Nonlitigation Risk and Pricing Audit Services

In this study we expand the audit fee model introduced by Simunic (1980) and extended by Houston et al. (1999) by adding a third factor, nonlitigation risk, which refers to general business risks and/or opportunities that extend beyond litigation risk or the conduct of the audit (e.g., opportunities for future audit and nonaudit revenues, potential damage to the auditor's reputation from involvement with a client). In an experiment, we ask audit partners and managers to assess various risks and develop an audit plan after reviewing one of four risk-increasing audit scenarios—the discovery of an error, the discovery of a GAAP inconsistency, a client buyout where the audited financial statements are used in the determination of the exchange price, and the loss of a major client customer. We find that, in the error and buyout cases, audit fee increases are explained only by the planned increase in audit investment; in the GAAP inconsistency case, the audit fee increase is explained in part by the planned increase in audit investment, but to a greater extent by residual litigation risk; in the loss of customer case, the audit fee increase is explained by the planned audit investment, residual litigation risk, and nonlitigation risk. These results suggest that business risk is comprised of at least three factors (acceptable audit risk, residual litigation risk, and nonlitigation risk), and that auditors are compensated to act as auditors, provide insurance for investor losses, and bear risks associated with factors that extend beyond the conduct of the audit. We also discuss how nonlitigation risk can clarify the results of previous research and be used in future research.