The Association Between Financial Reporting Risk and Audit Fees Before and After the Historic Events Surrounding SOX

Abstract

This study investigates whether the association between financial reporting risk and audit fees changed during 2000-2003: a time period marked by momentous and historic events for auditors. We find a positive statistically and economically significant relationship between financial reporting risk and audit fees paid to Big 4 auditors. More importantly, we predict and find that the relation between financial reporting risk and audit fees strengthened significantly in 2002 and 2003, consistent with a shift in the way auditors priced risk, likely in response to the events surrounding the Sarbanes-Oxley Act of 2002. Finally, we provide evidence that a commercially developed, comprehensive risk measure effectively proxies for an element of risk beyond what has traditionally been captured by various risk measures in audit fee models: namely, the risk that financial statements have been intentionally misstated. We believe this risk measure will be of interest to future researchers.

Keywords: audit fees, financial reporting risk, audit risk, Sarbanes-Oxley

JEL Classification: M49, M41, M43, G38