AUDITING: A JOURNAL OF PRACTICE & THEORY

Vol. 25, No. 1

May 2006
pp. 85–98

Earnings Management, Litigation Risk,

and Asymmetric Audit Fee Responses
Lawrence J. Abbott, Susan Parker, and Gary F. Peters
SUMMARY: This study examines the association between audit fees and earnings
management, using publicly available fee data. We hypothesize that, due to asymmetric
litigation effects, audit fees decrease (increase) with a client’s risk of income-decreasing
(increasing) earnings management risk. We also hypothesize that the positive relation
between income-increasing earnings management risk and audit fees is heightened for
clients that are high-growth firms. We test our hypotheses with a sample of 429 public,
non-regulated, Big 5 audited companies, using fee data for the year 2000. We find
that downward earnings management risk, as estimated by negative (i.e., income-
decreasing) discretionary accruals, is associated with lower audit fees. We also doc-
ument that upward earnings management risk, as estimated by positive discretionary
accruals, is associated with higher audit fees and that the interaction of this risk with
an industry-adjusted price-earnings ratio has an incrementally significant, positive ef-
fect on fees. We interpret our findings as consistent with a conservative bias on the
part of auditors. The conservative bias arises from asymmetric litigation risk in which
income-increasing discretionary accruals exhibit greater expected litigation costs than
income-decreasing discretionary accruals (Simunic and Stein 1996; Palmrose and
Scholz 2004; Palmrose et al. 2004; Richardson et al. 2002; Heninger 2001).

INTRODUCTION

L
itigation risk is a fundamental aspect of an auditor’s fee-setting process (Simunic
and Stein 1996). Prior archival audit fee research has generally focused on client
financial health in proxying for the auditors’ litigation risk cost component (Pratt
and Stice 1994; Simon and Francis 1988; Simunic 1980). However, recent audit-planning
research suggests that auditors also consider earnings management risk in their risk-
assessment process. In particular, Bedard and Johnstone (2004) find that auditors respond
to earnings management risk with ex ante increases in planned audit hours and billing rates.
In this study, we expand this line of research and investigate whether auditors asymmetri-
cally respond to income-increasing versus income-decreasing earnings management risk
when considering litigation risk and ex post determination of audit fees.1

1
We use the term asymmetric fee response to describe audit fee decreases (increases) in reaction to income-
decreasing (increasing) earnings management risk. Audit fee effects may be attributable to either audit scope
revisions that address areas of assessed earnings management risk or simply a risk premium.

Lawrence J. Abbott is an Associate Professor at the University of Memphis, Susan Parker

is an Associate Professor at Santa Clara University, and Gary F. Peters is an Associate
Professor at the University of Arkansas.

Submitted: October 2004

Accepted: December 2005

85
86 Abbott, Parker, and Peters

We hypothesize that audit fees decrease (increase) with a client’s risk of managing
earnings downward (upward) due to asymmetric litigation risk outcomes. We draw on three
research streams in forming our hypotheses. First, Heninger (2001) finds a significant pos-
itive relation between income-increasing abnormal accruals—a common proxy for earnings
management—and subsequent auditor litigation. Second, Palmrose and Scholz (2004) ex-
amine restatements and demonstrate that: (1) annual restatements trigger auditor litigation
at a higher rate than bankruptcies, and (2) 83 percent of restatements that elicit litigation
involve reversals of previously income-increasing accounting. Finally, Barron et al. (2001)
show that auditor assessments of litigation risk and planned audit investments are higher
when potential errors overstate—as opposed to understate—financial performance. These
studies suggest an asymmetric fee response on the part of the auditor to income-increasing
versus income-decreasing earnings management.
Following Barron et al. (2001), we also hypothesize that the audit fee effects resulting
from a client’s propensity to manage earnings upward will be magnified for clients within
greater litigation risk environments. We categorize high price-earnings (P/E) clients as those
facing greater litigation risk. High P/E clients likely have incentives to inflate their earnings
to meet earnings growth expectations (Bedard and Johnstone 2004; Richardson et al. 2002;
Dechow et al. 2000). In turn, the incentive to inflate earnings is greatest for high-growth
clients since these firms are most severely punished by investors for missing earnings
forecasts in the form of a ‘‘stock market torpedo’’ (Skinner and Sloan 2002). Moreover,
such a ‘‘torpedo effect’’ could prompt future litigation, given the large, negative stock price
reaction at the time of the earnings disappointment (Skinner and Sloan 2002; Stice 1991).
To address our research question, we examine a sample of 429 audit fee disclosures
from proxy statements filed in 2001. Consistent with prior research, we use negative (pos-
itive) discretionary accruals to proxy for income-decreasing (increasing) earnings manage-
ment (Heninger 2001; DeFond and Park 1997; Subramanyam 1996). Following Bedard and
Johnstone (2004), we also construct a client-specific, industry-adjusted P/E ratio. Using
multivariate regressions controlling for client size, complexity, financial condition, and cor-
porate governance structure, we document lower (greater) audit fees for client firms with
income-decreasing (increasing) discretionary accruals. Moreover, the positive relation be-
tween income-increasing discretionary accruals and audit fees is incrementally greater for
high P/E ratio firms.
To our knowledge, our study is the first to provide archival evidence using audit fees
to support arguments for an asymmetric response on the part of auditors to income-
increasing versus income-decreasing earnings management risk. Barron et al. (2001) posit
that asymmetrically planned audit investments are rational if the risk faced by the auditor
is asymmetric with regard to the direction of misstatement. Although auditors may not be
‘‘under-auditing’’ income-decreasing discretionary accruals, they do appear to adjust audit
effort or extract risk premiums depending on the direction of earnings management risk.
Notably, this is somewhat at odds with the traditional audit risk model, which directs
auditors to address the general risk of material misstatements or inherent risk (Auditing
Standards Board [ASB] 1983). Generally Accepted Auditing Standards (GAAS) do not
define inherent risk in terms of income-decreasing versus income-increasing components.
Accordingly, the audit risk model suggests that any deviation from an unbiased report,
regardless of direction, should result in greater auditor effort. Our results suggest that the
conventional audit risk model may not be adequately capturing auditor pricing behavior
with respect to earnings management risk.

