Auditor Fees and Auditor Independence:

Evidence from Going Concern Reporting Decisions

by

Marshall A. Geiger*
University of Richmond

and

Allen D. Blay
Florida State University

*Contact Author:
University of Richmond
1 Gateway Road, Richmond, VA 23173
mgeiger@richmond.edu
804-287-1923

Electronic copy available at: http://ssrn.com/abstract=1943124

ABSTRACT: In this study we examine the association between audit service fees and non-audit
service (NAS) fees and the auditor’s final decision regarding the type of opinion to render to a
financially distressed client. Along with examining current fee levels and reporting decisions we also
test the DeAngelo (1981) auditor independence model by examining the association between future fee
receipts and current reporting decisions. Using data from the post-SOX reporting period of 2004-2006
and a stringent control sample, we find that the magnitude of NAS fees received in the current year is
negatively related to the likelihood of the auditor modifying the audit opinion for going-concern
uncertainty. We also find that current going-concern modification decisions are negatively related to
total fees received by auditors in subsequent years. Our findings suggest that concerns over the relation
between auditor fees and the possible impairment of auditor independence, as reflected in going-concern
modification decisions, are supported in the more recent years for highly distressed clients.

Electronic copy available at: http://ssrn.com/abstract=1943124

 Auditor Fees and Auditor Independence:
Evidence from Going Concern Reporting Decisions

1. Introduction

“Independence is the cornerstone of the accounting profession and one of its most precious
assets.” Robert Mednick, Chair, American Institute of Certified Public Accountants (AICPA)
Board of Directors, 1997.

Without independence there is no need for external auditors attesting to the purported accuracy and

completeness of company financial information (Sutton 1997; Wallace 2004). Thus, the possible

adverse effect of auditors providing additional non-audit services (NAS) to audit clients and the

question of impaired auditor independence, in fact or appearance, has historically been a concern of

the public accounting profession (Mautz and Sharaf 1961; AICPA 1978; Simunic 1980, 1984) and

has been a longstanding apprehension of regulators, legislators and other market participants (US

Senate 1976; US House of Representatives 1985; SEC 2000a; SOX 2002; Zeff 2003a, 2003b;

PCAOB 2009).

The association between fees received by audit firms and the possible impairment of auditor

independence, particularly with respect to going concern reporting decisions, continues to be of

considerable interest to regulators and market participants in the current economic environment. In

fact, reporting on financially distressed companies has recently received heightened attention from

the Financial Accounting Standards Board (FASB) as well as the Public Company Accounting

Oversight Board (PCAOB) in their respective efforts to establish accounting and auditing policy.

While the professional requirements for assessing going concern in the U.S. have historically resided

in the auditing standards, the recent proposal by the FASB would charge financial statement

preparers with assessing and reporting on their company’s ability to continue as a going concern

3
 (FASB 2008).1 In addition, the PCAOB has had ongoing discussions regarding the issues

surrounding going concern reporting (e.g, PCAOB 2009) and recently issued a request for a

summary of the academic research on GCM reporting in order to inform their continuing

deliberations (Glover 2011).

In this study we examine the association between both current and future audit service fees

and non-audit service (NAS) fees received by external auditors in the U.S. and their final decisions

regarding the type of opinion to render to a financially distressed client. If the receipt of fees from a

client is likely to impair auditor independence, we would expect to find a negative association

between both current and future fees and auditors’ going-concern modification (GCM) reporting

decisions (Kida 1980; DeFond, Raghunandan, and Subramanyam 2002). Yet, prior research

examining audit and NAS fee disclosures in the U.S. has generally not found the expected

association of NAS fees and impaired auditor independence when assessing GCM reporting

decisions (DeFond et al. 2002: Geiger and Rama 2003; Lim and Tan 2008; Robinson 2008;

Callaghan, Parkash, and Singhal 2009). The results of these U.S. studies are in stark contrast to the

findings in other countries that have publicly disclosed audit fees for some time (Sharma and Sidhu

2001; Firth 2002; Basioudis, Papanastasiou, and Geiger 2008).

To date, however, GCM opinion research on U.S. firms has typically included the initial

years of the SEC’s mandatory fee disclosures, which began with proxy statements filed with the SEC

after February 5, 2001, which also largely coincided with the enactment of the Sarbanes-Oxley Act

(hereafter SOX). However, research suggests that auditor reporting decisions regarding going-

concern may have changed subsequent to the period surrounding the initial fee disclosures and the

enactment of SOX (Geiger, Raghunandan, and Rama 2005; Fargher and Jiang 2008; Feldmann and

1
The proposed standard would require preparers to present additional financial statement disclosures either when the
statements are not prepared on a going concern basis or when there is substantial doubt as to an entity's ability to continue as
a going concern through the next fiscal year.

4
Read 2010). Further, SOX mandated considerable restrictions on the provision of NAS from external

audit firms to attest clients, thereby significantly reducing the magnitude of NAS fees obtained by

firms from their audit clients (Ghosh and Pawlewicz 2009). It is not clear whether the overall

reduction in NAS fees received from clients in the post-SOX environment would be expected to

exert less influence on auditor decision-making due to the lower magnitude of these fees, or greater

influence due to the audit firm’s desire to ensure collection of all the possible fees from clients. This

is partially due to the scarcity of allowable NAS services after SOX, as well as the possible reduction

in the number of clients offering these revenue opportunities to their external audit firm (Ghosh and

Pawlewicz 2009).

Thus, it remains an empirical question whether the prior U.S. research results hold in the

post-SOX reporting environment due to possible changes in auditor reporting decisions, as well as

the impact of new NAS fee restrictions and revenue opportunities on auditor decision-making. In

addition, examining a more recent audit environment would minimize much of the uncertainty and

implementation issues surrounding SOX that may have existed in the initial years, and would also be

a period where the restriction of NAS would have become more commonplace. Therefore, an

examination of auditor fees and reporting decisions several years after the initial fee disclosures were

mandated would provide evidence on whether the initial lack of association persists, or whether

auditor independence may appear to be more impaired in the post-SOX environment (Geiger et al.

2005; Feldmann and Read 2010).

Several commentators have argued that it is not only the receipt of current NAS fees that

might impair auditor independence, but the direct receipt of all types of fee revenue, including basic

audit fees that create the economic bond between the auditor and the client (Mautz and Sharaf 1961;

SEC 2000a; Kinney and Libby 2002). Accordingly, the relation between audit fees and reporting

5
 decisions has received considerable attention in the literature (Lennox 1999; DeFond et al. 2002;

Firth 2002; Geiger and Rama 2003; Hay, Knechel, and Wong 2006; Lai 2009). Still others have

argued that it is not current fee revenues but the potential for garnering future fees from the client

that could pose the greatest threat to auditor independence (DeAngelo 1981; Beck et al. 1988; POB

1995; Levitt 2000; Coffee 2002; U.S. House of Representatives 2002). If an auditor is too focused

on receiving future audit and NAS fee revenues from an existing client, independence in the current

period may be compromised in order to retain the client as an ongoing engagement (DeAngelo 1981;

Beck, Frecka, and Solomon 1988; Levitt 1998; Huang, Raghunandan, and Rama 2009). If auditors

try to appease clients by not rendering a GCM audit opinion in hopes of retaining the company as a

client, examination of subsequent fees received represents an additional test of the impairment of

independence associated with possible client retention efforts on the part of auditors (DeAngelo

1981; Levitt 1998, 2000).2

We empirically examine these issues and conduct a study that differs from prior research in

several important ways. Our study examines the association of fees received by the auditor and

reporting decisions in the post-SOX period of 2004-2006.The fee disclosures examined in our study

represent the restricted levels of allowable NAS services auditors can provide to attest clients post-

SOX and also covers a relatively stable economic period in the U.S. We also advance the literature

by providing one of the first empirical tests of DeAngelo’s (1981) assertion that auditors are

interested in retaining future revenue streams by examining the association of current GCM

reporting decisions and subsequent fees. As argued in Callaghan et al. (2009), our study also

employs a more stringent sample of distressed control firms that are more likely to receive extensive

2
DeAngelo (1981) relates the auditor’s independence to the present value of future excess revenues over the duration of the
auditor-client relationship. Thus, an auditor lacking independence would be very concerned about both subsequent audit fees
and non-audit fees that may be earned by retaining the client.

6
 consideration of a GCM opinion from their auditor.3 Accordingly, we assess a more appropriate

control sample of distressed firms in our examining of GCM opinion decisions.

An analysis of 1,479 financially distressed companies, including 180 with first-time GCM

opinions, from 2004 to 2006, indicates that after controlling for other reporting and fee related

factors, NAS fees in the current year are significantly negatively associated with GCM audit

opinions. Further, the negative relation between GCM audit opinions and NAS fees also holds when

examining NAS-to-total fee ratios, unexpected NAS and audit fees, and controlling for the

endogeneity of audit fees, NAS fees, and GCM opinions. Additionally, we find audit fees are

significantly positively associated with GCM opinions after controlling for endogeneity between the

opinion, audit fees and NAS fees. When assessing the DeAngelo (1981) auditor independence model

we find evidence of a significant negative association between current GCM opinion decisions and

subsequent total fees received from the current audit client, providing further evidence that auditors

may also be interested in appeasing clients in the current period in order to maintain future revenue

streams.

As part of our robustness tests, we replicate the DeFond et al. (2002) and Geiger and Rama

(2003) studies and show that our divergent findings are due to differences in auditor reporting

decisions in the more recent time period, as well as our more stringent control sample. Specifically,

we find no evidence of a negative association between NAS fees and GCM opinions in the earlier

sample period using the DeFond et al. (2002) model and our control sample criteria, or using the

DeFond et al. (2002) model and control sample criteria during our 2004-2006 sample period. In

3
Prior researchers (e.g., DeFond et al. 2002; Fargher and Jiang 2008; Lim and Tan 2008; Robinson 2008) have identified
companies with either negative net income or negative cash flow from operations as distressed companies in deriving their
non-GCM control samples. We only consider companies that have both of these criteria to exhibit sufficient levels of
financial distress for their auditors to consider issuing them a GCM opinion. Satisfying these sample selection criteria restrict
our control sample to those financially stressed companies that would be most likely to be considered candidates for a GCM
opinion, but were nonetheless rendered an unmodified opinion.

7
 addition, using a matched pairs approach similar to Geiger and Rama (2003) we find a significant

negative association between NAS fees and GCM opinions in our post-SOX period of 2004-2006.

We also present several additional robustness tests that confirm the findings of our main analyses.

The remainder of the paper is organized as follows. Section 2 provides a brief background

and literature review and presents the study’s hypotheses. Section 3 discusses the research method.

Section 4 presents the main results and Section 5 presents robustness and additional tests in support

of our main findings. Section 6 concludes the paper with implications, limitations, and future

research suggestions.

2. Background, prior research and hypotheses

NAS fees, independence, and auditor going-concern judgments

The possible adverse effect of NAS fees on auditor independence, or on the appearance of auditor

independence, has long been an issue of concern for auditors, academicians, regulators, legislators,

and the investing public (Mautz and Sharaf 1961; Hylton 1964; US Senate 1976; AICPA 1978; Zeff

2003a, 2003b). At issue is whether the revenues obtained from the additional NAS service revenues

might create a heightened situation where the external auditor becomes too closely aligned with the

client and begins to lose a true sense of independence, which in-turn affects the auditor’s judgment.4

These concerns, arising even before SOX and the Enron and WorldCom financial frauds, led the

SEC to adopt a statute requiring public companies to disclose the amount and type of audit and NAS

fees paid to their auditor (SEC 2000a, 2000b). Then Congress, during the drafting of the SOX

legislation, concluded that significant NAS fees adversely impacted auditor independence, leading to

4
For a more detailed discussion of the relation between NAS fees and auditor’s going-concern opinion decisions see DeFond
et al. (2002), Geiger and Rama (2003), DeFond and Francis (2005) and Basioudis et al. (2008).

8
 SOX’s substantial restrictions on allowable NAS engagements for attest clients (U.S. House of

Representatives 2002; U.S. Senate 2002).

Mautz and Sharf (1961), DeAngelo (1981), Dye (1991), POB (1995), among other

commentators, argue that the economic tie between auditors and their clients that pay them directly

is fraught with difficulty, particularly in situations where effort and processes are not directly or

easily observable, and information asymmetry abounds. Such is the situation involving an external

audit and the resultant auditor’s opinion. Accordingly, prior research has examined the association

between NAS fees and various measures of auditor independence.5 Of relevance to our study is

prior research that has examined the association of NAS fees and the auditor’s reporting decisions in

the U.S.6 Since the decision regarding what type of audit report to render (GCM or not) to a client is

fully under the control of the auditor, Reynolds and Francis (2000), DeFond et al. (2002) and Lim

and Tan (2008) argue that it represents a direct assessment of auditor independence, and the possible

impairment of that independence associated with receiving NAS fees.

5
See Francis (2006) and Lim and Tan (2008) for expanded discussions of the research on NAS fees and various measures of
auditor independence. For example, considerable research has been performed on the association between NAS fees and the
levels of discretionary accounting accruals. A substantial disadvantage of assessing auditor independence by examining
client’s financial reporting practices is that auditors have only an indirect effect on the level of financial accruals reported by
their client.
6
The relation between NAS fees and auditor reporting behavior has also been previously examined in non-US reporting
contexts. For example, research has been performed in Australia where audit fee data have been publicly disclosed since
1980. However, the results are somewhat mixed. Wines (1994) presents evidence of a negative association between NAS fees
and the issuance of qualified reports during 1980-1989. Sharma (2001) and Sharma and Sidhu (2001) conclude that higher
NAS fees were associated with a lower likelihood of receiving GCM reports. In contrast, Barkess and Simnett (1994) and
Craswell (1999) in two large sample studies find no significant association between the level of NAS fees and Australian
audit report qualifications.
In a study on U.K. firms, Lennox (1999) examined NAS fees surrounding the initial fee disclosure requirements instituted
in 1991. His results suggest that NAS fees were not significantly associated with auditors rendering a GCM opinion. Yet,
Firth (2002) examined auditor decisions to issue qualified opinions in the U.K. and the relationship between all qualification
decisions (including going-concern qualifications) in the year 1996 and relative level of audit and NAS fees. He finds a
significant negative association between NAS fee levels and receiving a qualified opinion. Basioudis et al. (2008) examine
auditor reporting for 2003 and find that financially stressed companies with high audit fees were significantly more likely to
receive a GCM audit opinion, whereas companies with high NAS fees were significantly less likely to receive a GCM audit
opinion.

9
 In an early large sample study of audit and NAS fee disclosures and audit reporting

decisions, DeFond et al. (2002) examined U.S. firms’ initial release of audit and NAS fee

information for the 2000 reporting year and concluded that there is no significant association

between either audit fees or NAS fees and audit opinions on financially stressed companies. In

addition, they find no association when examining unexpected NAS fees or after controlling for

endogeneity of fees and audit opinions. A contemporaneous U.S. study by Geiger and Rama (2003)

also examined initial fee disclosures for a sample of 66 GCM companies and a matched sample of

66 similarly financially stressed, non-GCM companies. They conclude that audit fees were

positively associated with going-concern modifications, but that NAS fees were not significantly

associated with GCM decisions.

A later study by Lai (2009) also examined the association between NAS fees and GCM

opinions surrounding the initial fee disclosure requirement for the period June 30, 1999 to June 30,

2002. They find that audit firms were more likely to render a GCM opinion after audit and NAS fees

were publically disclosed. In addition, Callaghan et al. (2009) examined companies filing for

bankruptcy from January 1, 2001, to March 16, 2005, and the association of prior opinion type

(GCM or not) from the 2000 to 2004 reporting period. Their results do not indicate any association

between GCM opinions and levels of NAS fees, audit fees, nor the ratio of NAS fees to total fees.

Robinson (2008) examined the association between providing tax services, as part of the overall

NAS fees, and audit opinions for companies filing for bankruptcy from 2001 to 2004. Her results

also do not reveal any association between prior opinions and aggregate audit and NAS fees;

however, she does find a significant positive relation between the level of tax service fees (both fee

levels and the ratio of tax fees to total fees) and the likelihood of correctly issuing a GCM opinion

prior to bankruptcy. Lim and Tan (2008) examine NAS fees and GCM opinions in their broad

10
assessment of audit quality and find that industry specialist audit firms (defined as the firm auditing

the largest amount of industry revenues) are more likely to issue a GCM opinion when NAS fees are

high, and that NAS fees have no significant effect on GCM decisions of non-specialist audit firms.

Similar to Robinson (2008), they attribute their findings to knowledge spillovers for industry

specialist audit firms leading them to be more likely to issue an appropriate GCM opinion to a

financially troubled client. Thus, the extant research in the U.S. has generally not found a significant

overall negative association between aggregate NAS fees and auditor’s reporting decisions on

distressed clients. In fact, the only studies finding any significant association between NAS fees and

GCM decisions find a positive association for specific subsets of firms or type of NAS fees.

In addition, several studies suggest that auditor reporting in the face of NAS fees may have

changed in the more recent post-SOX years. For example, Ghosh and Pawlewicz (2009) present

evidence that post-SOX levels of audit fees are significantly higher and levels of NAS fees are

significantly lower than pre-SOX levels. The effect of these new fee levels on audit decision-making

has not yet been adequately examined. The general reduction in overall NAS fees received from

clients in the post-SOX environment could exert less influence on auditor decision-making due

simply to the lower magnitude of fees reducing the economic tie between the firm and that audit

client. In contrast, however, reducing the allowable types of NAS services auditors can provide attest

clients may produce greater threats to independence. This is due to the audit firm’s possible desire to

retain all the NAS fees available from clients due to the scarcity of allowable NAS services, as well

as the possible reduction in clients offering these revenue opportunities to their external auditor

(Ghosh and Pawlewicz 2009).

Further, Fargher and Jiang (2008) and Feldmann and Read (2010) both demonstrate that

auditor GCM reporting decisions may have changed in the post-SOX period. Specifically, Fargher

11
and Jiang (2008) examine GCM reporting in Australia, and Feldmann and Read (2010) examine

GCM reporting on U.S. firms and they both conclude that audit firms were initially more

conservative and issued GCM opinions with greater frequency right after the enactment of SOX, but

then in years after 2003 appear to have reversed their reporting postures and become less

conservative in the subsequent post-SOX years. Thus, it remains an empirical question as to whether

the prior research results on the relation between NAS fees and GCM reporting surrounding the

initial fee disclosures hold true in the later post-SOX auditing and reporting environment in the U.S.

In order to determine whether the results of prior U.S. studies, most notably DeFond et al.

(2002) and Geiger and Rama (2003), persist in the more recent post-SOX auditing environment, we

examine the association of NAS fees and the possible impairment to auditor independence by

assessing whether auditors’ report more favorably on distressed clients from whom they receive

higher current NAS fees. Thus, our first research hypothesis (in the alternate form):

H1: There is a negative association between opinions modified for going concern and the
magnitude of current year non-audit service fees paid to the audit firm.

Audit fees and GCM reporting

In addition to the concern surrounding NAS fees, several authors have noted that it is not just the

“extra” NAS fees that could impair independence but the receipt of all fees that poses a threat to the

auditor’s ability to remain independent (Mautz and Sharaf 1961; SEC 2000a; Kinney and Libby

2002; Carcello 2005). Since auditors receive all fees directly from their clients, the receipt of any

fee (audit or NAS) has the potential to impair auditor independence. For example, DeAngelo (1981),

Simunic (1984) and Beck et al. (1988) all model the economic tie between auditors and their clients

as a combination of all service fees received, not just NAS fees. The receipt of any fee, regardless of

type, increases the auditor-client economic bond.

12
 Further, since clients pay all fees directly to their audit firms, examining one type of audit fee

necessitates the examination of all fees paid to the audit firm. Accordingly, prior researchers and

regulators (Abdel-khalik, 1990; SEC 2000b; DeFond et al. 2002; Firth 2002; Whisenant,

Sankaraguruswamy, and Raghunandan 2003; Basioudis et al. 2008) have argued that examining the

magnitude or impact of NAS fees cannot be properly accomplished without also concurrently

assessing the level of audit service fees paid by clients.

Therefore, we also examine the association between current audit service fees and auditor

reporting decisions. Based on prior audit fee and audit reporting research we expect a positive

association between current audit service fees and GCM reporting decisions (Simunic 1980; Francis

1984; Geiger and Rama 2003; Basioudis et al. 2008). This is because companies that receive a

GCM opinion from their auditor typically require additional audit work throughout the current audit

engagement in order for the audit firm to support the report modification decision to the client

company (Kida 1980). Thus, our second hypothesis (in the alternate form):

H2: There is a positive association between opinions modified for going concern and the
magnitude of current year audit service fees paid to the audit firm.

Subsequent fees and GCM reporting

As noted above, prior research has examined the effect of current year fees on current year audit

reporting decisions, yet the empirical effect of possible future fee revenues (or the loss of these fees)

on current audit reporting decisions remains largely unaddressed.7 Consistent with the arguments in

Mautz and Sharaf (1961), DeAngelo (1981) and Beck et al. (1988) perform analytical examinations

7
In a time-related study, Cahan, Emanuel, Hay, and Wong (2008) examined the association of NAS fee changes and length
of years NAS fees were purchased from the auditor leading up to the reporting year and compare these with levels of the
client’s reported discretionary accruals in New Zealand. They find that, overall, discretionary accruals levels were not
significantly related to growth rates in NAS fees leading up to the reporting year, nor were they related to the length of time
the client purchased NAS services prior to the reporting year. However, they do find some evidence that the interaction of
NAS fee duration and client importance measures are positively related to discretionary accruals.

13
 of audit fees and the economic bonding between the auditor and their client and suggest that the

retention of future fees is a significant impediment to independence that may impair current auditor

decision-making.

In this context, DeAngelo (1981) defines the auditor’s economic interest with respect to their

existing client as a future “quasi-rent” stream in which quasi-rents represent the present value of

future revenues (less costs) over the expected duration of an auditor-client relationship. These future

net revenues include both audit service revenues and NAS revenues generated by having the

company as an ongoing audit client. Accordingly, all fee retention efforts can negatively impact

auditor decision-making (AICPA 1978; Levitt 2000), and auditors who perform NAS for audit

clients have an added economic incentive beyond the audit fee revenues. Thus, the expectation of

future audit and NAS fees, and any increased effort on the part of auditors in attempting to ensure

these revenue streams, may influence judgments made on current audit engagements. In an audit

reporting context, this would result in auditors not issuing GCM opinions to their financially

distressed clients who would otherwise receive a GCM opinion in hopes of retaining their incumbent

status, and therefore ensure future revenue streams from these clients.8

Prior research in economics and psychology has also demonstrated that expectations of future

benefits are significant motivators of current decision-making (Loewenstein 1987; Tversky and

Kahneman 1991; George and Jones 2000; Frederick, Loewenstein, and O’Donoghue 2002). In fact,

the expectation of future benefits can outweigh one’s present position as a motivator for current

decision-making (Nuttin 1985). Research also reveals that expectations of future benefits are

8
In contrast, there is also an economic incentive for auditors to issue GCM opinions to financially troubled clients. Indicating
the auditor’s substantial doubt with respect to the client’s continued viability in their audit opinion helps insulate the auditor
from litigation losses in case the client company fails and files for bankruptcy. Carcello and Palmrose (1994) find that in
bankruptcy litigation cases against audit firms, those firms that rendered GCM opinions to clients before bankruptcy filing
had significantly lower frequency and magnitude of payouts than those that did not render a GCM opinion prior to
bankruptcy filing.

