The results of this paper contribute to the understanding of the determinants of audit firms’ initial audit price discount decisions. The results suggest that concentration of audit firms within the local audit market has a stronger influence on non-Big 4 audit firms’ initial pricing decisions compared to Big 4 firms’ initial pricing decisions. In addition, the results are of interest to regulators and managers who are concerned about the effect of audit market concentration on audit pricing and audit quality.
Eshleman, J. D. and B. P. Lawson. 2017. Audit Market Structure and Audit Pricing. Accounting Horizons 31 (1): 57 – 81.
Increasingly, regulators, standard setters, and audit clients have expressed concern over the level of concentration in the U.S. audit market. The primary concern is that audit market concentration could result in higher fees for audit clients, which is supported by economic theory that suggests a positive association between concentration within an industry and industry prices. Despite this theory and the concerns that exist, the association between increased concentration within the U.S. audit market and audit fees remain unclear. Previous studies have examined this issue with mixed results. As a result of the mixed evidence that exists, the authors choose to re-examine the association between audit market concentration and audit fees.
The authors use two settings to examine whether and how audit market concentration affects audit fees. First, they examine how concentration is related to audit fees in a sample of stable auditor-client relationships. Next, they examine how audit market concertation affects audit fees in a sample of firms that switch auditors. They conduct these examinations using a large sample of U.S. audit engagements covering the years 2000 – 2013.
This paper adds a new dimension to the research on strategic alliances by focusing on auditing rather than governance, performance, funding, or equity participation. It also identifies incomplete contracts as the driver of audit complexity, and extends the audit fee literature by documenting that the number of strategic alliances is a significant determinant of audit fees. Finally, the authors’ evidence that strategic alliances result in higher audit fees provides empirical support for the largely theoretical argument that incomplete contracts are complex.
Demirkan, S. and N. Zhou. 2016. Audit Pricing for Strategic Alliances: An Incomplete Contract Perspective. Contemporary Accounting Research 33 (4): 1625-1647.
A strategic alliance is a long-term contract between multiple firms where resources are pooled to accomplish preset objectives, creating dependence between otherwise legally independent firms. Prior research has focused on the emergence, management and survival of alliances; consequently, there is not substantial research on the relation between strategic alliances and auditing. This paper fills that void by investigating how auditors price their audit services for firms involved in strategic alliances.
The authors conduct a study on the pricing of audit services for strategic alliances through compiling data and utilizing descriptive statistics.
Taken together, the results of this study suggest that dividends provide information to auditors and mitigate concerns over their clients’ earnings quality. It appears dividends provide incremental information to auditors beyond other audit risk indicators, such as low earnings persistence or high accruals. These findings also suggest that firms’ dividend-paying status provides an easily observable cue to auditors and others that can be used when assessing a firms’ earnings quality.
Lawson, B. P. and D. Wang. 2016. The Earnings Quality Information Content of Dividend Policies and Audit Pricing. Contemporary Accounting Research 33 (4): 1685 – 1719.
This study further explores the earnings quality information content of firms’ dividend policies by examining whether auditors incorporate this information into the assessment of their clients’ earnings quality as reflected in their audit pricing decisions. The authors choose to delve into the question of whether dividends’ association with higher earnings quality influences auditors’ risk assessment of their clients. In addition, they examine the incremental earnings quality information that dividends can provide auditors by testing two separate earnings risk settings.
The authors test two separate earnings risk settings by using audit fees and financial statement data from 2004 to 2012.
This study contributes to the auditor-client realignment literature by examining whether auditors’ client acceptance and pricing decisions vary with firm ownership structure, which was not investigated before. It also documents a significant association between the identity of the successor auditor and firm ownership structure following the resignation of the incumbent auditor. This is important given the potential consequences of auditor changes to both auditors and their clients.
Khalil, S. and M. Mazboudi. 2016. Client Acceptance and Engagement Pricing following Auditor Resignations in Family Firms. Auditing: A Journal of Practice and Theory 35 (4): 137 – 158.
