What If Auditing Was Not 'Low-Margin Business'? Auditors and Their IPO Clients as a Natural Experiment

Abstract

We use the IPO setting to examine the relation between the auditor's exposure to legal liability, audit fees and audit quality. Consistent with the increase in litigation liability that an IPO audit implies, we find that auditors earn much higher fees for IPO engagements than for first-year, post-IPO engagements. Moreover, these higher fees are strongly associated with our proxy for the auditor's litigation exposure under the 1933 Act, the size of the IPO. In addition, we find that pre-IPO accruals are significantly less than first-year post-IPO accruals. Overall, we find no evidence to suggest that IPO companies engage in opportunistic earnings management. Taken together, IPOs do not appear to be "low-margin" engagements for auditors, nor does it seem that auditors permit their IPO clients an increase in accounting discretion.

Keywords: Auditing, Litigation, Litigation risk, Abnormal accruals, Audit fees, Earnings management, Initial public offerings

JEL Classification: M49, M41, M43, K22, G24