Japan's Big 3 Firms' Response to Clients' Business Risk: Greater Audit Effort or Higher Audit Fees?

This study examines whether and how the Big 3 audit firms in Japan respond to clients' business risk and whether their responses vary. Two possible approaches to addressing clients' higher business risk are increasing audit effort (e.g., increasing total audit hours or assigning more experienced staff to the audit team) and charging a risk premium to cover possible future losses without increasing audit effort. Although the auditing standards and audit fee determination guidelines issued by the Japanese audit profession apparently assume that an auditor chooses the first approach to respond to clients' high business risk, the approach adopted by each Big 3 firm is an empirical issue. By analyzing data on audits conducted by the Big 3 Japanese firms using structural equation modeling and ordinary least squares regression, we find that responses to clients' higher business risk vary among the firms. While two of the firms increase audit effort and charge a risk premium for audits with higher business risk, the third firm responds to clients' business risk only by increasing audit effort. In addition, the strength of the relationships between clients' business risk and audit effort/fees varies among the firms.