Auditing: A Journal of Practice & Theory, May 2006

Earnings Management, Litigation Risk, and Asymmetric Audit Fee Responses 87

The remainder of our paper is as follows. The next section reviews prior research and
develops our hypotheses. The third section presents sample selection and research design.
The fourth section discusses results and limitations, and the final section concludes.

PRIOR RESEARCH AND HYPOTHESES

The auditor’s cost of gathering evidence and producing an audit opinion is generally
broken down into two elements: a resource cost component, which is increasing in the level
of auditor effort, and an expected future loss component (Simunic and Stein 1996). Simunic
(1980) models the expected loss component as the product of (1) the likelihood of litigation
and (2) the expected present value of possible future losses that may arise from auditing
this period’s financial statements. Several research streams suggest that the auditor’s ex-
pected loss component may be influenced by the direction of earnings management.
Heninger (2001) documents a positive association between income-increasing abnormal
accruals and ex post auditor litigation. Complementing these findings, Palmrose and Scholz
(2004) show higher litigation rates against auditors for annual restatements than for client
business failures. They also find that, on average, restatements of previously income-
increasing accounting choices generated cumulative, negative abnormal returns of 13 per-
cent, compared to negative 3 percent for restatements of income-decreasing accounting
choices. Combined, these studies suggest that the likelihood of auditor litigation depends
on the magnitude and direction of earnings management. Accordingly, it appears reasonable
that the auditor’s assessment of expected losses would vary depending on whether the result
of the accounting discretion is income-increasing or income-decreasing.
Houston et al. (1999) investigate the conditions in which accounting choices influence
the auditor’s assessment of audit and litigation risk. Using an experimental design, Houston
et al. (1999) find that the presence of accounting choices reflecting higher risks of account-
ing irregularities leads to higher litigation risk assessments and fee premiums. More im-
portantly, these authors find when potential accounting irregularities are present, auditor
litigation risk assessments dominate the audit risk model’s inherent risk assessments in
explaining auditor planning behavior. Similarly, Barron et al. (2001) posit a conservative
bias model of auditor behavior. They show auditors’ assessments of litigation risk and
planned audit investments were higher (lower) when potential errors increased (decreased)
financial performance. However, the results of Houston et al. (1999) and Barron et al. (2001)
are constrained in that their earnings management construct does not have a publicly avail-
able analog.
In an empirical setting that utilizes a publicly available proxy for earnings management,
Lee and Mande (2003) examine how the passage of the Private Securities Litigation Act
(PSLRA) affects auditors’ incentives to curtail earnings management. Assuming that the
PSLRA reduced auditor litigation exposure, their tests find that after the PSLRA, income-
increasing discretionary accruals rise for auditees of Big 6 firms (i.e., those firms with the
most reputational capital).
The results of Heninger (2001) and Palmrose and Scholz (2004) suggest that the like-
lihood of auditor litigation depends on the magnitude and direction of earnings manage-
ment. The results of Houston et al. (1999) and Lee and Mande (2003) suggest that auditors
incorporate the magnitude and direction of discretionary accruals into their litigation risk
assessments. Finally, Barron et al. (2001) argue that an increase (decrease) in audit invest-
ments for misstatements that increase (decrease) net income is rational if litigation outcomes
are correspondingly asymmetric. Thus, the asymmetric impact of income-increasing versus
income-decreasing earnings management on the auditor’s expected loss function suggests

Auditing: A Journal of Practice & Theory, May 2006

88 Abbott, Parker, and Peters

a correspondingly asymmetric impact on audit fees. This leads to our first hypothesis (stated
in alternative form):

H1: Audit fees decrease (increase) with income-decreasing (increasing) discre-

tionary accruals.

