Audit Journal
Auditing: A Journal of Practice & Theory Vol. 29, No. 2 November 2010 pp. 115–140
American Accounting Association DOI: 10.2308/aud.2010.29.2.115
Do Abnormally High Audit Fees Impair Audit Quality?
Jong-Hag Choi, Jeong-Bon Kim, and Yoonseok Zang
SUMMARY: This study examines whether and how audit quality proxied by the magnitude of absolute discretionary accruals is associated with abnormal audit fees, that is, the difference between actual audit fee and the expected, normal level of audit fee. The results of various regressions reveal that the association between the two is asymmetric, depending on the sign of the abnormal audit fee. For observations with negative abnormal audit fees, there is no significant association between audit quality and abnormal audit fee. In contrast, abnormal audit fees are negatively associated with audit quality for observations with positive abnormal audit fees. Our findings suggest that auditors’ incentives to deter biased financial reporting differ systematically, depending on whether their clients pay more than or less than the normal level of audit fee. Our results are robust to a variety of sensitivity checks. Keywords: audit quality; abnormal audit fees; earnings management. Data Availability: Data are publicly available from sources identified in the paper.
INTRODUCTION his study examines whether the association between audit fees and audit quality is asymmetric and thus nonlinear in the sense that the association is conditioned upon the sign of abnormal audit fees. We define abnormal audit fees as the difference between actual audit fees i.e., actual fees paid to auditors for their financial statement audits and the expected, normal level of audit fees. Actual audit fees consist of two parts: 1 normal fees that reflect auditors’
T
Jong-Hag Choi is an Associate Professor at Seoul National University, Jeong-Bon Kim is a Chair Professor at City University of Hong Kong, and Yoonseok Zang is an Assistant Professor at
American Accounting Association DOI: 10.2308/aud.2010.29.2.115
Do Abnormally High Audit Fees Impair Audit Quality?
Jong-Hag Choi, Jeong-Bon Kim, and Yoonseok Zang
SUMMARY: This study examines whether and how audit quality proxied by the magnitude of absolute discretionary accruals is associated with abnormal audit fees, that is, the difference between actual audit fee and the expected, normal level of audit fee. The results of various regressions reveal that the association between the two is asymmetric, depending on the sign of the abnormal audit fee. For observations with negative abnormal audit fees, there is no significant association between audit quality and abnormal audit fee. In contrast, abnormal audit fees are negatively associated with audit quality for observations with positive abnormal audit fees. Our findings suggest that auditors’ incentives to deter biased financial reporting differ systematically, depending on whether their clients pay more than or less than the normal level of audit fee. Our results are robust to a variety of sensitivity checks. Keywords: audit quality; abnormal audit fees; earnings management. Data Availability: Data are publicly available from sources identified in the paper.
INTRODUCTION his study examines whether the association between audit fees and audit quality is asymmetric and thus nonlinear in the sense that the association is conditioned upon the sign of abnormal audit fees. We define abnormal audit fees as the difference between actual audit fees i.e., actual fees paid to auditors for their financial statement audits and the expected, normal level of audit fees. Actual audit fees consist of two parts: 1 normal fees that reflect auditors’
T
Jong-Hag Choi is an Associate Professor at Seoul National University, Jeong-Bon Kim is a Chair Professor at City University of Hong Kong, and Yoonseok Zang is an Assistant Professor at
References: Ashbaugh, H., R. LaFond, and B. Mayhew. 2003. Do nonaudit services compromise auditor independence? Further evidence. The Accounting Review 78 3 : 611–639. Ball, R., and L. Shivakumar. 2006. The role of accruals in asymmetrically timely gain and loss recognition. Journal of Accounting Research 44: 207–241. Becker, C., M. DeFond, J. Jiambalvo, and K. Subramanyam. 1998. The effect of audit quality on earnings management. Contemporary Accounting Research 15 1 : 1–24. Chaney, P., D. C. Jeter, and L. Shivakumar. 2004. Self-selection of auditors and audit pricing in private firms. The Accounting Review 79 1 : 51–72. Chen, C-Y., C-J. Lin, and Y-C. Lin. 2008. Auditor partner tenure, audit firm tenure, and discretionary accruals: Does long auditor tenure impair earnings quality? Contemporary Accounting Research 25 2 : 415–445. Choi, J.-H., J.-B. Kim, X. Liu, and D. A. Simunic. 2008. Audit pricing, legal liability regimes, and Big 4 premiums: Theory and cross-country evidence. Contemporary Accounting Research 25 1 : 55–99. ——–, ——–, ——–, and ——–. 2009. Cross-listing audit fee premiums: Theory and evidence. The Accounting Review 84 5 : 1429–1463. ——–, and T. J. Wong. 2007. Auditors’ governance functions and legal environments: An international investigation. Contemporary Accounting Research 24 1 : 13–46. Chung, H., and S. Kallapur. 2003. Client importance, nonaudit services, and abnormal accruals. The Accounting Review 78 4 : 931–955. Craswell, A., J. R. Francis, and S. Taylor. 