Financial report readability and audit fees: a simultaneous equation approach

Abstract

Purpose

This paper aims to investigate whether audit fees and financial report readability are bi-directionally related.

Design/methodology/approach

The authors test their hypotheses with empirical data. Specifically, they adopt a two-stage simultaneous equation regression model to assess the bi-directional relationship between audit fees and financial report readability.

Findings

While poor readability increases the fees charged by the auditor, higher audit fees improve the readability of the financial reports.

Research limitations/implications

This study is based on US data. Future research may extend this study to other countries.

Practical implications

Poor financial report readability encumbers stakeholders of the firms. Understanding the interaction between financial report readability and audit fees will help both auditors and firm managers.

Social implications

Audit committees aggressively negotiating for lower audit fees should be aware of the link of low audit fees, potentially indicative of poor quality, to less readable reports. Investors and regulators too should be concerned about this relationship, especially in instances when auditors low-ball audit fees or when firms aggressively negotiate for lower audit fees.

Originality/value

To the best of authors’ knowledge, this study is the first to document the bi-directional relationship between financial report readability and audit fees and assess the positive impact of audit fees on financial report readability.

Citation

Xu, Q., Fernando, G., Tam, K. and Zhang, W. (2020), "Financial report readability and audit fees: a simultaneous equation approach", Managerial Auditing Journal, Vol. 35 No. 3, pp. 345-372. https://doi.org/10.1108/MAJ-02-2019-2177