Assessing auditors' business risk.

Abstract

This study estimates the effect that the auditor's assessment of his business risk has on his acquisition of evidence and his pricing of audit services. Auditor's business risk (ABR) is defined as the uncertainty in the auditor's cash flows that arises because there is some probability of the auditor incurring a loss from litigation, adverse publicity or other events arising in connection with his examination of the client's financial statements. The portion of ABR that evidence can reduce is referred to as evidence-sensitive ABR. The portion of ABR that cannot be reduced with evidence is referred to as insurance ABR. The auditor is expected to respond to evidence-sensitive ABR by acquiring costly evidence and to insurance ABR by including a risk premium in his fee offer. Both the amount of evidence and the risk premium are expected to affect the auditor's offer. Audit effort is used to measure evidence and the price per unit of effort is used to measure the risk premium. Audit effort is hypothesized to be positively correlated with evidence-sensitive ABR. The price per unit of effort is hypothesized to be positively correlated with insurance ABR. The regression results support both hypotheses. All four variables selected to represent evidence-sensitive ABR have positive coefficients as predicted. Three of the evidence-sensitive ABR variables are significant at the 0.01 level and the fourth is significant at the 0.06 level. Four of the five variables selected to capture insurance ABR have positive coefficients as predicted. The levels of significance for these coefficients range from 0.01 to 0.13. An unexpected result is that the fifth variable, relating to a client as a going concern, has a negative and significant coefficient.