The Joint Determination of Audit Fees, Non-Audit Fees, and Abnormal Accruals

Prior research has estimated piecemeal the determinants of audit fees, non-audit services fees and abnormal accruals. Intuition, informal analysis, and a variety of theories of various aspects of auditor-client interaction suggest that audit fees, nonaudit fees, and abnormal accruals are jointly determined. We address this endogeneity issue by modeling the confluence of audit fees, fees for non-audit services and abnormal accruals in a system of simultaneous equations. Using audit and non-audit fee data from the U.K. for 1994-2000, we find evidence consistent with knowledge spillovers (or economies of scope) from auditing to non-audit services and from non-audit services to auditing. While knowledge spillovers from non-audit services to auditing is a known result [e.g. see Simunic (1984)] the presence of knowledge spillovers from auditing to non-audit services is a new result. Contrary to recent results in Ferguson et al. (2001) and Frankel et al. (2002), we do not find support for the assertion that fees for non-audit services increase abnormal accruals. In fact, we find that nonaudit fees decrease abnormal accruals. We also find evidence that audit fees increase abnormal accruals. Finally, our evidence is not consistent with audit firms playing pricing games, bribery or the demand and supply effects of abnormal accruals. The findings are robust to preliminary tests with U.S. data.