14
 typically disproportionately discounted so that the expectation of more immediate benefits have the

greatest impact on current decision-making (Rappaport 1990; Chapman 1996, 2000; Ebert 2010).

Thus, the link between current GCM decision-making and expected future revenues may be stronger

in the more immediate subsequent periods than for lengthy periods into the future.

Accordingly, we examine the association between current reporting decisions and

subsequent revenues as an additional test of the influence of total fees on auditor decision-making

(DeAngelo 1981; Gul, Tsui, and Dhaliwal 2006).9 To the extent that current expectations of

subsequent fee revenues are reflected in actual future fees, we assess the possible impairment of

auditor independence by examining the relation between future fees received from the audit client

and current GCM reporting decisions. Consistent with the arguments of DeAngelo (1981), Beck et

al. (1988), Gul et al. (2006) and Lai (2009), we expect a negative association between GCM opinion

decisions and total fees received in future years. This is because the audit firm has incentive to try to

retain the client into the future in order to obtain all possible subsequent revenues, not just NAS or

audit service revenues individually. Thus, our third hypothesis (in the alternate form):

H3: There is a negative association between opinions modified for going concern and the
magnitude of subsequent fees paid to the incumbent audit firm.

3. Research method

Sample

Using the Audit Analytics database, we first identify firms that received a GCM audit opinion in the

years 2004-2006. We start with the year 2004 based on prior research regarding the shift in auditor

9
The link between fees and auditor independence in the GCM decision assumes that some situations exist where the auditor
might otherwise conservatively modify the audit opinion, but does not because of independence threats. This line of research,
and all research relating going-concern opinions to auditor independence, assumes that the auditor has potential financial gain
from not modifying an audit opinion. This is potentially not true if the client subsequently fails in the next year and therefore
pays no future fees. However, auditors do not modify opinions solely to indicate expected client failure. In fact, prior
research has found that between 80 – 90 percent of companies receiving a GCM opinion do not fail in the subsequent year
(Altman 1968; Nogler 1995). Thus, expressing substantial doubt does not mean that the auditor would uniformly expect no
future fees from a client.

15
 reporting decisions after SOX (Fargher and Jiang 2008; Feldmann and Read 2010) and end in 2006

in order to allow a sufficient number of years for the subsequent fees analysis. In addition, our

examination period represents a relatively stable economic period in the U.S., after the turmoil of the

large financial frauds surrounding SOX, and prior to the economic downturn and financial crisis

beginning near the end of 2007. Consistent with prior research, we restrict our analysis to companies

that received a first-time GCM because issuing a modified opinion in subsequent years is less risky

for the auditor and constitutes a different decision model that may not include the perceived risk of

losing a disgruntled client (Geiger, Raghunandan, and Rama 1998; DeFond et al. 2002; Carcello and

Neal 2003).

We then obtain our distressed non-GCM firms by identifying firms in Compustat with year

ends from 2004-2006 that had both negative income and cash flows from operations in the same year

but did not receive a GCM opinion from their auditor. Following the arguments in Callaghan et al.

(2009), requiring our distressed control firms to exhibit both of these financial stress criteria in the

same fiscal year more appropriately restricts our control sample to those firms that are most likely to

be considered for a GCM opinion by their auditors.10 Our selection procedure, while more

restrictive than prior studies (e.g., Mutchler, Hopwood, and McKeown 1997; DeFond et al. 2002)

provides a more representative control sample of highly financially distressed non-GCM firms for

which auditors must exercise professional judgment regarding a GCM opinion decision. Thus, we

believe our selection procedures for the control sample enables us to conduct a more rigorous,

focused and appropriate examination of auditor’s GCM opinion decisions.

Consistent with prior going concern reporting studies (Behn, Kaplan, and Krumwiede 2001;

10
For example, McKeown, Mutchler, and Hopwood (1991) and Hopwood, McKeown, and Mutchler (1994) classify a
company as being financially distressed if one of four financial stress signals were exhibited in the fiscal year of the audit
opinion being examined or in the preceding two years. DeFond et al. (2002) require a firm to exhibit either negative income
or negative cash flows from operations to be included in their distressed non-GCM control sample.

16
 Blay and Geiger 2001; Carcello and Neal 2003; Geiger and Rama 2003), we restricted our analysis

to companies in the manufacturing sector (SIC 20 to 39) to eliminate confounding industry effects

and to keep the financial ratios consistent with the development of the financial stress models we

employ. We then require firms to have complete audit report, audit firm and fee information for the

current year available in the Audit Analytics database, as well as all necessary financial and share

price data available in the Compustat and CRSP databases. Results of our screening and data

requirements yielded 1,479 observations: 180 companies receiving a first-time going-concern

modified audit opinion (the GCM sample), and 1,299 distressed companies that did not receive a

going-concern modified opinion (the non-GCM sample). Among the observations are 854 unique

firms. Of the non-GCM sample, 362 firms appear more than once in the analysis. Of the GCM

sample, 71 firms received a clean opinion in at least one other year in the sample period. No firms

appear in the GCM sample more than once because we include only first-time GCM observations.

Because observations for specific firms could be included in the sample more than once, all p-values

presented in multivariate models control for firm-clustered error terms.

Research model

Following prior research by DeFond et al. (2002), Cahan et al. (2008) and Callaghan et al. (2009) we

test our hypotheses by estimating the coefficients in the following logistic regression that models the

auditor's probability of issuing a going concern modified audit opinion to a financially distressed

client:11,12

11
We also include yearly dummy variables (not reported in the model specifications or in the tables) for the models estimated
in the paper in order to control for any differences among the years in our examination period.
12
We primarily use the DeFond et al. (2002) model in our main analyses for comparability to prior research that found no
significant relation between NAS fees and GCM opinions. In sensitivity testing, we apply other models to demonstrate the
robustness of our findings.

17
 OPINION = β0 + β1 (SIZE) + β2 (PROBANKZ)) + β3 (AGE) + β4 (BETA)
+ β5 (RETURN) + β6 (VOLATILITY) + β7 (LEV) + β8 (PLOSS)
+ β9 (ROA) + β10 (INVESTMENTS) + β11 (CFFO)
+ β12 (ISSUE_DEBT) + β13 (ISSUE_EQUITY) + β14 (SELL_ASSETS)
+ β15 (DISC_OPER) + β16 (BIG4) + β17 (REPORTLAG)
+ β18 (DFT) + β19 (log (TOTAL_FEE)) + β20 (log (AUDIT_FEE))
+ β21 (log (NAS_FEE)) + β22 (log (FEERATIO))
+ β23 (log (FUTURE_FEES)) + ε (1)

where:
OPINION = an indicator variable equal to 1 for firms with going concern modified
opinions, 0 otherwise
SIZE = natural logarithm of total assets at the end of the year measured in
millions of dollars
PROBANKZ = probability of bankruptcy score from Zmijewski (1984)
AGE = natural logarithm of the number of years the company has been listed
on a stock exchange
BETA = the firm's beta estimated using a market model over the fiscal year
RETURN = the firm's stock return over the fiscal year
VOLATILITY = the variance of the residual from the market model over the fiscal year
LEV = total liabilities over total assets at the end of the fiscal year
PLOSS = an indicator variable equal to 1 if the firm reports a bottom-line loss
in the previous year, 0 otherwise
ROA = return on total assets at the end of the year
INVESTMENTS = short- and long-term investment securities (including cash and cash
equivalents) deflated by total assets at year-end
CFFO = cash flows from operations deflated by total assets at the end of the year
ISSUE_DEBT = an indicator variable equal to 1 when the firm issues new debt during the
year, 0 otherwise
ISSUE_EQUITY = an indicator variable equal to 1 when the firm issues new equity during
the year, 0 otherwise
SELL_ASSETS = an indicator variable equal to 1 when the firm sells fixed assets during
the year, 0 otherwise
DISC_OPER = an indicator variable equal to 1 when the firm indicates a discontinued
operation in the current year, 0 otherwise
BIG4 = an indicator variable equal to 1 when the auditor is a member of the
Big 4, 0 otherwise
REPORTLAG = number of days between fiscal year-end and the audit report date
DFT = an indicator variable equal to 1 when the firm is in default on debt, 0
otherwise

18
log (TOTAL_FEE)= the natural logarithm of the total fees paid to the incumbent auditor
log (AUDIT_FEE) = the natural logarithm of the audit fees paid to the incumbent auditor
log (NAS_FEE) = the natural logarithm of the non-audit fees paid to the incumbent auditor
FEERATIO = the ratio of non-audit fees to total fees paid to the incumbent auditor
log (FUTURE_FEES)= the natural logarithm of the total fees paid to the incumbent auditor in
the subsequent two years

Variables of interest
In the model above, the last five variables—log (TOTAL_FEE), log (AUDIT_ FEE), log (NAS_FEE),

FEERATIO, and log (FUTURE_FEES) — are our variables of interest and are added to the model in

various combinations to test our hypotheses. If NAS fees impair auditor independence, we expect a

negative coefficient on log (NAS_FEE) and on FEERATIO. However, based on prior research we

expect a positive association between GCM opinions and log (AUDIT_FEE). Since these two fee

components are expected to have opposite signs, we cannot offer an a priori expectation of the

direction of association between GCM opinions and the total fees received in the current year by the

auditor.

In our third hypothesis we examine the association of current GCM decisions and the fees

received by incumbent auditors in subsequent years (FUTURE_FEES). Prior research suggests that

individuals put a heavily disproportionate weight on expected benefits in the immediate future

compared to expected benefits to be received at later times (Chapman 2000; Frederick et al. 2002;

Elbert 2010). The disproportionate discounting of expected future benefits, especially for benefits

expected beyond the very near term, is referred to as “temporal discounting.” Temporal discounting

is the cognitive bias to drastically discount, much more than any rational expectations of discounting

would dictate, the expected future benefits that are not anticipated to be received in the very

immediate future (Chapman 1996; 2000). Temporal discounting bias goes far beyond both

individual preferences for present or immediate reward (i.e., gratification), as well as the uncertainty

of the attainment of the benefits in the future (Frederick et al. 2002). Accordingly, for our main

19
analyses we use a relatively short subsequent fee period of two years. We then report results for

varying subsequent time periods in our later analyses.

Additional control variables

Following prior research our model includes controls for both contributing and mitigating

factors found to be related to auditor GCM report decisions (e.g., Mutchler et al. 1997; Reynolds and

Francis 2000; Behn et al. 2001; DeFond et al. 2002; Hay et al. 2006; Callaghan et al. 2009). As

noted in SAS No. 59, level of financial distress is an important factor in the auditor’s decision, and

although we have tried to include only highly stressed companies in our samples, we provide

additional control for financial distress by including the probability of bankruptcy in our model.

PROBANKZ is the probability of bankruptcy score from Zmijewski (1984), with higher values

indicating a higher probability of bankruptcy. The log (AGE) variable is also included because

younger firms are more prone to failure (Dopuch, Holthausen, and Leftwich 1987; DeFond et al.

2002). We include three additional market-based measures, RETURN, BETA, and VOLATILITY.

RETURN, the stock price return over the fiscal year, and BETA, the systematic risk of the firm's

stock return, are expected to be negatively associated with GCM opinions. VOLATILITY, the return

volatility exhibited by the firm’s stock over the fiscal year, is expected to be positively associated

with GCM opinions. Other contributing factors in our model include LEV and PLOSS because firms

with higher leverage and those that have reported net losses in the past are more likely to receive a

going concern modified report (Kida 1980; Reynolds and Francis 2000). We include CFFO

(operating cash flows divided by total assets) because poor operating cash flows are often associated

with the probability of bankruptcy, and the Zmijewski (1984) bankruptcy score does not include a

cash flow measure.

