Is the Audit Fee Disclosure a Leading Indicator of Clients' Business Risk?

Abstract

SUMMARY This study hypothesizes a link between observed audit prices and future reported changes in clients' economic condition. As predicted, results from a traditional audit fee model, estimated using a large sample of U.S. public company engagements spanning from 2000 to 2007, reveal a significant inverse relation between audit fees and the one-year-ahead change in a measure of clients' operating performance. Additional analysis indicates that the relation extends to more forward-looking changes (up to five years ahead) and is stronger for negative versus positive changes in performance. Results also indicate that audit fees reflect future changes in clients' earnings that are unaccounted for by analysts' forecasts. In contrast, the findings reveal little evidence of a relation between audit fees and future changes in clients' solvency, including bankruptcy status. Collectively, the study's results provide initial evidence suggesting that the audit fee disclosure is a leading indicator of the operating performance dimension of clients' business risk. Data Availability: Data are available from public sources cited in the text.