Audit market concentration,audit fees,and audit quality: A cross-country analysis of complex audit clients

Regulators around the world are concerned about the potentially harmful effects of high audit market concentration on audit pricing and quality. However, results in the overall literature have failed to reach consensus on this issue. We contribute to this debate by arguing that the audit market is segmented and that concentration in the Big 4 segment of the market leads to higher audit pricing. Accordingly, our analyses use international data and focus on concentration within the Big 4 group of firms across countries. We find that audit fees are increasing in our concentration measure for clients where the barriers to entry by competing auditors are higher, as proxied by client size, international operations, and IFRS use. Finally, we find evidence that audit quality is decreasing in Big 4 market concentration for these types of engagements. This indicates a wealth transfer from shareholders to audit firms when auditor concentration is high because these complex clients are charged more, but receive audits that are of lower quality.     

Auditor size and audit quality

Regulators and small audit firms allege that audit firm size does not affect audit quality and therefore should be irrelevant in the selection of an auditor. Contrary to this view, the current paper argues that audit quality is not independent of audit firm size, even when auditors initially possesses identical technological capabilities. In particular, when incumbent auditors earn client-specific quasi-rents, auditors with a greater number of clients have ‘more to lose’ by failing to report a discovered breach in a particular client's records. This collateral aspect increases the audit quality supplied by larger audit firms. The implications for some recent recommendations of the AICPA Special Committee on Small and Medium Sized Firms are developed.     

The Effect of IPO Risks on Auditors’ Decisions: Auditor Designation Case

This study examines the effect of audit risks in the Korean initial public offering (IPO) market on the designated auditors’ decisions. The Korean External Audit Act requires firms to switch from incumbent to new auditors designated by the Securities and Futures Commission after the firm announces a future IPO. This study shows the effects of audit risks by examining if the quality of reported earnings and audit fees significantly differs between IPO‐eligible and IPO‐ineligible firms. Empirical tests first show that discretionary accruals are significantly lower for IPO‐ineligible firms than for IPO‐eligible firms in both the IPO designation period and the following review period. We interpret this result to mean that designated auditors evaluate the IPO‐ineligible (and eventually failed) firms’ listing possibility as low. Second, audit fees are higher for IPO‐ineligible firms in the auditor designation period. This reflects the fact that designated auditors are exposed to future audit risks associated with firms’ post‐IPO financial market troubles if IPO‐ineligible firms attempt to go public. Our study contributes to IPO‐related research by showing the effects of auditors’ risk evaluation on discretionary accruals and audit fees. This study also contributes to accounting policymaking regarding auditor independence.     

The impact of corporate governance on auditor choice: Evidence from China

As the largest and fastest growing emerging market, China is becoming more and more important to investors throughout the world. The purpose of this paper is to investigate the determinants of firms’ auditor choice in China in respect of their corporate governance mechanism. Normally firms have to take a trade-off in their auditor choice decisions, i.e., to hire high-quality auditors to signal effective audit monitoring and good corporate governance to lower their capital raising costs, or to select low-quality auditors with less effective audit monitoring in order to reap private benefits derived from weak corporate governance and less-transparent disclosure (the opaqueness gains). We develop a logit regression model to test the impact of firms’ internal corporate governance mechanism on auditor choice decisions made by IPO firms getting listed during a bear market period of 2001–2004 in China. Three variables are used to proxy for firms’ internal corporate governance mechanism, i.e., the ownership concentration, the size of the supervisory board (SB), and the duality of CEO and chairman of board of directors (BoDs). We classify all auditors in China into large auditors (Top 10) and others (non-Top 10), assuming the large auditors can provide higher quality audit services. The empirical results show that firms with larger controlling shareholders, with smaller size of SB, or in which CEO and BoDs chairman are the same person, are less likely to hire a Top 10 (high-quality) auditor. This suggests that when benefits from lowering capital raising costs are trivial, firms with weaker internal corporate governance mechanism are inclined to choose a low-quality auditor so as to capture and sustain their opaqueness gains. On the other hand, with improvement of corporate governance, firms should be more likely to appoint high-quality auditors.     

