Amsterdam Business School
The impact of engagement partner
disclosure on audit fees：
Moderating effects of firm size and corporate governance
Name: Suyi Liu
Student number: 10825134 Date: 21/06/2015
Word count: 10,965
Thesis supervisor: Raak, Jeroen van
MSc Accountancy & Control, specialization Accountancy Faculty of Economics and Business, University of Amsterdam
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Statement of originality
This document is written by student Suyi Liu, who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economic and Business is responsible solely for the supervision of completion of the work, not for the contents.
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Abstract
This paper examines the impacts on audit fees caused by engagement partner signature requirement in the United Kingdom. As the PCAOB is considering this implementation mandatory in the U.S market, it is necessary to study the empirical evidence from other representative market. In this paper, it has been found that in the first year after the implementation of the signature requirement, the increase in audit fees is more pronounced in larger firms. Apart from that, corporate governance quality has been proved to be related to the association between signature requirement and audit fees. Firms with higher corporate governance quality pay less audit fee and this effect is also pronounced in companies with higher quality.
Key words: partner identity disclosure requirement; signature; audit fees; corporate
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Content
1.Introduction ... 4
1.1 Background ... 5
1.1.1 The PCAOB ... 7
1.1.2 Signature requirement for disclosure ... 8
1.2 Audit Partner Signature Requirement Practices ... 9
1.3Motivation of this study... 10
2.Literature review and hypothesis ... 11
2.1 Auditor reporting responsibility ... 12
2.2 Audit fees ... 13 2.3 Corporate governance ... 15 2.4 Hypothesis development ... 17 2.4.1 Research question ... 17 3. Research methodology ... 19 3.1 Sample selections ... 19
3.2 Regression models and variables definitions... 20
4. Empirical results ... 22
4.1Univariate results ... 22
4.2 Regression results ... 23
5. Summary, implications and limitations ... 28
5.1 Summary and conclusions ... 28
5.2 Limitation and further analysis suggestions ... 31
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1. Introduction
Given the increased concerns about how the engagement partner signature implementation impacts on auditing issues, this paper provides empirical evidence about the implementation in the United Kingdom. The consequence of such a requirement, like the change of audit fees, is believed to cause interests of manages and report users. All the time, audit quality is an unobservable characteristic and could not be measured directly through numbers. Public and those stakeholders with non-financial background then shift their attention to audit fees because of its comparability. Audit fees could be compared not only in the industry similar companies but also within the firm for different years. To some extent, audit fee is linked to audit quality. In general, high audit fees either means that the client is a large size firm and therefore requires time and money consuming audit or means that the audit firm has quite reputation, like BIG 4 and charges more than small auditing firms. Therefore, if everything goes well within one firm, the amount of audit fee should stay at a similar level for several years. However, after the signature disclosure requirement, audit fee could be changed due to other factors. The results of this paper provide better understanding.
The expectation that there is an increase in audit fees in the post signature period has been tested in the paper of Carcello and Li (2013). Based on that, the effect is examined whether it is pronounced in larger firms. Also, considering some contributions, a new variable, corporate governance quality, is examined if it is related to the association between audit fees and signature requirement. The research is located in the United Kingdom as it is mandatory required to switching to engagement partner identity disclosure. And all data is collected from Datastream database. Findings in this paper indicate that the effect of increasing audit fees caused by the implementation is pronounced in larger firms. Corporate governance quality is related to the association mentioned above: firms with higher corporate governance quality pay less audit fees in the post signature requirement period, and this effect is also
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pronounced in higher quality companies.
Next section provides more detailed background information about this topic. It will tell a scandal that is the trigger for renewed proposal issued by the PCAOB in 2013and discusses the motivations of this study. Chapter 2 illustrates prior literature and previous findings related to the topic and the process of designing the hypothesis. Chapter 3 shows the methodology part. It is mainly about the sample selection and filtering procedures and provides definitions of variables in the regression models. Chapter 4 provides tables about the empirical results of data and regression models. After which, it provides analysis of its meanings. Chapter 5 is the conclusion and summary part, the implications of practices about auditing issues, the limitations of this study and suggestions for further research.
1.1 Background
In 2013, a scandal about insider trading occurred in KPMG. The former partner Scott London who was responsible for KPMG audit services in Los Angeles revealed customer information to the jeweler Bryan Shaw. Scott London is a 50 years old CPA, and worked in KPMG since 1984. He is the firm partner of KPMG's Pacific and Southwest and the main auditor of Herbalife and Skechers. Bryan Shaw is a 52 years old jeweler. The two people met at the country club in 2005 and soon became friends. From 2010 to 2012, Mr. London used his position at KPMG to reveal confidential data of five KPMG audit clients about non-public information (such as unpublished mergers and acquisitions and quarterly reports information) to Shaw, The latter person then takes use of the information for stock and options operations to make his own interests.
The indictment of the Securities and Exchanges Committee (SEC) listed dozens of illegal insider trading cases between Shaw and Mr. London. One of the cases is Mr. London revealed quarterly report information of Deckers to Shaw before its announcement in 28 Oct 2010 and then Shaw bought 25 call-option of Deckers. Due
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to a 7.6% increase in the share price after the announcement, Shaw made a profit around 10.7 million. The federal prosecutors in Los Angeles had charged Scott London of securities fraud for criminal sentences. KPMG claimed its audit report of the company's shareholders are no longer effective, but said there is no reason to believe that the two companies have substantial false statement of the accounts. The incident has shown a loss of the image of the public auditors, and the performance of the auditing firm in the financial crisis has been under tremendous pressure. Herbalife in a market oriented announcement said that the unpublished KPMG's former partner has served as the auditor of its company, and added that the charges against this person means the 2010, 2011 and 2012 financial report issued by the audit opinion has failed. However, Herbalife said its audit committee and management still believe that financial reporting fairly reflects the company status in the corresponding period. KPMG said the 22000 partners and staff in USA unanimously condemned the partner's bad behavior: the person is in violation of the company's strict system and safeguard measures, betrayed trust of clients and colleagues of the company, and showed deliberate disregard of KPMG history long professional spirit in his actions (KPMG 2013). After this accusation, KPMG was forced to resign from the external audit of the two USA corporations.
