Review of Accounting Studies, 3, 365–385 (1998)
1998 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
The Effects of Business Risk on Audit Pricing
Woodrow Wilson School, Princeton University
Wharton School, University of Pennsylvania, 2426 Steinberg Hall-Dietrich Hall, Philadelphia, PA 19104-6365
Abstract. This paper examines the pricing of business risk by homogeneous auditors in a two period model.
Incumbent auditors learn the client’s business risk type during the course of the engagement. They subsequently
compete in prices with prospective auditors. In such an environment, we show that equilibrium audit fees do not
fully reﬂect the cost of business risk. Moreover, there exists differential auditor turnover between high and low
risk ﬁrms; cross-subsidization of the audit fees of high risk ﬁrms by low risk ﬁrms; and low-balling by auditors.
Auditors have been inundated with shareholder lawsuits. Malpractice-litigation costs of Big
Six accounting ﬁrms, after insurance recoveries, have substantially increased, and by 1993
amounted to nearly twelve percent of these ﬁrms’ total accounting and auditing revenue
(Lambert (1994)). Furthermore, claims against non-Big Six ﬁrms rose by two-thirds from
1987 to 1991. In 1990, the seventh largest accounting ﬁrm in the United States, Laventhol
and Horwath, ﬁled for bankruptcy. The failure of Laventhol and Horwath was mainly
attributed to incurred and anticipated litigation costs. The ﬁrm’s chief executive ofﬁcer
contended that litigation arose, not from inadequacies in its professional performance, but
from the perception that the ﬁrm had a “deep pocket” (Arthur Andersen, et al. (1992, 3)).
Similarly, O’Malley (1993, 84–85), chairman and senior partner of Price Waterhouse,
claimed that “unwarranted litigation and forced settlements constitute the vast majority
of claims against accountants” and that shareholders demand compensation from auditors
even if the auditor is not responsible for shareholders’ losses.
Against this background of increasing potential liability exposure due to circumstances
that are largely outside the auditor’s control, it is important to consider the effect of business
risk on audit pricing. Business risk, which is the focus of this paper, is deﬁned by the Amer-
ican Institute of Certiﬁed Public Accountants (AICPA) (1992) as having two components:
client’s businessrisk, the risk associated with the client’s continued survival and well-being;
and auditor’s business risk, the risk of potential litigation costs and other expenditure from
association with a client irrespective of whether or not an audit failure is asserted. Thus,
we interpret business risk as the risk to the auditor of a lawsuit that remains after taking
all steps required under the Statements of Auditing Standards (SAS) while performing the
audit and issuing an audit report. It must be stressed that it is often impossible for the
auditor to avoid being sued regardless of due diligence efforts. O’Malley (1993, 93) argues
that “the auditors may be sued by anyone who suffered a ﬁnancial loss even though that
person may never have so much as glanced at an audit report. The auditors need not have
done anything to cause the loss.”