In this part of dissertation, there is a grief introduction about this dissertation, which includes the following context: the background and overview of related researches in this paper; the motivation for doing this study and a introduction of the structure of this paper.
Firth (1997) notices that the responsibility of auditor is reporting comparative correct financial information to shareholders in an independent position. However, what makes regulators concern more about is the client-auditor relationship, especially the economic relation, which formed in the long-term cooperation may have impact on auditors’ independent position. For a long time, because of the dependence of auditors’ fees on client firms, therefore, the controversy about whether this economic dependence might impair auditors’ independence position and audit quality make many empirical researches in the area. The impairment of audit independence caused by the economic relationship will result in the audit opinion shopping.
Previous studies consider about the affects of audit fees on audit quality in two ways: high audit fees paid to auditors may be the reflection of the complexity of auditing process and also increase auditors’ effort. However, on the other hand, large audit fees paid to auditors might easy to build the economic bonding between client and auditors, thus, auditors are easy to compromise to audit independence, as the fear of losing highly profitable fees. Though a lot studies have researched the relationship between audit fees and audit quality, most of the studies just have blue results for their studies (Hoitash, Markelevich and Barragato, 2007).
Basing on the theory that examining the fees paid by client firms will better analyze the relation between audit independence and audit quality, this paper uses the methodology consistent with the way used in previous studies, i.e. Kinney and Libby (2002), Choi, Kim and Zang (2006), Hoitash et al (2007), in which develop a methodology that is depended on the notion that audit fees related to expected fees have effect on audit independence and quality. Therefore, being same as previous studies here will use to audit fees model to measure the expected fees in order to compare with the actual fees paid to auditor. Using the methodology in Choi, Kim and Zang’s (2006) study, the differences between actual fees and expected fees are divided into two parts: the positive one and negative one, which helps us to compare whether there is any different reflection when auditors are paid less or excess their expectation. As for the proxy for examining audit quality, the discretionary accruals model which drawn from previous literature are selected. As suggested by Choi, Kim and Zang (2006), the modified Jones’ model for discretionary accruals is used in this paper. The variables in models are selected according to previous studies which consider the influence on audit fees from perspectives of client firms’ sizes, auditing risk, complexity and the size of audit firms (Chan, Ezzamel and Gwilliam, 1993). Beside dividing abnormal fees into positive subsample and negative subsample, the combined sample is cut into other two subsample which are based to the sizes of audit firms, which aims to examine the different behaviors to audit fees between BIG4 auditors and NON-BIG4 auditors. Thus, the objective in this paper is to prove whether abnormal fees might result in lower audit quality and whether there is different behavior to abnormal fees between BIG4 and NON-BIG4 auditors.
Continuing the previous study which is finished by Chan, Ezzamel and Gwilliam (1993), this study uses the data collected from UK market in order to find out related evidence from this market and 787 observations cover the period from 2006-2008 are collected from UK quoted public companies will help to examine audit fees paid to auditors. In addition to examine the relation between abnormal audit fees and audit quality, this study also follows the investigation which is finished by Ashbaugh, LaFond and Mayhew (2003) which focuses the study on whether the payment of non-audit fees has influence on audit independence. To extent this study, the paper here will test the ratio of non-audit fees to total fees paid to auditors which aims to find whether there is a positive relation between increased ratio of non-audit fees and decreased audit quality. Being different with Ashbaugh et al’s (2003) research which analyzes non-audit fees in full sample, this non-audit fees here will be analyzed in subsample with positive abnormal fees and subsample of negative fees respectively, thus, whether non-audit fees have different influences on audit quality when auditors are paid higher or lower fees than their expectation should be examined.
The motivation for doing this study is based on the aim that finding out whether the economic bonding between auditors and client firms is existed really, as this relationship is one of the most controversial topic in public and academic area, especially after the Enron even and the failure of Anderson, this topic motivates more and more interesting in this area. However, according to the results of previous studies, many studies failed to prove the existent of this relationship between auditors and client firms, and the results in other relative studies are ambiguous. Moreover, because of active economic environment and accounting events, most studies paid attention on American market, as for other markets, seldom of relative investigations can be found. The aim in this study is try to find out relative evidence from UK market.
