1. Introduction
Over recent decades, natural disasters, global warming, and other ecological problems have occurred frequently. With the development of global industrialization, countries around the world are facing severe environmental challenges, which also pose some threats to global economic development, human health, and social stability. How to realize the coordinated development between the economy and the environment has never been more urgent [
1,
2]. There is no doubt that achieving the aim of sustainable development by adjusting the process of resource allocation and economic construction is important. Sustainable development can meet the need of future generations while achieving contemporary development goals, which also emphasizes economic coordination, energy conservation, and environmental governance. Sustainable growth not only mobilizes the participation of the public, the government, and enterprises in environmental governance, but also realizes the harmonious coexistence of the economy, nature, and society [
3]. When it comes to how to realize the construction of sustainable development, although the prior environmental protection, such as green innovation, is significant [
4,
5], the environmental regulation after the event, such as environmental punishment, is also necessary [
6].
According to the latest Environmental Performance Index Report (2020), released by Yale University and Columbia University, China’s environmental performance ranks 120th among 180 countries. Economic growth has resulted in severe environmental degradation since the opening-up policy in 1978, and thus sustainable development is becoming important. On 15 March 2021, at the ninth meeting of the Central Committee on finance and economics, President Xi Jinping chose carbon neutrality and carbon peak as the topic and formulated the goal of achieving carbon peak by 2030 and carbon neutral by 2060. As early as 1999, China’s Environmental Protection Administration set up administrative penalties for environmental protection to attenuate firms’ pollution behaviors. Since then, local environmental protection departments have punished the environmental pollution behaviors of firms according to the law. Furthermore, the report of the 19th CPC National Congress pointed out that establishing an effective environmental penalty system is important. During the 13th Five-Year Plan period, there were 833,000 environmental administrative penalties issued, and the fines for environmental administrative penalties totaled RMB 53.61 billion. Environmental administrative penalties play a fundamental role in sustainable growth.
The Auditing Standards for the Chinese Certified Public Accountants No. 1631-Consideration of Environmental Information in the Audit of Financial Statements, issued by the Chinese Institute of Certified Public Accountants in 2006, requires auditors to pay attention to environmental matters. Presently, only a small amount of literature has researched the reaction of auditors to negative environmental events. These studies mainly focus on environmental information disclosure [
7], greenwashing [
8], government environmental regulation [
9], and environmental liability insurance [
10]. The disclosure of environmental administrative penalties, which reveal environmental misconducts of firms, provides an opportunity to measure firm environmental risks. It is important to study how environmental administrative penalties affect auditors’ decisions, especially for audit fees, which is the external embodiment of audit risk and audit cost. However, to the best of our knowledge, there is a paucity of direct empirical evidence on whether audit fees are affected by environmental administrative penalties. Therefore, the study investigates the interface between environmental risks and audit fees, and it examines how environmental administrative penalties shape auditors’ behaviors.
China, the largest developing country and the largest emitter of greenhouse gases in the world, is facing a conflict between economic growth and environmental protection [
11]. Firms in China have sufficient incentives to engage in pollution control efforts to improve environmental conditions, and China is the largest emitter of greenhouse gases [
12] and the largest investor in energy utility [
13]. Besides that, the data of environmental penalties comes from the website of the Institute of Public and Environmental Affairs (IPE). The database regularly collects information on environmental administrative penalties, including fines, reasons, and so on, which lays a foundation for our research in the context of China.
The aim of this study is to examine whether environmental administrative penalties affect audit fees, using data of heavily polluting listed firms in China that have been revealed by the Institute of Public and Environmental Affairs (IPE). In brief, our findings include the following aspects: Firstly, the study finds that environmental administrative penalties are significantly positively associated with audit fees. Secondly, the findings reveal that the effective internal control attenuates the positive association between environmental administrative penalties and audit fees, but the regional environmental regulation enhances the positive impact of firms’ environmental administrative penalties on audit fees. Thirdly, the impact of environmental administrative penalties on audit fees mainly comes from the “risk premium mechanism” rather than the “cost compensation mechanism”, and the response from audit fees can encourage firms to engage in green innovation activities.
One of the main contributions of our research is that we measure environmental administrative penalties from four dimensions including the number of penalties, the fine of penalties, the severity of penalties, and the department of penalties, which is more comprehensive compared with previous studies. The historical studies gauged environmental penalties using dummy variable [
14] or the kinds of violation [
15]. Secondly, additional evidence that environmental administrative penalties have impacts on firms is found. Although previous studies found that environmental administrative penalties can stimulate the environmental enthusiasm of peer enterprises [
16] and increase financing constraints [
15], how environmental administrative penalties affect audit fees remains unknown. The study provides empirical evidence on the relationship between environmental administrative penalties and audit behavior. Thirdly, the study sheds new light on what factors influence audit fees. While prior work concerning audit fees has mainly focused on client characteristics [
17], auditor characteristics [
18,
19], and external environmental uncertainty [
20,
21], research on environmental risks is scarce. So, how environmental risks influence audit fees from the perspective of environmental administrative penalties is depicted.
