Do Auditors Charge a Risk Premium? Evidence from the Association between Derivative Hedging and Audit Fees

Although prior literature has documented a positive association between business risk and audit fees, it remains unclear whether, in addition to expending greater audit effort on riskier clients, auditors also charge a risk premium. This is an important issue because a risk premium is a deadweight loss. We examine this issue in the context of hedging derivative usage in the U.S. oil and gas exploration and production industry. While derivative hedging reduces business risk, the auditing of derivative instruments requires greater auditor effort. Consistent with the existence of a risk premium in audit fees, we find a negative relationship between the extent of hedging and audit fees. This relationship is weaker when the derivative instruments held by firms are less effective in offsetting the underlying risks and when internal control weaknesses prompt auditors to increase their efforts on auditing of derivative instruments. We contribute to the literature by documenting a deadweight component in audit fees that is unrelated to audit quality