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Initial Audit Fees

Discounting and Audit

Quality: The Role of the

Audit Committee

MSc Thesis

! ! ! ! ! ! ! ! !

Name: Ahmad Tariq

Student Number: 10252401

Date of Submission: 23rd of June 2014

Thesis Supervisor: Prof. dr. V.R. O’Connell

MSc Accountancy and Control, variant Accountancy 2013-2014 Faculty of Economics and Business, University of Amsterdam!

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Abstract

On August 16th, 2011, The Public Company Accounting Oversight Board (PCOAB) issued a

concept report in order to solicit the public perception and comments on methods to further enhance auditor independence. Particularly, the PCOAB inquires whether auditor remunerations paid by the client create financial bonding and dependency. Consequently, the Board notes that higher audit failure rates in new audit engagements might be linked to unrealistic pricing. Therefore, the Board is concerned that a new auditor might be more susceptible to managerial pressure if, in order to attract new clients, initial year’s audit fees are set below initial year’s audit costs. This pricing practice, better known as ‘low-balling’, has been subject to several prior studies, examining the possible association between ‘low-balling’ and audit quality, arguing contradictory results. This paper tries to give a better understanding of the pricing practice of initial audit engagements, pre-global financial crisis and during the global financial crisis. Furthermore, this paper elaborates prior research by examining the relationship between low-balling and earnings management. Prior studies have found that audit committees have an influence on audit fees (Zaman et al., 2012) and on audit quality (Abbott et al., 2003). Additionally, this paper examines the possible intervening relationship of an effective audit committee on the relationship between low-balling and earnings management. My results indicate low-balling in a more severe extent in the global financial crisis era, compared to the pre-global financial crisis era. In contrast to PCOAB’s concerns, no significant impairing effect of low-balling on audit quality has been found. Furthermore, my results indicate that an audit committee in an effective form weakens the relationship between low-balling and audit quality, indicating greater monitoring of the external auditor and acting as a substitute of the external auditor.

Key words: initial audit fee discounting, auditor independence, audit quality, global

financial crisis, audit committee

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Acknowledgements

First and foremost, I would like to express my gratitude to God, Allah the Almighty, for being my strength and guide throughout this research. Without His countless blessings, I would not have had the wisdom, nor would I have the physical ability to complete the research successfully. Furthermore, I would like to express my sincere gratitude to His Holiness Hazrat Mirza Masroor Ahmad, head of the worldwide Ahmadiyya Muslim Jama’at, for his prayers and guidance.

I would like to express my sincere thanks to my thesis supervisor, Prof. Dr. Vincent O’Connell for his guidance, understanding and patience during the process of execution of my research. Besides my supervisor, I would also like to express my sincere appreciation to Dr. Jeroen van Raak, who has sacrificed much time in assisting and guiding me regarding data collection and methodology.

I would also like to thank my family and in particular my mother, for their support, encouragements, patience and faith in me throughout the last years.

Finally, but not less importantly, I would like to thank my dear friends who have always been available to support me. In particular, I would like to thank my good friends and fellow students, Frank de Vries and Wytse Dijkstra, for their moral support throughout this process, as well as the wonderful time we had writing our thesis in the university library.

