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 Abnormal Audit Fees and Audit Quality: The
Importance of Considering Managerial Incentives in
Tests of Earnings Management

John Daniel Eshleman

Department of Accounting
E.J. Ourso College of Business
Louisiana State University
Baton Rouge, LA 70803
Email: jeshle1@tigers.lsu.edu

Peng Guo
Department of Accounting
E.J. Ourso College of Business
Louisiana State University
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Baton Rouge, LA 70803
Email: pguo3@tigers.lsu.edu

accepted
First Version: August 2012

manuscript
This Version: July 2013

We thank Robert Knechel (Editor), Ken Reichelt, Jared Soileau, two anonymous reviewers, and all workshop participants
at Louisiana State University. All errors that remain are our own.
Abnormal Audit Fees and Audit Quality: The Importance of Considering Managerial
Incentives in Tests of Earnings Management

Abstract: Are high audit fees a signal that the auditor exerted more effort or a signal that the
auditor may be losing her independence? Prior literature offers conflicting evidence. In this
paper, we re-examine the issue on a sample of clients who have both the incentive and the ability
to use discretionary accruals to meet or beat the consensus earnings forecast. We find a negative
relationship between the level of abnormal audit fees paid by the client and the likelihood of
using discretionary accruals to meet or beat the consensus analyst forecast. The evidence is
consistent with the notion that abnormal audit fees are indicative of greater effort on the
engagement. In other words, the results suggest a positive relationship between abnormal audit
fees and audit quality. We show that the conflicting evidence in prior research was caused by
research designs which did not consider the incentives of the manager.

Keywords: Audit Quality; Audit Fees; Discretionary Accruals; Meet-or-Beat.

JEL Classifications: M42; M41.

Data Availability: All data are available from public sources quoted in the text.

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 I. INTRODUCTION

A growing body of accounting literature examines the relationship between audit fees and

audit quality. Researchers are interested in this relationship because, ex ante, it is not clear

whether receiving higher fee revenue from a client will improve audit quality or harm it. On the

one hand, it could be argued that an auditor who receives abnormally high audit fees from a

client will lose her independence and allow the managers of the client firm to engage in

questionable accounting practices (DeAngelo 1981). There is currently empirical support for this

notion in the audit literature. Both Choi et al. (2010) and Asthana and Boone (2012) find a

positive relationship between abnormally high audit fees and the magnitude of discretionary

accruals, implying that auditors receiving high fees tolerated more discretion. However, it is also

possible that audit fees are a measure of audit effort, i.e., higher fees indicate that the auditor

worked more hours, signaling greater effort.

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To the extent that audit fees are a measure of audit effort, low audit fees could harm audit

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quality. In support of this view, Lynn Turner, former Chief Accountant at the Securities and

Exchange Commission (SEC) writes:

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“…Certainly throughout the 1980s and 1990s, corporations, sometimes with the

assistance of their audit committees, “twisted” the arms of independent auditors to reduce

their audit fees. Our experience includes corporations who competitively bid their

independent audit work solely to reduce their fees well below levels that could generate a

reasonable return for the auditors. In turn, the audit firms reduced the level of work they

needed to perform in their role as gatekeepers for investors. Inevitably inferior audits

resulted.” (Turner 2005)

2
 There is also empirical evidence supporting this argument in the literature. Blankley et

al. (2012) document a negative relationship between abnormal audit fees and the likelihood of

issuing an accounting restatement. This is consistent with auditors receiving low fees

performing less thorough audits, thus leading to a higher likelihood of material misstatements.1

Researchers typically dissect audit fees into a normal and an abnormal component.2

Normal audit fees are the expected fees given the client’s size, risk, and complexity. The

difference between the actual audit fee paid and the fee that was expected given the client’s size,

risk, and complexity is the abnormal component. Assessing what we know about the

relationship between abnormal audit fees and audit quality is complicated for at least two

reasons. First, the different studies use different audit fee models to dissect audit fees into a

normal and an abnormal component. Second, and perhaps most importantly, a central problem

with comparing the mixed evidence across studies is the wide variety of measures used to proxy

for “audit quality”. preprint

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In this paper, we attempt to shed light on the conflicting evidence by performing a study

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of the relationship between abnormal audit fees and audit quality using a new research design.

Specifically, we examine whether clients paying abnormal audit fees are more or less likely to

use discretionary accruals to meet or beat the consensus analyst forecast (see Davis et al. 2009).

This measure of audit quality is similar to prior literature which examines the propensity of firms

to meet or beat analysts’ forecasts (e.g., Reichelt and Wang 2010; Asthana and Boone 2012).

The difference is that we only consider firm-years in which the firm’s earnings before

1
Note that it is also possible that low audit fees do not harm audit quality. This would occur if the auditors “eat
time” to complete the audit on budget (e.g., Schelleman and Knechel 2010). If this happens, the auditor’s profit
margin is lower but audit effort is not.
2
Although this is common practice, it would be more correct to divide audit fees into three components: (i.) normal
fees, (ii.) an error component, and (iii.) abnormal fees. In this way, abnormal audit fees would be those that exceed
a confidence interval surrounding the estimate of normal audit fees. We discuss this in more detail in section VI.

3
discretionary accruals (i.e., the firm’s pre-discretionary earnings) are less than the consensus

analyst forecast, thus making it more likely that the manager has the incentive to use

discretionary accruals to meet or beat the consensus forecast.3 In addition, we require that the

consensus earnings forecast does not exceed the firm’s pre-discretionary earnings by more than

five percent of total assets4, making it more likely that the manager has the ability to use

discretionary accruals to meet or beat the consensus forecast (Davis et al. 2009). This approach

essentially identifies clients that met or beat the consensus earnings forecast but would have

missed the target in the absence of income-increasing discretionary accruals.

Our approach has advantages over simply using the absolute value of discretionary

accruals as a proxy for audit quality. When using the absolute value of discretionary accruals to

proxy for audit quality, one is assuming that all discretionary accruals are equally harmful to

earnings quality. This need not be the case as managers can use discretionary accruals to signal
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the firm’s true profitability rather than use them opportunistically (Subramanyam 1996).5 This

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measure also has advantages over simply using the likelihood of a client meeting or beating

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analysts’ forecasts by two pennies or less, as used in such studies as Asthana and Boone (2012).

Firms with earnings slightly above the consensus forecast could have achieved those earnings

using accruals-based earnings management, real earnings management (e.g., cutting R&D,

delaying maintenance, or offering sales discounts), or using expectations management.

However, auditors are only concerned with mitigating accrual-based earnings management.

Thus, classifying all firm-years with earnings slightly above the consensus forecast as being “low

3
Graham et al. (2005) provide survey evidence consistent with this notion. Specifically, they find that 73.5% of
CFOs consider meeting or beating analysts’ forecasts to be important.
4
We choose the 5 percent cutoff because Dechow, Sloan, and Sweeney’s (1995) suggest that up to 5 percent of
assets is a plausible magnitude of earnings management.
5
For example, Krishnan (2003) finds that the discretionary accruals of Big-4 clients have a stronger association with
future profitability than do the discretionary accruals of other clients. This implies that not all discretionary accruals
are equally harmful to earnings quality.

