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    Pricing of Risky Initial Audit Engagements.
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 02.04 Predecessor Auditor Factors 
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    Title:
    Pricing of Risky Initial Audit Engagements.
    Practical Implications:

    This research contributes to the initial engagement literature by providing evidence that successor auditors charge higher fees to their clients that previously reported disagreements and other reportable events. The authors also contribute to the literature by examining fees over a six-year period surrounding the auditor change. More importantly, they find that only Big 4 auditors appear to charge higher fees following disclosures of disagreements and other reportable events. Finally, the authors add to the existing literature on audit fees for risky clients, especially the internal control weakness literature, by providing evidence that disagreements and other reportable events are priced incremental to internal control issues.

    Citation:

    Elliott, J. A., A. Ghosh, and E. Peltier. 2013. Pricing of Risky Initial Audit Engagements. Auditing: A Journal of Practice & Theory 32 (4): 25-43.

    Keywords:
    audit fees, auditor changes, Big 4 auditors, engagement risk
    Purpose of the Study:

    In this study, the authors 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. They group adverse disclosures embedded in auditor change filings into four categories: clients with 

    1. Internal control weaknesses,
    2. Going concern issues or those filing for bankruptcy,
    3. Disagreements with the predecessor auditor, and
    4. Other reportable events.

    Because prior studies examine internal control weaknesses and going concern opinions, the authors focus on auditor-client disagreements and other reportable events, including restatements, management integrity issues, scope limitations, illegal acts, and reaudits. A fundamental distinction between this study and prior studies on risk and fees is that the authors measure client risk based on public information available to auditors before they accept an engagement.

    The authors investigate the association between an ex ante measure of risk (using information in auditor change 8-K filings) and audit fees for initial engagements. The authors also examine whether the size of the successor/predecessor auditor affects fees. Finally, they examine inter-temporal fee changes, i.e., how fees change subsequent to a switch and how fees change prior to the switch, for both risky and other clients.

    Design/Method/ Approach:

    The auditor change and fee data are obtained from Audit Analytics. Data for the financial variables are from Compustat Annual files.  The final sample consists of 2,396 auditor switches over the years 2001 to 2011. The categorization based on auditor change 8-K filings indicates that 317 auditor switches have a disagreement or other reportable event disclosed in the filings, while the remaining 2,079 observations do not report any such issue.

    Findings:
    • The authors find that firms disclosing reportable events or auditor-client disagreements pay a fee premium of about 23 percent compared to less risky initial engagements.
    • They find that only clients switching to Big 4 auditors pay higher fees when disclosing disagreements or other reportable events in the 8-K.
    • The results indicate that Big 4 auditors charge a fee premium for risky clients, but not non-Big 4 auditors.
    • Over the three years prior to the auditor switch, audit fees for risky Big 4 clients increase by about 36 percent. Following the auditor switch, the fee premium persists for at least three years.
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment, Predecessor Auditor Factors