Accounting Research Center, Booth School of Business, University of Chicago

Auditors' Perceived Business Risk and Audit Fees: Analysis and Evidence
Author(s): Timothy B. Bell, Wayne R. Landsman and Douglas A. Shackelford
Source: Journal of Accounting Research, Vol. 39, No. 1 (Jun., 2001), pp. 35-43
Published by: Wiley on behalf of Accounting Research Center, Booth School of Business,
University of Chicago
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Journalof AccountingResearch
Vol.39 No. I June 2001
Printedin U.S.A.

Auditors' Perceived Business Risk

and Audit Fees: Analysis
and Evidence
TIMOTHY
AND

B. BELL,*
DOUGLAS

WAYNE R. LANDSMAN,t
A. SHACKELFORDt

Received 5 January 1999; accepted 11 July 2000

ABSTRACT
This study analyzes the relation between auditors' perceived business risk
and audit fees to determine whether audit firms or their clients bear the
expected legal costs of business risk. We predict that hourly audit fees and
the number of audit hours are increasing in business risk. Using confidential
survey data collected by a large international accounting firm for 422 audits,
we find that high business risk increases the number of audit hours, but not the
fee per hour. This implies that firms perceive firm-level differences in business
risk and obtain compensation through billing additional hours, not by raising
the hourly charge.

1. Introduction
This paper analyzes the relation between the audit fee and the auditor's
assessment of the risk of litigation arising from association with the client
("auditor business risk" as defined by SAS No. 47). The purpose of the paper
is to determine the "incidence" of business risk, i.e., to determine whether
* KPMGLLP; tUniversity of North Carolina;
tUniversity of North Carolina. We thank Bob
Elliot and workshop participants at the 1994 American Accounting Association annual meeting,
Emory University, the University of Illinois, University of Pittsburgh, and Stanford University
for their helpful comments. We also thank executives of the firm who provided the data for this
study, auditors from a variety of firms whose comments have enhanced the paper, and Susan
Eldridge for research assistance. Landsman and Shackelford received financial support from
the Center for Financial and Accounting Research, the University of North Carolina.
35
Copyright (?, University of Chicago on behalf of the Institute of Professional Accounting, 2001

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36

T. B. BELL, W. R. LANDSMAN, AND D. A. SHACKELFORD

audit firms or their clients (through higher audit fees) ultimately bear the
legal costs of business risk. We test the relation by examining data collected
by an international auditing firm.
The paper focuses on the legal costs of business risk, which arise solely
from association with the client.' In principle, the legal costs of business
risk do not include legal costs arising from failure to conduct an appropriate audit. Although the legal costs of business risk and audit failure may
be correlated and litigation costs are not separately delineated between the
two legal costs, they arise for different reasons. The auditor is paid a fee to
attest to the assertions contained in the client's financial statements, and
presumably the fee reflects the work the auditor must perform to reduce
inherentriskto an acceptable level (i.e., the profit-maximizing level). In contrast, businessriskis, by definition, a residual risk that, in principle, cannot
be eliminated or reduced below a certain level.
In a competitive equilibrium, audit fees should reflect the expected costs
of auditor business risk. The cost of business risk can be shifted from firms
to clients (i) explicitly through a firm's assessment of a company's risk and
inclusion of the risk in the firm's bid, or (ii) implicitly where the available
information about the riskiness of the company is efficiently impounded in
a market-determined (albeit not publicly disclosed) audit price and explicit
consideration of a company's risk is not required for an individual audit
firm.
Contrary to the competitive model prediction that audit fees reflect business risk, auditors from several international firms tell us that there is little
correspondence, if any, between business risk and audit fees. Auditors provide a variety of reasons for their inability to shift these litigation costs to
clients. Some auditors assert that business risk is not explicitly considered
in the determination of audit fees because it cannot be measured. Others
assert that business risk aggregated over a set of clients is measurable but
cannot be disaggregated at the client level.2 Still other auditors claim that
measurement and disaggregation are possible, but that unspecified market
conditions preclude inclusion of business risk in audit prices. One possible
market condition that could result in audit firms absorbing much of the
cost of business risk is price elastic demand arising from an excess supply
of auditors. If this is the case, the audit firm must withdraw from the engagement of a risky client or accept lower profits. Another option, which
may maintain the current profitability of the audit, is to lower the cost of
audit production, either through technological innovation, or by reducing
the level of assurance provided.
1 Legal costs associated with business risk comprise a variety of direct costs, including judg-

