Client Environmental Risks, Law Enforcement, and Audit Fees

This study explores the impact of environmental risks on audit fees by exploiting the establishment of environmental courts in China as an exogenous shock. Using a sample of listed companies in China, we find that auditors charge significantly higher audit fees following the establishment of environmental courts in their clients’ domiciled prefectures. This effect is attenuated if their client firms have political connections or when the local government is under greater pressure in regards to economic development. We also identify litigation risks, financial risks, and reputation risks as three key channels underlying the impact of environmental risks on audit fees. Our key findings are amplified for firms audited by Big 10 audit firms or by auditors specializing in auditing firms in polluting industries. Finally, audit firms assign more environmental specialists to clients confronting elevated environmental risks. Overall, our results suggest that environmental risks are factored into audit fees.