SUMMARY: This study examines the association between audit fees and earnings
management, using publicly available fee data. We hypothesize that, due to asymmetric
litigation effects, audit fees decrease (increase) with a client’s risk of income-decreasing
(increasing) earnings management risk. We also hypothesize that the positive relation
between income-increasing earnings management risk and audit fees is heightened for
clients that are high-growth firms. We test our hypotheses with a sample of 429 public,
non-regulated, Big 5 audited companies, using fee data for the year 2000. We find
that downward earnings management risk, as estimated by negative (i.e., incomedecreasing)
discretionary accruals, is associated with lower audit fees. We also document
that upward earnings management risk, as estimated by positive discretionary
accruals, is associated with higher audit fees and that the interaction of this risk with
an industry-adjusted price-earnings ratio has an incrementally significant, positive effect
on fees. We interpret our findings as consistent with a conservative bias on the
part of auditors. The conservative bias arises from asymmetric litigation risk in which
income-increasing discretionary accruals exhibit greater expected litigation costs than
income-decreasing discretionary accruals (Simunic and Stein 1996; Palmrose and
Scholz 2004; Palmrose et al. 2004; Richardson et al. 2002; Heninger 2001).
SUMMARY: This study examines the association between audit fees and earningsmanagement, using publicly available fee data. We hypothesize that, due to asymmetriclitigation effects, audit fees decrease (increase) with a client’s risk of income-decreasing(increasing) earnings management risk. We also hypothesize that the positive relationbetween income-increasing earnings management risk and audit fees is heightened forclients that are high-growth firms. We test our hypotheses with a sample of 429 public,non-regulated, Big 5 audited companies, using fee data for the year 2000. We findthat downward earnings management risk, as estimated by negative (i.e., incomedecreasing)discretionary accruals, is associated with lower audit fees. We also documentthat upward earnings management risk, as estimated by positive discretionaryaccruals, is associated with higher audit fees and that the interaction of this risk withan industry-adjusted price-earnings ratio has an incrementally significant, positive effecton fees. We interpret our findings as consistent with a conservative bias on thepart of auditors. The conservative bias arises from asymmetric litigation risk in whichincome-increasing discretionary accruals exhibit greater expected litigation costs thanincome-decreasing discretionary accruals (Simunic and Stein 1996; Palmrose andScholz 2004; Palmrose et al. 2004; Richardson et al. 2002; Heninger 2001).
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