The structure of this paper follows: the next part is a literature review in related area which introduced both early and latest studies; and then is the development of hypotheses the resource of relative theory and the contribution of hypotheses are included in this part. The design of methodology is presented in chapter 4 which has a description of important models in detailed. Furthermore, the chapter after it is the description of sample and the result of test, which is also the center of this study. The limitation and conclusion will be displayed in the last chapter which gives an overview and comment of this study.
There is a literature review of relative studies in this part. The literature review covers the studies in relative area which includes the result of studies and the development of methodology related to the investigation. The primary previous studies are displayed and concluded in this chapter.
1. The importance of auditor independence
Since the collapse of Enron in US and the scandal of Andersen, the world’s capital market confidence was reduced (Beattie and Fearnley, 2002). A large of the attention is paid on accounting and auditing practices, especially on the auditor independence. As some scholars (Beattie and Fearnley, 2002) point about that the independence of auditor is the base of the public confidence to audit process and the guarantee of the quality of financial information. In addition to this, rather than a benefit to investors, auditing also reduces the cost of information exchange for two sides (Douch, 1980 and Simunic, 1982). From these words, we can easily know that a high quality of auditing information might ensure the reliability of market information, therefore, many experts in this area focus their empirical researched on factors for the reduction of auditor independence in order to find out the reasons for impairing auditor independence. The economic bonding between client and auditor account for an important position in this kind of research.
2. Review on the payment of high audit fees on opinion shopping
DeAngelo (1981) shows the evidence through investigating the “low balling” phenomenon in audit market that when audit firms have a significant economic benefit on client firms, audit quality and independence are easy to be reduced. The same as DeAngelo’s (1981) research, Magee and Tseng (1990) also have similar conclusion. Authors extend the previous research (DeAngelo, 1981) to find out in which condition the economic bonding may lead to the impairment of audit independence. The study provides a result that when auditors’ compensation is tied to the decision of audit opinion and then, their independence is more likely to compromise to economic bonding. Frankel, Johnson and Nelson (2002) take the research in this area to provide empirical evidence for the relation between audit fees and earnings management. Their study is based on data selected from 3074 proxy statement listed in SEC in the period from Feb 5, 2001 to June 15, 2001. The evidence of this research confirms the assumption that there is an association between audit fees and the possibility of the compromise of audit independence. Kinney and Libby (2002) continue the research from Frankel, Johnson and Nelson (2002). Through analyzing the empirical research which has been done in the previous study, authors draw up a conclusion that auditors are probable to loss their independence in reducing their willingness to resist with client-induced biased in reporting audit opinion, when there is a strong economic benefit between auditors and clients.
However, some empirical tests in the same area conclude the opposite results. Craswell, Stokes and Laughton (2002) do the research to indentify whether fee dependence have impairment on audit independence. They do the research from both aspects of national market level and local market level, but they find evidence neither from national market level and local market level can demonstrate that fee dependence has negative impact on audit quality. In other words, the economic bonding is not existed in the auditor-client relationship.
In the following paragraphs, literature review about the impact of abnormal audit fees and non-audit fees on audit opinion shopping are shown.
2 .1 The review of abnormal audit fees on opinion shopping
From the literature review above, the evidence for the opinion shopping through the behavior of paying high non-audit fees is still absent. And some auditors (Kanodia and Mukferji,1994) point out that switching incumbent auditors cause clients loss initial engagement and negotiate fees, beside this, switching auditors is less likely for client firms to achieve clean opinion (Chow and Rice, 1982) and event more conservative audit opinion (Krishnan, 1994). Therefore, comparing with paying high non-audit services fees and switching auditors, paying auditors with higher audit fees is a more efficient and less risk approach in opinion shopping (Fang and Hong, 2004).
However, although there are some proofs can provide the assumption that higher audit fees, on some extent, can exert impact on audit quality, to analyze the relation between abnormal audit fees and audit quality, there are many factors should be concerned about, as these factors (no just economic bonding) also result in high fees. Some practitioners extend their research in this area by analyzing the association abnormal between audit fees and the changes in audit opinions.
