Earnings Autocorrelation, Earnings Volatility, and Audit Fees David B. Bryan Assistant Professor of Accounting - The University of North Florida Terry W. Mason Assistant Professor of Accounting - Kansas State University J. Kenneth Reynolds * Associate Professor of Accounting - Florida State University ABSTRACT: This study posits that earnings autocorrelation and earnings volatility are associated with audit fees. Earnings autocorrelation and earnings volatility represent time-series of earnings characteristics that may affect an auditor’s perception of inherent risk. In response to greater inherent risk, auditors should conduct more extensive substantive testing in order to reduce the overall risk associated with the audit. We find a negative (positive) association between earnings autocorrelation (volatility) and audit fees. The results indicate that a change in the interquartile range in earnings autocorrelation and earnings volatility combined is associated with a change in audit fees of approximately $305,500 for the average firm in our sample. We also find that the relation between earnings autocorrelation and audit fees is amplified for specialist auditors, consistent with specialist auditors responding to uncertainty in earnings more thoroughly than non-specialists. Draft Date: November 2015. Please do not cite without permission of the authors. Keywords: audit fees; auditor specialization; earnings autocorrelation; earnings volatility * Corresponding Author: [email protected] We thank Bruce Billings, Allen Blay, Landon Mauler, Robbie Moon, Rick Morton, Josette Pelzer, and the workshop participants at Florida State University for their helpful comments on prior versions of this study. Earnings Autocorrelation, Earnings Volatility, and Audit Fees ABSTRACT: This study posits that earnings autocorrelation and earnings volatility are associated with audit fees. Earnings autocorrelation and earnings volatility represent time-series of earnings characteristics that may affect an auditor’s perception of inherent risk. In response to greater inherent risk, auditors should conduct more extensive substantive testing in order to reduce the overall risk associated with the audit. We find a negative (positive) association between earnings autocorrelation (volatility) and audit fees. The results indicate that a change in the interquartile range in earnings autocorrelation and earnings volatility combined is associated with a change in audit fees of approximately $305,500 for the average firm in our sample. We also find that the relation between earnings autocorrelation and audit fees is amplified for specialist auditors, consistent with specialist auditors responding to uncertainty in earnings more thoroughly than non-specialists. Keywords: audit fees; auditor specialization; earnings autocorrelation; earnings volatility I. INTRODUCTION We propose that earnings autocorrelation and earnings volatility are important earnings characteristics impacting audit risk. Although these characteristics may constitute elements of inherent risk for the auditor, the associations and directions are ambiguous for reasons discussed later. As inherent risk increases, auditors should perform additional substantive testing in order to reduce the overall risk associated with the audit. We anticipate that this additional effort will drive audit fees higher. Using audit fees as a measure of audit effort, our findings are consistent with lower (higher) earnings autocorrelation (volatility) increasing the auditor’s assessment of inherent risk, leading to a highly economically significant effect on audit fees. Auditing standards specify audit risk as the product of three components: inherent risk, control risk, and detection risk (AICPA 2006; PCAOB 2010). Inherent risk represents the auditor’s assessment of the risk of a material misstatement without considering a firm’s internal control over financial reporting, control risk is the auditor’s assessment of the risk that a material misstatement will not be prevented or detected by the firm’s system of internal control, and detection risk is the risk that the auditor will not detect a material misstatement during the course of the audit (AICPA 2006). The audit risk model implies that if an auditor assesses a higher level of inherent risk or control risk, then more substantive testing must be conducted during the audit in order to lower detection risk so that overall audit risk is reduced to an acceptable level. Therefore, factors that cause auditors to assess a higher degree of inherent risk or control risk should increase the amount of effort the auditor has to put forth during the audit. Earnings autocorrelation is a time-series characteristic of earnings that reflects the degree to which prior-period earnings are informative about current-period earnings. Prior research 1 suggests that seasonal differences in quarterly earnings are correlated, and that the autocorrelation is approximately 0.34 to 0.44, on average (Bernard and Thomas 1990; Ball and Bartov 1996). Earnings volatility reflects the dispersion in earnings over time, with higher volatility representing wider fluctuations in earnings. Prior research finds that earnings have become more volatile over time (Givoly and Hayn 2000; Dichev and Tang 2008), making volatility an increasingly important earnings characteristic. In the presence of low autocorrelation and/or high volatility, earnings are less certain and more difficult for auditors to assess against a benchmark expectation, thus making them more difficult to audit. On the other hand, those same earnings characteristics may imply a lower risk of managerial manipulation of earnings, which will reduce the auditor's assessed risk of fraud in the financial statements. These competing potential drivers of audit risk create an interesting framework for examining whether and how auditors incorporate these characteristics into their audit risk assessments. Factors viewed as increasing risk exposure will lead the rational auditor to expend additional effort to manage that risk. Greater (or lower) audit effort should be reflected in higher (or lower) audit fees. Prior audit fee research has identified associations between audit fees and several variables that capture inherent risk. For example, research has found that a higher proportion of inventory and accounts receivable to total assets is associated with higher audit fees (Simunic 1980), with the explanation for this association being that these accounts are more difficult to audit and require greater auditor effort. In this study, we argue that time-series of earnings characteristics can also affect assessments of inherent risk and influence the extent of auditor effort. Further, prior research also finds that analysts, who are among the most sophisticated users of financial information, make systematic errors in assessing volatile earnings (Dichev and Tang 2009), 2 suggesting that volatility makes earnings more difficult to understand and interpret. Similarly, auditors may also experience greater difficulty assessing highly volatile earnings. Hence, in addition to impacting inherent risk itself, weak earnings autocorrelation and/or a wide dispersion in the earnings distribution may make assessing inherent risk more difficult, in turn requiring greater audit effort. We also examine the impact of auditor specialization on the association between these earnings characteristics and audit fees. Prior research suggests that in-depth industry knowledge allows specialist auditors to provide higher quality audits than non-specialists (e.g., Balsam et al. 2003; Reichelt and Wang 2010). In-depth industry knowledge may enable specialists to respond to low earnings autocorrelation or high earnings volatility more efficiently than non-specialists, suggesting the possibility of a weaker association between earnings autocorrelation (volatility) and audit fees for specialist auditors. Alternatively, specialist auditors may respond to low earnings autocorrelation or high earnings volatility by auditing more thoroughly than non- specialists. This could occur if, relative to non-specialists, specialists are either (1) better able to identify the risks associated with low earnings autocorrelation or high earnings volatility, or (2) more concerned about protecting a reputation for providing high quality audits. These reasons imply a strengthening in the association between earnings autocorrelation (volatility) and audit fees. The results of our study provide strong evidence of a negative (positive) association between earnings autocorrelation (volatility) and audit fees, consistent with our hypotheses. We also find that specialist auditors charge higher fees than non-specialists in response to low earnings autocorrelation, consistent with specialists reacting more thoroughly to uncertainty in 3 earnings. However, we do not find evidence that earnings volatility affects audit fees differently for specialist auditors. This paper provides two primary contributions to the literature. First, we identify two economically significant factors that affect audit fees. Our results suggest that a change in the interquartile range in earnings autocorrelation and earnings volatility is associated with a change in audit fees of $253,700 and $51,800, respectively, for the average firm in our primary sample, for a combined impact of $305,500. By comparison, a change in the interquartile range in total accruals, return on assets, and audit report lag is associated with a change