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.     

How audit effort affects audit quality: An audit process and audit output perspective

Using a unique dataset of audit days in China from 2006 to 2011, this paper examines the relationship between audit effort and audit quality from the perspective of audit process and audit output. The results show that audit effort significantly increases the probability of audit adjustments, which inhibits positive earnings management and improves the quality of audited financial statements. We also find that audit effort does not have a significant effect on the issuance of modified audit opinions overall, but that a modified audit opinion is more likely to be issued in the absence of an audit adjustment. Furthermore, we find that the impact of audit effort on audit quality is attenuated when clients are more complex and when audit firms are larger. Collectively, our evidence suggests that audit effort plays an important role in improving audit quality by influencing audit process and audit output. Our study extends the literature on the impact of audit effort on audit quality in emerging markets, and the conclusions have important implications for the improvement of China’s audit market efficiency.     

The effect of small audit firms’ failure to remediate the PCAOB’s quality control criticisms on audit market segmentation

This paper examines the role of the Public Company Accounting Oversight Board (PCAOB) quality control inspection program on market segmentation of small firms’ audit services. Specifically, we investigate how non-remediation of quality control criticisms (QCCs) affects the supply and demand of low-quality audits. We find that remediation of QCCs improves audit quality for small accounting firms. However, some small accounting firms do not remediate QCCs (NR firms) and continue to provide low audit quality. We investigate how NR clients react to the disclosure of non-remediation of QCCs. We find that NR clients with low agency costs are more likely to retain NR firms after the disclosure of non-remediation. This finding is consistent with our expectation that voluntary QCC remediation creates a low-quality audit market segment for NR firms. Our findings suggest that the public disclosure of QCCs is not sufficient to remove low-quality auditors. Instead, NR clients use the disclosure of non-remediation of QCCs as a signal to sort themselves into segments based on their demand for audit quality. We are the first to study and find that PCAOB inspections, and specifically the voluntary nature of remediation and public disclosure of lack of remediation, create market segmentation.     

An empirical analysis of audit fee price competition after the Korean 1999 Omnibus Cartel Repeal Act

This study examines the audit service market in Korea after the 1999 Omnibus Cartel Repeal Act to determine if increased competition has led to audit fee discounting. Until 19 December 2001, when the Korean government enacted The Financial Supervisory Regulations, researchers could not address questions related to price competition in the Korean audit market due to data limitations. The new regulations allow researchers to examine audit effort for the first time because both audit hours and audit fees are now recommended disclosures. We use audit fee data of Korean companies for the 6-year period 1999–2004, and find evidence that total audit fees paid have been increasing but audit fees per hour have been decreasing. We also find that Big 5 auditing firms’ fees per hour are significantly lower than non-Big 5 auditing firms and are decreasing across time. These price pressures should be of concern to regulators and investors because prior research has demonstrated that price competition leads to discounting, which can result in unrealistically low audit fees and poor audit quality. Finally, as in previous research, we also find discounting of initial audit engagements in the Korean market.     

The impact of audit committee expertise on audit quality: Evidence from UK audit fees

Governance regulators currently place great emphasis on ensuring the presence of financial expertise on audit committees (Sarbanes-Oxley, 2002; UK Corporate Governance Code 2010–2016). Underlying this is a belief that greater expertise enhances the effectiveness of audit committees and, by extension, the quality of the external audit. This study investigates the impact of audit committee expertise on one measure of audit quality - audit fees paid by FTSE350 companies. Our analysis finds that audit committees possessing greater levels of financial expertise are associated with higher audit fees. When we segregate financial expertise between accounting and non-accounting, we find that the positive impact identified is driven by non-accounting expertise. Furthermore, when we separate FTSE100 and FTSE250 firms we find the impact of financial expertise is confined to FTSE250 firms. Our findings are important as they highlight the usefulness of segregating financial expertise between specialists and non-specialists, something which regulators in the UK and in the USA currently do not do. Our findings also highlight the potential value of audit committee expertise in smaller as opposed to larger listed firms, suggesting that the value of expertise to audit quality depends on the specific financial reporting challenges firms face.     

Relation between external audit fees, audit committee characteristics and internal audit

This study examines whether the existence of an audit committee, audit committee characteristics and the use of internal audit are associated with higher external audit fees. Higher audit fees imply increased audit testing and higher audit quality. We find that the existence of an audit committee, more frequent committee meetings and increased use of internal audit are related to higher audit fees. The expertise of audit committee members is associated with higher audit fees when meeting frequency and independence are low. These findings are consistent with an increased demand for higher quality auditing by audit committees, and by firms that make greater use of internal audit.     