The content of the paper is as follows: In
Section 2, the literature related to the study is presented.
Section 3 introduces the theory and research hypotheses.
Section 4 introduces the data, variables, and empirical model.
Section 5 presents the results.
Section 6 examines the mechanism and consequence.
Section 7 presents four robustness tests. Finally,
Section 8 provides conclusions, recommendations and limitations.
3. Theory and Research Hypotheses
According to Simunic [
33], audit fees consist of the costs during audit procedures and the compensation of potential risks. The audit cost includes human resources, time resources, and material resources. The risk premium comes from the possible losses, such as reputation risks and litigation risks. The Auditing Standards for the Chinese Certified Public Accountants No. 1631, Consideration of Environmental Information in the Audit of Financial Statements, emphasizes the importance of assessing both favorable and unfavorable environmental matters throughout the audit process, and unfavorable environmental matters include the economic consequences due to environmental penalties [
8]. Thus, environmental administrative penalties may affect audit fees in two ways.
On the one hand, the adverse economic consequences brought by environmental administrative penalties increase firms’ risks and then lead to higher risk premiums. Firstly, environmental administrative penalties bring higher audit fees because of business risks. The punished firms will face rectification requirements such as production restriction, shutdown, or business suspension, and their production capacity may be constrained due to industrial policies [
28]. The firms’ business licenses will be revoked, or the firms will be closed directly, which may result in serious uncertainties regarding future operations. In addition, based on the signaling theory, it is believed that customers and investors will be aware of firms’ environmental risks with the disclosure of environmental administrative penalties, and the pessimistic expectations from investors and consumers appear, which influence earning fluctuation [
36,
37]. So, auditors can evaluate the operational risk via environmental administrative penalties and charge higher audit fees [
38]. Secondly, environmental administrative penalties increase reputation risks and auditors charge higher audit fees. Based on reputation theory, reputation is an important intangible asset of a corporation, and environmental performance is linked to corporate reputation [
39,
40]. Zou et al. [
14] also found that environmental violation events can harm corporate reputation. In October 2011, Beijing entered the haze weather period. At the end of the same month, the US embassy released a message via microblogging regarding Beijing PM2.5 exceeding the standard, but the Chinese government never disclosed the PM2.5 data, which aroused media and public discussion. After the “PM2.5” event in 2011, environmental risks attracted extensive attention from the media [
41]. The media reports and traces the reasons for firms being punished, because of industry competition and social responsibility [
42]. These negative reports can not only increase firms’ negative reputation and auditors’ perceptions about risks, but also may transfer media pressure to auditors who provide services for firms. In such circumstances, the public will pay more attention to auditors, which will lead to the risk of audit failure being discovered, reputation loss [
43] and litigation risks [
44]. Liu et al. [
45] argue that auditors incorporate firms’ reputation risks into their decision of audit fees.
On the other hand, auditors may also spend more resources including human, material, and time to make correct decisions and charge higher cost compensation. Auditors may also spend more audit effort to make correct decisions. When firms are subject to environmental administrative penalties, they may have more potential environmental risks. To deal with these risks, auditors will conduct a more detailed environmental risk assessment, formulate a comprehensive audit plan, select appropriate auditors with professional competence and carry out more detailed tests. In addition, when auditors perceive higher environmental risks, they will allocate more hours to obtain adequate audit evidence, and it is necessary to make good use of experts’ work to clearly recognize firms’ environmental risks throughout the audit process [
10]. Accordingly, environmental administrative penalties may force auditors to spend more audit effort and charge higher audit fees.
In sum, to reduce audit risk, auditors may choose to charge higher audit risk premiums to cope with operation risks and reputation risks. In addition, auditors may also choose to spend more effort. In other words, environmental administrative penalties could affect audit fees through the “risk premium mechanism” or “cost compensation mechanism”. Hence, we propose the following predictions:
Hypothesis 1 (H1). Firms’ environmental administrative penalties lead to higher audit fees.
Hypothesis 1a (H1a). Firms’ environmental administrative penalties lead to higher audit fees through the “risk premium mechanism”.
Hypothesis 1b (H1b). Firms’ environmental administrative penalties lead to higher audit fees through the “cost compensation mechanism”.
The internal control is an internal governance factor that affects the relationship between environmental administrative penalties and audit fees. The internal control system includes the internal environment, risk assessment, control activities, communication, and internal supervision. It is an important criterion to judge whether the firm’s internal governance environment is good or not.
Many studies show that effective internal control is the guarantee to improve operation efficiency [
46,
47]. The adverse economic consequences caused by environmental administrative penalties will be alleviated when the internal control environment is effective. Firstly, the punished firms may suffer rectification or shutdown, which will lead to operation uncertainties, such as the decrease in cash flows, stock return and market value [
29,
30,
32]. Secondly, firms may be subject to industrial constraints and may be required to make industrial adjustments after being punished, especially for heavily polluting companies. However, compared with other firms, it is believed that the ability to deal with market shocks and maintain business safety is stronger for firms with better internal control. Undoubtedly, the effective internal control can alleviate the adverse impact of environmental administrative penalties on firms, which may lead to lower audit fees. Hence, we give the following prediction:
Hypothesis 2 (H2). The effective internal control weakens the positive impact of firms’ environmental administrative penalties on audit fees.
