Auditing Section Research Summaries Space

A Database of Auditing Research - Building Bridges with Practice

This is a public Custom Hive  public

Posts

  • Jennifer M Mueller-Phillips
    Abnormal Audit Fees and Restatements
    research summary posted October 20, 2014 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
    Title:
    Abnormal Audit Fees and Restatements
    Practical Implications:

    The conclusion that audit fees are associated with the risk of audit failure may impact auditors as they face pressure to reduce audit fees. Auditors should consider this risk based on the client’s position as well as trying to minimize risk related to audit fee reductions. Similarly, client’s audit committee should consider the trade-off between current fees and the risk of restatement. With the changes that SOX introduced, regulators should review how changes in audit fees affects the quality of financial statements over time.

     

     

    For more information on this study, please contact Dr. David Hurtt.

    Citation:

    Alan I. Blankley, David N. Hurtt, and Jason E. MacGregor. 2012. Abnormal Audit Fees and Restatements. Auditing: A Journal of Practice & Theory: 31 (1): 79-96.

    Keywords:
    Restatements, audit fees, audit quality
    Purpose of the Study:

    Overall, this paper investigates whether there is a relationship between audit fees and subsequent financial statement restatements. The authors investigated whether audit firms charged more for audit services prior to a restatement compared to non-restatement clients. Past research finds that this relationship has a positive correlation. However, the authors revisited this relationship for the post-SOX period based on multiple factors:

     

    • The relationship of audit fees to future restatements is unclear since high fees may increase restatement probability due to independence issues, while low fees may increase the probability of future restatement because they potentially reflect lower levels of service or effort.
    • SOX affects the auditor-client relationship through changes such as partner rotation and prohibiting some non-audit services provided to audit clients. Research revealed a shift in firms increasing pricing for risk.
    • With the recent economic downturn, companies trying to decrease audit fees could be focusing on cutting cost instead of focusing on the quality of the financial statements.
    • Past research was inconclusive on the relationship between future restatements and audit fees because of the time frame studied as well as the omission of an internal control strength variable.

     

    Finding a clear relationship between audit fees and future restatements could have implications in how auditors, audit committees, and regulators view audit fees in a post-SOX business environment. As a result, the study could impact fee negotiations from the standpoint of audit quality.

    Design/Method/ Approach:

    Audit fee and restatement data was collected from Audit Analytics for the 2002 through 2009 period. The authors used two statistical models to study the association audit fees may have with future restatements. First, using an audit fee model based on prior research, the authors derived the abnormal or unusual audit fee after controlling for audit risk, client complexity, internal control strength and other influences on fees. In the second model, the authors tested a robust logistic regression model where the variable of interest was the abnormal audit fee derived from the first model. 

    Findings:
    • The authors find that abnormal audit fees are negatively associated with the probability of future financial statement restatements.
    • When audit fees are noticeably high, the likelihood of restatement is low. When audit fees are noticeably low, the likelihood of restatement is high.
    • When audit fees are abnormally low, there may be pressure for auditors to maintain the profitability of the engagement by minimizing hours to complete the audit.
    • This relationship is robust when the model included or excluded a variety of internal control and restatement variables.
    Category:
    Accountants' Reporting, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, Restatements
  • Jennifer M Mueller-Phillips
    Are All Industry Specialist Auditors the Same?
    research summary posted October 13, 2015 by Jennifer M Mueller-Phillips, tagged 05.0 Audit Team Composition, 05.01 Use of Specialists e.g., financial instruments, actuaries, valuation, 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 11.0 Audit Quality and Quality Control 
    Title:
    Are All Industry Specialist Auditors the Same?
    Practical Implications:

    The results have implications on two fronts. First, the findings indicate that auditors pursue different production and pricing strategies in different segments of the market, suggesting that the Big 4 audit firms respond to the competitive pressures in each submarket. Second, the evidence raises questions about the construct validity of market share-based measures of industry specialization, which have been used extensively in the literature. The evidence suggests that auditors who obtain a large market share by auditing a large proportion of the industry sector may actually do so by producing lower quality, lower cost audits. As such, these auditors are not acting as true specialists in the sense of using specialized training and knowledge to raise the quality of the audit performed.

