Do Auditors Allow Earnings Management When Audit Fees are Low?

Abstract

Much of the extant audit research focuses on the impact of excess audit fees paid to the auditors on earnings management. However, there is limited empirical evidence on whether auditors tolerate earnings management when audit fees are low, i.e., below the level of normal fees. Using a large sample representing post-SOX years 2004-2008, we first estimate abnormal (unexpected) audit fees as a residual from a regression of audit fees on several determinants of audit fees. Next, we run a regression of abnormal accruals and other measures of earnings management on abnormal audit fees and control variables. Our results consistently indicate that earnings management is significantly associated with negative abnormal audit fees. In other words, auditors appear to allow earnings management when audit fees are less than the expected fees. To the best of our knowledge this is the first study to examine the relation between abnormal audit fees and the likelihood of fraudulent financial statements. Our findings have important implications for regulators, members of the audit committee, investors, and others.

Keywords: Earnings Management, Discretionary Accruals, Audit Fee, Fraud-Scores