Non-Audit Services, Earnings Management and Debt Covenant Violation

Abstract

The purpose of this study is to examine whether non-audit fees are associated with earnings management in a debt covenant violation context.I argue that management engages in earnings management in response to debt covenant violations; however, the choice of income-increasing or income-decreasing discretionary accruals is dependent on the expectation of the waiver decisions. On the one hand, management has incentives use income-increasing accruals to report more favourable financial results if a waiver is expected to be granted on the debt covenant violation. On the other hand, if it is expected that creditors will deny a waiver, management will use income-decreasing accruals to create a secret reserve which can be used to stage a false turnaround in a later stage. The auditors who are reluctant to forgo the lucrative non-audit fees may sacrifice their independence and sign off on a set of manipulated financial statements. The modified Jones model is employed to calculate discretionary accruals. I regress non-audit fees on discretionary accruals after taking into account a number of control variables on a U.S. debt covenant breach sample.The findings of this study show a significant negative relationship between non-audit fees and discretionary accruals in the non-waiver group, providing some evidence that auditors may be prepared to sign off on manipulated financial statements in order to retain lucrative non-audit fees. Interestingly, I do not find a significant positive relationship between non-audit fees and discretionary accruals in the waiver group suggesting that auditors maintain their independence. Taken together, these two findings indicate that auditors may allow management to engage in income-decreasing manipulation as opposed to income-increasing manipulation.This study is the first study to test the relationship between non-audit fees and auditor independence in a debt covenant violation context, which I believe is an important setting for earnings management to occur in, but the role of auditor has not yet been examined. My study shows that auditors may allow downward earnings management, perhaps because they perceive it to be less visible and exposed to lower litigation risks. My finding of no earnings management in the waiver group is consistent with auditors maintaining their independence. These findings are relevant to regulators as they have primarily been focusing on the high-profile audit failures which let the firms report overstated earnings and net assets. My results suggest that regulators should also direct their attention to downward earnings management, as it is the auditor’s responsibility to ensure the audited financial statements are free of all manipulations.