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    Client Risk Management: A Pecking Order Analysis of Auditor...
    research summary posted November 5, 2014 by Jennifer M Mueller-Phillips, last edited February 19, 2015, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management 
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    Title:
    Client Risk Management: A Pecking Order Analysis of Auditor Response to Upward Earnings Management Risk
    Practical Implications:

    Earnings management has received significant attention in the business press and from regulators and investors. Auditors are expected to constrain earnings management and, more generally, to enhance the quality of financial reporting. The passage of the 2002 SOX Act has substantially increased the legal liability for auditors and, therefore, has influenced their mindset toward conservative reporting. The results of this study show how auditors respond to earnings management risk via audit pricing and client retention decisions in a sequential way. The type of strategies that auditors employ varies with the level of earnings management risk. If the trade-off between return and risk is acceptable, auditors are willing to retain clients that engage in upward earnings management by charging higher audit fees. However, if the risk exceeds an acceptable level, auditors will choose to resign. The study provides evidence that a pecking order of auditors’ strategies exists in response to various risk levels in the post-SOX period.

     

    For more information on this study, please contact Gopal Krishnan.

    Citation:

    Krishnan, G., L. Sun, Q. Wang, and R. Yang. 2013. Client Risk Management: A Pecking Order Analysis of Auditor Response to Upward Earnings Management Risk. Auditing: A Journal of Practice and Theory 32 (2): 147-170.

    Keywords:
    Earnings management, discretionary accruals, audit fees, auditor resignations, client risk management
    Purpose of the Study:

    Managing engagement risk, the overall risk of an auditor’s association with a particular client, is a paramount objective for all auditors. Successful management of client risk is important to preserve an auditor’s reputation and mitigate the risk of litigation. The demise of Arthur Andersen is a sad testimony to the significance of client risk management. Despite the obvious importance of this issue, empirical evidence on how auditors employ systematic strategies to mitigate engagement risk is sparse. In particular, most prior research has used a piecemeal approach to study auditor responses to high-risk clients. The objective of this study is to provide empirical evidence on a dual strategy of charging higher audit fees and resigning from clients with the risk of upward (i.e., income-increasing) earnings management. Specifically, the authors conduct a pecking order analysis of these two possible strategies using a large sample of client-observations audited by Big 4 auditors in the post-Sarbanes-Oxley (SOX) era.

    Design/Method/ Approach:

    The authors use a sample of 8,513 observations from 2002 through 2008 in the post-SOX era. Performance-adjusted signed discretionary accruals are used to measure upward earnings management. The authors first conduct background analyses of the associations of accruals and audit fees with the likelihood of auditor resignations, then, conduct a pecking order analysis. The pecking order analysis uses a discrete dependent variable capturing the auditor’s ordered responses, assigning a value of 2 for firms with auditor resignations and a value of 1 and 0 for firms with large and small abnormal audit fees, respectively.

    Findings:
    • Audit fees are positively associated with signed discretionary accruals.
    • The likelihood of auditor resignation is positively associated with the level of signed discretionary accruals.
    • An auditor’s decision to resign from a risky client hinges on prior-period abnormal audit fees. If the auditor is already charging higher fees, then the auditor has less flexibility to increase fees in the future, leading to a higher possibility of auditor resignation.
      • The following order of strategies is used in response to upward earnings management. First, abnormal audit fees are increased when the trade-off between risk and return is at an acceptable level. Second, auditor resignation is likely when the trade-off exceeds the acceptable level.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Earnings Management