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    Is the Audit Fee Disclosure a Leading Indicator of...
    research summary posted October 3, 2013 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity 
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    Title:
    Is the Audit Fee Disclosure a Leading Indicator of Clients’ Business Risk?
    Practical Implications:

    The results of this study have very important implications regarding how stakeholders respond to the disclosed audit fee and business risk. Stakeholders could devote special attention the audit fee disclosure that is mandated by the SEC as it has the potential to reveal risk information. Additionally, the results of this study should warrant increased awareness on the part of the auditors when they price an audit because audit firms should consider what the public believes the audit fee implies about the client’s business risk.

    For more information on this study, please contact Jonathan D. Stanley.
     

    Citation:

    Stanley, J.D. 2011. Is the audit fee disclosure a leading indicator of clients’ business risk? Auditing: A Journal of Practice and Theory 30 (3): 157-179.

    Keywords:
    audit fees; audit pricing; client business risk
    Purpose of the Study:

    Client business risk is defined as the risk that an audit client’s economic condition will deteriorate in the future. This risk is critical in the auditor’s determination of the price of the audit because the client’s business risk also affects the auditor’s business risk as well as audit risk. This study aims to investigate if the audit prices, as revealed through audit fee disclosures made mandatory by the SEC in 2001, provide the public with information of a client firm’s business risk. Although the requirement to disclose audit fees was put in place with regulatory intent, it is suggested that how auditors price the audit reveals the auditor’s perception of the client’s risk which they would otherwise not be able to disclose. The existence of this relationship is examined based on the correlation between audit fees and future changes in the clients’ economic condition. The ability for auditors to foresee future changes in a client’s economic condition display a level of sophistication in auditor judgment that shines a favorable light on auditor competence as expert service providers.

    Design/Method/ Approach:

    This study was conducted using firm-year observations during the 2000-2008 time period. Proxies for client business risk such as earnings, operating cash flows, leverage, and liquidity were used to perform a principal components analysis. The financial data was obtained from Compustat and matched with information from Audit Analytics. 

    Findings:
    • A significant inverse relationship between audit fees and the one-year-ahead change in a measure of client’s operating performance exists.
    • This relationship extends more for changes up to five years ahead and is stronger for negative as opposed to positive changes in performance.
    • Audit fees reflect future changes in a client’s earnings that analysts’ forecast do not identify.
    • Little evidence was found to support the existence of a relationship between audit fees and incremental changes in clients’ solvency.
    • An insignificant relationship between audit fees and a client’s future bankruptcy status was identified.
    • Both solvency and bankruptcy are dimensions of a client’s business risk that the audit fee is unable to capture.
    • The findings suggest that audit fees reflect information that is unknown by even other sophisticated market participants.
    • The results collectively suggest that the audit fee disclosure is a leading indicator of the operating performance and business risk of a client.
       
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Business Risk Assessment (e.g. industry - IPO - complexity), Client Risk Assessment