Felice Matozza, Anna Maria Biscotti, Eugenio D'Amico, Alberto Dello Strologo
Companies facing serious financial distress are more likely to engage in income-increasing earnings management than healthy firms in order to mask poor performance. In these contexts, audit firms might increase substantive tests, that should constrain discretionary accruals, as well as charging risk premiums, both resulting in growing audit fees. The different components of audit fees, namely a fee premium for auditors’ efforts or risk premium, however, have an opposing impact on audit quality. This paper aims thus to investigate how the business context status of a client might differently affect the auditors’ pricing policies and commitments in the audit process. We address our research questions adopting a matched sample consisting of bankrupt and healthy US firms in the post-SOX period, between 2005 and 2015. Consistent with our predictions, the results show a significant propensity of ex-post bankrupt firms to adopt upward earnings management. In these critical contexts, it reveals that auditors are primarily concerned about obtaining a risk premium, especially in the first year of an engagement, rather than extending the audit efforts to constrain earnings manipulation. By contrast, the higher audit fees charged to healthy companies by the newly appointed auditors result in effective audit efforts, therefore improving the earnings quality. This study thus provides evidence that in riskier business contexts auditors prefer conservative approaches to pro-active commitments by primarily adjusting risk premiums in response to a higher litigation risk. The paper contributes to the extant literature by documenting the existence of a component in the audit fees that results in low audit quality.