Litigation Risk, Audit Quality, and Audit Fees: Evidence from Initial Public Offerings

TLDR

The study investigates how auditor exposure to legal liability affects audit quality and audit fees in the IPO context. The authors analyze IPO audits to assess the relationship between litigation exposure and audit outcomes. They find that pre‑IPO audited accruals are more negative than post‑IPO accruals, auditors charge higher fees for IPO engagements, and a substantial portion of these fees is linked to litigation exposure, indicating that higher litigation risk is associated with both improved audit quality and higher fees.

Abstract

ABSTRACT: We use the IPO setting to examine the relation between auditor exposure to legal liability and audit quality and audit fees. With regard to audit quality, we report robust evidence that pre-IPO audited accruals are negative and less than post-IPO audited accruals. In contrast to extant literature, our findings provide scant support for the inference that auditors acquiesce to opportunistic earnings management by issuers in an attempt to increase the offering price. With regard to audit fees, we find auditors earn higher fees for IPO engagements than post-IPO engagements. While inherent differences in auditor responsibilities between IPO audits and post-IPO audits should lead to higher fees for IPOs, a substantial portion of IPO audit fees (in levels and changes) is associated with our proxy for the auditor’s 1933 Act exposure. Overall, our results suggest that both audit quality and audit fees are higher in a higher-litigation regime, consistent with the effects an increase in litigation exposure should have on auditor incentives.