20
 In addition, the model includes several additional factors that are likely to mitigate the

probability of receiving a going concern opinion. The SIZE variable, measured as log (assets) at the

end of the year, is included because large firms have more negotiating power in the event of

financial difficulties and hence are more likely to avoid bankruptcy (Reynolds and Francis 2000).

We include ROA because more profitable firms are less likely to receive GCM opinions. The

variable INVESTMENTS is included because firms with large cash and investment securities have

more resources to rely on in the event of financial difficulties (De Fond et al. 2002). We also

include separate variables for ISSUE_DEBT, ISSUE_EQUITY and SELL_ASSETS because firms that

are able to raise additional funding during the year from increased borrowing, issuing stock (public

or private), or selling assets or operating units are less likely to receive a GCM opinion from their

auditor (Mutchler et al. 1997; Behn et al. 2001; Geiger and Rama 2003), and we expect a negative

coefficient on these factors.13 Similarly, we include an indicator variable for whether the firm

discloses a discontinued operation during the reporting year. We expect a negative association

between DISC_OPER because these firms have both modified their former firm strategy (Behn et al.

2001) as well as have additional resources to sustain their ongoing operations (Mutchler et al. 1997).

We also include the indicator variable BIG4 because prior research argues that Big 4 auditors are

more likely to issue going concern audit opinions to stressed companies (Mutchler et al. 1997). We

include REPORTLAG because audits of financially troubled companies are often more time-

consuming and going concern modifications have been found to be associated with longer audit

reporting lags (Chen and Church 1992; Behn et al. 2001; Geiger et al. 2005). Finally, expanding the

DeFond et al. (2002) model, we include DFT in our model because clients in default on debt are

13
We use a change of 10% in each of these balance sheet components for the reporting year as indicators of raising additional
funds through selling assets, equity or increased borrowing.

21
 most likely to receive going-concern modifications (Chen and Church 1992; Geiger and Rama 2003;

Robinson 2008; Menon and Williams 2010).

4. Results

Descriptive Statistics

Table 1 presents the descriptive statistics for our full sample of 1,479 firms on the variables used in

the going concern model in both equation (1) and other models presented later, as well as a

comparison of variable means between the GCM and non-GCM sub-samples in the second panel.14

The last five rows present the measures of audit and NAS fees used in our current and subsequent

year analyses. Our sample firms have an overall smaller mean FEERATIO at 0.15 than those

examined in DeFond et al. (2002) having a mean FEERATIO of 0.49. This decrease in proportionate

NAS fees is indicative of SOX limiting the amount of NAS fees that can be provided to audit clients,

and is consistent with prior research on the reduction in NAS fees post-SOX (Ghosh and Pawlewicz

2009).

--INSERT TABLE 1 HERE --

Overall, the firms in our study have a mean total assets of $217.53 million, which is larger

than the firms examined in Geiger and Rama (2003) of $118 and smaller than those in DeFond et al.

(2002) of $813 million. In addition, the mean PROBANKZ for our firms is 0.70, which is very

similar to the firms examined in Geiger and Rama (2003) of 0.70, but is substantially higher than for

the firms examined in DeFond et al. (2002) of 0.22. This high mean PROBANKZ suggests that our

sample selection procedures have identified firms that are most likely to be considered for a possible

GCM opinion by their audit firm. The remaining control variable means for our overall sample are

14
All continuous variables are winsorized at the 1 and 99 percent levels.

22
 similar to those reported in prior studies on financially distressed firms and GCM opinion recipients

(DeFond et al. 2002; Geiger and Rama 2003; Callaghan et al. 2009).

The second panel in Table 1 presents an examination of the mean differences between the 180

GCM firms and the 1299 non-GCM firms. With respect to our fee measures, we find that non-GCM

firms have higher mean NAS_FEE and FEERATIO levels in the current year (p-value = .06 and .02,

respectively). However the levels of TOTAL_FEE, AUDIT_FEE, and FUTURE_FEES are not

significantly different between the two groups. In addition, as expected, we find that GCM firms on

average have higher stock price declines, volatility, leverage, reporting lags, and are more likely in

default on their debt; and on average have lower betas, fewer investments, less cash flow from

operations, issue equity less often and are less likely to have a Big 4 audit firm. Of particular note,

however, is the similarity between the GCM firms and the non-GCM firms in terms of SIZE, AGE,

PLOSS, ROA, and PROBANKZ. These univariate results reinforce the efficacy of our sample

selection procedures in identifying an equivalent control sample of non-GCM firms in terms of size,

age, profitability, and financial stress that appear most likely to be considered by their auditor for a

GCM opinion. Table 2 presents the Pearson correlation matrix for the variables used in the study.15

--INSERT TABLE 2 HERE --

Multivariate analyses

GCM opinions and current year fees – tests of H1 and H2

Table 3 presents the results of estimating the logistic model in equation (1) using current year fee

measures to test our first two hypotheses. Following DeFond et al. (2002), model 1 presents a

baseline case of our going concern model without including any of the fee variables, and models 2-5

15
Tests for multicollinearity on all multivariate models indicate that variance inflation factors (VIF) never exceed 10, and in
most cases are less than 2. Therefore, multicollinearity does not appear to be a significant problem in any of our models.

23
 sequentially introduce various combinations of our fee variables. Model 3 simultaneously tests both

of our first two hypotheses by including log (NAS_FEE) and log (AUDIT_FEE) in the model.

--INSERT TABLE 3 HERE --

The results indicate that model 1 does a reasonably good job of explaining the going concern

decision. The pseudo R2 is 30 %, and we find significance in the predicted direction at p-value < .10

for the coefficients on SIZE, VOLATIVITY, LEV, INVESTMENTS, CFFO, ISSUE_EQUITY,

REPORTLAG, and DFT.16 Similar to prior research, we do not find significance in the predicted

direction for the coefficients on AGE, BETA, ISSUE_DEBT, SELL_ASSETS, and DISC_OPER

(Dopuch et al. 1987; DeFond et al. 2002; Callaghan et al. 2009). Also of note is our lack of

significance on the PROBANKZ variable, further reinforcing that our sample selection procedures

provided a similarly distressed sample of non-GCM control firms in comparison to our GCM sample

firms.

Models 2-5 introduce the following combinations of our fee ratios to the model: log

(TOTAL_FEE) alone, both log (AUDIT_FEE) and log (NAS_FEE), FEERATIO alone, and both log

(TOTAL_FEE) and FEERATIO, respectively. The results of model 2 examining the association

between OPINION and log (TOTAL_FEE) indicates that there is no significant overall association

between total fees paid in the current year and GCM opinion decisions (p-value > .10). These

findings with respect to total fees are similar to those of DeFond et al. (2002).17

However, a very different picture emerges once we separate the current year’s audit service

fees and NAS fees. The results of model 3 examining the association between OPINION and both

log (AUDIT_FEE) and log (NAS_FEE) indicates that there is no significant positive association

16
All p-values reported in the paper are based on two-tailed tests.
17
Geiger and Rama (2003) present an examination of audit fees and NAS fees separately, but did not examine the combined
total fees paid to the auditor.

24
 between GCM opinions and audit fees (p-value = .31), however we do find a significant negative

association between NAS fees and receipt of a GCM opinion (p-value = .04). While these NAS fee

results are consistent with our hypotheses, they are in stark contrast to those of prior researchers

examining earlier audit and NAS fee disclosures in the U.S. (DeFond et al. 2002; Geiger and Rama

2003; Callaghan et al. 2009). Our analysis reveals a significant reduction in the probability of

receiving a GCM opinion when NAS service fees are high.

Our significant NAS fee findings are also echoed in our NAS fee ratio analyses. In models 4

and 5 we assess the FEERATIO, representing the proportion of NAS fees to total fees paid to the

company’s auditor in the current year.18 Results of the model 4 regression indicate that the higher

the FEERATIO, the lower the probability of receiving a GCM opinion (p-value = .01). Further,

model 5 results indicate that the FEERATIO results hold (p-value = .01) even after controlling for

the level of total fees, which again is positive but not significant in this expanded regression (p-value

= .68).

Similar to the findings in DeFond et al. (2002), our results provide no support for Hypothesis

2 with respect for audit service fees. However, in contrast to DeFond et al. (2002) and Geiger and

Rama (2003) we find strong and consistent support for Hypothesis 1 with respect to current year

NAS fees and auditor reporting decisions. Unlike earlier research, we find a significant negative

association between NAS fee levels and the receipt of a GCM opinion in the more recent U.S.

reporting environment of 2004-2006.

GCM opinions and subsequent fees – tests of H3

18
Examining the ratio of NAS fees to audit service fees, or the ratio of the log (NAS_FEE) to the log (TOTAL_FEE), or the
ratio of the log (NAS_FEE) to the log (AUDIT_FEE) produces similar results to those presented in the paper for FEERATIO.

25
In order to examine our third hypothesis with respect to the relation between current reporting

decisions and fees received in subsequent years, we analyze the sum of total fees received by the

incumbent auditor for the two years immediately after the current year. We eliminate ten firms (8

GCM firms and 2 non-GCM firms) from the subsequent fees analysis because they filed for

bankruptcy in the subsequent year and, accordingly, did not remain viable for at least one subsequent

year.

Table 3, Model 6 presents the results of estimating the logistic model in equation (1) using

our subsequent fee measure (FUTURE_FEES) to test the third hypothesis. The results presented in

Table 3 indicate a marginal negative association between current year auditor GCM reporting

decisions and subsequent fees collected by the incumbent auditor (p-value = .08). These results

provide some support for Hypothesis 3, as well as for DeAngelo’s (1981) model of auditor

independence.

To assess whether our subsequent fee results are sensitive to the length of the subsequent fee

period assessed (i.e. two years), we examine varying lengths of time for the subsequent fee period.

Specifically, when we expand our subsequent fee examination period to three years, four years, or all

available years of subsequent fees through fiscal year 2010, we obtain results consistent with those

presented. In each of these analyses we continue to find a significant negative association between

subsequent total fees received by the auditor and current GCM opinions (p-value < .10). In addition,

examining only the fees in the next year, or taking a present value of future fees by using a .10

discount rate (similar to DeAngelo (1981) for each of the subsequent periods assessed (i.e., two

years, three years, four years, and all available years) produces substantively the same results as

reported. Further, we do not find any association if we analyze audit and non-audit fees separately,

26
indicating that it is the summation of all future fees that is associated with current GCM opinion

decisions.

Controlling for expected fees

As noted by DeFond et al. (2002) and Callaghan et al. (2009), a potential limitation of the analysis in

Table 3 is that auditor independence may be influenced by the amount of client fees relative to their

expected amounts, rather than the nominal amounts. As such, auditors may be influenced by whether

the client is a source of unusually high or low NAS and audit service fees. Therefore, following prior

research, we model audit and NAS fees in order to develop an expected fee level that will then

enable us to calculate the “unexpected” portion of fees paid by our sample companies to their audit

firms. Specifically, we draw on the work of Simunic (1980), Beck et al. (1988), Craswell, Francis,

and Taylor (1995), DeFond et al. (2002), Frankel, Johnson, and Nelson (2002), Whisenant et al.

(2003) and Hay et al. (2006) to identify variables explaining audit service fees and NAS fees.

