The contextual nature of the association between managerial ability and audit fees

Abstract

PurposeThis study examines whether auditors’ pricing decisions on managerial ability are affected by auditor litigation risk (financial distress or financial crisis), auditor’s familiarity with their client or regulatory changes in the post-Sarbanes–Oxley Act of 2002 (SOX) era.Design/methodology/approachBuilding on the extant audit fee literature, this study constructs an audit fee determinants model to examine how context affects auditors’ pricing of managerial ability.FindingsAuditors offer a larger fee discount to more able client management teams when auditors face lower litigation risks or are more familiar with the client. Furthermore, managerial ability has a more pronounced effect on audit fees in the post-SOX era when managers are mandated to play more active roles in financial reporting (i.e. certification of financial statements required by SOX 302).Research limitations/implicationsBased on the audit risk model (Simunic, 1980), Krishnan and Wang (2015) show that the managerial ability of an audit client is relevant and important to auditors’ pricing decisions. This study demonstrates that managerial ability exhibits a non-linear relationship with audit fees and contextual factors, such as litigation risk, and that auditors’ familiarity with managers can alter the negative association between audit fees and managerial ability. This study extends Krishnan and Wang’s study by offering additional insights into auditors’ use of soft information such as managerial ability. Furthermore, the findings add to the literature on the impact of SOX on audit fees by suggesting that SOX has not only increased overall audit fees (Ghosh and Pawlewicz, 2009; Huang et al., 2009), it has also increased auditors’ price sensitivity to soft information (e.g. managerial ability).Practical implicationsThis study provides insights for audit firms and client companies who are interested in understanding audit fee-pricing decisions. The findings also suggest that auditors need to be sensitive and responsive to various contextual factors when making pricing decisions.Originality/valuePrevious studies have not addressed the non-linear relationship between audit fees and soft information about managerial ability.