The Relationship Between Segment-Level Manipulations And Audit Fees

David Hurtt, Bradley E. Lail, Jason MacGregor
2013 Journal of Applied Business Research  
We examine the auditorssensitivity to manipulative financial reporting by investigating the relationbetween audit fees and segment-level manipulations. Segment reporting provides an interestingsetting to examine auditor risk assessments because of the discretion affordedto management under existing regulations. Segment manipulations, a form of classificationsmoothing, are not in violation of accounting standards; nevertheless, thesemanipulations violate the spirit of faithful representation by
more » ... istorting theperformance of a subset of the reporting unit at the expense of (or to thebenefit) of another subset. Because disaggregatedinformation is used by analysts and investors in bottom-upforecasting, these distortions can influence firm value even though they do notaffect bottom-line net income. Ourmeasure of classification smoothing measurescost shifting between core operating segments and non-core segments to proxyfor segment manipulation. We find thataudit fees, a proxy for the auditors risk assessment, have a positiveassociation with segment-level manipulations. Subsequent analyses suggest that higher auditfees are also due to the additional effort exerted in the presence of segment-levelmanipulations. Further, auditors appearjustified in charging higher fees to clients that engage in segmentmanipulations as we document evidence of a positive association betweenrestatements and segment-level manipulations. Collectively, these results suggest thatauditors are aware of the risk associated with companies that engage in segment-levelmanipulations and auditors respond appropriately by charging higher fees anddoing additional work.
doi:10.19030/jabr.v29i4.7930 fatcat:obfov22f2jhtfgywdhmt2xfnhe