Do adjustments bring auditors peace of mind? The effect of previous audit adjustments on current-year audit pricing

Purpose: This paper aims to investigate the effect of prior years’ audit adjustments, a proxy for auditors’ private information regarding the persistence of their clients’ audit risk, on audit pricing in the current year. Design/methodology/approach: The authors use unique data sets of audit adjustments and audit fieldwork days from China, and a regression approach, to test their hypothesis. Findings: The authors find that larger previous audit adjustments are associated with higher current-year audit fees, which is partially attributed to increased audit effort. The authors further document that the results are more pronounced when audit adjustments are consistently made in the same direction or more recent; in these cases, a larger percentage of the total effect is also attributable to the risk premium, instead of audit effort. Finally, the authors find that the effect of previous audit adjustments on current-year audit fees is stronger for firms with younger chief executive officers and specialist auditors. Originality/value: To the authors’ best knowledge, they are the first to test the implication of auditors’ private information in setting audit fees. In addition to demonstrating that audit fees consist of a risk premium and a component to cover related costs, the authors further show variations in the relative importance between costs and risk premium under various contexts.