Advances in Accounting 54 (2021) 100547

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Advances in Accounting
journal homepage: www.elsevier.com/locate/adiac

Income smoothing and audit fees

Hsihui Chang a, L.C. Jennifer Ho b, *, Zenghui Liu c, Bo Ouyang d
a
Drexel University, USA
b
University of Texas at Arlington, USA
c
Western Washington University, USA
d
Great Valley School of Professional Studies, Pennsylvania State University, USA

A R T I C L E I N F O A B S T R A C T

Keywords: In this study, we examine the effect of income smoothing on auditors' pricing decisions. Analyzing a sample of
Income smoothing 12,823 firm-year observations from U.S. companies in non-regulated industries for the period 2000–2018, we
Audit fees find that income smoothing is negatively associated with audit fees, suggesting that auditors favorably view
Earnings management
smoothed earnings. This result holds when we control for other variables that have been identified as de­
Signaling
terminants of audit fees in prior literature, including client-specific (e.g., client size, audit complexity, litigation
risk, and corporate governance), auditor-specific (e.g., auditor quality, auditor tenure, and auditor expertise),
and engagement-specific (e.g., audit opinion, busy season, reporting lag) factors. Our results also hold across (1)
alternative smoothing measures (with and without considering the use of accruals to smooth earnings), (2)
different sources of income smoothness (innate vs. discretionary components) and (3) various robustness tests.
Overall, our evidence supports the notion that auditors perceive income smoothing as signaling rather than
opportunistic behavior, and thus charge lower audit fees. To our knowledge, this is the first study that examines
income smoothing directly from the perspective of auditors.

1. Introduction
Income smoothing is generally defined as “the intentional damp­
ening of fluctuations” in earnings series over time (Beidleman, 1973).
Prior literature and existing evidence suggest two different views
regarding whether income smoothing is harmful or beneficial to market
participants and/or corporate stakeholders. The “informational” view
argues that managers use income smoothing to reveal their private in­
formation about firms' future performance, which could enhance firm
valuation and earnings informativeness (e.g., Badertscher, Collins, &
Lys, 2012; Baik et al., 2020; Trueman & Titman, 1988; Tucker & Zar­
owin, 2006). However, the “opportunistic” view highlights the possi­
bility that managers engage in income smoothing as an opportunistic
behavior. This perspective implies that income smoothing is used to
obfuscate information about firms' true economic performance, which
could result in earnings opacity and lead to value erosion. (e.g., LaFond,
Lang, & Ashbaugh-Skaife, 2007; Leuz, Nanda, & Wysocki, 2003). We
shed new light on this debate by exploring how auditors perceive in­
come smoothing and whether they incorporate it into their pricing de­
cisions. It is essential to evaluate firms' earnings1 smoothing from the
perspective of auditors since they have a better understanding of
managerial incentives for income smoothing given their direct access to
both management and corporate accounting records.2
Our research is also motivated by the survey evidence in Graham,
Harvey, and Rajgopal (2005) that managers overwhelmingly favor a
smooth earnings path and are willing to sacrifice real economic value for
it: almost 97% of the managers in the survey prefer a smooth earnings
path and 78% agree that they would be ready to compromise firm value
to achieve it. Of particular interest in their findings is that a majority of
the managers (67%) believe that less volatile earnings may lead to more
favorable terms of trade with external stakeholders other than investors
such as suppliers and customers, which suggests that income smoothing
might be favored by external stakeholders. Our study intends to provide
an archival/empirical investigation on this issue by examining whether

* Corresponding author.
E-mail addresses: hc336@drexel.edu (H. Chang), lichinho@uta.edu (L.C.J. Ho), liuz3@wwu.edu (Z. Liu), bzo1@psu.edu (B. Ouyang).
1
In this study, we use “income” and “earnings” interchangeably.
2
Demerjian, Lewis-Western, and McVay (2020) argue that income smoothing is context-specific and a thorough understanding of managerial incentives is
important to examining the economic impact of income smoothing.

https://doi.org/10.1016/j.adiac.2021.100547
Received 9 June 2020; Received in revised form 1 July 2021; Accepted 1 July 2021
Available online 16 July 2021
0882-6110/© 2021 Elsevier Ltd. All rights reserved.
H. Chang et al.
income smoothing influences the pricing decisions of auditors, one
group of corporate external stakeholders.3
There are competing arguments that suggest either a positive or
negative relationship between income smoothing and audit fees. On one
hand, managers have incentives to smooth out earnings volatility and
send signals of lower business risk and bright future performance to
stakeholders for better terms of trade (e.g., Dou, Hope, & Thomas,
2013). To the extent that a firm's (i.e., a client's) business risk is a
determinant of audit fees (e.g., Simunic1980), income smoothing may
favorably influence auditors' pricing decisions and lead to lower audit
fees. On the other hand, income smoothing can be used by managers to
intentionally conceal information about a firm's true economic perfor­
mance, which could increase the likelihood that firms engage in
opportunistic earnings management and intentional financial mis­
reporting. As a response, auditors may charge higher audit fees to cover
the heightened litigation risk arising from the use of income smoothing
as an opportunistic reporting behavior. These two competing arguments
suggest that the impact of income smoothing on audit fees is ultimately
an empirical question.
We use two empirical proxies of income smoothing to examine its
relationship with audit fees. Following Leuz et al. (2003) and Francis,
LaFond, Olsson, and Schipper (2004), we construct the first proxy of
income smoothing as the volatility of net income relative to that of
operating cash flow for the past three to five years. We adopt the second
proxy from Lang, Lins, and Maffett (2012) to take into account man­
agers' use of accruals to smooth out earnings volatility. It is calculated as
the negative correlation between cash flow from operations and total
accruals.
Using a sample of 12,823 firm-year observations from U.S. com­
panies in non-regulated industries for the period 2000–2018, we find
that the degree of incoming smoothing is negatively associated with the
amount of audit fees, suggesting that firms with more smoothed earn­
ings are perceived to be less risky by auditors and therefore pay lower
audit fees. This result holds when we control for other variables that
have been identified as determinants of audit fees in prior literature,
including client-specific (e.g., client size, audit complexity, litigation
risk, and corporate governance), auditor-specific (e.g., auditor quality,
auditor tenure, and auditor expertise), and engagement-specific (e.g.,
audit opinion, busy season, reporting lag) factors.
We further differentiate between “innate” earnings smoothness and
“discretionary” earnings smoothness, and assess whether auditors view
these two differently when they evaluate earnings smoothness.
Following Lang et al. (2012), we use the residuals from the regression of
earnings smoothing determinants as the proxy of discretionary earnings
smoothness. We find that both innate earnings smoothness and discre­
tionary earnings smoothness are negatively related to audit fees, indi­
cating that regardless of the source of the smoothed earnings, auditors
offer more favorable pricing terms when they deal with clients with a
higher degree of income smoothing.4
We next conduct cross-sectional analyses using a set of factors
identified in prior literature that may attenuate or strengthen the asso­
ciation between audit fees and income smoothing. These factors capture
firms' information asymmetry, ownership structure, and operation size.
3
Some studies suggest that auditors can be considered as unique corporate
insiders (Carcello et al., 2002; Gul et al., 2003).
4
Our finding that the negative association between income smoothing and
audit fees also exists for discretionary smoothness measure is consistent with
Das, Hong, and Kim (2013) who find income smoothing is a result of efficient
contracting and managers are rewarded for their efforts to smooth the earnings
stream, even if discretionary accruals are used to smooth out earnings. Spe­
cifically, Das et al. (2013) document a negative association between earnings
volatility and CEO compensation (including cash bonus and others) and find
that CEOs are rewarded even when they use discretionary accruals to reduce
earnings volatility.
2
Advances in Accounting 54 (2021) 100547
Using analyst coverage as a proxy for information asymmetry, we find
evidence that the negative association between audit fees and income
smoothing attenuates for firms with higher analyst coverage (i.e., lower
information asymmetry), which is consistent with the argument that
auditors likely perceive managers' income smoothing behavior as
informative rather than opportunistic for firms with higher information
asymmetry (i.e., lower analyst coverage). Regarding ownership struc­
ture, our overall evidence suggests that when firms with higher insti­
tutional ownership engage in income smoothing, auditors might
perceive the smoothing behavior to be more likely used as an opportu­
nistic earnings management tool and therefore charge higher audit fees.
In addition, the analysis for firm size reveals that for both overall and
innate smoothness measures, larger firms benefit less from income
smoothing as the reduction in audit fees is less pronounced. One inter­
pretation of this result is that larger firms likely face lower information
risk due to higher investor interest and wider analyst/media coverage,
which could reduce their incentives to use income smoothing as a
signaling device to reduce information asymmetry.
We also perform a battery of tests to evaluate the robustness of our
empirical findings. First, we use a one-to-one propensity score matching
approach to capture the potential differences between firms with high
and low income smoothing. We further control for endogeneity by (1)
adding firm fixed effects into the regressions and (2) employing a change
analysis where both dependent and independent variables in the
regression analysis are replaced by the change in the value of the vari­
ables from year t − 1 to year t. We also conduct an additional test that
controls for the potential influence of “managerial ability” on income
smoothing (Baik et al., 2020; Demerjian, Lewis-Western, & McVay,
2020). Moreover, we include both the performance-adjusted discre­
tionary accruals (Kothari, Leone, & Wasley, 2005) and the earnings
conservatism score as calculated in Khan and Watts (2009) to control for
a firm's financial reporting quality. In all of these robustness tests, our
inferences remain unchanged. Finally, we examine whether the main
results differ between the pre- and post-SOX environment and find that
SOX does not appear to have a significant effect on the relationship
between income smoothing and audit fees. A subsample analysis after
removing observations in the financial crisis period (i.e., 2008 and
2009) also indicates that our main results continue to hold.
Our paper makes the following contributions. First, our paper con­
tributes to the ongoing research exploring the costs and benefits asso­
ciated with income smoothing. As discussed earlier, income smoothing
can be used by managers as a signaling device to reveal their private
information about firms' future performance or as an opportunistic tool
to conceal the true volatility of past earnings performance. While several
prior studies examine the costs and benefits of income smoothing in
terms of firm valuation (Rountree, Weston, & Allayannis, 2008), cost of
capital (Francis et al., 2004; Trueman & Titman, 1988), market liquidity
(Goel & Thakor, 2003; LaFond et al., 2007); debt contracting (Demer­
jian, Donovan, & Lewis-Western, 2020), informational efficiency (Baik
et al., 2020; Tucker & Zarowin, 2006), and supplier-customer relation­
ships (Dou et al., 2013), little research has been conducted regarding
how auditors perceive income smoothing. We shed light on this issue by
exploring whether auditors incorporate income smoothing into their risk
assessments and pricing decisions. To our knowledge, this is the first
study that examines income smoothing directly from the perspective of
auditors. In this way, our findings also complement and extend the
survey evidence of Graham et al. (2005) by providing an archival/
empirical investigation on managers' belief that income smoothing can
influence the risk perception of various stakeholders.
Second, we contribute to the audit pricing literature. Many prior
studies have identified firm-specific, auditor-specific, and engagement-
specific characteristics as determinants of audit fees. Prior auditing
literature has also extensively explored the impact of various risk fac­
tors, such as the client inherent risk and auditor business risk, on audit
fee decisions. Our study extends this line of literature by adding income
smoothing as another determinant of audit fees. We provide archival
H. Chang et al. Advances in Accounting 54 (2021) 100547

