The Relationship between Aggressive Real Earnings Management and Current and Future Audit Fees

Abstract

We examine the relationship between aggressive income-increasing real earnings management (REM) and current and future audit fees. Managers pursue REM activities to influence reported earnings and, as a consequence, alter cash flows and sacrifice firm value. We posit that the implications of REM are considered in auditors’ assessments of engagement risk related to the client’s economic condition and result in higher audit fees. We find that, with the exception of abnormal reductions in SG&A, aggressive income-increasing REM is positively associated with both current and future audit fees. Additional analyses provide evidence consistent with increased effort combined with increased risk contributing to the current pricing effect with increased business risk primarily driving the future pricing effect. We therefore provide evidence that aggressive income-increasing REM activities have a significant influence on auditor pricing behavior consistent with the audit framework associating engagement risk with audit fees.

Keywords: Audit Fees, Business Risk, Audit Risk, Aggressive Real Earnings Management

JEL Classification: G21, G34, M41