Earnings management risk and audit pricing: Evidence from big bath accounting

Abstract

We examine whether big baths (large and non-recurring charges) affect auditors’ risk assessments and therefore result in higher audit fees. Prior studies have found that there is an asymmetric reaction from auditors on firms’ income-increasing/decreasing accruals. We argue that auditors’ response to big baths is distinguishable from other types of earnings management as big baths provide incremental information to auditors beyond other earnings manipulation indicators. Our findings show that audit fees are significantly higher for firms with big baths, compared to other firms. We also present evidence that the positive relation between big baths and audit fees is stronger for firms with weaker corporate governance and greater information asymmetry. Overall, our results suggest that auditors expand their audit effort to mitigate the greater audit risk attributable to big baths, which in turn lead to higher audit fees.