Drawing on these sources, and considering additional variables that we expect may be important fee

determinants in more recent periods, we estimate the following models for audit fees and NAS fees,

respectively:

log (AUDIT_ FEE) = β0 + β1 (SIZE) + β2 (PROBANKZ)) + β3 (AGE) + β4 (RETURN)

+ β5 (VOLATILITY) + β6 (LEV) + β7 (PLOSS) + β8 (ROA)
+ β9 (INVESTMENTS) + β10 (ISSUE_DEBT) + β11 (ISSUE_EQUITY)
+ β12 (SELL_ASSETS) + β13 (DISC_OPER) + β14 (BIG4)
+ β15 (REPORTLAG) + β16 (BM) + β17 (RESTATE) + β18 (INVRECRATIO)
+ β19 (SEGNUM) + β20 sqrt (EMPLOYEES) + β21 (PENSION)
+ β22 (FORGN) + β23 (BADCONTROLS) + ε (2)

log (NAS_ FEE) = β0 + β1 (SIZE) + β2 (PROBANKZ)) + β3 (AGE) + β4 (RETURN)

27
 + β5 (LEV) + β6 (PLOSS) + β7 (ROA) + β8 (INVESTMENTS)
+ β9 (ISSUE_DEBT) + β10 (ISSUE_EQUITY) + β11 (SELL_ASSETS)
+ β12 (DISC_OPER) + β13 (BIG4) + β14 (BM) + β15 (RESTATE)
+ β16 (INVRECRATIO) + β17 (SEGNUM) + β18 sqrt (EMPLOYEES)
+ β19 (PENSION) + β20 (FORGN) + β21 (ACCEL_FILER)
+ β22 (ACQ) + ε (3)
where the new variables in equation (2) and (3) are defined as:

BM = book value of equity divided by the market value of equity at the end of
the year
RESTATE = an indicator variable equal to 1 when the firm announces or restates
prior financial information during the year, 0 otherwise
INVRECRATIO = inventory plus accounts receivable divided by total assets at the end of
the year
SEGNUM = number of reported business segments
sqrt(EMPLOYEES)= square root of the number of employees employed by the company
PENSION = an indicator variable equal to 1 if the firm offered an employee pension
or post-retirement plan, 0 otherwise
FORGN = an indicator variable equal to 1 if the firm had foreign operations during
the year, 0 otherwise
BADCONTROLS = an indicator variable equal to 1 if the firm reported an internal control
weakness (SOX 404 or 302) during the year, 0 otherwise
ACCEL_FILER = an indicator variable equal to 1 if the firm was an accelerated filer, 0
otherwise
ACQ = an indicator variable equal to 1 if the firm acquired another company
during the year, 0 otherwise

All other variables are as described in equation (1).

The model of audit service fees in equation (2) is estimated with log (AUDIT_ FEE) as the

dependent variable. The model of NAS fees in equation (3) is estimated with log (NAS_FEE) as the

dependent variable. Following DeFond et al. (2002), equation (3) is also used to explain FEERATIO

because FEERATIO is a scaled measure of NAS fees. The independent variables in equations (2) and

(3) are then combined to estimate log (TOTAL_FEE). The coefficients based on these models are

shown in Table 4. The results indicate that each of the models has reasonable explanatory power,

28
with adjusted R2s ranging from 5% to 74%, with FEERATIO having the lowest R2, and with the vast

majority of the fee variables having significant coefficients in the expected direction for one or more

of the fee models.

--INSERT TABLE 4 HERE --

Following prior research we use the error terms from the fee models in Table 3 to proxy for

the unexpected levels of fees paid to the company’s auditor. We then replace the fee variables used

in Table 3 with the unexpected fee variables and repeat the analyses. The resulting regressions are

presented in Table 5. Again, model 1 in Table 5 is a benchmark analysis identical to model 1 in

Table 3, and models 2-5 again introduce various combinations of the unexpected fee variables.

Consistent with our earlier results, we find that log of unexpected (TOTAL_FEE) is not significantly

associated with OPINION (p-value = .52). We also find that log of unexpected (AUDIT_FEE) is not

significantly associated with OPINION (p-value = .92). However, consistent with the earlier results

reported in Table 3 we continue to find that log of unexpected (NAS_FEE) and the unexpected

FEERATIO are significantly negatively associated with OPINION (p-value = .03 and .02,

respectively). Model 5 adds an additional control for log of unexpected (TOTAL_FEE) to the

unexpected FEERATIO model and the results indicate that the unexpected FEERATIO results remain

negative and significant (p-value = .02). These unexpected fee results present consistent additional

evidence in support of a negative association between current levels of NAS fees and auditor GCM

opinion decisions.

--INSERT TABLE 5 HERE --

Controlling for endogeneity

As noted by DeFond et al. (2002) and Geiger and Rama (2003), a potential limitation to our findings

is that going concern opinions, audit fees, and NAS fees may be endogenous. For example,

29
Whisenant et al. (2003) show that audit fees and NAS fees are endogenously determined. In

addition, all of our fee variables (except for our measure of total fees) involve audit and NAS fees

together in some combination. Thus, in the presence of endogeneity, it may be difficult to

unambiguously interpret the results of our models that use the FEERATIO, or those that use the log

(AUDIT_FEE) and log (NAS_FEE) together. Accordingly, following prior research, and because

joint estimation of a simultaneous system of equations with one or more dichotomous dependent

variables (e.g., GCM decisions) is problematic, we implement a two-stage procedure recommended

by Woolridge (2000). We employ a system of three structural models: one for each of our three

endogenous variables — OPINION, log (AUDIT_FEE) and log (NAS_FEE) — where each is a

function of the other two and select exogenous variables. Specifically, the three models are as

follows: (1) we model OPINION using all independent variables in equation (1) and include log

(AUDIT_FEE) and log (NAS_FEE) as endogenous independent variables, (2) we model log

(AUDIT_FEE) using all independent variables in equation (2) and include OPINION and log

(NAS_FEE) as endogenous independent variables, and (3) we model log (NAS_FEE) using all

independent variables in equation (3) and include OPINION and log (AUDIT_FEE) as endogenous

independent variables.

In the first stage, we model each of our three endogenous variables as a function of all of the

exogenous variables in the system (reduced-form models). We use ordinary least squares regressions

to estimate the two fee models and a probit regression to estimate the going concern model because

the simultaneous system requires normally distributed residuals. In the second stage we estimate the

structural models after replacing each endogenous explanatory variable with the predicted value

from the first stage, which we term GCHAT, AUDHAT, and NASHAT. We then employ the "omitted

variables" variant of the Hausman (1978) test to check for the presence of endogeneity (Hausman

30
1978; Woolridge 2000) and find that OPINION, log (AUDIT_FEE) and log (NAS_FEE) are

endogenous in all three models (p-value < .01), providing evidence that OPINION, log

(AUDIT_FEE) and log (NAS_FEE) are jointly determined for our samples of distressed firms.

Accordingly, in order to control for the presence of endogeneity we re-estimate our three

second-stage structural regressions replacing the endogenous independent variables with our fitted

variables - GCHAT, AUDHAT, and NASHAT. Table 6 reports the results of these revised regressions.

The first regression in the table presents the results of estimating the OPINION model and the next

two regressions present the results of estimating the log (AUDIT_FEE) and log (NAS_FEE) fee

regressions using the fitted endogenous variables. Our main concern is with the possible effect of

endogeneity on OPINION in the first regression. Results of the OPINION regression indicate that the

coefficients on AUDHAT and NASHAT retain their positive and negative signs, respectively, and

actually become statistically stronger in this regression (p-value < .00) in comparison to the results

presented in Table 3. Thus, after controlling for potential simultaneity bias induced by endogeneity,

we find a significant positive association between audit fees and GCM opinions, and even stronger

results for the negative association between NAS fees and GCM opinions, providing support for

both Hypothesis 1 and Hypothesis 2.

--INSERT TABLE 6 HERE –

5. Robustness and additional tests

Replication of and comparison to DeFond et al. (2002)

In order to assess whether our results are due to the time period examined and not to methodological

differences between our study and that of prior researchers, particularly with DeFond et al. (2002),

we replicate their study as follows. First, following their sample selection criteria we identify all

firms in Compustat for fiscal 2000 with either negative net income or negative cash flow from

31
 operations that have all necessary data available in Compustat, CRSP and AuditAnalytics. This

process yielded 113 first-time GCM recipient firms and 1,328 distressed non-GCM firms. Although

this sample is slightly larger, it compares favorably to the 96 first-time GCM recipient firms and

1,062 distressed non-GCM firms used in DeFond et al.’s (2002) analysis.19 Using this combined

sample of firms from 2000 we then re-estimate our regression models in Tables 3 through 6 and

obtain similar results to those reported by DeFond et al. (2002). Using our expanded regression

models we also do not find any significant negative association of NAS fees in any form (i.e.,

NAS_FEE, FEERATIO, Unexpected log (NAS_FEE), or endogeneity-adjusted NASHAT) with GCM

reporting decisions for the 2000 period.

Next, we limit the distressed 2000 sample year firms to: 1) those with both negative net income

and negative cash flow from operations (n=750), 2) those with both negative net income and

negative cash flow from operations with SIC codes between 2000 and 3999 (n=492), and 3) those

with PROBANKZ greater than .50 but less than .93 (representing those cases requiring the most

amount of audit firm judgment; n=270). Re-estimating all models using these three subsets of

distressed firms from 2000 produces very similar results to those presented in DeFond et al. (2002).

Specifically, all three sets of analyses indicate that there is no significant negative association of

NAS fees in any form (i.e., NAS_FEE, FEERATIO, Unexpected log (NAS_FEE), or endogeneity-

adjusted NASHAT) with GCM reporting decisions for the 2000 period.

We then follow the DeFond et al. (2002) sample selection process for the later period and assess

expanded samples of 2004-2006 firms by including: 1) all manufacturing firms with negative net

income or negative cash flow from operations (n=4,024), and 2) all firms with negative net income

or negative cash flow from operations regardless of their SIC code (n=9,548). Analyses of these

19
Our procedure identifies more sample firms which is likely due to the fact that the DeFond et al. (2002) fee data was hand
collected and we rely on AuditAnalytics which is a more comprehensive database.

32
expanded samples produces similar results to those of DeFond et al. (2002) in that we find no

significant association between GCM opinions and NAS fees for these expanded, less financially

stressed samples in the 2004-2006 period. These additional analyses suggest that it is in examining

the highly stressed non-GCM firms (those with both negative net income and negative cash flow

from operations) where we are able to identify the influence of NAS fees on GCM decision-making.

However, the effect is only found in the 2004-2006 time period and not in the earlier period

representing the initial fee disclosures. Thus, it appears critical that future analyses of GCM

decision-making be conducted on control firms that exhibit sufficient levels of stress that would

cause the auditor to give serious consideration to rendering a GCM opinion, and not on expanded

samples that include firms that exhibit only minimal indicators of financial distress.

Matched-pairs approach similar to Geiger and Rama (2003)

In order to provide additional assurance regarding our primary findings, we follow Geiger and Rama

(2003) and match our 180 GCM firms with 180 similarly stressed non-GCM firms. For each of the

years in our 2004-2006 period, we matched the GCM experimental sample firms with a control firm

that did not receive a GCM, but exhibited both negative net income and negative cash flows from

operations. We matched first on PROBANKZ, next on size (in total assets), and finally on 2-digit

SIC classifications, as in Geiger and Rama (2003). For all 180 firms, we were able to find a suitable

match with similar bankruptcy prediction likelihood, firm size, and 2-digit industry. This procedure

ensured that we included similar companies with respect to reporting year, financial stress, size and

industry in our experimental and control samples.

The sample selection procedure produced a well-matched sample. Untabulated comparisons

indicate similar mean total assets (p-value =.93) for GCM firms (229.40) and non-GCM firms

33
(217.40). Similarly, we find no differences in PROBANKZ (p-value =.92) between the two groups.