While the above hypothesis is similar in spirit to the earnings management risk hy-
pothesis of Bedard and Johnstone (2004), there are three important differences that merit
discussion. First, Bedard and Johnstone (2004) do not consider auditor behavior in response
to actual managerial financial reporting decisions encompassing discretionary accruals. Sec-
ond, the earnings management risk construct of Bedard and Johnstone (2004) was essen-
tially a dichotomous variable that did not address income-increasing versus income-
decreasing earnings management.2 This distinction is critical since our income-increasing
and income-decreasing partition allows us to directly test the competing predictions of the
audit risk model and the conservative bias model of Barron et al. (2001).3 Third, Bedard
and Johnstone (2004) only investigate the relation between earnings management risk fac-
tors and ex ante planned audit effort and fee premiums.4 Our setting allows us to explicitly
investigate the association between the actual management accounting choices and ex post
auditor actions, namely charged audit fees.
Following Barron et al. (2001), we also hypothesize that the risk effect resulting from
a client’s propensity to manage earnings is magnified for clients in greater litigation risk
environments. Much prior research recognizes accruals as a means of managing earnings
(Dechow et al. 2000; Dechow and Skinner 2000; Jones 1991). Dechow et al. (2000) find
that high-growth firms—characterized by high earnings-to-price multiples—are more likely
to use large accruals to manage earnings. The incentive for managing earnings on the part
of these high-growth firms is to meet earnings growth expectations and avoid negative
earnings surprises (Bedard and Johnstone 2004; Richardson et al. 2002; Dechow et al.
2000).
In turn, the incentive to inflate earnings is greatest for high-growth clients since these
firms are most severely punished by investors for missing earnings forecasts in the form of
a ‘‘stock market torpedo,’’ which could prompt future litigation (Skinner and Sloan 2002).
Collectively, this research suggests high P/E clients face greater litigation risk environ-
ments, thus leading to our second hypothesis (stated in alternative form):

H2: Audit fee effects resulting from a client’s propensity to manage earnings
upward are magnified for clients within greater litigation risk environments
as identified by ‘‘high-growth’’ or high price-earnings (P/E) clients.

2
Bedard and Johnstone (2004) derive an earnings management risk-assessment score from nine dichotomous yes/
no audit-planning questions. Although their measure was additive in nature, approximately 81 percent of their
observations had zero earnings management risk factors and less than 4 percent had more than 2. Also, the
additive nature of their measure does not distinguish between income-increasing and -decreasing earnings man-
agement risk.
3
The audit risk model would suggest that any misstatement—regardless of direction—should result in greater
audit work. Thus, a positive relation between income-decreasing discretionary accruals and audit fees is predicted
by the audit risk model.
4
Discussions with Big 4 audit personnel suggest that audit procedures and scope often change with financial
events and / or reporting decisions occurring after the completion of audit planning.

Auditing: A Journal of Practice & Theory, May 2006

Earnings Management, Litigation Risk, and Asymmetric Audit Fee Responses 89

METHOD
Sample Selection
SEC rules requiring fee disclosures became effective for proxies filed on or after Feb-
ruary 5, 2001. We first examined all proxies (excluding mutual funds and other financial
registrants) filed with the SEC between February 5, 2001 and March 16, 2001 for which
there was a corresponding fiscal year-end 10-K available by March 16, 2001. To expand
the original sample of 310 firms, we then selected a random sample of 250 proxy filings
from March 19, 2001 to June 30, 2001, resulting in a preliminary sample of 560. After
deleting observations with missing variables on Compustat (primarily those needed to es-
timate discretionary accruals), or those from 15 two-digit industries that contained fewer
than 20 non-sample firms over which to estimate nondiscretionary accruals, 473 companies
remained. We also eliminated 44 firms that engaged non-Big 5 auditors, resulting in a final
sample size of 429 firms.

