RISK ADJUSTED AUDIT PRICING: THEORY AND EMPIRICAL EVIDENCE (OPTION PRICING)

Most scholars agree that auditing has multiple roles. However, the insurance role of auditing (insurance hypothesis) has received considerable attention lately. This thesis studies how the recent surge in audit lawsuits affects audit practices. I use the option pricing modelling methods to study the insurance hypothesis of auditing. Empirical hypotheses are then generated based on the theoretical model. I perform the empirical tests mainly through the analysis of audit fee data during 1988 and 1992 in countries which require audit fee disclosure in their financial statements.; In brief, empirical results suggest that despite the recent surge in audit lawsuits, auditors mainly perform a role of alleviating information asymmetry. Proxies for information risks, as used in this study, affect audit pricing significantly and consistently across all countries. The insurance proxies, however, have explanatory power only in countries with well-documented audit lawsuits. Moreover, empirical evidence is inconsistent with the argument that the recent litigation surge has reached a global crisis level. For example, many countries studied are found to have reported net decreases in audit fees.; Strict audit liability concept is also found to be economically unfeasible. Average audit fee is currently only a tiny fraction of the implied liability. To convert the currently due diligence based liability regime to a strict liability regime would require fee increases of a phenomenal scale. Despite many arguments against the recent tide of audit litigation, audit lawsuits are probably the most effective tool for investors to enforce higher precision standards. Countries experiencing audit litigation problems invariably have more rigorous auditing standards. However, their audit fees are also much higher. The crux in alleviating the litigation crisis is to locate a cost and precision level which is acceptable to all parties.