Do Auditors Perceive Real Earnings Management as a Business Risk?

Abstract

We examine the relationship between real earnings management (REM) and audit fees. While studies have investigated the influence of accrual-based earnings management on audit fees, empirical research is silent on whether REM activities explain audit fees. We report a positive association between both current and prior period REM and audit fees and show that firms with greater incentives to manage earnings drive this relationship. The prior period REM finding indicates that auditors perceive REM as a business risk, whereas the current period effect could reflect either perceived business risk or auditor effort. To provide more insight on the current period effect, we extend our analysis into the banking industry and examine a REM activity (gains trading) that is less likely to require additional audit effort. We again document a positive prior period REM effect but do not find support for the current period effect. Thus, our banking analysis supports the notion that the prior period effect captures increased business risk, and suggests the current period effect in our main analyses is attributable to increased auditor effort. Our study provides evidence that an ancillary cost of REM is higher audit fees.