A Stress Test of the Effects of Bankruptcy Risk, Accounting Quality and Corporate Governance on Audit Fees: Evidence from Hong Kong during the Asian Financial Crisis

This paper studies how a client's bankruptcy risk, together with its accounting quality and corporate governance, affect audit pricing. We use the unusual economic conditions of the 1998 Asian financial crisis as a stress test of the effect of these factors on audit pricing in Hong Kong. We find that audit fees are highly sensitive to a client firm's financial condition, corporate governance, and accounting quality. Firms with high risk of failure paid significantly higher audit fees. Firm's with lower quality earnings due to abnormal/discretionary accruals generally paid higher audit fees, although this effect is moderated by the firm's financial condition. We also find that well-governed firms with above median financial condition paid significantly lower audit fees. Our results, and related prior research, are well explained through use of a more comprehensive risk model that incorporates accounting as well as auditing uncertainties.