Hoitash, Markelevich and Barragato (2007) consider the high audit fees paid to auditors on two aspects: one is the positive side which suggests paying high fees can increase auditors’ effort in their jobs, thus, the quality also be improved; the other is the negative side which suggests that high audit fees paid to auditors may enhance the economic dependence on clients, thus, auditors’ independence is easy to compromise to economic benefit and audit quality also reduced. In the research, they examine the fees paid to auditors between the period over 2000-2003, using two metrics to assess audit quality: the accruals quality measure and the absolute value of performance-adjusted discretionary accruals. They predict abnormal audit fees by using pricing model from previous studied Simunic (1980), and consider about the factors may have impact on fess pricing, such as risk, complexity, and company size. The outcome of this investigation shows the conclusion that abnormal audit fees might result in economic bonding and thus impair audit quality.
Similarly, Choi, Kim, and Zang (2006) have the same category of abnormal audit fees: the positive abnormal fees and the negative abnormal fees, the sample in this research constituted by the data collected from 9820 listed large companies’ audit fees observations during 2000-2003 period. Study also choose model from Simunic (1980) to estimate the audit fees. The result of the regression model shows that evidence that the possibility of auditors’ independence compromise to economic bonding is depending on whether clients may pay higher audit fees than the normal fees. In another word, audit quality will be impaired by abnormal fees.
Fang and Hong (2004) also issue the opinion about the abnormal fees that high fees paid to auditors may be caused by the real improvement in companies; therefore, the positive increase in audit opinion may also cause the increase in audit fees. Authors examine the relation between abnormal audit fees and audit quality by comparing the audit opinion in present year with the prior year, and find out the association between the abnormal fees and the changes of opinions. The database in this research is comprised by Chinese listed companies during the period from 2000-2002. Through the testing in regression model, authors find that the result is consistent with the positive relation between abnormal audit fees and improvement in audit opinion, which provides evidence that client companies succeed in opinion shopping through overpaying to auditors.
2.2 The relation between the size of audit firms and audit quality
But one point worth researcher to notice is the higher payment of audit fees does not mean the tendency of opinion shopping necessarily. Some evidences from other area can proof that the purpose of opinion shopping is not the only reason of high audit fees.
Simunic (1980) issues his opinion in the research of audit pricing that the competition in audit market is function of fees pricing. The same as this theory, the research on the low balling behavior (DeAngelo, 1981; Kanodia and Mukferji, 1994) confirm the opinion that competitive market will produce influence on audit fees. In addition to this, the audit firm sizes, the quality of auditors also have effects on audit price. Francis (1984) analyzes the effect from audit firm size on audit fees. Author researches for the evidences by comparing the differences of audit fees of Big-8 (Big-4 now) firms and of non-Big-8 firms over the period from 1974-1978 in Australian market. The research provides the evidence that there is larger size audit firms will result in higher audit fees, at the same time, study demonstrates that higher audit fee is consistent with higher audit quality. The similar research is done recently by Choi, Kim, Liu and Simunic (2008) through using a large sample from 15 countries and a cross-country regression. Beside this, study links the research to audit characteristic and legal environment. After analyzing the difference between the fees in Big-4 firms and non-Big-4 firms, authors achieve the conclusion that the relation between firm size and the level of audit fees is existed. According to the interview finished among auditors (Chan, Ezzamel and Gwilliam, 1993), the BIG 6 and NON-BIG6 (BIG4 now) auditors confirm that the BIG6 premium might exist if comparing with very small audit firms, but no medium size firms. The interview here reflects a phenomenon that the difference in audit fees between BIG4 and NON-BIG4 audit firms are not so obvious.
2.3 The payment of non-audit services fees on opinion shopping
The provision of non-audit services by audit firms to client firms is another controversial topic in opinion shopping. Policy makers argue that the provision of audit and non-audit services to same clients is possible to reduce the level of auditors’ independence (Houghton and Ikin, 2001). At the same time, auditors protect themselves by arguing that supplying non-audit services does not impair their independence, because these works are often be done by different partners and staff. For a long time, researchers have never stopped investigating in the area.
