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  • Jennifer M Mueller-Phillips
    A Reexamination of Audit Fees for Initial Audit Engagements...
    research summary posted December 3, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 04.0 Independence and Ethics 
    Title:
    A Reexamination of Audit Fees for Initial Audit Engagements in the Post-SOX Period
    Practical Implications:

    The results of the study strongly suggest that initial-year audit discounts are quite common and substantial in the post-SOX period. Although the existence of lowballing seems to be a threat to independence, at least in appearance, the existing research on lowballing provides mixed results on its impact on audit quality. The findings will likely be of interest to the PCAOB as it searches for ways to bolster auditor independence and other regulators because many, including the GAO, believe that without non-audit service fees, auditors are less likely to offer ‘‘loss-leader’’ fees for audits.

    For more information on this study, please contact Rosemond Desir.

    Citation:

    Desir, R., J. R. Casterella, and J. Kokina. 2014. A Reexamination of Audit Fees for Initial Audit Engagements in the Post-SOX Period. Auditing: A Journal of Practice & Theory 33 (2):  59-78

    Keywords:
    Audit fees, auditor independence, lowballing, PCAOB
    Purpose of the Study:

    On August 16, 2011, the Public Company Accounting Oversight Board (PCAOB) issued a concept release seeking comments on ways to enhance auditor independence. The Board notes that higher failure rates in new audit engagements might be linked to unrealistic pricing. The Board’s concern is that a new auditor might be more susceptible to management pressure if initial-year audit fees are set artificially low.

    Prior to the passage of the Sarbanes-Oxley Act (SOX) of 2002, empirical evidence shows that auditors discounted their initial-year audit fees. This practice is known as lowballing and it occurs when auditors price initial-year audit fees lower for new clients with the expectation of increasing the fees substantially in later years in order to recoup their initial losses. Lowballing was expected to decrease significantly after the enactment of SOX.

    Indeed, findings of a study on audit pricing in initial-year audits seem to confirm that Big 4 auditors charged a fee premium on new auditor-client relationships in 2006. However, it is not clear if more recent post-SOX initial-year audits are free of lowballing. In the current study, the authors investigate whether lowballing exists in new auditor-client relationships in an ‘‘extended’’ post-SOX environment for the years 2007 to 2010. 

    Design/Method/ Approach:

    The authors analyze audit fee data for years 2006 through 2010 for publicly-traded companies that are Big 4 and non-Big 4 clients. The focus of the study is on initial audits following auditor dismissals as there are very few auditor resignations. The audit fee data were collected from Audit Analytics database and financial data – from Compustat.

    Findings:

    The results suggest that both Big 4 and non-Big 4 accounting firms discounted their initial-year audit fees during the sample period (2007–2010), with fee discounts ranging from 16 to 34 percent. In addition, the authors find no evidence of initial-year audit fee discounts (or premiums) in 2006. 

    Category:
    Auditor Selection and Auditor Changes, Client Acceptance and Continuance, Independence & Ethics
    Sub-category:
    Audit Fee Decisions, Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc
  • Jennifer M Mueller-Phillips
    Abnormal Audit Fees and Audit Quality: The Importance of...
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 11.0 Audit Quality and Quality Control, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    Abnormal Audit Fees and Audit Quality: The Importance of Considering Managerial Incentives in Tests of Earnings Management.
    Practical Implications:

    This paper provides new evidence on the fee-quality relationship using the propensity to use income-increasing discretionary accruals to meet or beat analysts' forecasts. The evidence in this paper suggests that abnormal audit fees are positively related to audit quality. This result is consistent with concerns raised by regulators that lower audit fees could reflect a lower level of effort provided by the auditor. This is important, given the trend of declining audit fees in recent years. By finding different results using a more focused sample of firms with the incentive and ability to manage earnings, this study highlights the importance of considering the context when performing tests of earnings management. This information is of interest to regulators, such as the SEC.

    Citation:

    Eshleman, J. D., & P. Guo. 2014. Abnormal Audit Fees and Audit Quality: The Importance of Considering Managerial Incentives in Tests of Earnings Management. Auditing: A Journal of Practice & Theory 33 (1): 117-138.

