)
(-1.52)
(-0.22)Yes8825.55%
(-1.69) (-1.45)
0.0000 -0.0012
-0.0290* -0.0000
Audit Fee
Abnormal Audit Fee
-0.0024***
(6) -0.0022** 0.0000 -0.0000 5.64% (6) (-1.10)
(1.27) (-3.08)
(-0.78)Yes882
(-2.17) (-1.69)
(-1.45)
-0.0291* -0.0124 -0.0003
(5)
-0.0024**
-0.0291*
(-1.73) (-1.36)
0.0000 0.0000
(0.64) (0.03) Yes 6.48% (5)-0.0022***
(-2.79)
(-1.01) (-0.92)
(-2.14) 882
-0.0131 -0.0006 -0.0000
(4)
-0.0023***
(4)
(-2.89) -1.87)
(0.76)
(-0.97)
(-0.14)Yes8825.95%
(-2.23) (-1.52)
(-1.75) 0.0000 -0.0003 -0.0001*

-0.0024** -0.0300* -0.0147 -0.0000
(3)
-0.0026** -0.0009**
-0.0001
(3) -0.0024**(-2.44)
(-1.50) (-2.55)
6.34%
(0.54) (0.10) (-2.50) (-0.95)
Yes882
(-1.67) (-1.29)
Panel A: Results of Regressions of Income-Increasing (Negative) ALLP on Abnormal Fee Measures3
0.0000 0.0000 Panel B: Results of Regressions of Income-Increasing (Negative) ALLP on Actual Fee Measures11
-0.0013
-0.0285* -0.0124 Variable Total Fee Nonaudit Fee
Abnormal Total Fee
-0.0027***
0.0000 5.69% (2) -0.0003 -0.0001*
(2) -0.0288
(-2.37) (-1.49) (0.82) Yes (-2.64) (-1.06) (-1.76)
-0.0024** (-1.64) (-0.15) 882

-0.0143 -0.0000
EXEMPT X LTOTFEE
Year Controls
PASTLLP LTOTFEE
Variable EXEMPT LNAFEE
(1) (1)Intercept
TIER1
LOSS EBP TCAP
Adj. R2

202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
0.0004*
(9) -0.0018
(-0.57) (-0.51) (-0.12) (-0.52)

-0.0000 0.0001(1.57) (1.68)
(-1.86)
0.0000
(-0.39)
(0.29)
(-0.62)
Yes
5.59%
-0.0001 -0.0000 -0.0542* -0.0043 -0.0000 952
Fee Ratio (continued on next page)
0.0004*
(8) (-0.68)
(-0.12)
(-0.52)
0.0001
(1.58) (1.68) (-1.88)
(-0.41)
0.0000
(0.28)
(-0.61)Yes9525.42%
-0.0001 -0.0000 -0.0000 -0.0545* -0.0044 -0.0000
(7)
0.0001** 0.0004**
0.0000
(0.36) (2.07)
-0.0540*
(2.02)
-0.0061 0.0000
(0.09) Yes 6.34%
(-1.48) (-1.56) (-0.68) (-1.86) (-0.58) (-0.40) 952
-0.0001 -0.0003 -0.0000 -0.0000
Audit Fee
(6)
0.0001**
0.0000 -0.0057 0.0000
(0.11)
-0.0000 5.61%
(-0.48)Yes952
(-1.63) (0.29) (2.18)
0.0005*(1.82) (-1.84)
(-0.53)
(-0.70)
-0.0001 -0.0000 -0.0535*
0.0001*
(5) -0.0004**(-2.42) 0.0000 -0.0000

(0.01)
(-0.64)
(1.87) (1.98)
0.0004**
-0.0065
(-1.83) (-0.59)0.0000
(0.11)
-0.0000
(-0.54)Yes 6.12%
-0.0530* 952
Nonaudit Fee
(4)
0.0001**
0.0000 5.81%
-0.0000 -0.0000 (1.95)
-0.0067
(0.10)
-0.0000
(-0.02) (-0.65) 0.0004*(1.71) (-1.84) (-0.61) (-0.53)Yes952

-0.0534*
0.0002*
(3) 0.0000
(0.37)
(-0.70) (1.82) (1.75)

0.0004*
(-1.83)
(-0.65)
0.0000 -0.0000
(0.07)
(-0.45)Yes952
6.68%
Panel : Results of Regressions of Income-Increasing (Negative) ALLP on Actual Fee Measures
-0.0000 -0.0530* -0.0074

Total Fee
0.0001*
(2) 0.0000
(0.35)
(-0.73)
(1.94) (1.80)
0.0005*
-0.0073
(-1.83)
(-0.64)
0.0000 -0.0000
(0.06) (-0.46)
Yes9525.77%
-0.0000 -0.0529*
EXEMPT X FEERATIO
EXEMPT X LNAFEE
EXEMPT X LAFEE
Year Controls
Variable FEERATIO PASTLLP