Since the collapse of auditing firm Arthur Andersen caused by the Enron scandal a decade ago, regulatory authorities have been concerned about the four remaining large auditors, PricewaterhouseCoopers (PWC), Deloitte, Ernst & Young (Ernst & Young) and KPMG, may be involved in similar scandals and lead to a serious loss of customers. After which, the four representative multinational accounting firms have been constantly claimed to public that Andersen's case has been fully taken into considerations and the quality of audit is sufficient to meet the public, market and regulatory demands in the following audits. But the outbreak of the Mr. London event shows to the public that there also could be another irritating possibility: it is more difficult to execute monitoring activities once the auditor abuses his authority to facilitate his own interests.
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Although KPMG reacted to this scandal timely and condemned the behavior of Mr. London, it has so far declined to say how many companies’ audit work he is responsible for. Therefore, investors can't confirm whether Mr. London is still responsible for the audit work of other listed companies, because under the current law, such information is not publicly disclosed. Because of this, after the outbreak of this scandal, regulatory agencies and more and more researchers, began to focus on enhancing the transparency of information of auditing firms and auditors to achieve a sunshine operation. Doty indicated that the identity of the public company auditors is confidential, but investors support to end this secrecy. With more details being reported of KPMG insider trading scandal, the chairman James Doty of the PCAOB renewed calls for disclosure of senior auditors’ identity in 2013.
1.1.1 The PCAOB
“The Public Company Accounting Oversight Board (PCAOB) is a nonprofit corporation established by Congress to oversee the audits of public companies in order to protect investors and the public interest by promoting informative, accurate, and independent audit report”, this statement is obtained directly from the PCAOB official website. Except from the function mentioned on its official website, the PCAOB also takes charge of the audits services, including compliance reports submitted under federal securities laws to facilitate protection for investors.
After the Enron event, the Sarbanes-Oxley Act of 2002 was passed to provide better regulations for audit. The monitoring activities include the approval of the Board’s rules and standards, (SEC Rules: 17CFS 2011). The rulemaking process of the PCAOB is used not only in the registration, inspection programs but also in standard-setting and enforcement programs. The aim of the PCAOB is to improve audit quality through better regulations, decrease the risks of auditing failures in the U.S. as well as avoiding financial sandals and increase public confidence in both the financial reporting process and auditing work (PCAOB Release 2006).
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Among those reports that are prepared by the PCAOB after its inspection, the Board also chooses part of them and makes it available to the public. However, some information is restricted from public disclosure, or its disclosure is hindered, which means public have no access to these information (PCAOB 2009). Especially after the insider trading scandal in KPMG, some information that is restricted and
non-disclosed, in some people’s eyes, is ought to be open to pubic. Public now have interests of the engagement partner behind the audit and the authorities is considering disclosing such information which is confidential before.
1.1.2 Signature requirement for disclosure
The PCAOB has been considering mandating the disclosure of the identity of the engagement partner’s name for years. After a discussion of Concept Release in 2009, the PCAOB issued a proposed rule that would require the engagement partner to sign the report in 2011 (PCAOB 2011). What enhances the issuing of proposal for naming the audit partner in 2013 is the crime of Scott London, a former KPMG LLP senior partner, being involved in an insider-trading scandal that is deliberately explained in the introduction part.
In Dec 4 2013, the PCAOB unanimously voted to issue an amended proposal. Audit regulators voted to propose requiring auditing firms to identify their partner in charge of each client’s audit. The aim of this act is giving investors more transparent information and more confidence as well as increasing auditor’s accountability. (Michael Rapoport 2011). The action taken by the PCAOB provided some reviews of the board's 2011 proposal on the same issue, but overall indicated that the board still plans to move forward with its previous plan.
The proposal would require that the engagement partner to be named every year in the audit report included in each company's annual report (Michael Rapoport 2013). This
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disclosure requirement is not currently compulsory in the U.S, but some other
counties, like the U.K, have implemented this requirement. In the proposal, except for the signature disclosure requirement, other things related to audit issues, such as audit procedures, performances, audit risk measurement, remain unchanged. By providing the details about the auditors participated in the audit reporting, investors and other financial report users will get more information. As a result of that, the usefulness of the reports will increase. At the same time, the disclosure improves the transparency of audit reports. On the one hand, it makes auditors aware of the responsibility in ethical way and makes them perform the audit more carefully. On the other hand, firms are driven to buy high quality audit services.
Based on the expectation of the PCAOB, many studies have been conducted to examine the consequences. It is expected that perceived audit quality should be improved because of enhanced transparency, but there could be a gap between perceived audit quality and actual audit quality. It has been found that partner’s accountability has improved because of the transparency of audit reporting and the outcome of regulatory changes on earnings quality is valuable to for policy makers (DeFond 2010). The audit quality had been improved, from both academic and empirical standpoint. But to public and stakeholders with non-financial background, audit quality is an unobservable characteristic and cannot be measured directly through numbers. Therefore, audit fees attract people’s attention due to its comparability as it can be compared not only with other similar companies but also within the firm itself for different years. Thus, it is meaningful to study the impacts on audit fees caused by the signature disclosure requirement.
