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  • Jennifer M Mueller-Phillips
    Audit Market Structure and Audit Pricing
    research summary posted April 19, 2017 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions 
    Title:
    Audit Market Structure and Audit Pricing
    Practical Implications:

    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.

    Citation:

    Eshleman, J. D. and B. P. Lawson. 2017. Audit Market Structure and Audit Pricing. Accounting Horizons 31 (1): 57 – 81. 

    Keywords:
    audit pricing, auditor switches, audit market concentration, and lowballing.
    Purpose of the Study:

    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. 

    Design/Method/ Approach:

    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.    

    Findings:
    • The authors find, in their test of non-changing audit clients, a significantly positive association between audit market concentration and audit fees.
      • The authors find that the positive association is driven by the inclusion of MSA-level indicator variables in the audit fee model that they chose. For example, when they control for MSA-level fixed effects in their models, they find the association between audit market concentration and audit fees changes from significantly negative to significantly positive.
    • The authors’ test of initial audit fee discounts indicates that increases in concentration significantly reduce the discounts.
    • The authors provide some evidence that the effect of local audit market concentration on audit fees is more pronounced for smaller clients.
    • The authors find that concentration is positively associated with audit quality, as proxied by abnormal accruals. 
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions
  • Jennifer M Mueller-Phillips
    Audit Pricing for Strategic Alliances: An Incomplete...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity 
    Title:
    Audit Pricing for Strategic Alliances: An Incomplete Contract Perspective
    Practical Implications:

    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. 

    Citation:

    Demirkan, S. and N. Zhou. 2016. Audit Pricing for Strategic Alliances: An Incomplete Contract Perspective. Contemporary Accounting Research 33 (4): 1625-1647.

    Purpose of the Study:

    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. 

    Design/Method/ Approach:

    The authors conduct a study on the pricing of audit services for strategic alliances through compiling data and utilizing descriptive statistics.  

    Findings:
    • The authors find that the nonverifiability of information and potential agency behavior in alliances increase audit complexity, resulting in higher audit fees.
    • The authors find that auditors are less likely to issue going-concern modified opinions when there is an increase in strategic alliances; moreover, an increase in strategic alliances is associated with a reduction in bankruptcy risk as measured by Altman Z-Scores.
    • The authors find that an increase in strategic alliances is unrelated to the likelihood of financial misstatements.
    • The authors find that an increase in strategic alliances is unrelated to internal control weakness opinions. 
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Business Risk Assessment (e.g. industry - IPO - complexity)
  • Jennifer M Mueller-Phillips
    The Earnings Quality Information Content of Dividend...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions 
    Title:
    The Earnings Quality Information Content of Dividend Policies and Audit Pricing
    Practical Implications:

    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. 

    Citation:

    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. 

    Purpose of the Study:

    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. 

    Design/Method/ Approach:

    The authors test two separate earnings risk settings by using audit fees and financial statement data from 2004 to 2012. 

    Findings:
    • The authors find that dividend-paying firms pay lower audit fees than nondividend-paying firms after controlling for various determinants of audit pricing decisions.
    • The authors find that audit fees are significantly lower (higher) for dividend-initiating (-omitting) firms compared to benchmark audit fees.
    • The authors find that the negative association between audit fees and earnings persistence is more pronounced for dividend firms, suggesting that as earnings persistence increases, dividends provide auditors with assurance regarding the lower audit risk embedded in more persistent earnings. 
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions
  • Jennifer M Mueller-Phillips
    Client Acceptance and Engagement Pricing following Auditor...
    research summary posted January 17, 2017 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions 
    Title:
    Client Acceptance and Engagement Pricing following Auditor Resignations in Family Firms
    Practical Implications:

    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. 

    Citation:

    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. 

    Keywords:
    client acceptance, audit pricing, auditor resignations, and family firms.
    Purpose of the Study:

    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. 

    Design/Method/ Approach:

    The authors analyze results obtained using a sample of auditor resignations over the post-SOX period 2004-2012.

    Findings:
    • The authors find that Big 4 auditors are more likely to serve as successor auditors following auditor resignations in family firms as opposed to non-family firms.
    • The authors find that the likelihood of having Big 4 auditors serving as successor auditors is higher in family firms managed by a family member or by a professional manager. This implies that big 4 auditors perceive family firms as being less risky than their non-family counterparts following auditor resignations, irrespective of whether a family member is involved in management or not.
    • The authors find that the change in audit fees following auditor resignations in family firms is significantly smaller than that in non-family firms after controlling for a wide battery of variables that affect the change in audit fees. 
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions
  • Jennifer M Mueller-Phillips
    Client business models, process business risks and the risk...
    research summary posted November 14, 2016 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Client business models, process business risks and the risk of material misstatement of revenue
    Practical Implications:

    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. 

    Citation:

    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. 

    Keywords:
    business risk auditing, risk-based auditing, risk assessment, analytical procedures, strategic management, and business models.
    Purpose of the Study:

    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. 

    Design/Method/ Approach:

    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. 

    Findings:
    • The author finds that, with a few exceptions, surrogates for entry-level auditors made the subtle yet important distinctions among process-level business risks given the requirements of two different business strategies.
    • The author finds that the participants were able to report risk assessments for the critical Production process such that the indirect effect of process-specific business risk mediated the direct relationship between judgments of process performance and the RMM of revenue.
    • The author finds that the participants were able to make the distinction between the two different business strategies and could correctly indicate that there is no significant difference in the RMM of revenue for the two strategies when product generation performance was relatively high and business risk was relatively low. 
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Business Risk Assessment (e.g. industry - IPO - complexity)
  • 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
  • Jennifer M Mueller-Phillips
    Audit Market Concentration, Audit Fees, and Audit Quality:...
    research summary posted July 18, 2016 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 11.0 Audit Quality and Quality Control 
    Title:
    Audit Market Concentration, Audit Fees, and Audit Quality: Evidence from China
    Practical Implications:

    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. 