    Keywords:
    audit fees, audit quality, discretionary accruals, meet-or-beat, earnings management
    Purpose of the Study:

    In this study, the authors attempt to shed light on the conflicting evidence by performing a study of the relationship between abnormal audit fees and audit quality using a new research design. Specifically, the authors examine whether clients paying abnormal audit fees are more or less likely to use discretionary accruals to meet or beat the consensus analyst forecast.

    A growing body of accounting literature examines the relationship between audit fees and audit quality. Researchers are interested in this relationship because, ex ante, it is not clear whether receiving higher fee revenue from a client will improve audit quality or harm it. On the one hand, it could be argued that an auditor who receives abnormally high audit fees from a client will lose their independence and allow the managers of the client firm to engage in questionable accounting practices. However, it is also possible that audit fees are a measure of audit effort, i.e., higher fees indicate that the auditor worked more hours, signaling greater effort. To the extent that audit fees are a measure of audit effort, low audit fees could harm audit quality.

    Design/Method/ Approach:

    Audit fee and auditor data are obtained from Audit Analytics, financial statement data are obtained from Compustat, and analyst forecast data are obtained from the I/B/E/S database. The authors perform tests on two samples of 4,476 firm-years and 1,670 firm-year observations spanning 2000 to 2011.

    Findings:

    The authors find that clients paying higher abnormal audit fees are significantly less likely to use discretionary accruals to meet or beat the consensus analyst forecast. If abnormal audit fees are held at their mean, a one-standard-deviation increase in abnormal audit fees decreases the client's likelihood of using discretionary accruals to meet or beat the consensus forecast by approximately 5 percent. This is consistent with higher audit fees being indicative of greater auditor effort and, ultimately, better audit quality. The authors obtain similar results whether they use the audit fee model of Choi et al. (2010), the one proposed by Blankley et al. (2012), or their own audit fee model.

    Category:
    Audit Quality & Quality Control, Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, Earnings Management
  • Jennifer M Mueller-Phillips
    An Experimental Investigation of the Influence of Audit Fee...
    research summary posted October 15, 2013 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 03.0 Auditor Selection and Auditor Changes, 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management 
    Title:
    An Experimental Investigation of the Influence of Audit Fee Structure and Auditor Selection Rights on Auditor Independence and Client Investment Decisions
    Practical Implications:

     Lowballing has been cited as a threat to auditor independence and manager performance in regulatory reports and academic research. This study suggests that auditors may face independence issues at the beginning of a client relationship under the lowballing fee structure because of the uncertainty of retaining a client. The study also suggests, however, that these independence issues seem to dissipate over time. Therefore, auditors should be aware of these potential opportunities to lose objectivity when they acquire new audit clients and continue to rely on professional skepticism to evaluate management assertions.

    For more information on this study, please contact Darius J. Fatemi.
     

    Citation:

    Fatemi, D. J. 2012. An Experimental Investigation of the Influence of Audit Fee Structure and Auditor Selection Rights on Auditor Independence and Client Investment Decisions. Auditing: A Journal of Practice and Theory 31(3): 75-94.

    Keywords:
    Audit fees; auditor independence; experimental economics; manager investment; auditor selection.
    Purpose of the Study:

    The purpose of this paper is to investigate the effect of audit fee structure on auditors, their clients, and investors. The author wanted to specifically investigate how a lowballing audit fee structure as opposed to a flat rate fee structure impacts:

    • manager investment decisions
    • the degree of investigation of management decisions by auditors
    • the price that investors pay for shares of the company

    The author also investigated whether a cause-effect relationship exists between the use of a lowballing audit fee structure (in which auditors provide initial services at reduced prices but at higher prices in later periods) and auditor independence when retention is of concern to the auditor.

    Design/Method/ Approach:

    The author utilized an experimental market using undergraduate accounting majors that were randomly assigned to the roles of managers, investors, and auditors.  The auditors followed either a lowballing fee structure or a flat rate fee structure. Auditor selection was performed by either the managers or the investors. The managers bid on firm assets and provided a disclosure of the value of the assets to the investors. Auditors decided the extent to which they investigated managers’ claims and either concurred with manager’s disclosures or they provided information that the auditors believed to be more accurate.

