This paper aims to investigate the influence of firm underperformance duration on audit fees. Grounded in the behavioral theory of the firm, underperformance duration indicates the length of time a firm’s performance falls below its industry-based aspiration level. The authors hypothesize that persistent underperformance intensifies pressure for short-term earnings improvements from shareholders, thereby increasing managerial risk-taking or misconduct and, consequently, audit risk and fees.
Using 71,682 US firm-year observations spanning from 2001 to 2022, we regress audit fees on the firm’s underperformance duration together with a set of control variables adopted from well-established audit fee models. Various robustness checks, including a firm fixed-effect model, an alternative proxy and measurement for firm underperformance duration and the entropy-balanced method, are also adopted.
The results reveal a positive association between the duration of underperformance and audit fees, suggesting that auditors interpret sustained performance shortfalls relative to aspiration levels as indicators of heightened risk. However, the marginal effect of the underperformance duration on audit fees diminishes over time, consistent with auditor learning or the normalization of perceived risk as the client’s performance becomes more predictable. The authors also find that a longer audit report lag correlates with extended underperformance duration, suggesting increased auditor effort and supporting our audit risk hypothesis. Finally, the authors find that auditor–client tenure could moderate the positive relationship between audit fees and underperformance duration, implying that familiarity and trust partially offset auditors’ perceived heightened risk.
This study enriches the audit fee literature by emphasizing the significance of firm underperformance duration in influencing audit pricing.