LAFEE
BIG5 LOSS EBP TIERI TCAP
(1) LMVE
MB Adj. R2

202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
>? OlS' s* a ? 3
ss:
(S
ALLP= 0+ yiEXEMPT+ y2FEE+ 3E E X FEE + yABlGS + y5MB+y6LMVE+ yiLOSS+ y%PASTLLP + y9EBP + y^TIERl^ + ynrCAPM + YEARCONTROLS + e. Br
>j ALLP= 0+ E E + y2UFEE + y3EXEMPTX UFEE+ yABIG5 + y5MB+y6LMVE + y7LOSS + ysPASTLLP + 9E + y^TlERl^ + ynTCAPt_x + YEARCONTROLS g
01 significance levels, respectively, for a two-tailed test.
, are based on standard errors adjusted for firm-level clustering. 3.
Please see Table 1 for variable definitions. ^
Panel B: The regression model is: ?
g. a Panel A: The regression model is: ^
I. ?
i-?
-.-?- ^
3 ^ co Cr o p'>?Ino ^?
I
o >oo 1<? ET
? SO ^ O

202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
For each fee measure, we present results for two specifications. The first specification esti
mates the relation between ALLP and each abnormal and actual fee measure for all banks. The
second specification (column 3) distinguishes between small banks that are exempt from FDICIA
and Section 404 of SOX and large banks, thereby allowing the relation between ALLP and fee
measures to vary across these two classes of banks.26
The results in column 2 of Table 4, Panel A indicate that the coefficient on UTOTFEE is not
significant, but the results in column 4 indicate that the coefficient on UN AFEE is significant at the
0.10 level. These results suggest that income-increasing earnings management via ALLP is in
creasing in unexpected nonaudit fees. In terms of the control variables, LOSS and PASTLLP (in
column 4) are significantly related to ALLP. Interestingly, there is no difference in abnormal LLP
between clients of BIG5 and non-BIG5 auditors. As expected, the capital ratios are not signifi
cantly associated with ALLP, confirming the reduced capital management incentives through
ALLP in the post-1990 period.
Turning to the second specification (columns 3 and 5 of Table 4), the coefficients on UTOT
FEE and UNAFEE are not significant, indicating no relation between income-increasing earnings
management and unexpected fees for large banks.27 In contrast, the coefficients on EXEMPT X
UTOTFEE and EXEMPT X UNAFEE are negative and significant at the 0.05 level. In addition,
both the sum of the coefficients on UTOTFEE and EXEMPT X UTOTFEE and on UNAFEE and
EXEMPT X UNAFEE are significantly negative at the 0.01 level. These results indicate that
income-increasing ALLP is higher for audit clients that are small banks (and, therefore, are exempt
from the regulatory oversight) that pay higher abnormal total fees or abnormal nonaudit fees to
their auditors.
The results in Table 4, Panel indicate that the coefficients on EXEMPT X LTOTFEE and
EXEMPT X LNAFEE are negative and significant at the 0.05 level.28 Overall, these results are
consistent with the results based on unexpected fee measures reported in Panel A, indicating that
our findings are not sensitive to the use of actual or unexpected fees. In addition, the results
document that only small banks that are exempt from regulatory compliance exhibit a significant
relation between earnings management via income-increasing LLP and fees paid to the auditor. In
short, our findings suggest that the potential impairment of auditor independence may be serious
only for small banks and not for large banks.
Association between Income-Decreasing (Positive) Abnormal LLP and Abnormal and Actual
Fee Measures
The results reported in Table 5, Panel A show that UTOTFEE is not significantly associated
with income-decreasing ALLP. However, the coefficients on EXEMPT X UTOTFEE and EX
EMPT X UNAFEE are negative and significant at the 0.05 level.29 These results indicate that
higher unexpected total fees and unexpected nonaudit fees paid to auditors of exempt small banks
are associated with a lower level of income-decreasing ALLP. Turning to columns 2 and 3 of Panel
B, LTOTFEE is positively and significantly associated with ALLP at the 0.01 level in each of those
regressions. One interpretation of this result is that clients of auditors who pay higher total fees
26 For the abnormal fee regressions, we have 170 (70) bank-year (banks) observations for which EXEMPT = 1. For the
actual fee regressions, we have 177 (72) bank-year (banks) observations for which EXEMPT = 1.
27 We also estimate model (3) using only observations for which EXEMPT = 0 (i.e., large banks). We find that the
coefficients on UTOTFEE and UNAFEE are insignificant at the 0.20 level for both income-increasing and income
decreasing ALLP, indicating no evidence of fee dependence for large banks.
28 We mean-center the fee variables to reduce problems with multicollinearity among the interaction terms (Neter et
al.1989; Aiken and West 1991).
29 For the abnormal fee regressions, we have 142 (70) bank-year (banks) observations for which EXEMPT = 1. For the
actual fee regressions, we have 157 (74) bank-year (banks) observations for which EXEMPT = 1.


