Determination of Segment Reporting Manipulations and Auditor Responses

Abstract

We examine the auditors' sensitivity to manipulative financial reporting by investigating the relation between audit fees and segment-level manipulations. Segment reporting provides an interesting setting to examine auditor risk assessments because of the discretion afforded to management under existing regulations. Segment manipulations involves shifting earnings from one segment to another. It is not a violation of accounting standards per se, but violates the spirit of faithful representation by distorting the performance of a subset of the reporting unit at the expense of (or to the benefit) of another subset. Because disaggregated information is used by analysts and investors in bottom-up forecasting, these distortions can influence firm value even though they do not affect bottom-line net income. Our measure of classification smoothing measures cost shifting between core operating segments and non-core segments to proxy for segment manipulation. We find that audit fees, a widely used proxy for the auditors' risk assessment, have a positive association with segment-level manipulations. Subsequent analyses suggest that higher audit fees are also due to the additional effort exerted in the presence of segment-level manipulations. Further, auditors appear justified in charging higher fees to clients that engage in segment manipulations as we document evidence of a positive association between restatements and segment-level manipulations. Collectively, these results suggest that auditors are aware of the risk associated with companies that engage in segment-level manipulations and auditors respond appropriately by charging higher fees and doing additional work. Additional analysis indicates auditors take longer to complete the audit for companies engaging in segment manipulation, indicative of the auditor doing additional work and future restatements is positively associated with segment manipulations.