Do Auditors Charge a Risk Premium? Evidence from the Association between Derivative Hedging and Audit Fees

44 Pages Posted: 23 Aug 2018

See all articles by Tharindra Ranasinghe

Tharindra Ranasinghe

American University

Lin Yi

University of Houston, Clear Lake

Ling Zhou

University of New Mexico

Date Written: July 13, 2018

Abstract

Although prior literature has documented a positive association between business risk and audit fees, it remains unclear whether, in addition to expending greater audit effort on riskier clients, auditors also charge a risk premium. This is an important issue because a risk premium is a deadweight loss. We examine this issue in the context of hedging derivative usage in the U.S. oil and gas exploration and production industry. While derivative hedging reduces business risk, the auditing of derivative instruments requires greater auditor effort. Consistent with the existence of a risk premium in audit fees, we find a negative relationship between the extent of hedging and audit fees. This relationship is weaker when the derivative instruments held by firms are less effective in offsetting the underlying risks and when internal control weaknesses prompt auditors to increase their efforts on auditing of derivative instruments. We contribute to the literature by documenting a deadweight component in audit fees that is unrelated to audit quality.

Keywords: audit fees, economics of auditing, derivatives, hedging, risk management

JEL Classification: G32, L71, L84, M41, M42

Suggested Citation

Ranasinghe, Tharindra and Yi, Lin and Zhou, Ling, Do Auditors Charge a Risk Premium? Evidence from the Association between Derivative Hedging and Audit Fees (July 13, 2018). Available at SSRN: https://ssrn.com/abstract=3229910 or http://dx.doi.org/10.2139/ssrn.3229910

Tharindra Ranasinghe (Contact Author)

American University ( email )

United States

Lin Yi

University of Houston, Clear Lake ( email )

2700 Bay Area Blvd. Box 42
Houston, TX 77058
United States

Ling Zhou

University of New Mexico ( email )

107 Humanitites Building
Albuquerque, NM 87131-1221
United States
(505)277-0335 (Phone)

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