3. The influence of non-audit fees on audit independence
As to the audit independence, there are many definitions for it. DeAngelo (1981a, p.186) defines audit independence as ‘the conditional probability of reporting a discovered breach’; Knapp (1985) provides the definition as ‘the ability to resist client pressure’; the definition from AICPA (1992) is ‘an attitude/state of mind’; according to Magill and Previts’ (1991) definition, audit independence is ‘a function of character, with the attributes of integrity and trustworthiness being key’ and ISB (2000) defines audit independence as ‘the freedom from those pressure and other factors that compromise, or can reasonably be expected to compromise, an auditor’s ability to make unbiased decisions’. Although there are somewhat differences between those definitions of audit independence, they have a common point that is the importance of objectivity and integrity (Beattie and Fearnley, 2002).
Beside provide the audit services to clients, audit firms also provide other services to clients, these services are called non-audit services, such as management advisory and consulting, but the compliance related services, such as taxation and accounting advice, are also included in them. However, as many experts (Beattie, Brandit and Fearnley, 1996) point out that this kind of non-audit services related closely to the annual reporting round. Therefore, the use of ‘consultancy’ for non-audit services is somewhat wrong.
What is discussing most in academy about the provision of non-audit services is the potential conflict of interest faced by audit firms who receive large non-audit fees from their audit clients. For example, after the Enron case, it was disclosed that Andersen received $25m in audit services fees and $27m for non-audit fees (Beattie and Fearnley, 2002). So, such high non-audit services fees paid to audit make public and scholars to suspect that the provision of non-audit services increases the economic bonding between auditors and clients. Many investigations are based on the assumption that the provision of non-audit fees reduces auditors’ independence, as they fear for losing high profit engagement with clients in the future; therefore, they are probably to give up independence for high profit.
3.1 The review of the researches in association between non-audit fees and audit quality
In the early 1980s, researchers had found that the percentage the revenues from providing other services in audit firms had increased lot (Barkess and Simnett, 1994). The early empirical study is done by Simunic (1984). Author establishes his study on the assumption that those client companies who purchase non-audit services have a higher audit fees paid to auditors than audit fees from those companies who do not purchase non-audit services, and both of them hire the same incumbent auditors. In this investigation, author just focus the test in Big-8 (Big-4 now) firms, which avoids the differences on audit quality, and selects a database compromise of 397 US listed companies. From the research, he finds out than there is a positive relation between non-audit services and audit fees.
Simon (1985) continues previous research (Simunic, 1984) in this area by using more recent data in the period from 1978-1983. His research depends on the voluntary disclosure from proxy statements (the non-audit services fee is not disclosed that time). His research also produces the result that client firms who purchase non-audit services have higher audit fees than those companies without the engagement of non-audit services with audit firms.
The evidence from UK market (Ezzamel, Gwilliam and Holland, 1996) constitutes the research on the data from 314 UK listed companies. From the study, authors found out similar result consistent with previous researches (Simunic, 1984; Simon, 1985). To be different from above studies, this study joints non-audit services with other factors together to investigate the effects on audit pricing. Many previous researches have confirmed the phenomenon that the positive relationship between the purchase of non-audit services and higher audit fees paid by clients exists. But the existence of this relationship causes regulators, practitioners and public’s attention about whether this economic bonding between client firms and auditors might impair audit independence.
Barkess and Simnett (1994) concern about independence on two aspects, one perspective is to examine whether those clients purchase other services from auditors are less likely to receive qualified opinion; the other one is the determination of the relationship between the provision of other services and audit service by comparing those companies who provide non-auditor services but do not change auditors and those companies change auditors. In the study, the sample is compromised by the Top 500 listed companies in Australia for each of the years from 1986 to 1990. From the study, they conclude the result that 85%of the companies in the research purchased non-audit services from the incumbent auditors and the increase in the percentage in stable in the period. In addition to this, their result supports the point that there is a positive relationship between audit fees and the provision of non-audit services. As far as the audit independence concerned, their research show that there is not identified relationship between the supply of non-audit services and the type of audit report, as they found that there were 308 qualified opinions in the total sample of 2094 audit reports. Therefore, they concluded that there was not enough evidence can demonstrate the hypotheses that auditors were less likely to issue the qualified opinion when the level of non-audit services to clients was higher. In other words, the provision of other services does not impair audit independence.
However, Wines (1994) concluded the opposite result by testing 100 public companies on the Australian Stock Exchange at 30th June 1980, in the sample, 24 of these companies were failed to do the test, therefore, and author examined the 76 left for over the period of ten years. From the test in these 76 listed companies, author drawn up the findings that 7 of 76 companies paid a higher level of remuneration for non-audit services to auditor than the provision of audit services and those companies with non-qualified opinion had higher payment of non-auditor services fees than those companies with qualified opinion (28 companies. Hence, Wines gives the summary that the evidences from the research in 76 listed companies associate with the assumption that the provision of non-audit services has impairment on auditors’ independence. Wines (1994) also points out the limitation in his research is difficulty in assessing audit quality by considering the frequency with which auditing firms issue qualified opinions. However, one problem in Barkess and Simnett (1994) and Wine (1994) studies is that their sample is not large enough in test.
Craswell (1999) makes advantage in his study by using a larger data sample and makes the evidence related to auditors’ actual decisions. The fiscal-year data chose by author to examine are obtained from ‘who audit Australia’, the sample is consisted by 885 public listed companies in 1984, 1477 in 1987 and 1079 in 1994, the results show that in each of the year (1984, 1987, 1994) the result does not associate with the assumption that non-audit services have negative effect on auditor independence, which is consistent with Barkess and Simnett (1994). But one limitation in his research is that this study just compares the companies with qualified opinions with those companies with unqualified opinions, while a better test should compare the companies with qualified opinions with such companies with clean opinions but experienced problems and likely to raise qualifications.
Although most of the investigation have done by researchers show that the provision of non-audit services does not impair audit independence, regulators still hold the assumption that auditors will prefer to give up their independence in order to obtain more non-audit services fees from clients (DeFond, Raghunandan and Subramanyam, 2002), especially after the Enron accounting scandal. In 2002, the Sarbanes-Oxley Act (the ‘Act’) imposed the prohibition on the provision of non-auditor services, which based on the direction of enhancing auditor independence, reducing ‘conflict of interest’ and the concern that ‘all non-audit services were not created equal’ (American Institute of CPAs, 2002). At the same time, the US Securities and Exchange Commission (SEC, 2002) made the revision the Commission’s regulations related to the non-audit services, which are consistent with the content in Sarbanes-Oxley Act.
After the prohibition on non-auditor services added in Sarbanes-Oxley Act and SEC was carried out, many scholars continue the prior researches in this area. Frankel, Johnoson and Nelson (2002) used a sample constituted of 3074 proxy statements, used two indicators (discretionary accruals and the likelihood of firms meeting earning benchmark), to test whether audit independence would be reduced when the non-audit services grew. The consequence of the research indicates the evidence that there is an association for the assumption that auditors likely tend to sacrifice their independence when the non-audit services fee is high. Ashbaugh, LaFond and Mayhew (2003) continued this research, but the conclusion challenges the results made by Frankel, Johnoson and Nelson (2002). In the test, they used the same indicators as prior one. In the test, they find that there is no relation between positive discretionary accruals and auditor fee metrics; furthermore, their test proof that the relation between fee ratio and the likelihood that firms beat analysts’ forecasts is not existed, in other words, auditors’ independence will not compromise to clients’ high non-audit services fees.
4. Review of the development of models
In empirical studies, the relative models will help to connect independent variables together in order to analyze the relation between each variable. In the study of the relation between audit fees and audit quality, the most important models are the model for measuring audit fees and audit quality. In this part, a review of the development and modification of two models is displayed.