ment and settlement costs, attorneys' fees, as well as a variety of indirect costs, including management's opportunity costs, regulatory sanctions, and the loss of professional reputation.
2 Morgan and Stocken [1998] develop a theoretical model in which cross-subsidization
of business risk from high business risk clients to low business risk clients is an equilibrium
outcome.

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AUDITORS' PERCEIVED BUSINESS RISK AND AUDIT FEES

37

Using data from the audit workpapers of a sample of 422 U.S. audits performed in 1989, we conduct cross-sectional tests of the relation between
audit fees and business risk as perceived by the auditor. We find evidence
that audit fees are increasing in the engagement partners' assessments of
business risk. However, the increase in audit fees arises solely from an increase in audit hours. The audit fee charged per hour is unchanged. This
finding implies that firms perceive firm-level differences in business risk
and obtain compensation through working additional hours. We find no
evidence that a risk premium is earned through higher hourly fees.

2. ResearchDesign
2.1 REGRESSION MODELS

We expect that auditors will recover the cost of business risk by adjusting
the price per unit of audit service. In addition, if more work reduces the
probability of litigation costs arising from business risk, the expected costs
associated with business risk are endogenous and the quantity of audit hours
also varies with business risk.3Thus, we predict that both the audit price and
the quantity of audit hours will be increasing in business risk.
We measure audit fees both in aggregate, i.e., quantity x price-DOMBILLD
(domestic billings), and in components, i.e., quantity-DOMHRS (domestic
hours), and price-FEEPER HOUR (DOMBILLD/DOMHRS). Our tests are
conducted using a log-linear form similar to that employed by O'Keefe,
Simunic, and Stein [1994].
lnfi = Bo + BIlnAi ?+

BiyilnAi

(1)

where fdenotes audit fees, A is client size, and y represents all other client
characteristics, including perceived business risk, for client i.4 This specification emphasizes size as the principal determinant of audit effort with the
remaining independent variables reflecting the curvature of the size relationship. However, as in O'Keefe, Simunic, and Stein [1994], our results are
not dependent on the size interaction.5
3 In the extreme case, an auditor may decline a new engagement, or withdraw from an
existing engagement, upon learning that the business risk exposure is excessive. The AICPA,
in its 1993 Audit Risk Alert, GeneralUpdateon Economic,Regulatory,and Accountingand Auditing
Matters,states: "Successful audits are a result of a number of factors, including acceptance of
clients with integrity...." See Huss and Jacobs [1991] for discussion of an examination of
pre-engagement decision processes and risk containment programs by independent auditors.
4 When audit fees are measured using price (FEE PER HOUR), we do not state the dependent variable in natural logarithms because it is already size adjusted.
5 Consistent with prior studies, e.g., O'Keefe, Simunic and Stein [1994], we assume that
the audit pricing model is a function of only immediate audit expenses and revenue. To the
extent future expenses and revenues impact current audit prices, the model is mnisspecified.
Moreover, care should be exhibited in drawing inferences from empirical tests which rely on
a single year of expenses and revenue data.

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T. B. BELL, W. R. LANDSMAN, AND D. A. SHACKELFORD

38

Audit fees (DOMBILLD) likely are measured with little error because
they are subject to the external discipline of the client. Conversely, the
components-quantity (DOMHRS) and price (FEE PER HOUR)-may be
measured with error because they are principally for internal management
purposes. For example, on a fixed fee engagement, auditors may underreport their hours if their performance is evaluated relative to budgeted
hours. If so, quantity will be understated and price will be overstated.
The explanatory variables include a measure of perceived business risk
(BUSRISK), which is detailed below, and the same set of explanatory variables used by O'Keefe, et al. [1994]: total assets (ASSETS) as a measure of
client size, the percentage of foreign to total assets (FRGN), operational
complexity (CMPLX), number of separate audit reports (TREPORTS), liabilities to assets (LEVERAGE),SEC filing status (PBLC), and inherent risk
(INHRISK).
2.2 DATA DESCRIPTION

