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The Effects of Endogenous Information Acquisition about Business Risk on Audit Pricing

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This paper examines the pricing of business risk by homogeneous auditors in a two-period model. Incumbent auditors optimally determine the amount of information to acquire about the business risk of a client. They subsequently compete in prices with prospective auditors. In such an environment, we show that there exists differential auditor turnover between high and low risk firms; cross-subsidization of the audit fees of high risk firms by low risk firms; and low-balling by auditors. Moreover, we show how changes in the timing and magnitude of litigation events as well as cyclical changes in the business risk environment affect information acquisition and consequent audit pricing be- havior.
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