1.2 Audit Partner Signature Requirement Practices
“The European Union's (EU's) Eighth Company Law Directive requires at least the statutory auditors carrying out the statutory audit on behalf of the audit firm" to sign the auditor's report ((Directive, European Parliament and the Council 2006)). This
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proposal involves conforming legislation by all EU members. The United Kingdom requires the auditor's report to present the name of the participated auditors (PCAOB 2013). Besides the United Kingdom, other countries, Taiwan as well as Australia implement the same requirement. Although the proposal is not adopted in all developed areas, it is suggestive that there is a global trend toward better transparency about auditing.
After the anonymous vote on December 4 2013 by the PCAOB, comments are due on February 3 2014.The efforts are accompanied with some controversy. Two board members, Jay Hanson and Jeanette Franzel, hedged their votes with assertions that they wouldn’t support a final standard, partly because the costs could outweigh the benefits. Franzel (Board member of the PCAOB) thought that the key questions are whether and how additional transparency about the identities of engagement partners and other participants in audits would resolve a particular need or problem, oblige appropriate policy objectives, and impose compliance of other costs.
After the PCAOB released its first proposal, it received 248 feedback letters, and in April 2014 held a 2 day public hearing. According to the PCAOB's chief auditor Martin Bormann, after the controversy of the proposal, the PCAOB plans to release revised proposals in 2015. Bormann pointed out that PCAOB hopes to republish a revised proposal for the audit criteria in 2015, mainly to address the objections to the initial plan.
1.3Motivation of this study
First, it extends the previous study results by providing more evidence to show how the identification of engagement partner related to changes in audit fees. As the proposal came out just few years ago, it is widely believed that the preliminary study direction is how the requirement will influence auditing procedures and results. Therefore, most of the prior literature examined issues like audit quality after the implementation of audit partner disclosure requirement. Despite some studies showed
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a connection between audit fees and disclosure of identification, they did not make in-depth examination of this relationship. This paper will extend prior literature by studying the relationship from more aspects, setting more variables and testing if those effects are pronounced with variables to see how disclosure of audit partner identity affect audit fees.
Second, it provides empirical evidence for regulators and standard-setters. The PCAOB first put forward this issue in 2009, and then called for execution in 2013. The board has not officially mandate standards around counties, yet they do have the tendency to pass the requirement of disclosure, especially after some accounting and auditing scandals occurred in recent years. Some main countries have adopted the proposal and their operating results are consistent with regulators’ expectations. However, considering many of auditing characteristics are unobservable, PCAOB need more study results about the impacts of such a disclosure to help them in decision making process.
Third, it fills the gap in this auditing field. As the PCAOB issued proposed rule of disclosure requirement in 2013, studying the consequences of the signature requirement is a relatively new topic. In this field, the first paper which directly tested changes in audit quality and audit fees after the implementation of audit partner disclosure requirement was issued in 2013 (Carcello and Li 2013). The authors also called for further research to fill in the blank of this field since it is so new that there are still so many questions can be examined.
2. Literature review and hypothesis
To consider how to reform the audit process, it should be known that the interests related parties need auditors to perform which responsibilities in the first place. Wallace Wanda (1980) analyzes the economic role of audit by pointing out that the audit can be satisfied from three aspects. It is concluded in the following:
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First, it relates to agency theory: shareholders will delegate substantial rights to the management. The interests between shareholders and board directors may conflict. Then shareholders may think they must take more actions to protect their own interests. In this circumstance, independent audit is helpful to reduce the cost of inherent proxy. Second, it helps to solve the problem of asymmetric information. In other words, shareholders lack enough internal information to understand the company's internal progress. Therefore, the directors of the company appoint an independent auditor to show that they are willing to provide management records. Third, it plays the role of insurance. Auditor liability risk (in fact, the insurance provided by the auditor) guarantees that investors can receive the corresponding compensation after the loss.
2.1 Auditor reporting responsibility
The concept of auditor responsibility is defined as “The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud” (AU Section 110). Whenever, a high quality audit report is never separated from auditor independence. Robert Mednick has stated that “independence is the cornerstone of the accounting profession and one of its most precious assets” (Mednick 1997, 10).
Raghunandan has regarded that the outcome of an audit process is its audit report, which is the only message the public could acquire about what the auditors have done during the audit and what the conclusion is (Raghunandan et.al 2006). With the development of securities market, auditor increasingly receives concerns by the government, investors and the public. Enterprise financial report is the main
information that investors pay close attention for making better investment decisions. Because investors have no access to the real situation within one entity, there is serious asymmetric information which contributes to agency problems. The agency problem directly affects the operational efficiency of enterprises. Therefore, it needs
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an independent third party to audit the financial position of a firm to reduce agency cost. Independent auditor is an important mechanism of corporate governance to reduce the information asymmetry of the investors and enterprises so as to reduce the agency cost, and also publishes audit opinion of the underlying economic conditions. The higher the quality of audit is, the more the agency cost reduces.
Certified public auditors’ opinion is an important indicator for authorities to monitor the listing companies (PCAOB 2011). Once the company violations are investigated to be truly occurred, it will seriously affect the company's reputation, increase corporate legal risk, generate significant damage to the image of the enterprise and may cause great harm to investors. Under the litigation motivation, if auditors are legally obliged for audit failures, they have an incentive to provide high-quality audit services to avoid the costs of litigation suits (DJ Skinner 2009). If the auditor is unable to reveal the irregularities of the enterprise and issues incorrect audit opinion which leads to the economic loss of the user, the auditor will face punishments from the authorities. The main risk is that the regulatory authorities might revoke the qualifications of certified public auditors, which is a fatal blow to the firm as well as the auditor. Therefore, for the sake of reducing the audit risk to avoid the failure of audit that generates legal liability and impairs career reputation, there are incentives for auditors to implement audit procedures more prudently.