    Findings:

    Compared to the flat-rate fee structure, managers under a lowballing fee structure scheme were:

    • more willing to make a high cost/return investment
    • more concerned with the credibility of their reports
       

    Auditor behavior is summarized as a response to past manager choices: when managers were especially willing to invest and be honest, auditors performed fewer tests of manager disclosures. Additionally, under manager selection and when lowballing existed, auditors attributed a higher accuracy to investigations indicating high manager investment than tests that suggest low investment, while accuracy assessments of favorable and unfavorable test results did not differ under investor selection. Finally, auditor retention under manager selection was negatively impacted by both unreliable auditing and disagreements with managers, but retention was only affected by unreliable auditing under investor selection.

    Category:
    Auditor Selection and Auditor Changes, Client Acceptance and Continuance, Independence & Ethics
    Sub-category:
    Audit Fee Decisions, Impact of Fees on Decisions by Auditors & Management
  • Jennifer M Mueller-Phillips
    Are Capitalized Software Development Costs Informative About...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment 
    Title:
    Are Capitalized Software Development Costs Informative About Audit Risk?
    Practical Implications:

    In general, the results of this study provide empirical evidence that capitalized software development costs are incrementally informative about the client’s business risk and the overall audit risk.

    • First, although intangible assets play an increasing role in firm valuation, very little is known about whether and how auditors regard these assets in assessing audit risk. Thus it fills a void in the literature on the auditor’s assessment of capitalized software development costs.
    • Second, this study examines a setting that mitigates the client’s business risk. It is important in that while economic models predict that audit fees reflect business risk, there is some evidence that audit practice does not support a relation between business risk and audit fees
    • Third, this study could be viewed as a ‘‘bridge’’ between the limited literature on investor valuation of capitalized software assets and auditing
    • Fourth, this study also shed light on how auditing under certain circumstances could potentially enhance the informativeness of recognized assets that are subject to a high degree of information asymmetry and managerial discretion

    For more information on this study, please contact Gopal V. Krishnan.

    Citation:

    Krishnan, G. V., and C. Wang. 2014. Are Capitalized Software Development Costs Informative About Audit Risk? Accounting Horizons 28(1): 39-57.

    Keywords:
    audit fees; SFAS No. 86; business risk; software development costs; earnings management.
    Purpose of the Study:

    Capitalization of software research and development costs (SDC) is controversial and is the only exception to SFAS No. 2 that calls for immediate expensing of R&D costs. The purpose of this study is to examine whether capitalized SDC are informative about audit risk. Audit risk is the risk that the auditor renders an incorrect opinion on whether the financial statements are in compliance with GAAP.

    Design/Method/ Approach:

    This sample consists of 564 firm-year observations representing 157 software firms (SIC code 7372) for the period 2004 through 2009. The authors estimate a regression of the log of audit fees on a variety of determinants of audit fees and two measures of lagged capitalized SDC.

    Findings:
    • The authors find that on average capitalized SDC has a negative impact on audit fees after controlling for traditional measures of client risk (e.g., negative return on assets, high leverage, going concern opinions, accounting restatements, and internal control problems).
    • The results hold for firms where capitalization is inconsequential to beating analysts’ forecasts, firms that are older or have low analysts’ following.
    • The study does not find a significant association between audit fees and capitalized software development costs for firms that meet or beat analysts’ forecasts or have high analysts’ following.

    The authors claim their results support the notion that capitalized software development costs signal lower business risk—especially for firms with low earnings management risk or high private information (information asymmetry).

    Category:
    Auditor Selection and Auditor Changes, Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment
  • Jennifer M Mueller-Phillips
    Are There Adverse Consequences of Mandatory Auditor...
    research summary posted July 27, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 15.0 International Matters, 15.04 Audit Firm Rotation 
    Title:
    Are There Adverse Consequences of Mandatory Auditor Rotation? Evidence from the Italian Experience.
    Practical Implications:

    The consequences of mandatory rotation appear to be (1) higher audit fees, and (2) lower-quality audited earnings following rotation (which is consistent with the evidence in non-mandatory settings). The authors conclude with some conjectures on how the negative effects of mandatory rotation observed in Italy might be even greater in countries with larger audit markets and larger clients, such as the United States and other European Union countries, which should give regulators pause. Another unintended consequence of mandatory rotation in the United States would be to reduce an audit firm’s industry expertise. A rotation rule in the United States and other large economies could disrupt the market and fundamentally change the way accounting firms are organized for the delivery of audits. 