We estimate the relation between audit fees and auditor business risk
using confidential data from 422 U.S. audits performed by an international
public accounting firm in 1989. The audit firm gathered these data from
firm-specific audit workpapers through a survey of its audit engagement
partners in charge of a stratified random sample of 1,000 audits (100 from
each of 10 broad industry categories). The survey was conducted for internal management purposes, independent of our research.6 Responses were
reviewed by firm management.7 All data relate to 1989 audits and 1989
financial disclosures.
The staff received 606 responses. We deleted responses that did not relate
to full- scope financial statement audits (e.g., limited reviews) and those that
had missing data. To ensure data accuracy,for publicly-traded firms we crossmatched financial statement data extracted from the audit workpapers with
publicly-availablefinancial statement disclosures. Four- hundred-twenty-two
survey responses remain and are the target of this investigation.
Table 1 presents descriptive sample statistics for the 422 audits. The
median audit was conducted on a company with $22 million in assets
(ASSETS), $5 million in owners' equity (EQUITY), $17 million in sales
(SALES), and $434 thousand in operating income (OPERATING INCOME). The median company has experienced cumulative 20-percent
6

The data are the confidential property of the audit firm.

7 The survey was completed following the annual audit. Ideally, ex ante estimates of the

auditor's business risk and other factors would be available. However, anticipation of litigation
risk prior to the completion of the audit is not necessary to recover expected litigation costs. For
the purpose of testing the incidence of expected litigation costs, it does not matter whether the
auditor perceives high risk before, during, or at the end of the audit. What matters is whether
the auditor perceives high risk by the end of the audit, and whether the auditor is able to
recover some of the expected cost associated with the risk. We assume that any biases arising
if the partner's assessment of the firm characteristics changed after setting the audit fees are
uncorrelated with the variables of interest in this study.

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AUDITORS' PERCEIVED BUSINESS RISK AND AUDIT FEES

39

1
TABLE
for 422 Audits,
Audit Workpapers
fromn1989 Proprietary
DescriptiveStatisticsof SelectedVariables
CollectedThroughSurveyof Audit EngagementPartners
Maximuirn
Median
Minimum
Std Dev
Mean
8,115,120
69
21,840
530,885
150,313
ASSETS ($000s)
2,476,190
4,568
-444,921
177,272
34,882
EQUITY ($000s)
15,097,500
17,191
26
854,401
130,223
SALES ($000s)
320,000
434
-180,080
22,853
1,903
OPERATINGINCOME ($000s)
837%
20%
-91%
92%
44%
SALESGROWTH
75
6
0
8
8
#YEARS CLIENT
8%
NEW CLIENT
2%
NEW COMPANY
83%
UNQUALIFIED OPINION
445
30
3
64
52
DOMBILLD ($000s)
535
9,250
103
984
839
DOMHRS
$235
$59
$17
$20
$62
FEE PER HOUR
65%
0
0
7%
1%
FRGN
5
3
1
1.0
2.5
CMPLX
25
1
1
2.7
2.4
TREPORTS
463%
73%
0
43%
72%
LEVERAGE
17%
PBLC
5%
INHRISK
6%
BUSRISK
ASSETSis totalassetsinvestedin domesticoperations;EQUITYis totalconsolidatedshareholders'equity;
SALESis total consolidated revenue; OPERATINGINCOME is income (loss) from continuing operations on
consolidated basis; SALESGROWTH is percentage change in sales over two-yearperiod; # YEARSCLIENT
is the nuniber of years that the company has been a client; NEW CLIENT is one if the firm is a new client;
otherwise zero; NEW COMPANYis one if 1989 was the first year that the company existed, otherwise zero;
UNQUALIFIED OPINION is one if the audit opinion is unqualified with or without explanatory paragraph
for accounting changes or lack of consistency; otherwise zero; DOMBILLD is the total fees billed for audit
work on domestic operations (in thousands); DOMHRS is the total audit hours for the client's domestic
operations; FEE PER HOUR is DOMBILLD/DOMHRS; FRGN is the percentage of foreign to total assets;
CMPLX measures operational complexity on a five point ordinal scale where 1 denotes "verysimple" and 5
denotes "verycomplex"; TREPORTS is the total number of separate audit reports related to current audit
engagement; LEVERAGEis the client's total liabilities to total assets; PBLC is a categorical variable where 1
is a client with publicly traded debt or equity securities and 0 otherwise; INHRISK is a categorical variable
where 1 indicates perceived high inherent risk for the client; and BUSRISKis a categorical variable where
1 indicates perceived high business risk for the client.

