AMSTERDAM BUSINESS SCHOOL, FACULTY OF ECONOMICS AND BUSINESS, UNIVERSITY OF AMSTERDAM
HOW DOES CORPORATE
GOVERNANCE AFFECT AUDIT FEE
Empirical Evidence From Chinese Listed Companies
Yingying YAUN 10605576 MSc Control
Supervisor: dr. Qi Yang
Abstract
This paper studies the interaction between corporate governance and audit fee using empirical evidence from Chinese A-share listed companies. The results prove that audit fee, which is used to measure audit quality, is related to corporate governance. Financial factors such as return on equity and corporate governance factors such as number of board member influence audit fee significantly. On the other hand, some financial factors, such as debt ratio and equity ratio, and non-financial factors such as the separation of duties between board director and manager are not significantly related to audit fee. This paper provides evidence from Chinese stock market to test these relations because evidence from a different business environment can provide more aspects for scholars to make comparisons and for companies to make better decisions.
Table of Content
INTRODUCTION ... 3
1. Background ... 3
2. Motivations and Structure ... 5
LITERATURE REVIEW ... 5
1. Modern Corporates and Agency Theory ... 5
1) Why Corporate Governance Exists ... 5
2) Why Audit Firms Are Needed ... 6
3) Corporate Performance and Management ... 7
2. Audit Risks and Audit Fee ... 8
3. Audit Fee Driven Factors ... 8
DATA AND TEST MODEL ... 11
1.Data ... 11
2.Test Model... 12
3. Variables and Hypothesis ... 14
1) Variable Summary ... 14
2) Financial Variables ... 15
3) Corporate Governance Variables ... 15
4) Control Variable ... 16
RESULTS ... 17
1. Statistic Summary ... 17
3． Regression ... 0
CONCLUSION ... 0
1. Summary and Conclusions ... 0
2. Contribution and Limits ... 1
INTRODUCTION
1. Background
This study is about the relationship between corporate governance and audit fee. Some previous research reveals that corporate governance is the driven factor that affects audit fee because management has the intention to use a third party for detailed audit and independent supervision, which increase the time and labour od audit firm and as a result, increase the audit fees. Other research suggests that corporate governance works as an internal auditing and monitoring mechanism that improves the quality of company’s performance and financial disclosure. Namely, better corporate governance decreases the effort audit firm has to pay during auditing and as a result decreases the audit fee. To add more evidence on this subject, this study uses empirical evidence of Chinese listed companies to examine the relationship between corporate governance and audit fee.
After a series of financial frauds and scandals, public and stakeholders are paying more attention on how a company does its business, control the risks and supervise the operation. This creates the requirement of information disclosure for stakeholders because a company is the centre of all these information. However, there is information asymmetry between stakeholders and companies, stakeholders and public need an independent third party to justify the information provided by a company. Laws and regulations have been taken into action to assure the third party opinions are unbiased. Especially after the big financial frauds of Enron and Arthur Anderson, Sarbanes-Oxley Act (SOX), which was enacted by the Congress of U.S., was authorized to protect business environment, especially to keep public confidence. It requires all listed companies providing financial reports and statements to reveal their performance, and internal control report to prove that they have set up some mechanism to prevent potential frauds and risks. Besides, the most special requirement about SOX is that top management has to sign on these reports and statements as a suggestion that management is aware of the financial performance and internal control procedure, which means that management is now responsible not only for shareholders but also for stakeholders. Also according to SOX, a third party needs to audit the information provided by companies and give independent opinions about the quality of those information.
Among those objectives mentioned above, audit firm works as a third party, whose opinions would add credit on the information disclosed. Yet how can stakeholders and public believe that there is no manipulation during auditing, namely, the audit quality is guaranteed. So there has been attention on the quality of audit as an important research topic which could provide evidence and analysis for real companies and stakeholders to understand and make decisions. However audit quality is very difficult to verify because of its nature---uneasy to observe. This leads researchers to use other factors that are closely related to audit quality as indicators to show audit quality. The most widely used one is audit fee. Audit fee is the basic measurement for the market
value of audit service. In competitive market environment, the price paid for audit service---audit fee, should fairly indicate the real value of audit service and price is the most direct and obvious element that reflect audit quality. From this perspective, study the factors that affect audit fees would help us to know more about audit market, fairness of audit fee and audit quality. It would also help stakeholders to know more about the independence of audit firms and the information of companies for decision making.
According to laws and regulations, corporates need to disclosure audit fee paid to audit firm as an evidence for stakeholders to judge whether the relationship between corporate and audit firm is fair and whether the opinion audit firm provides is unbiased. In western countries such as U.S.A. and U.K., laws and regulation are well developed to ensure that proper supervision is given over a company externally and internally. However, in China, stock market is still in its early developing phase, relative regulations and perform principles are not as clear and effective as they are in western countries. It is until 2001 did China Securities Regulatory Commission enact the requirement that listed companies have to disclosure not only its own financial and governmental information but also have to public auditing details. Before this requirement, the audit market in China had several kinds of problems such as unfair competition and abnormal high (low) audit fees. Some IPO companies could offer financial bribe for change of qualified performance to go public, which leads to higher audit fees, meanwhile some audit firms try to offer lower-than-market audit price for more clients to compete in severe environment which leads to low audit fees.