    Citation:

    Cahan, S. F., D. C. Jeter, and V. Naiker. 2011. Are All Industry Specialist Auditors the Same? Auditing: A Journal of Practice & Theory 30 (4): 191-222.

    Keywords:
    audit fees, audit quality, auditor market share, industry specialization, market segmentation, product differentiation
    Purpose of the Study:

    Auditor industry specialization continues to attract considerable attention in the literature. This may reflect the importance that clients place on industry specialization, e.g., 80 percent of companies viewed industry expertise or specialization as being an important factor in choosing an auditor. Most commonly, archival studies identify industry specialist auditors using a market share-based measure where a significant share, or an industry leading share, of the industry’s audit fees is used to designate specialists. However, a market share-based measure is problematic because market share depends jointly on the proportion of clients audited and the average size of those clients. For example, it is possible to attain a large industry market share by auditing a few relatively large clients in an industry or many relatively small ones. The question the authors examine is as follows: Are industry specialists who obtain a high market share in disparate ways similar in terms of product (audit) quality and price (audit fees)?

    Design/Method/ Approach:

    The authors begin with all client-years from 2003 through 2007 with requisite data available from Compustat and Audit Analytics. For the audit fee sample, the data requirement to compute the control variables results in a final sample of 9,565 client-year observations. For the discretionary accruals model, the additional data requirements needed to estimate discretionary accruals and the control variables for Equation (3) result in a final sample of 9,396 client-year observations. Sixty-one industries are represented by observations in both the audit fee and discretionary accruals samples. 

    Findings:

    The authors find evidence of higher (lower) audit quality when the auditor attains a high market share by auditing a lower (higher) proportion of clients in the industry. Combined, the findings suggest that industry specialists who gain market share by auditing a small proportion of clients in an industry pursue a product differentiation strategy, offering a higher quality, but more costly, audit. On the other hand, those specialists who gain market share by auditing a large proportion of clients follow a cost minimization strategy, competing on price and sacrificing quality. The authors do not find any evidence that the Big 4 operates as a tight oligopoly either in the overall audit market or within industry markets, whether defined at the national or local level. In summary, the results suggest that not all industry specialists are the same.

    Category:
    Audit Quality & Quality Control, Audit Team Composition, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, Use of Specialists (e.g. financial instruments – actuaries - valuation)
  • 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
    Home:
    home button
  • Jennifer M Mueller-Phillips
    Audit Hours and Unit Audit Price of Industry Specialist...
    research summary posted June 2, 2016 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 11.0 Audit Quality and Quality Control, 11.04 Industry Experience 
    Title:
    Audit Hours and Unit Audit Price of Industry Specialist Auditors: Evidence from Korea
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    Industry specialist auditors; Audit effort; Audit fee premium; Audit quality
    Purpose of the Study:

    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. 

    Design/Method/ Approach:

    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.

    Findings:
    • 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. 
    Category:
    Audit Quality & Quality Control, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations
  • Jennifer M Mueller-Phillips
    Audit Partner Tenure and Audit Planning and Pricing.
    research summary posted October 20, 2015 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 15.0 International Matters, 15.03 Audit Partner Rotation 
    Title:
    Audit Partner Tenure and Audit Planning and Pricing.
    Practical Implications:

    This study provides the first evidence using U.S. data on the relationships between audit planning and pricing and audit partner tenure. Importantly, the results speak to the requirement in SOX Section 203 that audit partners on public clients rotate every five years. The second set of results concerns changes in auditor risk responsiveness during the period 2002 to 2003. Because there are very few longitudinal studies of engagement effort that feature a consistent sample of clients over time, this study contributes to understanding of changes in audit firms’ risk responsiveness.

    Citation:

    Bedard, J. C., and K. M. Johnstone. 2010. Audit Partner Tenure and Audit Planning and Pricing. Auditing: A Journal of Practice & Theory 29 (2): 45-70.

