Companies in areas experiencing drought conditions face heightened business risks – and therefore are required to pay significantly higher audit fees, a new study by the American Accounting Association has found.
As part of the study, researchers looked at data from 50,736 firms from the U.S. spanning the years 2001-2015 and used an industry-standard model to account for variations in auditing fees.
Ultimately, the researchers found that companies headquartered in states with severe or extreme drought conditions paid, on average, 8.98% higher audit fees than companies headquartered in states with normal conditions.
It was found that two conditions exacerbated the effect of drought on audit fees: a higher concentration of business operations in the headquarters state; and lower accruals quality.
According to the association, the “first condition makes sense, since it means more of the business’s operations would be exposed to drought risk”.
However, it said the second condition “includes things such as a company that records significant sales on credit, even though it hasn’t been received yet. This may be considered low-quality financial information, which could be seen as increasing risk for auditors – who then raise their prices”.
Cameron Truong, co-author of the study and a professor of accounting at Monash University said: “The main idea here is very simple: climate risk may seem unrelated to auditing, but it is not trivial. Firms, auditors, and regulators should be paying attention to this risk.”
“Put simply, companies with higher business risk are also more likely to have errors in their financial statements, such as sales on credit that were recorded as income but are unlikely to be collected.”
He added: “Because auditors are responsible when financial statements are incorrect, auditing firms often charge higher fees when they feel there may be high odds of inaccurate financial information.”