Abnormal Audit Fees: Cause of Impaired Audit Quality or Consequence of Unobserved

Factors?

Abstract

While some studies suggest that positive abnormal audit fees (cause) impair auditor

independence, others consider they (result) compensate for unobserved factors. To reconcile

these conflicting views, I measure audit quality with the association between going concern

opinion Type I (II) errors and positive abnormal audit fees, hereafter T1P (T2P), to capture the

effect of unobserved factors (economic bonding) separately. By carefully controlling possible

confounders and 1,905 different combinations of control variables, I find how unobserved factors

introduce T1P. Conversely, T2P stands for all combinations and a battery of robustness tests,

suggesting additional audit fees, beyond those meant to compensate for unobserved factors,

cause more Type II errors (economic bonding). I further find that economic bonding is positively

associated with earnings management and auditor tenure and negatively associated with audit

committee independence and auditors’ reputation concerns. On the contrary, I do not find audit

quality compromised due to lower audit fees.

JEL Classifications: M41; M42; M48.

Keywords: Abnormal audit fees; Unobserved factors; Type I errors; Type II errors.

I. Introduction

The relation between abnormal audit fees (defined as the difference between actual and

expected audit fees) and audit quality is an essential issue in auditing literature. However, prior

studies present conflicting views about abnormal audit fees. Some suggest extra audit fees

“compromise” audit quality (Choi, Kim, and Zang 2010; Asthana and Boone 2012), whereas
others suggest unobserved factors1 (some of them cause low accounting quality2) necessitate

higher audit fees to compensate for more audit effort or risk (Doogar, Sivadasan, and Solomon

2015; Hribar, Kravet, and Wilson 2014). The latter view not only suggests the opposite direction

of causality but also makes it difficult to infer whether extra audit fees result in economic

bonding between auditors and clients (Francis 2011). More importantly, these unobserved factors

and endogeneity hinder research on the relationship between abnormal audit fees and both audit

and accounting quality by making it challenging to identify causality among them.

Audited financial statements, resulting from a negotiation process between the auditor and the

client (Gibbins, Salterio, and Webb 2001), are the joint effort of both parties (Antle and Nalebuff

1991; Hogan and Wilkins 2008). Proxies based on financial statements inevitably introduce

endogeneity (Hribar et al. 2014). Auditors have limited influence over enhancing financial

statements and curbing aggressive client behavior; accordingly, they charge higher fees for risks

beyond their control. In contrast, if their clients are responsible, the financial statements can be

high quality without much audit effort. This complexity makes disentangling economic bonding

from the effect of unobserved factors difficult.

To overcome these challenges, my initial approach is to adopt proxies that disentangle these

two effects. Auditors have relatively more control over audit reports. Hence, going-concern

opinions (GCOs) are a more direct measure of audit quality with lower measurement error

(DeFond and Zhang 2014). In addition, audit fees are decided before audit opinions, making

1
There may be unobserved risks or factors that researchers have not accounted for, but auditors notice and
incorporate into audit fees. Although they have been named “unobserved”, there is no evidence that these factors are
unmeasurable or invisible. Instead, it could be because there are too many factors affect audit fees and some critical
factors are simply not included in some prior studies. The number of possible unobserved factors could be limitless.
Hence, the goal of this study is to show how to prevent them from significantly confounding inferences rather than
identify all of them.
2
Because many accounting quality studies and audit quality studies use the same proxies, they suggest different
causal paths: higher audit fees cause lower quality or lower quality causes higher audit fees. This highlights the
advantage of audit quality proxies that are less affected by clients for endogeneity issue.
GCO-based proxies less subject to reverse causality (mentioned above). Further pairing GCO

Type I and Type II errors with positive abnormal audit fees makes them ideal for distinguishing

unobserved factors from economic bonding.

