Auditing Section Research Summaries Space

A Database of Auditing Research - Building Bridges with Practice

This is a public Custom Hive  public

research summary

    The Relationship between Aggressive Real Earnings Management...
    research summary posted April 19, 2017 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 14.0 Corporate Matters, 14.01 Earnings Management 
    135 Views
    Title:
    The Relationship between Aggressive Real Earnings Management and Current and Future Audit Fees
    Practical Implications:

    Prior research concerning audit fees and earnings management has focused primarily on accruals management. This article shows how the audit fee and audit risk models support auditors’ pricing behavior in a REM setting. Specifically, the results are consistent with auditors, after observing aggressive REM, increasing current audit fees to cover the cost of additional effort required to gain reasonable assurance that the financial statement are free of material misstatements and increase both current and future audit fees to cover increases in perceived business risk.     

    Citation:

    Greiner, A., M. J. Kohlbeck, and T. J. Smith. 2017. The Relationship between Aggressive Real Earnings Management and Current and Future Audit Fees. Auditing: A Journal of Practice and Theory 36 (1): 85 – 107. 

    Keywords:
    audit fees, business risk, audit risk, and aggressive real earnings management.
    Purpose of the Study:

     The authors examine whether aggressive real earnings management (REM) activities are associated with audit fees. Prior research focuses on accruals-based earnings management and suggests that auditors extract additional audit fees to cover costs associated with increased engagement risk, which includes audit risks related to the issuance of an incorrect opinion and nonaudit risk related to impaired reputation, fewer business opportunities, and the inability to collect desires and future audit fees. The distinction between accrual and real earnings management is important for auditors because the potential effects on company performance and engagement risks are different. REM alters normal firm operations, impacts current and future cash flows, imposes additional costs, and sacrifices firm value. Whether auditors charge higher fees for earnings management behavior that does not violate generally accepted accounting principles if important to study as clients continue to pursue REM to meet reporting objectives. 

    Design/Method/ Approach:

    The authors utilize a conceptual audit fee model to identify specific examples within this framework where REM is likely to increase engagement risk and thereby increase audit fees through either increased effort, a risk premium, or both. They perform further analysis to better understand the sources between aggressive REM and fees.

    Findings:
    • The authors find, overall, a positive association between aggressive REM and both current and future audit fees.
    • The authors find that changes in aggressive REM are associated with changes in fees.
    • The authors find that only current aggressive REM is positively associated with audit report delays.
    • The authors find evidence that the associations between aggressive Rem and future fees are driven by firms with higher REM incentives.
      • Further, they find that the future effect of aggressive REM is stronger among firms constrained by balance sheet bloat.
    Category:
    Corporate Matters, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, Earnings Management