A Study on Audit Pricing and Market Assessment of Risk (2011)

INTRODUCTION This research investigates auditee systematic risk in audit pricing decisions. A number of empirical studies present evidence on audit fee pricing and identify many factors that impact such fee. Cobbin (2002) has an extensive review of studies on audit fees. The seminal Simunic study (1980) used US data and since then many international studies have replicated the basic regression model that include several variables. Most studies find that differences in audit fee are explained by client attributes like size, audit effort and audit risk. Audit risk is theoretically defined as a combination of inherent risk, control risk and detection risk and is expressed as AR = IR X CR X DR Where, AR= Audit risk, IR = Inherent risk, CR = Control risk and DR = Detection risk (Arens, Elder, Beasley, 2009). Inherent risk is client specific and includes many macro and micro factors. The purpose of this study is to determine if systemic risk of a firm (as measured by the market [beta]) affects audit pricing decisions. We believe that the inclusion of [beta] as one of the components in inherent risk may be appropriate after considering some of the micro and macro factors in the KPMG audit model (Bell, Mars, Solomon, & Thomas, 1997). Effect of Client's Risk on Audit Fees As defined in the model above, control risk is the probability of the client's internal control system failing to prevent financial statement misstatements exceeding the auditor's predetermined assessment of such risk. In the era of the implementation of internal control reporting requirements following the passage of Sarbanes-Oxley (SOX), the components of internal control suggested by the 2004 Committee of Sponsoring Organizations of the Treadway Commission (COSO) framework are considered in the assessment of internal control risk. Abbott et al (2003) consider the quality of audit committees (COSO mandated corporate governance factors) in predicting audit fees. Raghunathan and D. V. Rama (2006) report that the audit fee in the year 2004 (internal control disclosures required by Section 404 of the SOX) was significantly higher than in the prior year. Huang et al (2009) have considered audit fee differences in pre-and post-SOX continuing and initial audits. They report that the initial fee discounts seen in 2001 Big 4 audits are not available in the post-Sox 2006 audit fee. Detection risk deals with auditor specific issues in performing the audit. Some studies have considered differences in quality of Big 4 vs. Non-Big 4 audit fees (Simunic 1980) and auditor specialization (Cahan et al 2008) in audit fee determination. Healy (2005) suggests a key role for auditors as intermediaries in the capital markets for reducing investor information risk. He suggests that audit pricing must provide for higher quality audits that may reduce the risk of fraud. He suggests that this type of high quality audit work may even reduce litigation risk for auditors. Role of Systemic Risk [beta] is a market risk indicator of a stock's volatility in relation to the market's volatility and since auditors play a role in the capital markets' certification processes, [beta] may well affect in determining audit fee. Just like an investor, an auditor accepts several clients from a portfolio of firms and hence has a selection problem. According to Markowitz (1952), systematic risk of a firm (audit client) should affect the selection problem. Various liquidity, profitability and leverage ratios (Cobbin 2002) used to estimate audit risk may also contain some unsystematic risk elements that may be somewhat biased. Capital Asset Pricing Models developed by Sharpe (1964) and Lintner (1965) and Mossin (1964) suggest that the appropriate measure for determining a firm's systematic risk is [beta]. Betas ([beta]) may better capture client risk in any audit pricing model, since it reflects the firm's business risk as viewed in the financial markets. …