2.2 Audit fees
According to J Morgan (1995), auditors use remarkably comparable audit technologies, it is supposed that the cost of performing the audit is constant across the auditors for the engagement. Whenever carrying out a new action, it will cause costs and benefits. The proposal of signature disclosure might bring benefits for investors due to the improvement of transparency and usefulness of financial information, but its cost is primarily related to changes in audit fees.
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and represent the audit cost, cost of capitals in the process and indicate what they have done; the other is the potential contingent liability due to lawsuits and affairs caused by audit failures. Audit fees vary significantly with the firm size, complexity of the audit procedures, riskiness of the engagement, and other audit elements and characteristics (Simunic and Stein 1996, 121). The amount of audit fees depends on total audit work and expected future losses from legal liability caused by audit failures (Carcello et.al.2002). Kurt Desender (2007) stated that control mechanism for reducing the likelihood of opportunistic or deceitful reporting behavior is to purchase high quality audit services.
It is suggested that when investors or board of directors reward managers for employing reputable auditors, what the managers respond by is hiring reputable auditors consistently (Mayhew et.al.001). Corona (2010) also stated reputational concerns have universally been perceived to generate a positive impact on auditing firms' execution of their monitoring and attesting functions. Therefore, disclosure of engagement partner put pressure on auditors to keep their reputation. Hard work always should be rewarded, which leads to an increase in audit fees. Another way to generate changes in audit fees is that some boards may demand differentially audit quality to protect the board’s own interests. The board may pursue protection of its reputation capital and avoid legal liability caused by inappropriate audit opinions by purchasing differentially higher audit quality (Carcello et. al 2002). Because of the incentives, higher audit quality usually implies higher audit fees. Therefore, audit fees also increase.
When mentioning cost, it always relates to its corresponding management, including audit cost. Audit cost management is a control method to achieve the audit goal through the reasonable allocation of resources to realize the minimum audit costs (TP DiNapoli 2007). Generally, audit costs include the cost of capital, direct and indirect labor cost and time cost of the audit work (Incurred Cost DCAA 2015). It can be achieved by two ways in real practices.
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One is strictly controlling the audit procedures and minimizes intermediate procedures as much as possible. Audit procedure is the sum of all the steps taken by the auditor to achieve the audit objective. In the process of audit, the more complicated the process is, the higher the audit cost occurs. So to reduce the audit cost, audit procedures must be strictly controlled. In order to realize the effective control of the audit process, it is required to analyze and design the audit procedures from a whole to avoid
duplications and ensure the effectiveness of the audit procedures.
The other way is transferring the audit costs reasonably. It focuses on the
comprehensive utilization of audit results. Improving the quality of audit report and information timeliness and pertinence is one practice to realize information resource sharing of the audit work. Except those involving state secrets, commercial secrets and other inappropriate disclosure content, audit results should be all disclosed to the community to realize social sharing and maximize utilization.
2.3 Corporate governance
There are many definitions of corporate governance. “A system of rules, practices and processes by which a company is directed and controlled” is the definition abstracted from Investopedia website. Corporate governance in a narrow sense refers to a kind of supervision executed by the owner (mainly referring to shareholders) to the operator. That is, through a system arrangement, to reasonably define and configure the relationship between the owner and the operator's rights and responsibilities. The goal of corporate governance including ensuring the maximization of the interests of shareholders and preventing the deviation between the operators and the owners (MU Chapra 2002). Its main characteristics are the internal control of corporate governance structure which is composed of the shareholders meeting, the board of directors, the board of supervisors and managers (Cars Jan van Gool et.al 2008).
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Among those compositions of corporate governance, audit committee plays an important role. McMullen (1996) found that companies with dynamic audit
committees had fewer errors, indiscretions, and shareholder suits than firms without audit committees. The audit committee system of listed companies is an important system arrangement in corporate governance, especially has been further improved after the 2002 Sarbanes Oxley Act. It has a positive impact on many other countries and regions, and has become one of the most active and effective system in the improvement and perfection of corporate governance in recent years. Wright (1996) suggests that audit committee is strongly associated with the quality of financial information.
According to the definition of the Sarbanes act of the United States, the audit
committee is “a group which is composed of the board of directors of a securities firm (or an equivalent group)”. Its purpose is to monitor the company's accounting,
financial reporting and the reliability of audited financial statements. Independence is always a crucial concept in board quality for various kinds of committees. As an independent financial strength of the board of directors, the audit committee has strengthened the independence of external audit, and strengthened the authenticity and reliability of the financial report information (PH Dembinski 2006). When the
certified public accountant in the audit process found a major problem, he can directly communicate with the audit committee. In this way, it is helpful to the timely
resolution of major issues and ensures the independence of external auditors. Besides, when the audit opinion is in disagreement with management authorities and its
independence is threatened, communication of the audit committee could protect the independent assurance role.
It is never easy to define a good corporate governance system components as there could be so many factors in determining the quality. Cotter et. al. (1997) has
acknowledged positive associations between board independence and actions that are in the best interests of shareholders. Fama and Jensen (1983) discovered that outside
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directors have a particularly strong motivation to avert and detect opportunistic or inappropriate reporting behavior by managers. Nevertheless, a board also could be defined as diligent. Srivastava summarized that a diligent board includes factors such as the number of board meetings and the behavior of individual board members surrounding such meetings (RP Srivastava et.al 2015). In addition to these mentioned above, the factor, number of board meetings, is easy to observe for measurement. Conger et.al. (1998) suggested that more frequent board meetings is positively associated with board effectiveness. Abbott et al. (2003) found that audit committees comprised completely of independent directors who meet at least four times annually are related to reduced likelihood of financial misstatement.
