Rising audit fees provide an early warning sign that a company is headed for deep financial trouble, according to a recent academic paper.

Jonathan Stanley of Auburn University recently published his findings that an increase in a company's audit fees one year can be linked to a decline in a company's financial performance the following year. He also asserts a rise in audit fees can signal trouble as far as five years in advance. The American Accounting Association recently published the study, Is the Audit Fee Disclosure a Leading Indicator of Clients' Business Risk?, in its quarterly academic journal.

Stanley believes the findings should be helpful to average investors who are calling on management and auditors to give more warning when companies are in dire financial condition. “In my view, checking auditing fees should be a basic investment activity, like checking short interest and analysts' earnings forecasts,” he said in a statement.

The study focused on data from about 5,000 U.S.-based companies from 2000 through 2008 with an asset median of $240 million and average audit fees of $1.15 million. As indicators of financial performance, the analysis focused on return on assets, determined both by earnings and cash flow. The analysis controlled for factors that might affect audit fees, like amount of company assets, number of business segments, amount of leverage, and the magnitude of inventory and accounts receivable.

Stanley said auditing fees were significantly related to improvements or declines in a company's financial performance during the following year, and to a lesser extent the next four years as well. He also found a correlation, though not as strong, between falling audit fees and an improvement in financial performance.

The logic is sound, the author notes, because auditors do more work and therefore charge more in fees where they perceive more risk – and that perception is based on access to corporate data that investors can't see. Auditors will do more work where they see a lack of resources to provide reliable data, where they sense executives feel pressured to distort results to conceal declining performance, or where auditors are worried about their own litigation or reputational risk, Stanley contends. “Factors that drive up auditing costs can also easily have a negative impact on a company's future,” he said.

AAA says it has more studies under way that look further at the relationship between changes in audit fees and changes in financial performance. One is gathering evidence that will link the amount of audit fees to the later discover of misstatements, fraud and comment letters from the Securities and Exchange Commission. Another is drawing a link between audit fees and plunging price declines in company stock, credit ratings, and the filing of class action security lawsuits.

In fact, those authors are beginning to argue that audit fee information is so valuable it should be disclosed to investors at the time the fees are negotiated rather than a year later when published in a proxy statement, AAA said.