202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
(9)0.0022***
0.0001
(3.29) (0.84) (-1.21)
(0.36) (-3.00)
(-0.98) 0.0000 (-1.05)

Abnormal Fee Ratio
-0.0002 -0.0006 -0.0000 -0.0001*** (continued on next page)
0.0022***
(8)
-0.0001***
0.0001
(3.29) (0.89) -0.0003
(-1.57) 0.0000 -0.0000
(0.26) (-2.97)
(-1.10)
0.0023***
(7)
-0.0001***
0.0001 0.0001
(3.49) (0.81) -0.0001
(0.80) (-0.91) 0.0000 -0.0000
(0.37) (-3.10)
(-1.04)
Abnormal Audit Fee
0.0023***
(6) (3.51)
(0.80) 0.0000
(0.43) 0.0000
(0.38) (-1.21)
0.0001 (-3.12)
-0.0000 -0.0001***
0.0022***
(5) 0.0001
(3.27) (0.69)
(-1.00)-0.0002**(-2.48)
(0.54)
0.0000 -0.0000
(-1.09)
(-3.00)
-0.0000 -0.0001
TABLE 5Relation Between Income-Decreasing (Positive) ALLP and Fee Measures
0.0022***
(4)
-0.0001***
0.0001
(3.31) (0.83)
-0.0001* 0.0000 -0.0000
(0.35)
(-1.82) (-1.15) (-2.97)
0.0023***
Panel A: Results of Regressions of Income-Decreasing (Positive) ALLP on Abnormal Fee Measures8
(3) 0.0001 0.0001

(0.78) (1.05) 0.0000
(0.49)
(3.52) -1.96) (-1.05)-0.0001***(-3.14)
-0.0003** -0.0000
Abnormal Total Fee
0.0028***
(2)
-0.0001***
0.0001 0.0000
(0.78) 0.0000 0.0000
(0.43) (0.05)
(3.53) (0.14) (-3.13)
REG X UFEERATIO
EXEMPT X UTOTFEE EXEMPT X UNAFEE
EXEMPT X UAFEE
UFEERATIO
UTOTFEE
Intercept
UNAFEE UAFEE
Variable EXEMPT
(1) BIG5 LMVE
MB
?i 8osa I >3
a. >o co S
O3

202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
(9)0.0014** 0.1028*** 0.0494***
(9)
0.0027***
(2.07) 0.0000
(3.55) (2.90)
-0.0000
(0.20) (-0.62)
Yes 14.03% (4.29) (-1.22)
736
Abnormal Fee Ratio
Fee Ratio
-0.0002 (continued on next page)
0.1021*** 0.0490***
0.0027***
(8)
0.0010**
0.0000
(2.09)
(0.16)
-0.0000
(8) -0.0001
(-0.62)Yes736
(3.59) (2.88) 13.98%
(4.30) (-0.60)
0.1035*** 0.0477***
(7)
0.0013** 0.0044***
0.0000 -0.0000
(7)
(2.38) (2.91)
(-0.54)Yes736
(2.95) (0.07) 13.64%
(4.20) (-0.05)
-0.0000
Abnormal Audit Fee
0.1046*** 0.0473***
0.0013** 0.0044***
0.0000
(0.10)
(6) (2.84) -0.0000
(6)
(2.33) (3.25)
(-0.54)Yes736
13.66%
-0.0001
(4.20) (-0.47)
0.1027*** 0.0500*** 0.0034***
(5)
0.0015**
(2.09) (3.70) (2.86) -0.0000
(0.30)
0.0000
(-0.67)
Yes736
14.80%
(5) (4.26)
(-0.91)
0.0001
(1.39)
-0.0002
Variable Total Fee Nonaudit Fee Audit Fee 0.0030***
(4)
0.1030*** 0.0482***
0.0001
(4)
0.0013** (4.25) (1.37)
0.0000 -0.0000 Yes

(1.99) (3.65) (2.87)
(0.24)
(-0.67) 14.18%
(-0.68)
736
-0.0001
0.0055*** 0.0002***
0.1033*** 0.0483***
(3) -0.0002
(4.18) (-0.57)
(-0.77) (3.13)
0.0011**
0.0000
(3) (0.10)
-0.0000 Yes
Panel A: Results of Regressions of Income-Decreasing (Positive) ALLP on Abnormal Fee Measures8
(2.03) (2.64) (2.97) 13.99% Panel B: Results of Regressions of Income-Decreasing (Positive) ALLP on Actual Fee Measures
(-0.55) 736 -0.0002