Regression Model and Variable Definitions

Following prior research, our regression model is as follows:

LNAFEE ⫽ b0 ⫹ b1DISCACC*INCR ⫹ b2DISCACC*DECR

⫹ b3P/E*DISCACC*INCR ⫹ b4SIZE ⫹ b5SQSUBS ⫹ b6FORSUBS
⫹ b7INVREC ⫹ b8RECURLOS ⫹ b9LEVERAGE ⫹ b10GOINGCON
⫹ b11PERCOSBD ⫹ b12BORDMEET ⫹ b13 ACINDACT ⫹ e.

Variable definitions are summarized in Table 1.

Consistent with prior studies, our dependent variable (LNAFEE) is the natural log of
audit fees (in 000s). Our primary test variables are the firm’s estimated discretionary ac-
cruals (DISCACC) and the industry-adjusted price-earnings ratio (P/E). We estimated dis-
cretionary accruals (DISCACC) for each sample firm using the cross-sectional variation of
the Jones (1991) model, as modified by Dechow et al. (1995). The cross-sectional method
is appropriate here because it allows comparisons across firms with different corporate
governance characteristics and does not assume that the coefficients will be stationary over
time.
We calculated our price-earnings ratio (P/E) as the fiscal year-end closing price (Com-
pustat item 199) for 2000 divided by the year 2000 net income (not including extraordinary
items, Compustat item 18). We then industry adjust the P/E ratio by taking the difference
between the client’s P/E ratio and the mean P/E ratio for all firms within the same industry
(two-digit SIC code).5 In subsequent regressions, the P/E ratio is retained only if the in-
dividual sample firm P/E exceeds the industry, and enters the regression as the amount by
which the firm P/E exceeds the industry interacted with positive discretionary accruals.

Control Variables
The research on the determinants of audit fees is well developed, and explanatory
models have adjusted R2s in the 70–80 percent range (Craswell et al. 1995; Simon and
Francis 1988; Francis and Simon 1987). Recent research by Carson et al. (2003) confirms
that audit fee models are generally well specified. Following the above studies we include
control variables for size, complexity, health, governance structures, and auditor type. SIZE

5
Industry P / E ratios were calculated by using all firms on Compustat for each two-digit SIC code.

Auditing: A Journal of Practice & Theory, May 2006

90 Abbott, Parker, and Peters

TABLE 1
Definition of Variables

Variable Name Description

Dependent Variable
LNAFEE The natural log of audit fees (000s).
Test Variables
DISCACC*INCR The absolute value of discretionary accruals times an indicator variable
with the value 1 if the accruals are income-increasing, and 0
otherwise.
DISCACC*DECR The absolute value of discretionary accruals times an indicator variable
with the value 1 if the accruals are income-decreasing, and 0
otherwise.
P / E*DISCACC*INCR Industry-adjusted PE ratio (only if in excess of industry-median P / E
ratio, and 0 otherwise) times the absolute value of discretionary
accruals, if positive.
Control Variables
SIZE Natural log of total assets (in millions).
SQSUBS Square root of the number of consolidated subsidiaries.
FORSUBS Proportion of foreign subsidiaries to total subsidiaries.
INVREC Proportion of total assets in inventory and accounts receivable.
RECURLOS An indicator variable equal to 1 if the sample firm has experienced at
least two annual net losses in the past three years.
LEVERAGE The sample firm’s debt / asset ratio in the sample year.
GOINGCON An indicator variable equal to 1 if the firm received a going concern
modification in the sample year, and 0 otherwise.
PERCOSBD The percentage of outside directors on the board.
BORDMEET The number of full board meetings in the sample year.
ACINDACT An indicator variable equal to 1 if the audit committee is fully
independent, meets at least four times in the sample year, and
includes at least one financial expert.

is measured as the natural log of total assets (Compustat item 6). We control for client
complexity by including the square root of the number of consolidated subsidiaries
(SQSUBS) and the proportion of foreign subsidiaries to total subsidiaries (FORSUBS, both
from firm 10-Ks). INVREC measures the proportion of total assets in inventory (Compustat
item 3) and accounts receivable (Compustat item 2). We use an indicator variable (RE-
CURLOS) to control for client health. RECURLOS is coded 1 if the client has experienced
a loss (Compustat item 18) in two of the prior three years. LEVERAGE (the sample firm’s
debt/asset ratio, using Compustat items 9 and 6) is used to measure the client’s business
risk, related to their financial structure and debt level. Finally, we include an indicator
variable (GOINGCON) coded 1 if the client received a going-concern modification in the
sample year, and 0 otherwise (Compustat item 149 and the firm’s 10-Ks).
Recent U.S. audit market research has documented several significant associations be-
tween board/audit committee characteristics and audit fees. Boards and audit committees
that are more independent of management are hypothesized to have a greater demand for
audit scope and quality, resulting in higher audit fees (Carcello et al. 2002, Abbott et al.
2003; and others). We measure board composition (PERCOSBD) and activity (BORD-
MEET) using the proportion of non-employees on the full board and the number of board
meetings held in the sample year, respectively. Following Abbott et al. (2003), we code
ACINDACT as 1 when the audit committee is entirely independent, includes at least one

Auditing: A Journal of Practice & Theory, May 2006

Earnings Management, Litigation Risk, and Asymmetric Audit Fee Responses 91

expert, and meets at least four times per year.6 All corporate governance information was
collected from the sample firms’ proxy statements.

