A recent study of thousands of corporate audits from across the United States, which appears in Auditing: A Journal of Practice & Theory, shows that companies in areas experiencing drought conditions faced heightened business risks – and were therefore required to pay significantly higher audit fees. The finding highlights the need for an increased focus on the myriad ways climate change affects business operations and expenses.

"The main idea here is very simple: climate risk may seem unrelated to auditing, but it is not trivial," says Cameron Truong, co-author of the study and a professor of accounting at Monash University. "Firms, auditors, and regulators should be paying attention to this risk."

"Put simply, companies with higher business risk are also more likely to have errors in their financial statements, such as sales on credit that were recorded as income but are unlikely to be collected," Trong said. "Because auditors are responsible when financial statements are incorrect, auditing firms often charge higher fees when they feel there may be high odds of inaccurate financial information."

It is well-established that global climate change is related to increased drought risk. And drought is known to directly increase business risk for sectors such as agriculture and energy production, and to indirectly increase business risk for other industry sectors.

"We wanted to better understand the economic costs of climate change risk in the audit context," Truong says. "In this case, the impact appears to be substantial."

The researchers looked at 50,736 firm-years data from the U.S., spanning the years 2001-2015, and used an industry-standard model to account for variations in auditing fees. Ultimately, the researchers found that companies headquartered in states with severe or extreme drought conditions paid, on average, 8.98% higher audit fees than companies headquartered in states with normal conditions.

Two conditions exacerbated the effect of drought on audit fees: a higher concentration of business operations in the headquarters state; and lower accruals quality. The first condition makes sense, since it means more of the business's operations would be exposed to drought risk. The second condition includes things such as a company that records significant sales on credit, even though it hasn't been received yet. This may be considered low-quality financial information, which could be seen as increasing risk for auditors – who then raise their prices.

The researchers note several best practices to reduce risk. First, if possible, operate your business across different geographic areas, to reduce the likelihood that a majority of operations will face drought at the same time. Second, maintain high quality accounting information. Third, maintain good internal controls and governance. The last two points could help reassure your auditors, and keep your auditing expenses from going up.

"We acknowledge these suggestions are somewhat common sense, but it does not hurt to remind management," Truong says. "We have found that many companies are not doing well in these areas, and that puts them at greater risk when drought hits."

The paper, "Climate Risk and the Price of Audit Services: The Case of Drought," is co-authored by Mukesh Garg and Chris Adrian of Monash University.

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