Abnormal Total Fee
0.0055*** 0.0002***
(2)
0.1052*** 0.0470***
-0.0001
0.0013** (3.12)
(2)
(4.17) (-0.68)
(0.12)
-0.0000
(-0.56)Yes736
(2.10) (3.09) (2.89) 13.64%
0.0000
EXEMPT X LTOTFEE
Year Controls
Variable PASTLLP LTOTFEE

EXEMPT
(1)
LNAFEE
EBP
(1)Intercept
LOSS TIER1 TCAP
Adj. R2

202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
(9) 0.1025***
0.0003
-0.0013**
-0.0000 -0.0000
-0.0001***
(0.20)
0.0021**
(3.50)
0.0299**
-0.0000 -0.0000 Yes
(1.11) (-2.08) (-0.44)
(2.21) (2.22) (-0.09) 12.32%
(-3.48) (-0.29) 788

Fee Ratio
0.1021***
-0.0001*** 0.0021** 0.0299**
(8) 0.0003
(1.07) -0.0000 -0.0000
(-0.41) (-0.20) (-3.49) (2.21) (3.50)
-0.0000
(2.22) (-0.09) (-0.28) Yes 12.27%
788
-0.0000
0.0935***
0.0348**
(7)
0.0002** -0.0002*** 0.0021**
(2.17)
(0.30) 0.0000
(0.43)
(-0.14) (-0.29)Yes788
(-1.14) (-3.83) (2.23) (3.13) (2.54)
0.0002 12.74%
-0.0001 -0.0000 -0.0000
0.0935***
0.0022** 0.0348**
(6)
0.0002** -0.0002***
(2.18) -0.0001 0.0000
(0.44) (2.23) (3.13) -0.0000
(2.53) -0.0000
(-0.13) (-0.28)Yes788
12.74%
(-1.14) (-3.84)
0.0002*** 0.0993***
0.0312**
(5)
0.0021**
0.57)
0.0001 0.08)
0.0000 3.83)
(3.36)
Yes788
(2.32) (2.37) (-0.09) (-0.28) 12.46%
(-0.77)
-0.0001 (" -0.0000 -0.0000
Variable Total Fee Nonaudit Fee Audit Fee

0.0991***
0.0311**
(4)
-0.0002*** 0.0022**
0.0000 (2.32) (3.35) (2.38) Yes
(0.07) (-3.84)
(-0.09) 12.43%
(-0.55) (-0.29) 788

-0.0001 -0.0000 -0.0000
0.0897*** 0.0344***
0.0021**
(3)
-0.0003***
0.0000
-0.0001 (0.95) (2.18) (3.03)
-0.0000
(2.58)
-0.0000 Yes 13.68%
Panel : Results of Regressions of Income-Decreasing (Positive) ALLP on Actual Fee Measures (-1.28) (-4.99) (-0.14) (-0.21) 788
0.0344**
(2)
0.0021**
0.0000
(-0.14) (-0.22)Yes788
(0.94) (-4.99) (2.18) (3.03) (2.59) 13.66%
(-1.26) -0.0003*** 0.0896***

-0.0001 -0.0000 -0.0000
EXEMPT X FEERATIO
EXEMPT X LNAFEE
EXEMPT X LAFEE
Year Controls
FEERATIO PASTLLP
LAFEE
BIG5 LOSS TIER1 TCAP
LMVE
EBP
(1)
MB Adj. R2

202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
& Is S* ^-hi s
i: s*
g >3 ALLP=7o+yiEXEMPT+ y2UFEE+ 3E E UFEE+ y4BIG5 + y5MB+y6LMVE + 7lLOSS+ ysPASTLLP + 9E + yxJIERlt_x + ynTCAPt_x + YEARCONTROLS |? ALLP= y0+ylEXEMPT+y2FEE+ 3E E X FEE + y4BIG5 + y5MB+y6LMVE+ ynLOSS + ysPASTLLP + 9E + y?OTIERlt_x + ynTCAPt_x + YEARCONTROLS + e.
* Indicate 0.10, 0.05, and 0.01 significance levels, respectively, for a two-tailed test.
? t-statistics, in parentheses, are based on standard errors adjusted for firm-level clustering,
3 Please see Table 1 for variable definitions.
g Panel B: The regression model is:
o g; a Panel A: The regression model is:
(g " +8. !? r
g- "