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Table of Contents

1. Introduction ... 4

2. Previous Research and Hypotheses Development ... 7

2.1 Initial Audit Fees Discounting ... 7

2.1.2 Audit Quality ... 8

2.1.3 Low-Balling and Earnings Management ... 9

2.2 Low-balling and the Global Financial Crisis ... 11

2.3 Audit Committees ... 13

2.3.1 Audit Committees’ Influence on Audit Fees and Earnings Management ... 16

2.4 Research Delineation and Framework ... 18

3. Data Selection ... 19

4. Methodology ... 22

4.1 Initial Audit Fees Discounting ... 22

4.1.1 Self-Selection Bias (1) ... 23

4.1.2 Audit Fee Model (2) ... 23

4.1.3 Control Variables ... 24

4.2 Audit Quality ... 25

4.2.1 The Audit Quality Model ... 26

4.2.2 Total Accruals (3) ... 27

4.2.3 Expected Total Accruals (4) and Discretionary Accruals (5) ... 28

4.3 Audit committee effectiveness ... 28

4.3.1 Audit Committee Effectiveness Model (6) ... 30

4.3.3 Control Variables ... 30

5. Empirical results ... 32

5.1 Descriptive Statistics ... 32

5.2 Regression Results of the Audit Fee Levels (Hypothesis 1 and 2) ... 37

5.2.1 BIG4 vs. Non-BIG4 ... 40

5.4 The Association Between Low-Balling and DACC (Hypothesis 1 cont.) ... 40

5.6 Results Intervention Audit Committee Effectiveness (Hypothesis 3) ... 44

6. Conclusion and Discussion ... 47

References ... 50

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1. Introduction

Recent instances of auditors’ failures in detecting questionable accounting practices (Lustgarten, 2006), among the recent accounting scandals leading to companies’ bankruptcy, have increased researchers’ and regulator’s interest in auditor independence. On the 16th of August 2011 the Public Company Accounting Oversight Board (PCAOB) issued a concept report in order to solicit the public perception and comments on methods to further enhance auditor independence, objectivity and professional skepticism. Particularly, on page 17, the PCAOB inquires whether payments by the client to the auditor create financial bonding and dependency (PCAOB 2011, p.17), consequently, the Board is concerned that a new auditor may be susceptible to managerial pressure if, in order to attract new clients, initial years’ audit fees are set below initial years’ audit costs (Casterella et al., 2014). Regulators believe

that audit fee cutting on initial engagement impairs auditor independence, since audit firms are likely to recoup losses on the initial years’ audit on subsequent audits. To clarify, in a congressional hearing, a former chief accountant of the Securities and Exchange Commission noted “auditors propose a lower fee in the first year of an audit relationship in order to gain

the account, and this has a negative impact on the quality of the first-year audit.” Consistent

with regulators’ concern, the aforementioned audit fees pricing practice, hereinafter referred to as “low-balling”, has been subject to a number of studies to examine its possible influence on auditor independence (DeAngelo, 1981; Dye, 1991; Craswell and Francis, 1999; Lee and Gu, 1998; Lustgarten, 2006; Raghunandan et al., 2009), however, the research reports many contradictory results. Reputable prior researchers have found a negative relationship between impaired auditor independence and audit quality, subsequently leading to a more active managerial intervention in financial reporting, i.e. earnings management. This study elaborates prior research by examining the relationship between low-balling and earnings management as a proxy for audit quality, comparing the era prior to the global financial crisis with the financial crisis era. An additional analysis has been conducted by incorporating the potential moderating effect of the corporate governance structure, as proxied by the effectiveness of the audit committee mechanism.

There are two major conflicting theoretical arguments in existing academic literature regarding initial audit pricing. On the one hand, DeAngelo (1981) and Chan (1999) suggest that the practice of low-balling arises due to auditor start-up costs and client switching costs, giving the incumbent auditor a cost advantage over competitors, and allowing the incumbents to earn ‘quasi rents’ by setting audit fees above avoidable costs in subsequent audits. 4

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DeAngelo (1981) adds that the competition between auditors to gain excess over quasi-rents causes competitors, seeking for new clients, to low-ball on the initial audit fees, with the expectation to charge regular fees on subsequent audits. The results of DeAngelo’s (1981) analysis imply it is not the fee cutting that is the actual source of impaired auditor independence; rather, the source is the anticipated quasi rents.

