Classification Shifting and Big 4 Audit Fee Premium

Abstract

Classification shifting involves misclassifying operating expenses as non-recurring expenses to inflate the core earnings of the company. Managers are motivated to misclassify earnings because the market participants focus more on core earnings rather than just the bottom line GAAP earnings. Classification shifting does not lead to a change in the GAAP based net income and hence also limits the scrutiny of regulators and auditors. Though prior research indicates that Big 4 auditors are better than Non-Big 4 auditors in preventing accruals based earnings management, systematic evidence on former’s ability in curbing such misclassification is surely missing. Therefore we extend prior research and examine if Big 4 auditors are relatively more likely to reduce classification shifting compared to Non-Big 4 auditors. Our results indicate that clients of Big 4 auditors report significantly lower levels of classification shifting compared to clients of Non-Big 4 auditors. Additionally, our results also indicate that Big 4 auditors charge higher fees than Non-Big 4 auditors and such higher fees are associated with a significant reduction in classification shifting.

Keywords: Classification Shifting, Big 4 Auditors, Audit Fee Premium