There have been numerous papers focused on audit fee. But audit fee is still a topic worth discussing because as circumstances changes by time, audit fee changes are driven by different factors. Or factors that used to have significant influence are no longer having that obvious influence anymore. These changes need to be captured and studied so management and investors could make decisions accordingly and stakeholders could have latest information concerning their interests. Among all the variables that influence audit fee, corporate governance is a special one because corporate governance could demand better auditing which increases the fee, also corporate governance could reduce audit fee by implementing better governance which could cut down the time and effort auditors need to spend. While there is continuous number of studies on the interaction between corporate governance and audit fee in U.S.A., the most studies are financial elements such as the debt ratio and profit gaining ability.
One of the most important characters of modern corporate is that ownership and management are separate. But this separation also results in agency problem, and corporate governance is supposed to solve this problem. More theory and analysis on agency theory and corporate governance will be elaborated in the following section. Effective corporate governance should be able to limit management’s rights, monitor the company’s function, add credits on financial reports, and reduce auditors’ risks. As briefly introduced above, this research mainly examines the relationship how corporate governance affects audit fee. We have the research question as:
How does corporate governance affect audit fee---empirical evidence form Chinese listed companies.
2. Motivations and Structure
Chinese stock market is developing in an outstanding rate. As more laws and regulations are issued, corporates, audit firms and even the whole market are changing accordingly. Corporate governance has changed in order to be coincidence with the environment. Yet similar research on corporate governance and audit fee with latest empirical evidence is rare. This research intended to check the relationship between corporate governance to verify whether the relationship is still the same and whether specific elements that affect audit fee still contribute the same percentages as they did before in audit fee.
The following paper is structured in four parts: the first part is literature review which gives more information about the theoretical basis for this paper---first state the reasons why we need corporate governance and auditors using agency theory, then we stated previous research concerning the interaction of these two to give readers a general picture. The second is data sampling and model building, which shows the resource for data and principles how data was selected, and reveals how this research calculates data sample. Besides, hypotheses are also explained in this section; the third section is test results with analysis; the last section is the conclusion of the paper with contributions and limits stated.
LITERATURE REVIEW
1. Modern Corporates and Agency Theory
In this section, first agency theory is used to explain why corporate governance and audit firm exist. This part also elaborates how corporate governance affects corporate performance positively. After this, we explain the basis for auditors to settle the audit price, namely audit risks. Second, there are studies stated related to this topic to show a general picture of recent research results.
1) Why Corporate Governance Exists
Agency theory is concerned with resolving problems that exist in agency relationships which is, between principals (such as shareholders) and agents of the principals (for example, company executives). Agency theory problem arises when the desires or goals of principal and agent are in conflict, and the principal is unable to verify (because it is difficult and/or expensive to do so) what the agent is actually doing. Jensen and Meckling thought that agency problem was caused by outsider (dispersed) ownership. There are two types of ownerships——insider ownership and
outsider ownership. Inside owners could have decision- making rights (if inside owners are also parts of the management) or corporate governance rights (if inside owners are also parts of board)to run the company, which directly influence firm’s performance.
Agency problem happens when agency performs the controlling tasks of a company, and also seeks to maximize its own utility and self-interested, which possibly cause a conflict of different interest against the company as a whole. Jensen and Meckling (1976) presented a case to demonstrate the conflict between managers and owners. This “own utility and self-interested” can be described as private benefits. Because of private benefits, the inside owners want to avoid the over-monitoring by outside shareholders. Owners set up board and corporate governance system such as to control management from acting in their own interests while against the owners’. As we can see here, there are interest conflicts between management (part of which could also be internal owners) and corporate governance (board). Agency theory gives us a lot to think about how to balance the power of management and board. A stream of empirical research shows that agency problem is an important issue. Christie and Zimmerman (1994) suggest that managers with a low growth rate and high free cash flows are more likely to reach non-optimal activities by accounting manipulation and increase the risks (Gul and Tsui 2001). As a result, audit firms with high risks are more likely to charge high audit fee. Agency theory helps us to explain the association between audit fees and management behaviour.
In short, agency problem causes separation of duties and because of private interests, corporate governance is needed to limit management’s behaviour.
2) Why Audit Firms Are Needed
In a well-developed corporate structure, management, which supposed to represent the owners to maximize shareholders’ interests, has the rights to run the business but with limitation on power. On the other hand, owners themselves set up corporate governance (board included) to monitor and guide management to behave in the best interests of owners. Yet in this cycle there is still something missing---stakeholders and the public. Different from corporate governance that could obtain at least some of the real information, stakeholders are absolutely blocked from real information of a corporation. They have to rely on information published by corporation. So stakeholders desperately need an independent third party that can provide accurate and unbiased information to prove that management is making right decisions and is representing the welfare of stakeholders, and corporate governance is monitoring management properly. What is more, stakeholders are not the only ones who want an independent opinion, so does owners (corporate governance) since they could obtain part of the while information of the company such as financial performance, which is the most important thing for owners.
3) Corporate Performance and Management
Studies have shown that agency management has an interaction with corporate performance. Because of private benefits, the inside owners want to avoid the over-monitoring by outside shareholders and thus prefer a more dispersed ownership structure. They tend to not only maximize the firm value, but their utility over the private benefits. However, on the other side, inside owners also expect stock dividends, especially when percentage of equity ownership that agency owns increases, which indicates that inside owners’ interests are more increasingly associated with company’s interests. Inside owners need to find the balance between achievements of private benefits and corporate performance.
Firm performance is usually measured by Tobin’s Q, using agency theory and relative agency problem to elaborate the curve, which shows the interaction between percentage of equity ownership and firm performance, is clear and reasonable. In brief, inside owners holds company’s shares and also have the power of corporate governance and decision-making. Inside owners need to find a balance of private benefits and firm performance to maximize both self-utilities and shareholders’ interests. As more shares an inside owner, such as a manager, has the cost of getting private benefits is higher since this brings negative effects on firm’s performance under most circumstances. This concern urges inside owners to focus more on firm performance, which is shown as the rising part of Tobin’s Q.
As mentioned above, agency theory helps to support that the firm performance has positive relationship with the board of directors. However, when the ownership reaches certain level, another type of problem may occur due to the ownership concentration. Ownership concentration expresses that shareholders with large amount of stocks will have significant impact on the control of the firm. It can influence the performance of the firm either in a positive way or a negative way. If the incentive of those large shareholders is to maximize the firm value, then they will use their control rights to better monitor the firm, to reduce agency costs and to ensure the goals of the firm can be reached (Jensen and Meckling). This view is coinciding with the prediction above. In this case, the ownership concentration will enhance the existing firm performance. On the other hand, some other literature (La Porta et al., 2000 and Shleifer and Vishny(1997) )argued that large shareholders may have other goals, under this circumstances, another kind of problem will occur due to the conflict interests between large shareholders and small shareholders. Large shareholders will support decisions that benefit them most at the expense of those small shareholders. Morck el at (1998) supported this point of view and mentioned in their paper that the entrenchment effect will have the major impact on firms performance when managerial stock ownership beyond certain percentage. For example large shareholders will take advantage of their control right to persuade firm to make investments that benefits them most instead of the firm. The ability of persuasion is even strengthened when those large shareholders play important roles in the board. In addition, Thomsen and Pedersen (2003) stated that ownership concentration would affect the shareholders’ risk appetites. Those large shareholders often have less diversified portfolios, thus intend to focus on low-risk projects. Low risk means the possibility of loss is low but at the same time return is low as well, consequently, lead to a negative impact on firm’s performance, which is shown as the falling part of Tobin’s Q.
2. Audit Risks and Audit Fee
Audit fee is positively affected by audit risks. China Registered Accountants Auditing Standards (CRAAS) declares that audit risk is the possibility that audit firm issues inappropriate audit opinions because of big frauds. Auditors should apply audit procedure to evaluate the risk and perform auditing based on the evaluation in order to control the risks. Previewing risks is a crucial part of this procedure because it examines the probability that auditors fail to discover the frauds. Usually, listed companies that have more auditing risks will cost auditors more time and effort to reduce risks to a certain level directly or indirectly. As a self-earned organization, audit firm also need to cover its cost and that is why audit risks will lead to increasing audit fee. Besides, the higher the risk is, the more likely that audit firm will be facing lawsuits and other fees such as fines from governmental organizations. That is why audit firm needs to increase audit fee. It is clear to see that if audit risk is high, no matter it is driven by inside factors or outside environment, audit fee will increase.
3. Audit Fee Driven Factors
Francis (1984) found that company scale affected audit fee obviously. Before Francis, Taylor and Baker’s study showed that the same relationship existed. Francis, Taylor and Baker all used total capital audited companies to measure the scale of companies. Taffler and Ramalinggam (1982) used audited companies’ sales to measure scale of companies. Firth (1997) studied factors that affected audit fee using empirical evidence from New Zealand and found that total asset, receivables and outside risks were the most significant factors that influenced audit fee. They also tested profit, net asset and total asset and concluded that these factors were positively related to audit fee. Yet inventory, scale were not significant factors. Francis and Stokes (1986) tested data from small-scale Australia listed non-financial companies and found that “big 8” audit firms had more audit fee. But for large-scale non-financial companies, whether the audit firm is one of the “big 8” was not that an important factor on audit fee. Palmrose (1986) showed that if a client who purchased auditing service and non-auditing service at the same time, it would increase audit fees. Non-auditing service would provide extra information for auditing service and would cost auditors more effort. Firth thought that fixed cost, expected loss and profits were also factors that influence audit fee.
Low, Tan and Koh (1990) used evidence from Singapore and revealed that inventory, long term debt and currency ratio did not have much influence on audit fee. Abde-khailk (1990), Barkers and Simnett (1994) showed in their research that there was no obvious interaction between non-auditing service and audit fee. Chan et al. (1993) did a study in UK market and concluded that “big 6” audit firms did charge more than non-big 6 audit firms. This would provide some contribution on the argument that characters of audit firm affect audit fee. Generally speaking, most of the studies are based on Simunic’s model or modified Simunic’s model. Most of the scholars’ empirical research found that the complicity of auditing affected audit fee;
audit fee was related to audit risks, and non-audit service and audit service are positively related.
The literature on relations between governance and company activities and events has grown considerably in recent years, but a smaller set of papers addresses the relation between corporate governance and auditing. Carcello et al. (2002), Abbott et al. (2003), Fan and Wong (2005), and Goodwin-Stewart and Kent (2006) found that there was a positive relation between governance and auditing, because the demand for stronger corporate governance induced a company to apply more and better quality resources to auditing and control. Cohen and Hanno (2000) found that superior governance reduced substantive testing which reduced audit fee. Bedard and Johnstone (2004) relied on partners’ assessments of risk in planning and pricing decisions and found that planned audit fees varied positively with earnings management risk and identified the risks require more effort from auditors. Existing papers show that three main parts are concerned with corporate governance: stock structure, board independence and board performance. For stock structure, it can be measured by how concentrate the stocks are and the nature of shareholders; Board independence is usually measured by the number of independent board numbers and separation of duties; Board performance is showed by how well board participates in daily supervision and fulfil their duties.
1）Stock structure
According to Jensen and Meekling’s agency model, theoretically speaking, the more concentrated the stocks are, the less agency cost will be. Song studied the effect of top shareholders on agency costs and found that agency cost was negatively related to stock concentration. In Chinese stock market, too much concentration means some certain shareholders have too much power. If top shareholders have absolute right over corporate governance, it certainly has bad influence on other shareholders. Under this consideration, too much concentration will lead to severe agency conflicts and higher agency cost. We conclude that stock structure will affect how auditors evaluate risks and then affect audit pricing. Government owns a large amount of listed companies’ stocks due to the special economic environment in China. When government is the actual top shareholder, there would be complicated agency contracts and conflicts, as well as a weak control and execution inefficiency within the corporation. Therefore, agency cost, auditing risks and costs will be higher. There have been increasing private listed companies in Chinese stock market recently. Agency theory suggests that thinks the private-owned companies will decrease cost obviously because of following reasons:
1. The property ownership of private company is clear. This kind of ownership can deal with some certain problems more easily.
2. The superposition of property and management rights can reduce the cost of supervision.
3. Long-time stock exchanges between members of private companies are beneficial to both monitor and corporate restrain.
2) Board Independence
As the most important internal supervision system, board exercises right to supervise management and daily operation. So it can prevent people from owning too
much power by controlling problems, reduce the agency cost and control risks. Whether the board can exercise the right or not, it is more important to ensure the independence between the ownership and management rights, namely separation of duties (board director and general manager). If the percentage of independent board member is larger, namely with a more independent the board, corporates can set up a better internal control system to resist risks, and to keep neutral during decision making process without manipulation due to economic benefits. From this perspective, an independent corporation should have lower demand for audit service after the board uses corporate governance to control risks, which reduces time and effort required during auditing procedure. However, the more independent the board is, the more possible that the board transfers risks to audit firms by requiring more complete and in-depth auditing to protect shareholders and reputation. From this perspective, audit fee could increase because the requirement of complete and in-depth auditing increases auditing workload. In China, board has the right to choose audit service and double check auditing scope and fee. As a result, independent board has more power over these issues and have the choice to require more audit service for the company to develop in the long term instead of focusing on short period fiscal figures.
Another sign for board independence is the separation of duties. Suppose board director and manager are the same person, manager will have negative influence on board and board will apply loose control on management. If the board has one person serve two positions, the agency cost and risks of frauds are higher which leads to higher audit fee. This is because of private benefits. As we mentioned earlier, the board is supposed to control and monitor management to ensure that management acts in the best interests of owners and stakeholders. However, if management is also in charge of board, the monitor and control functions would be easily weaken by manipulations.
3）Board Performance
Carcello et al. (2002) thought that the better performance of the board, the more effective monitor over financial reports and daily operations. The diligence of Board is connected with the daily action of board. Academic community has two opinions: one is that the board that always has meetings performs better. The other is that higher frequency of board activities reflects the bad business management of the company. And that is why board needs meetings frequently. According to the corporate governance principle, executives should carry out their duties on the basis of benefits of companies and all stockholders. The diligent board has the better quality of financial reports. Strong control environment helps to minimize the range of control risks and auditing steps (reduce the cost of auditing). But how exactly board performance, such as how involved the board members are and how many useful suggestions they come up with, is difficult to measure. For this reason, this paper uses only board meeting numbers as a variable because board meeting times is the only element can be shown in numbers and available in the database.
4）Top Management
Top management holds the stocks means that top management is also the shareholder. In this case, agency and owners have the same benefits: to reduce agency conflicts and agency costs. Jensen thought that managers who had large amount of stocks could reduce the agency cost to a low level. This is because when top
management at the same time is also shareholders, management has the same interests as owners and would act more in shareholders’ interests, which reduce agency cost and by focusing on long-term performance, fulfilling management duties, providing real information. These actions are all going to reduce auditors’ workload and audit risks. Morcx, Shleirer and vishny (1988) showed that when top management holds 0-5% or more than 25% of the total shares, management acts in the best interests of owners, this phase is called Convergence of Interest Effect. When management holds 5%-25% percentage of share, top management has up-going power on corporate and external powers such as controls and monitor become less effective. In China, top management usually owns less than 5% share. Based on Convergence of Interest Effect, this should improve board’s work efficiency, and reduce auditors’ risks. As a result auditing pricing is lower.
DATA AND TEST MODEL
1.Data
This research uses Simunic’s model as test model. Data of factors that affect audit fee was obtained from CSMAR database. So was audit fee. The reason why this paper uses data from CSMAR is because CSMAR database is the largest database containing all information of Chinese listed companies. Information includes financial reports and statements, management information, corporate governance, internal control and other related information. All the independent variables, financial and non-financial variables are all available in this database. There are several steps concerning data selection. First, after logged in, I collected data form corporate research column and downloaded every independent variables needed for the model, merged all data into one Excel sheet. To be specific, I chose data of A-listed companies of year 2013. Above all is the procedure of original data collection. Second, eliminate several kinds of data using Excel filter function:
1). Reject data that contains other fees besides audit fee; 2). Reject data that has no fees listed;
3). Reject data that from IPO because of possible earnings management because IPO companies have a great chance to modify their financial and non-financial figures to reach the requirements in order to go public. So information from IPO companies may not be accurate;
4). Reject data that comes from S-share, B-share, H-share and ST-share because of there stocks are applied to special laws and regulations and could affect the test results. 5). Reject data that has audit fee yet without disclosure of variables or misses some variables;
Third use Excel VLOOKUP function to match all the independent factors using stock number, which is the unique sign for all A-share listed companies without duplicates. Then we calculated the percentage of government-owned stock and log value of audit fee. After these steps, 458 effective sample data is selected and we used Stata to analyse the data.
2.Test Model
According to Simunic’s model, audit fee E(c) = c*q+E (d)*E (e).
c: the resources spent per unit auditing, including opportunity cost and audit firm’s profit;
q: workload for auditors;
E (d): predicted loss due to auditing reports;
E (e): the possibility that predicted loss would actually happen;
We can tell from the above equation that the main parts of audit fee are c*q and E (d)*E (e). For each unit of resource needed within a certain time period, the cost---c, maintains the same, which means that we can see “c” as constant. And the resource totally spent is obviously determined by the workload---q. So c*q is positively related to q and E (d)*E (e) is negatively related to q. What is more, E (e) could also be reflected as the risks that occur after auditors issue their opinions after test, analyse and evaluate. The risks are the possibility that auditors fail to identify frauds, or being cheated by audited companies. As a result, audit firms have to pay for lawsuits or fines. Lawsuits and fines are mainly infected by laws, supervision departments and characters of clients so E (e) is not related to workload “q”. E(d) on the other hand is negatively related to workload because the more used resources means the workload increases and the more it is likely to identify mistakes and flaws, which helps auditors to provide proper auditing opinions.
We assume a general relationship of how corporate governance (q) affects auditing
(a) by using the Paul Griffin Model (Paul Griffin, al. 2008).
In this figure, u represents the quantities of internal control and auditing resources used by a company with relative costs (C1, G1), or (C2, G2), or (C3, G3), each
represent levels of equal governance for various combinations of a and q. The profit-maximizing amounts of auditing are at q1, q2, q3, the cost/governance combinations
This model is also a reflection of what was explained in the introduction Section. Not only corporate governance affect auditing but auditing also affects corporate governance. This means there is some point that is the max efficiency point. However, there is limited research, especially empirical evidence using recent data to test if the relation still exists.
This research uses Simunic’s model as general guide and adjust several variables accordingly. In 1977, Simunic used empirical evidence of 397 U.S.A. listed companies and found that debt to asset, industry type, audit opinions, and internal control affected audit fee significantly. Among all these variables, asset is the most significant factor. As suggested in Simunic’s models, we adopt the similar relationship between audit fee and other independent variables:
LogFee=α+β1 roa+ β2 roe+ β3 da+ β4 er+ β5 dpas+ β6 dpal+ β7 govshare+ β8 seperights
+β9 bdmeetn + β10 nboard+ β11 indboard+ β12 manashare+ β13 audittyp+ε
3. Variables and Hypothesis
1) Variable Summary
Table 1. Variables Summary
Title Name Explain Predicted
Sign Dependent
Variable
logfee Log value of audit fee
Control Variable
audittyp audit opinion standard=1 non-standard=0
Independent Variables
roa return on asset net profit/asset - roe return on equity net profit/equity -
d/a debt to asset debt/asset +
er equity ratio equity/asset -
dpas debt payment ability in short term
asset/debt in short-time
-
dpal debt payment ability in long term
asset/debt in long-time
-
govshare stock number owned by government
(percentage)
government-owned/ total shares -
bdmeetn board meeting number in absolute value -
seperights separation of rights same person=1 different person=0
- nboard board member number in absolute value -
indboard independent board number
in absolute value - manashare stock owned by top
management
2) Financial Variables
(1). Return on Asset (ROA), Return on Equity (ROE) and Equity Ratio (ER)
ROA, ROE and ER are measurements of the ability to earn profits and the gains for shareholders. These show the ability of a company to develop in the long term. Most of the time, this ability is shown or transferred as cash flow. With sufficient cash flow generated a company could pay its debts, invest and run its business. This would reduce audit risks and therefore decrease audit fee. By which we assume:
H1: ROA, ROE and ER affect audit fee negatively (2). Debt to Asset (D/A)
D/A is a reflection of the debt payment ability of listed companies. If D/A is large, the debt of a company is high which means that potential auditing risks are high. Besides, the possibility that the companies are going to bankrupt is higher. With worse ability to pay debt, management faces more financial pressure which could possibly leads to financial manipulation and fraud. This would add more auditing risks and increase audit fee to a higher level. By which we assume:
H2: D/A affects audit fee positively
(3). Short-term Debt Payment Ability (DPAS) and Long-term Debt Payment Ability (DPAL)
These two have the similar characters as variables mention in 2). However DPAS and DPAL may affect audit fee in different degrees. As listed companies are required to disclosure information annually, and usually investors are more able to identify short-term risks because investment environment changes in the long term require more information that short-time risks. If existing investors and potential investors evaluate that long-term risks are more difficult to identify, they would consider the company more risky to invest in the long run. This would also affect auditors’ evaluation for risks for the same reason. By which we assume:
H3: DPAS and DPAL affect audit fee positively, and DPAL affect audit fee more than DPAS does
3) Corporate Governance Variables
(4) Stock-holding Structure (govshare)
Stock structure is used to evaluate the stability of a corporate. We use total shares on the market and shares owned by government to calculate how much owned shares weight among total shares. There are special characters of government-own stock. Companies that have important role in the industry or supported by regulations could be protected by government to maintain their stock prices or receive fund (cash flow) to support these companies. This means investors and stakeholders’
risks are lower and so are auditing risks, then lead to lower audit fee. By which we assume:
H4: Stock-holding structure affect audit fee, especially government owned significant affect audit fee.
(5) Independence of Board (SepeRights and IndBoard)
In this study, we check whether board director and CEO is the same person as the variable of separate rights (SepeRights) because in modern corporate, CEO who represents the management and board director who represents the shareholders have different interests. Therefore board is the system which is used to solve this conflict by supervising. If the director and CEO are the same, it means supervise themselves. This will reduce the power of board and increase the fraud risks of financial reports. Auditor will carry out more auditing service to control the risk which will increase the auditing fee. Another variable is the number of independent board member (IndBoard). Within a board, more independent board members can assure the board is independent from management. By which we assume:
H5: independence affect audit fee negatively (independence reduce audit fee) (6). Management (manashare)
Top management owned stock means that top management is part of the owners. In this case top management has the same interests as shareholders---the profit for company and equity for shareholders. In Chinese listed companies, top management owned stocks number usually is less than 5% of the total number. Top management would focus more on long-term development rather than short-term financial indexes. So management would strengthen corporate governance and lower auditing risks, which result in lower audit fee. By which we assume:
H6: Top management own stocks will affect audit fee negatively (7) Board (BdMeetN)
We use board-meeting times to measure how well board applies its duty. As it is required by law, listed companies have to hold board meeting at least twice. The more the board meetings, the more financial information is prepared and checked. This procedure would improve better internal control and provide better information to reduce auditing risks and time. Besides, with a greater number of board members, the less likely manipulations and frauds would happen. By which we assume:
H7: Board meeting times affect audit fee negatively
4) Control Variable
We sign audit opinion type as “Audittyp”. There are two types of audit opinions: Standard audit opinion and Non-standard audit opinion (unqualified opinion with emphasis and unqualified opinion). If auditing, audit firm provides non-standard audit opinion, which means that audit risks is increasing, audit firm probably add more audit fee to cover the increased risks. In this research, we see Audittyp as a control
variable, and will not discuss specifically in the test results. However we do believe that audit opinion affect audit fee even thought we did not test this variable.
RESULTS
1. Statistic Summary
Statistic summary of data is as followed in Table 1.
As showed in the table, the average log value of audit fee is 5.8714. The lowest audit fee is 200000 RMB and the highest is 11600000 RMB, which is 58 times of the lowest audit fee. Average number of board number is 9, among which the least is 4 and the most is 18. Average independent board member number is 3, among which the min is 2 and the max is 6 companies’ top management holds share of their corporations among the total 458 sample data. This year mean number of board meeting is 9, the least is 2 and the most is 26, which is 13 times the least. Average ROA is 0.32, which is not an advantage for company. The max value of is 137.7 while the min value is only -1.75, which means that ROA differs in a great range. We did not expect ROA to be so different. Similarly, ROE varies from -2.83 (min) to 224.92 (max), which is also a wide range. The average debt to asset ratio is 0.61, which is not safe for companies because it means that 61% of asset has to cover the debt, which increase the risks. Average short-term debt payment ability is 1.88 while the average long-term debt payment ability is only 0.39. This means that generally speaking, companies have better short-term debt payment ability. However this is not desirable for a company’s long-term development. As mentioned early, investors/owners/shareholders are more likely to get information for short-term performance instead of long-term. So with a worse debt payment ability in long term could decrease investors’ interests and increases the future risks. Especially, debt payment ability in long-term is -16.76 min and only 0.96 max. Compared with short-term debt payment ability, long-short-term debt payment ability is a lot weaker.
Table 2. Correlations and Covariance
roa roe da er dpas dpal govshare seperights bdmeetn nboard indboard manashare
roa 1 roe 0.6298 1 da 0.2939 0.4966 1 er -0.2939 -0.4966 -1 1 dpas -0.0645 -0.0642 -0.1557 0.1557 1 dpal -0.2939 -0.4966 -1 1 0.1557 1 govshare -0.0115 -0.0161 0.0293 -0.0293 -0.0315 -0.0293 1 seperights -0.0915 -0.038 -0.0073 0.0073 0.0034 0.0073 0.0121 1 bdmeetn -0.0303 -0.0486 0.0401 -0.0401 -0.0941 -0.0401 -0.0751 0.0877 1 nboard -0.0458 -0.0262 -0.0375 0.0375 -0.0909 0.0375 0.0625 0.0822 0.0379 1 indboard -0.0194 -0.0252 -0.0091 0.0091 -0.1196 0.0091 0.0315 0.0239 0.0497 0.7823 1 manashare -0.0053 -0.0075 -0.0034 0.0034 -0.0096 0.0034 -0.0061 -0.1028 0.0728 0.0083 0.0395 1
3． Regression
In this regression we can see that we have an “F” of 7.70, which means that the test model we use is reasonable. R-squared is 0.16, which means that the test model could be used as a test model, but it is not very representative and need to be improved. ROA has a p value of 0.834, which means that ROA is not an obvious driven factor. ROE has a p value of 0.547, which means ROE dose not affect audit fee significantly either. So we get our first conclusion that H1 is rejected because ROA and ROE are not significant. Same as our prediction, short-term debt payment ability is a variable that affect audit fee but not in a significant way. The p value of “dpas” is 0.046. We do not have a p value of long-term debt payment ability because “dpal” is in line with log value of audit fee. And also debt to asset is not like what we predicted, as the results suggests, D/A is not as significant as short-term debt payment ability with a p value of 0.261. So we conclude that H2 and H3are rejected.
As the test results show that number of stocks owned by government has a p value of 0.615, which means “govshare” is not significant. However, board meeting times, how much top management owns shares, board number and the independence of board (“seperight”) are all significant variables. We reject H4 and H5, and accept H6 and H7. In summary, we conclude that financial factors that reflect future development (ROA, ROE, and DPAL) are not significant driven factors of audit fee. Financial factors that reflect debts and assets affect audit fee. Corporate governance factor---stock structure does not have an obvious relationship with audit fee. Other two governance factors--- board independence and board involvement are significant driven factors of audit fee.
