Do auditors consider clients’ compliance with environmental regulations?

Abstract

Purpose This study aims to examine whether auditors are sensitive to their clients’ compliance with environmental regulations. Under current auditing standards, auditors’ responsibilities with respect to the detection and reporting of violations of environmental regulations by their clients are limited and quite vague. However, a client’s noncompliance with environmental regulations potentially increases audit risk and audit task complexity. This study aims to shed light on how compliance with environmental regulations may affect audit risk and auditor effort. Design/methodology/approach The authors develop proxies for environmental compliance risk using actual US pollution-related data in three areas: (1) the toxic chemicals released to the environment, (2) Superfund liabilities identified in the National Priority List of Superfund Sites and (3) compliance costs for environmental-related violations, including fines, penalties and court-ordered spending for future remediation measures. The authors examine the impact of environmental risk on audit fees from each compliance area. The authors also construct a proxy of complexity in environmental regulations to investigate the aggregated compliance risk on audit fees. The analysis controls for client firm size, operational complexity and the riskiness of the audit engagement. Findings Using a longitudinal sample from 2000 to 2012, the authors find that audit fees are higher for clients with environmental compliance risk. Further analysis indicates that the complexity in corporate environmental regulations has a more direct impact on audit fees than the magnitude of individual environmental risks. The findings are consistent with auditors charging higher fees when auditing clients with environmental compliance issues. This study contributes to environmental accounting research and the auditing literature concerning the impact of environmental risk on audit task complexity. Originality/value There is broad literature that links auditor effort with the audit client’s operational or business risk. It is unknown whether audit engagements encompass environmental risks, specifically audit client’s compliance with the applicable environmental regulations. This study extends the existing audit literature by explicitly exploring the impact of audit clients’ compliance with environmental regulations on audit fees. The findings of the study shed light on whether auditors consider environmental compliance proactively in audit engagements.