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

See all articles by Gopal V. Krishnan

Gopal V. Krishnan

Bentley University

Lili Sun

University of North Texas - Department of Accounting

Qian Wang

Iowa State University - College of Business

Rong Yang

Rochester Institute of Technology

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

Krishnan, Gopal and Sun, Lili and Wang, Qian and Yang, Rong, Client Risk Management: A Pecking Order Analysis of Auditor Response to Upward Earnings Management Risk (November 28, 2012). Auditing, A Journal of Practice & Theory, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1578441 or http://dx.doi.org/10.2139/ssrn.1578441

Gopal Krishnan (Contact Author)

Bentley University ( email )

175 Forest Street
Waltham, MA 02452
United States
781-891-2477 (Phone)

Lili Sun

University of North Texas - Department of Accounting ( email )

1155 Union Circle #305219
Denton, TX 76203-5017
United States
940-565-3077 (Phone)

Qian Wang

Iowa State University - College of Business ( email )

Ames, IA 50011-2063
United States

Rong Yang

Rochester Institute of Technology ( email )

Saunders College of Business
Rochester Institute of Technology
Rochester, NY 14623
United States

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