On the other hand, Dye (1991) argues that a critical element of DeAngelo’s (1981) argument is based on the assumption that the incumbent auditor has more bargaining power than the client, meaning that the incumbents’ capacity to raise fees in subsequent years is a result of the incumbents’ market power. In contrast to DeAngelo (1981), Dye (1991) offers an alternative approach and assumption, namely; clients can use their bargaining power and insist the auditor keep the audit fees at the level of auditors’ avoidable costs. In this case there would be neither quasi-rents as argued by DeAngelo (1981), nor would there ever be fees discounting at initial engagement. Furthermore, Dye’s (1991) theoretical framework suggests that the clients could capture the entire cost saving, through using their bargaining power and thereby forcing the auditor to settle the fees and accepting zero quasi-rents. Thus, while according to DeAngelo (1981) it is the auditors’ bargaining power, according to Dye (1991), it is the clients’ bargaining power that is the main driver for the audit fees. Furthermore, Dye (1991) adds that when quasi-rents are not publically disclosed and therefore hidden from investors, a client in a strong bargaining position might still allow an auditor to charge audit fees above avoidable costs, in the hope of gaining a more favorable audit opinion. Hence, according to Dye’s (1991) theoretical framework low-balling only persists when audit fees are not publically disclosed.

Both above mentioned theoretical arguments have been tested extensively in recent academic research, however the results are unconvincing (Wahab and Zain, 2013; Lustgarten, 2006; Craswell & Francis (1999). A recent study conducted by Lustgarten (2006) finds evidence for lowballing in a setting in which audit fees are publically disclosed. Based on the arguments and findings mentioned above, this study primarily examines the relationship between low-balling and earnings management. In addition, this study expects the audit market to be in a state of irregularity in the period post-Lusgarten (2006), as caused by the global financial crisis, leading to a challenging environment for both companies and their auditors (Allen and Cerletti, 2008; Frank et al., 2008). I expect auditors to respond to this economic distress by either being more eager to gain excess over the quasi-rents, i.e. low-ball in a higher intensity, or by increasing their professional skepticism (Sercu, et al., 2006) and increasing their audit effort (Mautz and Sharaf, 1961; Bernard et al., 2008), i.e. low-ball in a 5

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lower intensity. Therefore, a second objective and the main contribution to existing literature, this study tries to give a better understanding of the effect of the global financial crisis on the pricing of initial audit engagement.

Several prior studies have examined the relationship between the existence of an audit committee and audit fees (Collier and Gregory, 1996; O’Sullivan, 1999). Rather than only focusing on the existence, a subset of more recent studies have examined the effectiveness of an audit committee and its association with audit fees and audit quality. There are two major theoretical arguments in audit committee, audit fees and audit quality literature. On the one hand, an effective audit committee is likely to seek an enhanced audit quality and as greater audit effort is necessary, this would consequently lead to higher audit fees (Zaman et al., 2011). On the other hand, if the existence of an effective audit committee enhances the quality and strength of the internal control mechanism, a reduction of audit fees would be expected (Felix et al., 2001). However, prior research has solely focused on the effect of an effective audit committee on audit fees and audit quality, separately. Since there in no debate in existing literature regarding the possible moderating influence of the audit committee on the practice of low-balling and earnings management, this study contributes by elaborating prior research, giving a better understanding of the role of an effective audit committee in mediating between initial audit fee pricing and earnings management.

First, this study addresses some of the econometric issues existing in accounting research. Despite the extensive amount of literature regarding auditor choice and auditor switching, most studies address auditor switches using a dummy variable to indicate the actual auditor choice. However, actual auditor choice is likely to be endogenously driven, as argued by Chaney et al. (2004). Therefore, this study adopts a model to correct for potential self-selection bias within auditor choice. Second, this study finds evidence of differences in initial audit pricing in the pre-financial crisis era and the financial crisis era. Third, this study finds evidence of an intervening relationship between initial audit fees discounting and audit quality, measured by managerial intervention. This finding is consistent with DeAngelo’s (1981) theoretical framework, arguing that regardless of audit fees’ disclosure, initial audit fees are being discounted. Furthermore, this finding might be interesting for regulators who are concerned about the adverse impact of reductions on initial audit fees. Fourth, my results suggest that the relationship between initial audit fees discounting and audit quality is weakened by an effective audit committee. This indicates that effective audit committees act as a substitute for the external auditor, hence leading to a decrease in audit fees. On the other hand, an effective audit committee grants greater client bargaining power and better 6

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monitoring of the external auditor and implements better internal audit control, hence leading to an increase in audit quality.

