AUDIT LITIGATION AND THE PRICING OF AUDIT SERVICES

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AUDIT LITIGATION AND
THE PRICING OF AUDIT SERVICES
by
Teo Eu-Jin
and
Keith A. Houghton
The University of Melbourne
Victoria, 3010 Australia
Correspondence can be directed to:
Email: k.houghton@ecomfac.unimelb.edu.au
Fax: +61 3 9349 2397
November 2000
Acknowledgements
This paper has benefited from the helpful advice and comments of Christine Jubb, Harold Luntz, Ian
Malkin (all of The University of Melbourne), Daniel Stepniak (University of Western Australia),
Keith Alfredson (Chair of the Australian Accounting Standards Board) and two anonymous referees
for the 2001 American Accounting Association Mid-Year Conference.AUDIT LITIGATION AND THE PRICING OF AUDIT SERVICES
ABSTRACT
This paper examines the impact of audit litigation on audit fees. It is argued that the
reputation of an audit firm is correlated to the perceived audit quality provided. Audit quality
is related positively to audit fees ceteris paribus, and audit litigation impacts on reputation
negatively because it may be seen as an indicator of a lack of audit quality.
The negative association between audit litigation and audit fees suggested is argued to be
exacerbated by, (1) locality; and (2) auditor industry specialization factors. It is argued that
litigation against a national audit partnership concerning an audit carried out by a particular
state office will have a more marked effect on local market fees than on the audit firm’s fees
nationally. Arguably, this is because of the presence of audit quality concerns perceived as
specific possibly to that office in addition to any deficiencies suggested in (national) practice-
wide policies or procedures. Also, auditors specialising in auditing entities in a particular
industry and who are sued over such audits face decreases in audit fees greater than those
confronting litigated non-specialists. Arguably, the litigation suggests that the auditor is
incapable potentially of delivering reliably the higher level of audit quality expected of a
specialist.
The general proposition, together with the two extensions involving locality and
specialization, are tested using the population of writs issued between 1987 and 1999 alleging
negligence over audit opinion dates from 1987 to 1994 in Australia. Audit fees for
companies using litigated auditors and matched pair companies with non-litigated auditors are
examined for each listed company from 1988 to 1995. Controlling for the effects of various
audit fee influences documented in previous literature, it is observed that the litigated auditor
companies’ fees are significantly lower than those of their matched-pair non-litigated auditor
counterparts. This result is more marked when locality and specialization factors are
considered.
Key Words: Audit Litigation, Audit Fees, Market for Audit Services
Data Availability: The data used is from public sources identified in the paperAUDIT LITIGATION AND THE PRICING OF AUDIT SERVICES
1.0 INTRODUCTION AND MOTIVATION
Audit fee modelling and audit litigation studies are two distinct yet related research areas in
auditing. Inquiry has isolated various factors observed to affect the level of audit fees paid.
A different literature has identified certain antecedents to audit litigation, and some of the
consequences of litigation and other reputation-reducing events for auditors. The research
1focus has been on the effect of such phenomena on an auditor’s client base, and their impact
2on the security prices of the auditor’s clients. The present study investigates whether a
relationship exists between audit litigation against a given firm and audit fees charged to
clients of the same firm.
This study links two lines of inquiry (audit fees and audit litigation). If audit litigation is
identified as an omitted variable in an audit fee model, then including it would represent one
more step in developing a fuller, more comprehensive model. In a similar vein, the study
adds to the state of knowledge with respect to the effects of audit litigation (and other
reputation-reducing events), because it examines whether or not there is an audit fee impact
consequential to litigation. Either of these outcomes will contribute to the audit literature.
Prior studies suggest that audit quality perceived is related positively to audit fees; the greater
the value auditees place on audits by apparently highly competent and independent auditors is
reflected in the increased fees they pay to those auditors (see Simon and Francis, 1988;
Craswell, Francis and Taylor, 1995). While positive aspects of competence and
independence are well researched, the same is not true of negative aspects; that is, decreases
in (real or perceived) competence or independence leading potentially to audit fee reductions.
Yet there is no reason logically why both positive and negative influences should not affect
fees. If auditees are willing to pay more to competent, independent auditors, should they not,
conversely, be willing to pay less for the services of an auditor whose competence or
3independence is perceived to be compromised? This study is one of the few that test this
4latter proposition, which remains uninvestigated in the context of audit litigation.2.0 PREVIOUS LITERATURE
The relevant literature falls mainly into two types, (1) the fee effects of reputation-reducing
events other than litigation; and (2) the impact of litigation on areas of auditing other than
audit fees. Davis and Simon (1992) researched whether auditors sanctioned by the US
Securities and Exchange Commission (SEC) experienced a decline in fees. Firth (1990)
studied whether criticism by the United Kingdom’s Department of Trade had an effect
similar, and looked at whether auditees switched away from firms criticised. Wilson and
Grimlund (1990) investigated whether the SEC sanctions prompted auditor switching
behaviour. The relationship between reputation-reducing events and auditor switching was
tested in Firth (1990), noted above, and in an Australian setting by Zhivov, Jubb and
Houghton (1995), who studied this in the context of audit litigation because regulatory action
against auditors is rare in Australia. Other research dealing directly with litigation, such as
that by Franz, Crawford and Johnson (1998), has been concerned with how the event affects
auditees’ share prices.
None of the litigation studies appears to appreciate why audit litigation may reflect on
perceptions of compromised audit quality, and hence potentially audit fees and auditor
reputation decreases. It is contended that failing to grasp this legal dimension has led to the
acceptance of ideas that are not sound. This paper addresses this theoretical gap by linking
legal concepts surrounding audit litigation to notions of audit quality. Arguably, this
synthesis is overdue and is required for a more holistic understanding of the dynamics of
audit litigation, a phenomenon sustained ultimately by interpretations of and a reliance
procedurally on legal rules and principles.
One might argue that this study replicates essentially Firth (1990) and Davis and Simon
(1992) in an Australian context by substituting audit litigation for Department of Trade and
SEC sanctions respectively as the variable of interest. However, such a view is flawed both
theoretically and methodologically. Private litigation in the courts is qualitatively different
from executive action by public law bodies. Godfrey et al (1994) points out that regulators as
rational self-interested utility maximisers are not motivated always by the public interest
when exercising their powers democratically conferred. Pragmatically, this suggests that
action by government agencies including corporate regulators against auditors may not be
2driven necessarily by audit failures perceived, but potentially instead by the desire to raise
public profile or justify existence on the public purse by being seen to be “doing something”.
In contrast, the high direct (and opportunity) costs of commencing and sustaining self-funded
private litigation and the significant financial consequences of defeat (at least in some
jurisdictions) suggest the presence of an arguable case of audit failure. This is because
plaintiffs will not rationally commence actions unless they believe they have a reasonable
chance of success (or settlement). Zhivov et al (1995) conclude therefore that “[b]etter as a
market measure of problems associated with a particular audit is actual litigation undertaken
against the auditor.” Private litigation thus is the reputation-reducing event preferable for
investigating audit fee effects associated potentially with a perceived lack of audit quality,
because any impact following this more likely would be linked to the latter.
Additionally, Davis and Simon (1992) drew their conclusions from testing survey data. Their
fee information represented responses to Simon and Francis’ (1992) questionnaire concerning
price-cutting in new audit engagements. This raises problems firstly because only a relatively
small proportion of clients changes auditors in any particular year. Furthermore, various
factors influence auditor switching and may have affected the companies in Francis and
Simon’s study to a greater degree than others. All this suggests that the external validity of
Davis and Simon’s (1992) study is questionable because their sample may not be