GCM firms had higher LEV (p-value=.03), lower BM (p-value=.01), and were less likely to be an

accelerated filer (p-value =.01). No other dependent or control variables were significantly different

(p-value <.05) between the GCM and the control firms. Results of multivariate analyses

(untabulated) were substantively the same as those reported for the full samples. Specifically, we

replicate our results reported in Tables 3-6 of our main analysis with significant results (p-value

<.05) on all test variables reported in our primary analyses. Most notably, we continue to find a

significant negative coefficient for log (NAS_FEE) (p-value =.04), for log (FEERATIO) (p-value

=.03), and for log (FUTURE_FEES) (p-value =.06) using these reduced matched samples. In

addition, the results hold when controlling for expected fees and endogeneity as in our primary

results. These findings further demonstrate that our results are robust to different sample selections,

as long as we consider firms with sufficient levels of distress to justify consideration of a GCM.

Additional tests

In order to assess whether our results may be driven by companies (particularly non-GCM

companies) that previously had low or no NAS fees paid to their audit firm and in the observation

year significantly increase their purchases of NAS services, we re-perform our equation (1)

regression and replace our fee variables with: (1) an indicator variable for whether the client engaged

the audit firm for the first time to perform NAS services in the current year, (2) an indicator variable

for whether the client engaged the audit firm for the first time to perform NAS services in the

subsequent year, (3) the percent change in NAS fees from the prior year to the current year, (4) the

percent change in NAS fees from the current year to the subsequent year, (5) an indicator variable if

the client increased their NAS fee consumption in the current year by 20 percent or more over the

34
previous year, and (6) an indicator variable if the client increased their NAS fee consumption in the

subsequent year by 20 percent or more over the current year. Results of these re-estimated regression

models (untabulated) indicate that none of the six alternative NAS fee measures are significantly

associated with GCM opinions individually or in combination, at conventional levels (p-value >

.25). In sum, these additional tests are generally consistent with those of Cahan et al. (2008) and

suggest that our earlier reported findings are not overly sensitive to “new” NAS clients in the current

year or the expectation of providing new NAS fees in the subsequent year, or to clients purchasing

substantially greater levels of NAS fees than in the previous year.

We also examine whether subsequent viability affects our results by including a subsequent

bankruptcy indicator variable into equation (1), and by limiting our analyses to only those firms that

did not file for bankruptcy in the succeeding year. Results of these re-estimated models are

substantively the same as those presented. Thus, subsequent viability status does not appear to

significantly affect our reported results.

In a recent study, Menon and Williams (2010) suggest that market reaction to GCM reporting

is largely driven by default status and the amount of institutional ownership of the audited firm.

While our models incorporate default status, if we include the percentage of institutional ownership

into equation (1) modeling GCM opinions and equation (2) modeling audit fees we find that these

variables are not significant in any of the models at conventional levels (p-value > .25), and do not

substantively alter any of our NAS or audit fee regression results.

In a recent working paper, Griffin and Lont (2009) have suggested that the inability of prior

research to find a significant negative relation between NAS fees and GCM opinions is due

primarily to data analysis issues and suggest a grouping procedure as a more robust analysis

technique. In contrast to prior published research and the findings of our study, they suggest that

35
NAS fees and GCM opinions were negatively associated prior to 2004, but were not significantly

associated after 2003. In order to assess the robustness of our results, we employ their technique and

construct 20 groups for each of our three years based on the ratio of NAS to audit fees and calculate

the percentage of GCM opinions in each group (GCMPCT) and assign weights to the groups starting

with .05 for the smallest NAS ratio group to 1.0 for the largest ratio group (RATIO_GROUP_WT).

We then perform two sets of analyses: 1) we regress our RATIO_GROUP_WT variable on GCPCT

with and without accounting for company size (defined as total assets) and risk (defined as having a

net loss in the prior year), and 2) we replace our FEERATIO variable with the RATIO_GROUP_WT

in models 4 and 5 in Table 3 and re-estimate our logistic regressions. Results of these regressions

(untabulated) continue to indicate a significant negative relation between NAS and GCM opinions.

Specifically, the coefficient on the RATIO_GROUP_WT variable continues to be negative and

significant (p-value < .01) in each of the regressions.

We also test whether our models are sensitive to our choice of control variables. We find

that the results presented are not influenced by the removal of non-significant control variables and

also do not appear to be sensitive to the singular removal of other significant control variables in our

models. Accordingly, our results appear generally robust with respect to the selection of control

variables.

In sum, the consistent results of these additional tests indicate that our finding of a significant

negative association between NAS fees and GCM reporting decisions for distressed firms in the

period 2004-2006, although sensitive to the identification of an appropriate distressed control

sample, is robust across various models, variable specifications and analysis techniques. In addition,

our finding of a significant negative association between total subsequent fees received by the

36
 incumbent auditor and current GCM reporting decisions for distressed firms also appears robust

across various models and several subsequent time period specifications.

6. Conclusion

In this study we empirically investigate the claim that fees paid to auditors may impair auditor

independence by negatively impacting decision-making. In contrast to prior research, we examine a

more recent post-SOX period in the U.S. and support the validity of such independence concerns by

presenting consistent evidence regarding the negative association between NAS fees and auditor

going-concern opinion decisions. We find strong support for the contention that higher levels of

NAS fees paid to auditors reduces the frequency of going-concern opinion modifications. In

addition, when we examine the association between future fees received by the incumbent auditor

from their audit clients we find a negative association between the auditor’s current year going-

concern modification decision and the levels of total fees obtained from the client in later years.

These results provide evidence consistent with the argument of DeAngelo (1981) and others that

auditors may attempt to appease clients in the current year in order to maintain fee revenues in future

years.

In addition, we also demonstrate that prior findings in the U.S. of no relation between NAS

fees and going-concern modification decisions (DeFond et al. 2002; Geiger and Rama 2003) are

robust to our more stringent control sample selection criteria and alternative models. We document

that findings related to going-concern decisions and NAS fees in the U.S. are sensitive to the time

period examined and selection of appropriate control samples of distressed non-GCM firms.

An important limitation to our, and all similar NAS fee studies, however, is that although we

report a significant association between NAS fees and auditor reporting decisions, we cannot infer

37
causality. Even though we control for level of financial stress and cash available from operations in

our models, we cannot completely rule out the possibility that GCM firms have lower NAS fees

simply due to the inability to pay for such additional services from their auditor. Notwithstanding

this limitation, our empirical evidence with respect to the negative association of current NAS fees

and total subsequent fees, and auditor independence, proxied by GCM decisions, is consistent with

the long held concern regarding the economic tie between auditors and their clients (Mautz and

Sharaf 1961; Hylton 1964; Levitt 2000; Zeff 2003a; Carcello 2005). While SOX has limited the

amount of NAS fees auditors can obtain from their clients, our results suggest that the attainment

and preservation of these fees, as well as the potential for earning all types of future fees from

clients, significantly reduces the incidence of going-concern modifications.

Our findings regarding the negative relation between future fees and current auditor decision-

making provides considerable impetus for additional research examining whether this association is

present in other auditor decision-making contexts beyond GCM opinion decisions (e.g., client

acceptance and retention decisions, evaluations of internal controls, perceptions of audit risk).

Research on the relation between the type and magnitude of fees auditors obtain from clients and

auditor decision-making may inform both audit firms and standard-setters with respect to specific

types of engagements and the judgments or behaviors most likely to be affected.

38
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 Table 1
Descriptive Statistics and Comparisons of 180 Going-Concern Modified and 1,299 Financially
Distressed Non-Going-Concern Modified Firms During 2004-2006a
Mean Differences in
Full Sample (n=1,479) Sub-Samples
GCM Non-GCM
Variables Mean SD Min Max (n=180) (n=1,299) p-value
ASSETS ($000,000) 217.53 1,040.04 0.35 18,112.00 229.87 215.83 0.89
PROBANKZ 0.70 0.38 0.00 1.00 0.73 0.69 0.19
Age (in years) 13.05 8.39 1.00 56.00 13.40 13.00 0.64
BETA 1.09 0.71 -0.60 3.00 0.96 1.12 0.01
RETURN -0.01 0.78 -0.88 3.84 -0.16 0.01 0.03
VOLATILITY 0.00 0.00 0.00 9.24 0.00 0.00 0.00
LEV 0.50 0.49 0.00 7.50 0.98 0.44 0.00
PLOSS 0.85 0.35 0.00 1.00 0.84 0.86 0.68
ROA -0.36 0.75 -500.10 515.00 -0.42 -0.35 0.61
INVESTMENTS 0.48 0.31 0.00 0.97 0.34 0.50 0.00
CFFO -0.36 0.51 -3.39 0.92 -0.83 -0.30 0.00
ISSUE_DEBT 0.30 0.46 0.00 1.00 0.33 0.30 0.32
ISSUE_EQUITY 0.74 0.44 0.00 1.00 0.55 0.77 0.00
SELL_ASSETS 0.05 0.21 0.00 1.00 0.03 0.05 0.33
DISC_OPER 0.12 0.32 0.00 1.00 0.09 0.12 0.31
BIG4 0.61 0.49 0.00 1.00 0.37 0.64 0.00
REPORTLAG 73.38 26.15 24.00 213.00 82.24 72.16 0.00
DFT 0.08 0.28 0.00 1.00 0.28 0.06 0.00
BM 0.25 0.62 -2.70 1.73 -0.15 0.31 0.00
RESTATE 0.16 0.37 0.00 1.00 0.12 0.16 0.07
INVRECRATIO 0.21 0.20 0.00 0.82 0.23 0.20 0.07
SEGNUM 1.58 1.30 1.00 12.00 1.54 1.58 0.62
Sqrt(EMPLOYEES) 0.50 0.72 0.00 13.57 0.45 0.50 0.34
PENSION 0.10 0.30 0.00 1.00 0.07 0.10 0.24
FORGN 0.49 0.05 0.00 1.00 0.50 0.49 0.52
BADCONTROLS 0.07 0.25 0.00 1.00 0.07 0.06 0.70
ACCEL_FILER 0.72 0.45 0.00 1.00 0.53 0.75 0.00
ACQ 0.09 0.29 0.00 1.00 0.08 0.09 0.46
TOTAL_FEE ($000) 727.82 2,501.02 2.00 67,300.00 670.32 735.78 0.71
NAS_FEE ($000) 116.98 458.63 0.00 10,900.00 77.70 122.42 0.06
AUDIT_FEE ($000) 610.84 220.93 2.00 59,500.00 592.62 613.37 0.89
FEERATIO 0.15 0.16 0.00 0.90 0.12 0.16 0.02
b
FUTURE_FEES ($000) 1329.68 4263.10 0.00 98,765.00 1,219.88 1,344.90 0.71

45
a
Financial distress is defined as having both negative net income and cash flow from operations in the same year.
b
For 1,469 distressed firms that did not file for bankruptcy in the subsequent year.
All p-values are two-tailed.