    Keywords:
    audit effort, audit partner tenure, audit pricing, risk management, rotation
    Purpose of the Study:

    This paper investigates the association between audit engagement partner tenure and audit planning and pricing. Limitations on partner tenure for public company engagements exist in many developed countries. For instance, in the U.S., the AICPA’s SEC Practice Section has long had a professional requirement that audit partners of public clients be rotated at least once every seven years. Section 203 of the Sarbanes-Oxley Act (SOX) codifies a partner tenure limitation for public companies into law, and reduces the period to five years. Proponents of frequent partner rotation argue that the auditor’s independence and objectivity suffer from long tenure with the client, which may result in lower audit quality, and that the fresh perspective of a new partner is thereby beneficial. However, many in the auditing profession maintain that mandatory partner rotation causes unnecessary costs, and may in fact impair audit quality. This position is derived from concerns that while client information is stored in the workpapers, each new engagement partner faces a certain amount of information asymmetry due to less history of client interaction.

    Design/Method/ Approach:

    The data includes client characteristics and plans for audit engagements of publicly traded companies to be conducted during 2002 and 2003, gathered by the participating audit firm in support of its client continuance decisions. The final sample size is well over 500. The models consider 20022003 risk assessments and audit planning/pricing decisions for the firm’s continuing public clients in 2002, i.e., those that the firm audited in 2001 and prior years.

    Findings:
    • The level of planned effort does not differ for clients having longer versus shorter tenure partners.
    • Engagements with longer partner tenure have significantly higher realization rates, suggesting that client demand for services of those partners and associated reduction in fee pressure enables a greater return on their engagements.
    • Results reveal that relative to the prior year engagement of the client, audit effort increases in the year of the partner change.
    • Planned realization rates decline in the year of the partner rotation.
    • In combination, the results suggest that tightening the term of mandatory partner rotation from seven to five years removes a service valued by clients.
    • Levels of risks related to financial reporting quality, management integrity, and internal controls are positively associated with the levels of planned effort in 2002.
    • Changes in assessments of financial reporting risk, management integrity risk and internal control risk are positively associated with changes in planned effort from 2002 to 2003.
    • Overall, the authors conclude that from 2002–2003, the firm’s risk response was strong in 2002, and further increased in 2003. This change was more predominant in effort rather than unit pricing, which has positive implications for audit quality.
    Category:
    Engagement Management, International Matters
    Sub-category:
    Audit Fees & Fee Negotiations, Audit Partner Rotation
  • Jennifer M Mueller-Phillips
    Auditor Industry Specialization and Evidence of Cost...
    research summary posted October 21, 2015 by Jennifer M Mueller-Phillips, tagged 05.0 Audit Team Composition, 05.02 Industry Expertise – Firm and Individual, 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations 
    Title:
    Auditor Industry Specialization and Evidence of Cost Efficiencies in Homogenous Industries.
    Practical Implications:

    The results of this study are important to audit firm clients, audit firms, and audit regulators as they evaluate the benefits and costs of industry specialization. For auditors and their clients, the evidence indicates that specialist auditors in homogenous industries, even when complex accounting is involved, achieve economies of scale that are passed on to clients. Clients in homogenous industries appear to benefit from a lower cost audit without a decrease in audit quality. Moreover, audit firms may benefit from increased client retention in these industries because of their expertise and competitive price. And, though audit regulators have expressed concern about concentration in the audit market, the results indicate that concentration can improve audit firms’ economies of scale in homogenous and complex industries without reducing audit quality. As audit clients, audit firms, and audit regulators consider industry specialization, this paper provides support for auditor specialization in homogenous industries.

    Citation:

    Bills, K. L., D. C. Jeter, and S. E. Stein. 2015. Auditor industry specialization and evidence of cost efficiencies in homogenous industries. The Accounting Review 90 (5): 1721-1754.