4
audit quality” firm-years likely misclassifies some clients who used expectations or real earnings

management to beat the forecast.6

We find that clients paying higher abnormal audit fees are significantly less likely to use

discretionary accruals to meet or beat the consensus analyst forecast. If abnormal audit fees are

held at their mean, a one-standard deviation increase in abnormal audit fees decreases the client’s

likelihood of using discretionary accruals to meet or beat the consensus forecast by

approximately 5 percent. This is consistent with higher audit fees being indicative of greater

auditor effort and ultimately better audit quality. We obtain similar results whether we use the

audit fee model of Choi et al. (2010), the one proposed by Blankley et al. (2012), or our own

audit fee model.

This study offers at least two contributions to the auditing literature. First, this paper

provides new evidence on the fee-quality relationship using the propensity to use income-
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increasing discretionary accruals to meet or beat analysts’ forecasts. The evidence in this paper

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suggests that abnormal audit fees are positively related to audit quality. This result is consistent

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with concerns raised by regulators (e.g., Turner 2005; Bockwaldt 2010) that lower audit fees

could reflect a lower level of effort provided by the auditor. This is important, given the trend

of declining audit fees in recent years (Telberg 2010). Second, by finding different results using

a more focused sample of firms with the incentive and ability to manage earnings, this study

highlights the importance of considering the context when performing tests of earnings

management. The evidence in this paper suggests that simply examining the magnitude of a

firm’s discretionary accruals may not be sufficient evidence to infer the extent of earnings

management at the firm. This is important because prior research on audit quality utilizes the

6
Indeed, the literature provides evidence that managers use both real earnings management and expectations
management to achieve earnings benchmarks (Gunny 2010 and Cotter et al. 2006, respectively).

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magnitude of discretionary accruals is a proxy for earnings management, and thus, a valid proxy

for audit quality (e.g., Francis and Reynolds 2001; Frankel et al. 2002; Balsam et al. 2003;

Chung and Kallapur 2003; Francis and Yu 2009; Boone et al. 2010; Choi et al. 2010; Reichelt

and Wang 2010; Lopez and Peters 2012; Asthana and Boone 2012).7 As we illustrate in this

study, assuming that higher magnitude of discretionary accruals are indicative of greater earnings

management, without considering the incentives of the manager or the predicted direction of

earnings management, can lead to erroneous inferences.

The rest of the paper is organized as follows. Section II contains a review of related

literature, section III is the research design, section IV contains the sample selection criterion and

descriptive statistics, and section V contains the main empirical results. Section VI contains

robustness checks and section VII concludes.

II. RELATED LITERATURE

Theory
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There are two main views on the relationship between abnormal audit fees and audit

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quality. The first view is that abnormally high audit fees are indicative of bribes or economic

rents being earned by the auditor (Kinney and Libby 2002). Thus, higher audit fees than what is

justified by the workload of the audit may cause the auditor to lose her independence and allow

the client to engage in more questionable accounting practices.8 This may happen because audits

are conducted by audit partners and not audit firms. This means that the audit partner in charge

of a given audit enjoys the vast majority of the additional revenue from the client while

7
Of course, we are not suggesting that we discard all evidence from papers which use the absolute value of
discretionary accruals as a proxy for audit quality. The majority of these papers also use alternative proxies as a
robustness check. However, we do believe researchers should exercise caution when choosing audit quality proxies
and strive for better measures of audit quality.
8
As a real-life example, Kinney and Libby (2002) note that Enron’s actual audit fee was two and half times that of
its estimated normal audit fee during the year 2000. Thus, Enron’s auditor was economically bonded to Enron and
lost its independence.

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spreading the risk across the entire audit firm (Trompeter 1994). We refer to this view as the

“economic bonding view”.

The second view is that higher audit fees are indicative of greater auditor effort, and thus,

a higher quality audit. Higher audit fees are the result of the audit firm working longer hours

and/or the audit firm charging a higher rate because it is a better auditor. Conversely, low audit

fees indicate less audit work, and hence, lower audit quality. Increasing audit effort is one way

an auditor can respond to a heightened risk of earnings management (Francis and Krishnan

1999).9 This view is echoed by the Public Company Accounting Oversight Board (PCAOB),

which targets firms with low audit fees relative to other firms in the same industry, when

deciding which external audit firms to review (Bockwoldt 2010). The PCAOB is assuming that

firms paying low audit fees are receiving low quality audits. We refer to this view as the “effort

view”. Therefore, with arguments for both sides, the effect of abnormal audit fees on audit

quality is an empirical issue. preprint

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Literature

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Early studies failed to find a significant relationship between abnormal audit fees and

audit quality (e.g., DeFond et al. 2002).10 Subsequent research allowed the relationship between

abnormal fees and audit quality to depend on the sign of the abnormal fees and found that

abnormally high audit fees are associated with a higher magnitude of discretionary accruals

(Choi et al. 2010; Hoitash et al. 2007). This is consistent with abnormally high audit fees

causing the auditor to lose her independence, thereby allowing the manager to record higher

9
For example, using a proprietary dataset, Schelleman and Knechel (2010) find that clients with high short-term
accruals are assigned more supervisors, assistants, and support personnel. In addition, these clients are charged
higher audit fees. This suggests that auditors respond to earnings management risk by increasing audit effort and
audit fees.
10
There is a considerable body of research on the effect of non-audit fees on audit quality (e.g., Frankel et al. 2002;
Ashbaugh et al. 2003; Chung and Kallapur 2003; Larcker and Richardson 2004; Blay and Geiger 2013). We do not
review this literature as our focus is on audit fees.

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magnitudes of questionable accruals, consistent with the economic bonding view. In addition,

Asthana and Boone (2012) present evidence consistent with the economic bonding view. They

find that clients with abnormally high audit fees exhibit a higher magnitude of discretionary

accruals and are more likely to meet or beat analysts’ EPS forecasts by two cents or less.11

In support of the effort view, Blankley et al. (2012) find that clients paying abnormally

high audit fees are less likely to subsequently restate their earnings. This is consistent with the

auditors doing a better job on the audit and preventing accounting irregularities from taking

place. In addition, Higgs and Skantz (2006) find a positive relationship between earnings

response coefficients, a measure of perceived audit quality, and abnormal audit fees.12

Thus, the literature offers mixed evidence. There are two studies which support the effort

view (Higgs and Skantz 2006; Blankley et al. 2012) and three studies which support the

economic bonding view (Choi et al. 2010; Asthana and Boone 2012; Hoitash et al.2007).
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However, the results of one study do not directly contradict the results of the other. In other

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words, we still do not know whether the different findings are attributable to different audit

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quality proxies, different audit fee models, or simply different sample periods/sample selection

criteria. This makes it difficult to assess what we know about the fee-quality relationship.

Examining the results of the studies jointly, one can imagine a scenario which supports either

point of view. For example, in support of the effort view, one can view the negative relationship

between abnormal audit fees and accounting restatements as evidence that the auditors exerted

more effort on the audit and thus prevented restatements from occurring. The positive

relationship between abnormally high audit fees and the magnitude of discretionary accruals may

11
The authors also find that abnormally low audit fees are associated with lower audit quality. They attribute this
finding to large clients with high bargaining power, who bargain for lower fees and lower audit quality.
12
The rationale for this measure is that if investors perceive the financial statements as being more credible, they
will assign a lower cost of capital to the firm’s equity, which will result in a greater response to earnings news.
However, this measure only captures investors’ perceptions of audit quality.

