Earnings Management, Litigation Risk, and Asymmetric Audit Fee Responses

Abstract

This study empirically examines the asymmetric association between the auditor's assessment of litigation risk and earnings management, using publicly available fee data. Following the experimental work of Barron et al. (2001), we document decreases (increases) in audit fees with clients' risk of managing earnings downward (upward). We also find that the positive fee association is greater for clients facing greater litigation risk resulting from negative earnings surprises. We test our hypotheses with a sample of 429 public, non-regulated, Big 5-audited companies, using fee data for the year 2000. We interpret these findings as consistent with auditors' assessments of decreased (increased) litigation risk imposed by conservative (aggressive) clients. This interpretation is consistent with the positive relation between accruals and auditor litigation (Heninger 2001; Lys and Watts 1994), the relation between restatement and larger accruals (Richardson et. al 2003) and the relation between restatements and auditor litigation (Palmrose and Scholz 2000).

Keywords: discretionary accruals, conservative reporting, audit fees

JEL Classification: M41