The remainder of this paper is structured as follows: First, section 2 provides a summary of the theory and evidence found in prior literature, as well as this study’s conjectures. Second, section 3 discusses this study’s data collection procedures. Third, section 4 will shed light on the empirical methodology used to test the hypotheses. Fourth, section 5 provides the empirical results of the analyses, and lastly, section 6 concludes.

2. Previous Research and Hypotheses Development

2.1 Initial Audit Fees Discounting

Low-balling occurs when an auditor prices the initial years audit fees lower for new clients with the expection of increasing the fees substantially in subsequent audit years, in order to recover for the losses in the initial audit year. Additionally, Lee and Gu (1998) argue that low-balling refers to the process of deep discounts at the initial engagement granted by the external auditor, while having the intention to enter a potential long-term client-auditor relationship. DeAngelo’s (1981) clarifies this based on her theoretical model, stating that low-balling occurs when the initial engagement fee is below production costs, being the total of start-up and regular audit costs. Moreover, she demonstrates that incumbent auditors have competitive advantage over auditors seeking to displace them. This cost advantage arises from start-up and client switching costs, which yield quasi-rents to incumbent auditors. The DeAngelo (1981) theoretical model characterizes prospective quasi-rents as the difference between future fees to be charged and costs of subsequent audits. In order to attract a client, and thus gain future quasi-rents excess, auditors seeking to displace the incumbent auditor must implement a cut in their initial audit fees such that the net present value of the audit is zero (Peel, 2013). Furthermore, Lustgarten (2006) argues that when switching auditor is costly (start-up costs) to both the client and the auditor, the incumbent auditor has a competitive advantage, and has the privilege and expectation that the loss suffered in the initial audit year will be recovered by raising the audit fees in subsequent audit years. Moreover, solely in a circumstance in which the auditor also expects the client to be retained, the auditor is willing to cut on initial year’s audit fees. Raghunandan et al. (2009) add that the auditor start-up costs may even been seen as an investment made by the auditor. Furthermore, previous research has shown that auditors are likely to increase the audit fees in subsequent audit engagement years. Hay et al. (2006) note that longer audit firm tenure is associated with 7

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higher fees. This is a concern, since it is consistent with low-balling, although further investigation will be useful. This finding is confirmed by prior research, as Simon and Francis (1988) found that there is a significant reduction in audit fees in the first two years of an audit engagement, with an increase of these fees to normal levels by the fourth year for continuing engagements.

According to Chan (1991), fee cutting on initial audits is driven as a competitive response by auditors. Auditors bid for the right to become the incumbent auditor, which gives them the advantage of receiving extra profits i.e. quasi rents on future audits, as a result of incumbency (Lustgarten, 2006). Therefore, the occurrence of low-balling is more likely in an audit market in which competition between audit firms is intense. Although there is widespread academic evidence of low-balling in the pre-financial crisis era (e.g., Lustgarten, 2006), regulators have not explicitly banned low-balling.

2.1.2 Audit Quality

Audit quality, according to DeAngelo (1981a), is defined as the joint probability that an auditor will both detect a breach, i.e. material misstatement in the financial statements, and the likelihood the breach will be reported by the auditor. Several prior studies have examined the possible determinants of audit quality. Audit quality is defined as the joint probability that an auditor will discover a breach within the financial statements and the auditors’ willingness to report the breach. According to DeAngelo (1981) the probability of an auditor discovering a breach depends on the auditors’ tec

hnological capabilities, the audit procedures employed on a given audit, the extent of sampling etc. The conditional probability that an auditor will report a possible breach is a measure of auditor independence from a specific client (DeAngelo, 1981; Watts and Zimmerman, 1981). This clearly demonstrates the interrelationship between, on the one side auditor independence, and on the other side, audit quality. Two major elements can be derived from DeAngelo’s (1981a) definition of audit quality, (1) auditors’ competence, and (2) auditor independence, whereas audit quality is a function of the aforementioned elements (Azizkhani et al, 2006). Auditors’ competence is an auditors’ ability to detect material misstatements in financial statements, which is determined by several factors. The most significant factor is the qualifications of auditor, which are an initial indicator of the auditors’ knowledge and capabilities in auditing. According to (Karim and Sunder, 2011) auditors’ knowledge can be classified into two elements, i.e. client-specific knowledge and a 8

