How do auditors view managers’ voluntary disclosure strategy? The effect of earnings guidance on audit fees

Abstract

a b s t r a c tThe objective of this study is to examine the relation between attributes of earnings forecasts issued by managers and audit fees. Although there is an extensive literature on managers' disclosure of earnings forecasts, there is a paucity of research on how auditors incorporate information from these voluntary disclosures. We find that the issuance of an annual or quarterly management earnings forecast in the prior period is positively associated with the current period audit fees. Our results indicate that on average, audit fees are higher by about 7% for firm-years associated with an annual forecast. Among the firms that issue earnings forecasts, we find no association between audit fees and likelihood of updating a previously issued earnings forecast, indicating that auditors do not view such behavior negatively. Further, we find audit fees to be positively associated with the error and the bias (or optimism) in the forecasts for annual forecasts but not for quarterly forecasts. Overall, these results suggest that management's forecast behavior captures higher business risk for the auditor via greater risk of earnings management or litigation risk.

Audited financial reporting and voluntary disclosure as complements: A test of the Confirmation Hypothesis

“…To the extent that the other control variables in the audit fee regressions do not entirely control for litigation risk, one could observe an association between audit fees and earnings forecasting activity. Second, auditors could view firms making earnings forecasts as potentially more risky audits, because they are more likely to use forecasting to manipulate their stock price, or to engage in earnings management to meet their forecasts (e.g., Krishnan et al, 2009). Moreover, to the extent to which forecast accuracy can be obtained through earnings management, it could be correlated with litigation risk.…”

Does Intellectual Capital Disclosure Matter for Audit Risk? Evidence from the UK and Italy

“…Similarly, PCAOB suggests to auditors some measures in order to facilitate the use of non-financial disclosure to avoid fraud [66]. In this framework, Krishnan et al argued that the choice of managers to disclose voluntary information is associated with the audit risk, since through that way, auditors could have more basis for their evaluation about the overall level of their clients' business risk and found a positive association between audit fees (which is considered as a proxy of audit risk) and some features of management's earnings forecasts such as likelihood, bias, error and frequency [67].…”

“…Thus, voluntary disclosure reduces audit risk, whether the company's credibility on financial information achieve satisfactory levels. Auditing standards, practitioners and scholars recently emphasized the relevance of examining also non-financial disclosure in order to evaluate audit risk [67].…”

“…Other factors affecting the audit risk-quantitative ones-refer to the size of the company, usually measured by total revenues, total assets or total shareholders' equity [43]. Literature about this topic is limited and there is a call for more research to explore how different types of non-financial and voluntary information can play a role in the evaluation of the audit risk [67], therefore we formulate the following research hypotheses:…”

Pro forma disclosures, audit fees, and auditor resignations

“…Prior research documents that auditors view the presence of SEC enforcement actions as an additional risk factor (Krishnan et al, 2010). If auditors are aware that (1) pro forma disclosures could be misleading, and (2) such disclosures are on the SEC's ''radar screen'', subjecting them to SEC enforcement actions for optimistic pro forma reporting, auditors should rationally increase their scrutiny of pro forma disclosures, which could lead to audit fee increases and, possibly, to a greater likelihood of resignation.…”