The authors of this paper extend current research by examining whether firm ownership structure is associated with client acceptance and pricing decisions following the resignation of the incumbent auditor. More specifically, the authors test whether the identity of the successor auditor (Big 4 or non-Big 4) and the change in audit fees following auditor resignations in family firms are significantly different from those in non-family firms in the U.S. They further investigate whether the aforementioned results hold when the identity of the CEO managing a family firm and the percentage of shares held by the family members are accounted for. Finally, the authors examine whether the likelihood of financial restatements in family firms over the two-year period following the incumbent auditor resignation is significantly different from that in non-family firms.
The authors analyze results obtained using a sample of auditor resignations over the post-SOX period 2004-2012.
The importance of understanding the operation of a client’s business and its competitive environment to achieve an effective audit is well-known. More specifically, the PCAOB requires that an auditor understand the company’s objectives and strategies and those related business risks that might reasonably be expected to result in risks of material misstatement. Valid understanding also is necessary to both interpret results from analytical procedures and to engage in effective professional skepticism for management’s assertions. The author’s results reveal a previously unreported level of understanding of process-oriented business risks and their association with the RMM of revenue for essentially new staff auditors.
Wright, W. F. 2016. Client business, models, process business risks and the risk of material misstatement of revenue. Accounting, Organizations and Society 48: 43-55.
There are undeniable benefits for financial auditors to understand a client’s business strategy, strategic objectives and critical business processes, as well as understanding the business risks of a client’s business model during the reporting period. In fact, an inadequate understanding of business risks can result in an audit failure. While business risk auditing continues to be a central framework for auditing, whether auditors can achieve the necessary in-depth understanding of the business risks generated by different strategies and business models remains unclear. Current research tests for understanding of the theory of business risk auditing, but this author tests the premise that informed graduate students acting as surrogates for staff auditors will understand and implement in their judgments the process risk implications of different business strategies and business models. This should prove important because the existing literature indicates inconsistent results on auditor’s ability to conduct an effective strategic analysis.
The author conducted a 2x2 randomized between subjects design. The participants were all accounting Masters students who were a few weeks from their graduation. These participants were presented with an array of facts, until ultimately deciding which business strategy applied and assessing the performance and the associated business risk of each of the five processes of the case.
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.
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.
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.
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.
This study is important given the continued concerns expressed by global regulators about the potential harm to audit quality caused by concentrated audit markets. The separation of offsetting direct and indirect effects of concentration on audit quality enhances the understanding of how concentration influences audit quality and could explain why the previous studies document mixed evidences. The study also provides evidence on how audit fees play an important role in the association between concentration and audit quality and that regulatory interventions changing one of the offsetting effects could produce potential unintended consequences.
Huang, T., Chang, H., and Chiou, J. 2016. Audit Market Concentration, Audit Fees, and Audit Quality: Evidence from China. Auditing: A Journal of Practice and Theory 35 (2): 121-145.
The potential effects of recent audit market concentration on audit fees and audit quality have been a point of concern for policy makers. The primary concern is that this concentration reduces clients’ choice of audit service suppliers, strengthens auditor’s market power, and encourages complacency among auditors, resulting in higher audit fees but lower audit quality. Despite the concern, the extant literature provides mixed evidence on the consequences of audit market concentration. The situation between developed countries where audit markets are dominated by the Big 4 audit firms, and the Chinese Ministry of Finance (MOF) is starkly different. As a result, the MOF has expressed concern about the competitive and immature Chinese audit market characterized by many small-seized audit firms, which increases auditors; incentives to compete for clients by providing fee discounts, resulting in low audit quality. The difference in attitudes toward concentration between the developed countries and China as well as the fact that China is a setting where competition is thriving, while most of the developed countries are more concerned about lack of competition is the primary motivation behind the authors examination of the Chinese audit market. The objective of the paper is to investigate the effect of concentration on audit quality in a setting with significant competition a relatively weak legal environment.
The authors employ path analysis to further examine the indirect effects of concentration on audit quality through audit fees. The sample consists of 12,334 Chinese firm-year observations from 2001-2011. Audit market concentration is measured at the city level as the market shares of the local top 4 audit firms and two Herfindahl indexes of audit fees earned from listed clients of the local top 4 and all audit firms in a city-year grouping, respectively.
This paper asks whether auditors recognize the volatility of OCI and incorporate it into pricing of audits. They find that audit fees do reflect changes in OCI and that these changes reflect various risk factors associated with OCI. The findings suggest that auditors already recognize the difficulty in assessing value of fair value items which run through OCI—reinforcing regulator concerns about fair value valuation.
