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Litigation Risk and Audit Fees: The Impact of Qualitative Factors

Using D&O insurance premia from the 2001-2004 Tillinghast D&O insurance surveys as a proxy for litigation risk, we show that audit fees are positively associated with litigation risk even after controlling for several quantitative risk factors known to influence both the insurance premium and audit fee. We attribute this positive association to the parallel development of risk assessment expertise by both D&O insurers and auditors and to their overlapping sources of qualitative risk information. The significant association between D&O premia and audit fees also provides external validation for the auditor’s risk assessment process. Finally, we partition accounting firms based on their audit methodologies and find that the audit fees charged by risk-based auditors are more strongly associated with litigation risk than those charged by firms using more traditional audit approaches.