How individual auditor characteristics impact the likelihood of audit failure: Evidence from China

Audit failure imposes a severe loss on investors and damages market participants' confidence in financial reporting quality. This study investigates the impacts of individual auditor characteristics on the likelihood of audit failure. Chinese regulators mandate listed firms to disclose the engagement auditors' identity. Furthermore, the information regarding individual auditor characteristics in China is also publicly available. Utilizing this unique setting, we examine the relationship between individual auditor characteristics and the likelihood of audit failure in China during the period from 2000 to 2009. We document that individual auditors with more auditing experience are less likely associated with audit failure. We also find a weaker negative relationship between auditor education level and audit failure. Our study has important implications for both auditors and regulators by shedding lights on the determinants of audit failure and by providing guidance to the human resource management in audit firms.     

Risk-preparedness mechanism and audit quality: Evidence from mandatory increase of professional indemnity insurance and professional risk fund

We examine the risk-preparing benefits of Chinese audit firms’ professional indemnity insurance (PII) and professional risk fund (PRF) by using the Notice on Adjusting the Application Requirement of Audit Firms for Securities Qualifications as an exogenous shock. This policy requires audit firms to raise the sum of the cumulative compensation limit of their PII and PRF from 6 million to 80 million yuan. It is found, first, that the capital market regards this policy revision as a signal to strengthen investor protection and responds positively; client firms with high audit risks have a stronger response. Second, auditors’ governance of financial information has strengthened, resulting in the significant improvement of their clients’ financial reporting quality, with a stronger effect on firms with higher earnings management risk. There is no evidence that audit firms pass the costs on to their clients. Finally, the mismatch between auditors and new client firms is alleviated. We show that in an emerging market with weak investor protection, establishing a sound risk-preparedness mechanism for audit firms and strengthening the capacity for civil compensation ex post greatly improve the adaptive degree between international auditing standards and the legal environment of China, thereby enhancing the overall service quality of the audit market.     

Employee quality and audit fee: evidence from China

This study investigates the association between employee quality and audit fee. Using data for firm-level employee quality (as proxied by employee education) from Chinese listed firms from 2011 to 2018, we find that firms operated by high-quality employees enjoy lower audit charges. The association between employee quality and audit fee is more pronounced in firms with a culture of high integrity. Our 2SLS estimation helps us establish a causal link between employee quality and audit fee. The final validity tests suggest that high-quality employees contribute to lower audit fee by reducing audit risk and audit effort.     

Transaction costs and competition among audit firms in local markets

We develop a measure to capture an audit firm's competitive position in a local audit market based on the transaction costs of changing audit firms included in DeAngelo's (1981) multi-period audit pricing model. Our competition measure reflects the size difference between the largest audit firm in a market specified by client industry at the city level and the other audit firms operating in that market. We find that audit fees of a client decrease as this size difference increases. This result suggests that smaller audit firms charge lower audit fees because of their competitive disadvantage to the local largest firm.     

Code of ethics quality and audit fees

Using a sample of U.S. firms from 2003 to 2018, we examine the effect of an audit client’s code of ethics quality on audit fees. We find that clients with a lower code of ethics quality pay significantly higher audit fees, suggesting that auditors perceive such clients as riskier and charge greater risk premiums. We also find that such clients have higher litigation risk and auditors spend greater effort when auditing such clients. Our study is among the first to demonstrate the role of a client’s code of ethics quality in audit pricing. Overall, our findings are consistent with codes of ethics being useful to auditors in assessing managers’ financial representations and providing value to firms.     

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.     

Audit firm merger and the strategic response by large audit firms

We examine the impact of a change in the audit industry structure in China as a result of two recent mergers involving large non-Big 4 audit firms. The ‘New Big’ audit firms, Ruihua and BDO Lixin, became the third and fourth largest audit firms in China following audit firm mergers, outranking both EY and KPMG in terms of total audit revenues in 2013. We find a significant audit fee and audit quality increase for the New Big audit firms relative to the Big 4 audit firms following the mergers. While this finding could be interpreted as an increase in quality as a result of audit firm consolidation, we find that this net effect is due to a decrease in audit fees and audit quality for the Big 4 following the mergers, rather than an increase in audit fees and audit quality by the New Big audit firms. We discuss the implications of our findings for various regulators.     

Agency costs and product market competition: The case of audit pricing in Greece

Jensen and Meckling (1976) argue that agency costs are not dependent on product market competition. However, elsewhere in the economics literature, theoretical analysis and empirical research have indicated that product market competition reduces agency costs by reducing the marginal cost of eliciting effort from agents. We investigate the relationship between product market competition and audit fee, as an example of agency cost. Taking advantage of a proprietary data set for Greek audit firms, we find that the audit fee and audit hours are inversely associated with client firm product market competition. We conclude that audit effort, as an agency cost, is reduced where competitive forces reduce the need for shareholders to bear the costs of monitoring agents.     

Audit fee lowballing: Determinants,recovery, and future audit quality

Prior research on the link between lowballing (LB) of audit fees and audit quality is inconclusive. Using more recent data and an innovative design, we define LB engagements as those where the audit fee discount is at least 30 percent. We consider three research questions to understand the possible link between LB and audit quality. First, we investigate whether the two variables that are often associated with auditor independence in the literature—non-audit fees and client importance—are related to LB. Second, we test whether lowballing auditors recoup initial audit fee discounts in the future period. Lastly, we investigate the relation between recovery of audit fees and future audit quality. We find that non-audit fees in the first year of engagement are negatively related to the propensity to LB. LB is significantly positively related to client importance for client firms switching from a non-Big N to another non-Big N auditor while the relation is insignificant for client firms switching from a Big N to another Big N auditor. The results of non-audit fees and client importance indicate that economic dependence does not motivate audit firms to lowball. Further, lowballing auditors tend to recoup their initial fee discounts in subsequent periods via increases in audit fees. Using multiple measures of audit quality, we do not find a significant relation between recovery of audit fees and future audit quality. Overall, contrary to regulators’ concerns, our results suggest that LB does not impair audit quality.     

Social trust and the demand for audit quality

Our study explores the association between social trust and the demand for audit quality. We argue that social trust reduces the demand for audit quality because it mitigates agency problems. By exploring Chinese listed firms, we find that firms in regions with higher social trust are less likely to choose big auditors, suggesting that higher social trust is associated with lower demand for audit quality. This finding arises because social trust disciplines managers by creating norms and relational networks to constrain opportunistic behaviors. Moreover, firms in high-trust regions have higher financial reporting quality, and the influence of social trust is more pronounced for firms with severer agency problems. Our results suggest that social trust allows firms to rely less on quality audits.     

Taxing audit markets and reputation: An examination of the U.S. tax shelter controversy

From 2002 to 2007, the nation's largest CPA firms faced allegations of illegal activity related to the sale of tax shelters: EY, KPMG and PwC paid fines; KPMG was investigated by a federal grand jury; and EY faced a criminal inquiry. These shelter events occurred shortly after the 2002 collapse of Arthur Andersen, when policy makers were concerned about audit market concentration. This is the first paper to provide a chronological summary of how the tax shelter controversy started and ended. We investigate the stock market reaction to tax shelter news developments between 2003 and 2005 to make inferences about the market's view of audit competition and CPA firm reputation. Our results are consistent with market concern over large audit firm concentration, evidenced by large negative returns for clients of all audit providers upon the KPMG grand jury investigation announcement. We also find that tax shelter activities impact both the reputation of the accounting profession and the individual CPA firms marketing tax shelter products.     

What do we know about audit quality?

This paper reviews empirical research over the past 25 years, mainly from the United States, in order to assess what we currently know about audit quality with respect to publicly listed companies. The evidence indicates that outright audit failure rates are infrequent, far less than 1% annually, and audit fees are quite small, less than 0.1% of aggregate client sales. This suggests there may be an acceptable level of audit quality at a relatively low cost. There is also evidence of voluntary differential audit quality (above the legal minimum) along a number of dimensions such as firm size, industry specialization, office characteristics, and cross-country differences in legal systems and auditor liability exposure. The evidence is very positive although there is some indication that audit quality may have declined in the 1990s, in which case there could be merit in recent reforms such as the Sarbanes-Oxley Act of 2002 in the US. However, we do not know from research the optimal level of audit quality and therefore whether we currently have ‘too little’ or ‘too much’ auditing? Despite this lacuna we are entering an era of more mandated auditing in response to high-profile corporate governance failures including the Enron–Andersen affair. Finally, while recent reforms have scaled back the scope of non-audit services due to independence concerns, a case can be made that audit quality will always be somewhat suspect if other services are provided that are perceived to potentially compromise the auditor's objectivity and skepticism. For this reason public confidence in audit quality may be increased by proscribing all non-audit services for audit clients. Recommendations are also proposed with respect to legal liability reform and changes in partner compensation arrangements.     

Local creative culture and audit fees

This paper examines the association between local creative culture and audit fees. Using a large, unbalanced panel data of listed US firms between 2004 and 2018, we find evidence that firms headquartered in US counties with high creative culture tend to pay higher audit fees than firms headquartered in counties with low creative culture. We also find that such firms tend to have longer audit report lag and are subject to more shareholder litigation. Cross-sectional tests show that real earnings management, managerial risk-taking propensity, and external corporate governance environment moderate the positive association between creative culture and audit fees. The positive association between local creative culture and audit fees remains robust to controlling for endogeneity concerns. Our study contributes to the emerging literature on local creative culture by providing evidence that local creative culture encourages managers and employees to undertake risky initiatives, thereby increasing audit risks.