RESULTS
Descriptive Statistics
Table 2 (Panel A) shows the distribution of sample firms by focus industry, and the
comparison with the Compustat population. Thirty-three percent of the observations are
manufacturing firms (SIC codes 3400–3999), and 27 percent are in consumer products and

TABLE 2
Sample Selection Results

Panel A: Distribution of Observations by Focus Industry

Number of Compustat
Corresponding Observations Population
Focus Industry Two-Digit SIC Codes (%) (%)a
Construction 15–17 6 (1.4) 1.1
Consumer products and food 20–33 115 (26.8) 19.3
Energy 10–14, 46, 49 43 (10.0) 9.3
Financial Servicesb 60–64, 67 2 (0.5) —
Information and Communication 48, 73, 78, 79, 84 66 (15.4) 24.4
Manufacturing 34–39 140 (32.6) 24.3
Personal services, healthcare 72, 80, 83 4 (0.9) 2.3
Commercial services, education 75, 76, 82, 87, 89 8 (1.9) 3.1
Real Estate 65, 70 3 (0.7) 1.7
Retail and Wholesale 50–59 27 (6.3) 10.4
Transportation 40–42, 44, 45, 47 13 (3.0) 2.4
All other 1, 2, 7, 8, 99 2 (0.5) 1.6
Total Firms 429 100 (rounded)

Panel B: Distribution of Observations by Auditor

Number of Compustat
Auditor Observations (%) Population (%)c
Andersen 88 (20.5) 20.4
Deloitte & Touche 69 (16.1) 16.0
Ernst & Young 95 (22.1) 22.5
KPMG Peat Marwick 71 (16.6) 16.8
PricewaterhouseCoopers 106 (24.7) 24.3
Total 429 100.0
a
Calculated based upon all firms in the active Compustat database, excluding financial services firms.
b
These firms are financial information services firms such as Dow Jones and Moody’s, which are not subject to
the same regulatory environment as banks and other financial services companies.
c
Calculated based upon all firms in the active Compustat database, excluding those firms lacking auditor
information, and those audited by non-Big 5 auditors.

6
Our audit committee measures control for the possibility of an omitted, correlated variable. To wit, Xie et al.
(2003) find that companies with effective audit committees exhibit lower discretionary accruals.

Auditing: A Journal of Practice & Theory, May 2006

92 Abbott, Parker, and Peters

food (SIC codes 2000–3399), while the population includes 24 percent and 19 percent,
respectively. Panel B shows the distribution of observations by auditor. The representation
of these firms in the sample mirrors that of the overall population.
Table 3 provides descriptive statistics for the sample. Mean (median) audit fees were
$831,200 ($308,500). The mean (median) estimated discretionary accruals are income-
decreasing for sample firms at ⫺0.032 (⫺0.005) and the raw price-earnings ratio has a
mean (median) value of 12.56 (11.75). The industry-adjusted P/E has a mean (median) of
4.896 (2.21).
The mean (median) firm size measured by assets is $4.6 billion ($573 million). Firms
exhibit a mean of square root of subsidiaries of 3.9. The mean proportion of foreign sub-
sidiaries to total subsidiaries is .18. The mean INVREC score was 0.27. Thirty-one percent
of firms experienced a loss in two of the three years preceding the sample year. The mean
level of leverage is 21 percent. Ten percent of firms received a going-concern modification
in the prior year. Sixty-nine percent of the directors of the full boards of sample firms are
independent, and the mean (median) board meetings is 6.9 (6.0). Forty percent of the firms
meet our joint threshold for expert presence, independence, and activity of the audit
committee.7

