Restatements of financial reporting arise from many sources including changes in accounting rules, changes in reporting entity, accounting errors, and fraud (or “irregularities”). Theory predicts that audit effort (measured by audit fees) and financial report restatements should be negatively associated because more audit effort means that auditors should be more likely to find errors or other issues that could lead to later restatement (Shibano 1990; Matsumura and Tucker, 1992; Lobo and Zhao, 2013). However, other studies have found either a positive association or no association between audit fees and subsequent restatements (Kinney et al., 2004; Stanley and DeZoort, 2007; Cao et al., 2012; Hribar, Kravet, and Wilson, 2014). There is an ongoing inconsistency between the theory and empirical findings in this area (Lobo and Zhao, 2013).

In this study, we investigate the relationship between audit fees and two specific types of restatements: those caused by either fraud or errors. Whereas errors are unintentional misapplications of GAAP, or mistakes in data analysis, fraud is intentional and deliberate misreporting. Prior research provides evidence that investors differentiate between errors and irregularities (e.g., Palmrose, et al., 2004) and market reaction is greater to irregularities than to errors.

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Copyright © 2018 National Association of Certified Valuators and Analysts. This article first appeared in Journal of Forensic & Investigative Accounting 10, no. 3 (December 2018), 332-356.

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