Audit Fees, Earnings Management, and Litigation Risk: Evidence from Japanese Firms Cross-Listed on U.S. Markets

(ProQuest: . denotes formulae omitted.)INTRODUCTIONAccounting research on litigation risk and audit fees beganin 1980. Simunic (1980) found that audit fees reflect risk differences across litigation regimes. From 1984 to 1999, researchers had done several empirical research to find evidence linking litigation risk to audit fees. However, their findings are inconclusive due to lack of a large sample of audit fees data (Francis, 1984; Chung & Lindsay, 1988; Chan, Ezzamel & Gwilliam, 1993; Johnson, Walker & Westergaard, 1995; Craswell & Francis, 1999). Seetharaman, Gul & Lynn (2002) used cross-listed firms data and found that U.K. auditors charge higher fees for their sendees when their U.K. based clients are cross-listed in U.S. markets, but not for U.K. firms cross-listed in non-U.S. markets. The finding suggests that audit fees reflect risk differences across different litigation regimes. Choi, Kim, Liu & Simunic (2009) examined data from 14 countries and asserted that auditors charge higher fees for firms that are cross-listed in stronger legal regimes. Based on previous literature, we can obsene that audit fees are influenced by the difference in litigation environment. In other words, litigation risk is an important determinant of audit fees.Another fundamental determinant of audit fees is earnings management risk. Bedard & Johnstone (2004) found that auditors respond to earnings management risk with ex ante increase in planned audit hours and billing rates. Abbott, Parker & Peters (2006) found that audit fees are inversely related to income-decreasing discretionary accruals. They also found that the positive relationship between audit fees and positive discretionary accruals is magnified for high P/E firms. Our paper uses both of these aspects - litigation and earnings management risk - to analyze audit fees.We find methodology limitation in existing audit fees research when analyzing samples of cross-listed and non-cross-listed firms. For examples, Seetharaman, Gul & Lynn (2002) matched the sample by size and industry, while Choi, Kim, Liu & Simunic (2009) matched the sample by country, year, and industry. They did not analyze the sample using a more rigorous matching model. Recent audit research suggests that the potential threat of selection bias in auditing research is likely to occur when researchers compare large and small accounting firms that have different characteristics. Lawrence, Minutti-Meza, & Zhang (2011) found that after using the propensity score matching (PSM) models, the treatment effect of Big 4 auditors turned to be insignificantly different from those of non-Big 4 auditors with respect to their clients' discretionary accruals.To the best of our knowledge, empirical research on the association between audit fees and earnings management using Japanese data is still limited. Yazawa (2011) performed research on the association between audit fees and earnings management, but he did not consider the effect of litigation environment on audit fees. In this paper, we consider the effect of audit fees, earnings management risk, and litigation risk using a sample of Japanese firms cross-listed in the U.S. markets to answer several questions: what is the correlation between audit fees and difference litigation environments and whether the extent of the correlation between audit fees and earnings management in one litigation environment is different from that in another litigation environment.To answer these questions, we use the PSM model to control for differences in firm characteristics between two litigation environments and carried multivariate regression tests to verify three hypotheses about the correlations among audit fees, earnings management risk and litigation risk.Based on our results, we found that there are differences in audit fees under different litigation environments after using the PSM model, and that audit fees increase with litigation risk. …