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knowledge that is more general in scope. On the other hand, auditors independence, determines whether an auditor will report a material misstatement or not. Auditor independence is a vital issue in the market for auditing services (Lee & Gu, 1998), while many definitions exist in the literature. DeAngelo (1981) defines the level of auditor independence as the conditional probability that, given a breach has been discovered, the auditor will report the breach. Following this definition, the level of auditor independence is a major determinant of the societal perception of the right of existence for the auditing profession (Lee & Gu, 1998).

Following reputable prior literature, and consist with Krishnan’s (2003) arguments that these two characteristics of audit quality are unobservable, this study will proxy for audit quality using a measure of earnings management. The level of discretionary accruals as proxy for audit quality gives a robust measure to indirectly capture earnings management, since it provides an indication of management’s active intervention in reporting earnings (Dechow et

al., 1995).

2.1.3 Low-Balling and Earnings Management

The practice of low-balling has been subject of extensive academic research (DeAngelo, 1981; Dye, 1991; Lee and Gu, 1998; Lustgarten, 2006; Raghunandan et al., 2009). Regulators believe that fee cutting on initial engagements impairs auditor independence, as firms must recoup losses on initial audit from subsequent audit fees. This creates an interest on behalf of the auditor in the continued existence of the client relationship and an incentive to be more lenient in the audit and give a more favourable audit opinion. Moreover, the effect of the practice of initial audit fee discounting on auditor independence and audit quality could lead to an agency problem. According to Wahab and Zain (2013) the main factor affecting audit services is agency costs, since the appointment of an auditors’ purpose is to reduce the information asymmetry between stakeholders (principals) of the financial statements and the firms’ managers (agents). If the auditor fails to maintain the stakeholder’s trust, the auditing profession loses its legitimacy.

There are two major conflicting theoretical arguments in existing literature with regards to initial audit pricing behavior. On the one hand, DeAngelo (1981) and Chan (1999) found that the low-balling practice arises because of start-up costs for auditors and switching costs for clients. These factors give the incumbent auditor an advantage over auditors seeking new client relationships, and therefore allows the incumbent auditor to set higher audit fees 9

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for subsequent audits. DeAngelo (1981) furthermore states that the competition between auditors to gain excess over the quasi-rents, which are available on subsequent audits, cause client seeking auditors to lowball initial audit fees below their initial engagement costs. Thus, this is only the case when auditors expect to charge audit fees above costs on future audits. According to Watts and Zimmerman (1979) it is unlikely that auditors are completely independent from their client’s managers. The amount of independence is clearly less than perfect independence when the auditor is interested in future quasi-rents or future economic benefits specific to a given client relationship. Therefore, according to DeAngelo (1981), in order to maintain or to retrieve the perfect auditor independence it is mandatory for the auditor to not have an interest in client’s future financial performances. This clearly states that in DeAngelo’s (1981) theoretical model, it is not the fees cutting that is the actual source of impaired auditor independence; rather, the source is the anticipated quasi rents.

On the other hand, Dye (1991) argues that a critical element of DeAngelo’s (1981) argument is based on the assumption that the incumbent auditor has more bargaining power than the client. Therefore, it is the incumbent’s market power that allows auditors to raise fees above internal costs in subsequent audits. Dye (1991) however, offers an alternative approach and assumption, namely, the client has more bargaining power than the auditor and can use it to keep the fees at the specific level of the auditors’ fundamental audit costs. In contrast to DeAngelo (1981), who assumes that the auditor captures the entire cost saving on subsequent audits, Dye’s (1991) theoretical model suggests that the client could capture the entire cost saving by forcing the auditor to lower the audit fees to the level of the audit cost. Hence, it is the client’s bargaining power that forces the auditor to settle the fees, thereby accepting zero quasi-rents. Furthermore, Dye (1991) argues that it is more likely that the clients have stronger incentives to use their bargaining power, when quasi-rents earned by auditors impair investors’ confidence in clients’ financial statements. This is the case when investors already recognize that there are quasi-rents, which could give the impression about the auditors’ stake in a maintained client-auditor relationship. Consequently, the clients’ financial statements are likely to be perceived less reliable. Dye (1991) argues this scenario could only occur in a situation in which quasi-rents are publicly disclosed. Otherwise, the client is in the strongest bargaining position and might still allow the auditor to earn positive quasi-rents for a more favorable audit report (Lustgarten, 2006).