4.1 Review of the development of audit fees model
Since Simunic (1984) develops the audit fees model in order to predict the expected audit fees, the model has been developed lot in these years. In the beginning, Simunic (1984) provides the theory that the audit fees level will be affected by the several factors, such as the client firms’ sizes, the complexity of auditing process, audit firms’ sizes and audit risk. The following scholars provide the related variables for model which the used to decide expected audit fee.
Chan, Ezzamel and Gwilliam (1993) point out in their study audit size is an explanatory variable which has important influence on the determinant audit fees. In the study, authors suggest to use the measurement of turnover to control audit size, which is also the measurement of client firms’ sizes. However, the use of turnover as determining is not unproblematic because the definitions of turnover are varying widely between companies and industries. Therefore, to measure audit size and client firms sizes, many researchers choose the total assets as variable. To consistent with previous studies, Ashbaugh, LaFond and Mayhew (2003); Choi, Kim and Zang (2006); and Hoitash, Markelevich and Barragato (2007) use the nature log of total assets to control client firms’ sizes and audit size. In addition to using total assets and turnover as proxies to audit size, on most investigations, likes Ashbaugh et al (2003) choose the number of employees to quantize audit size. Both of these scholars use number of business segments and geographic areas in measuring audit sizes.
As for the measurement of complexity of audit process which is another reason for increasing audit fees, Chan et al (1993) suggest to use the number of subsidiaries to measure it. According to previous studies (Ashbaugh et al ,2003; Hoitash et al ,2007), the proportion of foreign subsidiaries will have influence on the increase of audit fees, therefore, the ratio between foreign subsidiaries and total number of subsidiaries is selected to measure this effect on audit fees. Furthermore, Choi, Kim, Liu and Simunic (2008) use the ratio of the sum of inventories and receivables to total assets to present complexity. Lastly, the dummy of gain or loss before extraordinary items is a popular variable in latest studies, such as the study in Hoitash et al (2007).
The level of risk in audit processing is another factor causes increase in audit fees. Turley and Cooper (1991) provide the hypothesis that there is a positive relation between audit risk and audit fees. Chan et al (1993) predict higher risk makes consequence in higher audit fees is because auditors want to take the excess fees than normal level as an ‘insurance’ premium and this hypothesis is supported by interview findings. Most of previous studies focus on using such variables as liquidity ratio (the ratio between current liabilities and current assets), and gearing ratio (the leverage), to test the level of audit quality. However, as previous scholars point out that the audit risk which is the reflection of the nature of the business of the enterprise and the control of enterprise is difficult to measure. Therefore, the subjective judgments in measuring audit risk are hard to avoid.
The level of client firms’ performances is will also has impact on audit fees. According to the interviews between audit partners (Chan, Ezzamel and Gwilliam, 1993), it is confirmed that there is a link between the level of client firms’ profitability and the level of audit fees, and the association between them is negative. Furthermore, it is commonly agreed that when a client is facing with financial pressure is more likely to ask for controlling overhead costs wich might be result in higher audit fees. To measure the level of this variable, Chan et al (2003) use the return on equity to measure it, while other researchers like Hoitash et al (2007) and Chan, Kim, Liu and Simunic (2008) use the return on assets to measure this.
Beside variables above, there are other potential reasons which might also cause the changes in audit fees. However, seldom of previous studies pay attention on these potential variables (Chan, Ezammel and Gwilliam, 1993) according to the study finished by Chan et al (1993), the control of ownership is also one of the variables in audit fees model. The hypothesis in their paper makes the assumption that the extension of audit services will be a factor in the ownership control as companies with a diverse ownership structure are required a higher quality audit. Therefore, the audit fees are increased. However, it is difficult to measure the extension of ownership control directly. The timing variable is another reason in the fluctuation of audit fees (Chan et al, 1993). According to the audit season in UK market, the accounting year between 1 December and 31 March is the busy season, others are non-busy, and the former season will increases audit fees as auditors have a comparatively shorter deadline in it. Moreover, though test, authors find that the legal liability also have impact on the level of audit fees, as the evidences demonstrate that legal liability is a fee-increase factor. Lastly, other variables, such as the location of auditors, are seldom be used as variables in investigations.
4.2 Review of the development of discretionary ac