The regional environmental regulation is an external governance factor affecting the relationship between environmental administrative penalties and audit fees. Environmental regulation can not only impact corporate environmental governance behavior [
48], but also audit fees [
9].
With the gradual strengthening of environmental regulation, the possibility of firms being punished increases significantly. Stronger environmental regulation also draws more public’s environmental attention, which results in higher earning fluctuation [
49]. In addition, under the strict environmental regulation, the media will pay more attention to firms’ pollution behaviors and deliver more negative reports of punished firms, which arouses firms’ reputation risks. Therefore, auditors, the entities to which reputation risks may be transferred, face higher litigation risks and more serious reputation threats when auditing in areas of strict environmental regulation. In addition, auditors need to be more knowledgeable about environmental rules, regulations, and legal provisions to avoid audit failure. At the same time, it is important to understand deeply the environmental risks in the process of production and operation, even making use of experts’ work when necessary [
9]. Therefore, in areas with strict environmental regulation, auditors fall into more serious uncertain risks and spend more audit effort, which requires higher audit fees. Therefore, we present the following prediction:
Hypothesis 3 (H3). Stronger regional environmental regulation enhances the positive impact of firms’ environmental administrative penalties on audit fees.
8. Conclusions, Recommendations and Limitations
8.1. Main Conclusions
The construction of ecological civilization is a responsibility all over the world. As the largest developing country, China also makes its contributions. In 2021, China set carbon peak and carbon neutral as the aim to achieve sustainable development. Besides that, environmental administrative penalties also play a fundamental role in ecological protection.
Although audit fees have gained considerable attention from many scholars, research on how environmental administrative penalties affect audit fees is scarce. The study attempts to fill the gap. Using data of heavily polluting listed firms in China, which have been revealed by the Institute of Public and Environmental Affairs (IPE) from 2011–2019, the study examines the relationship between environmental administrative penalties and audit fees from four dimensions including the number of penalties, the fine of penalties, the severity of penalties, and the department of penalties. The findings show the following:
(1) Environmental administrative penalties are significantly positively associated with audit fees. In other words, the impacts of the number of penalties, the fine of penalties, the severity of penalties, and the department of penalties on audit fees are all significantly positive.
(2) Effective internal control can attenuate the positive association between environmental administrative penalties and audit fees, but regional environmental regulation can enhance the positive impact of firms’ environmental administrative penalties on audit fees.
(3) The impact of environmental administrative penalties on audit fees mainly comes from the “risk premium mechanism” rather than the “cost compensation mechanism”, and the response from audit fees can encourage firms to engage in green innovation activities.
8.2. Recommendations
Presently, China is in an important period of economic transition, and achieving high-quality economic development has become the requirement of the times. Environmental protection is vital to economic development, human health, and social stability, and environmental administrative penalties are an important means of environmental protection. According to our findings, we show the following recommendations.
(1) For auditors, with the development of the sustainable and green economy, auditors, who are the important external stakeholders, should punish the poor environmental performance of enterprises by increasing audit fees and thus encourage firms to decrease their environmental pollution. In addition, our research also exhibits that the internal control and regional environmental regulation can regulate the relationship between environmental administrative punishment and audit fees. In particular, auditors need to take firms’ internal control and regional environmental regulation into account when making decisions and treat them differently.
(2) For firms, when firms receive environmental administrative penalties, there will be many adverse economic consequences from environmental penalties, such as business risk, reputation risk and higher audit fees. Therefore, it is necessary for firms to invest more in environmental governance and consider the long-term benefit.
(3) For governments, our findings point out that auditors can give proper response to firms being punished by requiring higher audit fees and encouraging firms to engage in green innovation, which means that environment governance can be effective by mobilizing stakeholders. So, when carrying out environmental regulation, the government should combine the strength of stakeholders in the capital market and show a “1 + 1 > 2” effect on environmental protection.
8.3. Limitations and Future Work
Although our study considers various conditions, there are also several limitations.
(1) The research reflects the relationship between environmental administrative penalties and audit fees in China. However, China, the largest developing country, is different from other countries in terms of economic system and market characteristics, especially compared to developed ones. Thus, evidence from other countries would help to obtain more general results. We expect future research to develop the study by examining non-Chinese listed firms.
(2) The article selects the number of penalties (Pen-Num), the fine of penalties (Pen-Fine), the severity of penalties (Pen-Sev), and the department of penalties (Pen-Dep) as the characteristics of environmental administrative penalties. There may be many meaningful features that we have not considered, so other characteristics of penalties should be explored in the future.
(3) The data of environmental administrative penalties come from manual collection, due to the difficulty and workload of data acquisition, and thus only the heavily polluting enterprises are researched in the study. When the data acquisition is more convenient, the sample can be extended to all listed companies.