The Importance of Business Risk in Setting Audit Fees: Evidence from Cases of Client Misconduct

Abstract

Previous research (Bell, Landsman and Shackelford, Journal of Accounting Research, 2001) provides survey evidence that, for the clients of a large audit firm, audit clients with higher perceived business risk bear the expected costs of this risk with higher audit fees. We examine this relation between audit fees and business risk for audit clients doing business in developing countries where bribery of top government officials is accepted business practice. We hypothesize that bribery-paying clients impart potential legal and reputation costs on auditors and hence have higher business risk. Our evidence indicates that audit fees were higher for clients that disclosed paying bribes and for those that had not disclosed paying bribes but had operations in developing countries in which bribery was an acceptable form of business conduct. We conclude that the evidence is consistent with an audit market where audit firms knowingly assess business risk at the client level, then pass its expected costs to the client in the form of higher audit fees. Our evidence is inconsistent with an audit market that does not price business risk, or where auditors cross-subsidize fees between high and low risk clients as modeled by Morgan and Stocken (Review of Accounting Studies, 1998).