    Citation:

    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.

    Keywords:
    audit market concentration, audit fees, audit quality, and China
    Purpose of the Study:

    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. 

    Design/Method/ Approach:

    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.

    Findings:
    • The authors’ findings support the claim that concentration influences audit fees; furthermore, the positive effects of concentration on audit fees is consistent with clients having a limited choice of audit service suppliers and audit firms having greater market power in concentrated audit markets. The increased market power reduces auditors’ fear of client loss and allows them to charge higher fees.
    • The authors’ findings suggest that audit market concentration has no significant overall effect on client earnings quality.
    • The authors’ findings support the notion that concentration results in poor audit quality through auditor overconfidence and complacency.
    • The authors find that concentration increases audit fees and such increases in turn improve earnings quality, suggesting that when the audit market becomes more concentrated, auditors with increased market power become less lenient with clients and charge higher fees to devote more resources and effort to audit tasks, leading to higher audit quality.
    • The authors’ findings suggest that auditors are less likely to issue modified audit opinions when the market becomes more concentrated.
    • The authors find that in concentrated audit markets auditors have greater market power and lower cost of tell the truth and can charge higher audit fees to devote more resources and efforts to the audits that they carry out.
    Category:
    Audit Quality & Quality Control, Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions
  • Jennifer M Mueller-Phillips
    The Volatility of Other Comprehensive Income and Audit Fees
    research summary posted July 18, 2016 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations 
    Title:
    The Volatility of Other Comprehensive Income and Audit Fees
    Practical Implications:

    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.

    Citation:

    Huang, H., S. Lin, K. Raghunandan. 2016. The Volatility of Other Comprehensive Income and Audit Fees. Accounting Horizons 30 (2): 195-210.

    Keywords:
    Other comprehensive income; audit fees; fair value audits
    Purpose of the Study:

    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.

    Design/Method/ Approach:

    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.

    Findings:

    The authors find:

    • A positive relationship between volatility in OCI volatility and audit fees, with or without controlling for other factors that influence audit fees.
    • Changes in OCI have predictive power for audit fees above and beyond changes in net income, suggesting items that flow through OCI are incorporated into audit pricing.
    • When breaking out OCI volatility into its components, the authors find audit fees incorporate volatility in foreign currency translation, available-for-sale investments, and minimum pension liabilities.  Audit fees increase as volatility of these items increases.
    • Audit fees have a negative relationship with volatility of cash flow hedges.  These hedges offset risk in the underlying prices; therefore, volatility in the hedges is indicative of firms successfully hedging against risk.  These firms pay lower audit fees.
    Category:
    Client Acceptance and Continuance, Engagement Management
    Sub-category:
    Audit Fee Decisions, Audit Fees & Fee Negotiations
  • Jennifer M Mueller-Phillips
    Spatial Competition at the Intersection of the Large and...
    research summary posted June 15, 2016 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 05.0 Audit Team Composition, 05.08 Impact of Office Size 
    Title:
    Spatial Competition at the Intersection of the Large and Small Audit Firm Markets
    Practical Implications:

     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.

    Citation:

    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.

    Keywords:
    spatial competition, market for audit services, market space, differentiation, small audit market
    Purpose of the Study:

    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. 

    Design/Method/ Approach:

    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.

    Findings:
    • The authors find that the audit fee large audit firms charge decreases with the success of small audit firms at aligning themselves with the large firms in their market space.
    • The authors’ findings suggest that spatial competition from small audit firms significantly impacts the large audit firm market; in fact, spatial competition from small audit firms has a greater effect on the large audit firm market than spatial competition from other large audit firms.
    • The authors find that small audit firms that enter the large audit firm market and are perceived as being competitors with the Big 4 firms can improve their competitive positions as compared to other small audit firms.
    • The authors find that small audit firms benefit from obtaining market shares similar to those of large audit firms, whereas large audit firms are harmed by the added competition.
    • The authors find that distance from the closest competitors by market share is an important factor of competition in the small audit firm market; however, it is important to determine distance from whom, large audit firm or small audit firm, as they have opposite signs. 
    Category:
    Audit Team Composition, Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Impact of Office Size
  • Jennifer M Mueller-Phillips
    Executive Equity Risk-Taking Incentives and Audit Pricing.
    research summary posted January 19, 2016 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 14.0 Corporate Matters, 14.10 CEO Compensation 
    Title:
    Executive Equity Risk-Taking Incentives and Audit Pricing.
    Practical Implications:

    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.

    Citation:

    Chen, Y., F. A. Gul, M. Veeraraghavan, and L. Zolotoy. 2015. Executive Equity Risk-Taking Incentives and Audit Pricing. The Accounting Review 90 (6): 22052234.

    Keywords:
    executive compensation, audit fees, vega, misreporting, SOX
    Purpose of the Study:

    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.

    Design/Method/ Approach:

    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.  

    Findings:
    • The authors show that for clients with a high executive vega, audit firms charge higher audit fees. This follows the logic that clients with higher vega have a higher likelihood to misreport and that auditors consider that likelihood when pricing audit services. The authors also found that the increase in fees is not related to the effort needed to audit expenses related to stock-based compensation.
    • The introduction of the Sarbanes-Oxley Act weakens the association between vega and audit fees.
    • CEO characteristics affect the relationship between vega and audit fees. Specifically, the positive association between vega and audit fees is stronger when the CEO is older and when the CEO is the board chair.
    Category:
    Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, CEO Compensation, Client Risk Assessment

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