The Relationship Between Segment-Level Manipulations And Audit Fees

Abstract

We examine the auditor’ssensitivity 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 distorting 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 auditor’s 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.