evidence on this issue by using a large sample (12,823 firm-year ob­ 2. Literature review and hypothesis development
servations), a recent time period (2000–2018), alternative smoothing
measures (with and without considering the use of accruals to smooth Our hypothesis is built on two streams of research: audit pricing and
earnings), and different sources of income smoothness (innate vs. income smoothing.
discretionary components).
Third, our study adds to the existing literature on the relationship
2.1. Audit pricing literature
between financial reporting quality and audit fees. Gul, Chen, and Tsui
(2003) indicate that firms with higher discretionary accruals pay higher
2.1.1. Client and/or auditor characteristics as determinants of audit fees
audit fees. Choi, Sohn, and Yuen (2018) find that auditors demand a fee
Prior audit research generally identifies two factors that jointly in­
premium for firms that engage in real earnings management. Both Lee,
fluence an auditor's pricing decision: risk characteristics of a client as
Li, and Sami (2015) and DeFond, Lim, and Zang (2016) offer evidence
well as audit coverage/effort. In his seminal paper, Simunic (1980)
that firms with higher accounting conservatism benefit from lower audit
models the audit process from a supply-side perspective and demon­
fees. We add to this stream of research by exploring the relationship
strates that certain client and/or auditor characteristics are associated
between audit fees and income smoothness, another important earnings
with the extent of audit work/effort, which in turn affects audit fee
property that potentially affects financial reporting quality.5 Note that
determination. Simunic (1980) and many subsequent studies have
our findings hold after controlling for other measures of financial
shown three primary determinants of audit pricing: client size, audit
reporting quality, indicating that income smoothing has an incremental
complexity, and client risk. These factors impact the auditor's planned
effect. In other words, the effect of income smoothing on audit fees is
audit effort and the estimated risk premium priced in the quoted fees.
above and beyond that of other financial reporting quality measures.
According to Simunic (1980), audit fees are positively related to firm
Finally, our study extends a recent study by Bryan, Mason, and
size. Simunic (1980) also hypothesizes that the size of audit fees is an
Reynolds (2018) where they document a positive association between
increasing function of audit complexity because the more complex the
audit fees and earnings volatility. The argument is that higher earnings
client's business operations, the more likely that auditors have to spend
volatility is likely to cause uncertainty in earnings streams, which might
more time and effort to complete the engagement. Using various
increase the difficulty of audit work and perceived level of audit risk and
complexity metrics, prior empirical evidence is generally consistent with
therefore result in higher audit fees. To the extent that a primary
the hypothesized positive association between audit complexity and
motivation for managers to engage in income smoothing is to reduce
audit fees.
earnings volatility and inherent business risk, our study complements
Risk characteristics of a client may impact an auditor's pricing de­
and extends theirs by identifying an underlying mechanism (i.e., income
cisions as they are associated with the auditor's client-specific business
smoothing) by which the positive association between earnings vola­
risk. As defined by AICPA (1992), client-specific business risk consists of
tility and audit fees documented in Bryan et al. (2018) could be
two components: (1) the client's business risk, which is the risk associ­
explained by firms' reporting incentives and choices.6
ated with the client's continued survival and well-being, and (2) the
The remainder of the paper is organized as follows. Section 2 reviews
auditor's business risk, which is related to potential litigation risk and
relevant literature to develop our hypothesis. Section 3 discusses the
risks of being associated with the client regardless of whether an audit
research methodology. Section 4 describes data and sample. Section 5
failure is asserted. Morgan and Stocken (1998) interpret the business
presents and discusses the results. Section 6 concludes.
risk as “the risk to the auditor of a lawsuit that remains after taking all
steps required under the Statements of Auditing Standards (SAS) while
performing the audit and issuing an audit report” (p. 365). Their model
5
Similar to accrual-based and activity-based earnings manipulations, income examines the role of information regarding client-specific business risk
smoothing can be viewed as a particular form of earnings management. Prior on audit pricing and shows that audit fees, in general, increase with the
literature, however, suggests that income smoothing differs from other forms of perceived business risk.
earnings management in the following important aspect. As suggested by many Existing empirical evidence is generally consistent with the above
studies (e.g., Graham et al., 2005), the primary motivation for managers to theoretical prediction. For example, several prior studies (e.g., Palm­
engage in income smoothing is to reduce earnings volatility because a smooth rose, 1986; Seetharaman, Gul, & Lynn, 2002; Simunic, 1980; Simunic &
earnings path is perceived as less risky to investors, creditors and other market
Stein, 1996) document that auditors charge a fee premium in response to
participants (e.g., Graham et al., 2005; Trueman & Titman, 1988). In addition,
higher levels of client-specific litigation risk. Using the survey data from
through its signaling property, income smoothing can reduce the uncertainty
about future profitability, which in turn could reduce return volatility and
U.S. audits performed by an international public accounting firm in
firms' idiosyncratic risk. Smooth income streams also have a lower incidence of 1989, Bell, Landsman, and Shackelford (2001) also document a positive
bad news, which could result in lower return volatility as well (Rogers, Skinner, association between client-specific business risk (i.e., litigation risk) and
& Buskirk, 2009).Other forms of earnings management, however, are more audit fees. Furthermore, the increase in audit fees due to the heightened
likely to be used as an opportunistic tool to inflate earnings numbers for litigation risk primarily comes from the increase in the number of audit
achieving short-term goals such as meeting or beating analysts' forecasts. This hours but not the fee per hour.
incentive difference is important because in contrast to the traditional mana­ Using the data derived from engagement partners' risk assessments of
gerial opportunism view of earnings management, income smoothing can also participating audit firms during 2000–2001, Bedard and Johnstone
be perceived as a tool for enhancing shareholder value. This alternative view (2004) show that auditors increase their engagement efforts and billing
indicates that the positive association between earnings management and audit
rates for clients if clients' corporate governance and monitoring mech­
fees documented in prior studies (e.g., Choi et al., 2018; Gul et al., 2003) does
anism are weak and when earnings management risk is relatively high.
not necessarily exist in the case of income smoothing.
6
As a related study, Bryan and Mason (2020) examine whether earnings
Their results suggest that auditors base their audit planning and pricing
volatility affects audit report lag. They find that firms with lower earnings decisions on the assessments of both aggressive accounting practices and
volatility exhibit longer audit report lag, which is interpreted to be consistent adequacy of corporate governance.
with auditors responding to less volatile earnings with increased effort. In Focusing on an alleged client misconduct that is not illegal and not
addition, they find that the negative association between earnings volatility and directly related to financial statement disclosures, Lyon and Maher
audit report lag is stronger for firms with higher degree of earnings smoothing, (2005) hypothesize and find that audit fees are higher for clients that
a finding consistent with the argument that income smoothing is viewed as an disclose paying bribes for doing business in developing countries where
opportunistic earnings management tool. In contrast to their findings, our re­
sults appear to suggest that auditors view income smoothing more as a signaling
device than as an opportunistic behavior from the audit pricing perspective.