8
be attributable to firms with volatile operating environments. In fact, firms with more volatile

and risky operating environments are charged higher fees, which can explain why fees are

positively related to the magnitude of discretionary accruals. For example, Schelleman and

Knechel (2010) use private audit firm data and find that auditors respond to high levels of short-

term accruals by assigning more supervisors, assistants, and support staff to the engagement. On

the other hand, the results can be interpreted differently to support the economic bond view. The

higher magnitude of discretionary accruals for firms with higher audit fees is consistent with

auditors losing independence and allowing the client to use more discretionary accruals. Since

accounting restatements are often triggered by auditors (Francis 2004, 348), the lower likelihood

of issuing an accounting restatement for clients with higher audit fees can be interpreted as

evidence that the auditors chose not to force the client to restate its earnings so as to protect their

reputation. In summary, the effect of abnormal audit fees on audit quality is not clear; it is an

empirical issue we examine in this study. preprint

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III. RESEARCH DESIGN

Audit Fee Model

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To shed light on the cause of mixed findings in the literature, we examine the association

between abnormal audit fees and the likelihood of firms using income-increasing discretionary

accruals to meet or beat the consensus EPS forecast. Our variable of interest is abnormal audit

fees. These are audit fees not explained by the size, complexity, or risk of the client. Normal

audit fees are estimated as the residual from the following OLS regression estimated separately

for each year to control for the changing pricing of risk over our sample period (Charles et al.

2010)13:

13
Results are similar if we estimate abnormal audit fees by industry-year instead.

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 _ _ 2

< Insert Table 1 >

Variables are defined in Table 1. Subscripts i and t indicate firm and year, respectively.

We exclude firms which received a going concern or ineffective internal control audit opinion.14

In addition, we exclude firm-years in which the client switched auditors. The model attempts to

control for four factors which affect the level of audit fees charged to the client. The first factor

is size. We include the natural logarithm of total assets ( ) and the square root of the

number of employees ( preprint

) to control for client size, as we expect larger clients to be

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charged higher audit fees.

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The second factor is risk. We include a handful of measures to capture risk as we expect

more risky firms to be charged higher audit fees as compensation for the higher risk (Simunic

and Stein 1996). To this end, we include the relative amount of the firm’s assets that are

accounts receivable and inventory ( ), the proportion of current assets at the firm ( ),

the current ratio ( ), performance ( ), leverage ( ), whether the firm reported a loss

( ), and whether the firm received a qualified opinion ( ).

The third factor which affects audit fees is the complexity of the audit. Firms with more

complex operations are expected to be charged higher audit fees (Simunic 1980). To capture

14
Results are robust to including these observations and including indicator variables for going concern opinions
and internal control weaknesses in the audit fee model.

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client complexity, we control for the number of geographic segments the firm has ( ),

the number of business segments the firm has ( ), whether or not the firm pays

foreign income taxes ( ), and whether or not the firm issued new equity recently

( ). We expect the coefficients on each of these variables to be positive, indicating that

more complex clients are charged higher audit fees (Casterella et al. 2004; Hay et al. 2006).

Finally, a fourth factor which affects audit fees is auditor and engagement attributes (Hay

et al. 2006). For example, with their brand-name reputation, Big-N auditors are able to charge a

fee premium (Ireland and Lennox 2002). In addition, Second-tier auditors (Grant Thornton and

BDO Seidman) may be able to earn fee premiums as well. We therefore include the indicator

variables and 2 .15 We control for whether the auditor is an industry specialist by

including , , and because it is well documented that

industry specialists earn fee premiums (Francis et al. 2005; Fung et al. 2012).16 We include

_
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because we expect that auditors will charge lower fees in the initial years of the

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engagement, a common practice known as ‘low-balling’. We include the size of the local audit

practice (
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) because we expect that larger audit offices are able to charge higher

audit fees. We include controls for client bargaining power ( ), audit scale ( , and

the interaction of auditor scale with industry leadership ( ) following

Fung et al. (2012). Fung et al. show that audit offices with a larger scale offer discounts to their

clients; this effect is somewhat attenuated when the auditor is an industry leader in the city. The

model includes industry fixed effects, where industries are defined using the industry definitions

in Ashbaugh et al. (2003).

15
There is evidence that Second-tier auditors provide audit quality similar to Big-4 auditors (Boone et al. 2010).
16
Following Francis et al. (2005) and Reichelt and Wang (2010), we define cities using metropolitan statistical areas
(MSAs) as classified by the U.S. Census Bureau. The MSA cross-map is available at:
http://www.census.gov/population/www/metroareas/metroarea.html. If a city is not on the map, we hand-collect the
closest MSA using Google Maps.

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 < Insert Table 2 >

Panel A of Table 2 reports the average coefficients from estimating the audit fee model

by year. The coefficients on both of our size proxies (i.e., and ) are

significantly positive, consistent with larger clients being charged higher audit fees. Clients with

higher current ratios ( ) and higher return on assets ( ) are charged significantly lower

audit fees, consistent with auditors charging lower fees to less risky clients. The significantly

positive coefficient on indicates that clients receiving qualified opinions are charged

significantly higher audit fees. The significantly positive coefficients on ,

, and suggest that auditors charge a premium for complex clients.

Finally, the majority of the auditor attribute variables have the predicted sign. The model

explains approximately 82.4 percent of the variation in audit fees, which is consistent with prior

literature (e.g., Francis et al. 2005; Choi et al. 2010; Blankley et al. 2012).

Discretionary Accruals
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The main analysis in this study is performed on a sample of firm-years in which the

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firm’s earnings before discretionary accruals are less than the consensus EPS forecast.

Therefore, the dependent variable ( ) equals one if the firm uses income-increasing

discretionary accruals to meet or beat the consensus forecast, and zero otherwise. In order to

calculate “pre-discretionary earnings”, we must estimate the client’s discretionary accruals. We

calculate discretionary accruals using the cross-sectional Jones (1991) model as modified by Ball

and Shivakumar (2006)17:

∆ 2

Where,

17
We obtain similar results if we use performance-adjusted discretionary accruals, as suggested by Kothari et al.
(2005).

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 = Total accruals, calculated as net income less operating cash flows.
∆ = Sales revenue less prior year’s sales revenue.
= Gross property, plant, and equipment.
= Operating cash flows.
= An indicator variable equal to 1 if the firm reports negative operating cash flows,
zero otherwise.

All variables are scaled by average total assets.18 Discretionary accruals are estimated as the

residual from the model. We estimate the model separately for each two-digit SIC code

industry-year, requiring at least 20 observations per industry-year.

Panel B of Table 2 reports the mean and median from estimating Equation (2)

separately for each industry-year combination. The average (median) explanatory power of the

model is 47.9% (56.7%). This is consistent with recent work in this area (e.g., Cheng et al. 2012

report an average of 45.56% using the cross-sectional Jones model augmented with return on

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Meet or Beat Test
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The main test is a test of whether firms paying higher audit fees are more likely to meet

or beat their annual earnings target via discretionary accruals.19 Our proxy for the firm’s annual

earnings target is the latest consensus (median) analyst forecast prior to the firm’s earnings

announcement. The only observations included in this test are firms whose earnings before

discretionary accruals were less than the consensus analyst forecast. This increases the

likelihood that the manager has an incentive to opportunistically use discretionary accruals.

Restricting our sample in this way makes it more likely that any manager who meets or beats an

18
We also include an intercept scaled by average total assets for two reasons. First, it helps control for
heteroskedasticity (Kothari et al. 2005, 173). Second, one cannot interpret the fit of the model (i.e., the ) if the
intercept is suppressed. As a practical matter, results are robust to using discretionary accruals estimated with no
intercept.
19
This test has been used in prior literature such as Davis et al. (2009) and Boone et al. (2012).

