Do Auditors Charge a Client Business Risk Premium? Evidence from Audit Fees and Derivative Hedging in the U.S. Oil and Gas Industry

Forthcoming, Review of Accounting Studies

54 Pages Posted: 23 Aug 2018 Last revised: 20 Oct 2021

See all articles by Tharindra Ranasinghe

Tharindra Ranasinghe

American University

Lin Yi

University of Houston, Clear Lake

Ling Zhou

University of New Mexico

Date Written: October 1, 2021

Abstract

Prior literature finds that auditors charge higher fees for riskier clients. One reason for this is that auditors expend greater audit effort on riskier clients. However, it is unclear whether they also charge an additional client business risk premium. We investigate this issue employing a detailed, hand-collected dataset of hedging derivative usage by U.S. oil and gas exploration and production firms. Even though the auditing of derivative instruments requires greater auditor effort, hedging significantly reduces client business risk. Consistent with the presence of a client business risk premium in audit fees that gets attenuated when clients reduce their risks by employing derivative hedging, we find a negative association between audit fees and the extent of derivative hedging by clients. Further underscoring the role of risk reduction in this relationship, we find the above negative association to be weaker when the risk management efficacy of derivative instruments is comparatively lower. This negative association is also weaker when effort expended in auditing derivatives is likely to be especially high. We contribute to the literature by providing strong evidence for the presence of a client business risk premium in audit fees.

Keywords: Audit fees, economics of auditing, client business risk, derivatives, hedging, risk management

JEL Classification: G32, L71, L84, M41, M42

Suggested Citation

Ranasinghe, Tharindra and Yi, Lin and Zhou, Ling, Do Auditors Charge a Client Business Risk Premium? Evidence from Audit Fees and Derivative Hedging in the U.S. Oil and Gas Industry (October 1, 2021). Forthcoming, Review of Accounting Studies, Available at SSRN: https://ssrn.com/abstract=3229910 or http://dx.doi.org/10.2139/ssrn.3229910

Tharindra Ranasinghe (Contact Author)

American University ( email )

United States

Lin Yi

University of Houston, Clear Lake ( email )

2700 Bay Area Blvd. Box 42
Houston, TX 77058
United States

Ling Zhou

University of New Mexico ( email )

107 Humanitites Building
Albuquerque, NM 87131-1221
United States
(505)277-0335 (Phone)

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