Climate risk and the price of audit services

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Summary

Climate change is making droughts more frequent, intense, and longer-lasting, posing serious risks to businesses—especially those reliant on water, like agriculture, food processing, and power generation. Additionally, even firms outside these sectors can also be indirectly affected due to supply chain disruptions. This study explores how such drought-related risks influence auditing practices, particularly the pricing of audit services.

The study finds that companies located in drought-affected states paid significantly higher audit fees—up to nearly 9% more—compared to those in normal conditions. The increase is largely driven by auditors' heightened concern over financial risk, weaker internal controls, and poor reporting quality during crisis periods.

Additionally, firms with operations spread across multiple states experienced smaller increases in audit fees, showing that geographic diversification can mitigate climate-related risks. The findings offer valuable insights for auditors, company executives, and policymakers, emphasizing the need to integrate climate risk into business and regulatory decision-making. As climate events like droughts become more common, understanding their financial impact is crucial for building resilient businesses and audit systems.

Takeaways for auditors, firm management, and investors

  • Climate change is an important audit risk factor. Auditors need to incorporate environmental risk factors into their audit planning and assessments.
  • Diversification is an effective strategy to mitigate the adverse impact of climate-related business risk.
  • The findings underscore the need for auditing standards to specifically address climate-related risks in audit planning and risk assessment procedures.

Implications for research

  • While there is virtually no disagreement among researchers that climate change poses substantial costs to the economy, an important issue for business risk assessment now is what exactly these costs are, how to measure them, and how to address them. This study addresses this important question by quantifying the effect of drought on risk assessment of auditors (via audit fees) and documenting that this effect is widespread due to an integrated economy.
  • Our study highlights the importance of climate-related risk as an audit fees determinant. In particular, this research responds to the concerns from professional bodies in relation to key climate change implications for audit work to ensure compliance with accounting standards and regulations.

Want to know more?

Cameron Truong, Mukesh Garg, Christofer Adrian; Climate Risk and the Price of Audit Services: The Case of Drought. AUDITING: A Journal of Practice & Theory 1 November 2020; 39 (4): 167–199.

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