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SUMMARY
This study investigates the relationship between audit pricing and litigation risk. The main question posed in the research is: Are audit fees adequate to compensate auditors for litigation risk? The answer to this question is an essential element in assessing the severity and implications of the liability crisis in auditing.
The paper approaches the question in several stages. First, there is an economic analysis of audit pricing. Second, there is a review and reinterpretation of the empirical literature related to audit pricing. Lastly, new evidence is provided from a sample of 249 audits done by a Big 6 auditor. The main results from these analyses are: increased litigation is likely to result in a demand displacement from high-quality to low-quality auditors; the archival evidence suggests that audit fees do reflect variations in litigation risk and that there is some evidence of the predicted demand displacement; and the evidence from the audits included in the sample suggests the incremental contribution margin from the change in audit fees attributable to litigation risk factors appeared to be adequate to cover the costs of litigation for the audit firm performing the audits during the period studied.
Key Words: Audit fees, Auditor litigation, Economics of auditing.
Much has been written about the litigation crisis facing public accounting firms in the United States (e.g., Arthur Andersen & Co. et al. 1992). An alleged consequence of the high rate of litigation against auditors is the possible business failure of one or more firms. For example, in their Statement of Position (Arthur Andersen & Co. et al. 1992, 1), the Big 6 argue that:
The flaws in the liability system are taking a severe toll on the accounting profession. If these flaws are not corrected and the tort system continues on its present inequitable course, the consequences could prove fatal to accounting firms of all sizes. (emphasis added)
But auditing is, and has always been, a business in which the auditor must assume the risk of an uncertain rate of return from an engagement. One reason why the return is uncertain is because financial statements can contain undetected material misstatements which may be revealed after an audit report has been issued. Such ex post revelations may lead to accusations of negligence...