2.4 Hypothesis development
2.4.1 Research question
Based on the Simunic model (1980), Carcello and Li analyzed regression results and concluded that in the first year after the signature requirement implementation, audit fees are significantly higher in the post-signature period than in the pre-signature period (Carcello and Li 2013). As prior literature mainly focused on studying the impact of disclosure requirement, it solely proved a connection between the disclosure and audit fees instead of showing how the audit fees will be impacted. Therefore, based on the existed conclusion that audit fees will increase after identification disclosure, this paper aimed to examine how the disclosure requirement will make an influence on audit fees. Although such a behavior increased transparency of operating condition and is the expectation of stakeholders, investors also care about the benefit of this change as well as its cost. Considering investors’ concern, the following research question is put forward and believed of high interest to intended users:
How does the implementation of audit partner identification disclosure make an impact over the changes of audit fees?
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H1: The positive association between the implementation of audit partner disclosure
requirement and audit fees is more pronounced for larger companies.
As stated above, audit work will differ from companies due to company size. It can be simply understood that large firms have big amount of transactions and larger amount of assets, which contributes to more complicated financial statements in the end of the year compared with relatively small size entities. Regarding the misstatement level, auditors will work harder and execute more analytical procedures to issue an appropriate opinion in the audit report. Thus, with the same level of growing care caused by signature disclosure requirement, auditors have heavier workload among larger size companies, resulting in a pronounced increase impact on audit fees in bigger firms compared to relative small size firms.
H2: The association between the implementation of audit partner disclosure
requirement and audit fees is related to the quality of corporate governance in the company.
After the disclosure requirement, auditors get more pressure to issue an appropriate auditing opinion. Together with SOX 302 and 404, one quite crucial step in performing an audit is the testing of internal control system as well as the routine activities. The better the corporate governance in a company is, the better the risk management could be. And if a firm operates good risk management, it reduces the likelihood that auditors think the internal control inefficient. The materiality level could then be improved, which means larger room for detection risk and less analytical procedures--leading to decreased audit work. Also, high quality corporate governance system to some extent indicates a good internal audit system, which is absolutely taken into account by external auditors when determining the overall audit procedures. High frequency of meetings, independent level of various committees as well as the activities of offering corporate social reporting, are all regarded as characteristics that a successful corporate governance system should have. Therefore, it is predicted that higher quality corporate governance system results in a decrease in
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audit fees.
3. Research methodology
3.1 Sample selections
The research is set in the United Kingdom market background because the signature requirement began for the firms in the U.K and is mandatory implemented after 2009. As it is conducted as a time-series study, there are some possible other factors in determining the audit fees. In this paper, firm size as well as firm corporate governance quality is focused after the impact of signature requirement on audit fees. With mandatory switching, it increases the comparability within the same economic environment. The sample collection is presented in the table 1.
TABLE1
Sample selection in the U.K market
U.K firms listed on the London Stock Exchange 2,355
Delete:
Firms without audit fees data or lacks audit fees data in either 2009 or 2010
1,715
Firms do not exist both one year before and the first year with the
signature requirement 126
Firms without necessary financial data to compute variables 201
Final sample for audit fee analysis 313
The data is collected for the firms listed in the London Stock Exchange from the database Datastream. Because the signature requirement began after April 2009, the last year before the signature requirement could be either 2008 or 2009 depending on the firms’ fiscal year-end (Carcello and Li 2013). Thus, the data period is set from 2008 to 2010 with a total of 2,355 firms. With the most important dependent variable,
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firms without audit fees data for a total of 1,715 had been deleted. As for the regression analysis, firms without necessary data for computing the control variables and lacking of audit fee data in 2009 or 2010 as well as the firms that do not exist both on prior to the signature requirement and the first year with the signature requirement have been filtered. After the deletion of unqualified samples, it leaves 313 firms with a total of 626 observations for empirical analysis.
3.2 Regression models and variables definitions
According to the models used in Carcello and Li (2013), the dependent variable for audit fee analysis is set as the natural logarithm of total audit fees (LNAFEE). The regression models for testing hypothesis are represented as below:
H1: LNAFEEt = b0 +b1SIGNATURE +b2SIZEt +b3ROAt +b4LEVERAGEt +b5LOSSt + b6MBt+b7CFOt
+b8RECEIVABLEt+b9INVENTORYt+b10FOREIGNt+b11BUSYt+Industry Dummies
+b12SIGNATURE x SIZE
Following is the explanation of variables used in the two regression models. Because this paper examine the impacts of moderating effects of specific variables, the regression models are determined on the basement of model used in Carcello and Li (2013). There are only few changes to the model. Thus, the defined measurement of variables are as the same as Carcello and Li’s. LNAFEE is the natural logarithm of audit fees for year t. Signature is an indicator variable coded 1 if the fiscal year is the first year when the signature requirement is effective and 0 if the fiscal year is the last year before the signature requirement. Size represents the firm size measuring at natural log of total assets at the end of year t. Profitability is measured at ROA and LOSS respectively. ROA is earnings before extraordinary items divided by total assets at the end of year t. LOSS is 1 if net income in year t is negative and 0 otherwise. LEVERAGE is measured at total debt divided by total assets at the end of year t. MB represents the market to book value ratio calculated as market value divided by book value at the end of year t. CFO is measured at cash flow from operations computed as
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cash flow from operations divided by total assets at the end of year t. RECEIVABLE is the total accounts receivables divided by total assets at the end of year t. Similar to RECEIVABLE, INVENTORY is total inventories divided by total assets at the end of year t. FOREIGN equals 1 if the firm has foreign transactions in year t or 0 otherwise. BUSY equals 1 if the firm fiscal year-end in year t is between December and March or 0 otherwise. In the model, industry fixed effect is controlled based on two-digit industry code and adjust for firm and year clustering effect. The test variable is SIGNATURE x SIZE (Sigsize), which is expected to be positively associated with LNAFEE as it is supposed that the increase on audit fees after the implementation of signature requirement should be pronounced in large firms.