    Citation:

    Cameran, M., Francis, J. R., Marra, A., & Pettinicchio, A. 2015. Are There Adverse Consequences of Mandatory Auditor Rotation? Evidence from the Italian Experience. Auditing: A Journal of Practice & Theory 34 (1): 1-24.

    Keywords:
    audit fees, audit market regulation, auditor rotation, earning quality
    Purpose of the Study:

    Mandatory auditor rotation was recently proposed for the European Union and is also under consideration in the United States. On April 24, 2013, the Legal Affairs Committee approved a proposal for a 14-year rotation rule. However, the full European Parliament has not yet acted on the recommendation. At the heart of the case for mandatory rotation is the belief that bad things can happen when auditors have long tenure. On the other hand, it may be the case that bad things do happen in the short-tenure setting due to a learning curve effect. Short tenure occurs when there is a change in auditor and there is evidence that earnings quality is lower during the first few engagement years, which is consistent with a learning curve on new audits.

    There has been little research into either the benefits or costs of rotation in a true mandatory setting that could inform intelligent policy making. Given the existing body of evidence, it appears the European Commission is advocating a major change to the audit market that is not supported by extant research. Even worse, the Commission could cause lower quality audits since there would be more frequent auditor changes under a mandatory rotation rule and, therefore, more frequent audits with short tenure and potentially lower quality. This paper helps fill this gap by examining Italy, where mandatory rotation of auditors has been required since 1975, and examines potential negative consequences of mandatory audit firm rotation.

    Design/Method/ Approach:

    The sample is comprised of 204 publicly listed companies in Italy audited by the Big 4 accounting firms over the period 20062009, resulting in 667 firm-year observations in the sample, although the specific sample size varies from test to test depending on data availability. The sample has 52 auditor changes, 36 of which are mandatory rotations (17.6 percent of firms), plus another 16 auditor changes that are voluntary (7.8 percent of firms). 

    Findings:
    • First, for the outgoing auditor, there is no evidence of lower-quality audits due to shirking in the final-year engagement. However, there is some evidence of abnormally higher fees, as the final-year fees are 7 percent higher than normal. This suggests there may some opportunistic pricing, since the authors find no evidence of abnormally higher audit effort in the final-year engagement. The PCAOB report does not identify this as a negative consequence, but the evidence suggests it adds to the cost of mandatory rotation.
    • Second, for the incoming auditor, audit effort (hours) is abnormally higher by 17 percent in the initial engagement, but initial fees are discounted by 16 percent relative to ongoing engagements. However, the authors also find that future audit fees following the first-year audit are abnormally higher by approximately 76 percent of first-year fees.
    • Third, the authors document that earnings quality is lower during the first three engagement years relative to later years of auditor tenure (large abnormal accruals and less timely loss recognition). On average, abnormal accruals are 36 percent larger in the first three years relative to later years of tenure.
    Category:
    Client Acceptance and Continuance, International Matters
    Sub-category:
    Audit Fee Decisions, Audit Firm Rotation
  • Jennifer M Mueller-Phillips
    Audit Fees and Investor Perceptions of Audit...
    research summary posted September 9, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 09.0 Auditor Judgment, 09.06 Adequacy of Disclosure 
    Title:
    Audit Fees and Investor Perceptions of Audit Characteristics.
    Practical Implications:

    These findings provide important insight into investors’ current perceptions of auditor independence, particularly in the absence of relative or comparative information, and suggests that it might be useful for regulators, when contemplating additional disclosure requirements, to allocate some attention to disclosures that have the potential to enhance investor perceptions of auditor independence. The findings of this study contribute to the forum of debate concerning the current state of audit-related disclosures and their value for investors.