Prior to 2001, US firms were not mandated to publicly disclose audit fees they paid to auditors (Lustgarten, 2006). This makes prior research pre-2001 more limited, since it has been based on private surveys. Post-2001, Craswell and Francis’s (1999) study suggests that 10

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Dye’s (1991) theory can be tested by comparing audit price-setting practices in audit markets with- and without public disclosure. Their results are consistent with Dye’s (1991) theoretical arguments. As noted by Lustgarten (2006), regulators perceive discounting of initial audit fees impairs auditor independence and subsequently is likely to lead to a higher magnitude of earnings management. In contrast, DeAngelo (1981) argues that initial audit fees discounting does not impair auditors’ independence, since fee reductions are sunk in future periods. Following Dye’s (1991) framework, this research expects that low-balling will impair auditor independence, leading to a higher magnitude of earnings management. Hence, I hypothesize:

H1: There is a positive association between initial audit fees discounting and earnings management in the financial crisis era.

2.2 Low-balling and the Global Financial Crisis

Financial reporting quality and the quality of external audits has received increased attention, as a result of the global financial crisis (Bajaj and Creswell, 2008). The Investor Advisory Group (2011) of the PCAOB’s in its report states; “…serious questions have been

raised both about the quality of these financial institutions’ financial reporting practices and about the quality of audits that permitted those reporting practices to go unchecked”. Recent

literature has shown that audit clients were able to cut on their audit fees. McCann (2010) reports that audit fees fell in 2008 and 2009. Moreover, Whitehouse (2010) reports that 63% of the S&P 500 firms won price concessions for 2009 from their external auditor. Regulators have expressed their concern about lower audit fees, assuming that lower audit fees will lead to cutbacks of the audit effort and consequently delivering lower perceived audit quality.

On the one hand, the global financial crisis could cause audit firms to lowball to a more intense amount. Consistent with the theoretical framework designed by DeAngelo (1981), one could argue that in economic distress and illiquid markets, auditors are more willing to be lenient during audit pricing negotiations, since audit firms may be more eager to gain excess over the quasi-rents. Specifically when there is the assumption that economic conditions shall recover within the subsequent years and hence auditors will be able to recover the losses with audit fees at regular level in subsequent years.

On the other hand, the financial crisis caused a challenging environment for companies and their auditors, with declining economic conditions and illiquid markets (Allen and Cerletti, 2008; Frank et al., 2008). Obviously this has led to greater risk to which auditors are exposed. Auditors are expected to respond to increases in risk by increasing their 11

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professional skepticism (Sercu et al., 2006) and increasing their audit effort (Mautz and Sharaf, 1961; Bedanrd et al., 2008; Bell et al., 2008). Additionally, based on the theoretical framework of Xu et al. (2013), auditors have three strategies to manage risk, being (1) resigning from risky clients, (2) increasing the propensity to issue modified audit reports, and (3) increasing audit effort. As part of their risk mitigation approach, auditors will act more cautiously in response to increased business risk, which consequently can result in increased audit effort (Bell et al., 2008), consistent with the third strategy as argued by Xu et al. (2013). Prior literature supports this theory that auditor will put increased audit effort in a higher risk environment (Simunic, 1980; Choi et al., 2008). According to Krishnan and Zhang (2014) additional audit effort can be in the form of more conservative client risk assessment, a more extensive audit procedure score, increasing the amount of audit evidence perceived as appropriate to reduce the audit risk, obtaining more expert advice, a higher proportion of audit operations done by experienced personnel and a greater engagement involvement by the audit partner. Obviously this increased effort is associated with a higher amount of audit fees (DeAngelo, 1981). Consistent with Xu et al. (2013), I predict that in a period of global financial crisis, where there is greater regulatory assessment, greater exposed risk of audit failure, heightened potential for reputational damage and increased litigation risk, it is more difficult for auditors to obtain sufficient appropriate audit evidence to reduce these risks to an acceptable level. This hypothesis will focus on the third strategy as argued by Xu et al. (2013), and makes the assumption that increasing the audit effort as a response to the increased risk associated with the financial crisis, will lead to higher audit fees, as argues by several prior papers. Based on these finding, this study examines whether this is also applicable for initial audit fees. Moreover, consistent with the deep pockets theory, I assume that audit firms will increase the audit fees as a result of increased exposure to litigation risks. Based on this assumption, I thus hypothesize:

H2: The intensity of initial audit fee reduction is less severe in the financial crisis erathan in the pre-financial crisis era.

In order to make the comparison between the pre- and financial crisis era, this study compares the level of initial audit fees reductions granted in 2009, i.e. during the financial crisis, and 2005, i.e. pre-financial crisis. There are a couple of motivations why I choose the year 2005 as to reflect the pre-financial crisis era, mainly being that the audit market witnessed unprecedented changes during the period from 2002 to 2004 (Raghunandan et al.,

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2009). The auditing market was in a significant state of flux in this specific period, caused by some significant events. First, the Enron bankruptcy occurred in late 2001 and the immediate congressional hearing that started regarding the role of Arthur Anderson, Enron’s auditor. The allegations and the hearing against Arthur Anderson are likely to have had an impact on auditors’ actions, causing an unstable audit marke. Consequently, the enactment of SOX in 2002 has led to significant changes in the auditing profession. Similarly, the SOX 404 section became applicable, with requirement for audited internal control reporting. Auditors and others have noted that there was a learning curve associated with the application of this SOX addition. Based on the audit market irregularities described, I expect the audit market to be stable in 2005 as no significant events occurred during that year, and all effects of irregularities prior to this year are likely to be diminished.

2.3 Audit Committees

Audit committees are operating committees within the corporate governance system, with the primary task to undertake oversight of the financial reporting process (Zaman et al., 2011). In general, audit committees have responsibilities including (1) overseeing the choice of accounting policies and principles, (2) hiring external auditors and overseeing the audit process, and, lastly (3) monitoring the internal control process (Chan et al., 2013). Furthermore, Abbott et al. (2003) argue that audit committees play an important role in the audit scope negotiations process. Therefore, the audit committee has a significant involvement in accepting the external auditor. For example, audit committees usually discuss the audit scope and plan with the auditor to check the adequacy of audit coverage (Chan et

al., 2013). DeZoort (1997) surveyed audit committee members and documents that a primary

duty of audit committees is to review the external auditors’ work, suggesting that audit committees are actively involved in external audit tasks. Consequently, the audit committee has the final say on whether the company should engage in a new company-auditor relationship.

The role of the audit committee is important to stakeholders, as better quality financial reporting improves market performance (Wild, 1996). Over the last few years, the role of the audit committee has evolved and has progressively been redefined from a voluntary monitoring mechanism to a mandatory, as regulated by SOX 2002, integral governance mechanism to improve the quality of information flows to shareholders. According to Abbott and Parker (2000) the audit committee is currently a key component of the oversight function 13

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and the focus of increased public and regulatory interest. Additionally, Aldamen et al. (2012) add that an audit committee is the core monitoring mechanism for shareholder and other constituents, especially in the light of the many accounting scandals which have occurred, e.g. Enron, WorldCom, Paramalat etc. Furthermore, prior research has suggested that audit committees also promote and strengthen the existence of an internal audit function, subsequently leading to higher quality reporting (Turley and Zaman, 2004). Following the financial scandals mentioned before, regulators have stepped in by putting additional requirements for effective working audit committees. In order for an audit committee to be effective, based on the US audit committee regulation i.e. the Sarbanes Oxley-Act 2002, states that an audit committee should consist of at least one financial expert and all of the audit committee members should be independent non-executive directors.