growth in sales over the past two years (SALES GROWTH) and has been
a client of the audit firm for six years (# YEARS CLIENT). Two percent
of the sample are newly incorporated companies (NEW COMPANY).Eight
percent are new clients (NEW CLIENT). Eighty-three percent received an
unqualified opinion (UNQUALIFIED OPINION).
The audit of the domestic operations for the median sample firm
was conducted in 535 hours (DOMHRS). The median audit fee was $30
thousand (DOMBILLD). The median fee per hour (FEE PER HOUR) was
$59. Most firms have no foreign assets but the percentage of foreign to total
assets (FRGN) ranged up to 65 percent. The sample includes firms with
a wide range of operational complexity (CMPLX). The auditor produced
one audit report for the median firm (TREPORTS), but the total ranged
up to 25. The median firm has a debt-to-asset ratio (LEVERAGE)of 0.73.
Seventeen percent have publicly-traded equity or debt securities (PBLC).

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40

T. B. BELL, W. R. LANDSMAN, AND D. A. SHACKELFORD

Clients are drawn from many industries, with 23 percent in manufacturing,

and 17 percent in the financial services industries.
We measure inherent risk by the engagement partner's answer to the
following question: What is your assessment of the overall risk that a material
error will occur in the client's accounting process-low, average, or high?
Survey respondents classify 37 percent of the audit clients as low inherent
risk, 58 percent as average, and 5 percent as high. Our inherent risk measure,
INHRISK,equals one if the partner assesses that the client has high inherent
risk.
We measure perceived auditor business risk by the engagement partner's
answer to the following question: What is your assessment of the firm's risk
of litigation, sanctions imposed by regulatory bodies or impaired professional reputation due to association with this client-low, average, or high?
Respondents classify 44 percent of the audit clients as low auditor business
risk, 50 percent as average, and 6 percent as high. As with the measure of
inherent risk, auditors' perceived business risk, BUSRISK,equals one if the
partner assesses that the client has high business risk.8
Equation (1) shows each explanatory variable interacted with client size,
which we measure as the natural logarithm of clients assets. We predict a
positive coefficient on the interaction of BUSRISK and size, which we will
interpret as evidence that audit fees are increasing in business risk.

3. RegressionResults
3.1 PRINCIPAL FINDINGS

Table 2 presents regression summary statistics. Column A indicates that

the coefficient on BUSRISK* ln(ASSETS) is positive when the dependent
variable is the natural logarithm of total domestic audit fees (DOMBILLD).
This finding is consistent with audit revenues increasing in perceived business risk.
Columns B and C report results using disaggregated audit fees. In
Column B, the dependent variable is the natural logarithm of quantity
of domestic audit hours (DOMHRS). Consistent with our predictions, the
BUSRISK*In (ASSETS) coefficient in Column B is positive and significantly
greater than zero. This finding is consistent with the quantity of audit hours
increasing in perceived business risk.
In Column C, the dependent variable is the effective audit price
per hour billed (FEE PER HOUR). Contrary to expectations, the
BUSRISK* ln(ASSETS) coefficient in Column C is not significantly different from zero, indicating that the audit price is not increasing in perceived
business risk.
When the dependent variable is total audit fees or total audit hours,
the coefficients on the control variables are similar to those reported in
8 None of our experimental inferences is altered when the two measures are entered separately instead of combined.

