The Effect of Conditional Conservatism on Audit Fees

In this paper, I provide evidence on the effect of conservatism on audit fees. While prior studies investigate a wide variety of issues related to conservatism, there is scarce evidence on the effect of conservatism on auditor-client negotiations, specifically, audit fees charged by audit firms. This study fills the gap by investigating whether accounting conservatism significantly affects audit fees. It is plausible to predict that accounting conservatism lowers auditor’s litigation and reputation risk by lowering net assets and curbing managements’ tendency to misreport, and that the lower litigation and reputation costs induce lower audit fees. However, another line of literature argues that firms with a strong tone-at-the-top or monitoring mechanism (i.e., conservative reporting) may require stricter audit procedure, thus resulting in higher audit fees. Thus, whether conservatism positively or negatively affects audit fees remains an empirical question. Using a sample of 9,543 firm-year observations during the 2000-2010 period in Korea, the empirical results suggest that a firm’s conditional conservatism has a significant negative impact on the firm’s audit fees. The negative effect is incremental to effects of other known determinants of audit fees documented by prior literature, as well as, factors including corporate governance, measures of discretionary accruals, and audit hours. Further, these results are robust to a battery of sensitivity checks. Importantly, the findings remain significant after replacing the audit fee variables with abnormal audit fees, robust to reverse causality, endogeneity, exclusion of risky clients, alternative measures of conservatism, and controlling for audit firm-specific characteristics. Overall, the findings of this paper are consistent with conditional conservatism being an important determinant of audit fees.