The Pricing of Client Risk by Big N and Non Big N Audit Firms: 1996-2004

Abstract

Using 8,028 observations from publicly listed companies in Australia over the nine year period 1996-2004, this study provides an investigation into the pricing of client risk by audit firm type (Big N firms as compared to non-Big N firms). The period is specifically chosen as it allows us to examine risk pricing over a period of structural change with the move from the Big 6 (1996-1998) to the Big 5 (1999-2001), and following the demise of Arthur Andersen in 2001, to the Big 4 (2002-2004). Over the period identified, the audit firms also claim to have placed a greater emphasis on the identification of client risk, and professional indemnity insurance costs, an indicator associated with risk, increased substantially in magnitude. For the entire period we find that Big N firms charge higher rates for client risk compared to the non-Big N firms, with the pricing differences between auditor types being most pronounced during the Big 4 era. Over time, both Big N and non-Big N firms appear to have increased their pricing for prior year losses while unexpectedly reducing their pricing of risk associated with current year profit or loss. A significant difference over time between the Big N and non-Big N firms is that the Big N have significantly increased their pricing of risk associated with leverage, a measure of long-term financial risk, while this risk factor was priced on a constant basis for non-Big N firms.