Information of Test model:
Source ESS df MS
Model 5.54193439 11 0.503812217
Residual 29.0391052 444 0.06540339
Total 34.5810396 455 0.076002285
logfee Coefficient Standard Error T-statistic |P|>t [95% Conf. Interval]
audittyp 0.1048 0.0538 1.9500 0.0520 -0.0010 0.2106 roa -0.0005 0.0024 -0.2000 0.8430 -0.0052 0.0043 roe -0.0008 0.0013 -0.6000 0.5470 -0.0033 0.0018 da 0.0162 0.0144 1.1300 0.2610 -0.0121 0.0446 dpas -0.0098 0.0049 -2.0000 0.046* -0.0195 -0.0002 govshare 0.0087 0.0173 0.5000 0.6150 -0.0253 0.0427 seperights 0.0043 0.0306 0.1400 0.8880 -0.0557 0.0644 bdmeetn 0.0111 0.0032 3.5000 0.001*** 0.0049 0.0173 nboard 0.0283 0.0099 2.8600 0.004*** 0.0088 0.0478 indboard 0.0490 0.0274 1.7900 0.0740 -0.0048 0.1028 manashare 0.3536 0.3084 1.1500 0.2520 -0.2526 0.9597 _cons 5.2603 0.0896 58.7200 0.0000 5.0843 5.4364
Note: Variables "er" and "dpal" are in liner relationship with depedent variable and are not listed above
er 0 (omitted)
dpal 0 (omitted)
R-squared = 0.1603 Adj R-squared = 0.1395
Root MSE = 0.25574
Test Model: LogFee=α+β1 roa+ β2 roe+ β3 da+ β4 er+ β5 dpas+ β6 dpal+ β7 govshare+ β8 seperights +β9 bdmeetn + β10 nboard+ β11 indboard+ β12 manashare+ β13 audittyp+ε
Table 3. OLS Regression Results On Interaction Between Financial Factors, Non-financial Factors And Audit fee
Number of obs = 456 F( 11, 444) =7.70 Prob > F = 0.0000
CONCLUSION
1. Summary and Conclusions
How corporate governance relates and interacts with auditing procedure to influence the fee paid by companies has been an interesting topic for accounting research and practice. Knowledge of this interaction can help professionals and regulators understand better on corporate governance, including auditing, which has increased substantially since the passage of SOX. In order to examine whether the interaction still exists and to test the significance of all variables, we review a set of other scholars’ research. First we analyze why corporate governance using agency theory. Owners and managers have different interests and the separation of powers which leads to information asymmetry, this is why we need a third party and audit service. Then we elaborate studies about factors including financial and non-financial factors that affect audit fee to give readers a general understanding of audit fee driven factors. After that we give more information and analysis on corporate governance and relative studies about corporate governance and audit fee. There are general two opposite opinions about the interaction between corporate governance and audit fee. One thinks that corporate governance reduces audit fee, the other think that corporate governance increases audit fee. This is also the motivation of this paper--- to see exactly which is the relation between these two.
Before we test the data, we clarify the meaning of variables and hypothesis. In this research, the data is selected from Chinese A-share listed companies and uses State to process data and get the test results of each variable.
Our review of the research shows mixed results that can be used as evidence for future research. We extend the literature by stating and testing variables and using Simunic’s model. From the perspective of finance performance, we predicted that better would result in less audit fee. This is partly supported by out test results---ROE has significant influence on audit fee. From the perspective of corporate governance, we predicted that superior governance on the one hand would reduce audit fee because governance reduces the possible risks for auditors. On the other hand, corporate governance may demand more audit service to monitor management and reduce risks for the company. The extent of how much corporate governance affect audit fee should be the balance of these two effects.
We conclude corporate governance still has an influence on audit has an effect on audit fee. But some factors proved to be significant in other research are not significant in this paper. This can be explained by the special nature of Chinese stock market and audit pricing principles. In China, government has power to assist and guide stock market to develop in a healthy way. But this also results in the outcome that some regular market pattern and study results from other countries are not suitable for Chinese market. Besides, an important reason is that in China, audit fee is not determined by demand like in western countries, instead it is determined by regulations and negotiation between audit firm and companies. These definitely have a great influence on audit fee pricing. Yet it could also be a great research topic for later studies, especially those in China.
2. Contribution and Limits
This paper studies the interaction between corporate governance and audit fee. Even though the results are not the best, still they can provide evidence on this topic. Recently there has been increasing attention on corporate information disclosure. This is why stakeholders are paying attention on audit quality. However audit quality is not easy to measure. Most research used audit fee as the most significant measurement because fee is the most obvious reflection of the value of the service. As a result, scholars would like to pay attention on audit fee to see what determines audit pricing. Usually there are two general columns: financial driven factors and non-financial driven factors. In this paper, I used both some financial and non-financial factors as variables because it is not realistic in real business that audit fee is driven only by financial factors or non-financial factors.
However, there are some limits of this paper:
First, test model and variables could be outdated. I used Simunic’s model and modified the variables. But the model may not be unbiased and the variables I chose may not still be the real driven factors. Because as economic environment, regulations and laws change, factors that used to have influence on audit fee could be irrelevant now. Judging from the description of the model, it does not fit perfectly as a low R-square and P value. Test model needs to be improved.
Second, data are unique and could not prove the interaction is exactly the same in other countries because of special character of Chinese business environment. I chose data from Chinese A-share listed companies and use 456 data to conduct to study. As we already know that China has special business environment. Use data from Chinese listed companies may be risky because the results may differ from other research. Yet this could also be the special contribution of this paper because it provides evidence on listed companies from a different economic environment.
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