The association between Type II errors and positive abnormal audit fees (hereafter T2P) is

better at capturing economic bonding since it is less confounded by unobserved risk (aka. risks

unknown to researchers but known to auditors [Francis 2011; Doogar et al. 2015]). If auditors

notice the unobserved risk, they tend to make more Type I (but not Type II) errors. If not, they

have no reason to charge a risk premium. Thus, T2P, less confounded by unobserved factors, can

more effectively assess auditor dependence, which entails ‘more willing’ to issue clean opinions

for engagements with the ‘same level’ of risk for extra audit fees.

On the other hand, the association between Type I errors and positive abnormal audit fees

(hereafter T1P) is better at capturing unobserved risk (or other unobserved factors)3. Unobserved

factors such as unobserved risk or auditors’ higher sensitivity to risk increase both audit fees and

Type I errors, but not Type II errors. This is because auditors are compensated for extra risk or

effort, not for lenient opinions.4 With the same standard for issuing GCOs but higher risk, more

Type I errors are expected5. Accordingly, T1P mainly captures the effect of unobserved factors.

Likewise, the association between Type I errors and negative abnormal audit fees (hereafter

T1N), and the association between Type II errors and negative abnormal audit fees (hereafter

T2N), can test whether below-normal audit fees jeopardize (cause) audit quality or reflect

(effect) client pressure or client bargaining power.

3
Throughout this paper, "other unobserved factors" refers to a range of unobserved variables other than risk, while
"unobserved factors" is a collective term encompassing both unobserved risk and other unobserved factors.
4
It is possible that an audit engagement has higher audit fees for more than one reason. For example, two million
dollars or extra risk and one million dollars for lenient opinion. T1P and T2P can measure the extent to which they
reflect unobserved factors and economic bonding, respectively.
5
When risk is higher, auditors are more likely to perceive potential problems. This increased sensitivity leads to a
higher likelihood of issuing GCOs, even if the company might not truly deserve one.
 Second, I control major potential unobserved factors.6 Regarding extra audit effort, I control

audit lag (Knechel and Payne 2001; Blankley, Hurtt, and MacGregor 2015; Bryan and Mason

2020) and client complexity. For unobserved risk, I include stock price volatility measured by

daily stock returns to capture other risks as this approach highly complements other annual

accounting and financial variables. To accommodate higher reputation concerns, I consider

whether auditors are Big 4 auditors and their expertise. I also consider material weakness,

earnings management, and SEC enforcement in additional tests. However, it is not feasible to

control everything. GCO firms are more likely to have incomplete data because of their difficult

financial situations. Controlling too many variables7 or those with substantial missing values may

introduce survival bias.

Hence, the third step is to conduct a sensitivity analysis based on 1,905 combinations of

different control variables in the audit fee and GCO accuracy models. Regressions on these 1,905

combinations can reveal potential effects of omitted variables. Even if some minor unobserved

factors are beyond these 1905 combinations, this comprehensive analysis should reveal patterns

across these regressions. If findings remain similar across these combinations, it implies that

unobserved factors do not have notable effect. Conversely, if outcomes vary within these

combinations, the patterns of these variations indicate how omitted variables lead to non-causal

associations.

638 of these 1,905 combinations are significant in T1P, suggesting that some of these control

variables, if not controlled, cause non-causal associations. To identify these factors, I conduct a

6
Some of these control variables might not be perfect proxies. In case they are not the main variable of interest or
focus, they may not pose a significant problem.
7
Whited et al. (2022) also warn the overuse of controls (kitchen sink approach). They point out that it is potentially
outcome of publication process and suggest that we should consider causal relationship when choosing controls
and avoid overuse of controls. Please also see Table 1 for scenarios on different casual relationships.
regression on these 1,905 regressions to measure the effect of not including certain control

variables. The results show that not controlling audit effort and sales growth in the accuracy

model and not including auditor expertise in the audit fee model increase the significance level

of T1P, consistent with Doogar et al. (2015) and Hribar et al. (2014) in suggesting that

unobserved factors or low accounting quality leads to high audit fees. On the other hand, T2P

holds significance in all 1,905 combinations, implying that additional audit fees, beyond those

meant to compensate for unobserved factors or low accounting quality, cause more Type II errors

(economic bonding) and indicating that T2P is an ideal proxy not sensitive to unobserved factors.

