Repeatedly Meeting-Beating Analyst Forecasts and Audit Fees

I. INTRODUCTION In this paper we examine the association between repeatedly meeting-or-beating analysts' earnings forecasts (MBE) and audit fees. Motivation for this paper comes from the well-documented role of MBE in influencing managers' actions and the importance assigned to MBE by investors, and the associated risk for firms and their auditors when firms miss analysts' forecasts. Analysts' forecasts serve as a proxy for the market's expectations and are one of three benchmarks that managers seek to meet (Degeorge et al., 1999). (1) Many prior studies have noted that companies have incentives to meet or beat analysts' forecasts of earnings per share (EPS) because investors and others care about such performance. For example, Bartov et al. (2002) and Brown and Caylor (2005) find that firms that consistently meet or beat analysts' forecasts tend to have a higher equity return premium. Jiang (2008) finds that firms beating earnings forecasts are more likely to receive an increase in bond ratings and a smaller initial bond yield spread. Further, prior research also finds that the rewards are higher for firms that consistently meet or beat forecasts; Kasznik and McNichols (2002) find that the market assigns higher values to firms that consistently meet or beat analysts' estimates while Duarte et al. (2008) and Brown et al. (2009) report lower cost of capital for firms that consistently meet or beat analysts' forecasts. Given the strong incentives of managers to meet or beat analysts' forecasts, many prior studies use MBE as a proxy for earnings management (e.g., Bartov et al., 2002; Bauman and Shaw, 2006; Burgstahler and Eames, 2006), and the SEC considers repeatedly meeting-beating analysts' forecasts as a factor in its regulatory actions (Bryan-Low, 2002; SEC, 2009). If auditors view managers of firms that repeatedly MBE as being more aggressive and/or more frequently engaging in earnings management, and hence assign higher inherent risk to such firms, then audit fees should be higher for such firms (either due to increased work, or due to increased risk premium). Conversely, Kasznik and McNichols (2002, p. 730) note that investors perceive that "firms that consistently meet expectations are less risky than those that do not" (emphasis added). If auditors share such perceptions, then audit fees should be lower for firms that repeatedly MBE. Negative earnings surprises lead to sharp declines in stock price and negative publicity for the firm (Brown et al., 1987; Matsumoto, 2002). Such declines in stock prices can, in turn, lead to shareholder lawsuits and auditors are often named as defendants in such lawsuits (Alexander, 1991; Tucker, 1991). Prior research suggests that litigation risk is positively related to audit fees (Simunic and Stein, 1996; Bell et al., 2001). Hence, firms with more occurrences of missing analysts' forecasts (i.e., fewer occurrences of MBE) may be viewed as opening themselves to litigation more often and hence viewed as more risky, which in turn can result in higher audit fees. However, if auditors view managers of firms that miss analysts' forecasts on multiple occasions as being not aggressive and hence assign lower inherent risk to such firms, then audit fees should be lower for such firms. Thus, ultimately, the association between repeatedly meeting-beating analysts' forecasts and audit fees is an empirical issue. In this study, we examine if audit fees are higher or lower for firms that repeatedly meet or beat analysts' forecasts. We use data from 791 non-financial firms that have analyst forecast data for all 12 quarters during the period from 2005 to 2007 and find that, after controlling for other factors usually included in audit fee models, audit fees are lower for firms that repeatedly meet or beat analysts' forecasts. This evidence indicates that auditors view firms that repeatedly meet or beat earnings forecasts as less risky, consistent with the suggestion in Kasznik and McNichols (2002). …