Earnings Management, Board Independence And Audit Fees Considering The Firm’s Profitability Level – Literature review

However, the main question of this study is that, Do earnings management and board independence relate to audit fees and does firm profitability affect audit fees in different firms? This relation is important for increasing the auditors’ insight about some corporate characteristics that affect their fees, measures for increasing auditors’ independence and the establishment of appropriate corporate governance mechanisms. Based on the result of Gul et al. and Alali, discretionary accruals are positively associated with audit fees. Prior studies tend to a negative association between corporate governance characteristics and audit fees. Tsui et al. found evidences that the independence of corporate boards is an important factor in auditors assessment of control risk and the determination of audit fees. They suggested that board independence is negatively related to audit fees. In the next section, we will review the literature.
This study examines the relation between earnings management, board independence and audit fees considering the firm s profitability level. It has been suggested that firms manage their earnings. Prior researches have indicated that economic bonding is associated with earnings management (Magee and Tseng, 1990; Leventis and Dimitropoulos, 2010). There is evidence to suggest that audit behavior related to tactics like “low balling” or “price cutting” (see Barber et al., 1987; Francis and Simon, 1987; Simon and Francis, 1988). As studied by DeAngelo, DeAngelo et al., Perry and Thomas and Gul et al., accruals may be used opportunistically by managers to conceal pool performance or to postpone a portion of unusually high current earnings to future years. Accounting estimates have high inherent risk and discretionary accruals are related to these accounting estimates, as such auditor is expected to collect more evidence, assign more experienced staff and closely reviews the work done when inherent risk is high. As a result, the cost of doing the audit increases (Arens et al, 2008).

Leventis and Dimitropoulos examined the effect of both earnings management and board independence on audit prices. The results based on a sample of 97 Greek companies during 2000 to 2004, showed that there is a positive association between audit independence and audit pricing. Also results indicated a positive association between audit pricing and earnings management for the small size companies. Their findings on company size showed that large firms do not bind their services with economic rentals are more likely to remain independent, probably for reasons of client visibility and reputation protection. Alali tested the relation between discretionary accruals and audit fees. Data were collected from Compustat Industrial and Audit Analytics during 2000 to 2006. Findings indicated that there is a positive and significant relation between discretionary accruals and audit fees. Therefore, the first hypothesis is stated as follows: electronic-loan.com
Hypothesis 1: There is a meaningful relation between earnings management and audit fees.
Prior studies suggested and documented a negative relation between corporate governance and auditing. These studies contend that better governance reduces control risk and ensures higher quality reporting, which enables a reduction in audit risk and fees. Cohen and Hanno interviewed subjects and concluded that superior governance enables auditors to reduce substantive testing. Tsui et al found a negative relation between board independence and audit fees and concluded that better governance reduces control risk, which decreases fees. They stated that the effective internal monitoring by the independent corporate boards provides higher reliability to accounting, which will reduce control risk and thus result in lower scope for audit work. Griffin et al tested the relation between corporate governance and audit fees. They studied some examples from 2000 to 2005. Findings indicated that better governance reduces the cost of auditing. They explained that better governance enhances the quality of financial statements and internal controls, which enables auditors to decrease the price of audit risk and reduce fees. Thus, the second hypothesis is stated as follows.

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