Client Risk Management: A Pecking Order Analysis of Auditor Response to Upward Earnings Management Risk

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