    Citation:

    Beck, A. K., R. M. Fuller, L. Muriel, and C. D. Reid. 2013. Audit Fees and Investor Perceptions of Audit Characteristics. Behavioral Research in Accounting 25 (2): 71-95.

    Keywords:
    audit fees, disclosure, investor perception
    Purpose of the Study:

    Very little information is provided to the investor about the audits performed or the nature of the relationship between the auditor and client. It is difficult for investors and other external constituents to observe important qualitative aspects of an audit engagement such as the experience level, technical competence, conscientiousness, or objectivity of audit personnel.

    The objectives of this research are two-fold. First, the authors investigate whether the provision of additional referent information about audit fees (percentile rank data relative to other firms in the industry that establish a comparative benchmark) alters user perceptions of audit characteristics. This enables them to determine what investors perceive, based on audit fees, about the audit characteristics, and whether their perceptions coincide with the audit feeaudit characteristic relationships identified in previous archival research. Second, the authors contrast the perceptions of investors who are merely supplied with the total dollar amount of the audit fees with the perceptions of investors who are told that a company’s audit fee is approximately average in comparison to the audit fees of other companies within the same industry. Making this latter comparison offers insights as to how investors perceive audit and company characteristics when lacking additional information, consistent with the current state of audit fee disclosures.

    Design/Method/ Approach:

    One hundred and fourteen accounting students were recruited to participate in the experiment. These students were enrolled in an undergraduate auditing course. The instrument was administered in two different semesters, but in the same course. The participants were randomly assigned to groups, and an initial ANOVA verified that there were no differences between the four groups in terms of age, gender, or investing experience. Participants were incented to participate via bonus points in the course. The evidence was gathered prior to January 2013.

    Findings:

    The results of the study suggest that investors do develop perceptions about a company and its audit based on audit fees, as the authors find that providing supplemental audit fee disclosures indicating the relative magnitude of a company’s audit fees significantly influences investor perceptions of auditor independence, auditor effort, and audit quality. Specifically, the authors present evidence that when fees are presented to investors as low, average, or high (as compared to industry averages), investors commensurately perceive audit quality and auditor effort as being low, average, or high, respectively. When not provided with any additional information concerning the audit fee (similar to the present state of disclosures), investors assess audit quality and auditor effort as being average. However, they find that while investors perceive auditor independence as low, average, and high when fees are presented as high, average, or low, respectively, investors not provided with any relative fee information assess auditor independence as low.

    Category:
    Auditor Judgment, Client Acceptance and Continuance
    Sub-category:
    Adequacy of Disclosure, Audit Fee Decisions
  • Jennifer M Mueller-Phillips
    Audit Fees and Social Capital.
    research summary posted July 23, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions 
    Title:
    Audit Fees and Social Capital.
    Practical Implications:

    By showing that the social capital where the firm is headquartered affects audit fees, this study makes an important contribution to the auditing literature. It shows that the social environment where the firm is headquartered can affect its relation with auditors and, consequently, the audit fees. This is a new way of looking at the auditor and client’s relation. Although the audit-fee literature is extensive, no studies the authors know of have investigated the possible impact of the social environment on how much the auditors charge. The study suggests that trust is an important component of the auditor-client relation, that local social capital proxies to some extent for auditor trust, and its impact on audit fees is meaningful.

    Citation:

    Jha, A., & Chen, Y. 2015. Audit Fees and Social Capital. Accounting Review 90 (2): 611-639.

    Keywords:
    audit effort, audit fees, client risk, social capital
    Purpose of the Study:

    Social capital is often defined as the mutual trust in society. The authors propose that the social capital in the county where a U.S. firm is headquartered can have an impact on how much the auditors trust the managers of the firm. Auditors arguably have less trust when a firm is headquartered in a county with low social capital. The authors argue that this lack of trust will increase the auditor’s effort and his or her fear of litigation and, therefore, will increase fees. The authors examine the impact of social capital on audit fees.

    Audit fees can increase due to more audit work and/or more expected losses. To further investigate which particular element drives up audit fees, the authors examine the impact of social capital on the auditor’s report lag, which is a proxy for the auditor’s effort, and on the firm’s litigation risk, which is a proxy for the auditor’s expected losses.