202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
engage in a higher level of income-decreasing earnings management. Although positive, the

insignificant coefficient on LNAFEE does not support the total fee results. Further, the coefficients
on EXEMPT X LTOTFEE and EXEMPT X LNAFEE are insignificant. These results differ from
the results in Panel A due to the use of different fee measures. If we do not control for factors
determining normal fees, we do not observe a significant relation between income-decreasing
ALLP and either unexpected total fees or unexpected nonaudit fees (see Panel A), indicating that
the results for income-decreasing ALLP are sensitive to the use of fees or abnormal fees.
Summary of Results
We briefly summarize our main results on the relation between income-increasing and
income-decreasing ALLP and unexpected total fees and unexpected nonaudit fees. We find that for
large banks, both unexpected total fees and unexpected nonaudit fees have no relationship with
either income-increasing or income-decreasing ALLP?i.e., unexpected total or nonaudit fees are
unrelated to earnings management behavior in large banks. In contrast, we find a significant
negative association between income-increasing ALLP and both unexpected total fees and unex
pected nonaudit fees for small banks relative to large banks. Recall that these small banks are
exempt from FDICIA (as well as Section 404 of SOX), which mandated assessments of the
effectiveness of internal control over financial reporting by managers and auditors. Furthermore,
we also document a significant negative association between unexpected total fees and unexpected
nonaudit fees and income-decreasing ALLP. These results are consistent with greater earnings
management by small banks that pay higher abnormal fees to the auditor. Collectively, our results
suggest that auditor independence may be lower when auditor fee dependence on the audit client
is higher, but only for small banks that are not subject to the same level of regulatory scrutiny as
large banks. We conjecture that auditors of small, exempt banks may not be as concerned with
earnings management perhaps because the failure of such a bank, if it occurs, will cause less
damage to the auditor's reputation than will the failure of a large bank. Alternatively, partners
auditing small, exempt banks may not be as closely monitored internally as partners auditing large
banks.31
Pooled ALLP Regressions

For consistency with prior research on banks (e.g., Ahmed et al. 1999; Kanagaretnam et al.
2004), we also estimate model (3) for the full sample (i.e., combining income-increasing and
income-decreasing ALLP) and present these results in Table 6. The coefficients on EXEMPT X
UTOTFEE and EXEMPT X UNAFEE are both negative and significant at the 0.05 level, indicat
ing that our finding of a positive relation between higher abnormal auditor fees and aggressive
earnings management for exempted banks is robust.
Association between Abnormal LLP and Abnormal Fee Measures in the Post-SOX Era
While banks with total assets of less than $500 million (less than $1 billion effective 2005)
were not subject to the annual reporting requirements mandated by Section 36 of the FDI Act, the
passage of SOX (Section 404) also exempts assessment of the effectiveness of internal control
over financial reporting by managers and auditors of small banks (banks with public float less than
$75 million). Therefore, we expect our results on the association between ALLP and unexpected
fees observed for small (exempted) banks to be similar in the post-SOX era. We examine whether
our results hold for a class of banks that are exempt from both FDICIA and SOX. Section 404 of
Also, note that EBP is positive and significant in both panels of Table 5, suggesting that firms are more willing to take
income-decreasing LLP when they have high earnings. This is consistent with income smoothing.
We thank an anonymous reviewer for these observations.


202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
TABLE 6
Results of Regressions of Pooled ALLP on Abnormal Fee Measures
Abnormal Abnormal
Variable Total Fee Nonaudit Fee
Intercept -0.0005 0.0004
(-0.87) (0.61)
EXEMPT -0.0001 -0.0001
(-1.35) (-1.37)
UTOTFEE 0.0000
(0.34)
EXEMPT X UTOTFEE -0.0005***
(-2.59)
UNAFEE -0.0001*
(-1.69)
EXEMPT X UNAFEE -0.0003**
(-2.54)
B1G5 0.0000 0.0000
(0.40) (0.33)
MB 0.0000 0.0000
(1.26) (1.26)
LMVE -0.0001* -0.0001*
(-1.90) (-1.75)
LOSS -0.0003 -0.0002
(-0.17) (-0.11)
PASTLLP 0.1345*** 0.1327***
(4.36) (4.33)
EBP 0.0501*** 0.0512***
(2.98) (3.00)
TIER1 0.0000 0.0000
(0.19) (0.21)
TCAP 0.0000 0.0000
(0.04) (0.10)
Year Controls Yes Yes
1618 1618
Adj. R2 9.27% 10.03%
*, **, *** Indicate 0.10, 0.05, and 0.01 significance levels, respectively, for a two-tailed test.
The regression model is:
ALLP = 0 + E E + y2UFEE + 3E E X UFEE + y4BIG5 + 5 + y6LMVE + y1LOSS + y%PASTLLP

+ y9EBP+ ymTIERlt_x + ynTCAPt_x + YEARCONTROLS + e.
SOX became effective in 2004 for accelerated filers?i.e., firms with a public float of $75 million
or more. We re-estimate model (3) for the years 2004 through 2006 by replacing EXEMPT with
NF (non-accelerated filers), which equals 1 for banks that are exempt from both Section 404 of
SOX and Section 36 of the FDI Act, and 0 otherwise. The results of this specification are in Table
7.


