The authors examine an important aspect of audit-client history and provide evidence on how the timing of auditor concessions in one period affects financial officers’ negotiation judgments in the subsequent period. They also show the importance of incorporating this variable into auditor-client negotiation studies. 

Cheng, M. M., H. T. Tan, K. T. Trotman, and A. Tse. 2017. The Impact of the Timing of a Prior Year’s Auditor Concessions on Financial Officers’ Judgments. Auditing: A Journal of Practice and Theory 36 (1): 43 – 62. 

Auditors and clients frequently engage in negotiations to resolve disagreements over financial reporting decisions. These negotiations ultimately lead to concessions being made either by the auditor, the client, or both. Existing research delves into the effect of strategies employed during negotiations in the current period, but this study differs by examining multi-period effects of negotiation strategies. Specifically, the authors consider the impact of negotiation history by investigating three concession timing strategies (concession-start, concession-end, and gradual concession) used by auditors in the previous negotiation period and their effect on financial officers’ negotiation judgments for the current year audit.  

The authors conduct an experiment where financial officers made negotiation judgments after receiving information about an auditor’s negotiation behavior in the prior year. 

• The authors find that financial officers expect a larger ultimate income-decreasing write-down and expect to provide more concessions to the auditor if their auditors had used a concession-start strategy rather than a concession-end strategy in the prior year.
• The authors find support for a mediation model in which an auditor’s prior-period concession provided at the end (rather than the start) of the negotiation positively increases managers’ expected ultimate write-down, which then positively affects their satisfaction with the negotiation outcome; in turn, negotiation outcome positively influences manager’s intention to continue a future relationship with the auditor. 

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Relationships between an auditor and the client have the capacity to impair auditor independence, which may have a negative impact on financial reporting quality. As such, research that examines issues that have the potential to impair audit quality should be important to the auditing profession. Furthermore, audit committees play a critical role in ensuring auditor independence and audit quality; therefore, it is important to consider the potential impact of the auditor’s economic dependence created by interlocking on audit quality. 

Hossain, S., G. S. Monroe, M. Wilson, and C. Jubb. 2016. The Effect of Networked Clients’ Economic Importance on Audit Quality. Auditing: A Journal of Practice and Theory 35 (4): 79 – 103.

The authors examine the association between audit quality and the economic importance of client networks that are created by audit committee member-audit partner interlocks, which occur when an audit committee member of a company is also an audit committee member of other companies that are audited by a common audit firm and engagement audit partner. When an audit partner audits several companies that have audit committee members in common, there is potential for a self-interest threat to auditor independence. The interlocked audit partner may perceive that disputes with the management of a particular client within the network may threaten future fee income from the other companies in the network; thus, these economic ties have the have the potential to erode auditor independence and, as a consequence, reduce audit quality.  

The authors test the association between each audit-quality proxy and each client network fee dependence measure using regressions based on unrestricted samples and samples of clients matched on their inherent propensity to be associated with an audit committee-audit partner interlock. 

• The authors find that network fee dependence is significantly associated with lower audit quality as measured by each of their audit-quality proxies, suggesting that the economic dependence created by such links may reduce the likelihood of an auditor issuing a first-time going-concern opinion and may increase the extent to which reported earnings are biased away from the level at which a neutral application of GAAP would precipitate.
• Collectively, the authors’ findings provide support for the contention that audit partner dependence on fees from other companies in the network created by audit committee member-audit partner interlocks erodes audit quality in economically significant client firms. 

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 The findings of this study suggest that the training and functional expertise of the CEO can affect the auditor’s perception of engagement risk, observed through a reduction in audit fees. They add to the growing literature of CEO characteristics which highlight how top managers influence firm outcomes.

 Kalelkar, R., S. Khan. 2016. CEO Financial Background and Audit Pricing. Accounting Horizons 30 (3): 325-339.

 Theory suggests that the audit pricing decision is a function of a client’s audit risk and business risk. Recent literature has suggested that CEO characteristics can affect how auditor’s perceive the firm’s audit risk and the resulting audit pricing decision. This paper addresses how the financial expertise of Chief Executive Officer influences audit fees. The authors hypothesize that a CEO’s financial expertise can affect the level of audit fees through two channels:

• Reducing the firm’s business risk through greater performance and profitability and

• Reducing the firm’s audit risk by improving the quality of the firm’s financial reporting.

Specifically, they suggest that a CEO’s financial expertise will lower both the firm’s audit risk and business risk resulting in lower audit effort and a corresponding reduction in audit fees.

The authors use a sample of firms with changes in CEO financial expertise between 2004 and 2013.  Specifically, they look at firms that switched from a CEO with financial expertise to a CEO with no financial expertise and vice versa, resulting in a sample of 77 firms and 81 changes in financial expertise.

Alternatively, to address the unobservable characteristics of the firm which may influence both accounting outcomes and CEO selection, the authors utilize an instrumental variables two-stage model.  They use the local density of financial firms as an instrument for the financial expertise of the focal firm.  The location of the firm can influence the financial expertise of the board of directors.  When the board holds greater financial expertise this can limit the demand for a CEO with similar functional expertise within the firm.

• The authors find that audit fees for firms with a financial expert CEO are lower by 8.5 percent, or $310,000.  The results are robust to controlling for CEO voluntary turnover, the simultaneous turnover of the CFO, firm fixed effects, as well as an instrumental variables approach.
• Consistent with their predictions, results suggest that a CEO’s financial expertise results in lower audit fees, potentially due to decreased audit risk and lower audit effort.