    Keywords:
    auditor industry specialization, audit fees, economies of scale, homogenous industries, complex industries
    Purpose of the Study:

    Audit firms specialize in certain industries hoping to enhance audit quality and achieve lower costs through knowledge transfer across clients. There has been mixed evidence to date regarding audit pricing for firms in specialized industries; most studies indicate that auditors charge a premium on their services, while others indicate that auditors discount their services due to achieved economies of scale. This paper examines the audit pricing effects of auditor industry specialization based on specific industry characteristics. Specifically, the authors:

    • Investigate whether the specialist auditor’s pricing behavior varies based on industry characteristics, like an industry’s similarity (homogeneity) of operations and complex accounting requirements.
    • Investigate whether the pricing decisions by the specialist auditor in industries where auditors achieve economies of scale depend on client bargaining power.
    Design/Method/ Approach:

    The authors collected audit firm market share data, operating expense data for each industry, information about AICPA audit and accounting guides, as well as data necessary to calculate control variables on companies with data available in the Audit Analytics database and Compustat. The information collected on these companies was for years 2004-2009.

    Findings:
    • The authors find that industry specialist auditors serving client firms in non-homogenous industries charge a fee premium. However, audit fees are incrementally lower for client firms in homogenous industries and client firms in homogenous and complex industries. This indicates that specialist auditors achieve cost efficiencies that are passed to clients who operate in homogenous industries. Additionally, when the client firm displays a relatively high degree of bargaining power, specialist auditors exhibit significantly lower fees.
    • The authors find that non-specialist auditors can also realize cost savings in homogenous industries, but charge higher fees to client firms in complex industries. Specialist auditors charge incrementally higher fees than non-specialists to client firms in complex, but not homogenous, industries. 
    • The authors find that audit quality provided by industry-specialist auditors in homogenous, or homogenous and complex, industries are not significantly different from other industries. These results support that specialist auditors generate production efficiencies without sacrificing audit quality. 
       
    Category:
    Audit Team Composition, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, Industry Expertise – Firm and Individual
  • Jennifer M Mueller-Phillips
    Business Strategy, Financial Reporting Irregularities, and...
    research summary posted April 17, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations 
    Title:
    Business Strategy, Financial Reporting Irregularities, and Audit Effort
    Practical Implications:

    This study provides several important contributions to the existing accounting literatures on financial reporting irregularities. The authors provide evidence that the differences in the client business risk of companies’ choice of business strategies is an underlying determinant of financial statement quality. Also, the findings provide evidence that auditors appear to recognize and adjust audit effort based on clients’ business strategies. This study is important because it identifies organizational business strategies as an important determinant of both financial reporting irregularities and audit effort based off publicly available data.

    For more information on this study, please contact Kathleen, A. Bentley.
     

    Citation:

    Bentley, K. A., T. C. Omer, and N. Y. Sharp. 2013. Business Strategy, Financial Reporting Irregularities, and Audit Effort. Contemporary Accounting Research 30 (2).

    Keywords:
    business strategies; audit effort; financial statement quality.
    Purpose of the Study:

    This study examines the effect clients’ business strategies have on the occurrence of financial reporting irregularities and the level of audit effect. Using Miles and Snow’s (1978, 2003) strategy typology, the authors attempt to provide evidence that increases the understanding of underlying determinates of financial reporting quality. They provide a measure of business strategy that requires only publicly available information and is generalizable across industries. Using these measures, this study is able to provide evidence of whether companies’ business strategies exhibit differences in the occurrences of financial reporting irregularities.

    Design/Method/ Approach:

    The authors of this study use the organizational strategy theory of Miles and Snow to develop a comprehensive measure of business strategy using publicly available data. Relying on this theory, the authors developed a discrete STRATEGY composite measure, which proxies for the organization’s business strategy. Higher STRATEGY scores represent companies with prospector strategies and lower score represent companies with defender strategies. Using logistic regression, the authors determine whether the company strategies are associated with financial reporting irregularities. Level of audit effort was determined using audit fee data. All of this data is combined and analyzed to produce overall conclusions.