H2: LNAFEEt = b0 +b1SIGNATURE +b2SIZEt +b3ROAt +b4LEVERAGEt +b5LOSSt + b6MBt+b7CFOt
+b8RECEIVABLEt+b9INVENTORYt+b10FOREIGNt+b11BUSYt+Industry Dummies
+b12CG+b13SIGNATURExCG
For the second hypothesis, all the control variables are defined the same as in the regression model 1 except for the test variable SIGNATURE x CORPORATE GOVERNANCE (sigCG). As for corporate governance, five dependent variables are selected from ASSETS 4 database in Datastream to together measure the corporate governance quality within a firm. These are audit committee independence (ACI), Corporate Governance Committee (CGC), Compensation Committee Independence (CCI), Meetings (MEET), and Corporate Social Report Global Activities (CSR) respectively. Then the five components are calculated as dummy variables to make regression analysis. ACI and CCI equals1 if the assessed grade is between 75 and 100 or 0 other wise. CGC equals 1 if the firm has its own corporate governance or 0 otherwise. MEET equals 1 if the number of board meeting is greater than 8 within one year or 0 otherwise. CSR equals 1 if the firm produces its own corporate social reporting to public or 0 otherwise. Finally, these five dummy variables are added together to become a new variable, namely, CG. The variable CG is predicted to be significantly related to LNAFEE as corporate governance quality within a firm is
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taken into account during audit services, but whether it is positive or negative related cannot be predicted. The test variable sigCG is examined if the effect is pronounced with higher quality of corporate governance. If there is a relation between corporate governance and the association, then sigCG is expected to be related in the same way (if CG is positive related, sigCG is positive either and vice versa).
4. Empirical results
4.1Univariate results
The following table shows the descriptive results of the control variables for the examination of the hypothesis.
Table2
Univariate results
Mean Sd Min Max
SIGNATURE 0.692 - 0 1 SIZE 14.332 1.595 10.163 19.469 ROA 0.263 1.11 -0.040 0.498 LEVERAGE 0.240 1.335 0 1.414 LOSS 0.217 - 0 1 MB 1.366 1.395 1.093 1.676 CFO 0.118 .0.135 -0.251 0.277 RECEIVABLES 0.148 0.541 0.047 0.408 INVENTORIES 0.089 0.20 0.025 0.183 FOREIGN 0.444 - 0 1 BUSY 0.730 - 0 1 CG 3.632 2.96 1 5
From the table 2, it can be seen that around 70 percent of the sample companies has the fiscal year that is the first year when the signature requirement is effective. From
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the column of CG variable, a mean number of 3.632 as well as the standard deviation indicate that more than half of the sample firms have good corporate governance quality.
4.2 Regression results
The following table is the regression results of the hypothesis. Since the variables in the two regression models differ a little and main variables are the same, the results are combined into one table for comparison.
Table 3 DV=LNAFEE
H1 H2
Coefficient t-statistics Coefficient t-statistics
SIGNATURE 3.910 4.36*** 4.154 3.59*** SIZE 0.827 13.40*** 0.912 10.99*** ROA -0.001 -1.62* -0.270 -2.17** LEVERAGE 0.136 1.42* 0.421 1.06* LOSS 0.035 1.93* 0. 858 1.96* MB 0.005 2.46** 0.262 4.11*** CFO 0.172 0.29 0.103 0.44 RECEIVABLES 0.046 2.79*** 0.337 3.06*** INVENTORIES -0.004 -0.32 0.134 -0.10 FOREIGN 0.577 3.26*** 0.049 1.98** BUSY 0.046 4.14*** 0.604 2.38*** SIGSIZE 0.277 3.97*** CG -3.872 -3.49*** SIGCG -0.064 -1.97**
24 n Adj. R² F-value 616 616 0.82 0.87 38.07 16.77 t statistics in parentheses * p < 0.10, ** p < 0.05, *** p < 0.01 H1 results analysis
The first column in table 3 shows the regression results of H1, which examines whether the increase trend in audit fees affected by signature requirement is pronounced in larger firms. The coefficient 3.91 of SIGNATURE is positive (t=4.36, p<0.05), suggesting the same conclusion as Carcello and Li concluded that companies pay higher audit fees in post signature period in 2013 . The target variable that is to be tested in H1, SIGSIZE, is significant (t=3.97, p<0.001) and positive (coefficient=0.277), which suggests that the cross analysis of variables between signature and firm size is positive associated with audit fees. The result is consistent with the prediction made in H1: the positive association between the implementation of audit partner disclosure requirement and audit fees is more pronounced for larger companies.
For these sample entities, the bigger size it has, the higher audit fees they will pay. Comparing the pre signature and post signature period, the percentage of audit fees increase is bigger in companies with larger amounts of assets. For other control variables, firms with lower ROA ratio and higher leverage ratio pay higher audit fees. Also, the result indicates that when a company reports a loss year, when a firm has a high market to book ratio and higher receivables; the amount of yearly audit fees will be charged more. Positive coefficient and significant t of both FOREIGN and BUSY indicates that firms has foreign transactions and fiscal year end between December and April, which is usually the busy period in auditing, pay higher audit fees.
