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The Impact of Litigation Risk on Auditor Pricing Behavior: Evidence From Reverse Mergers

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  • Lawrence J. Abbott
  • Katherine Gunny
  • Troy Pollard

Abstract

We use reverse mergers to examine the impact of litigation risk on audit fees. In a reverse merger, a private company merges with a public company, and the private company's management takes over the resulting publicly traded firm. Reverse mergers create a unique test setting to provide estimates on the litigation risk premium because, while the litigation risk for formerly private firms whose equity becomes publicly traded increases, the remaining auditee†and auditor†related characteristics remain virtually unchanged. We document a litigation risk premium of approximately 27 percent. Moreover, we document that equity dispersion impacts the audit fee pricing of litigation risk and this relation is dramatically magnified in the publicly traded realm. Finally, we find that institutional investors demand higher audit effort in the form of higher audit fees in both the private†and public†equity settings.Les auteurs ont recours aux fusions inversées pour étudier l'incidence du risque de litige sur les honoraires d'audit. Dans une fusion inversée, une société fermée fusionne avec une société ouverte, et la direction de la société fermée prend le contrôle de la société faisant appel public à l’épargne issue de l'opération. Les fusions inversées offrent des conditions exclusives d’étude visant la production d'estimations au sujet de la prime de risque de litige, car, même si le risque de litige augmente pour les sociétés auparavant fermées dont les titres seront désormais cotés en Bourse, les autres caractéristiques de l'audité et de l'auditeur demeurent pratiquement inchangées. Les auteurs constatent l'existence d'une prime de risque de litige d'environ 27 pour cent. De plus, ils observent que la dispersion des capitaux propres a une incidence sur l'intégration du risque de litige dans l’établissement des honoraires d'audit, cette relation se trouvant considérablement amplifiée dans l'univers des sociétés faisant appel public à l’épargne. Enfin, les auteurs constatent que les investisseurs institutionnels exigent un effort d'audit plus grand qui se traduit par des honoraires d'audit plus élevés, dans le contexte tant de sociétés à capital fermé que de sociétés à capital ouvert.

Suggested Citation

  • Lawrence J. Abbott & Katherine Gunny & Troy Pollard, 2017. "The Impact of Litigation Risk on Auditor Pricing Behavior: Evidence From Reverse Mergers," Contemporary Accounting Research, John Wiley & Sons, vol. 34(2), pages 1103-1127, June.
  • Handle: RePEc:wly:coacre:v:34:y:2017:i:2:p:1103-1127
    DOI: 10.1111/1911-3846.12300
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    Cited by:

    1. Wen, Fenghua & Chen, Meng & Zhang, Yun & Miao, Xiao, 2023. "Oil price uncertainty and audit fees: Evidence from the energy industry," Energy Economics, Elsevier, vol. 125(C).
    2. Jingyu Yang & Hai Wu & Yangxin Yu, 2021. "Distracted institutional investors and audit risk," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 61(3), pages 3855-3881, September.
    3. Mercedes Mareque & Angel Barajas & Francisco Lopez-Corrales, 2018. "The Impact of Union of European Football Associations (UEFA) Financial Fair Play Regulation on Audit Fees: Evidence from Spanish Football," IJFS, MDPI, vol. 6(4), pages 1-20, November.
    4. Hsieh, Tien-Shih & Kim, Jeong-Bon & Wang, Ray R. & Wang, Zhihong, 2020. "Seeing is believing? Executives' facial trustworthiness, auditor tenure, and audit fees," Journal of Accounting and Economics, Elsevier, vol. 69(1).
    5. Yiwei Li & Wei Song & Tingyu Sun & Qingjing Zhang, 2023. "The impact of shareholder litigation risk on income smoothing," Review of Quantitative Finance and Accounting, Springer, vol. 61(4), pages 1379-1413, November.

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