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earnings target did so using discretionary accruals. We also require that the difference between

the firm’s earnings before discretionary accruals and the consensus forecast be less than or equal

to five percent of the firm’s total assets. This makes it much more likely that the manager has

the ability to use discretionary accruals to achieve the earnings objective.20 This is in contrast to

meet or beat tests used in prior literature (e.g., Reichelt and Wang 2010; Asthana and Boone

2012). In these prior studies, the research design cannot distinguish managers who used

discretionary accruals to meet or beat the forecast from managers who used real earnings

management or expectations management to meet or beat the forecast. To test whether managers

are using discretionary accruals to meet or beat earnings targets, we estimate the following

model using generalized estimation equations21:

Φ |

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2
_
_ accepted
_ _

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Refer to Table 1 for detailed variable definitions. The symbol Φ refers to the cumulative

distribution function of the normal distribution, refers to the expectations operator, and

subscripts i and t indicate firm and year, respectively. We use semi-robust standard errors

clustered by firm (Peterson 2009). The dependent variable ( ) takes on the value of 1 if the

firm’s reported earnings are greater than or equal to the consensus analyst forecast, zero

20
We realize five percent of assets is an arbitrary cutoff. The results are robust to using alternate cutoffs of 4, 6, 7,
8, 9, or 10 percent of assets instead. In addition, the results are similar if we do not impose this “ability”
requirement.
21
For details, refer to chapter 23.5 of Greene (2008). To use this estimation technique, one can use the “xtgee”
command in STATA.

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otherwise.22 The variable of interest is . If abnormally high audit fees impair auditor

independence, we should observe a significantly positive coefficient on , indicating that

firms paying abnormally high fees are more likely to use discretionary accruals to meet or beat

analysts’ forecasts. On the other hand, if abnormal audit fees represent auditor effort, we should

observe a significantly negative coefficient on , suggesting that auditors receiving

abnormally high audit fees tolerate less earnings management.

The model controls for other known determinants of a firm meeting or beating targets

following Boone et al. (2012). The model controls for firm size ( ), the number of

analysts following the firm ( ), analyst forecast dispersion ( ), and the

length of time between the last analyst forecast and the earnings announcement ( ) to

control for cross-sectional differences in firms’ information environments which could affect

forecast accuracy (Davis et al. 2009).

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The model also controls for the level of incentives to meet or beat analysts’ forecasts.

We include sales growth (

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) and the book-to-market ratio (
) as proxies for firm growth,

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because growth firms have higher incentives to meet or beat analysts’ forecasts (Skinner and

Sloan 2002). We follow Boone et al. (2012) and include controls for return on assets ( ),

whether the firm reported increasing earnings ( ), leverage ( ), new equity issues

( ), operating cash flows ( ), prior year’s total accruals ( ), and firm age

( ).

The model also controls for other auditor characteristics which affect audit quality. We

include and 2 because prior literature finds evidence that these auditors perform

22
We only include the latest forecast from each analyst and we eliminate forecasts more than 90 days old. To avoid
losing precision in EPS decimal places, we construct our own consensus analyst forecast as the median using the
unadjusted detail file (Payne and Thomas 2003). All forecast data are adjusted for stock splits. Actual earnings
come from I/B/E/S.

15
higher quality audits (Francis and Krishnan 1999; Boone et al. 2010). We include controls for

industry specialization ( , , and ), the size of the

audit office ( ), audit tenure ( _ ), and the relative importance of the

client to the audit office ( _ ).23 We control for the client’s distance to the

closest SEC regional office ( _ ) because Kedia and Rajgopal (2011) find that clients

headquartered in cities further away from the SEC’s offices engage in greater misreporting.24

We include the ratio of nonaudit service fees to total fees ( _ ) because prior literature

finds that auditors receiving abnormally high nonaudit service fees may compromise their

independence on the audit (Blay and Geiger 2013). Finally, the model controls for the

concentration of the local audit market the client is headquartered in ( ) because

Boone et al. (2012) show that firms located in more concentrated, and hence, less competitive

audit markets, receive lower quality audits. The model includes industry and year fixed effects

with industries defined as in Ashbaugh et al. (2003).

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IV. SAMPLE SELECTION AND DESCRIPTIVE STATISTICS

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Audit fee and auditor data are obtained from Audit Analytics, financial statement data are

obtained from Compustat, and analyst forecast data are obtained from the I/B/E/S database.25

We require firms to have earnings before discretionary accruals less than the consensus analyst

forecast. We exclude financial and utility firms (SIC codes 4000-4999 and 6000-6999) as these

firms operate in regulated industries, which affects their incentives for earnings management.
23
Reichelt and Wang (2010) find that industry specialists tolerate less earnings management. Francis and Yu (2009)
and Francis, Michas, and Yu (2012) find that large offices perform higher quality audits. Johnson et al. (2002) find
that short audit tenure hinders audit quality. Reynolds and Francis (2001) find that relatively more important clients
receive higher quality audits.
24
The twelve SEC Regional offices are located in Washington D.C., New York, Philadelphia, Boston, Chicago,
Atlanta, Miami, Dallas-Fort Worth, Denver, Salt Lake City, San Francisco, and Los Angeles. Before 2007, the
regional offices include only Washington D.C., New York, Miami, Chicago, Denver, and Los Angeles.
25
Audit Analytics data is converted to the Compustat fiscal year convention. As an example, in Audit Analytics,
when a company’s fiscal year end is between January 1 and May 31 2007, the company’s fiscal year is considered to
be 2007. In Compustat, the company’s fiscal year is considered to be 2006.

16
We also exclude observations if the firm’s discretionary accruals have been positive in each of

the past three years. This requirement guards against the possibility that we are including firm-

years in which the manager does not have enough “cookie jar accruals” to manage earnings

upward.26 This process results in a sample of 4,476 firm-years in which the firms’ pre-

discretionary earnings are less than the consensus analyst EPS forecast. We refer this sample the

“Meet or Beat full sample”. We also require that the difference between the consensus forecast

and the firm’s pre-discretionary earnings be less than 5 percent of the firm’s total assets. This

requirement makes it more likely that the manager has the ability and the incentive to use

discretionary accruals to meet the earnings target. This requirement reduces our sample to 1,670

firm-year observations spanning 2000-2011. We refer to this sample as the “Meet or Beat

reduced sample”. We perform our tests on the both samples. We winsorize all continuous

independent variables at the 1st and 99th percentiles to reduce the influence of outliers.27 Table 3

outlines the sample selection procedure. preprint

accepted
< Insert Table 3 >

manuscript
< Insert Table 4 >

Table 4 reports descriptive statistics for both samples. We discuss descriptive statistics

for the reduced sample; the statistics for the full sample are similar. The mean value of is

0.447, suggesting that approximately 44.7 percent of firms with pre-discretionary income within

5 percent of total assets of the consensus analyst forecast end up beating the forecast. This

sample is biased toward large, more well-established firms, as indicated by the prevalence of

Big-4 auditors (the mean value of is 0.950, compared with 0.682 for the entire Audit

Analytics population during our sample period) and the relatively large assets of the sample

26
Results are not sensitive to including these observations.
27
Results are similar if we instead truncate all continuous independent variables at the 1st and 99th percentile.

17
firms (the median total assets of the sample is 1,562 million, compared with 227 million for the

Compustat population during our sample period.). The mean auditor concentration

( ) is approximately 0.289, consistent with recent research on audit market

concentration (e.g., Boone et al. 2012 report a mean audit market concentration of 0.289).