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The authors’ results indicate that the complexity associated with auditing more subjectively valued assets may affect audit fees in a manner that is not fully captured by the traditional log transformation. Based on their findings, the authors also suggest that future audit fee studies assess alternative mathematical transformations of client size variables.

Cullinan, C. P., H. Du, and X. Cheng. 2016. Size Variables in Audit Fee Models: An Examination of the Effects of Alternative Mathematical Transformations. Auditing: A Journal of Practice and Theory. 35 (3): 169-181.

Company size, typically measured as total assets, is an important factor in audit fee models. The size measure is usually transformed by taking the natural logarithm of total assets. The log of assets and the log of audit fees are used when studying audit fees to control for the non-linear relationship between asset size and audit fees. For example, as the population size (the number of individual assets held) increases, the sample size necessary to audit the population is only minimally affected, creating a non-linear relationship. This method was born from necessity after the realization that there was no true way to determine the form of the function; however, when this method became widely used, fair value accounting was not commonly used. Now that fair value accounting has become the “norm” and there are different methods of measuring fair value, mathematical transformations should be revisited. ASC 820 requires the disclosure of whether fair values were determined based on directly observable inputs (Level 1), indirectly observable inputs (Level 2), or unobservable inputs (Level 3). The authors combine the two insights regarding fair valued assets and mathematical transformations to examine whether the log transformation of different types of fair valued assets provides the best fit in an audit fee model, or whether other mathematical transformations may better reflect the non-linear nature of the relationship between different types of fair valued assets and audit fees. 

The authors examine these issues in audit fee models among closed-end mutual funds and among a broad-based sample of publicly traded companies.

• The authors find that for the closed-end audit fee model, the log transformation provides the best fit for Level 1 valued assets, while a square root transformation provides the best fit for assets valued using Level 2 inputs, and cube root best fits Level 3 valued assets.
• The authors’ findings are consistent with the idea that auditing the fair value of assets valued using Level 2 and Level 3 inputs may be more costly for auditors because they have to assess management’s evaluation of indirectly observable inputs and/or management’s own estimates of future cash flows and discount rates.
• The authors find that, for the broad-based sample, the audit fee model also indicates that the log transformation alone may not fully capture the non-linear relationship between assets of different levels of complexity and audit fees.
• The authors find that, for both the closed-end and broad-based samples, the significance of the other variables in the audit fee models can differ when the transformations of the size variables are allowed to vary. This suggests that a more rigorous test of non-size variables can be performed when the size variables are permitted to follow a better-fitting mathematical transformation. 

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The existing research is unclear about the mechanism behind the higher audit fees charged by the industry specialist auditors (ISAs). The fee premium can be explained either by higher audit hours or by higher audit fees per hour. Using Korean data, this study provides direct evidence of the source of the ISA fee premium. The results show ISAs spend more audit hours while charge lower unit price than non-ISAs, which indicates the ISA fee premium mainly comes from additional audit work performed by ISAs. One limitation of this study is the authors cannot differentiate the two potential explanations for the low unit price: cost savings arising from economies of scale or additional work performed by cheap audit labor.

Bae, G. S., S. U. Choi, and J. H. Rho. 2016. Audit Hours and Unit Audit Price of Industry Specialist Auditors: Evidence from Korea. Contemporary Accounting Research 33(1): 314-340.

Prior audit research documents the total audit fees charged by industry specialist auditors (ISAs) are higher than those charged by non-industry specialist auditors (non-ISAs). There are different explanations of this finding. Some argue ISAs charge higher fees for more audit work they conduct. Others argue ISAs charge higher fees because they have greater bargaining power over client. This paper is to explore the source of audit fee premiums associated with ISAs. In particular, the authors compare total audit hours and audit price per hour between similar audit engagements of ISAs and non-ISAs. By decomposing total audit fees into total audit hours and audit price per hour, the authors would at least identify one source of the ISA audit fee premium. A higher total audit hours spent by ISAs would imply ISAs exert greater audit effort and their audit quality is higher. In contrast, a higher audit price per hour charged by ISAs would imply ISAs can extract market power rents or expertise rents from their clients. 

The sample comprises audit engagements of Korea listed companies from 2000 to 2010. In Korea, audit hours are required to be disclosed in the companies’ annual reports. The authors first compare total audit fees and total audit hours between audit engagements of ISAs and non-ISAs, controlling for other engagement characteristics. Next, they compare the unit audit prices charged by ISAs and non-ISAs.

• Consistent with prior research, the authors find ISAs charge significantly higher audit fees than non-ISAs.

• Further, the authors find the higher audit fees are driven by additional audit hours spent by ISAs, which implies ISAs make more audit efforts than non-ISAs.

• They also find the audit price per hour charged by ISAs is significantly lower than that charged by non-ISAs.  They argue the lower unit price of ISAs could be either due to the benefit of economies of scale shared with clients or due to more audit work completed by low-pay junior auditors.   

• Supporting the argument that extra audit hours are translated into higher audit quality, the authors find ISAs are positively associated with higher accounting quality.

• The authors find consistent results when they limit their analysis within audit engagements of Big 4 accounting firms. Moreover, similar results exist when audit engagements are separate into large client group and small group and when the ISAs have dominant market shares. These findings refute the argument that the ISA fee premium is a result of superior bargaining power. 

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