Auditors’ Response to Classification Shifting: Evidence from US Firms

Abstract

The purpose of this study is to examine how external auditors react to clients’ earnings management through classification shifting. It draws on the theory that auditors perceive earnings management as a reflection of managers’ opportunism and potential litigation risk. Using audit fees, audit report lags and modified audit opinion as proxies for auditors’ responses, we find that classification shifting is positively associated with audit fees, audit report lags and the likelihood of auditors issuing a modified audit opinion. Our findings remain the same when we use a propensity score matched sample. An additional analysis shows that abnormal audit fees are also higher in firms with classification shifting. Overall, our results suggest that auditors tend to be more conservative when auditing firms with misclassification. As such, auditors charge a fee premium, make more audit effort, and report more conservatively when the clients engage in classification shifting activities.