How Auditors Price Business Risk : A Framework and Experiment

In this study, we develop and test a framework suggesting that auditors consider three sources of business risk when setting audit fees: (1) the level of audit investment and residual (acceptable) audit risk, (2) litigation exposure unrelated to audit risk, and (3) residual business risk. Residual business risk includes all risks and/or opportunities associated with the audit not captured by sources (1) and (2). We test the framework through an experiment with audit partners and managers. The results support the framework and suggest that audit fees reflect the different roles that auditors assume: auditor, insurer, and businessperson. We also discuss how researchers can apply the framework, especially residual business risk, to clarify some unresolved issues regarding audit fees and current issues faced by the audit profession