    Findings:
    • Companies following a prospector strategy are more likely than companies following a defender strategy to experience financial reporting irregularities across three samples of irregularities: SEC AAERs, shareholder lawsuits related to alleged accounting improprieties, and accounting restatements.
    • The business strategy measure represents client business risk and is not a substitute for financial reporting risk.
    • Clients following prospector strategies have higher audit fee, suggesting that auditors expend greater audit effort for these clients.
    • Despite higher audit fees for prospectors, fees are not high enough to account for the riskiness of these clients.
       
    Category:
    Client Acceptance and Continuance, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, Business Risk Assessment (e.g. industry - IPO - complexity)
  • Jennifer M Mueller-Phillips
    CEO Financial Background and Audit Pricing
    research summary posted October 12, 2016 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 14.0 Corporate Matters, 14.09 CEO Tenure and Experience 
    Title:
    CEO Financial Background and Audit Pricing
    Practical Implications:

     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.

    Citation:

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

    Keywords:
    CEO financial expertise; audit fees
    Purpose of the Study:

     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.

    Design/Method/ Approach:

    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.

    Findings:
    • 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.
    Category:
    Corporate Matters, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, CEO Tenure & Experience
  • Jennifer M Mueller-Phillips
    City-Level Auditor Industry Specialization, Economies of...
    research summary posted February 17, 2015 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:
    City-Level Auditor Industry Specialization, Economies of Scale, and Audit Pricing
    Practical Implications:

    The consolidation of audit firms from the Big 6 to the Big 5 in 1998, and then to the Big 4 in 2002, has raised concerns about the lack of competition in the large-client market (GAO 2003). However, while it is possible that the consolidation has reduced competition and increased prices, it could also have created efficiencies leading to reduced prices. This study shows that there is some merit in the "efficiency" argument that larger firms pass on an economies-of-scale discount to their clients. The finding provides some support for the GAO’s (2008) observation that there is little evidence of Big N oligopolistic pricing.

    For more information on this study, please contact Jagan Krishnan.

    Citation:

    Fung, Simon Y.K., Ferdinand A. Gul, and Jagan Krishnan. 2012. City-Level Auditor Industry Specialization, Economies of Scale, and Audit Pricing. The Accounting Review 87 (4): 1281-1307.

    Keywords:
    industry specialization; scale economies; audit pricing; client bargaining power
    Purpose of the Study:

    Increasing auditor size leads to two outcomes, which include industry specialization due to the expertise developed from expanding within industries, and economies of scale arising from spreading audit investment costs over a large client base. Academic research has examined the effects of industry specialization and, to a much lesser extent, the effects of scale economies, on audit pricing. The authors find that while the national operations of the Big N auditors are evenly divided, their scale of operations are significantly different at the city level. The purpose of this study is to examine whether (and in what settings) the benefits of scale economies at the city level are passed on to clients, particularly in light of concerns that the Big N audit firms dominate the audit market. Evidence on the effects of scale economies on the fees charged to audit clients is therefore of interest to regulators, auditors, and market participants.

    Design/Method/ Approach:

    The authors extract information of Big N auditors as well as their publicly listed audit clients in the U.S. for the period 2000–2007. Observations with missing information, those in the financial sector (which is regulated very differently), and foreign firms are excluded from the sample. The test sample includes 17,207 client-year observations across 54 two-digit SIC industries. Multivariate regressions are used to conduct statistical inferences.

