Auditors' Responses to Classification Shifting: Evidence from US Firms

SYNOPSIS: This study examines how auditors react to clients' engagement in classification shifting which refers to the intentional misallocation of line items within the income statement. We find that classification shifting is positively associated with audit fees, audit report lags, the issuance of a modified audit opinion, and auditor resignations. Additional analyses show that auditors' responses to multiple-year classification shifting are similar to our main findings. We further find that classification shifting is associated with a higher likelihood of financial misstatements in the classification shifting year, and future announcements of financial restatements. We also find that the probability of future restatements is even higher when audit clients engage in both classification shifting and real earnings management. Overall, our results imply that auditors become more cautious in response to audit clients' classification shifting behavior.