Overall, the descriptive statistics are in-line with recent research using similar samples (e.g.,

Davis et al. 2009; Boone et al. 2012). The distribution of industries in both samples is similar to

the population of firms on Compustat during our sample period. Panel C contains the

distribution of the major audit firms for the Meet or Beat reduced sample (The distribution is

very similar for the Meet or Beat full sample). PricewaterhouseCoopers and Ernst & Young

have the two largest market shares in our sample.28

V. EMPIRICAL RESULTS

preprint
Main Result

The main test is to assess whether firms which pay higher abnormal audit fees are more

accepted
or less likely to use discretionary accruals to meet or beat financial analysts’ forecasts. If firms

manuscript
paying higher fees tend to use discretionary accruals to meet or beat earnings targets more

frequently, this would suggest that the auditors are losing independence and allow the manager

more discretion in choosing accruals. To test this, we estimate Eq. (3)

< Insert Table 5 >

Table 5 reports the results. Using the full sample of firm-years in which the client’s

earnings before discretionary accruals are less than the consensus analyst forecast, we find a

significantly negative coefficient on abnormal audit fees (Z-stat. = -5.11), suggesting that clients

28
We do not tabulate correlation coefficients to save space. The Pearson correlation coefficient between and
is -0.11. We find that the variance inflation factors do not exceed 5 for any of our variables. This is well
below the threshold of 10 suggested in Kennedy (1992).

18
paying abnormally high audit fees are less likely to use discretionary accruals to achieve earnings

targets. The second regression includes only firm-years in which the forecasted earnings exceed

the client’s pre-discretionary earnings by less than five percent of total assets. We find similar

results using this more focused sample. The coefficient on is -0.255 and is significant at

the 1 percent level (Z-stat. = -3.10). The results suggest that abnormal audit fees are positively

related to audit quality; this supports the effort view. If abnormal audit fees are at the mean

value of -0.006, a one-standard deviation increase in abnormal audit fees, holding the value of all

other variables constant at their mean, decreases the likelihood of the client using discretionary

accruals to meet or beat the consensus forecast from 43.1% to 38.4% . This is approximately a 5

percent reduction in the probability of meeting or beating.29

At first glance, this result would appear to contradict Asthana and Boone (2012), who

find that clients paying abnormally high audit fees are more likely to meet or beat the consensus
preprint
forecast by two pennies or less. However, meeting or beating the consensus forecast by just a

accepted
few pennies is, by itself, not indicative of audit quality. The manager could have engaged in real

manuscript
earnings management or expectations management to achieve the earnings benchmark. The

auditor is only concerned with accruals-based earnings management. Thus, it is only when we

have evidence that the manager used discretionary accruals to achieve this benchmark can we

infer that audit quality was low. To conclude, we believe the evidence in Table 5 offers more

direct evidence on the relationship between abnormal audit fees and audit quality than does a

more straightforward meet or beat test used in prior literature.

Additional Analysis using Nonlinear Abnormal Audit Fees

29
The table also reports variance inflation factors (VIFs) to assess whether multicollinearity is likely to affect our
results. The VIFs are all well below the threshold of 10 recommended by Kennedy (1992), suggesting that
multicollinearity is likely not a concern.

19
 Since both Choi et al. (2010) and Asthana and Boone (2012) find a nonlinear relationship

between abnormal audit fees and audit quality, we test whether our results differ when taking this

nonlinearity into account. We follow Asthana and Boone (2012) and create the following two

variables:

= This variable equals abnormal audit fees estimated from equation (1) if
abnormal audit fees are positive, zero otherwise.
= This variable equals the absolute value of abnormal audit fees estimated from
equation (1) if abnormal audit fees are negative, zero otherwise.

We then replace our variable of interest, , with and and re-

estimate our meet or beat regression.

< Insert Table 6 >

Table 6 reports the results. Using the Meet or Beat full sample, the coefficient on

is a significant 0.385 (Z-stat. = 4.38), suggesting auditors receiving abnormally low

preprint
audit fees are more likely to tolerate earnings management from clients. The coefficient on

accepted
is not significantly different from zero. The results are similar when estimating the

manuscript
full model on the more focused Meet or Beat reduced sample. In sum, the evidence in Table 6

suggests a slight nonlinearity in the relationship between abnormal audit fees and audit quality.

The strongest effect seems to be abnormally low audit fees, which appear to be associated with

lower audit quality. This is consistent with recent concerns expressed by regulators about low

audit fees signaling low audit quality (Turner 2005; Bockwaldt 2010).30

30
We have also performed an additional test to reconcile our results with those of Choi et al. (2010) and Asthana
and Boone (2012). We regress the absolute value of discretionary accruals on and using the
Meet or Beat reduced sample. We include all control variables in Eq. (3) except those relating to forecast accuracy.
We find a negative relationship between and the absolute value of discretionary accruals, implying that
abnormally low fees improve audit quality. In contrast, when we change the dependent variable to the level of
discretionary accruals, rather than the absolute value, we find that the coefficient on is significantly
positive, suggesting that abnormally low audit fees harm audit quality. This result highlights the importance of
considering the predicted direction of earnings management when performing tests of earnings management.
Failure to consider the incentives of the manager can lead to erroneous inferences.

20
 VI. ROBUSTNESS CHECKS

We conduct a number of additional robustness checks to determine if our results are

sensitive to other specifications of the underlying fee and quality models. These tests are

summarized below.

Error in the Fee Model: Some readers may be concerned that the residual from the

audit fee model may simply be picking up random noise. To guard against this possibility, we

dissect abnormal audit fees into three components: (i.) normal audit fees, (ii.) an error

component, and (iii.) abnormal audit fees. Abnormal audit fees are those fees which exceed a

confidence interval based on the standard error of the predicted audit fees from the model. To

illustrate, consider a firm which pays total audit fees of $10. After estimating the audit fee

model, the firm’s expected or “normal” audit fee is determined to be $8 with a standard error of

$1. Using the approach typically used in audit fee research, one would say that the firm’s
preprint
abnormal audit fee is $2 ($10 - $8 = $2). However, if one considers the standard error of the

accepted
estimate of normal audit fees, any fees within the range of $7 to $9 would not be considered

manuscript
abnormal. Therefore, when taking the standard error of the estimate into account, the abnormal

audit fee is only $1 ($10 – ($8 + $1) = $1). Similarly, a firm paying total audit fees of $20, with

predicted audit fees of $22 and a standard error of $2 would have an abnormal audit fee of $0,

since the abnormal audit fee does not exceed the confidence interval. We re-estimate Eq. (3)

using this new definition of abnormal audit fees.31 We consider two methods of creating a

confidence interval surrounding our estimate of normal audit fees: (i.) the confidence interval is

defined as one standard error of the estimate of normal audit fees and (ii.) the confidence interval

is defined as two standard errors of the estimate of normal audit fees. In general, we find that

using this new definition of abnormal audit fees does not change our inferences.
31
We thank the editor for suggesting this test.

21
 Alternate Audit Fee Models: A second major concern is that the results we find here are

contingent upon our specific audit fee model. To alleviate these concerns, we have replicated all

of our results using abnormal audit fees derived from the audit fee model used in Choi et al.

(2010) and abnormal fees derived from the model used in Blankley et al. (2012). We achieve

results similar to those documented in the paper when using these alternate audit fee models.