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AUDITORS' PERCEIVED BUSINESS RISK AND AUDIT FEES

41

TABLE 2
OrdinaryLeastSquaresRegressionCoefficients(t-Statistics)
from CorrelationTestsBetweenAudit Fees
and PerceivedHigh BusinessRisk;ProprietaryDatafromn1989Audit WorkMapers
for 422 Audits;
CollectedThroughSurveyof AuditEngagementPartners
Regression model: dependent variable = Bo + Bs in ASSETSi+ ZBziy in ASSETSj
Dependent Variable

Intercept
ln(ASSETS)
FRGN * ln(ASSETS)
CMPLX* In(ASSETS)
TREPORTS In(ASSETS)
LEVERAGE' in (ASSETS)
PBLC In(ASSETS)
INHRISKt In(ASSETS)
BUSRISK In(ASSETS)
Adj. R2

A
Fees Billed
In(DOMBILLD)
8.381
(48.1)
0.115
(5.1)
0.002
(4.0)
0.027
(8.5)
0.004
(3.7)
-0.003
(-0.5)
0.019
(2.5)
0.049
(3.6)
0.025
(2.2)
0.58

B
Total Hours
ln(DOMHRS)
4.479
(28.5)
0.094
(4.7)
0.001
(3.7)
0.028
(10.0)
0.004
(4.1)
-0.001
(-0.1)
0.011
(1.7)
0.048
(3.9)
0.026
(2.5)
0.60

C
FEE PER
HOUR
45.422
(7.6)
2.218
(2.9)
0.019
(1.3)
-0.190
(-1.8)
-0.015
(-0.4)
-0.251
(-1.1)
0.470
(1.8)
-0.068
(-0.2)
-0.031
(-0.1)
0.04

DOMBILLD is the total fees billed for auldit work on domestic operations (in thousands); DOMHRS
is the total aticlit hours for the client's domestic operations; FEE PER HOUR is DOMBILLD/DOMHRS;
ASSETS is total assets invested in dromestic operations; FRGN is the percentage of foreign to total assets;
CMPLX measures operational complexity on a five point ordinal scale where 1 denotes "verysimple" and 5
denotes "verycomplex"; TREPORTS is the total number of separate audit reports related to current audit
engagement; LEVERAGEis the client's total liabilities to total assets; PBLC is a categorical variable where 1
is a client with publicly traded debt or equity securities and 0 otherwise; INHRISK is a categorical variable
where 1 indicates perceived high inherent risk for the client; and BUSRISKis a categorical variable where
1 indicates perceived high business risk for the client.

O'Keefe, Simunic, and Stein [1994], except the LEVERAGE* ln(ASSETS)

coefficient is not significantly different from zero. A possible explanation
for this difference is that O'Keefe, Simunic, and Stein [1994] exclude financial institutions, whereas our sample includes both industrial and financial
companies.

Conversely, in the FEE PER HOUR model, the size variable (ASSETS) is
the only coefficient that is significantly positive at the 0.01 level. This finding
indicates that the quantity of hours audit firms work and the amount they bill
are more sensitive to both business risk perception and the control variables
than the effective audit price per hour billed. Thus, it is not surprising that
the results from the DOMBILLD and DOMHRS estimations are similar because FEEPER HOUR is relatively constant across the explanatory variables.
Additional unreported analyses disaggregate the audit hours among partners, managers, senior and staff. We find that the BUSRISK* ln (ASSETS)

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42

T. B. BELL, W. R. LANDSMAN, AND D. A. SHACIKELFORD

coefficient is alwayspositive, but significant only for higher-cost factor inputs,

i.e., partners, managers, and seniors, not staff. It appears that the more experienced auditors conduct the additional work on high business risk clients.
3.2

