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  • 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
    Dual-Class Shares and Audit Pricing: Evidence from the...
    research summary posted April 16, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity 
    Title:
    Dual-Class Shares and Audit Pricing: Evidence from the Canadian Markets
    Practical Implications:

    This study provides evidence that dual class share structures increase audit risk.  In response, audit firms either increase the scope of the audit or charge a fee premium.

    Citation:

    Khalil, S., M.L. Magnan, and J.R. Cohen. 2008. Dual-Class Shares and Audit Pricing: Evidence from the Canadian Market. Auditing: A Journal of Practice & Theory 27 (2): 199-216.

    Keywords:
    audit pricing; ownership structure; dual-class shares; corporate governance
    Purpose of the Study:

    This study examines the impact that dual-class shares have on audit fees.  Dual-class shares exist when there are 2 or more classes of shares and they have disproportionate voting rights (i.e. voting rights are concentrated while the rights to the cash flows of the firm are more dispersed).  The presence of dual-class shares affects audit pricing through an increase or decrease of audit risk.  

    There are two competing hypotheses on how dual-class shares affect audit risk.  First, dual-class shares may entrench the  shareholder and thus reduce financial reporting quality. This view is known as the entrenchment perspective. Secondly, the alignment perspective posits that dual-class shares reduce audit risk because the holders (1) are poorly diversified, (2) protect their reputation and desire to pass wealth onto the next generation, and (3) manage the firm themselves. 

    The authors examine which of these competing hypotheses is dominant: dual-class shares represent increased risk to the auditor, or dual-class shares represent an effective governance mechanism (think: “tone at the top”) and therefore lower risk to the auditor.

    Design/Method/ Approach:

    The authors gather data on Canadian companies publicly traded on the Toronto Stock Exchange (TSX) for the year 2004. The authors create a ratio of ownership to control and compare audit fees for firms with a high ratio of ownership to control to firms with a low ratio using statistical techniques.

    Findings:

    Audit fees are higher for firms with dual class share structures, suggesting perceived audit risk is higher, although it is not clear whether the increase is due to increased audit effort or a risk premium. 

    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit fee decisions, Business Risk Assessment (e.g. industry - IPO - complexity)
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  • The Auditing Section
    Client Retention and Engagement-Level Pricing
    research summary posted April 13, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.06 Resignation Decisions, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 04.02 Impact of Fees on Decisions by Auditors & Management 
    Title:
    Client Retention and Engagement-Level Pricing
    Practical Implications:

    The results of this study are useful for regulators to consider the motives for auditor changes and to understand audit client portfolio management. The findings underscore the importance of engagement pricing as a determinant of audit firm’s client retention decisions.  Specifically, the evidence suggests that engagement pricing pressure occurs on more than an isolated basis and the audit firm’s inability to recover unexpectedly high labor usage is associated with the severing of the auditor-client relationship.

    Citation:

    Hackenbrack, K. E. and C. E. Hogan. 2005. Client Retention and Engagement-Level Pricing.  Auditing: A Journal of Practice and Theory 24 (1): 7-20. 

    Keywords:
    Engagement realization rates, client retention, engagement-level pricing, engagement management, client acceptance and continuance.
    Purpose of the Study:

    Prior research suggests that auditors do not accept new audit clients that are expected to yield audit fees insufficient to cover expected costs. This implies that auditors may not expect to frequently have engagements which generate insufficient rates of return in their portfolios. This study focuses on this matter by examining the relationship between engagement-level pricing and auditor retention decisions. The objectives of the study are to examine: 

    • whether audit firms find themselves in the position of earning an insufficient audit fee on more than an isolated occurrence 
    • how important engagement-level pricing is, relative to other factors, in audit firms’ client retention decisions 
    • Another important factor affecting client retention examined in the study is client delays which unexpectedly cause auditors to use more engagement hours than budgeted.  