Determinants and consequences of voluntary switches to Chinese auditors in Hong Kong

Hong Kong market regulators have permitted 12 large Chinese accounting firms to audit the financial statements of Chinese firms that cross list in Hong Kong (i.e., H-share firms) since 2010. This paper examines the characteristics of H-share firms that voluntarily replaced their Hong Kong (HK) auditors with Chinese auditors, and the market reaction to auditor switches following this policy. We find that 38 out of 147 H-share firms voluntarily switched to Chinese auditors during 2011–2013. Switching firms are larger in size and are less likely to use Big4; they also have less need for external financing, a longer cross listing history, and a lower percentage of foreign revenue. We also find that investors negatively react to the auditor switches from HK non-Big4 to China non-Big4, but do not react to the auditor switches from HK Big4 to China Big4. This suggests that investors perceived lower audit quality for China non-Big4.     

Auditor specialization, perceived audit quality, and audit fees in the local government audit market

Prior governmental research implies a positive relation between auditor specialization and audit quality, but the effect of specialization on audit fees is mixed. However, no single governmental study investigates the effect of auditor specialization on both audit quality and audit fees. Also, prior studies focus on either large- or small audit firms and often employ indirect proxies for audit quality. We study the effects of auditor specialization on perceived audit quality and audit fees. Our data represent both Big 5 and smaller audit firms and include three market-based measures of specialization. We survey 241 Florida local government finance directors and find that specialization is positively associated with perceived audit quality but not with audit fees. We also find that Big 5 auditors, often used as a proxy for higher audit quality in prior research, are not uniformly associated with increased perceived audit quality but consistently charge higher audit fees. Our results confirm a relation between measures of audit firm specialization and audit quality and raise questions regarding audit firm size and audit quality in the municipal sector. Our findings suggest that engaging specialized auditors may be good policy for many local governments.     

To switch or not to switch? The effect of audit firms’ economies of scale on audit firm switches after audit price deregulation in China

We exploit the unique setting of China’s 2014 audit price deregulation policy to examine whether audit firms use their economies of scale (EOS) to compete for clients. We find a significant increase in client firms switching from a non-EOS auditor to an EOS auditor after the audit price deregulation policy was implemented. The additional analyses show that EOS audit firms are more likely to offer audit fee discounts than non-EOS audit firms while retaining audit quality. We also find that the auditors’ EOS effect is more pronounced for highly homogeneous industries and firms paying high abnormal audit fees, firms in financial distress, and firms receiving less capital market attention than for less homogeneous industries and firms paying low abnormal audit fees, financially stable firms, and firms receiving more capital market attention. Finally, we find that the presence of state-owned enterprises and political connections both separately and jointly moderate the effect of audit firm–client realignments from a non-EOS auditor to an EOS auditor after the audit price deregulation. Overall, our study provides important insights for policymakers and regulators reviewing and developing new policies on audit services.     

The influence of auditor narcissism and moral disengagement on risk assessments of a narcissistic client CFO

Global capital markets rely heavily on independent and skeptical auditors as gatekeepers to provide assurance that corporate financial reports are free of material fraud. The rise of narcissism among the ranks of both client and audit professionals challenge this gatekeeper function. In addition, auditor moral disengagement may undermine auditor skepticism, further eroding public confidence in the integrity of financial reporting and the audit process. We conduct a quasi-experiment with 118 auditors from three international audit firms. In a simulated interview with a client CFO, we examine whether auditors underestimate risks of fraudulent financial statements due to the interactive effects of (1) client narcissism (manipulated verbally and nonverbally) and (2) auditor narcissism. We also examine the influence of auditor moral disengagement on client risk assessments. Results indicate that CFO verbal and nonverbal narcissism significantly influenced auditors’ assessment of management-related client risk. Moreover, auditor narcissism was found to interactively influence client risk inferences such that auditors higher in narcissism exhibited narcissistic tolerance (lower risk assessments) when the hypothetical CFO displayed high verbal narcissism. Auditor moral disengagement was negatively associated with client risk assessments. We discuss the implication of these findings on future audit judgment research, audit firm policy and training on maintaining auditor skepticism, and the audit oversight role of standard-setters.     

