Audit Fees and Earnings Downside Risk

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Abstract

We examine whether accounting-based earnings downside risk is captured in audit fees. Do auditors price accounting-based earnings downside risk or the expectation of future downward operating performance? Audit fees are determined partially based on risk because riskier audit clients are charged higher audit fees as a compensation for higher risk (Simunic and Stein 1996). Prior studies primarily examine the effect of litigation risk (Simunic and Stein 1996) and control risk (Jiang and Son 2014) on audit fees. However, no study that we are aware of considers accounting-based downside risk in the pricing of audit services. Accounting-based or earnings downside risk (EDR) is the expectation of future downward operating performance and is an important consideration when evaluating risk as it contains distinct information about the overall risk of the client firm. Konchitchki et al. (2016) demonstrate that earnings downside risk has a key role in risk assessment by documenting that earnings downside risk explains the variation in the cost of capital and this link is incremental to earnings attributes, accounting and risk factor betas, return downside risk, default risk, earnings volatility, and firm fundamentals. We find that earnings downside risk is significantly and positively associated with audit fees indicating that audit firms are more likely to consider earnings downside risk in their audit risk assessment for purposes of setting audit fees. Earnings downside risk is expected to reduce the acceptable level of audit risk due to the increased risk that client firm will experience financial difficulties as a result of downward operating performance in the future. The auditor will charge higher fees to compensate for this increased risk. We split the sample into Big4 and non-Big4 firms and find positive and significant relationship for both groups, between earnings downside risk and audit fees. This relationship is slightly less significant for non-Big 4 audit firms, but overall it appears that audit firms consider EDR when evaluating audit risk and audit firms may charge higher fees for firms with higher earnings downside risk.

Authors

• Laura Rickett, Cleveland State University

• Pervaiz Alam, Kent State University

• Paris Liu, Kent State University