Variables are defined as follows:

ASSETS = total assets at the end of the year
PROBANKZ = probability of bankruptcy score from Zmijewski [1984]
AGE = number of years the company has been listed on a stock exchange
BETA = the firm's beta estimated using a market model over the fiscal year
RETURN = the firm's stock return over the fiscal year
VOLATILITY = the variance of the residual from the market model over the fiscal year
LEV = total liabilities over total assets at the end of the fiscal year
PLOSS = an indicator variable equal to 1 if the firm reports a bottom-line loss in the previous year,
0 otherwise
ROA = return on total assets at the end of the year
INVESTMENTS = short- and long-term investment securities (including cash and cash equivalents) deflated by
total assets at year-end
CFFO = cash flows from operations deflated by total assets at the end of the year
ISSUE_DEBT = an indicator variable equal to 1 when the firm issues new debt during the year, 0 otherwise
ISSUE_EQUITY = an indicator variable equal to 1 when the firm issues new equity during the year, 0 otherwise
SELL_ASSETS = an indicator variable equal to 1 when the firm sells fixed assets during the year, 0 otherwise
DISC_OPER = an indicator variable equal to 1 when the firm reports a discontinued operation in the current
year, 0 otherwise
BIG4 = an indicator variable equal to 1 when the auditor is a member of the Big 4, 0 otherwise
REPORTLAG = number of days between fiscal year-end and the audit report date
DFT =an indicator variable equal to 1 when the firm is in debt default during the year, 0 otherwise
TOTAL_FEE = the total fees paid to the incumbent auditor in the current year
AUDIT_FEE = the audit fees paid to the incumbent auditor in the current year
NAS_FEE = the non-audit fees paid to the incumbent auditor in the current year
FEERATIO = the ratio of non-audit fees to total fees paid to the incumbent auditor in the current year
FUTURE_FEES = the total fees paid to the incumbent auditor in the subsequent two years.
BM = book value of equity divided by the market value of equity at the end of the year
RESTATE = an indicator variable equal to 1 when the firm announces or restates prior financial information during
the year, 0 otherwise
INVRECRATIO = inventory plus accounts receivable divided by total assets at the end of the year
SEGNUM = number of reported business segments
sqrt (EMPLOYEES) = square root of the number of employees employed by the company
PENSION = an indicator variable equal to 1 if the firm offered an employee pension or post-retirement plan, 0
otherwise
FORGN = an indicator variable equal to 1 if the firm had foreign operations during the year, 0 otherwise
BADCONTROLS = an indicator variable equal to 1 if the firm reported an internal control weakness (SOX 404 or 302) during
the year, 0 otherwise
ACCEL_FILER = an indicator variable equal to 1 if the firm was an accelerated filer, 0 otherwise
ACQ = an indicator variable equal to 1 if the firm acquired another company during the year, 0 otherwise

46
 Table 2
Pearson Correlation Matrixa
V1
ASSETS V2 V3 V4 V5 V6 V7 V8 V9 V10 V11
V2:PROBANKZ 0.369**
V3: AGE 0.114** -0.089**
V4: BETA 0.366** 0.300** 0.018
V5 RETURN 0.024 -0.042 -0.006 0.056*
V6:VOLATILITY -0.270** -0.147** -0.029 -0.108** 0.021
V7:LEV -0.165** 0.315** 0.086** 0.009 -0.011 0.036
V8:PLOSS -0.007 0.114** -0.099** 0.091** 0.022 0.074** -0.02
V9:ROA 0.181** -0.102** 0.065* 0.043 0.039 -0.069** 0.008 -0.108**
V10:INVESTMENTS 0.024 0.229** -0.209** 0.111** 0.045 -0.055* -0.301** 0.205** -0.146**
V11:CFFO 0.451** -0.216** 0.135** 0.061* 0.116** -0.138** -0.367** -0.121** 0.174** -0.151**
V12:ISSUE_DEBT 0.153** 0.146** 0.009 0.012 0.007 -0.048 0.227** -0.005 0.005 -0.158** 0.025
V13: ISSUE_EQUITY 0.152** 0.090** -0.036 0.116** 0.023 -0.077** -0.192** 0.118** -0.016 0.194** 0.009
V14:SELL_ASSETS -0.022 0.062* 0.020 0.091** -0.046 -0.030 0.039 0.025 -0.010 0.004 -0.049
V15:DISC_OPER 0.109** -0.037 0.197** -0.009 0.019 -0.004 0.046 -0.079** 0.056* -0.176** 0.089**
V16:BIG4 0.542** 0.375** -0.024 0.256** -0.024 -0.116** -0.138** 0.062* 0.010 0.295** 0.120**
V17:REPORTLAG -0.018 0.020 -0.022 -0.080** -0.057* 0.070** 0.167** -0.010** 0.015 -0.172** -0.023
V18:DFT -0.056* -0.014 0.107** -0.079** -0.022 0.040 0.210** -0.074** 0.039 -0.255** -0.026
V19:TOTAL_FEE ($000) 0.818** 0.388** 0.112** 0.275** -0.034 -0.171** 0.065* -0.003 0.107** 0.004 0.272**
V20:NAS_FEE ($000) 0.392** 0.187** 0.074** 0.133** -0.009 -0.041 -0.008 -0.025 0.084** -0.046 0.120**
V21:AUDIT_FEE ($000) 0.797** 0.389** 0.120** 0.273** -0.038 -0.180** -0.067** 0.012 0.100** 0.025 0.265**
V22:FEERATIO 0.244** 0.115** 0.056* 0.078** -0.004 -0.005 -0.006 -0.022 0.075** -0.041 0.073**
V23:FUTURE_FEES ($000) 0.276** 0.171** 0.019 0.137** 0.041 -0.088* -0.063* 0.028 0.013 0.095** 0.071**
V24:BM 0.209** -0.199** 0.145** -0.036 -0.094** -0.032 -0.539** -0.061* -0.089** -0.046 0.285**
V25:RESTATE 0.010 -0.015 -0.020 0.016 0.031 0.009 -0.023 -0.005 -0.039 0.022 0.001
V26:INVRECRATIO -0.130** -0.180** 0.187** -0.143** -0.042 0.019 0.21 -0.257** 0.181** -0.684** 0.134**

47
 Table 2, Pearson Correlation Matrix (cont)
V1 V2 V3 V4 V5 V6 V7 V8 V9 V10 V11
ASSETS
V27:SEGNUM 0.209** -0.022 0.207** 0.047 0.036 0.034 0.039 -0.134** 0.068** -0.287** 0.145**
V28:Sqrt(EMPLOYEES) 0.578** 0.167** 0.218** 0.175** -0.012 -0.117** 0.102** -0.117** 0.130** -0.259** 0.202**
V29:PENSION 0.511** 0.206** 0.224** 0.172** 0.016 -0.115** 0.129** -0.079** 0.115** -0.184** 0.168**
V30:FORGN 0.039 0.038 -0.064* 0.038 0.016 0.053* 0.018 -0.018 0.021 0.043 0.023
V31:BADCONTROLS 0.239** 0.057* 0.087** 0.089** -0.058* -0.024 0.037 -0.038 0.063* -0.120** 0.104**
V32:ACCEL_FILER -0.263** 0.198** 0.014 0.242** 0.074** -0.147** -0.083** 0.048* 0.061* 0.173** 0.087**
V33:ACQ 0.239** 0.007 0.033 0.058* 0.010 -0.029 -0.003 -0.093* 0.084** -0.206** 0.136**

V12 V13 V14 V15 V16 V17 V18 V19 V20 V21 V22
V13: ISSUE_EQUITY -0.019
V14:SELL_ASSETS 0.032 -0.012
V15:DISC_OPER 0.015 -0.078** 0.062*
V16:BIG4 0.051* 0.147** 0.031 0.018
V17:REPORTLAG 0.089** -0.079** 0.011 0.073** 0.007
V18:DFT 0.086** -0.084** 0.057* 0.065* -0.115** 0.141**
V19:TOTAL_FEE ($000) 0.139** 0.132** 0.075** 0.157** 0.543** 0.103** -0.007
V20:NAS_FEE ($000) 0.043 0.057* 0.056* 0.054* 0.308** 0.027 -0.009 0.449**
V21:AUDIT_FEE ($000) 0.134** 0.134** 0.062* 0.156** 0.535** 0.095** -0.002 0.979** 0.347**
V22:FEERATIO 0.019 0.037 0.043 0.016 0.215** 0.009 -0.013 0.275** 0.977* 0.171**
V23:FUTURE_FEES ($000) 0.011 0.075** -0.018 -0.035 0.185** -0.130** -0.073** 0.250** 0.161** 0.241** 0.118**
V24:BM -0.095** 0.071** 0.053* 0.031 0.056* -0.100** -0.040 0.074** 0.042 0.076** 0.053*
V25:RESTATE -0.027 0.016 0.017 0.024 -0.006 0.001 -0.001 0.021 0.026 0.008 0.004
V26:INVRECRATIO 0.031 -0.190** 0.062* 0.105** -0.259** 0.108** 0.175** -0.067* 0.015 -0.083** -0.099**
V27:SEGNUM 0.046 -0.083** 0.015 0.207** -0.049 0.100** 0.067** 0.204** 0.111** 0.193** -0.010
V28:Sqrt(EMPLOYEES) 0.154** -0.057* 0.023 0.185** 0.231** 0.112** 0.095** 0.562** 0.261** 0.547** 0.113**
V29:PENSION 0.104** -0.049 0.059* 0.161** 0.216** 0.025 0.075** 0.452** 0.240** 0.434** 0.089**
V30:FORGN 0.030 -0.026 0.010 -0.125** 0.056* -0.005 0.014 0.007 -0.020 0.012 0.081**

48
 Table 2, Pearson Correlation Matrix (cont)
V12 V13 V14 V15 V16 V17 V18 V19 V20 V21 V22
V31:BADCONTROLS 0.064* -0.013 0.046 0.075** 0.011 0.241** 0.062* 0.339** 0.072** 0.348** -0.050
V32:ACCEL_FILER 0.027 0.081** 0.014 0.027 0.187** -0.107** -0.040 0.224** 0.034 0.230** 0.084**
V33:ACQ 0.070* 0.043 0.063 0.067* 0.075** 0.055* 0.024 0.223** 0.174 0.202** 0.011

V23 V24 V25 V26 V27 V28 V29 V30 V31 V32
V24:BM 0.053*
V25:RESTATE 0.004 -0.030
V26:INVRECRATIO -0.099** 0.046 -0.024
V27:SEGNUM -0.010 0.051* 0.009 0.157**
V28:Sqrt(EMPLOYEES) 0.113** 0.049 0.020 0.159** 0.355**
V29:PENSION 0.089** 0.019 -0.002 0.103** 0.241** 0.575**
V30:FORGN 0.081** -0.012 -0.021 -0.021 0.009 0.016 0.015
V31:BADCONTROLS -0.050 0.051 0.075** 0.088** 0.138** 0.305** 0.209** 0.012
V32:ACCEL_FILER 0.084** 0.019 0.049 -0.124** 0.020 0.118** 0.132** 0.073** 0.067**
V33:ACQ 0.011 0.111** -0.034 0.063* 0.137** 0.191** 0.203** 0.014 0.104** 0.016
a
Variables are as defined in Table 1.
* Significant at the .05 level
** Significant at the .01 level

49
 Table 3
Regression Results for Going-Concern Modification Opinion Models for 180 Going-Concern Modified and 1,299 Financially
Distressed Non-Going-Concern Modified Firms During 2004-2006a
Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 b
Exp. Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value
Parameter Sign
Intercept 1.20 0.11 -1.50 0.41 -2.40 0.16 -0.90 0.17 -1.47 0.34 -0.49 0.23
SIZE - -0.44 0.00 -0.46 0.00 -0.49 0.00 -0.42 0.00 -0.46 0.00 -0.51 0.00
PROBANKZ + -0.14 0.73 -0.14 0.72 -0.13 0.75 -0.15 0.64 -0.16 0.62 0.08 0.76
log (Age) - -0.21 0.28 -0.21 0.27 -0.22 0.26 -0.24 0.14 -0.24 0.14 -0.24 0.28
BETA - 0.13 0.42 0.13 0.41 0.12 0.44 0.13 0.41 0.13 0.40 0.15 0.42
RETURN - -0.15 0.36 -0.15 0.36 -0.15 0.38 -0.14 0.27 -0.14 0.27 -0.10 0.38
VOLATILITY + 113.80 0.02 112.60 0.02 112.80 0.02 119.50 0.03 117.60 0.04 92.45 0.02
LEV + 0.83 0.00 0.83 0.00 0.82 0.00 0.83 0.00 0.83 0.00 0.61 0.00