Does Ethical Culture in Audit Firms Support Auditor Objectivity?

The suggested cause of constrained auditor objectivity has been centred on auditors' financial incentives and long audit tenure. Recent research has challenged those assumptions and questioned the effectiveness of auditor rotation to counteract short-tenure threats to auditor objectivity. Audit firms and regulators need to adopt methods for enhancing auditor objectivity that are effective in various auditor–client relationships. This study examines whether audit firm ethical culture is positively related to auditor objectivity. Based on the responses of 281 practising auditors, the findings indicate that auditors are more likely to make objective judgments in ethical cultures characterized by the rewarding of ethical behaviour and punishment of unethical behaviour, prevalence of ethical norms, visible ethical leadership, and low emphasis on obedience to authority. In conclusion, evidence indicates that auditors in audit firms with a strong ethical culture are more likely to maintain auditor objectivity than are auditors in less supportive cultures. This suggests that audit firms should promote a strong ethical culture to reduce the risk of constrained auditor judgment.     

AUDITOR PREFERENCES FOR LIABILITY LIMITATION

Debate over statutorily limiting auditor civil liability has implicitly assumed auditors are homogeneous in their preferences for capping liability. This study examines the preferences of auditors for limiting auditor liability and investigates reasons for the preferences. The study uses an Australian setting in which there has been a persistent debate for a decade or more over regulatory intervention in this area. The study provides a background to the debate over this issue and addresses the effects of two factors suggested by the extant literature, namely auditor size and the business risk of an auditor's client portfolio. These factors are argued to affect the expected costs of litigation facing auditors and therefore their preferences on capping liability. Using the submissions by audit firms on an Australian Companies and Securities Law Review Committee Discussion Paper on limiting auditor liability, the study finds larger audit firms that have greater capacities to lobby and greater expected costs of litigation from unlimited liability than smaller firms, dominate the respondents on the Paper and tend to be more supportive of liability limitation than smaller audit firms. Within the array of possible methods of capping liability canvassed by the Discussion Paper, the study documents evidence of diversity in preferences among audit firms. Larger audit firm size is associated with a preference for a group of methods that provides such firms with opportunities to benefit from the capping at the expense of the smaller audit firms. The method most preferred by the larger audit firms is the multiple of fee with a prescribed minimum. Perhaps not surprisingly, this is also the preferred method of the professional accounting bodies in Australia. As to the effect of the riskiness of the client portfolio on preferences for methods of limiting liability, the study finds that higher business risk in an auditor's portfolio is associated with a preference for methods that give greater control over their liability exposure. The study has implications for the impact of regulation of capping liability on competition in the audit services market.     

How Do Various Forms of Auditor Rotation Affect Audit Quality? Evidence from China

The Enron/Arthur Andersen scandal has raised concerns internationally about auditor independence, audit quality, and the need for regulatory action such as mandatory auditor rotation. China's unique institutional features provide a setting in which we can compare comprehensively the various forms of auditor rotation at different levels (partner vs. firm) and in different settings (voluntary vs. mandatory). In addition, institutional conditions vary dramatically across China, which provides us with an opportunity to test whether the development of market and legal institutions affects the impact of rotation on audit quality. We expect that auditors are less (more) constrained by market forces and less (more) self-disciplined to maintain audit quality in regions with less (more) developed market and legal institutions. Therefore, mandatory rotation may play a more (less) important role in less (more) developed regions. Using auditors' propensity to issue a modified audit opinion (MAO) as a proxy for audit quality, we find that firms with mandatory audit partner rotations are associated with a significantly higher likelihood of an MAO than are no-rotation firms. However, this effect is restricted to firms located in less developed regions. We find similar evidence for voluntary audit firm rotation although the significance level is much weaker than for mandatory partner rotation. Other forms of auditor rotations (i.e., mandatory audit firm rotation and voluntary audit partner rotation), have no effect on MAOs.     