    Design/Method/ Approach:

    To test the hypothesis the authors use a multivariate regression. The sample includes 28,634 firm-year observations that represent 5,167 firms and 57 industries, and spans the years 2000 to 2009. The data is collected from Audit Analytics and Compustat. All the firms must be headquartered in the U.S. and belong to a nonfinancial and non-regulated industry.

    Findings:

    The audit fees are significantly lower in high social-capital counties. A firm that is headquartered in a county with social capital in the 75th percentile pays about 12 percent less in audit fees compared to a firm headquartered in a county with social capital in the 25th percentile. The auditors take more time to sign off on their report for low social-capital clients. Furthermore, the probability of litigation involving the auditor is also higher in low social-capital counties.

    When the auditors are either located within a 100-kilometer (62.13 miles) radius of the client or in the same metropolitan statistical area (MSA) as the client, the effect of social capital on audit fees is tripled compared to when they are further away. Because of the increase in audit complexity due to Sarbanes-Oxley Act (SOX), social capital’s effect is stronger post-2004.These results suggest that auditors take into consideration the social capital of where the firms are headquartered in assessing their audit fees.

    The results do not necessarily suggest that auditors are violating professional guidelines that require that they exercise "professional skepticism" in auditing their clients. Rather, the results suggest that the extent of the skepticism can vary based on where their clients are headquartered.

    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions
  • The Auditing Section
    Audit Fees at U.S. Non-Profit Organizations
    research summary posted May 2, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations 
    Title:
    Audit Fees at U.S. Non-Profit Organizations
    Practical Implications:

    This study identifies relationships between attributes specific to non-profit organizations (see above) and external audit fees, and it has practical implications for non-profit organizations as well as auditors in negotiating audit fees.  The audit fee model can be useful for non-profit organizations that seek to benchmark their audit fees.  Additionally, this study shows that non-profits with higher quality internal oversight are willing to incur additional costs for monitoring by external auditors. Further, this study shows that Big 4 auditors earn a premium for their services in the non-profit sector (similar to the for-profit sector).

    Citation:

    Vermeer, T. E., K. Raghunandan, and D. A. Forgione. 2009.  Audit Fees at U.S. Non-Profit Organizations.  Auditing: A Journal of Practice and Theory 28 (2): 289-303.

    Keywords:
    Non-profit organizations, auditing, liquidity, audit committees, benchmarking
    Purpose of the Study:

    The purpose of this study is to examine audit fee determinants for non-profit organizations.  The study examines audit fee determinants applicable to all businesses, as well as non-profit specific attributes that are associated with audit fees.                   

    This study is motivated by recent scandals and governance failures in non-profit organizations (United Way, New Era Philanthropy, and American Cancer Society), which have led to increased scrutiny and regulations over these organizations and have resulted in increased external audit requirements.  Given the significant differences between non-profit organizations and for-profit businesses  culture, organizational structure, financial needs, accounting rules, financial reporting, financial statement users, and audit risk environment), the role of auditing can be significantly different for non-profit organizations.  Despite the economic significance of these organizations, little is known about determinants of audit fees for non-profit organizations.  

    This study uses survey data from large non-profit organizations to determine whether the following factors impact audit fees at non-profit organizations: 

    • Complexity, including size and asset composition
    • Need for resources, including donor contributions, external debt, and single audit requirements (federal awards)
    • Monitoring mechanisms, including internal audit and audit committee
    • Control variables, including financial stress, Big 4 auditor, industry, and non-audit fees
    Design/Method/ Approach:

    The authors obtained data on fiscal 2002 and 2003 audit fees and background information from surveys sent to chief financial officers of the largest non-profit organizations per GuideStar, Inc. Financial data are obtained from the GuideStar database. The authors used these data to examine the relationship between audit fees and the factors listed above. 

