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    Fee Pressure and Audit Quality
    research summary posted November 10, 2014 by Jennifer M Mueller-Phillips, tagged 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations, 11.0 Audit Quality and Quality Control, 11.08 Proxies for Audit Quality 
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    Title:
    Fee Pressure and Audit Quality
    Practical Implications:

    The results of this study are important evidence that a large proportion of audit engagements during the Recession were characterized by positive fee pressure, and that fee pressure was associated with lower audit quality during the Recession. The results suggest that auditors who experienced fee pressure from clients during the Recession were not able to maintain or increase audit effort in line with client risks due to pressure on fees. These results should be of interest to the PCAOB who expressed concern that audit fee pressure may have had negative effects on audit quality during the Recession.

     

    For more information on this study, please contact Mike Ettredge.  

    Citation:

    Ettredge, M., E. E. Fuerherm, and C. Li. 2014. Fee pressure and audit quality. Accounting, Organizations and Society 39 (4):247-263

    Keywords:
    Audit fee, audit quality, fee pressure, recession, misstatements, PCAOB
    Purpose of the Study:

    The purpose of this study is to investigate the association of audit fee pressure with audit quality during the recent recession. The Recession started in December 2007 and officially ended in June 2009. Regulators expressed concerns that clients may expect their auditors to share in the economic pain of the Recession by agreeing to fee reductions and that fee pressure might cause auditors to ease up on the rigor of audits or to curtail necessary audit work to cope with falling revenue. However, it is not clear that auditors would respond to fee pressure by reducing audit quality given the litigious climate in which they operate. Prior research suggests that auditors have incentives to maintain or increase audit effort when faced with greater engagement risk. This paper addresses this question empirically by:

    • Developing a model to proxy for fee pressure
    • Comparing the existence of fee pressure in pre-recession years (2006-2007), during the Recession (2008), and the year the Recession ended (2009)
    • Studying the association of fee pressure with misstatements of the financial statements, an inverse proxy for audit quality, during the Recession. 
    Design/Method/ Approach:

    The data for the main analysis are collected for public companies in 2008, the main year of the Recession. The authors compare each client’s actual fee in the test year (2008) with a benchmark audit fee to identify fee pressure. The benchmark audit fee is calculated using actual audit fee data from previous year (2007) to predict audit fees for the test year (2008). The authors use misstatements of financials as an inverse measure of audit quality. All else equal, a higher quality audit should lead to fewer misstatements of the audited financials. 

    Findings:
    • The authors find that fee pressure is significantly greater in 2008 than in both 2006 and 2007 suggesting that auditors faced increased fee pressure from clients during the Recession.
    • The authors find that fee pressure is positively associated with financial misstatements during the Recession (2008), but is not associated with misstatements in 2007 and 2009 and is only weakly associated in 2006. This suggests that the decrease in audit quality during the Recession year is related to fee pressure from audit clients.
    • In sensitivity analyses, the authors find that the impact of fee pressure does not differ for Big 4 vs. non-Big4 auditors or larger vs. smaller audit offices.
    • In sensitivity analyses, the authors find that fee pressure in 2008 is positively associated with the occurrence with severe misstatements, but not less severe misstatements. This result suggests that fee pressure during the Recession was associated with serious decreases in audit quality, not just with small errors in the financial statements. 
    Category:
    Audit Quality & Quality Control, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, Proxies for Audit Quality