3
H. Chang et al.
bribery of top government officials is an accepted business practice.7
They interpret their evidence to be consistent with auditors viewing
clients who engage in such behavior riskier and therefore charging
higher audit fees.
2.1.2. Impact of earnings quality on audit fee decisions
Several studies have examined the relation between earnings quality
and audit pricing. For example, Gul et al. (2003) focus on accrual-based
earnings management (AEM) and use discretionary accruals as a proxy
for earnings quality. Based on a set of Australian firms in 2001, they find
a positive association between discretionary accruals and audit fees,
which is consistent with the view that auditors perceive firms with
higher degree of AEM to be associated with higher audit risk, higher
audit effort and thus higher audit fees.
Abbott, Parker, and Peters (2006) document asymmetric audit fee
responses to AEM risk by considering income-increasing and income-
decreasing discretionary accruals separately. Specifically, using U.S.
data for the year 2000, they show that firms with income-decreasing
discretionary accruals are associated with lower audit fees, while
firms that report income-increasing discretionary accruals tend to have
higher audit fees. They interpret their findings to be consistent with a
conservative bias on the part of auditors which arises from the asym­
metric litigation risk associated with income-increasing vs. income-
decreasing AEM.
As an extension, the recent study by Choi et al. (2018) examines
whether auditors incorporate the implications of real earnings man­
agement (REM) into audit pricing decisions. Unlike AEM, REM is outside
of auditors' audit scope because it is not auditors' responsibility to
disentangle REM from optimal business decisions. Thus, auditors would
not care so much about REM in the determination of audit fees. How­
ever, to the extent that REM is an important mechanism for managers to
engage in opportunistic earnings management, auditors likely charge
higher audit fees for firms with higher REM because such firms are
associated with higher shareholder litigation risk. Based on a set of U.S.
firms during the 2000–2008 period, Choi et al. (2018) find a positive and
significant incremental association between REM and audit fees that is
beyond the effects of AEM, suggesting that auditors demand a fee pre­
mium for REM-intensive firms even after considering the effects of AEM.
Viewing accounting conservatism as an important qualitative attri­
bute that potentially enhances earnings quality, both Lee et al. (2015)
and DeFond et al. (2016) document that auditors strategically respond
to firms' conditional conservatism by adjusting audit fees. Specifically,
higher conditional conservatism leads to lower audit fees, supporting
the argument that more conservative reporting reduces firms' litigation
risk by providing more timely disclosure of bad news.
Recent research by Choi, Ki, and Kwon (2017) examines the associ­
ation between accruals quality and audit fees. They argue that accruals
quality is an indicator of firms' cash flow risk which is a priced risk
factor. Poor accruals quality weakens the mapping of accounting earn­
ings into cash flows, which is likely to increase the audit risk associated
with potentially fraudulent financial reporting. Thus, auditors have in­
centives to incorporate accruals quality into audit planning and imple­
mentation as well as audit pricing. Using Korean data for the 2000–2012
period, they find a negative relation between accruals quality and audit
fees, suggesting that auditors charge higher fees for firms with lower
accruals quality due to the heightened cash flow risk. Furthermore, by
separating the innate and discretionary components of accruals quality,
they show that both components are negatively associated with audit
fees but auditors appear more likely to respond to the innate component
than to the discretionary component.
In a related study, Bryan et al. (2018) examine how two additional
earnings attributes, earnings volatility and earnings autocorrelation, are
7
The results of Lyon and Maher (2005) are based on data before the passage
of the Foreign Corrupt Practices Act.
4
Advances in Accounting 54 (2021) 100547
associated with audit pricing. For earnings volatility, they argue and
find that earnings volatility is positively associated with audit fees since
more volatile earnings are less predictable, which could increase the
difficulty of the audit work and therefore increase audit effort and the
resulting audit fees. In addition, higher earnings volatility is likely to be
interpreted by the auditor as a signal of greater risk, which also suggests
a positive relation between earnings volatility and audit fees.
Regarding earnings autocorrelation, Bryan et al. (2018) argue that
lower autocorrelation (either positive or negative) tends to cause un­
certainty in earnings streams, which is likely to increase the difficulty of
audit work and perceived level of audit risk. Consistent with this argu­
ment, they find that firms with higher earnings autocorrelation are
charged lower audit fees. They also find that auditor industry speciali­
zation tends to attenuate the negative association between earnings
autocorrelation and audit fees, suggesting that specialists respond to
situations with lower earnings autocorrelation more efficiently than
their non-specialist counterparts.
2.2. Income smoothing literature
According to Beidleman (1973), income smoothing is the intentional
dampening of fluctuations in earnings series over time. Existing litera­
ture suggests two different views on the motivations of managers to
smooth income.
2.2.1. The “informational” role of income smoothing
The “informational” view argues that managers use income
smoothing to reveal their private information about firms' future per­
formance. Trueman and Titman (1988) argue that income smoothing
can enhance firm value by reducing firms' earnings volatility and
required rate of return. Goel and Thakor (2003) argue that income
smoothing can reduce the informational advantage for informed in­
vestors over uninformed investors and therefore increase trading
liquidity. This view also predicts that income smoothing can strengthen
the relation between current earnings and future earnings and therefore
the persistence and informativeness of earnings streams will be higher
(e.g., Tucker & Zarowin, 2006).
Empirically, several prior studies provide evidence that is consistent
with the “informational” view of income smoothing. Francis et al.
(2004) find that firms with higher degree of income smoothing tend to
have lower cost of capital for both equity and debt. Chen (2013) docu­
ments that firms that use income smoothing through both total accruals
and discretionary accruals are associated with lower information un­
certainty, as measured by stock return volatility, analyst earnings fore­
cast dispersion, and analyst earnings forecast error. Demerjian,
Donovan, and Lewis-Western (2020) indicate that income smoothing
improves the usefulness of earnings in debt contracting by increasing the
association between reported earnings and economic performance. Dou
et al. (2013) show that firms use income smoothing through discre­
tionary accruals to reduce the contracting risk with their suppliers or
customers, highlighting the signaling benefit of using income smoothing
to obtain better terms of trade with firms' stakeholders (Graham et al.,
2005).
In a related vein, both Demerjian, Lewis-Western, & McVay, 2020
and Baik et al., 2020 find that firms with high-ability managers are more
likely to engage in income smoothing. The arguments are (1) managers
must accurately forecast earnings in order to effectively smooth earnings
and (2) managerial ability has been shown to be positively associated
with the accuracy of both management earnings forecasts and accruals
(Baik, Farber, & Lee, 2011; Demerjian, Lev, Lewis-Western, & McVay,
2013). In addition, Demerjian, Lewis-Western, & McVay, 2020 show
that the income smoothing by high-ability managers is associated with
improved future operating performance. Furthermore, Baik et al., 2020
find that high-ability managers are more likely to smooth earnings by
incorporating forward-looking information into current earnings, thus
improving earnings informativeness. These findings support the view
H. Chang et al.
that income smoothing is beneficial.
2.2.2. The “opportunistic” role of income smoothing
The “opportunistic” view highlights the possibility that managers
engage in income smoothing as an opportunistic behavior. This
perspective implies that income smoothing is motivated to conceal the
volatility of past earnings performance instead of to signal future eco­
nomic performance. In this sense, income smoothing can exacerbate the
agency problem and lead to value erosion. For example, Fudenberg and
Tirole (1995) argue that managers have incentives to distort reported
accounting numbers to derive incumbency rents and extract private
benefits. DeFond and Park (1997) provide empirical evidence that
managers engage in income smoothing to reduce the volatility of per­
formance in order to derive their private control benefits at the expense
of shareholders.
Opportunistic income smoothing has been found to increase earnings
opacity and result in higher transaction costs and lower market liquidity
(LaFond et al., 2007; Lang et al., 2012). In addition, income smoothing
motivated by managers' opportunism could garble the communication
process and introduce noise to the earnings series, which in turn makes
the reported earnings less informative about a firm's future earnings and
cash flows. It also implies a lower persistence in earnings (Tucker &
Zarowin, 2006). Furthermore, research by Schrand and Zechman
(2012), Myers, Myers, and Skinner (2007) as well as Baik et al., 2020
indicates the possibility that smoothing decisions could increase the
frequency of intentional financial misreporting and subsequent litiga­
tion,8 highlighting another potential cost of income smoothing.
2.3. Hypothesis development
We conjecture that income smoothing affects auditors' risk assess­
ments and therefore their pricing decisions. However, whether its net
effect increases or decreases audit fees is unclear ex ante. On one hand,
income smoothing can reduce the volatility of earnings streams and
lower a firm's (i.e., a client's) inherent business risk (e.g., bankruptcy
risk), which can favorably influence the perception of various stake­
holders and therefore lead to better terms of trade (Graham et al., 2005;
Trueman & Titman, 1988). As discussed earlier, prior research has
shown that income smoothing is associated with higher firm valuation
(Rountree et al., 2008), greater earnings informativeness/decision use­
fulness (Demerjian, Donovan, & Lewis-Western, 2020; Tucker & Zar­
owin, 2006); lower cost of equity (Francis et al., 2004), lower stock
return volatility (Chen, 2013), lower cost of debt (Francis et al., 2004;
Trueman & Titman, 1988), lower analyst forecast dispersion (Chen,
2013), and lower contracting risk with suppliers and/or customers (Dou
et al., 2013). To the extent that client-specific business risks (i.e., the
risks associated with the client's continued survival and well-being) in­
fluence auditors' pricing decisions (Choi, Kim, Liu, & Simunic, 2008;
Khalil, Magnan, & Cohen, 2008; Krishnan, Krishnan, & Song, 2011), we
would expect that smoothed earnings lead to lower audit fees.
On the other hand, a large body of prior studies also indicate that
income smoothing can be used by managers to conceal information
about firms' true economic performance, heightening the risk of
opportunistic earnings management and intentional financial mis­
reporting. During good times when realized earnings are high, managers
may underreport earnings, while during bad times when realized earn­
ings are low, managers may inflate earnings to maximize their personal
benefits (Das, Shroff, & Zhang, 2009; DeFond & Park, 1997; Grant,
8
As argued by Baik et al., 2020, one possibility is that managers' initial ac­
counting adjustments (e.g., using accruals to shift income from the future to the
present) in smoothing decisions are based on an overly optimistic expectation of
future performance. When the optimistic earnings projections are not subse­
quently realized, managers could be motivated to engage in more aggressive
reporting in subsequent periods in order to maintain the earnings momentum.
5
Advances in Accounting 54 (2021) 100547
Markarian, & Parbonetti, 2009). LaFond et al. (2007) offer evidence that
smoothing results in less transparent earnings numbers and Leuz et al.
(2003) suggest earnings smoothing is an earnings management tool used
by insiders to hide their economic rent of private control. Myers et al.
(2007) observe that firms smooth income to maintain artificially long
strings of increasing EPS to meet earnings goals. Thus, income
smoothness “is not a de facto indication of greater decision usefulnesss or
higher earnings quality” (Dechow, Ge, & Schrand, 2010). Insofar as
opportunistic earnings management may intensify “auditor business
risk” such as litigation risk and the possibility of reputation loss due to
failure to detect material accounting misstatements (Gul et al., 2003;
Hogan & Wilkins, 2008), auditors may charge a higher risk-related
premium for smoothed earnings.
The above competing arguments suggest that ex ante the impact of
income smoothing on auditors' pricing decisions is not clear. Therefore,
we state our hypothesis in a non-directional null form as:
H1. There is no association between income smoothing and audit fees.
3. Research design
3.1. Proxies of income smoothing
We adopt two primary income smoothing proxies that are suggested
by prior research. The first proxy (SMTH1) focuses on the relation be­
tween net income and cash flow. If a firm engages in income smoothing
through the use of accruals, the volatility of the firm's net income will be
smaller than that of its cash flow (Francis et al., 2004; Leuz et al., 2003).
This proxy is calculated as negative one multiplied by the standard de­
viation of net income divided by the standard deviation of cash flow
from operations so that a larger value indicates a higher degree of in­
come smoothing. Following Lang et al. (2012), both net income and
operating cash flows in the derivation of the proxy are scaled by average
total assets on a rolling window requiring a minimum of three and a
maximum of five years of data ending in the current fiscal year.
Following Lang et al. (2012), our second income smoothing proxy
(SMTH2) is calculated by multiplying negative one with the correlation
between “the cash flow from operations scaled by total assets” and “total
accruals scaled by total assets”. SMTH2 is calculated using the similar
time window as SMTH1.9
In addition to SMTH1 and SMTH2, we include measures of “innate”
and “discretionary” earnings smoothness that are suggested by prior
research. Tucker and Zarowin (2006) argue that innate earnings
smoothness reduces information asymmetry and improves earnings
informativeness, while discretionary income smoothing is the result of
managers' intentional intervention and therefore will make earnings
noisier. Auditors have substantial accounting expertise and access to
detailed accounting records and therefore are likely to identify discre­
tionary earnings smoothness. To the extent that discretionary earnings
smoothness is indicative of greater earnings management (Lang et al.,
2012), auditors may charge a fee premium to compensate for the
increased audit effort resulting from the higher earnings management
risk. However, if the lower client-specific business risk from smoothed
earnings dominates the heightened earnings management risk, we still
expect the negative relationship between audit fees and income
smoothing to hold regardless of the source of the earnings smoothness.
To address this issue, we follow Lang et al. (2012) and Dou et al.
(2013) to decompose the two primary income smoothing proxies,
SMTH1 and SMTH2, into innate and discretionary components using the
following regression model:
9
We also follow Burgstahler, Hail, and Leuz (2006) to use a 10-year rolling
window in calculating SMTH1 and SMTH2. Our inferences are not altered.
H. Chang et al.
SMTH = α0 + α1 *SIZE + α2 *LEV + α3 *BM + α4 *STD SALE + α5 *LOSS
+ α6 *OPCYCLE + α7 *SG + α8 *OPLEV + α9 *AVECFO
+ Industry dummies + Year dummies + et
(1)
where SIZE is the natural log of total assets; LEV, leverage ratio, is
calculated as total debts deflated by total assets; BM is book-to-market
ratio, which is used as a measure of the firm's intangible intensity and
earnings growth; STD_SALE is a measure of the volatility of a firm's
underlying operating environment, which is calculated as the standard
deviation of sales over the past three to five years; LOSS is an indicator
variable with the value of one if a firm reports negative earnings and
zero otherwise; OPCYCLE is the length of a firm's operating cycle, which
is calculated as the natural log of number of days of accounts receivable
plus inventories; SG measures a firm's growth opportunities, which is
calculated as the average sales growth over the past three to five years;
OPLEV measures a firm's capital intensity, which is calculated as net
property, plant and equipment divided by total assets, and AVECFO is a
measure of a firm's general level of profitability, which is calculated as
average cash flow from operations divided by total assets measured over
the last five years.
Both industry and year dummy variables are included as well. As
discussed in Lang et al. (2012), all the right-hand side variables in the
above regression model are intended to capture the expected level of
earnings smoothness (i.e., innate smoothness), which is a function of the
firm-specific, industry-specific, and economy-wide attributes that affect
a firm's operating environment. Thus, the residual term of the above
regression model would capture the discretionary part of earnings
smoothness.
More specifically, the residual parts of the regressions for SMTH1 and
SMTH2 are scaled into percentile ranks within each fiscal year and
combined by taking the average as the proxy of discretionary smoothing,
hereafter referred to as DIS_SMTH.10 The predicted parts of these re­
gressions are treated in a similar way as the proxy of innate smoothing,
and hereafter are referred to as INNA_SMTH.
3.2. Empirical model
We use the following regression model to test our hypothesis.
LAUDIT = β0 +β1 *SMOOTH +β2 *SIZE +β3 *BM +β4 *BUSY + β5 *ROA
+β6 *QUICK +β7 *LEV +β8 *LOSS +β9 *INV REC +β10 *SPITEM
+β11 *BIGN +β12 *SQ SEG +β13 *FOPS +β14 *MOD+ β15 *SQ LAG
+β16 *EXPERT +β17 *TENURE +β18 *AUTO+β19 *IBVOL
+β20 *LNNAF +β21 *DIRINDEP+ β22 *DUALITY +β23 *DIREXP
+β24 *DIRFEMALE +β25 *ALTMANZ +Industry dummies
+Year dummies+ error
(2)
where
LAUDIT = the natural log of audit fees in thousands of dollars;
SMOOTH = the degree of income smoothing, which includes
SMTH1, SMTH2, INNA_SMTH, and DIS_SMTH with the calculation
described in the preceding section;
SIZE = the natural log of total assets;
BM = book-to-market ratio, which is used as a measure of the firm's
intangible intensity and earnings growth;
BUSY = an indicator variable with the value of one if the firm's fiscal
year end is December 31 and zero otherwise. It is a measure of auditors'
“busy season” that corresponds to the point in time when most com­
panies have their fiscal year-end;
10
Using the raw values of the residual and predicted parts decomposed from
SMTH1 (or SMTH2) does not materially change our inferences in the analysis.
6
Advances in Accounting 54 (2021) 100547
ROA = income before extraordinary items deflated by total assets;
QUICK = current assets divided by current liabilities;
LEV = leverage ratio, which is calculated as total debts deflated by
total assets;
LOSS = an indicator variable with the value of one if the firm reports
negative earnings (income before extraordinary items) and zero
otherwise;
INV_REC = the sum of inventories and receivables divided by total
assets;
SPITEM = 1 if the firm reports a special item and 0 otherwise;
BIGN = 1 if the firm is audited by a Big N auditor and 0 otherwise;
SQ_SEG = the square root of the number of business segments;
FOPS = 1 if the firm has foreign operations and 0 otherwise;
MOD = 1 if the firm receives a modified audit opinion and
0 otherwise;
SQ_LAG = the square root of days from the fiscal year end to the audit
report date;
EXPERT = 1 if the auditor is a city level industry specialist and
0 otherwise;
TENURE = the number of years for the auditor-client relationship;
AUTO = a measure of earnings autocorrelation, which is estimated as
the correlation between the percentage change in annual earnings series
at the first lag using a five-year estimation window (Bryan et al., 2018);
IBVOL = the standard deviation of annual income before extraordi­
nary items scaled by total assets at the beginning of the fiscal year using
a five-year window (Bryan et al., 2018);
LNNAF = the natural logarithm of non-audit fees in thousands of
dollars;
DIRINDEP = the percentage of independent directors on the board;
DUALITY = 1 if the firm's CEO is also the chair of the board and
0 otherwise;
DIREXP = the percentage of board members holding more than two
external board positions;
DIRFEMALE = the percentage of female directors on the board; and.
ALTMANZ = the Altman Z score in Altman (1968).
The primary variable of interest in regression (2) is SMOOTH. Given
that our hypothesis is non-directional, we do not predict the sign for the
coefficient on SMOOTH (i.e., β1). If β1 is significantly negative, then the
evidence is consistent with the amount of audit fees being reduced for
firms with higher degree of income smoothing. As discussed earlier, this
could occur because auditors view income smoothing as an effective
mechanism to reduce a firm's bankruptcy and other related business
risks. On the other hand, if income smoothing is primarily perceived by
auditors as an opportunistic earnings management tool which increases
auditors' litigation risk, β1 would be significantly positive.
In addition to the main test variable (SMOOTH), we include eighteen
firm-specific, three auditor-specific, and three engagement-specific
controls that are likely to affect the size of audit fees. Regarding the
firm-specific characteristics, SIZE and INV_REC are included as proxies
for client size and audit complexity respectively (see e.g., Chang, Cheng,
& Reichelt, 2010; Simunic, 1980). LOSS, SPITEM, BM, ROA, LEV,
QUICK, and ALTMANZ are included because prior research has shown
they are related to client-specific litigation and/or bankruptcy risk (e.g.,
Seetharaman et al., 2002; Simunic, 1980). SQ_SEG and FOPS are
included because they capture additional dimensions of audit
complexity. Prior studies (e.g., Choi et al., 2008; Simunic & Stein, 1996)
have shown that firms that are more diversified and more geographi­
cally dispersed require more audit work/effort and therefore are more
likely to pay higher fees to their auditors. We also include the amount of
a firm's non-audit service fees (LNNAF) to control its potential impact on
audit fees.11
Moreover, as suggested by Carcello, Hermanson, Neal, and Riley
11
Using total fees (NAS fees + audit fees) and the NAS fee ratio, which is
defined as the NAS fees divided by the total fees, yield similar results.
H. Chang et al. Advances in Accounting 54 (2021) 100547

