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    Conditional Conservatism and Audit Fees.
    research summary posted July 24, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment 
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    Title:
    Conditional Conservatism and Audit Fees.
    Practical Implications:

    The results should be of interest to regulators, standard setters, auditors, and firms. Regulators and standard setters may benefit from the results as they consider promulgating accounting rules and standards, particularly those involving fair value measures. Auditors and the firms’ managers may also benefit from the results by knowing the possible effect of accounting conservatism on audit fees and the moderating effect of the quality of corporate governance as they select auditors and accounting policies.

    Citation:

    Lee, H. S., Li, X., & Sami, H. 2015. Conditional Conservatism and Audit Fees. Accounting Horizons 29 (1): 83-113.

    Keywords:
    audit fees, conditional conservatism, corporate governance, litigation risk
    Purpose of the Study:

    Accounting conservatism is an important characteristic of the accounting information system. As a fast-growing literature, academic accounting research has developed measures of conservatism to capture this characteristic and has investigated the role of accounting conservatism in debt contracts and corporate governance quality. However, very little is known about the impact of conservatism on audit risk. In this paper, the authors first investigate whether the level of a company’s accounting conservatism affects audit risk, which they proxy with audit fees. More importantly, the authors investigate how corporate governance quality influences the relationship between conditional conservatism and audit fees. Higher corporate governance quality could lead to lower litigation risk, and hence lower audit risk. When the audit risk is low because of better corporate governance, higher conservatism is less likely to further reduce audit fees.

    Design/Method/ Approach:

    The sample includes 16,455 firm year observations in the annual Compustat Xpressfeed files with fiscal year-ends included in the years 20032009 with valid total assets, sales, and fiscal year-end stock price data. The authors obtain corporate governance data from Risk Metrics, which reduces the sample size to 4,814.They use three different models to estimate firm-year conditional conservatism: (1) the Basu standard regression, (2) the accruals-cash-flows-based model, and (3) the current and lagged earnings-changes model.

    Findings:

    The authors document that firms benefit from conservative reporting because higher conservatism decreases audit fees. The results indicate that higher levels of conditional conservatism are associated with lower audit fees. They find that the audit fee reduction associated with more conservative reporting is attenuated when corporate governance is stronger. The findings are consistent with the explanation that both better corporate governance and conservatism can reduce uncertainty. Therefore, firms with low corporate governance quality have more to gain from conservative reporting.

    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment