Erasmus University Rotterdam
Erasmus School of Economics
Accounting, Auditing & Control
Accounting & Auditing
Master Thesis
The Impact of Audit Client Complexity on the Audit Fee: the Role of Auditor Industry Specialization
Date: 28 July 2014
Name: Jian Guo (328226)
Supervisor: Mr. E.A. de Knecht RA
Co-reader: Mr. R. van der Wal RA
Acknowledgements
This thesis is written for the completion of the master program Accounting, Auditing and Control at the Erasmus University of Rotterdam. It can be seen as the final assignment of my scientific education and a starting point for my professional education to become a certified public auditor in the Netherlands. Therefore, the research subject has been carefully chosen that is embedded within the auditing theory: audit fee determination. The main motivation for this topic is that it is highly relevant to the practice. Since there is not a clear guideline to determine the level of audit fee, academic contribution of examining of audit fee determinants can be really helpful towards existing literature about audit fee determination.
It has been an intensive period to conduct the research and to write the master thesis, especially since the first time that I met my supervisor was eight weeks after handing in the application form and thesis proposal, what normally takes around three weeks. Nevertheless, I was able to finish the thesis and want to thank to several people who have supported me during the time of writing the thesis.
First of all, I want to thank my supervisor, Mr. E.A. de Knecht RA, who has provided me lots of valuable feedbacks and useful insights on a timely manner. The discussions with Mr. de Knecht were very helpful to obtain a questioning mind and critical view. This was not only helpful for my thesis, but also for my future career and life. Secondly, I want to thank EY Rotterdam for providing me a stimulating environment to write my thesis. I especially want to thank my supervisor at EY, Ms. Marloes de Vries RA, for giving me useful supports from practical aspects of the audit professions in relation to my thesis subject. Last but not least, I want to thank my parents, my girlfriend and my friends for their tremendous support during the final period of my master program.
Jian Guo
Delft, July 2014
Abstract
This thesis examines whether the auditor industry specialization would influence the impact of the audit client complexity on the audit fee. By using 10136 firm-years observations of U.S. listed companies from 2007 up to and included 2013, the findings indicate that the audit industry specialist fee premium exists for complex clients. In the supplemental tests, the difference in the audit fee the among complex and noncomplex companies has been confirmed to be statistically significant when controlling other fee determinants, consistent with the conclusion that industry specialists require a higher fee for compensating the education costs. When considered in conjunction with the prior research, this thesis provides another approach to measure the audit client complexity. The results suggest that companies of certain industries are more complex to audit due to their characteristic operations, and thereby require more efforts from auditors to perform the audit and ask for a higher audit fee.
Table of Contents
1. Introduction 6
1.1 Background 6
1.2 Relevance 8
1.3 Objective 9
1.4 Research question 9
1.5 Methodology 10
1.6 Demarcation and Limitation 10
1.7 Structure 11
2. Theoretical Background 12
2.1 Introduction 12
2.2 Agency Theory 12
2.2.1 Information Asymmetry and Agency Costs 12
2.2.2 Financial Statements Audit and the Costs 13
2.3 The Role of the Public Auditor 14
2.3.1 Audit Services 14
2.3.2 Certified Public Accounting Firms 15
2.3.3 The BIG 4 Network and Its Impact 15
2.4 Audit fee 16
2.4.1 Audit Pricing Model 16
2.5 The Determinants of the Audit Fee 17
2.5.1 Client Size 17
2.5.2 Client Business Risk 18
2.5.3 Client Complexity 18
2.5.4 Auditor Specialization 19
2.6 Summary 20
3. Prior Research 22
3.1 Introduction 22
3.2 Common Determinants of Audit Fee 22
3.3 Audit Client Complexity 26
3.4 Auditor Industry Specialization 29
3.5 Hypotheses Development 31
3.6 Summary 32
4. Research Design 34
4.1 Introduction 34
4.2 Research Approaches in Accounting 34
4.2.1 Quantitative Researches 35
4.3 Research Methodology 35
4.3.3 Control Variables 38
4.4 Sample Collection 40
5. Results 43
5.1 Introduction 43
5.2 Assumptions for Regression Analysis 43
5.3 Mean Differences of Client Complexity and Industry Specialists 46
5.4 Association of Client Complexity and Industry Specialists 47
5.5 Analysis of the Investigation Concerning the Audit Client Complexity and the Auditor Industry Specialization 48
5.5.1 Descriptive Statistics of the Regression Components 48
5.6 Interaction of Client Complexity and the Industry Specialists on the Audit Fee 50
5.7 Discussion 52
5.8 Summary 54
6. Conclusion 56
6.1 Introduction 56
6.2 Research Summary 56
6.3 Conclusions 56
6.4 Limitations 57
6.5 Suggestions for Further Research 58
References 59
Appendix 62
1. Introduction
1.1 Background
Nowadays, public auditors are accomplishing an indispensable role in the worldwide financial markets. They ensure the quality of the company’s annual financial statements and enhance the confidence of the public and the investors in the capital market. It is worth noting that, over the last decades, several well-known financial scandals exist in which public auditors are jointly responsible. Because of these scandals investors and stakeholders have paid huge prices. Consequently, maintaining a high level of audit quality to prevent such a scandal from happening again in the future should be the top priority to all audit firms.
Audit service provided by public auditors ‘is a professional service that improves the quality of information for decision makers’ (Arens, Elder, & Beasley, 2013 p.8). High quality information indicates that the firms’ annual financial statements are free of material misstatements, consequently, presenting a firm’s financial position in a true and fair view. In return to the service, companies are charged by the audit firms to compensate the effort from the public auditors, this is qualified as the audit fee. Because every company has its unique settings and industry environment, among firms the amount of audit fee varies.
In order to perform an audit, a certain amount of professional knowledge from public auditors is required. It is not only the knowledge about how to design and implement the audit procedures, but also specific knowledge regarding to the industry in which the client firm is operating. This industry specific knowledge is particularly valuable for understanding their client business and its business environment. Consequently, this specific knowledge can be qualified as the specialization of an audit firm, which is not required by any regulations but which is essential for maintaining a high quality audit engagement.
When preventing audit failures, the public auditor’s knowledge is crucial. Audit failure occurs when the public auditors stated that a firm’s annual financial statement is free of material misstatements when it is still contains material misstatements. Audit failure is one of the causes of the recent financial scandals. Financial scandals like Enron, WorldCom, Ahold and Vestia had a huge negative impact on the public confidence in the security markets. The involvement of public auditors in these incidents creates both by the regulators and by the public concerns about the audit quality.
In response to the financial scandals of Enron and WorldCom, the U.S. government in 2002 passed the Sarbanes-Oxley Act (SOx) with enhanced standards introduced to restore the confidence in the security market. One essential implementation of SOx is included in Section 404 (hereafter: SOx 404):
Issuers are required to publish information in their annual reports concerning the scope and adequacy of the internal control structure and procedures for financial reporting. This statement shall also assess the effectiveness of such internal controls and procedures.
The registered accounting firm shall, in the same report, attest to and report on the assessment on the effectiveness of the internal control structure and procedures for financial reporting.
The main interpretation of SOx 404 is the requirement of the corporate managers and the public auditors to report on the adequacy of the company’s internal control. Managers, as a part of the annual report, are required to publish an internal control report and the public auditors need to express their opinions about the effectiveness of the internal control structure of the firm. Consequently, in order to assess a firm’s internal control, public auditors have to be equipped with even more specific knowledge which enables them to have a better understanding about the firm and its industry.
Concerning some industries, performing a high quality audit only have audit procedure knowledge is not sufficient. Due to the complexity of an industry, to judge the line items in the annual financial statement it requires more specific knowledge. Typical operations within an industry or the decentralization of operations to complete the audit would require significant more efforts from the public auditors (Hay, Knechel, & Wong, 2006). For instance, it is well-known that the pharmaceutical industry requires a high research and development intensity. Statement of Financial Accounting Standards 2 suggested that ‘All research and development costs encompassed by this Statement shall be charged to expense when incurred’. However, International Accounting Standard 38 ‘Intangible Assets’ allows companies to capitalize development costs when it is able to produce probable future economic benefits under certain criteria. Consequently, in order to judge whether the expectation of a company is justified it requires the public auditors having a large amount of industry specific knowledge. If auditors are not educated in judging the company’s expectation, for the evaluation to maintain the level of the audit quality a third party should be involved. Alternatively, if public auditors in this industry are specialized, they would perform this audit in a more efficiently way. Consequently, to a certain extent, the complexity of an audit engagement relies on the specialization of the public auditors.
When a group of public auditors are more specialized than the other, it is not surprising that the charged fees are different as well. As signaled before, the audit fee is the compensation paid by firms for the audit effort by the public auditors. A problem with the determination of audit fee is that no clear guideline exists to follow. Concerning the determination of the audit fee, academicians have developed a theoretical model. This model separated the fee into two components: audit production and the present value of potential future costs associated with the current audit (Simunic, 1980). The audit production is a function of the audit hours and the audit cost per hour. Concerning the specialists, because they have an extra amount of knowledge to improve the efficiency of the audit the assumption is that the needed audit hours are less than non-industry specialists. However, to compensate their training investment specialists charge a higher fee per hour. Consequently, not is known whether an increase in the specialization to ease the industry complexity could create an increase or decrease in the audit fee.
Consequently, in improving the efficiency of an audit engagement particularly within relatively complex industries, it is essential to realize that specialization can be highly valuable. Specialized industry knowledge helps the public auditors ease the complexity of an audit and reduce their effort in the audit production. Because it is not clear whether audit clients pay a fee premium for the audit specialist, this thesis will investigate the correlated effect of specialization, generated to ease industry complexity, on the audit fee.
1.2 Relevance
Audit fee is mostly determined prior an audit engagement. At the time of contracting, public auditors should estimate the nature and the magnitude of the evidence needed to mitigate the uncertainty of an audit failure. In the U.S, public firms report the expenses paid for auditing their financial statement in their annual reports. However, it is still unclear what factors were used to determine the level of audit fee. Besides, the determinants of the audit fee are not clear-cut in addition due to the corresponding duty of the professional confidentiality within the public audit profession. Because of this feature, a number of researches have been performed to determine what factors are systematically associated with the audit fee.
Among the studies conducted, researchers confirmed that several factors with the audit fee are systematically correlated. For instance, audit client size, complexity, the public auditor’s size, brand names and specialization all showed a significant impact on the audit fee (Hay et al., 2006). Complexity and specialization are both confirmed to be positively associated with the audit fee. In prior researches, the proxy for complexity is mostly the number of subsidiaries (Hay et al., 2006). It is suggested that subsidiaries would increase the complexities of transactions and consequently requires more audit effort. However, this measurement of complexity is not associated with a particular industry. A limitation of this approach is that it assumes that the complexity among industries is equal. Since the complexity in addition varies due to the nature of an industry, this could create biased results. The contribution of this thesis is an alternative way to measure the complexity. In addition, when an industry is complex due to its required specialized knowledge, this complexity term becomes a subjective matter. Additional tests in this thesis are going to investigate whether specialization could influence the positive association of the complexity and the audit fee.
The approach is that the complexity of an audit due to the industry characteristics is subjective. The level of complexity would decrease if public auditors do have industry specific knowledge comparing with public auditors who do not have this knowledge. Specialized public auditors in addition are able to perform the audit differently than non-specialists do. Consequently, the difference in audit effort could cause a difference in the audit fee.
1.3 Objective
The purpose of this thesis is to determine whether specialization influences the correlation between the complexity and the audit fee, if so, in which direction. As signaled in the previous section, the public auditor’s specialization could be useful for certain complex industries. However, not is known whether this amount of specialization could create an increase or a decrease in the audit fee.