PLOSS + 0.14 0.61 0.14 0.61 0.11 0.69 0.06 0.83 0.06 0.83 0.24 0.59
ROA - 0.13 0.29 0.13 0.29 0.15 0.25 0.13 0.37 0.13 0.37 0.18 0.26
INVESTMENTS - -1.23 0.00 -1.23 0.00 -1.32 0.00 -1.36 0.00 -1.37 0.00 -1.34 0.00

CFFO - -0.92 0.00 -0.91 0.00 -0.92 0.00 -0.96 0.00 -0.95 0.00 -0.94 0.00

ISSUE_DEBT - 0.02 0.92 0.02 0.93 -0.02 0.94 0.01 0.95 -0.01 0.96 -0.01 0.92

ISSUE_EQUITY - -0.58 0.00 -0.59 0.00 -0.58 0.00 -0.58 0.01 -0.58 0.00 -0.56 0.01

SELL_ASSETS - -0.75 0.36 -0.75 0.36 -0.71 0.37 -0.69 0.20 -0.69 0.20 -0.62 0.35

DISC_OPER - -0.21 0.51 -0.21 0.50 -0.23 0.47 -0.24 0.47 -0.24 0.46 -0.32 0.48

BIG4 + 0.29 0.24 0.28 0.28 0.30 0.25 0.29 0.23 0.27 0.29 0.35 0.24

REPORTLAG + 0.01 0.07 0.01 0.08 0.01 0.08 0.01 0.04 0.01 0.05 0.00 0.10
DFT + 1.63 0.00 1.62 0.00 1.59 0.00 1.58 0.00 1.57 0.00 1.72 0.00
log (TOTAL_FEE) ? 0.03 0.84 0.06 0.68

log (AUDIT_FEE) + 0.15 0.31

log (NAS_FEE) - -0.05 0.04

FEERATIO - -1.70 0.01 -1.72 0.01

log (FUTURE_FEES) - -0.03 0.08

2
Pseudo R 0.30 0.31 0.31 0.31 0.31 0.40
a
Financial distress is defined as having both negative net income and cash flow from operations in the same year. All p-values are two-tailed. Variables are as
defined in Table 1.
b
For 1,469 distressed firms that did not file for bankruptcy in the subsequent year.
50
 Table 4
Fee Expectation Models for 180 Going-Concern Modified and 1,299 Financially
Distressed Non-Going-Concern Modified Firms During 2004-2006a
log (AUDIT_FEES) log (NAS_FEES) FEERATIO log (TOTAL_FEES)
Parameter Exp. Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value
Sign
Intercept 10.35 0.00 7.95 0.00 0.31 0.00 10.74 0.00
SIZE + 0.44 0.00 0.71 0.00 0.01 0.03 0.46 0.00
PROBANKZ + 0.25 0.00 0.59 0.11 -0.02 0.32 0.22 0.00
log (Age) + 0.09 0.02 0.14 0.62 -0.02 0.06 0.05 0.17

RETURN - -0.05 0.03 -0.10 0.40 0.00 0.76 -0.05 0.01

VOLATILITY + 24.45 0.08 36.60 0.00

LEV - -0.11 0.09 0.01 0.72 0.01 0.69 -0.11 0.07

PLOSS + 0.07 0.18 -0.04 0.83 -0.02 0.12 0.04 0.47
ROA - -0.03 0.29 0.10 0.39 -0.00 0.83 -0.04 0.26
INVESTMENTS + 0.03 0.79 -0.39 0.36 -0.03 0.25 0.00 0.97
+ -0.00 0.96 -0.32 0.18 -0.01 0.55 -0.01 0.83
ISSUE_DEBT
ISSUE_EQUITY + 0.09 0.07 0.08 0.90 0.00 0.98 0.08 0.07
+ 0.04 0.69 0.43 0.44 0.03 0.21 0.09 0.24
SELL_ASSETS
DISC_OPER + 0.22 0.00 -0.16 0.57 -0.02 0.31 0.19 0.00

BIG4 + 0.42 0.00 1.31 0.00 0.01 0.54 0.41 0.00

REPORTLAG 0.00 0.00 0.00 0.00
+
BM - -0.17 0.00 -0.27 0.25 -0.01 0.66 -0.19 0.00

RESTATE + -0.05 0.26 0.35 0.21 0.02 0.08 -0.00 0.94

INVRECRATIO + 0.25 0.10 1.06 0.37 0.05 0.19 0.33 0.00

SEGNUM + 0.01 0.52 0.08 0.44 0.00 0.62 0.01 0.45

sqrt (EMPLOYEES) 0.17 0.00 0.05 0.69 -0.01 0.22 0.16 0.00
+
PENSION + -0.11 0.22 0.27 0.36 0.02 0.20 -0.08 0.39

FORGN + -0.45 0.12 -3.37 0.14 -0.14 0.12 -0.69 0.08

BADCONTROLS + 0.79 0.00 0.67 0.00

ACCEL_FILER -0.64 0.01 -0.01 0.29 0.02 0.64
-
ACQ 1.20 0.00 0.04 0.01 0.12 0.03
+
Adjusted R2
0.72 0.19 0.05 0.74
a
Financial distress is defined as having both negative net income and cash flow from operations in the same year. All p-values are two-
tailed.
All variables are as defined in Table 1.

51
 Table 5

Regression Results for Unexpected Current Year Fees and Going-Concern Modification Opinion Models for 180 Going-Concern
Modified and 1,299 Financially Distressed Non-Going-Concern Modified Firms During 2004-2006a
Model 1 Model 2 Model 3 Model 4 Model 5
Parameter Exp. Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value
Sign
Intercept 1.20 0.23 -1.22 0.23 -1.21 0.23 -1.23 0.23 -1.24 0.22
SIZE - -0.44 0.00 -0.43 0.00 -0.44 0.00 -0.44 0.00 -0.44 0.00
PROBANKZ + -0.14 0.95 -0.14 0.95 -0.12 0.72 -0.13 0.99 -0.13 0.98
log (Age) - -0.21 0.19 -0.21 0.23 -0.21 0.24 -0.21 0.25 -0.21 0.26
BETA - 0.13 0.42 0.12 0.41 0.12 0.42 0.13 0.35 0.13 0.37
RETURN - -0.15 0.51 -0.15 0.51 -0.15 0.52 -0.14 0.52 -0.14 0.53
VOLATILITY + 113.80 0.04 113.40 0.05 117.10 0.05 119.60 0.04 119.20 0.04
LEV + 0.83 0.00 0.83 0.01 0.82 0.01 0.81 0.01 0.82 0.01
PLOSS + 0.14 0.60 0.14 0.54 0.13 0.57 0.11 0.63 0.11 0.63
ROA - 0.13 0.23 0.13 0.22 0.14 0.20 0.13 0.23 0.13 0.22
INVESTMENTS - -1.23 0.00 -1.21 0.00 -1.26 0.00 -1.26 0.00 -1.25 0.00
CFFO - -0.92 0.00 -0.93 0.00 -0.94 0.00 -0.96 0.00 -0.97 0.00
ISSUE_DEBT - 0.02 0.96 -0.03 0.88 0.01 0.96 0.00 0.99 0.00 0.99
ISSUE_EQUITY - -0.58 0.00 -0.58 0.00 -0.58 0.00 -0.58 0.00 -0.58 0.01
SELL_ASSETS - -0.75 0.38 -0.75 0.41 -0.72 0.41 -0.74 0.38 -0.74 0.38
DISC_OPER - -0.21 0.52 -0.22 0.24 -0.21 0.26 -0.22 0.24 -0.23 0.48
BIG4 - 0.29 0.17 0.30 0.15 0.31 0.15 0.28 0.17 0.29 0.17
REPORTLAG + 0.01 0.07 0.01 0.09 0.01 0.08 0.01 0.07 0.01 0.07
DFT + 1.63 0.00 1.64 0.00 1.62 0.00 1.58 0.00 1.59 0.00
UNEXPECTED ? -0.10 0.52 -0.06 0.68
log (TOTAL_FEE)
UNEXPECTED + 0.02 0.92
log (AUDIT_FEE)
UNEXPECTED - -0.05 0.03
log (NAS_FEE)
UNEXPECTED - -1.63 0.02 -1.61 0.02
FEERATIO
Pseudo R2 0.30 0.30 0.31 0.31 0.31
a
Financial distress is defined as having both negative net income and cash flow from operations in the same year. All p-values are two-tailed. Variables are as
defined in Table 1.

52
 Table 6
Structural Models from Two-Stage Procedure After Controlling for Endogeneity for 180 Going-
Concern Modified and 1,299 Financially Distressed Non-Going-Concern Modified Firms During
2004-2006a
Dependent Variable = Dependent Variable =
Dependent Variable = OPINION log (AUDIT_FEE) log (NAS_FEE)
Parameter Coefficient p-value Parameter Coefficie p-value Parameter Coeffici p-value
nt ent
Intercept -10.38 0.01 Intercept 8.14 0.00 Intercept -16.91 0.00
SIZE 0.69 0.01 SIZE 0.24 0.00 SIZE -0.62 0.04

PROBANKZ 1.14 0.01 PROBANKZ 0.05 0.48 PROBANKZ 0.53 0.22

log (Age) -0.20 0.34 LEV -0.24 0.00 LEV 1.21 0.00

BETA -0.11 0.65 BIG4 -0.02 0.76 BIG4 0.68 0.08

RETURN -0.33 0.13 ROA -0.07 0.00 ROA 0.24 0.13

VOLATILITY 72.84 0.54 ISSUE_DEBT 0.11 0.01 ISSUE_DEBT -0.39 0.12

LEV 1.98 0.00 ISSUE_EQUITY 0.07 0.4 ISSUE_EQUITY -0.33 0.30

PLOSS -0.36 0.33 SELL_ASSETS -0.12 0.17 SELL_ASSETS 0.25 0.62

ROA 0.52 0.00 DISC_OPER 0.29 0.00 DISC_OPER -0.75 0.06

INVESTMENT -4.17 0.00 VOLATILITY 12.10 0.31 SEGNUM 0.05 0.57

S
CFFO -0.84 0.00 SEGNUM -0.02 0.39 log (Age) -0.16 0.55

ISSUE_DEBT -1.31 0.00 log (Age) 0.07 0.06 BM 0.07 0.94

ISSUE_EQUIT -0.48 0.10 BM -0.10 0.03 RESTATE 0.34 0.16

Y
SELL_ASSETS 0.33 0.54 RESTATE -0.14 0.00 RETURN -0.09 0.56

DISC_OPER -1.36 0.00 RETURN 0.00 0.88 INVRECRATIO 0.01 0.87

BIG4 3.59 0.00 INVRECRATIO 0.02 0.93 FORGN -2.30 0.29

REPORTLAG 0.00 0.42 FORGN 0.73 0.00 PENSION 0.59 0.07

DFT 1.81 0.00 PENSION -0.23 0.00 ACCEL_FILER -0.56 0.04

AUDHAT 2.56 0.00 BADCONTROLS 0.77 0.00 ACQ 1.15 0.00

NASHAT -3.36 0.00 INVESTMENTS 0.37 0.00 INVESTMENTS -1.25 0.07

PLOSS 0.11 0.03 PLOSS -0.19 0.53

REPORTLAG 0.00 0.08 sqrt -0.26 0.22

(EMPLOYEES)
sqrt 0.15 0.00 GCHAT 6.08 0.00
(EMPLOYEES)
GCHAT -0.65 0.00 AUDHAT 1.99 0.00
NASHAT 0.33 0.00

Model Chi-square = 222.03 Model F = 153.53 Model F = 17.01

p-value < .00 p-value < .00 p-value < .00
Pseudo R2 = .48 Adjusted R2 = .74 Adjusted R2 = .22
a
Financial distress is defined as having both negative net income and cash flow from operations in the same year.
All p-values are two-tailed. Variables are as defined in Table 1.
53