Auditor Independence: A Nonparametric Test of Differences Across the Big‐5 Public Accounting Firms

This small sample study provides additional evidence on the unsettled question of auditor independence: Does the provision of non‐audit services by an auditor compromise independence resulting in a poor quality audit? We also examine whether these findings vary across the “Big‐5” public accounting firms. Most prior studies addressing this question, using parametric approaches and various measures of audit quality, have reported conflicting results. Contrary to these studies, we use a non‐parametric approach and the probability of GAAP violation as a new measure of audit quality to address this question. Using data from a sample of Fortune 500 companies for the year 2000, we find that firms whose auditors provide substantial non‐audit services tend to have a higher propensity to violate GAAP. At the firm‐level analysis, we find that these results are more likely driven by few of the Big‐5 public accounting firms. For the remaining firms, the association between non‐audit services and quality of audit could not be established, primarily because of small sample size and lack of power in the test. Our main finding is consistent with other recent studies that provide evidence that the rendering of significant non‐audit services by auditors creates conflict of interest resulting in poor quality audits. Furthermore, our result of differences in these levels of association among the Big‐5 accounting firms represents a new finding, and suggests that there is a need for controlling them separately in research studies examining auditor independence.     

Audit market structure,fees and choice in a period of structural change: Evidence from the UK – 1998–2003

This paper presents evidence on audit market concentration and auditor fee levels in the UK market in the crucial period of structural change following the PricewaterhouseCoopers’ (PwC) merger and encompassing Andersen’s demise (1998–2003). Given the current interest in auditor choice, analysis is also undertaken at the individual audit firm level and by industry sector. There is evidence of significant upward pressure on audit fees since 2001 but only for smaller auditees. Audit fee income for top tier auditors (Big 5/4) did not change significantly while the number of auditees fell significantly, consistent with a move towards larger, less risky, clients. A decomposition analysis of the aggregate Big 5/4 concentration ratio changes over the period identifies the impact of four distinct consumer-based reasons for change: leavers; net joiners; non-par auditor switches; and (only for the audit fees measure) audit fee changes. Andersen’s demise markedly reduced the level of inequality among the top tier firms but PwC retained its position as a ‘dominant firm’. On switching to the new auditor, former Andersen clients experienced an initial audit fee rise broadly in line with inflation, with no evidence of fee premia or discounting. They also reported significantly lower NAS fees, consistent with audit firms and auditees responding to public concerns about perceptions of auditor independence. There is no general evidence of knowledge spillover effects or cross-subsidisation of the audit fee by NAS. The combined findings provide no evidence to indicate that recent structural changes have resulted in anticompetitive pricing; the key concerns remain the lack of audit firm choice and issues concerning the governance and accountability of audit firms.     

Auditor Fees, Market Microstructure, and Firm Transparency

Abstract:  Auditors, as corporate insiders, have access to private information regarding the firm's financial and business opacity that is unavailable to outside investors. We test whether auditors price their knowledge of firm opacity in their audit fees by examining two competing hypotheses. The first states that higher audit fees may reflect the greater risk that the auditor faces in auditing an opaque firm. Under this hypothesis, market based measures of opacity will be positively correlated with higher fees. The second hypothesis states that firms buy reputational capital from their auditor by paying high fees in an attempt to improve the market's perception of the firm's transparency. In this case, higher audit fees are negatively correlated with market based measures of opacity. Our results are consistent with the first hypothesis, that auditors price opacity risk into their fees.     

