Audit Pricing, Legal Liability Regimes, and Big 4 Premiums: Theory and Cross‐country Evidence*

Abstract

In this paper, we first develop a model in which national legal environments play a crucial role in determining auditor effort and audit fees. Our model predicts that (a) audit fees increase monotonically with the strength or strictness of a country's legal liability regime; (b) given a legal liability regime, Big 4 auditors charge higher audit fees than non-Big 4 auditors; and (c) the Big 4 fee premium is lower in countries with strong legal regimes than in countries with weaker legal regimes. We then test the model's predictions using a large sample of audit clients from 15 countries with different legal regimes where audit fee data are publicly available. The results of our cross-country regressions are consistent with the above three predictions and are robust to a variety of sensitivity checks. In addition, our hypotheses are all consistent with the pattern of auditor effort (measured by labor hours) observed in proprietary data sets from four countries whose legal regimes vary. Finally, we find that the effects of a legal regime on audit pricing and the Big 4 premium are more salient for the small client segment than for the large client segment. Overall, our results indicate that a country's legal environment plays an important role in determining auditor effort, audit fees, and the fee spread between Big 4 and non-Big 4 auditors. © CAAA.