Huang, H., S. Lin, K. Raghunandan. 2016. The Volatility of Other Comprehensive Income and Audit Fees. Accounting Horizons 30 (2): 195-210.
This study investigates whether auditors incorporate volatility in other comprehensive income (OCI) into fees. Increased attention from standard setters, both domestically and internationally, on fair value accounting has increased auditor focus on fair value financial instruments. Fluctuations in many of these assets are reflected in OCI, thus volatility in OCI may indeed influence the auditor’s inherent risk assessment. Other studies have shown that investors do not seem to accurately incorporate volatility of OCI in pricing, so it is an empirical question whether auditors can incorporate it into their risk assessment.
The authors use a sample of S&P 500 firms from 2002 to 2006 and supplement this sample with a comparable sample from 2008 to reinforce their findings. Data on OCI was hand collected from the SEC’s EDGAR database and combined with financial information from Compustat and auditor data from Audit Analytics. The authors exclude financial sector firms, resulting in a final sample of 1,858 firm-year observations.
The authors find:
This study illustrates new measures of spatial competition that incorporate the separate and distinct effects of competition within and between the large and small audit markets. This study also provides evidence that the pricing in the large firm market segment is affected by competitive pressure from small audit firms; furthermore, the study provides evidence of a differentiation premium that small audit firms are able to obtain by being perceived as competing in a bigger league than other small audit firms. Finally, the study contributes by examining measures of competition beyond the Herfindahl index in the audit firm market.
Bills, K.L. and N.M. Stephens. 2016. Spatial Competition at the Intersection of the Large and Small Audit Firm Markets. Auditing: A Journal of Practice and Theory 35 (1): 23-45.
Research in the past including a study performed by the Government Accountability Office (U.S. GAO) of the United States suggest that the large and small audit firm markets are two distinct markets in many respects; however, prior research also suggests that there is a component of the small audit firm market that competes for clients directly with firms operating in the large audit firm market. Within this study, the authors create measures of competition that take into account these two distinct markets and how their interaction may affect the competitive positions of the players in both markets. This is achieved by separately examining spatial competition within and between audit firms in both the large and small audit firm markets. Because the Department of the Treasury has emphasized the importance of small audit firms becoming viable suppliers for companies typically served by the large audit firm market, there is a need for a closer look at the smaller audit firm market and how its members can potentially compete with larger audit firms.
Data from Audit Analytics and Compustat was used to perform the tests of the hypotheses. Two separate samples were constructed– one sample including large audit firm clients and another sample including small audit firm clients. Large audit firms are defined as the Big 4 audit firms, and small audit firms are defined as all non-Big 4 audit firms.
The study results are important to regulators and audit practitioners as they show an association between executive compensation and auditor compensation. The study results show that high executive risk-taking incentives, as measured by vega, contributes to higher audit fees. These results provide important insights into how incentives designed to compensate and motivate executives can alter the audit fee structure.
Chen, Y., F. A. Gul, M. Veeraraghavan, and L. Zolotoy. 2015. Executive Equity Risk-Taking Incentives and Audit Pricing. The Accounting Review 90 (6): 2205–2234.
This study assesses whether there is an association between executive stock compensation and audit fees. The authors specifically investigate whether the sensitivity of CEO compensation to stock return volatility (vega) and stock prices (delta) are associated with audit fees. Prior literature shows that higher vega leads managers to engage in more financial misreporting. This increase in financial misreporting could in turn influence audit risk assessment and audit fees.
The main motivation for this study comes from the PCAOB’s recent related-party standard proposal. The proposed standard requires auditors to perform procedures to evaluate compensation practices when gaining an understanding of relationships between the company and its executive officers. In addition, current audit fee models do not consider executive compensation incentives in the pricing of audit services. Finally, there are extensive literatures on executive compensation and auditor compensation but no evaluation at the intersection of executive compensation practices and their effect on audit fees. This study attempts to address these gaps in the literature.
The authors employ an archival research methodology in this study. They obtain audit fee data from the Audit Analytics database and executive compensation from ExecuComp. The sample period is from 2000-2010. Company financial data is from Compustat Fundamentals Annual File.