Table 1
Variable definitions.
Panel A – Variables Used in Regression Model (1)

SMTH1 = -1*std.(net income/total assets)/std.(operating cash flow/total assets);

SMTH2 = -1*correlation of (cash flow/total assets) and (accruals/total assets);
SIZE = the natural log of total assets in millions of dollars;
LEV = leverage ratio, calculated as total debts deflated by total assets;
BM = book-to-market ratio;
STD_SALE = a measure of the volatility of the firm's underlying operating environment, calculated as standard deviation of sales over the past three to five years;
LOSS = an indicator variable with the value of one if the firm reports negative earnings and zero otherwise;
OPCYCLE = the length of the firm's operating cycle, calculated as the natural log of days of accounts receivable plus inventories;
SG = a measure of the firm's growth opportunities, calculated as the average sales growth over the past three to five years;
OPLEV = a measure of the firm's capital intensity, calculated as net property, plant and equipment divided by total assets; and
AVECFO = a measure of the firm's general level of profitability, calculated as average cash flow from operations divided by total assets measured over the last five years;

Panel B – Variables Used in Regression Model (2)

LAUDIT = the natural log of audit fees in thousands of dollars;

SMTH1 = -1*std.(net income/total assets)/std.(operating cash flow/total assets);
SMTH2 = -1*correlation of (cash flow/total assets) and (accruals/total assets);
INNA_SMTH = the innate earnings smoothness as defined by Lang et al. (2012);
DIS_SMTH = the discretionary earnings smoothness as defined by Lang et al. (2012);
SIZE = the natural log of total assets in millions of dollars;
BM = book-to-market ratio;
BUSY = 1 if the firm's fiscal year end is December 31, and 0 otherwise;
ROA = income before extraordinary items deflated by total assets;
QUICK = current assets divided by current liabilities;
LEV = total debts deflated by total assets;
LOSS = 1 if the firm reports negative earnings (income before extraordinary items) for the current year, and 0 otherwise;
INV_REC = the sum of inventories and receivables divided by total assets;
SPITEM = 1 if the firm reports a special item, and 0 otherwise;
SQ_SEG = the square root of the number of business segments;
FOPS = 1 if the firm has foreign operations, and 0 otherwise;
BIGN = 1 if the firm is audited by a Big N auditor, and 0 otherwise;
MOD = 1 if the firm receives a modified audit opinion, and 0 otherwise;
SQ_LAG = the square root of days from fiscal year end to the audit report date;
TENURE = the number of years for the auditor-client relationship;
EXPERT = 1 if the auditor is a city level industry specialist, and 0 otherwise;
AUTO = earnings autocorrelation as calculated by Bryan et al. (2018);
IBVOL = earnings volatility as calculated by Bryan et al. (2018);
LNNAF = the natural log of non-audit fees in thousands of dollars;
DIRINDEP = the percentage of independent directors on the board;
DUALITY = 1 if the firm's CEO is also the chair of the board, and 0 otherwise;
DIREXP = the percentage of board members holding more than two external board positions;
DIRFEMALE = the percentage of female directors on the board;
ALTMANZ = Altman Z score as calculated by Altman (1968);
Chg = when “Chg” is prefixed to a variable, it means the change in the value of the variable from year t-1 to year t.

