The Association of Pre-Audit Engagement Risk with Discretionary Accruals

Abstract

In an archival study of audits by multiple offices of three international audit firms, we examine whether pre-audit engagement risk assessments made by the auditor are associated with estimated post-audit discretionary accruals. We find that pre-audit engagement risk is significantly and positively associated with the estimated level of discretionary accruals reported in audited financial statements. As higher levels of discretionary accruals have been shown to be associated with higher risk of post-audit litigation, it appears that rather than taking actions that result in higher-risk clients reporting less aggressive discretionary accruals, auditors instead are accepting a higher post-audit risk for these clients.

Keywords: Discretionary accruals, engagement risk, earnings management

JEL Classification: M41, M43, M49