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Abnormal audit fees and accrual and real earnings management: evidence from UK

Mohammad Alhadab (Department of Accounting, Faculty of Finance and Business Administration, Al al-Bayt University, Mafraq, Jordan)

Journal of Financial Reporting and Accounting

ISSN: 1985-2517

Article publication date: 3 September 2018

1389

Abstract

Purpose

This paper aims to examine the relationship between abnormal audit fees and accrual-based and real-based earnings management by using a sample of 1,055 UK firm-year observations from 2006 to 2015.

Design/methodology/approach

Linear regression was used to test the hypothetical relation between abnormal audit fees and accrual and real earnings management. Following prior research, several proxies have been used to measure abnormal audit fees, accrual earnings management and real earnings management.

Findings

Abnormal audit fees were negatively associated with real earnings management. A higher level of abnormal audit fees was the major driver of enhanced audit quality, in turn reducing managers’ flexibility to use real earnings management and to manipulate reported earnings. Abnormal audit fees were found to be negatively associated with abnormal discretionary expenses, abnormal production costs and the aggregated measure of real earnings management.

Practical implications

This paper outlines the importance of considering any abnormal audit fees paid to audit firms. It is expected that the abnormal audit fees might compromise auditor independence and lead to a higher level of earnings management. However, the findings of this paper provide a new insight to many interested parties, e.g. regulators, audit firms, investors and creditors, that abnormal audit fees are associated with higher audit quality and higher financial reporting quality in the UK. Regulators in the meanwhile should reform the audit market by, e.g. revising the types of non-audit services that are provided for the same client, setting a cap on the maximum fees that can charged by auditors and monitoring earnings management practices. Audit firms should take into consideration that any charged abnormal level of audit fees may have a direct impact on audit quality.

Originality/value

This is the first study to examine the impact of abnormal audit fees on accruals and real earnings management after major regulatory changes that took place in the UK. These major changes are the adoption of the International Financial Reporting Standards in 2005 and the new legislation concerning the ethical standards issued by the UK Audit Practice Board in 2004. These two major changes are expected to have a direct impact on both earnings management and audit fees, notably for the largest public listed firms. This study also focuses on one of the very developed and attractive stock markets in the world, the UK FTSE 350 stock index, that incorporates that largest 350 public firms.

Keywords

Acknowledgements

Declaration of Conflicting Interests. The author declares no potential conflicts of interest with respect of the research authorship and/or publication of this article. There are no financial or personal relationships with other people or organizations that could inappropriately influence (bias) the work.

Citation

Alhadab, M. (2018), "Abnormal audit fees and accrual and real earnings management: evidence from UK", Journal of Financial Reporting and Accounting, Vol. 16 No. 3, pp. 395-416. https://doi.org/10.1108/JFRA-07-2017-0050

Publisher

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Emerald Publishing Limited

Copyright © 2018, Emerald Publishing Limited

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