202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
0.0002*
Nonaudit Fee
Abnormal
(5) -0.0029**(-2.34) (-1.40) -0.0001
(-0.90)-0.0007**(-2.49)
(1.49)
0.0002 (1.78) (continued on next page)
-0.0003
Years 2004-2006
(4) 0.0002
(1.63)
(-1.05) (-2.50) (1.68)
Abnormal
0.0002*
Total Fee
-0.0030**(-2.46) (-0.06)
-0.0002 -0.0000 -0.0008**
Results of Regressions of Abnormal LLP on Abnormal Fee Measures for Pre- and Post-2004 Periods
TABLE 7
Nonaudit Fee
Abnormal
(3) (-2.14)
(-1.59)
-0.0001
(-0.36) (-1.84)
-0.0001 -0.0000
(-1.52) (-1.34)
-0.0015** -0.0002 -0.0004*
Years 2000-2003
Abnormal
Total Fee (2) -0.0001
(-2.02) (-1.92) (-0.66)

(-1.99)
-0.0001
(-1.58)
(-1.34)
-0.0014** -0.0002* -0.0006** -0.0000
Panel A: Income-Increasing (Negative) ALLP
SMALL X UTOTFEE
SMALL X UNAFEE NF X UTOTFEE NF X UNAFEE
SMALL/NF UTOTFEE UTOTFEE

Intercept
UNAFEE UNAFEE
Variable
(1) BIG5
MB

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Abnormal
Nonaudit Fee
Abnormal
(5)0.0000
(0.53)
-0.0033**(-2.38)
(-0.10)
0.0232(-0.72)
(0.69)
0.0001 0.0000
(0.28)
Yes425 (continued on next page)
-0.0043 11.58%
Years 2004-2006
Years 2004-2006
Abnormal Nonaudit
0.0009 0.0007 0.0000 0.0000

Total Fee Fee (4) (5) (1.07) (0.78) (0.27) (0.20)
(4)
-0.0033***
0.0000
(0.72) (-2.69) (-0.17) (-1.33)
0.0001 0.0000
(0.78) (0.30) Yes 11.03%
Abnormal
Total Fee
425
-0.0044 -0.0233
Abnormal
Nonaudit Fee
Abnormal
(3) (2.05) (0.25) (-1.40) Yes 4.31%
0.0001** 0.0001 (-2.14) (-0.30) (-0.20)

-0.0138 -0.0000 -0.0000
457
-0.0592**
_Years 2000-2003_
Years 2000-2003
Abnormal Nonaudit
(2.36) (2.67) (0.84) (1.69)
Intercept 0.0033** 0.0026**

(1)_ (2) (3) SMALUNF 0.0001 0.0003*
(2) (1.98)
(0.03)
-0.0147
(-2.09) (-1.47) Yes Variable Total Fee Fee
3.47%
Abnormal
0.0001** 0.0000 (-0.23) (-0.31)

Total Fee
-0.0580** 457
-0.0000 -0.0000
Panel B: Income-Decreasing (Positive) ALLP

Panel A: Income-Increasing (Negative) ALLP
Year Controls
PASTLLP
Variable
(1)LMVE LOSS TIER1 TCAP
EBP Adj. R2

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Nonaudit (5)
Fee
Abnormal
0.1863**
-0.0001* -0.0002 -0.0001 -0.0000
(-1.80) (-1.33) (-0.50) -0.0001* 0.0003
(-1.92) (0.32) (2.35)
(-0.48)
Years 2004-2006
0.1924***
(4)
-0.0001**
Abnormal
-0.0001 -0.0001 (-0.38) -0.0000 (-1.99)
0.0005 (0.59) (2.90)
Total Fee
(-1.23) (-0.19) (-0.44)
-0.0000
0.0618*
(3)
-0.0003** -0.0001** 0.0018**
Abnormal
Fee
Nonaudit -0.0000 (-2.40) 0.0002
(1.37) (-1.85)
(2.14) (1.66)
(-0.04) (-2.12)
-0.0001*
Years 2000-2003
0.0003** -0.0009** 0.0019**

Abnormal (2) (2.11) (-2.29) 0.0001
(1.28) (-2.13) (-2.77) 0.0555
(2.36) (1.53)
Total Fee
-0.0001** -0.0001**
Panel : Income-Decreasing (Positive) ALLP
SMALL X UTOTFEE
SMALL X UNAFEE NF X UTOTFEE NF X UNAFEE
UTOTFEE UTOTFEE
Variable PASTLLP
UNAFEE UNAFEE
(1) LMVE LOSS