    The engagement-level pricing measure used in the study is the difference between “realized” realization rates (the ratio of the audit fee billed to the standard audit fee) and “expected” realization rates for each segment of the firm’s client portfolio. This measure is also referred to as an unexpected component of realization rates.

    Design/Method/ Approach:

    The authors employ a sample of fiscal 1991 public and private audit engagements of a Big 6 audit firm. The data used are from proprietary sources, including a survey, audit working papers, and a 1996 client list of the audit firm, as well as public sources. The authors use these data to examine the relationship between the unexpected component of realization rates and the audit firm’s client retention over the five-year window (fiscal 1991 - 1996).

    Findings:
    • The authors document that the likelihood of client retention over a five-year window decreases as the difference between realized realization rate and the expected realization rate decreases. 
    • The authors find that the probability of retaining a client decreases with a combination of the impact of client-induced delays on engagement hours and the auditor’s inability to recover unexpectedly high labor usage. The probability of client retention, however, does not depend on the realization rates alone or client-induced delays alone.
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit fee decisions, Resignation Decisions, Impact of Fees on Decisions by Auditors & Managmeent, Audit Fees & Fee Negotiations
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  • The Auditing Section
    Competition for Andersen's Clients (article and...
    research summary posted May 7, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.04 Predecessor Auditor Factors 
    Title:
    Competition for Andersen's Clients (article and discussion)
    Practical Implications:

    Audit firms may find this study interesting because it contributes to an understanding of the competitive nature of the U.S. audit market among the remaining Big Four firms.  Additionally, this study appears to have implications for audit firms operating in a market where a major accounting firm either leaves the market or dissolves.  Specifically, the results imply that a potential growth strategy for firms remaining in such markets may be to purchase the practices of such firms, where possible.  Further, this study appears to have implications for portfolio management related to small clients and large clients, since the audit fees for these firms behaved differently following the demise of Andersen. 

    Additionally, the results suggest that the decreasing number of Big Four audit firms may be detrimental to competitive forces in the audit market, which is of importance to audit market regulators in the U.S. and globally. Given that the dissolution of an audit firm is a very rare event, this study provides unique empirical evidence on the consequences of such a dissolution. 

    In their discussion of the study, Ramnath and Weber (2008) raise concerns related to what a purchase of an Andersen office really means and how this definition may differ across markets.  They also note that a more appropriate level to examine these issues would be the partner level (e.g. clients may have chosen to remain with their Andersen partner at their new firm).  

    Citation:

    Kohlbeck, M., B. W. Mayhew, P. Murphy, and M. S. Wilkins. 2008. Competition for Andersen's Clients. Contemporary Accounting Research 25 (4): 1099-1136.

    Ramnath, S. and J.P. Weber. Discussion of “Competition for Andersen’s Clients”. Contemporary Accounting Research 25 (4): 1137-1146.

    Keywords:
    auditor selection, auditor changes, Arthur Andersen, audit market competition
    Purpose of the Study:

    The authors study the competition for Andersen’s clients, with the following objectives:  

    • To investigate the competition for audit clients among the remaining Big 4 audit firms and the various approaches taken by the firms (e.g. purchasing entire offices versus targeting specific clients).
    • To investigate the association between the level of competition and audit fee changes, and whether client size affects this competition.
    • To provide evidence related to the GAO's concern that large clients have relatively few auditor choices after Andersen's demise.
    Design/Method/ Approach:

    The sample is comprised of 4,754 audit clients including 674 former Andersen clients from 65 Andersen offices, 39 of which were purchased by other Big 4 firms. Four types of Andersen client switches are considered: early switchers, clients who were part of a practice group purchased by another audit firm and stayed with that new firm, clients that switched auditors after the audit practice was purchased, and clients that were part of an Andersen practice office that was not purchased. The office purchase data was collected by examining press releases and articles to identify Andersen office purchases by other audit firms. This data was validated, when possible, by comparing it to the Public Accounting Report analysis of Andersen office purchases.  The authors use this data to examine audit fee changes and make inferences about the implications of reduced competition in the market for audit services.

