Client Risk Management: A Pecking Order Analysis of Auditor Response to Upward Earnings Management Risk
Auditing, A Journal of Practice & Theory, Forthcoming
40 Pages Posted: 29 Mar 2010 Last revised: 31 Jan 2013
Date Written: November 28, 2012
Abstract
This study examines Big N auditors’ client risk management strategy in response to the risk of upward (i.e., income-increasing) earnings management in the post-SOX era. Specifically, we empirically study the relation between clients’ signed discretionary accruals and subsequent audit pricing and auditor resignation decisions. We find that audit fees and resignations are positively associated with the risk of upward earnings management. We document a pecking order of auditor responses and find that auditors are more likely to respond in the order of charging higher abnormal audit fees if the trade-off between upward earnings management risk and return is within an acceptable level, and then resign if the risk is more severe and exceeds the auditors’ tolerance level. Our results are robust to alternative accruals measures, controlling for clients’ internal control quality and corporate governance characteristics.
Keywords: Earnings management, Discretionary accruals, Audit fees, Auditor resignations, Client risk management
JEL Classification: M40
Suggested Citation: Suggested Citation
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