GRADUATE SCHOOL OF BUSINESS STANFORD UNIVERSITY RESEARCH PAPER NO . 1696 R Auditor Independence and Earnings Quality Richard

We examine whether the provision of non-audit services by auditors is negatively correlated with firm value and the quality of earnings. Because of concerns regarding the effect of non-audit services on auditor independence, the Securities and Exchange Commission recently issued revised auditor independence rules requiring firms to disclose in their annual proxy statement the amount of fees paid to auditors for audit and non-audit services. Using data collected from over 4,000 proxies filed between February 5, 2001 and June 15, 2001, we find a significant negative market reaction to proxy statements filed by firms reporting higher than expected non-audit fees. Our evidence also indicates an inverse relation between the magnitude of non-audit fees and earnings management. Firms purchasing more non-audit services from their auditor are more likely to just meet or beat three earnings benchmarks – analysts’ expectations, prior year earnings, and zero earnings – and to report large discretionary accruals.