| This study investigates whether audit fee disclosures provide information about financially distressed clients' business risk. Specifically, the study examines the association between the unexpected portion of the audit fee and two complementary measures of the clients' future economic condition, future bankruptcy status (i.e., bankrupt versus non-bankrupt) and future earnings (i.e., return on assets). The study is motivated by stakeholder demand for information that reduces uncertainty surrounding firms and by anecdotal suggestions that the audit fee proxy disclosure is an informative indicator of firm risk. Drawing on the Simunic (1980) audit pricing model and prior research on the effect of client business risk on audit scope and pricing, the study hypothesizes an inverse association between unexpected audit fees and distressed clients' future economic condition. Results indicate that unexpected audit fees are not associated with the likelihood of bankruptcy. However, analysis of the clients' future earnings reveals a statistically and economically significant inverse relation between unexpected audit fees and one-year-ahead return on assets. Further analysis reveals that the relation (1) is evident using two-year-ahead return on assets, (2) is driven by unexpectedly high fees, (3) is primarily concentrated in the small client sector of the audit market, and (4) is robust to additional controls for client-size effects. Collectively, the study's findings offer initial evidence suggesting that disclosed audit fees are informative about distressed clients' future operating performance, but not about future bankruptcy events. |
