Pricing of Risky Initial Audit Engagements

This study analyzes the pricing of auditors’ business risk in the first year of an audit engagement. We posit that reportable events from the prior auditor’s tenure that are disclosed in the 8-K auditor change filing provide reliable information about the level of business risk for the incoming auditor. We hypothesize that for clients perceived as risky, the incoming auditor charges a fee-premium for bearing the higher risk. Our evidence is consistent with this expectation. Using a large sample of US publicly disclosed fee data from 2000-2006, we find that audit fees are about 4% lower for firms in the first year of an audit engagement compared to continuing engagements, which is consistent with incoming auditors low-balling or feediscounting to attract new clients. More importantly, rather than receiving a fee discount, firms that report problems in the 8-K auditor change filing pay a fee premium. Finally, fee discounting appears to be eliminated by the second year of the engagement for clients without problems while auditors of more risky clients continue to charge a fee premium for the first three years of the engagement.