    Findings:
    • Traditional determinants of for-profit audit fees appear to have a similar impact on audit fees for non-profit organizations.
    • Larger asset size and greater complexity are associated with higher audit fees.
    • Non-profits in poorer financial condition pay higher audit fees.
    • Greater debt leads to higher audit fees.
    The Big 4 audit fee premium also exists for non-profit clients. 
    • Non-profit organizations with a single audit incur higher audit fees. 
    • Audit fees are lower for non-profits in regulated industries (healthcare and education). 
    • Monitoring by external auditors complements, rather than substitutes for, other internal monitoring mechanisms such as audit committees and internal auditing departments. This is evidenced by the following:
      • Higher quality audit committees (i.e., audit committees being fully independent, having at least one CPA or other financial expert, and meeting at least twice per year) are associated with higher audit fees.
      • The presence of internal auditing is associated with higher audit fees.

    The authors argue this suggests that non-profits with quality internal oversight are willing to incur additional costs for monitoring by external auditors. 

    • Greater non-audit fees as a percentage of total fees leads to lower audit fees.  This suggests that the joint provision of audit and non-audit services may lead to increased efficiencies in auditing.
    Category:
    Client Acceptance and Continuance, Engagement Management
    Sub-category:
    Audit fee decisions, Audit Fees & Fee Negotiations
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  • The Auditing Section
    Audit Fees for Initial Audit Engagements Before and After...
    research summary posted April 23, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions 
    Title:
    Audit Fees for Initial Audit Engagements Before and After SOX
    Practical Implications:

    This study provides an analysis of initial-year audit fee discounts/premiums in the pre-SOX era (2001) and post-SOX era (2006). 
    The findings from this study suggest that concerns over initial-year audit fee discounts are not supported by empirical evidence in the post-SOX era, at least for the Big 4 auditors.  Additionally, this study provides empirical evidence that suggests the Big 4 have become more conservative in their client acceptance and pricing decisions in the post-SOX era.  The authors note that these results
    should be of interest to clients, auditors, and regulators, given the concerns expressed by regulators and legislators about the adverse consequences associated with initial-year fee discounts.

    Citation:

    Huang, H-W., K. Raghunandan, and D. Rama.  2009.  Audit Fees for Initial Audit Engagements Before and After SOX.  Auditing: A
    Journal of Practice and Theory
    28 (1): 171-190

    Keywords:
    : Audit pricing, auditor-client relationships, audit engagements, start-up costs, SOX, legislators
    Purpose of the Study:

    The purpose of this study is to examine initial-year audit fee discounts (i.e. “lowballing”) in the post-SOX era.  The study is motivated by concerns (from legislators, regulators, and the media) that auditors “lowball” initial-year audit fees in order to gain the job and that such lowballing can lead to reduced audit quality.  The authors discuss five factors that likely reduced lowballing of audit fees in the post-SOX era: 

    • Audit firms are more likely to price auditing as a stand-alone service and less likely to lowball audit fees to gain certain nonaudit service contracts, which are restricted by SOX.
    • Audit firms became more conservative in the post-SOX era and the increased conservatism is reflected in first-year fee pricing.
    • SOX 301 requires that the audit committee (instead of management) be responsible for compensating auditors. This could reduce client’s audit fee negotiation since the incentives of audit committee members (reputation) can be different from the incentives of management (cost-cutting).
    • The failure of Arthur Andersen led to a more concentrated audit market, which in turn changed the dynamics of audit pricing.
    • SOX 404 imposed significant additional demands on manpower resources and initial-year engagements, as well as presented a new source of revenues for auditors. 

    This study compares audit fees in the pre-SOX and post-SOX periods to determine whether lowballing of audit fees for initial-year audits becomes less likely in the post-SOX era.

    Design/Method/ Approach:

    The authors use data on U.S. publicly-traded non-financial companies for pre-SOX (2001) and post-SOX (2006) fiscal year-end audits. For each period, they compare audit fees (or change in audit fees) of first-year engagements with those of subsequent-year engagements to determine initial-year fee discounts or premiums. 

    The authors examine Big 4 and non-Big 4 clients separately. They exclude auditor resignations and the switches from Big 4 to non-Big 4 (and vice-versa).