Several prior studies have developed a measure to examine the extent to which an audit committee is a reasonable and reliable guardian of public interest, i.e. audit committees’ effectiveness. Aldamen et al.’s (2012) study identify the key attributes of an effectives audit committee as based on prior research, namely (1) an audit committees’ size and meeting

frequency, (2) an audit committees’ independence and (3) an audit committees’ financial expertise. Zaman et al. (2013) add that the effectiveness of an audit committee is not a

construct that can be easily modelled in empirical testing, arguing that the major constraints are the subjectivity of the term ‘effectiveness’, as well as the publicly available data. Nonetheless, drawing on prior research, Zaman et al. (2013) agree with Abbott et al. (2003) and Aldamen et al.’s (2012) theoretical framework, recognizing the same key dimension of audit committee effectiveness. Drawing of the recommendations on the SOX 2002 act, this study posits that for audit committees to be effective it should at least exhibit four characteristics. First, all members of an audit committee must be independent non-executive

directors. Second, at least one of the audit committee members must be a financial expert.

Third, an effective audit committee should meet at least quarterly. This is contradictory with the theoretical framework designed by Zaman et al. (2013), which states that a meeting frequency of three times a year is sufficient. As their research was based on UK data, focussing on different regulations, this study applies a minimum meetings frequency level of four meeting a year, consistent with the SOX 2002 regulation. Lastly, for an audit committee to function effectively, a minimum size of three members is required. Consistent with Zaman

et al. (2013), this study will adapt their study’s dimensions, since the constructs are premised

on their potential contribution to audit fees and audit quality. However, this research setting elaborates on their work examining the possible effect of an effective audit committee on the 14

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existing relationship between initial audit fees reduction and earnings management, rather than solely focusing on regular audit fees.

The first characteristic of an effective audit committee is its independence. Directors who are independent non-executive directors are expected to demand a higher quality of audit, and are expected to be more interested in reducing the likelihood of fraud and earnings management (Beasley, 1996; Hudaib and Cooke, 2005; Peasnell et al., (2005). Zaman et al. (2013) therefore suggest that when the audit committee consists of all independent non-executive directors, the committee will be able to exercise more power over management in demanding a greater scope of audit, leading to a better audit quality. However, as argued by Aldamen et al. (2012), independence of an audit committee may have a downside risk as well. Since the members are completely independent from management, this could mean that the audit committee members see less industry issues and are more likely to side with the auditor requiring fewer negotiations, consequently lowering the frequency of meetings. Consistent with Sharma et al.’s (2009) findings, this negatively impacts the level of monitoring.

The second characteristic is an audit committees’ financial expertise. As laid down in the SOX 2002 chapter regarding the requirements of an audit committee, for audit committees to be effective, their membership needs to include at least one member with relevant financial expertise. Even though the measurement of the definition of financials expertise is not explicitly mentioned, several publicly available databases include data in which a member is classified as either a financial expert or non-financial expert based on the annual reports of the company. Financially knowledgeable members are expected to perform their oversight roles in the financial reporting process more effectively (Zaman et al., 2012), such as detecting earnings management and detecting material misstatements (Raghunandan

et al., 2001). This expectation is confirmed by a more recent study conducted by Krishnan

and Visvanathan (2008), stating that accounting and financial expertize within the board that is characterized by strong governance contributes to greater monitoring by the audit committee and leads to enhanced accounting conservatism and consequently more reliable financial reporting. Moreover, an older study conducted by Krishnan (2005) provides evidence that audit committees with financial expertize have a reduced probability of being associated with the incidence of internal control problems. Additionally, DeZoort et al.’s (2002) research shows that audit committees members without financial expertise and experience may not be strong enough to protect audit quality and earnings management.

The third characteristic of an effective audit committees’ is diligence, i.e. the 15

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frequency of meetings held. In order for audit committees to be effective, they must be active

(Zaman et al., 2012). Prior research conducted by Raghunandan et al. (2001) adds that regular meetings between the audit committee and the external auditor make it more likely that the audit committee will remain informed and knowledgeable about relevant internal accounting and auditing issues. