An Examination of the Relationship between Audit Fees and Real Earnings Management Using a Simultaneous Equations Model

Abstract

Real earnings management (REM) is actions taken by management that deviate from normal business practices carried out to meet certain earnings thresholds. Cohen, Dey, and Lys (2008); Cohen and Zarowin (2010); and Chi, Lisic, and Pevzner (2011) find that increased audit scrutiny prompts companies to switch from accrual-based earnings management (ABEM) to REM. In contrast, Sohn (2011) and Greiner, Kohlbeck, and Smith (2013) conclude that REM results in heightened audit scrutiny based on their finding of a positive statistical association between REM and audit fees (a widely-used proxy for scrutiny). However, the positive association researchers observe could be due to companies switching from ABEM to REM in response to audit scrutiny, rather than auditors increasing scrutiny in response to detected REM. To further investigate whether auditors respond to REM with increased scrutiny we examine the relations between REM and audit fees using a simultaneous equations model which allows for effects in both directions. Using this testing approach, we find that the effects indeed occur in both directions. Stated explicitly, we find that higher audit fees cause more REM and that more REM causes higher audit fees. Our results provide additional evidence that auditors respond to REM with increased scrutiny even though these activities do not violate accounting rules.