Panel C – Moderating Variables

HIGH_COV = 1 if the number of analysts following the firm is above the sample median, and 0 otherwise;
HIGH_IO = 1 if the percentage of outstanding shares owned by institutional investors is above the sample median, and 0 otherwise;
BIG_SIZE = 1 if the SIZE of the firm is above the sample median, and 0 otherwise;

(2002) and Lai, Srinidhi, Gul, and Tsui (2017), we include four corporate
governance variables as additional controls: board independence
(DIRINDEP), CEO duality (DUALITY), board member expertise (DIR­
EXP), and board gender diversity (DIRFEMALE). Following Bryan et al.
(2018), both earnings volatility (IBVOL) and earnings autocorrelation
(AUTO) are also included.
In light of prior research, we include three auditor-specific variables
– BIGN, TENURE, and EXPERT – to control for auditor-specific attributes
that may cause variations in audit pricing. BIGN is included because
prior research (e.g., Ashbaugh, LaFond, & Mayhew, 2003; Choi et al.,
2008) documents the existence of a significant “Big N fee premium” with
the argument that the potential legal liability cost is greater for a Big N
auditor than for a non-Big N auditor. TENURE is included given the prior
finding that audit fees are lower in audits where the auditor is relatively
new to the engagement. EXPERT is a proxy for audit quality and prior
research has generally suggested that firms pay higher fees to auditors
who provide higher quality service (e.g., Reichelt & Wang, 2010).
Finally, we control three engagement-specific factors. BUSY is
included because audit fees are typically higher for an audit engagement
that is performed in the “busy” season. MOD is included due to the
previous research finding that a modified audit opinion heightens a
firm's litigation risk (e.g., Abbott, Parker, Peters, & Raghunandan,
2003). SQ_LAG is included since prior research (e.g., Knechel & Payne,
2001) indicates that audit report lag may be an indication of audit ef­
ficiency, which in turn affects the amount of audit effort and therefore
the size of audit fees. Detailed definitions for all variables included in
regression models (1) and (2) are summarized in Table 1.
4. Sample and data
Our sample is derived from the intersection of audit fee data from
Audit Analytics, the financial statement data from Compustat, and the
board of directors data from ISS (Institutional Shareholder Services,
formerly Risk Metrics). Our initial sample consists of 111,580 firm-year

7
H. Chang et al. Advances in Accounting 54 (2021) 100547

Table 2 Table 3
Sample information. Descriptive statistics (N = 12,823).
Panel A: Sample selection Variables Mean Median Std. Dev. p25 p75

Firm-year observations with audit fee data from Audit Analytics, 111,580 LAUDIT 7.51 7.49 1.07 6.80 8.23
2000–2018 SMTH1 − 0.79 − 0.73 0.47 − 1.03 − 0.44
Less: Firm-year observations in regulated industries (SIC 40–49 & SIC (34,207) SMTH2 0.58 0.77 0.46 0.38 0.93
60–69) INNA SMTH 0.69 0.73 0.22 0.55 0.86
Firm-year observations with missing information to calculate (26,291) DIS SMTH 0.48 0.48 0.25 0.26 0.70
income smoothing proxies SIZE 7.64 7.51 1.47 6.55 8.58
Firm-year observations with missing control variable (25,132) BM 0.45 0.38 0.32 0.24 0.59
information from Compustat or Audit Analytics BUSY 0.65 1.00 0.48 0.00 1.00
Firm-year observations with missing control variable (13,127) ROA 0.06 0.06 0.08 0.03 0.10
information from Institutional Shareholder Services (formerly QUICK 1.86 1.43 1.49 0.97 2.20
RiskMetrics) LEV 0.50 0.50 0.21 0.35 0.63
Firm-year observations in final sample 12,823 LOSS 0.13 0.00 0.34 0.00 0.00
INV REC 0.29 0.26 0.17 0.16 0.38
SPITEM 0.80 1.00 0.40 1.00 1.00
Panel B: Sample distribution by year SQ_SEG 1.62 1.73 0.53 1.00 2.00
Year N Percentage Cumulative Percentage FOPS 0.81 1.00 0.39 1.00 1.00
BIGN 0.94 1.00 0.23 1.00 1.00
2000 427 3.33% 3.33% MOD 0.34 0.00 0.47 0.00 1.00
2001 612 4.77% 8.10% SQ_LAG 7.28 7.48 0.96 6.93 7.75
2002 615 4.80% 12.90% TENURE 14.64 12.00 10.15 7.00 20.00
2003 677 5.28% 18.18% EXPERT 0.59 1.00 0.49 0.00 1.00
2004 691 5.39% 23.57% AUTO − 0.14 − 0.20 0.42 − 0.44 0.10
2005 674 5.26% 28.83% IBVOL 0.05 0.03 0.06 0.02 0.06
2006 652 5.08% 33.91% LNNAF 5.93 6.00 1.62 4.95 7.02
2007 659 5.14% 39.05% DIRINDEP 0.77 0.80 0.13 0.70 0.88
2008 604 4.71% 43.76% DIRDUALITY 0.47 0.00 0.50 0.00 1.00
2009 675 5.26% 49.02% DIREXP 0.22 0.20 0.18 0.09 0.33
2010 694 5.41% 54.43% DIRFEMALE 0.14 0.13 0.11 0.00 0.20
2011 721 5.62% 60.05% ALTMANZ 5.21 4.09 4.18 2.78 6.09
2012 742 5.79% 65.84%
2013 740 5.77% 71.61% Variables are defined in Table 1.
2014 725 5.65% 77.26%
2015 718 5.60% 82.86%
2016 719 5.61% 88.47%
2017 726 5.66% 94.13% Table 2 summarizes our sample selection process.
2018 752 5.87% 100% Panels B and C of Table 2 present the year and industry distribution
Total 12,823 100% of sample observations respectively. As shown in Panel B, the sample
observations are fairly evenly distributed across years, with a modest
Panel C: Sample distribution by industry upward trend. Panel C indicates that firms within the business equip­
Industry N Percentage ment industry account for nearly 24% of the sample, followed by firms
in the machining manufacturing (17.09%) and in wholesale and service
Non-durable Consumer Manufacturing 1096 8.55%
Durable Consumer Manufacturing 465 3.63% industries (16.19%). Firms from the industry of durable consumer
Machinery Manufacturing 2191 17.09% manufacturing comprise the least of the sample observations (3.63%).
Energy, Oil, Gas, and Coal Extraction and Products 608 4.74% Table 3 reports the descriptive statistics for the variables used in this
Chemicals 593 4.62% study. All continuous variables are winsorized at the 1% and 99% levels
Business Equipment industry 3074 23.97%
to alleviate the effect of potential outliers in the regressions.13 The mean
Wholesale and Service 2076 16.19%
Healthcare, Medical Equipment and Drugs 1377 10.74% and median of LAUDIT (natural log of audit fees in thousands of dollars)
Other Non-utility and Non-financial industries 1343 10.47% is 7.51 and 7.49 respectively. The mean and median values of all vari­
Total 12,823 100% ables are generally comparable to those in prior literature (e.g., Bryan
We use the Fama-French industry classifications. et al., 2018; Chang et al., 2010).
Table 4 reports the pairwise Pearson correlations matrix of the
regression variables.14 As shown, the correlation coefficients between
observations with audit fee data in Audit Analytics during the period audit fees and SMTH1 (SMTH2) are positive but not significant at the 5%
2000–2018. We exclude 34,207 observations because they are from or better level. The correlation coefficient between INNA_SMTH and
regulated industries (SIC 40–49 and SIC 60–69). We also exclude 26,291 audit fees is positive and significant at the 5% level, while the correla­
observations because we are not able to locate sufficient information to tion coefficient between DIS_SMTH and audit fees is negative but
calculate the income smoothing proxies (SMTH1, SMTH2, INNA_SMTH, insignificant. Given that the univariate analysis does not control for
and DIS_SMTH). Next, we delete 25,132 observations because of missing other variables that are associated with audit fees, we turn to
or insufficient data in Compustat or Audit Analytics to calculate the
control variables in the regression models. Finally, we delete additional
13,127 observations due to missing ISS data for governance variables. 13
Our regression results remain unchanged when the variables are not
Our final sample consists of 12,823 firm-year observations to test the
winsorized.
association between income smoothing and audit fees.12 Panel A of 14
For brevity, only Pearson correlations are reported. An analysis of
Spearman correlations shows similar results.

12
To examine the moderating effect of analyst coverage (institutional
ownership), our sample is further reduced to 12,653 (12,795) firm-year ob­
servations after merging with the I/B/E/S (Thomson Reuters Stock Ownership)
database.

8
H. Chang et al. Advances in Accounting 54 (2021) 100547

Table 4
Pearson correlations.
Variables (1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

(1) LAUDIT 1
(2) SMTH1 0.01 1
(3) SMTH2 0.01 0.76 1
(4) INNA_SMTH 0.09 0.25 0.26 1
(5) DIS_SMTH − 0.01 0.78 0.79 0.12 1
(6) SIZE 0.79 0.04 0.04 0.25 ¡0.02 1
(7) BM ¡0.11 ¡0.02 − 0.01 ¡0.23 0.05 ¡0.11 1
(8) BUSY 0.13 ¡0.02 ¡0.02 ¡0.02 0.01 0.06 0.00 1
(9) ROA 0.00 0.12 0.13 0.37 0.01 0.06 ¡0.42 ¡0.04 1
(10) QUICK ¡0.23 ¡0.16 ¡0.20 0.08 ¡0.12 ¡0.33 0.00 − 0.01 0.06 1
(11) LEV 0.21 0.10 0.11 ¡0.13 0.09 0.41 ¡0.19 0.09 ¡0.14 ¡0.37
(12) LOSS ¡0.03 ¡0.19 ¡0.21 ¡0.41 ¡0.07 ¡0.10 0.29 0.04 ¡0.56 0.04
(13) INV_REC ¡0.07 0.19 0.19 0.16 0.13 ¡0.15 0.08 ¡0.11 0.09 ¡0.17
(14) SPITEM 0.29 ¡0.06 ¡0.07 ¡0.09 ¡0.03 0.19 0.08 0.06 ¡0.21 ¡0.07
(15) SQ_SEG 0.37 0.03 0.05 0.03 0.03 0.31 0.03 0.09 ¡0.04 ¡0.20
(16) FOPS 0.36 ¡0.05 ¡0.04 0.10 ¡0.02 0.20 ¡0.05 0.03 ¡0.04 0.05
(17) BIGN 0.17 − 0.01 ¡0.02 0.03 ¡0.02 0.22 ¡0.05 − 0.01 ¡0.02 ¡0.11
(18) MOD 0.05 0.01 0.03 0.02 0.03 0.04 0.04 0.01 ¡0.05 ¡0.04
(19) SQ_LAG 0.06 0.03 0.03 ¡0.11 0.08 ¡0.19 0.11 0.05 ¡0.07 0.02
(20) TENURE 0.28 0.03 0.02 0.05 − 0.01 0.27 ¡0.08 − 0.01 0.05 ¡0.10
(21) EXPERT 0.17 0.09 0.08 0.02 0.03 0.20 0.02 − 0.01 0.03 ¡0.20
(22) AUTO ¡0.05 ¡0.04 ¡0.04 − 0.01 ¡0.08 ¡0.03 0.02 ¡0.03 − 0.01 − 0.01
(23) IBVOL ¡0.20 ¡0.26 ¡0.22 ¡0.25 ¡0.17 ¡0.24 0.05 0.05 ¡0.22 0.29
(24) LNNAF 0.50 0.02 0.04 0.15 0.00 0.56 ¡0.12 0.04 0.00 ¡0.20
(25) DIRINDEP 0.36 ¡0.03 ¡0.04 ¡0.02 ¡0.03 0.25 ¡0.09 0.06 0.02 ¡0.09
(26) DIRDUALITY 0.00 0.05 0.07 0.09 0.03 0.07 ¡0.04 0.06 0.04 ¡0.06
(27) DIREXP 0.36 ¡0.02 ¡0.03 0.02 ¡0.04 0.42 ¡0.09 0.09 ¡0.02 ¡0.16
(28) DIRFEMALE 0.33 0.04 0.03 − 0.01 ¡0.02 0.34 ¡0.13 − 0.01 0.06 ¡0.21
(29) ALTMANZ ¡0.31 ¡0.03 ¡0.04 0.21 ¡0.07 ¡0.30 ¡0.30 ¡0.09 0.45 0.54