BIG5 MB
I
l'I
Ci ?s; 3 e>
3. o >o > s s-s o ?
CA ?S

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Abnormal Fee
Nonaudit
(5)0.0631***
Yes
(3.30) (0.16) (0.52) 16.13%
0.0000 0.0000 387
Years 2004-2006
0.0601***
Total Fee (4)

0.0000 0.0000
(3.32) (0.35)
Yes387
Abnormal (0.28) 14.98%
0.0414**
Nonaudit
Abnormal
Fee (3) (2.03)
0.0000
(0.68) (-1.69) Yes
349
11.16%
-0.0001*
ALLP= To + y\SMALLINF + y2UFE + y3SMALL/NF X UFE + y4BIG5 + y5MB + y6LMVE + y1LOS + ysPASTL P+ y9EBP+ ymTIERlt_x + ynTCAPt_x
Years 2000-2003
0.0433**
Abnormal
Total Fee (2) (2.33)
0.0000
(0.30)
(-1.44)
Yes
349
12.72%
-0.0001 *, **, *** Indicate 0.10, 0.05, and 0.01 significance levels, respectively, for a two-tailed test,
Panel : Income-Decreasing (Positive) ALLP
+ YEARCONTROLS + e.
The regression model is:
Year Controls
Variable
TIER1 TCAP
(1)_ EBP Adj. R2

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We report results for the pre- and post-Section 404 of SOX periods. For the pre-Section 404
period (years 2000 through 2003), we interact SMALL with UTOTFEE and UNAFEE. For the
post-Section 404 period (years 2004 through 2006) we interact NF with UTOTFEE and UNAFEE.
Table 7, Panel A reports the results for income-increasing (negative) ALLP and Panel reports the
results for income-decreasing (positive) ALLP. We find that for income-increasing ALLP, the sum
of the coefficients on UTOTFEE and SMALL X UTOTFEE and on UNAFEE and SMALL X
UNAFEE are negative and significant at the 0.05 level. We also find that, for income-decreasing
(positive) ALLP, the coefficients on SMALL X UTOTFEE and SMALL X UNAFEE are negative
and significant at the 0.05 level. These results are consistent with the results in Tables 4 and 5,
suggesting that there is greater earnings management via abnormal LLP by small banks (less than
$500 million in total assets) that pay higher abnormal fees to the auditor. Turning to the post
Section 404 period, we find that, for income-increasing ALLP, the coefficients on NF X UTOT
FEE and NF X UNAFEE are both negative and significant at the 0.05 level. We do not find a
significant coefficient for income-decreasing ALLP. Overall, these results suggest that banks that
are exempt from both Section 36 of the FDI Act and Section 404 of SOX and pay higher abnormal
fees to the auditor engage in greater income-increasing earnings management via ALLP.
Sensitivity Tests
We conduct several sensitivity checks to assess the robustness of these results. First, we
summarize the results for audit fees and fee ratio reported in Tables 4 and 5. Recall that our main
results are based on unexpected total fees and unexpected nonaudit fees; however, consistent with
prior research on auditor fees for industrial firms (Ashbaugh et al. 2003; Srinidhi and Gul 2007),
we present results for audit fees and fee ratio as additional evidence. For income-increasing
(negative) ALLP, neither abnormal audit fees nor actual audit fees is significantly associated with
ALLP. On the other hand, unexpected fee ratio has a strong negative (p < 0.01) relation with
income-increasing ALLP for small banks. For income-decreasing (positive) ALLP, actual audit
fees have a positive (p < 0.05 or better) association with ALLP for both large and small banks;
however, this relation does not hold for unexpected audit fees. Abnormal fee ratio is negatively
associated with income-increasing ALLP for small banks (p < 0.01), but fee ratio is not signifi
cantly associated with income-increasing ALLP.
Second, we discuss the results (untabulated) for separate subsample analyses of small and
large banks. For income-increasing ALLP, our main results for unexpected total fees and unex
pected audit fees hold for the subsample analysis. More specifically, for large (non-exempted)
banks, there is no significant association between unexpected total fees and unexpected nonaudit
fees and income-increasing ALLP. For small (exempted) banks, the estimated coefficient for
unexpected total fees is ?0.0006 (p < 0.05), and for unexpected nonaudit fees the estimated
coefficient is -0.0002 (p < 0.05), consistent with our main results reported in Table 4, Panel A.
For income-decreasing ALLP, the only significant association is with unexpected nonaudit fees for
small (exempted) banks (estimated coefficient of -0.0003, < 0.01), consistent with the main
results reported in Table 5, Panel A.
Third, we assess the sensitivity of our results to omitting observations that have an abnormal
influence on our regressions. When we delete observations that have R-student values greater than
3 or less than ?3, the results for unexpected total fees and unexpected nonaudit fees for both
income-increasing and income-decreasing ALLP are similar to the results reported in Panel A of
Tables 4 and 5.32
Instead of deleting the top 1 percent of observations, when we winsorize the key variables at the top 1 percent for
income-increasing ALLP, the coefficient on EXEMPT X UTOTFEE is -0.0007 (significant at the 0.01 level). Similarly,