    Findings:
    • Pricing for initial-year audits for the Big 4 clients is significantly different in the post-SOX era, as compared with the pre-SOX era.
      • Big 4 clients received an initial-year audit fee discount of 24% in 2001.
      • Big 4 clients paid an initial-year audit fee premium of 16% in 2006.

    The authors suggest this implies that for the Big 4 auditors, concerns over initial-year discounting of audit fees are not supported by empirical evidence in the post-SOX period. 

    • As for non-Big 4 clients, the authors find some evidence (when examining the changes in audit fees from the preceding fiscal year) that non-Big 4 clients received initial-year fee discounts both in 2001 and 2006. The authors suggest this implies that competition is more intense in the non-Big 4 segment of the audit market in the post-SOX period, when compared to the Big 4 segment. 
    • Several interesting observations are noted by the authors:
      • Auditor resignations are more likely in 2006 than in 2001.
      • There are very few instances of a Big 4 firm serving as a successor auditor following the resignation of a predecessor auditor.
      • The likelihood of a Big 4 successor following a client-initiated dismissal is lower in 2005-2006 than in 2001.  The authors argue this implies that the Big 4 became more conservative in accepting new clients and/or non-Big 4 became more aggressive following SOX.
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit fee decisions
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  • Jennifer M Mueller-Phillips
    Audit Firms’ Client Acceptance Decisions: Does P...
    research summary posted July 18, 2016 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 05.0 Audit Team Composition, 05.02 Industry Expertise – Firm and Individual 
    Title:
    Audit Firms’ Client Acceptance Decisions: Does Partner-Level Industry Expertise Matter?
    Practical Implications:

     This paper contributes to the literature on auditor industry expertise in many ways. First, it extends previous studies on this topic to examine whether industry specialists demonstrate different risk preferences in client acceptance decisions. The finding that partner-level industry specialists are more likely to accept less risky clients may partly explain why industry specialists have better quality clients.

    Citation:

    Hsieh, Y., and Lin C. 2016. Audit Firms’ Client Acceptance Decisions: Does Partner-Level Industry Expertise Matter? Auditing: A Journal of Practice and Theory 35 (2): 97-120.

    Keywords:
    partner-level industry specialization, client acceptance decision, and Big N auditors
    Purpose of the Study:

    Recently, audit firms have paid more attention to client acceptance decisions due to increased litigation risk. As a result more and more studies have investigated what goes into making this important decision. However, most prior studies examine whether auditors evaluate client risk characteristics when making client portfolio management decisions and whether auditors change their portfolio management strategies in response to changed in response to changes in litigation liability. Few studies have examined the impact of auditor characteristics other than accounting firm size. Auditors with different attributes could have different risk considerations in making client portfolio management decisions. In fact, previous studies have suggested that auditors use industry experience as a risk management strategy to mitigate risk on client portfolio management decisions because industry specialists provide high-quality audits and thus decrease litigation risk and reflect a good client-auditor match. Audit firms make large investments in specialized industries, so specialist auditors have an incentive to shed risky clients to avoid litigation risk and protect their reputation; hence, whether audit firms use industry expertise as a risk management strategy to mitigate the effect of risk is an empirical issue. The authors of this paper hope to explore whether industry specialization affects the association between risk considerations and client acceptance decisions. 

    Design/Method/ Approach:

    The sample is restricted to Taiwanese listed companies audited by Big N audit firms from 1999 to 2010. The final sample contains 9,337 observations. A Client Acceptance Decision Model was created to examine the effect of auditor industry expertise on firms’ risk consideration when making client acceptance decisions. 

    Findings:
    • The authors find that auditors are less likely to accept clients with audit risk higher than that of existing clients.
    • The authors find that firm-level industry expertise has no significant effect on the association between risk consideration and client acceptance decisions.
    • The authors find that partner-level industry specialists alone are less likely to accept clients with higher financial risk or higher audit risk, which supports the hypothesis that partner-level industry specialization affects the association between risk factors and client acceptance decisions. No evidence is found that firm-level industry expertise alone affects risk considerations in client acceptance decisions. 
    Category:
    Audit Team Composition, Client Acceptance and Continuance
    Sub-category:
    Industry Expertise – Firm and Individual

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