An Empirical Analysis of Auditor Independence in the Banking Industry

We examine auditor independence in the banking industry by analyzing the relation between fees paid to the auditors of banks and the extent of earnings management through loan loss provisions. We also examine whether this relation differs across large banks whose managements are required under the Federal Deposit Insurance Corporation Improvement Act of 1991 to evaluate the internal control over financial reporting and whose auditors must attest to the report on the effectiveness of internal controls over financial reporting, and small banks that are not subject to such controls. Our results indicate a positive association between fees paid to the auditor and income-increasing earnings management through loan loss provisions. They suggest that, although banks face high levels of regulatory scrutiny, economic bonding between the auditor and the bank potentially impairs auditor independence. Our findings also indicate that this bonding is stronger for smaller banks that are subject to less regulatory oversight than are larger banks. Our results also suggest that the economic bond between the auditor and the bank is reflected in delayed recognition of loan write-offs and in a higher incidence of earnings benchmark beating behavior