THE IMPACT OF LITIGATION RISK ON AUDIT PRICING - A REVIEW OF THE ECONOMICS AND THE EVIDENCE

This study investigates the relationship between audit pricing and lit igation risk. The main question posed in the research is: Are audit fe es adequate to compensate auditors for litigation risk? The answer to this question is an essential element in assessing the severity and im plications of the liability crisis in auditing. The paper approaches t he question in several stages. First, there is an economic analysis of audit pricing. Second, there is a review and reinterpretation of the empirical literature related to audit pricing. Lastly, new evidence is provided from a sample of 249 audits done by a Big 6 auditor. The mai n results from these analyses are: increased litigation is likely to r esult in a demand displacement from high-quality to low-quality audito rs; the archival evidence suggests that audit fees do reflect variatio ns in litigation risk and that there is some evidence of the predicted demand displacement; and the evidence from the audits included in the sample suggests the incremental contribution margin from the change i n audit fees attributable to litigation risk factors appeared to be ad equate to cover the costs of litigation for the audit firm performing the audits during the period studied.