Abnormal Audit Fees and Earnings Management Using Classification Shifting

Journal of Accounting and Finance, Forthcoming

50 Pages Posted: 23 May 2018

See all articles by Xudong (Daniel) Li

Xudong (Daniel) Li

Monmouth University - Department of Accounting

Ying Guo

California State University, East Bay

Date Written: May 20, 2018

Abstract

Prior research has intensively debated whether abnormal audit fees purely indicate audit effort or client-auditor economic bonding (Francis 2011). However, this empirical debate is mostly based on the findings of the associations between audit fees and accrual-based earnings management. Unlike accrual-based earnings management, earnings management through classification shifting does not change the bottom-line numbers and thus involves lower litigation costs. Given the difference in litigation costs between the two forms of earnings management, the effect of abnormal audit fees on the incentives of auditor in dealing with the behavior of earnings management could be different. It is thus interesting to examine how audit fees affect auditors’ incentives on their clients’ earnings management with potential lower litigation risks.

Using data from years 2000-2010, we find a significant and positive cross-sectional association between the magnitude of abnormal audit fees and the level of classification shifting, a result supporting the notion that greater abnormal audit fees allow for more earnings management through classification shifting. This observed result further indicates that using abnormal audit fees to purely measure audit effort or economic bonding might be questionable as the effect of abnormal audit fees on opportunistic accounting practices could differ, depending on the specific form of earnings management activities associated with the level of potential litigation costs.

Keywords: Abnormal audit fees; Audit effort; Classification shifting; Earnings Management; Economic bonding; Knowledge transfer

JEL Classification: M41, M42

Suggested Citation

Li, Xudong (Daniel) and Guo, Ying, Abnormal Audit Fees and Earnings Management Using Classification Shifting (May 20, 2018). Journal of Accounting and Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3182871

Xudong (Daniel) Li (Contact Author)

Monmouth University - Department of Accounting ( email )

West Long Branch, NJ 07764
United States

Ying Guo

California State University, East Bay ( email )

25800 Carlos Bee Boulevard
Hayward, CA 94542
United States

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