Do Auditors Charge a Risk Premium? Evidence from the Association between Derivative Hedging and Audit Fees

Abstract

Prior literature finds that auditors charge higher fees for riskier clients. One reason for this is that auditors expend greater audit effort on riskier clients. However, it is unclear whether they also charge an additional client business risk premium. We investigate this issue employing a detailed, hand-collected dataset of hedging derivative usage by U.S. oil and gas exploration and production firms. Even though the auditing of derivative instruments requires greater auditor effort, hedging significantly reduces client business risk. Consistent with the presence of a client business risk premium in audit fees that gets attenuated when clients reduce their risks by employing derivative hedging, we find a negative association between audit fees and the extent of derivative hedging by clients. Further underscoring the role of risk reduction in this relationship, we find the above negative association to be weaker when the risk management efficacy of derivative instruments is comparatively lower. This negative association is also weaker when effort expended in auditing derivatives is likely to be especially high. We contribute to the literature by providing strong evidence for the presence of a client business risk premium in audit fees.