This study investigates whether auditors in their audit fee decisions incorporate the implications of potential litigation risk that may arise from their client firms’ earnings management through real activities manipulations. Healy and Wahlen (1999) state that there are two different ways to manage current-period reported earnings: through discretionary accruals and real business activities. The former, accrual-based earnings management (hereafter AEM), usually occurs toward the end of an accounting period. While it directly influences the amount of accounting accruals and thus reported earnings, AEM has no direct effect on cash flows. The latter involves adjusting real business activities. Specifically, managers can alter the timing and scale of sales, production, investment, and financing activities to manage earnings. These activities are conducted throughout the accounting period in such a way that a specific earnings target can be met (Zang 2012). Following Roychowdhury (2006), these real operation management activities that deviate from normal business practices with the primary objective of manipulating current-period earnings are referred to as real earnings management (hereafter REM). Unlike AEM, REM can have direct consequences on current and future cash flows (as well as accounting accruals), is more difficult for average investors to understand, and is normally subject to less external monitoring and scrutiny by auditors, regulators, and other outside stakeholders (Cohen, Dey, and Lys 2008). Furthermore, REM boosts short-term earnings at the expense of real operations (Roychowdhury 2006), as it causes real operations to deviate from their optimal levels, thereby dampening a firm’s ability to generate future cash flows in the long run. Earnings management by firms or managers is a central issue in accounting research because it causes severe damage to investor confidence and capital markets (Levitt 1998; Healy and Wahlen 1999). Thus, it has received a great deal of attention from both regulators and academics, and many prior studies have investigated various related issues. However, most of the prior studies related to earnings management limit their focus to AEM. With respect to the auditor’s perspective, studies document that auditors play an important role in restricting AEM (Becker et al. 1998; Fan and Wong 2005). In addition, AEM is shown to be related to higher audit fees because AEM reflects higher inherent risks (Gul, Chen, and Tsui 2003; Krishnan et al. 2013). Thus, auditors need to charge higher audit fees so that they can expand the scope of an audit to compensate for the increased audit risk.