Pricing of Risky Initial Audit Engagements

Abstract

SUMMARYWe reexamine the association between audit fees and risky initial engagements by developing an ex ante client-risk metric that is based on auditor change 8-K filings. We concentrate on auditor-client disagreements and other reportable events (restatement, management integrity, scope limitations, illegal acts, reaudits) disclosed in the 8-K auditor change filings. We find that audit fees are significantly higher for clients reporting disagreements and other reportable events in their 8-K auditor change filings for the initial year of engagement. However, the fee premium is only attributable to Big 4 auditors. While the Big 4 charge 45 percent higher fees when clients have disagreements or other reportable events, there is no such fee premium associated with non-Big 4 clients. More importantly, Big 4 predecessor auditors increase fees prior to the auditor switch as clients develop problems. Big 4 successor auditors continue to charge significantly higher fees for at least three years following adverse 8-K disclosures. Our results provide evidence on how successor and predecessor auditors incorporate risk in the pricing of audit fees, where risk is based on the information contained in auditor change 8-K reports.