Abnormal Audit Fees and Audit Quality: The Importance of Considering Managerial Incentives in Tests of Earnings Management

Abstract

SUMMARY Are high audit fees a signal that the auditor exerted more effort or a signal that the auditor may be losing her independence? Prior literature offers conflicting evidence. In this paper, we reexamine the issue on a sample of clients who have both the incentive and the ability to use discretionary accruals to meet or beat the consensus earnings forecast. We find a negative relationship between the level of abnormal audit fees paid by the client and the likelihood of using discretionary accruals to meet or beat the consensus analyst forecast. The evidence is consistent with the notion that abnormal audit fees are indicative of greater effort on the engagement. In other words, the results suggest a positive relationship between abnormal audit fees and audit quality. We show that the conflicting evidence in prior research was caused by research designs that did not consider the incentives of the manager. JEL Classifications: M42; M41. Data Availability: All data are available from public sources quoted in the text.

Fool's gold or value for money? The link between abnormal audit fees, audit firm type, fair‐value disclosures, and market valuation

“…But in the absence of risky assets, alternative interpretations (like economic rents) might apply because the auditor has fewer reasons to exert more effort and/or to charge a risk premium. This argument is similar to that provided by Eshleman and Guo (), who argued that the interpretation of abnormal audit fees depends on the incentives and the ability of the firms to manage earnings. Therefore, we expect an interaction effect of the abnormal audit fees with the proportion of Level 3 assets in addition to a main effect of the abnormal audit fees.…”

“…The interpretation of the abnormal audit fees can change if there are “red flags” indicating audit risks. Eshleman and Guo () made a similar claim but found that the abnormal audit fees have a positive effect on audit quality in situations where managers have the opportunity to manage earnings. Eshleman and Guo () did not use an interaction term but only considered the main effect (which is positive both in their study and in our study).…”

“…We use the estimated residuals of Equation as our abnormal audit fee variable (Blankley et al, ; Choi et al, ; Eshleman & Guo, ; Kanagaretnam et al, ; Mitra et al, )…”

“…This view is consistent with a higher reliability of the financial statements when the audit fees are higher than expected. Blankley et al (), Eshleman and Guo (), Higgs and Skantz (), Krishnan et al (), and Mitra et al () provided empirical evidence for this view. However, abnormal audit fees might also be associated with lower audit quality for two reasons.…”

Board Gender Diversity and Internal Control Weaknesses

“…Alternatively, if there is only one female board member that serves on the audit committee, then FEM_PCT2 and FEM_DUM would both equal 0. 6 We classify Grant Thornton and BDO Seidman as the Mid-tier auditors, following prior research (e.g., Boone, Khurana, & Raman, 2010;Eshleman & Guo, 2014a, 2014b. 7 Section 404 went into effect for accelerated filer firms with fiscal years ending on or after November 15, 2004.…”