SENSITIVITY TESTS

We conduct six sensitivity tests to determine whether our findings are

robust to alternative specifications. First, because we are unable to specify the "correct" theoretical audit pricing model, and BUSRISK could be
correlated with a variety of linear combinations of the control variables, we
reestimate all three models (DOMBILLD, DOMHRS, and FEEPER HOUR)
using numerous combinations of seven randomly selected variables from the
survey data base compiled by the audit firm as control variables. This "bootstrapping"approach confirms our findings. Among the 345 regressions that
we estimate using the random control variables, none produce a coefficient
on BUSRISK* In(ASSETS) that is significantly different from zero in the
FEE PER HOUR regression.
Second, a possible explanation for the insignificance of the BUSRISK*
ln (ASSETS) coefficient in the FEE PER HOUR model is multicollinearity
between it, PBLC, LEVERAGE,and INHRISK. We test an additional specification by dropping these control variables. This does not change the conclusions regarding business risk and unit audit price.
Third, to assess whether business risk differentially affects the audit fees
for public and private companies, we estimate the three primary regressions
with an additional variable, BUSRISK* ln(ASSETS) interacted with PBLC.
The coefficient on the interaction term is never significantly different from
zero.
Fourth, to learn whether the findings are attributable to failure to control
for potential differences between industrial and financial companies, we estimate the equations using the control variables from O'Keefe, et al. [1994]
for non-financial clients and the variables from the model presented in
Stein, Simunic, and O'Keefe [1994, p. 140] as controls for financial clients.
Inferences for BUSRISK*ln (ASSETS) are unaffected by the inclusion of
these industry variables.9
Fifth, to further examine the inclusion of both industrial and financial companies, we restrict the sample to industrial companies, as in
O'Keefe, Simunic, and Stein [1994]. In this specification the coefficients for
BUSRISK* ln (ASSETS) are not significantly different from zero in any regression. However, when the sample is segregated by employee status (i.e.,
partners, managers, seniors, and staff), as in O'Keefe et al. [1994], the
BUSRISK* ln(ASSETS) coefficient is significant for every employee group,
except staff fees or staff hours. As usual, the BUSRISK* in (ASSETS) coefficient is never significantly different from zero when the dependent variable
9 We also test for industry differences for financial institutions and all other major industry
classifications in our sample using industry categorical variables. Our findings are robust across
all major industry classifications.

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AUDITORS' PERCEIVED BUSINESS RISK AND AUDIT FEES

43

is FEE PER HOUR. These findings are consistent with firms increasing partner, manager, and senior hours (and thus fees) when they perceive high
business risk, but not altering staff inputs.
Finally, the log-linear specification in equation (1) emphasizes size as
the principal determinant of audit effort with the remaining independent
variables modeled to reflect the curvature of the size relationship. Inferences
are unaltered if the model is estimated in linear form. Conclusions also are
insensitive to whether size is interacted with the other independentvariables.

3. Concluding Remarks
This study analyzes the relation between auditors' perceived business risk
and audit fees. We predict that hourly audit fees and the number of audit
hours are increasing in business risk. Using audit data from a large international accounting firm, we find evidence that the firm increases the number
of audit hours, but not the fee per hour in the presence of high business risk.
This finding is consistent with both firms indirectly purchasing defensibility
through additional auditing and obtaining a direct risk premium through
additional profits.10Both interpretations are consistent with a positive correlation between business risk and audit fees. The paper provides some initial
insights into the relation between business risk and the structure of audit
fees. Additional research is needed to understand better the audit industry,
and audit pricing, and the influence of business risk on both.
REFERENCE
Huss, H. F., AND F. A. JACOBS."RiskContainment: Exploring Auditor Decisions in the Engagement Process." Auditing:A Journal of Practice& Theory(Fall 1991): 16-32.
MORGAN, J., AND P. STOCKEN. "The Effects of Business Risk on Audit Pricing." Review of
Accounting Studies 3(3) (1998): 365-385.
O'KEEFE, T. B.; D. A. SIMUNIC; AND M. T. STEIN. "The Production of Audit Services: Evidence from a Major Public Accounting Firm."Journal of AccountingResearch (Autumn 1994):
241-261.
STEIN, M. T.; D. A. SIMUNIC;AND T. B. O'KEEFE. "Industry Differences in the Production of
Audit Services." Auditing: A Journal of Practice & Theory (Supplement 1994): 128-142.

10 The finding also supports the predictions of incomplete business risk pricing in Morgan

and Stocken [1998].

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