Judicial hellholes and other differential characteristics: is state-level legal risk reflected in audit fee pricing?

Abstract

Purpose This study aims to examine the effect of state-level legal risk on audit fee pricing in the USA. This study hypothesizes that auditors are more likely to charge higher audit fees to clients headquartered in states with higher legal risk in terms of probability of being sued, expected size of damages allocated to the auditors and breadth of third parties able to claim damages. Design/methodology/approach This study hypothesizes that higher state-level legal risk leads to higher audit fees. To test this, this study estimates ordinary least squares regressions of audit fees for 56,576 company years from 2001 to 2018 with the three measures of state legal risk and other factors known to affect audit fees. Findings This study finds that state-level legal risk is positively associated with audit fee pricing for two of three measures. Interestingly, the third measure, breadth of third parties able to claim damages, is negatively associated with audit fees. Originality/value To the best of the authors’ knowledge, this paper fulfills an identified need and is the first study to comprehensively test the association between state-level differentials in legal risk and audit fees.