External Auditor Reassessment of Client Business Risk Following the Issuance of a Comment Letter by the SEC

Following Arthur Andersen's conviction for obstructing justice, auditors faced a one-time significant change in their regulatory environment because it was clear that (i) major audit partnerships could be closed and (ii) post Sarbanes-Oxley Act (SOX), regulators would take a far more attentive (aggressive) role. In response auditors considered whether the pricing of audits should be revised to take account of the increased risk of regulatory intervention and litigation. Obviously such re-pricing would need to be targeted at those firms for which the risks were greatest. One early warning signal of such events occurring is the issuance by the Security Exchange Commission (SEC) of a Comment Letter (CL). We investigate whether there is any evidence that if a client receives a CL this is used to re-price audit services. Specifically, we investigate whether issuance resulted in upward pressure on audit fees, and whether this effect was simply transient around the issuance period or alternatively persisted some years into the future. This research finds that after a client receives a CL, auditors adjust audit fees upwards in the period in which the CL is received. In addition it is shown that for subsequent periods in which the auditor does not spend time assisting the client respond to a specific CL, an initial rise in audit fee persists. This is consistent with the hypothesis that auditors reassess the reputation and litigation risk of the client on the basis of the SEC issuance of a Comment Letter.