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hypothesis and prior study results. When a firm has large size assets, like the outstanding total assets, it usually could be expected to have more complex business activities, organization structure, and tremendous transactions. These require more accurate evaluation of the time and workload in the assessment level in an audit engagement. And usually, auditors will perform more analytical procedures to obtain sufficient evidence in this kind of firms, which implies huge amount of audit fees. For the financial ratios, these will cause auditors skepticism during the audit work. Lower ROA implies the net asset gained compared to total assets is relatively low. High leverage ratio means that, in the company structure, debt part outweighs equity part. It is the same implication for the firm with a loss year, higher market to book value ratio, higher receivables. These conditions all imply that the firm may not have a good operation cycle or a promised foreground. It will certainly cause the auditors skepticism to investigate deeper whether the firm have problems or difficulties in the future. Especially after the SOX 404, auditors pay more attention to the going concern issues. The above discussed situations all have potential possibilities of not operating well in the future. Auditors will expense more time to perform analytical procedures and calculations to obtain sufficient and appropriate evidence in order to issue an appropriate opinion.
In summary, after the signature disclosure requirement, clients pay significantly higher audit fees, however, this impact is more pronounced in larger firms. It could be explained that larger firms have a larger group audience of report users. Public pay more attention to larger firms compared to small size firms. When an auditor recognizes the signature will be linked to his reputation and also probably the career prospect, audit work will be taken more seriously. It is like a demand and supply relationship. Larger firms have bigger amount of financial report users and, vice versa, in case of some failure events, large firms will have more issues to deal with, either the law regulation perspective or the ethical concerns. Therefore, audit fees increase after the signature disclosure requirement, this effect is more pronounced in larger firms due to the pressure put on auditors.
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H2 results analysis
The regression result of H2 is presented in the second column of table 3. The coefficient 4.154 of SIGNATURE with a t 3.59, p<0.001 still suggests that entities pay higher audit fees in post signature period comparing with pre signature period, which is consistent with the findings in Carcello and Li (2013). However, different with the control variables in the paper of Carcello and Li, a new control variable, namely, SigCG is added to the regression model to examine a new relationship. As stated before, SIGCG represents a cross analysis, intermediate term between corporate governance (CG) and signature to test if the corporate governance quality within a firm would be related with audit fees change after the impact caused by signature disclosure requirement.
CG is a new defined dummy variable which is composed of five independent variables, audit committee independence, corporate governance committee, compensation committee independence, meetings, and corporate social report global activities respectively. Apart from CG, other variables have the similar implications as the H1 results in the table 3. Firms that have larger size, lower ROA ratio and higher leverage ratio as well as the market to book value ratio, reporting a loss year, higher receivables and have considerable foreign transactions pay more audit fees in the post signature requirement period. These ratios are analyzed the same as in the H1 results analysis part.
As for variable CG, the results (t=-3.49, p<0.001, coefficient equals -3.872) shows firms corporate governance quality is significantly negatively related to audit fees, that is, firms with higher corporate governance quality pay lower audit fees after the signature requirement. This could attribute to good internal control mechanism that is taken into account by external auditors in the assessment level. When the corporate governance quality of a company is good, the responsible external auditors will receive the information that the internal system could be strong. Those factors, such as high frequency of board meetings, establishment of board committee and audit
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committee, and engagement in corporate social report activities, imply low possibilities of fraud and error which usually could result in material misstatements. Then the internal risk will be assessed lower. According to the audit risk equation, audit risk includes inherent risk (IR), control risk (CR) and acceptable detection risk (DR). When the assessed audit risk level is certain, DR is opposite to IR x CR. IR is the inherent risk and usually remain unchanged during the planning stage. Higher corporate governance quality means decreased control risk within a company. As a result, acceptable detection risk is increased, indicating the decreased amount of analytical procedures to obtain evidence. Therefore, firms with higher corporate governance quality pay less audit fees due to decreased audit workload.
The test result reveals SIGCG (t=-1.97, p<0.05) is significant negatively (coefficient=-0.064) associated with LNAFEE. From the variable CG result that firms with higher corporate governance quality pay less audit fees, the cross analysis between SIGNATURE and CG indicates that this effect is pronounced in higher corporate governance quality entities. But compared the results of the cross analysis between H1 and H2, t=1.97 of SigCG is quite smaller than t=3.97 of Sigsize. This comparison indicates that the pronounced effect with corporate governance of H2 is not as consuming as the pronounced effect with firm size in H1. It could be explained by the control risk. Despite that higher corporate governance quality is linked to lower control risk, the internal control system within a company is never be ideal and the control risk could not be reduce to a very low acceptable level. Also, auditors are required to keep skepticism during the whole audit work process; risks have to be assessed above a certain minimum level. In a word, comparing with firm size, because of the lower limit of control risk, corporate governance quality has upper limitation. After the signature disclosure requirement, auditors may perform higher audit quality work due to the potential effect on their reputation and career prospect. At this time, firms with high corporate governance quality shows benefits in that they afford less audit fees compared to other firms in the period when audit fees generally increased among the listed companies. The higher corporate governance quality the firm has,
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the less audit fees they will pay. This effect is also pronounced in higher corporate governance quality companies.
Overall, the regression results in table 3 are consistent with the prediction in H2: the association between the implementation of audit partner disclosure requirement and audit fees is related to the quality of corporate governance in the company. The results suggest that companies pay higher audit fees after the signature requirement and firms with higher corporate governance quality pay less audit fee expenses compared to firms with lower corporate governance quality. And this effect is pronounced in firms with higher corporate governance quality.
5. Summary, implications and limitations
5.1 Summary and conclusions
This paper examines the impact of partner signature disclosure requirement on audit fees from different aspects; whether the increased impact on audit fees caused by signature requirement is pronounced in larger firm and whether the association between audit fees and signature requirement is related to corporate governance quality. For appropriate comparisons, samples are located in the United Kingdom because it is required a mandatory switching to the signature disclosure requirement. All the samples are selected form the U.K. listed exchange market and all data are collected from database Datastream.
From the prior studies, it has been known that audit fees increased after the implementation of signature requirement. Based on that, this paper tests whether the relationship between increased audit fees and signature disclosure requirement is pronounced in larger firms. The regression result in table 3 is consistent with H1: the positive association between the implementation of audit partner disclosure requirement and audit fees is more pronounced for larger companies. Within the same time period, audit fees increased among companies, however, larger firms pay audit
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fees at a relatively high increased percentage level. Large scale entities attract more public sights in the financial condition and audit reports. With the signature disclosure requirement, auditors might decrease audit risk as well as the detection risk to obtain sufficient and appropriate evidence to issue an unqualified opinion. Comparing to the past, it requires more audit work, like increased analytical procedures, and contribute to higher audit fees.
In addition to examining if the increase trend in audit fees affected by signature requirement is pronounced in larger companies, this paper also examines a new relationship: whether the association between audit fees and signature requirement is related to corporate governance quality within the firm. New variable, corporate governance (CG) is added to build a new regression model to test the second hypothesis. Regression result in table 3 is consistent with the prediction of H2: the association between the implementation of audit partner disclosure requirement and audit fees is related to the quality of corporate governance in the company. CG and SIGCG is both significant negatively related with audit fees. It means that firms with higher corporate governance quality pay less audit fees compared to firms with lower corporate governance quality after the implementation of signature disclosure requirement. And in consistent with H1, this effect is also pronounced in firms with higher corporate governance quality.
This paper has limited contributions. It extends the previous study results by providing more evidence about how the identification of engagement partner related to audit fees. The two SIGNATURE variables in table 3 showed audit fees increased after the implementation of signature disclosure requirement, which provide robust check on prior study results. And many of the past studies focused on the impact on audit quality affected by the signature requirement, this paper offer different perspective of audit fees to potential interested users. Finally, as the proposal was issued in 2013, there is not much prior literature regarding the impact on auditing after the signature disclosure requirement. The results in this paper, to some extent,
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may fill the blank in this area.
In conclusion, the findings in this paper suggest that the engagement partner signature disclosure requirement in the U.K. makes audit fees increased in the post signature period. However, the increased percentage could be affected by many factors. In general, large firms do afford more audit fees than small firms. But due to the pronounced effect, the increase in audit fees is also higher than small scale firms after the proposal. Larger firms should be prepared to realize it since the yearly audit fees for some multinational companies could be significant big amount. Also, the intended report users, such as investors, stakeholders, public, should also have the recognition that the improvement of audit quality after the signature requirement is accompanied by the cost of an increase in audit fees and this effect is pronounced with larger firm size. Besides the findings in the first hypothesis, the results for the second hypothesis reveals that corporate governance quality is related to the association between audit fees and signature requirement. After the implementation, firms with higher corporate governance quality pay less audit fees, and this effect is also pronounced in firms with higher corporate governance quality. Although the corporate governance quality has an upper limit because the internal control mechanism as well as risk management within a company could never be ideal and perfect, it is still necessary for firms to have a corporate governance system that is regarded at least as effective and efficient.
Therefore, this paper suggests that, after the implementation of the signature disclosure requirement, firms of that corporate governance quality is assessed as weak or insufficient should pay more attention to this area since improved corporate governance quality leads to a decrease in audit fees and save the cost of capitals and therefore benefits the firm in the long run. As for firms that already have high corporate governance quality, they should keep the operation mechanism and improve it from necessary aspects to satisfy its own needs.
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5.2 Limitation and further analysis suggestions
There are also some limitations in this paper. Frist, it conducts a time-series study. Therefore, the results of the hypothesis could be caused by other undetermined factors which occurred during the same time when the signature disclosure requirement is implemented. This limitation is as the same as in paper Carcello and Li (2013) because it has not found ways to solve the unpredicted influencing factors, too. During the same period, there could also be other regulation changes and political effects, etc. This paper could not rule out these possibilities. However, considering the control variables, the findings in this paper still can be regarded as meaningful and robust evidence about the impact on audit fees.
Second, the sample size and the control groups are also limited. The samples used in this paper are selected from the U.K. market. After filtering the samples, it left only around 300 firms to be examined. It is not a big enough sample group as it is only located in one market. Further study could choose other counties that have implemented the same signature requirement to see if the impact caused by the proposal on audit fees is the same as in the U.K. market. But due to the differences among different countries, such as cultural discrepancies and political issues, the conclusion might attribute to various factors. In that case, criteria for filtering the samples should be deliberately determined to make sure that the impacts on audit fees are mainly affected by the engagement partner identity disclosure requirement. Also, market that has similar characteristics as the U.K. market and has not implemented the signature disclosure requirement could be selected for making control groups for comparisons.
Third, this paper adds a new variable corporate governance quality (CG) to the second hypothesis to examine if there is a relationship. Nonetheless, CG is not an independent variable; instead, it is composed of five different independent variables, audit committee independence (ACI), Corporate Governance Committee (CGC), Compensation Committee Independence (CCI), Meetings (MEET), and Corporate
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Social Report Global Activities (CSR) respectively. The reason to choose these variables is, on the one hand, they have important influences on corporate governance quality according to the prior literature; on the other hand, they are available in the Asset 4 database and convenient to gather data. Yet, the variable CG definition could not be seen as standard. Further analysis might add more variables to determine the corporate governance quality to see if there are more interesting findings. Apart from the new variable mentioned above, further research also could do more cross analysis about the signature and other attributes, such as accrual quality, earnings management and etc.
In summary, every time auditing change will make impact on different auditing characteristics, after which the empirical impacts and real practices need to be studied. The proposal of engagement partner signature disclosure requirement is relatively new and some impacts have been found, like the impact on audit fees, audit quality, earnings management, conservatism behavior, and accruals quality. This paper only makes little contributions and further studies should make more researches about this field in the future.
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