Variables (11) (12) (13) (14) (15) (16) (17) (18) (19) (20)

(1) LAUDIT
(2) SMTH1
(3) SMTH2
(4) INNA_SMTH
(5) DIS_SMTH
(6) SIZE
(7) BM
(8) BUSY
(9) ROA
(10) QUICK
(11) LEV 1
(12) LOSS 0.05 1
(13) INV_REC 0.05 ¡0.12 1
(14) SPITEM 0.17 0.14 ¡0.08 1
(15) SQ_SEG 0.22 − 0.01 0.02 0.16 1
(16) FOPS 0.03 0.02 0.00 0.22 0.23 1
(17) BIGN 0.16 − 0.01 ¡0.07 0.06 0.07 0.06 1
(18) MOD 0.04 0.01 ¡0.02 0.03 0.04 0.03 0.05 1
(19) SQ_LAG ¡0.06 0.06 0.03 0.03 ¡0.02 ¡0.05 ¡0.09 0.04 1
(20) TENURE 0.16 ¡0.05 0.00 0.09 0.15 0.11 0.17 ¡0.07 ¡0.07 1
(21) EXPERT 0.17 ¡0.08 0.12 0.02 0.11 ¡0.04 0.14 0.00 ¡0.02 0.11
(22) AUTO ¡0.02 0.02 0.06 ¡0.03 ¡0.03 ¡0.07 − 0.01 − 0.01 0.01 ¡0.02
(23) IBVOL ¡0.19 0.31 ¡0.13 0.02 ¡0.17 ¡0.04 ¡0.05 0.01 0.01 ¡0.15
(24) LNNAF 0.30 ¡0.04 ¡0.04 0.17 0.29 0.26 0.21 0.07 ¡0.20 0.21
(25) DIRINDEP 0.20 ¡0.03 ¡0.07 0.15 0.11 0.13 0.08 ¡0.03 0.04 0.14
(26) DIRDUALITY 0.05 ¡0.07 0.02 ¡0.04 0.06 0.01 − 0.01 0.03 ¡0.08 0.03
(27) DIREXP 0.25 0.01 ¡0.06 0.14 0.18 0.15 0.13 0.07 ¡0.12 0.11
(28) DIRFEMALE 0.25 ¡0.07 ¡0.05 0.12 0.14 0.06 0.12 ¡0.05 ¡0.03 0.23
(29) ALTMANZ ¡0.59 ¡0.20 0.06 ¡0.25 ¡0.23 ¡0.08 ¡0.12 ¡0.08 ¡0.05 ¡0.09

Variables (21) (22) (23) (24) (25) (26) (27) (28) (29)

(1) LAUDIT
(2) SMTH1
(3) SMTH2
(4) INNA_SMTH
(5) DIS_SMTH
(6) SIZE
(7) BM
(8) BUSY
(9) ROA
(10) QUICK
(continued on next page)

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H. Chang et al. Advances in Accounting 54 (2021) 100547

Table 4 (continued )
Variables (21) (22) (23) (24) (25) (26) (27) (28) (29)

(11) LEV
(12) LOSS
(13) INV_REC
(14) SPITEM
(15) SQ_SEG
(16) FOPS
(17) BIGN
(18) MOD
(19) SQ_LAG
(20) TENURE
(21) EXPERT 1
(22) AUTO 0.02 1
(23) IBVOL ¡0.19 0.00 1
(24) LNNAF 0.12 ¡0.04 ¡0.12 1
(25) DIRINDEP 0.06 ¡0.02 ¡0.07 0.08 1
(26) DIRDUALITY 0.05 − 0.01 ¡0.07 0.11 0.03 1
(27) DIREXP 0.06 ¡0.04 ¡0.04 0.30 0.27 0.07 1
(28) DIRFEMALE 0.13 ¡0.02 ¡0.14 0.18 0.26 0.00 0.17 1
(29) ALTMANZ ¡0.11 0.03 0.11 ¡0.20 ¡0.15 0.00 ¡0.18 ¡0.11 1

Variable definitions appear in Table 1. Bold values indicate significance at 5% level.

multivariate regressions to examine our hypothesis.15
5. Empirical results
5.1. Primary results
Table 5 presents the results of the pooled multivariate regression (2)
that examines our hypothesis. To correct for time-series dependence of
audit fees, we estimate all regressions with the standard errors clustered
at the firm level (Krishnan, Sun, Wang, & Yang, 2013).16 Year and in­
dustry fixed effects are included in all regressions as well. Columns (1)
and (2) report the results using SMTH1 and SMTH2 while columns (3)
and (4) focus on the association with INNA_SMTH and DIS_SMTH.
Overall, the high adjusted R-square (0.84) across columns is
consistent with the high explanatory power of audit fee models reported
in prior studies (e.g., Bryan et al., 2018; Chang et al., 2010). As shown in
columns (1) and (2) of Table 5, the coefficients on both SMTH1 and
SMTH2 are negative and significant at the 5% or better level, indicating
that, on average, auditors charge lower amount of audit fees for firms
with higher degree of income smoothing. In light of our earlier discus­
sion regarding how income smoothing would be associated with various
client-specific business risks, the evidence appears to suggest that, in
their pricing decisions, auditors perceive that the benefits of reduced
bankruptcy risk, possibly due to the signaling mechanism of income
smoothing, outweigh the perceived costs of the heightened litigation
risk with the opportunistic use of income smoothing.
As reported in columns (3) and (4) of Table 5, the coefficients on both
INNA_SMTH and DIS_SMTH are also significantly negative, providing
reinforcing evidence that the reduced client-specific business risk from
smoothed earnings dominates the heightened earnings management risk
in audit pricing decisions. In addition, the magnitude of audit fee
reduction on INNA_SMTH is significantly greater than that on DIS_SMTH,
indicating that auditors are sensitive to the difference between innate
and discretionary earnings smoothness and that they offer even larger
discounts for clients that exhibit higher degree of innate earnings
smoothness. Collectively, the results in Table 5 provide evidence that
income smoothing activities are rewarded by lower audit fees.
As indicated in Table 5, with the exception of ALTMANZ and BM, the
coefficients on all other firm-specific control variables are significant
with expected signs. That is, audit fees are positively related to client
size (SIZE), audit complexity (INV_REC, SQ_SEG and FOPS), and client-
specific risks (LEV, LOSS, SPITEM). As predicted, audit fees are nega­
tively related to ROA and QUICK, which is consistent with the notion
that clients with higher profitability and higher liquidity have lower
client-specific risk and therefore are charged lower audit fees. We also
find that the sign on LNNAF is significantly positive, indicating a posi­
tive relationship between audit and non-audit fees. Moreover, in line
with Bryan et al. (2018), audit fees are positively related to earnings
volatility (IBVOL) but negatively associated with earnings autocorrela­
tion (AUTO).
Consistent with Carcello et al. (2002), we find that audit fees are
positively associated with board independence (DIRINDEP) and board
expertise (DIREXP) but negatively related to CEO duality (DIRDUAL­
ITY), indicating that firms with stronger board governance demand
greater audit effort and therefore result in higher audit fees. We also find
a significant and positive sign on DIRFEMALE, suggesting that firms
with higher percentage of female directors on the board are charged
higher audit fees. This finding is consistent with Lai et al. (2017), which
documents a positive relation between board gender diversity and audit
fees.
Regarding the auditor- and engagement-specific control variables,
our results indicate that firms pay higher audit fees to (1) Big N auditors
(BIGN), (2) auditors that are designated as a city-level industry specialist
(EXPERT), and (3) auditors with longer tenure (TENURE). Also, audit
fees are higher for audit engagements that are conducted in the “busy”
season (BUSY) and that have a longer reporting lag (SQ_LAG). The as­
sociation between audit fees and MOD (modified opinions) is also
significantly positive. Overall, the direction and significance of the co­
efficients on control variables are consistent with prior literature (Hay,
2013; Hay, Knechel, & Wong, 2006).

15
To assess the degree of multicollinearity among the independent variables
5.2. Cross-sectional analyses
in the multivariate regression analysis, we conduct collinearity diagnostics
using variance inflation factors (VIF). All VIF scores in our regressions are less
than five, indicating that multicollinearity is unlikely to be a serious concern in 5.2.1. Information asymmetry
our regression results. Francis et al. (2004) show that firms with higher information
16
The regression results without clustered standard errors (not tabulated for asymmetry typically face greater information risk and other business
brevity) are similar to those with clustered standard errors. risks, and that investors adjust their trading terms (i.e., cost of capital) in

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H. Chang et al. Advances in Accounting 54 (2021) 100547

Table 5
Association between audit fees and income smoothing.
Variables Predicted (1) (2) (3) (4)

Sign LAUDIT LAUDIT LAUDIT LAUDIT

SMTH1 ? − 0.013***
SMTH2 ? − 0.010**
INNA_SMTH ? − 0.033***
DIS_SMTH ? − 0.008**
SIZE + 0.594*** 0.592*** 0.601*** 0.593***
BM − − 0.001 − 0.001 − 0.001 − 0.002
BUSY + 0.059*** 0.059*** 0.058*** 0.059***
ROA − − 0.027*** − 0.027*** − 0.027*** − 0.028***
QUICK − − 0.020*** − 0.021*** − 0.018*** − 0.020***
LEV + 0.048*** 0.047*** 0.041*** 0.048***
LOSS + 0.021*** 0.022*** 0.018** 0.022***
INV_REC + 0.081*** 0.080*** 0.083*** 0.080***
SPITEM + 0.045*** 0.045*** 0.044*** 0.045***
SQ_SEG + 0.076*** 0.076*** 0.075*** 0.076***
FOPS + 0.111*** 0.112*** 0.113*** 0.112***
BIGN + 0.006* 0.006* 0.007* 0.007*
MOD + 0.020*** 0.021*** 0.020*** 0.020***
SQ_LAG + 0.061*** 0.061*** 0.060*** 0.061***
TENURE + 0.015*** 0.015*** 0.015*** 0.015***
EXPERT + 0.020*** 0.020*** 0.020*** 0.020***
AUTO − − 0.008** − 0.008** − 0.008** − 0.008**
IBVOL + 0.001* 0.001* 0.003* 0.002*
LNNAF + 0.127*** 0.127*** 0.128*** 0.127***
DIRINDEP + 0.030*** 0.030*** 0.030*** 0.030***
DIRDUALITY − − 0.009** − 0.009** − 0.008** − 0.009**
DIREXP + 0.035*** 0.035*** 0.035*** 0.035***
DIRFEMALE + 0.034*** 0.034*** 0.034*** 0.034***
ALTMANZ − 0.010 0.010 0.009 0.010
Industry fixed effect Yes Yes Yes Yes
Year fixed effect Yes Yes Yes Yes
N 12,823 12,823 12,823 12,823
Adj. R-Square 0.842 0.842 0.843 0.842

Significance levels are two-tailed. Industry and year dummies are included, but not reported. *,**, *** denote the significance level of 10%, 5%, and 1%, respectively.
Standard errors are clustered by company (Gow, Ormazabal, & Taylor, 2010; Petersen, 2009). Variables are defined in Table 1.

