This study investigates whether an association between managerial opportunism and audit fees exists, and whether such an association differs according to the types of legal liability rule for auditors. Pratt and Stice (1994) report that auditors identify managerial background as the second-most important item affecting their assessment of litigation risk and suggest that future research addressing how risky clients affect auditors’ judgment of litigation risk would add to the existing understanding of the dynamics of audit pricing.
Prior research on the impact of management background on audit fees, however, has been sparse. Considering public accounting firms’ increasing litigation concerns in recent years, studies that examine the effect of management quality, specifically managerial opportunism pertaining to legal liability, on audit fees could make an incremental contribution to audit fee literature. In addition, an examination of this relation under different legal liability rules for auditors would provide some insight regarding how the effects of litigation risk and legal liability rule for auditors jointly determine audit fees.
We employ excess directors’ and officers’ (D&O) liability insurance coverage as a proxy for managerial opportunism. Most companies purchase D&O insurance to compensate managers for legal liability exposure resulting from their business decisions. D&O insurance also plays a governance role via the insurer’s scrutiny and coverage limits, and protects managers’ personal wealth from their risk-taking decisions made on behalf of shareholders (Holderness 1990; O’Sullivan 1997).
Yet, recent studies report that the purchase decision of D&O insurance or high D&O insurance coverage limits can be a proxy for managerial opportunism (e.g., Core 1997; Boyer and Delvaux-Derome 2002; Chalmers, Dann, and Harford 2002; Kim 2006; Chung, Wynn, and Yi 2008). Since firms would purchase D&O insurance coverage to approximate the expected legal liability, D&O insurance coverage can also capture litigation risk and the potential future losses (due to lawsuits against firms and managers). Thus, we use excess coverage beyond the expected coverage a firm would carry, after controlling for litigation risk.
Although D&O insurance is a common part of the compensation package for U.S. directors and officers, U.S. firms are not required by the SEC to disclose D&O insurance information in their filings. Consequently, we examine Canadian firms listed on the Toronto Stock Exchange between 2002 and 2004 because disclosures of D&O insurance coverage (and audit fees) are publicly available via a proxy circular of a firm.
The use of both Canadian firms cross-listed in the U.S. and firms with local listing only provides a natural setting to investigate the effect of different legal liability rules on audit pricing. Auditors of firms cross-listed in the U.S. are subject to the proportionate rule under which defendants are responsible for damages in proportion to the degree of their faults. In Canada, firms are subject to the joint and several liability rule. The joint and several liability rule requires that one defendant be responsible for all damages when other defendants are insolvent, regardless of the degree of his/her fault.
DeFond and Francis (2005) emphasize the importance of understanding the role of legal liability and litigation risk in achieving audit quality and suggest a comparative cross-country approach to the investigation of the research question. In the context of their discussion, the way in which litigation risk and legal liability rule for auditors jointly influence audit pricing decisions is an empirical question. Prior studies document an audit fee premium for client firms cross-listed in a strict legal regime (Seetharaman, Gul, and Lynn 2002; Choi, Kim, Liu, and Simunic 2006).
However, these studies assume that auditors’ expected legal liability increases due to high litigation risk in a strict legal regime, and do not consider the potential influence of the legal liability rule on auditors’ assessment of expected future losses and audit fees. Auditors of Canadian firms cross-listed in the U.S. face high litigation risk, but low or insignificant legal liability for managerial opportunism due to the proportionate rule. On the other hand, auditors of Canadian firms with local listing only face lower litigation risk, but high legal liability for managerial opportunism due to the joint and several liability rule. After controlling for litigation risk for firms cross listed in the U.S. markets, we examine whether the association between managerial opportunism and audit fess differs according to the legal liability rule.
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