Audit fees and client business risk during the S & L crisis: Empirical evidence and directions for future research

Abstract

We investigate the relation between independent audit fees and client business risk in the savings and loan (S & L) industry from 1983–1988. The extent to which independent auditors recognized and reacted to S & L client business risk is important for understanding independent auditors' behavior during the crisis. Evidence of an association between fees and client riskiness may bear upon litigation in which S & L regulators and investors are suing independent auditors for enormous sums of money, for allegedly negligent auditing. Economically rational auditors, who were attuned to client business risk, should haved priced this risk into their fees. Audit fees were regressed on variables representing client business risk for each of six years, 1983–1988. The consistent significance of these variables strongly suggests that independent auditors were sensitive to S & L riskiness throughout the middle 1980s. The variance in fees explained by the risk variables, and the magnitude of the coefficient on one of the risk measures suggest that increases in risk were accompanied by substantial, but perhaps ex post insufficient, fee increases. Additional research is needed to determine whether this fee premium is commensurate with independent auditors' current litigation costs, or if insufficient auditing or competition in the audit market caused auditors to underprice their services, given the risk they assumed.