Alternate Earnings Benchmarks: The third concern is the use of the consensus analyst

forecast as a proxy for the earnings target of the firm. There is a possibility that other

benchmarks are more important. For example, Kirk et al. (2012) provide evidence that the

forecast of a “key analyst” may be a more relevant benchmark than the consensus earnings

forecast. In addition, prior research has also used the latest individual analyst forecast in lieu of

the consensus forecast as a benchmark (Brown and Pinello 2007). We therefore re-perform our

main analysis using these two alternate benchmarks to define our dependent variable, . We
preprint
follow Kirk et al. (2012) in defining the key analyst.32 We continue to find a negative

accepted
relationship between abnormal audit fees and the likelihood of using discretionary accruals to

manuscript
meet or beat either of these two alternative earnings benchmarks.

Generalizability of Results: A fourth concern is that our finding of a negative

relationship between abnormal audit fees and audit quality only holds for our sample. We

believe that focusing on the smaller sample is appropriate, as it is the sample of observations in

which the manager is most likely to have both the ability and incentive to manager earnings.

Never the less, this sample is biased toward larger firms, raising the question of whether the

results we find are generalizable to other firms. To provide evidence on whether our results are

32
Each analyst is assigned a composite score based on eight analyst forecast characteristics. The characteristics are
experience, prior forecast accuracy, brokerage size, forecast horizon, forecast frequency, number of firms the analyst
follows, number of industries the analyst follows, and whether the analyst is on the All-America Research team, as
selected by Institutional Investor magazine. The analyst with the highest composite score is coded as the key
analyst. See Kirk et al. (2012) for more details.

22
generalizable to the larger population of firms, we construct a new dependent variable to proxy

for whether firms used discretionary accruals to meet or beat earnings expectations. This new

variable does not require analyst forecast data. We set the value of this dependent variable equal

to 1 if the firm’s discretionary accruals are in the top quartile ranking for the industry-year and

the abnormal stock market reaction33 during the firm’s earnings announcement window is

positive, zero otherwise. These are observations for which upward earnings management is most

suspicious. This research design gives us a much larger sample of 16,565 firm-years. We

continue to find evidence that abnormal audit fees are negatively related to the likelihood of

using discretionary accruals to meet or beat earnings expectations.

Alternate Discretionary Accruals Model: In all of our analyses, we rely on the Ball and

Shivakumar (2006) model to dissect accruals into a normal and discretionary component. We

have tried using performance-adjusted discretionary accruals suggested by Kothari et al. (2005)

and our results are qualitatively similar. preprint

accepted
VII. CONCLUSION

manuscript
Is auditors’ independence impaired by receiving abnormally high audit fees? Or, are

abnormally high fees simply an indication of greater effort on the engagement? In this study we

re-examine this issue using a restricted sample of observations where the clients have both the

incentive and the ability to manage earnings to meet or beat earnings benchmarks. We classify

firm-years as earnings management observations only if the firm achieved an earnings

benchmark but would not have achieved that benchmark without using income-increasing

discretionary accruals. We find that clients paying higher abnormal audit fees are less likely to

33
Abnormal returns are calculated as the raw return less CRSP’s value-weighted return for the three day window
centered on the firm’s earnings announcement date.

23
use income-increasing discretionary accruals to meet or beat earnings targets. This is consistent

with the notion that abnormal audit fees are an indication of greater auditor effort.

Although abnormal audit fees appear to be caused by increased auditor effort, this does

not necessarily result in better earnings quality. High-risk clients tend to exhibit lower earnings

quality and are subsequently charged higher audit fees (Schelleman and Knechel 2010). If we

simply observe the relationship between earnings quality and audit fees, we will find a positive

relationship. However, it is the riskiness of the client which is driving both the lower earnings

quality and the higher fees. Therefore, we caution researchers not to use abnormal audit fees as a

proxy for earnings quality.

This study is subject to limitations. First, the strength of our evidence depends on the

ability of our earnings management proxy to capture unobservable earnings management, and

hence, capture audit quality. We have attempted to mitigate this concern by focusing on a
preprint
sample of firm-years in which the managers have both the incentive and ability to manage

accepted
earnings. Never the less, we cannot rule out the possibility that our proxies are not capturing

manuscript
audit quality, as true audit quality is unobservable. Second, the strength of the evidence in this

paper also depends on the ability of our audit fee model to dissect audit fees into a normal

component and an abnormal component. To mitigate this concern, we have re-run all of our tests

using abnormal audit fees derived from alternative audit fee models.

This paper provides evidence to help resolve the debate on whether abnormal audit fees

are a sign of auditor effort or signal a loss of auditor independence. This information is of

interest to regulators, such as the SEC, who decide which firms to inspect using publicly

available information, such as audit fees. Our results suggest that targeting firms with low audit

fees, as is currently done by the SEC, is more likely to help the SEC find low quality audits. The

24
evidence in this study contrasts with that in prior literature (Choi et al. 2010; Asthana and Boone

2012). The difference appears to have been caused by the choice of audit quality proxy. In this

vein, our study highlights the need for audit research to strive for better proxies of audit quality.

The use of the absolute value of discretionary accruals as a proxy for audit quality, without

considering the incentives of the manager, can lead to erroneous inferences.

preprint
accepted
manuscript

25
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accepted
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30
 TABLE 1
Variable Definitions
___Variable___ _________________________Definition_________________________
Audit Fee Model Variables
= The natural log of audit fees.
= The natural log of total assets.
= The square root of the number of employees.
= The sum of accounts receivable and inventory, all scaled by total assets.
= The ratio of current assets to total assets.
= The current ratio, defined as current assets divided by current liabilities.
= Return on assets, defined as operating income after depreciation scaled by total
assets.
= The ratio of long-term-debt to total assets.
= An indicator variable equal to 1 if the firm reported negative net income, zero
otherwise.
= An indicator variable equal to 1 if the firm received a qualified audit opinion,
zero otherwise.
= The natural log of the number of geographic segments.
= The natural log of the number of business segments.
= An indicator variable equal to 1 if the firm pays foreign income taxes, zero
otherwise.
= An indicator variable equal to 1 if the firm issued new equity during the past
two years, zero otherwise.
= An indicator variable equal to 1 if the firm has a Big-N auditor, zero otherwise.

preprint
= An indicator variable equal to 1 if the auditor has the highest total audit fees in
the firm’s industry in a given year, zero otherwise.
= An indicator variable equal to 1 if the audit office has the highest total audit fees
in the firm’s industry in a given city in a given year, zero otherwise.

accepted
= An indicator variable equal to 1 if the firm’s auditor is both a national leader and
a city leader (i.e., if 1 and 1), zero

manuscript
otherwise.
_ = An indicator variable equal to 1 if the auditor’s tenure with the firm is less than
three years, zero otherwise.
2 = An indicator variable equal to 1 if the firm has a Second-tier auditor, zero
otherwise. Second-tier auditors are Grant Thornton and BDO Seidman (Chang
et al. 2010; Boone et al. 2010).
= The natural log of the audit office’s total fees for the year.
= The percentile rank of the number of audit clients for a given auditor in a city-
industry for a given year (values range from 0.01 to 1).
= The percentile rank of bargaining power, defined as the natural log of the firm’s
sales divided by the sum of the natural log of sales for all firms audited by the
company’s auditor for each city-industry combination (values range from 0.01
to 1).
Regression Analysis Variables (excluding variables included in Audit Fee Model)
= An indicator variable equal to 1 if the firm’s earnings per share is greater than or
equal to the latest consensus analyst forecast, zero otherwise. We only include
the latest forecast from each analyst and we eliminate forecasts more than 90
days old. To avoid losing precision in EPS decimal places, we construct our
own consensus analyst forecast as the median using the unadjusted detail file
(Payne and Thomas 2003). All forecast data are adjusted for stock splits.

