Does Lowballing Impair Audit Quality? Evidence from Client Accruals Surrounding Analyst Forecasts

The pricing of initial audit engagements has long been of interest to regulators because of audit quality concerns speculated to arise with lowball pricing tactics. However, there has been very little empirical investigation specifically aimed at understanding the link between audit fees and audit quality on new engagements. We examine a sample of initial engagements spanning 2000–2009 and find evidence suggesting that the magnitude of initial engagement discounting is positively associated with audit clients' ability to meet analyst forecasts using discretionary accruals. Additional analysis reveals that this effect is more pronounced before the passage of SOX. Further examination of the post-SOX period shows the effect is present in the latter half of our sample (2006–2009) but not in the years immediately following the passage of SOX (2002–2005). Additional supplemental tests suggest that the primary results are driven more by time and/or budget pressures than impaired independence. Overall, we interpret these results as consistent with longstanding concerns surrounding auditor lowballing and discuss the regulatory and practical implications for the audit profession with respect to the pricing and monitoring of new audit engagements