The Effect of Financial Constraints on Audit Fees

Research Question: From a supply-side and demand-side standpoint, it is conjectured that financial constraints elevate client-specific risk and lead to higher audit effort and fees. It is further posited that the effects of financial constraints on audit fees can be mediated by three possible channels: corporate cash holdings, discretionary accruals and corporate tax avoidance strategies. Motivation: Explicit evidence on how auditors react, in terms of audit fees to firms’ financial constraints is not available in the audit or finance literature. Idea: Financial constraints are defined as the frictions stemming from reasons such as credit constraints, inability to borrow, inability to issue equity, reliance on bank loans and illiquidity of assets that inhibit firms from funding desired investments (Lamont et al., 2001). This paper examines the effects of financial constraints faced by firms on audit fees, and the mediating effects of corporate cash holdings, discretionary accruals and corporate tax avoidance activities. Data: This study is based a large sample of U.S. listed firms from 2000 to 2016. Method/Tools: This study use the conventional audit-fee model, with an emphasis on controlling for fee determinants associated with firm risk, client characteristics, and audit and auditor characteristics. Findings: The results reveal that there is a positive and significant effect of financial constraints on audit fees. The finding is robust to alternative proxies of financial constraints and regression specifications. Moreover, the effects of financial constraints on audit fees are mediated positively by corporate cash holdings, discretionary accruals and corporate tax avoidance. Contributions: This study extends our understanding of how auditors incorporate an increase in client risk emanating from financial constraints, a hitherto untested audit-fee determinant. This study also contributes to the capital market literature that examines audit fees and financial constraints as well as to other studies that consider the implications of corporate cash holdings, financial reporting quality and corporate tax avoidance. This study also contributes to the emerging research that enriches our understanding of certain economic consequences of firms’ financial constraintsFinancial constraints, audit fees, corporate cash holdings, financialreporting quality, tax avoidance