1995. Auditor brand name reputations and industry specialization. Journal of Accounting and Economics 20 3 : 297–322. ——–, D. J. Stokes, and J. Laughton. 2002. Auditor independence and fee dependence. Journal of Accounting and Economics 33 2 : 253–275. DeAngelo, L. E. 1981. Auditor independence, “low balling,” and disclosure regulation. Journal of Accounting and Economics 3 2 : 113–127. Dechow, P. M., and I. D. Dichev. 2002. The quality accruals and earnings: The role of accrual estimation errors. The Accounting Review 77 Supplement : 35–59. ——–, R. G. Sloan, and A. P. Sweeney. 1995. Detecting earnings management. The Accounting Review 70 2 : 193–225. DeFond, M., and J. Jiambalvo. 1994. Debt covenant violations and manipulations of accruals. Journal of Accounting and Economics 17 1–2 : 145–176. ——–, K. Raghunandan, and K. Subramanyam. 2002. Do nonaudit services fees impair auditor independence? Evidence from going concern audit opinions. Journal of Accounting Research 40 4 : 1247– 1274. ——–, and K. Subramanyam. 1998. Auditor change and discretionary accruals. Journal of Accounting and Economics 25 1 : 35–67. Dye, R. A. 1991. Informationally motivated auditor replacement. Journal of Accounting and Economics 14 4 : 347–374. Francis, J., E. Maydew, and H. C. Sparks. 1999. The role of Big Six auditors in the credible reporting of accruals. Auditing: A Journal of Practice & Theory 18 2 : 17–34. Frankel, R., M. Johnson, and K. Nelson. 2002. The relation between auditors’ fees for nonaudit services and earnings quality. The Accounting Review 77 Supplement : 71–105. Higgs, J. L., and T. R. Skantz. 2006. Audit and nonaudit fees and the market’s reaction to earnings announcements. Auditing: A Journal of Practice & Theory 25 1 : 1–26. Hribar, P., and D. C. Nichols. 2007. The use of unsigned earnings quality measures in tests of earnings management. Journal of Accounting Research 45 5 : 1017–1053. Huang, H.-W., S. Mishra, and K. Raghunandan. 2007. Types of nonaudit fees and financial reporting quality. Auditing: A Journal of Practice & Theory 26 1 : 133–145. Kasznik, R. 1999. On the association between voluntary disclosure and earnings management. Journal of Accounting Research 37 1 : 57–81. Kim, J.-B., R. Chung, and M. Firth. 2003. Auditor conservatism, asymmetric monitoring, and earnings Auditing: A Journal of Practice & Theory November 2010 American Accounting Association 140 Choi, Kim, and Zang management. Contemporary Accounting Research 20: 323–360. Kinney, W. R., Jr., and R. Libby. 2002. Discussion of the relation between auditors’ fees for nonaudit services and earnings management. The Accounting Review 77 Supplement : 107–114. ——–, Z.-V. Palmrose, and S. Scholz. 2004. Auditor independence, nonaudit services, and earnings restatements: Was the U.S. government right? Journal of Accounting Research 42 3 : 561–588. Kothari, S. P., A. J. Leone, and C. E. Wasley. 2005. Performance matched discretionary accrual measures. Journal of Accounting and Economics 39 1 : 163–197. Krishnan, J., H. Sami, and Y. Zhang. 2005. Does the provision of nonaudit services affect investor perceptions of auditor independence? Auditing: A Journal of Practice & Theory 24 2 : 111–135. Larcker, D. F., and S. A. Richardson. 2004. Fees paid to audit firms, accrual choices, and corporate governance. Journal of Accounting Research 42 3 : 625–658. Myers, J., L. Myers, and T. Omer. 2003. Exploring the term of the auditor-client relationship and the quality of earnings: A case for mandatory auditor rotation? The Accounting Review 78 3 : 779–799. Petersen, M. A. 2009. Estimating standard errors in finance panel data sets: Comparing approaches. Review of Financial Studies 22 1 : 435–480. Raghunandan, K., and D. V. Rama. 2006. SOX Section 404 material weakness disclosures and audit fees. Auditing: A Journal of Practice & Theory 25 1 : 99–114. ——–, J. Read, and S. Whisenant. 2003. Initial evidence on the association between nonaudit fees and restated financial statements. Accounting Horizons 17 3 : 223–234. Reynolds, J. L., D. Deis, and J. R. Francis. 2004. Professional service fees and auditor objectivity. Auditing: A Journal of Practice & Theory 23 1 : 29–52. Ruddock, C., S. Taylor, and S. Taylor. 2006. Nonaudit services and earnings conservatism: Is auditor independence impaired? Contemporary Accounting Research 23 3 : 701–746. Sankaraguruswamy, S., and S. Whisenant. 2005. Pricing initial audit engagements: Empirical evidence following public disclosure of audit fees. Working paper, University of Houston. Simunic, D. A. 1980. The pricing of audit services: Theory and evidence. Journal of Accounting Research 18 1 : 161–190. ——–, and M. T. Stein. 1996. The impact of litigation risk on audit pricing: A review of the economics and the evidence. Auditing: A Journal of Practice & Theory 15 Supplement : 119–133. Whisenant, S., S. Sankaraguruswamy, and K. Raghunandan. 2003. Evidence on the joint determination of audit and nonaudit fees. Journal of Accounting Research 41 4 : 721–744. Zmijewski, M. E. 1984. Methodological issues related to the estimation of financial distress prediction models. Journal of Accounting Research 22 Supplement : 59–82. Auditing: A Journal of Practice & Theory American Accounting Association November 2010 Copyright of Auditing is the property of American Accounting Association and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder 's express written permission. However, users may print, download, or email articles for individual use.