Table 6
Association between audit fees and income smoothing conditional on analyst coverage.
Variables Predicted (1) (2) (3) (4)

Sign LAUDIT LAUDIT LAUDIT LAUDIT

SMTH1 ? − 0.011**
SMTH1*HIGH_COV ? 0.008*
SMTH2 ? − 0.010**
SMTH2*HIGH_COV ? 0.002*
INNA_SMTH ? − 0.038***
INNA_SMTH*HIGH_COV ? 0.021**
DIS_SMTH ? − 0.004*
DIS_SMTH*HIGH_COV ? − 0.017
HIGH_COV ? − 0.037*** − 0.032*** − 0.044*** − 0.031**
Controls Yes Yes Yes Yes
Industry fixed effect Yes Yes Yes Yes
Year fixed effect Yes Yes Yes Yes
N 12,653 12,653 12,653 12,653
Adj. R-Square 0.842 0.841 0.842 0.842

Significance levels are two-tailed. Control variables, industry and year dummies are included, but not reported. *,**, *** denote the significance level of 10%, 5%, and
1%, respectively. Standard errors are clustered by company (Gow et al., 2010; Petersen, 2009). Variables are defined in Table 1. The sample size is reduced to 12,653
after merging with Thomason Reuters Institutional Brokers Estimate System (IBES) data.

response to different levels of information asymmetry. Research by
Bhattacharya, Daouk, and Welker (2003) and Kerr and Ozel (2015) also
suggests that firms with poor information environments tend to use
more informative earnings to reduce information asymmetry. Thus, we
expect firms with higher information asymmetry to have greater in­
centives to engage in income smoothing as a signaling mechanism to
reap the benefit of reduced information asymmetry, which suggests that
the effect of reduced audit fees due to income smoothing could be
stronger (weaker) for firms with higher (lower) information asymmetry.
Using analyst coverage as a proxy for a firm's level of information
asymmetry, we perform an additional analysis to test the moderating
effect of analyst coverage on the association between income smoothing
and audit fees. Specifically, we add an interaction term of our income
smoothing proxy (SMTH1, SMTH2, INNA_SMTH, or DIS_SMTH) and
HIGH_COV to regression model (2). HIGH_COV is a dummy variable
with the value of one if the number of financial analysts following the

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H. Chang et al. Advances in Accounting 54 (2021) 100547

Table 7
Association between audit fees and income smoothing conditional on institutional ownership.
Variables Predicted (1) (2) (3) (4)

Sign LAUDIT LAUDIT LAUDIT LAUDIT

SMTH1 ? − 0.013***
SMTH1*HIGH_IO ? 0.002*
SMTH2 ? − 0.011**
SMTH2*HIGH_IO ? 0.001
INNA_SMTH ? − 0.029***
INNA_SMTH*HIGH_IO ? 0.017*
DIS_SMTH ? − 0.007
DIS_SMTH*HIGH_IO ? 0.002
HIGH_IO ? − 0.004 − 0.003 − 0.012 − 0.004
Controls Yes Yes Yes Yes
Industry fixed effect Yes Yes Yes Yes
Year fixed effect Yes Yes Yes Yes
N 12,795 12,795 12,795 12,795
Adj. R-square 0.842 0.842 0.843 0.842

Significance levels are two-tailed. Control variables, industry and year dummies are included, but not reported. *,**,*** denote the significance level of 10%, 5%, and
1%, respectively. Standard errors are clustered by company (Gow et al., 2010; Petersen, 2009). Variables are defined in Table 1. The sample size is reduced to 12,795
after merging with Thomson Reuters Stock Ownership data.

Table 8
Association between audit fees and income smoothing conditional on firm size.
Variables Predicted (1) (2) (3) (4)

Sign LAUDIT LAUDIT LAUDIT LAUDIT

SMTH1 ? − 0.011**
SMTH1*BIG_SIZE ? 0.002*
SMTH2 ? − 0.010**
SMTH2* BIG_SIZE ? 0.001
INNA_SMTH ? − 0.041***
INNA_SMTH* BIG_SIZE ? 0.028**
DIS_SMTH ? − 0.003
DIS_SMTH* BIG_SIZE ? − 0.014*
BIG_SIZE ? − 0.016*** − 0.015*** − 0.018*** − 0.015***
Controls Yes Yes Yes Yes
Industry fixed effect Yes Yes Yes Yes
Year fixed effect Yes Yes Yes Yes
N 12,823 12,823 12,823 12,823
Adj. R-Square 0.842 0.841 0.842 0.842

Significance levels are two-tailed. Control variables, industry and year dummies are included, but not reported. *,**,*** denote the significance level of 10%, 5%, and
1%, respectively. Standard errors are clustered by company (Gow et al., 2010Petersen, 2009). Variables are defined in Table 1.

firm is above the sample median and zero otherwise.17 If the effect of
reduced audit fees is less pronounced for firms with high analyst
coverage (i.e., low information asymmetry), then we expect the coeffi­
cient on this interaction term to be significantly positive.
The regression results are reported in Table 6. As shown in columns
(1) through (3), the coefficients on SMOOTH*HIGH_COV are all positive
and significant at the 10% or better level, indicating that the negative
association between audit fees and income smoothing is less pronounced
for firms with higher analyst coverage (i.e., lower information asymme­
try). In column (4), the coefficient on DIS_SMTH*HIGH_COV is negative
but not significant. Overall, the evidence is consistent with the predicted
moderating effect of analyst coverage/information asymmetry.
5.2.2. Institutional ownership
Matsumoto (2002) shows that firms with higher institutional
ownership are more likely to engage in upward earnings management, a
finding consistent with the view that institutional investors often over­
emphasize near-term profits. However, there is also evidence that
institutional investors play a monitoring role in curbing the degree of
upward earnings manipulations. For example, Bushee (1998) documents
17
We find similar results when the continuous variable (i.e., the number of
analysts following the firm) is used in the interaction terms.
that firms with higher institutional ownership are less likely to reduce
R&D spending to avoid earnings decreases. In addition, Ke, Petroni, and
Safieddine (1999) suggest that institutions usually have long investment
horizons and are more independent from management. Institutional
investors are most likely to monitor managers to protect their invest­
ment. Consistent with this argument, Ramalingegowda and Yu (2012)
indicate that institutional investors demand higher level of accounting
conservatism, which substantially reduces firms' bankruptcy risk. Given
the mixed findings in prior research regarding how institutional
ownership could mitigate or heighten firms' business risk, we do not
predict the sign of its moderating effect on the association between in­
come smoothing and audit fees.
We add an interaction term, SMOOTH*HIGH_IO, to regression model
(2) to examine this moderating effect. HIGH_IO is a dummy variable
with the value of one if the percentage of outstanding shares held by the
firm's institutional investors is above the sample median and zero
otherwise. The results are reported in Table 7. As shown in columns (1)
and (3), the coefficients on SMOOTH*HIGH_IO are positive and signif­
icant at the 10% level, indicating an attenuation effect on the negative
association between income smoothing and audit fees. In columns (2)
and (4), however, the coefficients on SMTH2*HIGH_IO and DIS_­
SMTH*HIGH_IO are positive but not significant. Taken together, we
have some evidence that is consistent with the argument that, when
firms with higher (lower) institutional ownership engage in income

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H. Chang et al. Advances in Accounting 54 (2021) 100547

Table 9 Matsumoto, 2002) show that larger firms are more likely to meet or beat
PSM analysis analysts' earnings forecasts, suggesting that larger firms may have
Panel A: Comparison of various variables between high-smoothing and matched low- higher incentives to engage in earnings management. To the extent that
smoothing firms in the PSM analysis income smoothing is used as an earnings management tool, this may
Variable (1) (2) (3) = (1)–(2) lead to the prediction that when income smoothing is used by larger
firms, it could more likely be perceived by auditors as an opportunistic
High-Smoothing Firms Low-Smoothing Firms Difference
behavior.
SIZE 7.779 7.727 0.052 By adding the interaction term, SMOOTH*BIG_SIZE to regression
BM 0.427 0.434 − 0.007
model (2), we provide evidence on how firm size moderates the rela­
BUSY 0.660 0.653 0.007
ROA 0.065 0.064 0.001 tionship between audit fees and income smoothing. Table 8 shows that
QUICK 1.838 1.833 0.005 for SMTH1 and INNA_SMTH, the coefficient on the interaction term is
LEV 0.502 0.509 − 0.007 significantly positive, indicating that the effect of reduced audit fees is
LOSS 0.106 0.101 0.005 less pronounced for larger firms. The coefficient on the SMTH2*BIG_­
INV_REC 0.283 0.281 0.002
SPITEM 0.811 0.801 0.010
SIZE is also positive but not significant. The coefficient on the DIS_­
SQ_SEG 1.657 1.650 0.007 SMTH*BIG_SIZE is significantly negative, which is inconsistent with the
FOPS 0.825 0.820 0.005 predicted moderating effect of firm size on the association between in­
BIGN 0.953 0.946 0.007 come smoothing and audit fees.
MOD 0.319 0.336 − 0.017
SQ_LAG 7.272 7.269 0.003
TENURE 15.381 15.018 0.363 5.3. Robustness tests
EXPERT 0.602 0.608 − 0.006
AUTO − 0.131 − 0.135 0.004
5.3.1. Propensity score matching (PSM)
IBVOL 0.037 0.038 − 0.001
LNNAF 6.008 6.012 − 0.004 We use the PSM approach to address the potential self-selection
DIRINDEP 0.779 0.774 0.005 concern pertaining to our sample firms. The concern arises because
DIRDUALITY 0.475 0.483 − 0.008 firms with high vs. low smoothing could differ systematically in certain
DIREXP 0.228 0.224 0.004 firm-specific characteristics, which in turn, could drive the differential
DIRFEMALE 0.141 0.141 0.000
ALTMANZ 5.203 5.094 0.109
audit fees between the two sets of firms.
N 3218 3218 We start the matching process with a logistic regression of SMTH1,
one of our primary measure of income smoothing, on all control vari­
Panel B: Association between audit fees and income smoothing — PSM sample
ables included in regression model (2) as well as year and industry
dummies. Next, we use the propensity scores obtained from the logistic
Variables Predicted (1) (2) (3) (4)
estimations to perform a one-to-one nearest neighbor match. This pro­
Sign LAUDIT LAUDIT LAUDIT LAUDIT cess results in a sample of 3218 observations for high-smoothing firms
SMTH1 ? − 0.006** and 3218 matched observations for low-smoothing firms. The process is
SMTH2 ? − 0.004* repeated for other smoothing measures (i.e., SMTH2, INNA_SMTH, and
INNA_SMTH ? − 0.029*** DIS_SMTH) as well.
DIS_SMTH ? − 0.005*
A comparison of the key variables that are used in the matching
Controls Yes Yes Yes Yes
Industry fixed Yes Yes Yes Yes process between the two sets of firms is presented in Panel A of Table 9.
effect There are no significant differences in those variables between high- and
Year fixed effect Yes Yes Yes Yes low-smoothing firms, suggesting that these two sets of firms do not differ
N 6436 6992 5892 3498
systematically across those firm-, auditor- and engagement-specific
Adj. R-Square 0.852 0.851 0.840 0.824
characteristics and therefore the self-selection concern is largely
The numbers reported in columns (1) and (2) are the mean values of the vari­ mitigated.
ables used in the matching process with the PSM analysis for high-smoothing Panel B of Table 9 reports the results based on the PSM regressions.
and matched low-smoothing firms respectively. Column (3) reports the differ­ Consistently, the coefficients on smoothing measures in columns (1)
ences and a two-tailed t-test is performed to test the significance of differences.
Variables are defined in Table 1.
Significance levels are two-tailed. Control variables, industry and year dummies Table 10
are included, but not reported. *,**,*** denote the significance level of 10%, 5%, Association between audit fees and income smoothing – including firm fixed
and 1%, respectively. Standard errors are clustered by company (Gow et al., effect.
2010Petersen, 2009). Variables are defined in Table 1. The sample size is Variables Predicted (1) (2) (3) (4)
reduced after applying the PSM method.
Sign LAUDIT LAUDIT LAUDIT LAUDIT