    Findings:
    • There are significant variations in the city-industry scale in the U.S. Big N audit market.
    • Industry specialist auditors at the city-level earn significant premiums (14.8 percent, or $226,000, on average) compared to non-specialist auditors; but audit fees decrease by 1.7 percent (or $25,900) for a one-decile increase in city-industry scale.
    • The effects of industry specialization and economies of scale on audit pricing are highly interactive. The negative effect of city-industry scale on audit fees applies only to industry specialist auditors, and the audit fee premium for industry specialization is smaller for auditors with a larger city-industry scale.
    • The industry specialization premiums are higher after SOX, although scale discounts are slightly smaller. However, the aforementioned interactive effects hold in both periods.
    • Client bargaining power exerts a moderating effect on both the specialization premium and the scale discount. Both specialist and non-specialist auditors pass on some scale discounts to clients with a high degree of bargaining power. However, only specialist auditors pass on scale discounts to clients with a relatively low degree of bargaining power. 
    Category:
    Client Acceptance and Continuance, Engagement Management
    Sub-category:
    Audit Fee Decisions, Audit Fees & Fee Negotiations
  • Jennifer M Mueller-Phillips
    Client-Auditor Supply Chain Relationships, Audit Quality,...
    research summary posted March 2, 2015 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 11.0 Audit Quality and Quality Control, 11.04 Industry Experience 
    Title:
    Client-Auditor Supply Chain Relationships, Audit Quality, and Audit Pricing
    Practical Implications:

    The results of this study provide empirical evidence of an association between supply chain knowledge and improved audit quality, as well as audit efficiency when this knowledge exists at a local level.  Audit firms often attempt to differentiate themselves by a certain level service and audit quality that can be provided based on specialized knowledge, such as industry experience.  Supply chain knowledge can add a new dimension to auditor knowledge and specialization.  By identifying an association between supply chain knowledge and audit quality and fees, this study demonstrates to audit firms an additional value-adding, quality-differentiating audit service. 

    For more information on this study, please contact Karla Johnstone.

    Citation:

    Johnstone, K. M., C. Li, and S. Luo. 2014. Client-Auditor Supply Chain Relationships, Audit Quality, and Audit Pricing. Auditing: A Journal of Practice and Theory 33 (4): 119-166

    Keywords:
    audit pricing; audit quality; supply chain relationships; industry expertise
    Purpose of the Study:

    This study examines the implications of auditor supply chain knowledge on audit quality and audit fee pricing.  The auditor may develop supply chain knowledge when performing the audit of both the supplier and its major customer.  This supply chain knowledge is a specialized understanding of the accounting and auditing issues in the revenue cycle that relates to both the supplier and its major customer.  This study examines the following potential impacts on an audit engagement as a result of supply chain knowledge:

    • As revenue recognition is often a significant audit area, as well as one of the highest areas subject to restatement, an auditor’s level of understanding of the revenue cycle is hypothesized to improve audit quality. 
    • An improved understanding of an audit client’s revenue cycle could also lead to audit efficiencies.  These efficiencies are hypothesized to be reflected in lower audit fees for auditors with supply chain knowledge. 
    • Supply chain knowledge can be developed and transferred at the local office and audit firm level.  The study hypothesizes that this knowledge transfer is stronger when the same office performs the audit of the both the supplier and customer rather than when both the supplier and customer are audited by difference offices in the same firm.  
    Design/Method/ Approach:

    The supply chain relationships for the years 2003 through 2010 were collected using the Compustat customer segment file , which identifies the names of major customers disclosed in the footnotes of the supplier’s 10-K.  Auditor supply chain knowledge was measured as the ratio of the number of supplier and major customer companies employing the same auditor divided by the total number of the supplier companies for the same auditor in the year.  This ratio was measured at both the city-office level and national level.

    Audit quality was measured using three common proxies: absolute discretionary accruals, existence of a restatement, and the propensity to meet or beat analyst’s earnings forecasts.

    Findings:
    • Auditor’s supply chain knowledge at the city level is associated with higher audit quality and lower audit fees for supplier companies compared to companies employing auditors with supply chain knowledge at the national level only, or auditors without supply chain knowledge.
    • This association is present only for suppliers that are highly dependent on their major customer.
    • The association is stronger among a subsample of companies for which the revenue cycle accounts are particularly important (those with high level of accounts receivable balances). 

    The results suggest that knowledge redundancy exists when a supplier and its major customer are audited by audit teams out of the same city level office.  They further suggest that this knowledge redundancy contributes to audit efficiencies, thus reducing audit fees where the city level supply chain knowledge exists.

    Category:
    Audit Quality & Quality Control, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, Industry Expertise – Firm and Individual

Filter by Type

Filter by Tag