Further cross-sectional analyses reveal that economic bonding is positively associated with

earnings management and auditor tenure and negatively associated with audit committee

independence and auditors’ reputation concerns. On the other hand, T2N and T1N are not

significant, suggesting auditors do not cut corners for underpaid engagements or succumb to

client pressure, consistent with client pressure is pronounced during the great recession

(Ettredge, Fuerherm, and Li 2014; Ettredge, Fuerherm, Guo, and Li 2017).

These "unobserved factors" hinder current research as Francis (2011) questions whether

abnormal audit fees really measure the threat of auditor independence or simply reflect more

audit effort and unobserved client risk. Extant literature only suggests unobserved factors exist

but does not explore what they are and how they affect inferences. This study identifies possible

unobserved factors, classify them with casual diagrams8 for different likely scenarios and explain

how and why they affect inferences. It reconciles conflicting results of prior studies by

demonstrating how fail to include relevant controls (638 of these 1,905 combinations) lead to

non-causal associations.

8
As suggested by Whited (2022), casual diagram is helpful for the construction of well-specified causal model.
 Doogar et al. (2015) conclude that fee residuals largely consist of unobserved factors.

However, they do not rule out or confirm the existence of economic bonding. This study clearly

indicates that economic bonding occurs by adopting proxies that separately measure economic

bonding and the effect of unobserved factors. This study resolves conflicting interpretations of

abnormal audit fees with inferences suggesting likely causality.

These more decisive and less biased (by unobserved factors) inferences have policy

implications. If abnormal audit fees adversely affect audit quality, regulators might want to

regulate them. If not, it suggests the market mechanism already provides an effective solution

that auditors adjust their fees to account for the extra effort required. Unnecessary intervention

may only deviate this mechanism from optimal conditions.

This study provides future research with a novel methodology to mitigate or explore

unobserved factors. Different proxies reflect different dimensions of audit quality (DeFond and

Zhang 2014; Aobdia 2019). To my best knowledge, this study is the first to use T1P and T2P as

proxies to explore the relationship between abnormal audit fees and audit quality. T2P is a robust

metric for auditor dependence. T1P can be a revised proxy for accounting quality. In this way,

accounting quality questions can be expanded from how good it is (Hribar et al. 2014) to how

and what specific factors affect it.

This study also expands the literature of GCOs in non-financially stressed firms9. A subtle

reason many GCO studies exclude non-financially stressed firms is that they have a weaker

9
I also test on financial stressed firms in additional tests, the inference remains. Common criteria for definition of
financial stressed firms such as negative net income or negative operating cash flows are easy to identify for normal
investors. Given their professional expertise, it is reasonable to assume auditors make GCO decisions based on more
than these straightforward considerations. Although occasionally unexpected bankruptcies could happen, these
“unexpected” cases should be random and few rather than associated with positive abnormal audit fees and their
existence as noise should make T2P less likely to be significant. Hence, if the results are still significant, these
unexpected bankruptcies would not be a reasonable alternative explanation.
association with GCOs. This might be because the stronger economic bonding of non-financially

stressed companies reduces their likelihood of receiving GCOs. Examining Type I and Type II

errors separately mitigates the limitation posed by the binary information from GCOs. These

refined proxies reveal that economic bonding is more prevalent among non-financially stressed

firms, which otherwise would be a blind corner and unexplored by previous studies. Integrating

Type I/II errors with abnormal audit fees generates more comprehensive and distinct measures.

Contrary to T2P and T1P, T1N and T2N can indicate whether audit quality is compromised due

to corner-cutting or client pressure.

The next section develops theoretical framework and motivation. Section III explains research

method and sample. Section IV reports the results. Section V presents sensitivity analyses, cross-

sectional analysis, and additional tests. Section VI concludes.