SMTH1 ? − 0.015***
SMTH2 ? − 0.023***
INNA_SMTH ? − 0.057***
smoothing, auditors might perceive the smoothing behavior to be more DIS_SMTH ? − 0.009**
Controls Yes Yes Yes Yes
(less) likely used as an opportunistic earnings management tool and Firm fixed Yes Yes Yes Yes
therefore charge higher (lower) audit fees. effect
Year fixed Yes Yes Yes Yes
5.2.3. Firm size effect
N 12,823 12,823 12,823 12,823
Large firms are generally associated with lower business risk, are
Adj. R- 0.909 0.910 0.912 0.911
followed by more financial analysts, receive wider media coverage, and Square
generate higher investor interest. Thus, larger firms likely face lower
Significance levels are two-tailed. Control variables, firm and year dummies are
information risk, which could reduce their incentives to use income
included, but not reported. *,**,*** denote the significance level of 10%, 5%,
smoothing as a signaling device to reduce information asymmetry.
and 1%, respectively. Standard errors are clustered by company (Gow et al.,
Moreover, firm size could affect managers' incentives to engage in 2010Petersen, 2009). Variables are defined in Table 1. Industry fixed effects are
earnings management to meet market expectations. Prior studies (e.g., not included since we already include the firm fixed effects.

13
H. Chang et al.
Table 11
Association between audit fees and income smoothing — change analysis.
Variables Predicted (1)
Sign ChgLAUDIT
ChgSMTH1 ? − 0.005*
ChgSMTH2 ? − 0.003*
ChgINNA_SMTH ? − 0.061**
ChgDIS_SMTH ? − 0.003
Change of Controls Yes
Industry fixed effect Yes
Year fixed effect Yes
N 10,498
Adj. R-Square 0.291
Significance levels are two-tailed. Industry and year dummies are included, but not reported. *,**,*** denote the significance level of 10%, 5%, and 1%, respectively.
Standard errors are clustered by company (Gow et al., 2010Petersen, 2009). Variables are defined in Table 1. The sample size is further reduced due to the “change
model” requirement.
through (4) are statistically negative at the 10% or better level, con­
firming our earlier results and providing further support to the docu­
mented negative association between income smoothing and audit fees.
5.3.2. Further control for endogeneity
We further control the endogeneity issue by conducting the
following tests. First, we add firm fixed effects into the regressions to
address the impact of any possible missing time invariant variables.
These results are reported in Table 10. As shown, our main results (i.e.,
the negative relationship between income smoothing and audit fees) still
hold after controlling for firm fixed effects.
We also employ a change analysis where both dependent and inde­
pendent variables in regression (2) are replaced by the change in the
value of the variables from year t − 1 to year t. The purpose of the
change analysis is to provide further support that the observed results in
the main analysis (i.e., Table 5) are reflecting the causal effect rather
than a simple association. As indicated in Table 11, the coefficients on
overall and innate earnings smooth measures (i.e., column (1) through
(3) are negative and significant at the conventional level after control­
ling for all other variables. The coefficient on the discretionary measure
(i.e., ChgDIS_SMTH), however, is negative but not significant. Overall,
the results based on the change analysis are still consistent with the
notion that auditors tend to perceive income smoothing as a positive
signal about the reduced inherent business risk.
Finally, because audit fees are unlikely to impact managers' income
smoothing behavior, reverse causality does not seem to be a concern for
our research design. However, like many audit pricing papers, our
regression model is also subject to correlated omitted variable problems.
One such variable is the client's managerial ability. High-ability man­
agers are more likely to engage in income smoothing (Baik et al., 2020;
Demerjian, Lewis-Western, & McVay, 2020), and auditors could charge
lower fees to clients with high-ability managers (Krishnan & Wang,
2015). To address this issue, we include a “managerial ability” score as
an additional control variable.18 The untabulated results are similar to
those reported earlier.
5.3.3. Additional robustness checks
Several additional tests are conducted to check the robustness of our
results. In the first two tests, we follow Francis and Wang (2008) and
focus on two measures of financial reporting quality: signed discre­
tionary accruals and earnings conservatism score. Specifically, we first
include the signed performance-adjusted discretionary accruals (Kothari
et al., 2005) to control for the firm's financial reporting quality in the
18
We use the managerial ability scores calculated by Demerjian, Lev, and
McVay (2012) in this analysis.
14
Advances in Accounting 54 (2021) 100547
(2) (3) (4)
ChgLAUDIT ChgLAUDIT ChgLAUDIT
Yes Yes Yes
Yes Yes Yes
Yes Yes Yes
10,498 10,498 10,498
0.290 0.291 0.291
regression model (2).19 Second, we use the earnings conservatism score
calculated in Khan and Watts (2009) as another control for a firm's
financial reporting quality. Untabulated results show that, after con­
trolling for these two proxies of financial reporting quality, audit fees are
still negatively and significantly associated with all measures of income
smoothness, suggesting that the effect of income smoothing on audit fees
is incremental to other financial reporting quality measures.
In the third test, we follow Tucker and Zarowin (2006) and use the
correlation between change in discretionary accruals and change in pre-
managed earnings (i.e., reported earnings minus discretionary accruals)
as an additional proxy for income smoothing. This variable measures the
extent to which firms use discretionary accruals to smooth out earnings.
Untabulated results show that the coefficient of this smoothing measure
in the regression model (2) is − 0.022, and the p value is smaller than
0.001, indicating that our inferences remain unchanged.
We also examine whether the association between audit fees and
income smoothing differs between the pre- and post-SOX period. Given
that SOX has a significant impact on both managers' earnings manage­
ment behavior (e.g., Cohen, Dey, & Lys, 2008) and auditors' evaluation
of corporate internal controls over financial reporting (i.e., SOX 404),
the association could differ after SOX implementation. To address this
issue, we run the regression analyses by adding an interaction term of
the four income smoothing proxies and SOX where SOX is a dummy
variable with the value of one if the firm-year observation is in the post-
SOX period (defined as years after 2002)20 and zero otherwise. Unta­
bulated results show that the coefficient on the interaction term is not
significant at the conventional level across the four smoothing measures,
suggesting that the negative association between income smoothing and
audit fees does not appear to differ systematically in the post-SOX era.
Finally, we remove years 2008 and 2009 from our sample to see if the
earlier results still hold. The idea is that the global economy and
corporate environment changed dramatically during the 2008–2009
period due to the financial crisis, which could have a potential impact on
client-specific business risk and therefore audit pricing. Untabulated
results without the 2008–2009 observations confirm our earlier finding
that firms with higher income smoothing are charged lower audit fees.
6. Conclusions
In this study, we examine the effect of income smoothing on auditors'
pricing decisions. Income smoothing could lower bankruptcy risk yet
increase earnings management risk. Thus, its impact on audit fees is an
empirical question. We find a negative relationship between the degree
19
Using the unsigned (i.e., absolute value) performance-adjusted discre­
tionary accruals yields similar results.
20
When the post-SOX period is defined as years after 2004, the results are
essentially the same.
H. Chang et al.
of income smoothing and the amount of audit fees, suggesting that
earnings streams with lower volatility are, in some sense, viewed
favorably by auditors. We also find some evidence suggesting that the
negative relationship is more pronounced when audit clients have (1)
lower analyst coverage, (2) lower institutional ownership, and (3)
smaller firm size. Overall, our evidence supports the notion that the
perceived benefits of the reduced bankruptcy risk, possibly due to the
signaling mechanism of income smoothing, outweigh the perceived
costs of the heightened litigation risk with the opportunistic use of in­
come smoothing.
Our study contributes to the long-standing debate on whether in­
come smoothing is value-enhancing or value-destroying to market par­
ticipants by investigating the impact of income smoothing on auditors'
pricing decisions. The perspective of auditors is important as auditors
have direct access to management and original accounting records;
therefore, auditors' pricing decisions might properly reflect the costs and
benefits of income smoothing. Consistent with the value-enhancing
view, our study documents an additional benefit of income smoothing
from the auditors' perspective.
We also contribute to the audit pricing literature by identifying
another determinant of audit fees. Contrary to prior empirical evidence
of the positive association between earnings management and audit fees,
our study finds the opposite and thus significantly extends prior studies
regarding the impact of earnings management on audit fees. Note that
our findings hold after controlling for alternative earnings management
tools, indicating that income smoothing has an incremental effect. In
other words, the effect of income smoothing on audit fees is above and
beyond that of other earnings management strategies.
Our results are potentially of interest to investors, creditors, man­
agers, auditors, regulators, and policy-makers. Investors and creditors
may be interested because our findings contribute to their understand­
ing of the managerial incentives behind income smoothing. Managers
may find our evidence important because we document that a benefit of
income smoothing is that it reduces audit fees. Moreover, auditors may
gain insights from our study by better understanding how earnings
smoothness is associated with their overall engagement risk assessment.
Finally, regulators and policy-makers may find our study beneficial
because we identify earnings smoothness, an important earnings attri­
bute that potentially affects financial reporting quality, is a determinant
of audit pricing decisions.
Declaration of interests
The authors declare that they have no known competing financial
interests or personal relationships that could have appeared to influence
the work reported in this paper.
The authors are grateful for the valuable comments provided by
Dennis Caplan (Editor), Susan Parker (Associate Editor), two anony­
mous reviewers, David Gilbertson, Yaou Zhou, Eric Lohwasser, as well as
the conference participants at the 2015 American Accounting Associa­
tion Annual Meeting, 2015 Northwest Accounting Research Group
Meeting, and 2016 American Accounting Association Western Regional
Meeting.
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