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 Actual earnings come from I/B/E/S.
= Abnormal audit fees, calculated as the residual from estimating Equation (1).
= The natural log of the number of analysts following the firm.
= Analyst forecast dispersion, calculated as the standard deviation of analysts’
EPS forecasts.
= The number of days between the last analyst forecast and the firm’s earnings
announcement day.
= An indicator variable equal to 1 if the firm’s earnings is greater than the
previous year, zero otherwise.
= The change in sales revenue scaled by lagged total assets.
= The ratio of book equity to the market value of equity.
= Cash flows from operations scaled by average total assets.
= Last year’s total accruals scaled by average total assets, where accruals are
calculated as net income less operating cash flows.
= The natural log of the number of years the firm has been on Compustat.
_ = Ratio of total fees received from the client to the total fees received by the audit
office for the year.
_ = An indicator variable equal to 1 if the firm is headquartered in the same
metropolitan statistical area as one of the SEC’s regional offices, zero otherwise.
The twelve SEC Regional offices are located in Washington D.C., New York,
Philadelphia, Boston, Chicago, Atlanta, Miami, Dallas-Fort Worth, Denver, Salt
Lake City, San Francisco, and Los Angeles. Before 2007, the regional offices
include only Washington D.C., New York, Miami, Chicago, Denver, and Los
Angeles.
_ = The ratio of nonaudit service fees received from the client to the total fees

=
received from the client.
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Audit market concentration, as calculated in Boone et al. (2012). This variable
is the sum of the squares of each audit office’s total fees scaled by the total fees

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earned by all auditors in a given metropolitan statistical area.
∑ , where equals the total audit fees for audit office j for a
given year and manuscript
equals the total audit fees earned by all auditors in the
city. There are N auditors in the city. Higher values indicate more concentrated
audit markets.
Variables Used in Additional Analyses (excluding variables used in main regression analysis)
= This variable equals abnormal audit fees estimated from equation (1) if
abnormal audit fees are positive, zero otherwise.
= This variable equals the absolute value of abnormal audit fees estimated from
equation (1) if abnormal audit fees are negative, zero otherwise.
For all city-level variables, we define cities using metropolitan statistical areas (MSAs) as classified by the U.S. Census Bureau.
The MSA cross-map is available at: http://www.census.gov/population/www/metroareas/metroarea.html. If a city is not on the
map, we hand-collect the closest MSA using Google Maps.

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 TABLE 2
Panel A: Audit Fee Model (Dependent Variable = ) N = 32,180
Variable estimate t-stat.
9.388 70.37 ***
0.425 41.91 ***
0.067 15.07 ***
0.104 2.23 **
0.482 11.72 ***
-0.036 -14.52 ***
-0.395 -18.04 ***
0.139 7.46 ***
0.093 13.67 ***
0.099 7.11 ***
0.087 10.32 ***
0.089 44.37 ***
0.259 19.44 ***
0.059 2.62 **
0.224 3.49 ***
0.009 0.64
0.129 11.48 ***
0.008 0.44
_ -0.018 -0.93
2 0.268
0.042
preprint 7.64
6.88
***
***
-0.303 -9.82 ***
-0.119
-0.063 accepted -8.89
-2.51
***
**
. 82.4%
Panel B: Discretionary Accruals Model Performance
manuscript N = 63,262
. 47.9%
. 56.7%
Panel A of this table displays the average coefficient estimates from a cross-sectional regression run separately for each year.
The dependent variable is the natural logarithm of audit fees ( ). The model includes industry fixed effects. Panel B
displays the Mean and Median Adjusted from estimating the cross-sectional Jones (1991) model as modified by Ball and
Shivakumar (2006) separately for each industry-year. All independent variables are winsorized at the 1st and 99th percentiles.
Variable definitions provided in Table 1.
*, **, *** Denotes significance at the 0.10, 0.05, and 0.01 level, respectively.

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 TABLE 3
Sample Selection
All Firm-years on Compustat with non-missing audit fee data on AuditAnalytics: 70,593
Less: Observations changing auditors, receiving Going Concern opinions, or material 14,555
weakness opinions:
Less: Observations with insufficient data to calculate abnormal audit fees: 23,859
Less: Observations with insufficient data to calculate discretionary accruals: 4,650
Less: Observations with missing analyst forecast data on I/B/E/S: 13,231
Less: Observations with insufficient data to calculate control variables: 1,243
Less: Observations in which firm's pre-discretionary earnings are greater than or equal 7,738
to the consensus analyst forecast:
Less: Observations in which the firm’s discretionary accruals have been positive in each 842
of the prior three years:
Meet or Beat Full Sample: 4,476
Less: Observations in which firm's pre-discretionary earnings are within 5 percent of 2,806
total assets of consensus analyst forecast:
Meet or Beat Reduced Sample 1,670

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 TABLE 4
Descriptive Statistics
Panel A: Meet or Beat full sample (N = 4,476)
Variable Mean Min. Q1 Median Q3 Max. Std. Dev.
0.386 0.000 0.000 0.000 1.000 1.000 0.487
-0.002 -1.283 -0.301 0.012 0.313 1.144 0.478
6,309 12 365 1,068 3,691 360,297 18,825
9.694 2.000 4.000 8.000 13.000 31.000 6.847
0.046 0.000 0.010 0.020 0.050 0.440 0.071
25.560 0.000 5.000 18.000 40.000 89.000 24.527
0.078 -0.456 0.041 0.088 0.137 0.353 0.119
0.512 0.000 0.000 1.000 1.000 1.000 0.500
0.167 0.000 0.002 0.139 0.270 0.674 0.166
0.092 -0.595 -0.003 0.072 0.178 0.906 0.221
0.507 0.046 0.260 0.420 0.642 2.180 0.369
0.210 0.000 0.000 0.000 0.000 1.000 0.408
0.189 0.000 0.000 0.000 0.000 1.000 0.391
0.095 -0.336 0.055 0.098 0.148 0.343 0.101
-0.068 -0.462 -0.100 -0.057 -0.023 0.182 0.090
2.882 1.946 2.398 2.773 3.401 4.094 0.649
0.933 0.000 1.000 1.000 1.000 1.000 0.251

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2 0.040 0.000 0.000 0.000 0.000 1.000 0.196
0.295 0.000 0.000 0.000 1.000 1.000 0.456
0.537 0.000 0.000 1.000 1.000 1.000 0.499

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0.217 0.000 0.000 0.000 0.000 1.000 0.412
18.852 14.306 17.750 18.924 19.822 21.759 1.721
_
_
0.124
0.042
0.000
0.000
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0.000
0.004
0.000
0.012
0.000
0.038
1.000
0.500
0.329
0.082
_ 0.129 0.000 0.000 0.000 0.000 1.000 0.336
_ 0.255 0.000 0.079 0.202 0.389 0.842 0.214
0.283 0.180 0.231 0.256 0.299 0.896 0.102
Panel B: Meet or Beat reduced sample (N = 1,670)
Variable Mean Min. Q1 Median Q3 Max. Std. Dev.
0.447 0.000 0.000 0.000 1.000 1.000 0.497
-0.006 -1.329 -0.295 0.011 0.297 1.146 0.475
7,081 21 571 1,562 4,939 275,941 19,383
10.019 2.000 5.000 8.000 14.000 32.000 6.771
0.046 0.000 0.010 0.020 0.040 0.460 0.073
24.199 0.000 5.000 16.000 36.000 89.000 23.874
0.101 -0.259 0.059 0.095 0.147 0.373 0.089