Regression Results
Multivariate regression results are presented in Table 4. The high R2 of the regression
(79% percent) suggests a good model fit.8 The coefficient estimates on all of our test
variables are statistically significant, providing support for our hypotheses. We find that
audit fees are significantly lower (higher) when the client firm’s discretionary accruals are
more income-decreasing (increasing) (p-values ⫽ .001 and 0.024).9 In economic terms, the
dollar impact of moving from the 20th to 80th percentile of the discretionary accrual dis-
tribution is approximately 5.5 percent of median audit fees.10
To put our results into further perspective, we note the results of Francis and Wang
(2005). These authors find that the mean, inflation-adjusted audit fee deviation from their
prediction model is approximately 3.3 percent of audit fees. Within this framework, Francis
and Wang (2005) find that audit clients used mandated audit fee disclosures to demand
changes in subsequent audit fees—i.e., those audit clients who were systematically over-
charged (undercharged) in 2000 paid relatively lower (higher) audit fees in 2001. In other
words, it appears that seemingly modest audit fee magnitudes (and similar in size to those
in the current study) are considered economically significant by market participants.
We also find that the effect of positive discretionary accruals has an incremental ex-
planatory effect when interacted with the industry-adjusted P/E ratio (p ⫽ 0.053, two-
tailed), confirming our hypothesis that perceived earnings management is of greater concern
(or perhaps more visible to auditors) for clients facing greater litigation risk resulting from
performance expectations that exceeds industry norms. Although the economic significance

7
Eighty-one percent of firms included at least one financial expert, 77 percent were entirely comprised of inde-
pendent directors, and 58 percent held at least four meetings in the sample year.
8
In terms of regression diagnostics, our highest documented pairwise correlation was 0.26. VIF scores revealed
no problems (all scores ⬍ 2). The calculated index was 8.42. According to Belsley et al. (1980), a condition
index of 5–10 indicates weak dependencies. Therefore, it appears that multicollinearity is not a problem. Our
Breuch-Pagan statistic was 10.15, suggesting that heteroscedasticity is not an issue.
9
Our empirical results differ from the Australian results of Gul et al. (2003), who find a significant relation only
in income-increasing subsamples.
10
Discretionary accrual values at the 20th and 80th percentiles were ⫺0.1452 and 0.1267, respectively. The increase
in audit fees resulting from moving between the 20th and 80th percentiles represents approximately $17,013 or
110 additional audit staff hours, if one assumes a billing rate of $150 / audit staff hour.

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Earnings Management, Litigation Risk, and Asymmetric Audit Fee Responses 93

TABLE 3
Descriptive Data

Standard 25th 75th

Variable Name Mean Median Deviation percentile percentile
AUDFEE (in $000s) 831.2 308.5 143.2 143 800
DISCACC ⫺0.032 ⫺0.005 0.644 ⫺0.109 0.080
P / E (raw) 12.563 11.750 20.676 ⫺0.730 20.280
P / E (industry-adjusted) 4.896 2.210 22.050 ⫺7.030 13.860
ASSETS (in millions) 4,595.8 572.9 1688.5 119 2483.2
SQSUBS 3.938 2.449 5.340 0.000 5.477
FORSUBS 0.184 0.130 0.322 0.010 0.300
INVREC 0.267 0.260 0.182 0.120 0.372
RECURLOS 0.315 0.000 0.465 0.000 1.000
LEVERAGE 0.210 0.173 0.349 0.010 0.292
GOINGCON 0.097 0.000 0.298 0.000 0.000
PERCOSBD 0.689 0.727 0.175 0.600 0.830
BORDMEET 6.890 6.000 3.623 5.000 9.000
ACINDACT 0.396 0.000 0.490 0.000 1.000
Variables are as defined in Table 1, with the exception of ASSETS (in millions). The natural log of total assets is
utilized in regression analysis.

of the coefficient is a matter of judgment, the results provide limited empirical support for
H2.
The majority of control variables are also significant. Consistent with prior research,
the coefficient estimates on SIZE, INVREC, SQSUBS, and RECURLOS are positive and
significant, as are corporate governance variables. Interestingly, we do not find support for
two of our risk measures, GOINGCON and LEVERAGE. The shift away from the joint and
several liability regime toward one of proportionate liability, combined with the defensive
role played by the audit qualification (Carcello and Palmrose 1994), may explain the lack
of significance for our GOINGCON variable. Menon and Williams (2001) also fail to find
a relation between leverage and audit fees and posit that leverage may not be an adequate
proxy for an auditor’s litigation risk.

Sensitivity Analysis
We conduct a number of sensitivity tests (not reported) to confirm the robustness of
our results. Prior research indicates that audit fees increase as a nonlinear (concave) function
of size. Thus, we partitioned our samples into two subsamples based on company size.
Regression results for both subsamples were qualitatively similar to those reported in Table
4. We also include additional variables from previous research in the primary and size-
partitioned regression tests. Our results are qualitatively unchanged when we include ROA,
growth in total assets, an indicator variable signifying a litigious industry (Carcello and
Palmrose 1994), and an indicator variable for whether the firm has a December 31 year-
end. When we include inside ownership (Gul et al. 2003) and interact inside ownership
with our test variables, our test variables continue to be significant at conventional levels.
We also include measures of restructuring, acquisitions, and debt placement and find our
primary results unchanged.