    Findings:
    • An Andersen office purchase by another audit firm reduced competition among the Big Four within a local market, resulting in increased market power by the remaining audit firms.
    • Larger clients that face limited options when seeking a new auditor did not receive fee discounts, whereas smaller clients with more audit firm options to choose from did receive fee discounts, indicating that competition for the smaller clients affected audit pricing.
    • Clients that continued with an office purchased by another audit firm did not receive fees discounts, while clients who sought a new auditor rather than remain with the purchasing firm paid higher fees. Finally, in markets where the Andersen office was not purchased, clients received fee discounts from their new auditor.
    • Firms that chose to purchase an Andersen practice office were more likely to have a presence in the local market before the purchase, were similar in size to the Andersen office, and had already acquired a significant number of early Andersen switching clients. Offices that were purchased earlier retained a higher percentage of clients compared to offices that were purchased in later periods.
    • Purchasing offices increased the number of clients gained relatively equally across all client size levels.
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit fee decisions, Predecessor Auditor Factors
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  • The Auditing Section
    Differences in Industry Specialist Knowledge and Business...
    research summary posted May 7, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 05.0 Audit Team Composition, 05.02 Industry Expertise – Firm and Individual, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Differences in Industry Specialist Knowledge and Business Risk Identification and Evaluation
    Practical Implications:

    The findings in this study are not intended to undermine the benefits of specialization in generic industries. Rather, they serve to highlight the importance and impact that specializing across differing industries has on auditor knowledge and experience.  From a
    practical perspective, the results of this study provide audit firms insights into the possible effects experience from industries of varying complexity has on auditors’ abilities to evaluate audit risks.  The results highlight the challenges in simply grouping industry specialists homogeneously, as the benefits accruing to specialists may vary depending on the nature and complexity of the industry.

    Citation:

    Moroney, R., and R. Simnett. 2009.  Differences in Industry Specialist Knowledge and Business Risk Identification and Evaluation.  Behavioral Research in Accounting 21(2): 73-89.

    Keywords:
    Behavioral decision theory; industry specialization; business risks
    Purpose of the Study:

    Prior literature has reported that auditors who are considered industry specialists outperform non-specialists on tasks within their area of expertise.  Noting that not all industries are the same, the authors build on this prior literature to examine the relative performance gains between auditors specializing in a complex (pension fund) industry vs. generic (manufacturing) industry.  Below are the primary objectives that the authors address in their study: 

    • The authors argue that the nature of a complex industry causes a specialist to possess a more developed sub-specialty knowledge base compared to his/her counterpart specializing in a generic industry.  In response, it is believed that the complex industry specialist will outperform the generic industry specialist in identifying appropriate business risks, within their respective industries.
    • The authors additionally examine information-gathering attributes. Specifically, they argue that complex industry specialists will 1) list more appropriate information sources, 2) list more appropriate evidence gathering processes, and 3) will list more appropriate accounts and related assertions when compared to generic industry specialist auditors.
    Design/Method/ Approach:

    An experiment, which uses Big 4 auditors ranging in experience from 2 to 27 years, is conducted. The average experience levels of the auditors are 5.2 and 4.6 years, respectively, for the complex and generic industry specialists. This data was collected in Australia, prior to 2009. Two expert panels of Big 4 industry specialists (one from each industry) were involved in the development of the experimental materials.  

    Findings:
    • Complex industry specialists (i.e., pension fund auditors) were able to list relatively more business risks when working in their industry than generic industry specialists (i.e., manufacturing auditors) were able to in their respective industry.
    • Complex industry specialists, working in their industry, were able to list a greater number of appropriate information sources and appropriate evidence gathering processes, compared to their generic industry peers. However, they were not able to list a greater number of accounts or related assertions.
    Category:
    Client Acceptance and Continuance, Audit Team Composition, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Business Risk Assessment (e.g. industry - IPO - complexity), Industry Expertise – Firm and Individual, Assessing Risk of Material Misstatement
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