New Auditors’ Decisions for Released Firms from the Mandatory Auditor Designation Rule: Evidence From South Korea

This study examines the effect of the mandatory designation rule on audit fees charged and audit hours rendered by auditors for firms released from the mandatory auditor designation rule in the Korean audit market. Under the mandatory auditor designation rule, which took effect in 1991, problematic firms are assigned new auditors by the Financial Supervisory Service. Previous studies suggest that this regulation positively affects the quality of audits by promoting auditor independence. Thus, this study hypothesises that firms that have been subjected to mandatory auditor designation improve the quality of their financial reporting, and that auditors hired after the mandatory designation period account for reduced audit risks when determining audit fees and audit hours. This study shows that audit fees and audit hours of firms released from the mandatory auditor designation rule are lower than those of other initial audit engagements. Taken together, this study's findings reinforce the notion that auditors’ perceptions of changes in audit risk yield corresponding changes in the audit fees they charge and audit hours they render.     

Audit office size,audit quality and audit pricing: evidence from small- and medium-sized enterprises

Using Swedish data, we investigate how audit quality and audit pricing vary with audit firm and office size. In contrast to prior studies, we use disciplinary sanctions issued against auditors not meeting the quality requirement as the measure of audit quality. We find no significant differences in the likelihood of sanctions between Big 4 audit firms and the fifth and sixth largest audit firms in Sweden (Grant Thornton and BDO). We refer to these collectively as ‘Top 6’. However, we find that the probabilities of warnings or exclusions from the profession are much higher for non-Top 6 auditors in Sweden than for Top 6 auditors. Furthermore, we find a strong negative association between the likelihood of sanctions and audit office size for non-Top 6 auditors. This association is insignificant for Top 6 audit firms. Audit fees follow a similar pattern and indicate that larger audit firms and offices put in more effort or have greater expertise. These results suggest that audit quality is differentiated in the private segment market. However, contrary to prior studies, our results suggest that the important dimensions are Top 6 versus non-Top 6 and the office size of non-Top 6 audit firms.     

The impact of auditor rotation on auditor–client negotiation

This paper reports the results of an experiment designed to investigate how mandatory audit firm rotation affects auditor–client negotiations. Drawing upon process theories of negotiation, we examine the strategies used by auditors and clients as well as the outcomes of their negotiations in alternative settings in which mandatory rotation is imposed or is not imposed. We posit that mandatory rotation changes (1) the dynamics of the audit market by increasing the number of clients who are in the market for a new auditor, and (2) the political costs to a client who switches auditors. These changes, in turn, alter the willingness of the auditor and the client to cooperate during negotiation. The results suggest that with mandatory rotation auditors adopt less cooperative negotiation strategies, producing asset values that are more in line with the auditor’s preferences than with the client’s preferences and more negotiation impasses.     

The market reaction to auditor resignations

Under UK company law, external auditors who resign must warn shareholders and creditors of any matter that ought to be brought to their attention. Auditor resignations and the subsequent change in auditor are informative corporate events. Resignation from office is likely to be a costly signal for the audit firm, particularly when the client is a quoted company. Our analysis of daily data suggests that there is a negative reaction to the auditor resignation on the date of the resignation letter, even though very few auditors indicate there were problems of which the shareholders and creditors should be made aware. This provides backing for the statutory rules on disclosure of the auditor resignation. We also find that the extent of the market reaction on the day of the resignation is related to the size of the resigning audit firm.     

Determinants of audit fees in Bangladesh

This paper reports the results of an analysis of the determinants of audit fees of both financial and non-financial companies in Bangladesh. The Bangladeshi audit services market is unusual in that there is no direct involvement of international audit firms in it. The results of the regressions show that the size of the auditee has the greatest influence on audit fees. Whilst there was no international Big Six grouping, it was possible to construct a group of Bangladeshi audit firms which commanded a price premium, based on their size and whether they had a link with an international firm of auditors. Financial services companies were found to have higher audit fees relative to non-financial companies. Subsidiaries of multi-national holding companies also had higher audit fees. The surprising result was that auditees which employed at least one qualified accountant had higher audit fees.