Real Earnings Management And Audit Fees

As the accounting standards has been implemented, the cost and risks of accrual-basedearnings management has increased greatly for listed companies. More and more paperpresents empirical evidence that managers can also manipulate reporting earning by adjustingreal activities, called real operation management (REM). Unlike accrual-based earningsmanagement, REM can have direct consequences on current and future cash flows, are moredifficult for average investors to understand, and are normally less subject to externalmonitoring and scrutiny by auditors, regulators, and other outside stakeholders. It causes realoperations to deviate from their optimal levels, thereby dampening a firm’s ability to generatefuture cash flows in the long run.This study investigates whether the auditors incorporate the implications of potentiallitigation risks arising from their client firms’ earnings management through real activitiesmanipulations. REM is related to higher audit fees because, to the extent that it reflectsmanagers’ opportunism, it is not realized in the future and is associated with assessments ofhigher inherent risks by auditors（Gul et al，2003）.Unlike AEM, the effect of REM on thelevel of audit fees is ex ante not clear. I posit that auditors also have stronger incentives tounderstand and detect REM which has become more pervasive in this period. Given thatREM is a more serious value-destroying earnings management method, they will chargehigher audit fees on firms with more extensive REM once they understand and detect it.This paper assume that the audit fees increase with the intensity of REM. As auditorsdetect this opportunism, they will issue non-standard audit opinions to keep auditingindependence and audit quality.This study is important for standarding audit and securitiesmarket.