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94 Abbott, Parker, and Peters

TABLE 4
Regression Results
(n ⫽ 429)

LNAFEE ⫽ b0 ⫹ b1DISCACC*INCR ⫹ b2DISCACC*DECR ⫹ b3P / E*DISCACC*INCR

⫹ b4SIZE ⫹ b5SQSUBS ⫹ b6FORSUBS ⫹ b7INVREC ⫹ b8RECURLOS
⫹ b9 LEVERAGE ⫹ b10GOINGCON ⫹ b11PERCOSBD ⫹ b12BORDMEET
⫹ b13ACINDACT ⫹ e
Expected Parameter
Variable Name Sign Estimate t-statistic p-value
Intercept 5.936 18.98 0.000
DISCACC*INCR ⫹ 0.152 2.26 0.024
DISCACC*DECR ⫺ ⫺0.178 ⫺3.32 0.001
P / E*DISCACC*INCR ⫹ 0.001 2.03 0.053
SIZE ⫹ 0.469 26.62 0.000
SQSUBS ⫹ 0.028 4.15 0.000
FORSUBS ⫹ 0.002 1.41 0.159
INVREC ⫹ 0.452 1.75 0.081
RECURLOS ⫹ 0.164 2.26 0.024
LEVERAGE ⫹ 0.010 0.13 0.893
GOINGCON ⫹ ⫺0.034 ⫺0.36 0.719
PERCOSBD ⫹ 0.345 2.76 0.061
BORDMEET ⫹ 0.015 1.72 0.086
ACINDACT ⫹ 0.163 2.54 0.011
Adjusted R2 ⫽ 0.7978 Model F-stat ⫽ 132.931 p ⬍ 0.0001
Two-sided p-values are reported.
Variables defined in Table 1.

We also investigate the effect of additional auditor characteristics. First, we control for
auditor tenures of 1, 2, or 3 years, since new engagements may result in lower fees. Second,
we drop each of the Big 5 auditors from the sample in turn, to test whether any one auditor
has an excessive influence on results. Third, some previous research has found a relation
between nonaudit fees and audit fees, and thus we include nonaudit fees as an independent
variable. Finally, we control for a potential industry-specialist fee premium (Craswell et al.
1995). None of these tests changes our results qualitatively.
In terms of the homogeneity of our audit fee model across industries, we performed
three sensitivity tests. First, consistent with Carcello et al. (2002), we included an industry
dummy variable for each of the one-digit SIC codes per Table 2. Second, we segregated
our sample into only those observations in the manufacturing sectors (SIC codes 2000–
3999). Third, we ran separate regressions for the Consumer Products and Food and Man-
ufacturing focus industries. We acknowledge that our industry categories may introduce
classification error. In all three sets of tests, our results remain qualitatively similar to those
reported in Table 4.
We test the robustness of the results to alternate definitions of discretionary accruals.
We used the Kothari et al. (2005) estimation method to calculate performance-matched
discretionary accruals and found results similar to those found in Table 4. Similar results
were found when using the Hribar and Collins (2002) accruals estimation technique. Our

Auditing: A Journal of Practice & Theory, May 2006

Earnings Management, Litigation Risk, and Asymmetric Audit Fee Responses 95

results remain qualitatively unchanged when we winsorize discretionary accrual values at

