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  • Jennifer M Mueller-Phillips
    The Relationship between Aggressive Real Earnings Management...
    research summary posted April 19, 2017 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 14.0 Corporate Matters, 14.01 Earnings Management 
    Title:
    The Relationship between Aggressive Real Earnings Management and Current and Future Audit Fees
    Practical Implications:

    Prior research concerning audit fees and earnings management has focused primarily on accruals management. This article shows how the audit fee and audit risk models support auditors’ pricing behavior in a REM setting. Specifically, the results are consistent with auditors, after observing aggressive REM, increasing current audit fees to cover the cost of additional effort required to gain reasonable assurance that the financial statement are free of material misstatements and increase both current and future audit fees to cover increases in perceived business risk.     

    Citation:

    Greiner, A., M. J. Kohlbeck, and T. J. Smith. 2017. The Relationship between Aggressive Real Earnings Management and Current and Future Audit Fees. Auditing: A Journal of Practice and Theory 36 (1): 85 – 107. 

    Keywords:
    audit fees, business risk, audit risk, and aggressive real earnings management.
    Purpose of the Study:

     The authors examine whether aggressive real earnings management (REM) activities are associated with audit fees. Prior research focuses on accruals-based earnings management and suggests that auditors extract additional audit fees to cover costs associated with increased engagement risk, which includes audit risks related to the issuance of an incorrect opinion and nonaudit risk related to impaired reputation, fewer business opportunities, and the inability to collect desires and future audit fees. The distinction between accrual and real earnings management is important for auditors because the potential effects on company performance and engagement risks are different. REM alters normal firm operations, impacts current and future cash flows, imposes additional costs, and sacrifices firm value. Whether auditors charge higher fees for earnings management behavior that does not violate generally accepted accounting principles if important to study as clients continue to pursue REM to meet reporting objectives. 

    Design/Method/ Approach:

    The authors utilize a conceptual audit fee model to identify specific examples within this framework where REM is likely to increase engagement risk and thereby increase audit fees through either increased effort, a risk premium, or both. They perform further analysis to better understand the sources between aggressive REM and fees.

    Findings:
    • The authors find, overall, a positive association between aggressive REM and both current and future audit fees.
    • The authors find that changes in aggressive REM are associated with changes in fees.
    • The authors find that only current aggressive REM is positively associated with audit report delays.
    • The authors find evidence that the associations between aggressive Rem and future fees are driven by firms with higher REM incentives.
      • Further, they find that the future effect of aggressive REM is stronger among firms constrained by balance sheet bloat.
    Category:
    Corporate Matters, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, Earnings Management
  • 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
    Size Variables in Audit Fee Models: An Examination of the...
    research summary posted August 31, 2016 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations 
    Title:
    Size Variables in Audit Fee Models: An Examination of the Effects of Alternative Mathematical Transformations
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    audit fee, fair valued assets, closed-end mutual funds, and non-linear.
    Purpose of the Study:

    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. 

    Design/Method/ Approach:

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

    Findings:
    • 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. 
    Category:
    Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations
  • 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
    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
    On the Benefits of Audit Market Consolidation: Evidence from...
    research summary posted March 31, 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, 11.07 Attempts to Measure Audit Quality 
    Title:
    On the Benefits of Audit Market Consolidation: Evidence from Merged Firms.
    Practical Implications:

    The study results are important to audit firms and audit clients as they show audit efficiency benefits (lower audit hours and improved audit quality) post-merger. Although a merger with an international Big 4 firm may bring some reputational improvements, mergers with domestic Big 10 firms create improvements in audit efficiency. Audit firms interested in merging in the Chinese market should consider the benefits of local expertise and higher fees in a merger transaction. These results provide further insights into mergers and acquisitions and the benefits of economies of scale when performing audits.   

    Citation:

    Gong, Q., O. Z. Li, Y. Lin, and L. Wu. 2016. On the Benefits of Audit Market Consolidation: Evidence from Merged Audit Firms. The Accounting Review 91 (2): 463488.

    Keywords:
    audit mergers, efficiency gains, audit fees, audit hours
    Purpose of the Study:

    This study assesses whether there is an improvement in audit efficiency associated with audit firm mergers. The authors specifically investigate if there is a change in audit hours, quality, and fees in the period after the audit firm merger. With the public disclosure of Chinese audit firm hours, the authors can empirically assess changes in audit operations subsequent to an audit firm merger.

    The Chinese audit market has undergone rapid transformation due to the increase in stock offerings and publicly traded firms. International Big 4 firms have increased financial and human resource investments in the Chinese audit firm market. In response to this changing environment, domestic Chinese firms have entered into merger transactions to bolster their market share to achieve economies of scale to compete with the Big 4 firms. The Chinese government and the China Institute of Certified Public Accountants (CICPA) have supported increasing the size for domestic firms. This rapid market consolidation provides a unique context to evaluate the effects on audit firm mergers on audit efficiency and quality. Due to limited empirical studies on audit firm mergers, the authors embark on this study to understand the impact of audit firm mergers on auditor effort and audit quality.

    Design/Method/ Approach:

    The authors employ an archival research methodology in this study. Audit firm merger information is from the CICPA database, financial newspapers, and audit firm websites. Audit firm client financial information is from the China Stock Market and Accounting Research Database (CSMAR). The sample period is from 2005-2009. Eighteen mergers are included in the sample population.

    Findings:
    • The authors find that audit firm mergers reduce audit effort represented by a 15.38 percent decrease in audit hours after an audit firm merger.
    • When assessing audit quality, the authors find that the probability of a financial statement decreases after an audit firm merger and that the probability of a modified audit opinion increases. These both support that audit quality improves after a merger. In addition, the probability of earning manipulation decreases with accounting conservatism increasing. The audit firm client’s accrual quality is not associated with audit firm mergers.
    • Combining the reduction in audit effort with the improvement in audit quality, these results show an improvement to audit efficiency after an audit firm merger. 
    • In supplemental analyses, the authors evaluate the effect of audit efficiency over time and note that the improvements occur over a three-year period with the highest reduction in audit effort (hours) occurring in the third year.
    • The authors also find that audit efficiencies are greater when the audit firm merges with a domestic Big 10 audit firm rather than with international Big 4 firm. The authors note that this difference could result from differences in the types of firms that the acquirers target.
    • In evaluating audit fees, the authors find that audit fees increase after an audit firm merger and the increase is not a result of market conditions.  
    Category:
    Audit Quality & Quality Control, Engagement Management
    Sub-category:
    Attempts to Measure Audit Quality, Audit Fees & Fee Negotiations
  • 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
    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
    Do Abnormally High Audit Fees Impair Audit Quality?
    research summary posted October 20, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 11.0 Audit Quality and Quality Control 
    Title:
    Do Abnormally High Audit Fees Impair Audit Quality?
    Practical Implications:

    The study provides useful insight into current regulatory debates on the auditor’s economic dependence on the client and increases understanding to the reasons why previous research provides mixed evidence on the association between various fee metrics and the extent of earnings management. If the association between abnormal fees and the magnitude of discretionary accruals is conditioned on the sign of abnormal fees, examining the association without reference to the sign of abnormal fees most likely leads to observations of insignificant associations, as also reported in most previous studies. This study’s findings suggest that future research on similar issues should take into account the asymmetric nonlinearity in the fee-quality relation.

    Citation:

    Choi, J. H., J. B. Kim, and Y. Zang. 2010. Do Abnormally High Audit Fees Impair Audit Quality? Auditing: A Journal of Practice & Theory 29 (2): 115-140.

    Keywords:
    audit quality, abnormal audit fees, earnings management
    Purpose of the Study:

    This study examines whether the association between audit fees and audit quality is asymmetric and thus nonlinear in the sense that the association is conditioned upon the sign of abnormal audit fees. The authors define abnormal audit fees as the difference between actual audit fees (i.e., actual fees paid to auditors for their financial statement audits) and the expected, normal level of audit fees. Actual audit fees consist of two parts: (1) normal fees that reflect auditors’ effort costs, litigation risk, and normal profits, and (2) abnormal fees that are specific to an auditor-client relationship. Normal fees are mainly determined by factors that are common across different clients, such as client size, client complexity, and client-specific risk, while abnormal fees are determined by factors that are idiosyncratic to a specific auditor-client relationship. As noted by Kinney and Libby, abnormal fees “may more accurately be likened to attempted bribes” and can better capture economic rents associated with audit services or an auditor’s economic bond to a client than normal fees or actual fees.

    Design/Method/ Approach:

    The authors obtain audit and nonaudit fee data from the Compustat audit fees file and all other financial data from the Compustat Industrial Annual File. The sample period for this study is restricted to the four-year period from 2000 to 2003. The full sample consists of 9,815 firm-years over the four-year sample period. They also construct a reduced sample of 7,061 observations that meet the data requirements for computing two additional variables. 

    Findings:

    The regression results reveal the following:

    • The proxy for audit quality is insignificantly associated with abnormal audit fees for the total sample of client firms with both positive and negative abnormal audit fees.
    • When the authors split total observations into those with positive abnormal fees and those with negative abnormal fees, the results change dramatically.
    • When the abnormal fees are positive, the magnitude of absolute discretionary accruals (an inverse measure of audit quality) is positively associated with abnormal fees, suggesting a negative relation between audit quality and positive abnormal fees.
    • In contrast, the association is insignificant when the abnormal fees are negative.
    • These findings imply that positive and negative abnormal fees create different incentive effects, for clients with positive abnormal fees, auditors are more likely to acquiesce to client pressure as abnormal audit fees increase, whereas for clients with negative abnormal fees, auditors are unlikely to compromise audit quality.
    • In contrast to the findings on the asymmetric association between abnormal audit fees and audit quality, the authors find no significant, comparable relation when abnormal nonaudit service (NAS) fees or abnormal total fees are used as a measure of auditor-client economic bond in lieu of abnormal audit fees.
    Category:
    Audit Quality & Quality Control, Engagement Management, Independence & Ethics, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Audit Fees & Fee Negotiations, Earnings Management, Earnings Management, Impact of Fees on Decisions by Auditors & Management
  • Jennifer M Mueller-Phillips
    Effect of Auditor Negotiation Experience and Client...
    research summary posted October 13, 2015 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations 
    Title:
    Effect of Auditor Negotiation Experience and Client Negotiating Style on Auditors' Judgments in an Auditor-Client Negotiation Context.
    Practical Implications:

    The results show that the benefit of greater negotiation experience is contingent on client negotiation stylethere is a benefit to assigning auditors with greater negotiation experience to negotiate with a contentious negotiation style client, but not for a client with a collaborative negotiation style.  Thus, there are potential effectiveness and efficiency gains from matching auditor negotiation experience (an auditor attribute) with client negotiation style (a client attribute).  This study is also helpful to audit researchers when they design negotiation experiments, specifically with respect to whether the negotiation experience level of participants matters in the contexts they examine. This study also contributes to the literature on the effect on auditor judgments of negotiations with clients that vary in their negotiation style.

    Citation:

    Fu, H., H. T. Tan, and J. Zhang. 2011. Effect of Auditor Negotiation Experience and Client Negotiating Style on Auditors' Judgments in an Auditor-Client Negotiation Context. Auditing: A Journal of Practice & Theory 30 (3): 225-237.

    Keywords:
    auditors’ negotiation experience, client negotiation style, negotiation outcome
    Purpose of the Study:

    The use of subjective judgment is pervasive in the preparation of financial statements, and disputes often arise between clients and auditors over accounting issues where GAAP is unclear. These disputes entail negotiations between clients and auditors, and financial statements have been characterized as a product of auditor-client negotiations. The outcomes of these negotiations have significant implications on audit quality and financial statement quality, and it is important to understand determinants that influence negotiation judgments made during auditor-client negotiations.

    Auditors and client managers bring to bear on auditor-client negotiations their own particular characteristics that influence judgments made during these negotiations. In this study, the authors investigate how client negotiation style (a client characteristic) and the auditor’s negotiation experience (an auditor characteristic) jointly influence auditors’ perceived negotiation outcome. Although prior studies have examined each characteristic separately, auditor-client negotiations likely entail variations in both characteristics. For instance, partners interviewed in Hatfield et al. indicate that audit clients vary in terms of whether they are collaborative or contentious negotiators. Auditors who enter into negotiations over audit adjustments with these different types of clients also vary in terms of their negotiation experience. Currently, the literature does not inform on how these factors interact.

    Design/Method/ Approach:

    The authors used a 2 X 2 between-subjects factorial design. Ninety-nine audit managers and partners from one of the Big 4 CPA firms in China completed the experiment during a regular training session. The final sample comprised 20 partners (21 percent) and 76 managers (79 percent), with mean years of audit experience of approximately 12.1 and 7.2 years, respectively. The evidence was gather prior to February 2010.

    Findings:

    The results show that auditors’ negotiation experience and client negotiation style interact to affect auditors’ perceived ultimate negotiation outcome. Specifically, client negotiation style moderates the effect of auditor negotiation experience. With a contentious negotiation style client, auditors with greater negotiation experience perceive a higher ultimate negotiated write-down compared to those with lower negotiation experience. In contrast, there is no experience effect for collaborative negotiation style clients. Similarly, auditor negotiation experience also moderates the effect of client negotiation style. Lower negotiation experience auditors perceive a lower write-down for contentious than collaborative negotiation style clients; there is no effect of client negotiation style for higher negotiation experience auditors. 

    Category:
    Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations

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