202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
Fourth, we examine the robustness of our results to interacting the capital management and
income smoothing variables with EXEMPT. Using income-increasing ALLP observations, we
re-estimate model (3) with the following interactions: EXEMPT X EBP, EXEMPT X TIER1, and
EXEMPT X TCAP. Untabulated results indicate that neither the capital ratios nor any of their
interactions are significant. Additionally, the income smoothing variable and its interaction are also
not significant. However, the coefficients on EXEMPT X UTOTFEE and EXEMPT X UNAFEE
continue to be negative and significant at the 0.05 level.
Finally, we examine the relation between abnormal LLP and auditor fees using an alternate
estimate of abnormal LLP. Ahmed et al. (1999) suggest that the earnings management through
LLP reported in prior research is conditional on the inclusion of beginning non-performing loans
(NPLt_i) in the abnormal LLP model. Our main results are robust to using estimates of abnormal
LLP after excluding NPLt_x from model (1).
VI. CONCLUSIONS
Despite the economic importance of the banking industry, there is limited research on the
various relationships that exist between banks and their auditors. We provide empirical evidence
on the relation between fees paid to the auditor and the extent of earnings management via loan
loss provisions in the banking industry. In particular, we study a setting where small banks are
exempt from regulatory scrutiny. Section 36 of the FDI Act, which was intended to aid early
detection of problems in the financial management of insured banks, requires an assessment of the
effectiveness of internal control over financial reporting by auditors. However, this requirement
does not apply to banks with total assets of less than $1 billion (less than $500 million until 2004).
We study whether there is a relation between earnings management via loan loss provisions and
fees paid to the auditor, particularly for banks that are exempt from the FDI Act.
We report several important findings. First, for large banks, we find that both unexpected total
fees and unexpected nonaudit fees are not related to either income-increasing or income
decreasing ALLP. These findings indicate that unexpected auditor fees are unrelated to earnings
management behavior in large banks, suggesting that auditor fee dependence is not a threat to
auditor independence in large banks. In contrast, we find a strong negative association between
income-increasing (negative) ALLP and both unexpected total fees and unexpected nonaudit fees
for small banks that are exempt from Section 36 of the FDI Act and Section 404 of SOX.
Furthermore, we also document a strong negative association between unexpected nonaudit fees
and income-decreasing (positive) ALLP. These results are consistent with greater earnings man
agement by exempt banks that pay higher abnormal fees to the auditor. Collectively, our results
suggest that auditor independence could be threatened when auditor fee dependence on the audit
client is higher, but only for small banks that are not subject to the same level of regulatory
scrutiny as larger banks.
Our results complement the findings of Altamuro and Beatty (2010), who link FDICIA re
quirements to improved loan loss provisioning. We also find that loan loss provisions of banks that
are subject to internal control requirements under FDICIA or SOX are independent of fees paid to
auditors. Additionally, we document that banks that are exempted from internal control require
ments under FDICIA or SOX are more likely to overstate earnings when the fees paid to auditors
are high.
Our results have several implications. First, they inform policymakers that auditor fees are
related to earnings management for small but not large banks. This suggests that any potential
the coefficient on EXEMPT X UNAFEE is -0.0003 (significant at the 0.01 level). For income-decreasing ALLP, the
coefficient on EXEMPT X UNAFEE is -0.0002 (significant at the 0.05 level). Once again, we find that unexpected total
and nonaudit fees are unrelated to ALLP for non-exempted banks.


202.43.95.117 on Wed, 13 Oct 2021 08:20:55 UTC
impairment of auditor independence through LLP could be a problem for small banks. Second, to
the extent that the FDICIA can be viewed as a precursor to SOX and to the extent that our results
for banks are generalizable to other industries, our findings of increased earnings management by
small banks that are less closely regulated are relevant to the debate on reducing the requirements
of SOX for small firms. Finally, our findings are timely and relevant given the recent banking
crisis and the response from governments around the world contemplating new regulations. In
particular, our results inform policymakers on the relationship that existed between fees paid to
auditors and the extent of earnings management in banks prior to the current banking crisis.
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Author(s): Kiridaran Kanagaretnam, Gopal V. Krishnan and Gerald J. Lobo

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