the 95 percent and 99 percent levels.
We also substitute the estimated discretionary accruals in 1999 for the year 2000 es-
timation, since it is unclear whether any audit fee effect might be due to auditors assessing
risk based on the earnings management history. We fail to document any relation between
prior-year accruals and current-year audit fees, suggesting that auditors respond to client
accounting discretion during the course of the audit.
The lack of a relation between prior-year accruals and current-year audit fees suggests
a scenario consistent with our observed results. In particular, discussions with several Big
5(4) audit partners and managers indicate that final audit fees are often influenced by
ongoing negotiations that relate to audit scope revisions that occur over the course of the
audit.11 Post-planning hours spent on an audit area may often change depending on the
emerging analysis of the financial statement account, most likely during the fieldwork stage
of the audit.12 We believe that audit-scope revisions arising from fieldwork-stage analysis
will follow the conservative bias model proposed by Barron et al. (2001). More specifically,
those accounts that appear to be potentially overstating income during the fieldwork stage
will compel senior audit personnel to recommend increases in audit scope. Those accounts
that appear to be potentially understating income during the fieldwork stage are less likely
to be the subject of increases in proposed audit scope. We believe this is due to the auditor’s
recognition that overstated income poses a greater threat to the auditor’s expected loss
function. As discussed in our ‘‘Limitations’’ section, our research design cannot distinguish
between this explanation and other possible scenarios. Nonetheless, this description is gen-
erally consistent with our results and representations made to us by Big 5(4) audit partners
and managers.
Limitations
Our dependence on a purely ex post research design creates several issues that merit
discussion. First, we cannot definitively ascertain how much of our documented incremental
audit fee response appears in the planning stage (with a concomitant increase in audit
fieldwork) or fieldwork (discovery) stage of the audit. Given our discussion with auditors
and the failure to document a relation between prior-year accruals and current-year audit
fees, we believe that meaningful fee changes occur during the fieldwork stage. Second, we
cannot determine whether our audit fee response to income-increasing accruals is due to a
risk premium or an increase in audit effort. We believe it is most likely the latter as several
recent studies have utilized audit fees as a proxy for audit effort (Abbott et al. 2003;
Carcello et al. 2002). Third, our analyses cannot disentangle whether auditors are, indeed,
doing sufficient work for income-decreasing accrual clients (as opposed to ‘‘under-
auditing’’), while simply doing more work—or charging a higher risk-related fee pre-
mium—for income-increasing accrual clients. Fourth, we cannot establish what, if any,
adjustments were made to pre-audit discretionary accruals as a result of the audit. This
weakness is common to any research design relying on publicly available audited financial

11
These revisions do not necessarily entail formally altering original risk assessments, but often involve supple-
mentary audit procedures and / or increased sample sizes to obtain additional audit coverage. Conversely, in cases
of income-decreasing discretionary accruals, auditors may reduce sample sizes or rely more heavily on analytical
procedures. Given that audit purchasers are often former Big 5 (4) personnel (Carcello et al. 2002), such
purchasers are likely cognizant of the reduced audit coverage and would seek to negotiate a reduction in audit
fees.
12
Das and Shroff (1996) find that firms performing poorly (well) in interim quarters increase (decrease) fourth
quarter earnings to achieve a desired annual earnings target. The authors conclude the majority of earnings
management transpires during the fourth quarter, which occurs after the audit-planning stage.

Auditing: A Journal of Practice & Theory, May 2006

96 Abbott, Parker, and Peters

statements. We believe prospective research design refinements addressing these limitations

are avenues for future research.
There are at least two other sample-related limitations to our paper, as well. First, our
industry classification scheme and sample period restrictions may introduce sampling risk,
thus hindering the generalizability of our results. Second, the exclusion of non-Big 5 au-
ditors from our tests may exacerbate such generalizability concerns.

CONCLUSION
This purpose of this study was to examine the impact of income-increasing versus
income-decreasing earnings management on auditor behavior. Using discretionary accruals
as our proxy for earnings management risk and concomitant litigation risk, we find that
audit fees decrease (increase) with income-decreasing (increasing) discretionary accruals.
We also find that the increase in audit fees for positive discretionary accruals is magnified
for high P/E firms. We attribute these findings to a ‘‘conservative bias’’ on the part of
auditors. This bias arises from asymmetric litigation outcomes concerning income-
decreasing versus income-increasing earnings management.
Although this evidence is at odds with the GAAS-based audit risk model, it is consistent
with an emerging stream of conservative bias literature, which provides evidence that the
audit risk model does not adequately capture auditor behavior concerning audit planning
and investment (Lee and Mande 2003; Hodge et al. 2002; Barron et al. 2001). For example,
Houston et al. (1999) find that, in the presence of accounting irregularities, the auditor’s
assessment of litigation risk or ‘‘the risk of loss or injury to an auditor’s professional
practice due to client relationships’’ dominates the traditional elements of the audit risk
model in the explanation of audit investment.
From an academic research perspective, DeFond and Francis (2004) note the need for
research to address the ‘‘role and importance of litigation in maintaining high audit quality.’’
To the extent income-increasing versus income-decreasing discretionary accruals proxy for
auditor’s assessment of higher versus lower litigation risk, our asymmetric findings suggest
that the litigation risk component of the auditor’s production function helps preserve high
audit quality. However, litigation could also have detrimental effects on overall financial
reporting quality to the extent that auditors’ attention over-emphasizes income-increasing
earnings management vis-à-vis income-decreasing earnings management. As such, audits
may not reflect the growing concerns exhibited by the SEC concerning income-decreasing
earnings management such as ‘‘Cookie-Jar’’ reserves. Since our tests cannot completely
disentangle the possible detrimental effects of litigation, we believe further research in these
areas would be warranted.

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