(Continued on next page)

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 TABLE 4: Descriptive Statistics (continued)

Std.
Variable Mean Min. Q1 Median Q3 Max. Dev.
0.518 0.000 0.000 1.000 1.000 1.000 0.500
0.189 0.000 0.029 0.169 0.298 0.676 0.166
0.110 -0.480 0.015 0.085 0.191 0.823 0.195
0.502 0.052 0.273 0.426 0.630 2.005 0.347
0.140 0.000 0.000 0.000 0.000 1.000 0.347
0.177 0.000 0.000 0.000 0.000 1.000 0.382
0.114 -0.144 0.072 0.109 0.156 0.326 0.073
-0.066 -0.344 -0.096 -0.060 -0.028 0.138 0.071
2.982 1.946 2.485 2.890 3.555 4.111 0.645
0.950 0.000 1.000 1.000 1.000 1.000 0.217
2 0.032 0.000 0.000 0.000 0.000 1.000 0.175
0.314 0.000 0.000 0.000 1.000 1.000 0.464
0.590 0.000 0.000 1.000 1.000 1.000 0.492
0.232 0.000 0.000 0.000 0.000 1.000 0.422
18.796 14.505 17.665 18.878 19.772 21.807 1.693
_ 0.107 0.000 0.000 0.000 0.000 1.000 0.309
_ 0.048 0.000 0.004 0.013 0.046 0.500 0.090
_
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0.120 0.000 0.000 0.000 0.000 1.000 0.325
_ 0.272 0.000 0.088 0.219 0.419 0.856 0.221
0.289 0.180 0.231 0.257 0.300 0.912 0.111
Panel C: Auditor Distribution for Meet or Beat reduced sample
Auditor E&Y KPMG Deloitte
accepted
PwC AA Grant Thornton BDO Seidman

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N 477 299 336 428 47 30 28
Percentage 28.6% 17.9% 20.1% 25.6% 2.8% 1.8% 1.7%
This table displays the mean, minimum, first quartile (Q1), median, third quartile (Q3), maximum, and standard deviation for
relevant variables used in the study. The Meet or Beat full sample includes all firm-years in which the firm’s pre-discretionary
earnings were less than the latest consensus analyst EPS forecast. The Meet or Beat reduced sample includes all firm-years in
which the firm has pre-discretionary earnings less than the consensus EPS forecast and the firm’s earnings are within 5 percent
of total assets of the consensus forecast. Both samples span 2000-2011. All continuous independent variables are winsorized at
the 1st and 99th percentiles to reduce the influence of outliers on the regression analysis. is the total assets of the
client, in millions of dollars. All other variable definitions are provided in Table 1. Panel C displays the distribution of auditors
for the Meet or Beat reduced sample. E&Y stands for Ernst and Young, PwC stands for PricewaterhouseCoopers, and AA stands
for Arthur Andersen.

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 TABLE 5
Abnormal Audit Fees and the Propensity to Use Discretionary Accruals to Meet or Beat Analysts'
Forecasts
Dependent Variable = |
Meet or Beat full sample Meet or Beat reduced sample
Variable Prediction estimate Z-stat. VIF estimate Z-stat. VIF
? 0.348 0.84 0.760 1.13
? -0.260*** -5.11 1.16 -0.255*** -3.10 1.24
- -0.066*** -2.96 2.91 -0.058* -1.66 2.77
- -0.008* -1.84 1.90 -0.011* -1.70 1.86
- 0.171 0.52 1.32 0.102 0.18 1.45
- -0.001 -0.69 1.22 -0.001 -0.89 1.28
+ 0.536 1.53 3.44 1.740** 2.22 4.22
+ 0.553*** 12.81 1.21 0.545*** 7.78 1.21
+ -0.864*** -5.41 1.33 -1.185*** -4.48 1.43
+ 0.287** 2.64 1.38 -0.052 -0.27 1.42
+ -0.075 -1.03 1.45 0.059 0.45 1.53
- -0.806*** -11.55 1.83 -0.825*** -6.78 1.57
+ -0.131** -2.29 1.13 -0.207** -2.08 1.16
+ -0.762** -2.20 2.78 -1.599* -1.77 3.68
+ 1.004*** 3.83 1.26 1.513*** 2.76 1.30

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+ 0.044 1.02 1.52 -0.003 -0.05 1.44
- 0.284* 1.79 3.23 -0.071 -0.25 3.38
2 - 0.430** 2.51 2.43 0.161 0.48 2.79
-
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0.078 0.94 3.34 0.013 0.10 3.46
- 0.018 0.31 1.74 0.061 0.68 1.82

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- -0.053 -0.51 4.15 0.095 0.59 4.23
- -0.009 -0.43 2.54 0.000 0.00 2.60
_ + -0.032 -0.49 1.09 -0.063 -0.54 1.12
_ - -0.216 -0.55 2.03 -0.234 -0.42 2.20
_ - 0.012 0.15 1.12 -0.154 -1.32 1.12
_ + -0.271* -1.92 2.14 -0.036 -0.15 2.19
+ 0.326 1.29 1.41 -0.019 -0.54 1.41
Yes Yes

4,476 1,670
756.05 296.04
This table displays estimated coefficients from a generalized estimation equations regression where the dependent variable
( ) is an indicator variable equal to 1 if the firm’s reported earnings were equal to or greater than the prevailing consensus
analyst forecast, zero otherwise. All Z-statistics are adjusted for semi-robust standard errors clustered by firm. is
abnormal audit fees, equal to the residual from estimating Equation (1). All other variable definitions are provided in Table 1.
The model includes year and industry fixed effects. All continuous independent variables are winsorized at the 1st and 99th
percentiles.
*, **, and *** denotes statistical significance at the 0.10, 0.05, and 0.01 level, respectively.

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 TABLE 6
Additional Analyses
Nonlinear Abnormal Audit Fees Test (Dependent Variable = | )
Meet or Beat full sample Meet or Beat reduced sample
Variable Prediction estimate Z-stat. VIF estimate Z-stat. VIF
? 0.350 0.84 0.744 1.10
? -0.123 -1.32 1.37 -0.143 -0.97 1.37
? 0.385*** 4.38 1.35 0.351** 2.42 1.36
Yes Yes
Yes Yes

4,476 1,670
753.68 294.10
This table displays estimated coefficients from two generalized estimation equations regressions where the dependent variable in
all regressions ( ) is an indicator variable equal to 1 if the firm’s reported earnings were equal to or greater than the
prevailing consensus analyst forecast, zero otherwise. All Z-statistics are adjusted for semi-robust standard errors clustered by
firm. equals abnormal audit fees if abnormal audit fees are positive, zero otherwise. equals the absolute
value of abnormal audit fees if abnormal audit fees are positive, zero otherwise. The table tests whether the results of Table 5
differ when allowing the relationship between and abnormal audit fees to vary with the sign of the abnormal audit fees. All
regressions include all control variables in Eq. (3) as well as industry and year fixed effects. All continuous independent
variables are winsorized at the 1st and 99th percentiles.
*, **, and *** denotes statistical significance at the 0.10, 0.05, and 0.01 level, respectively.

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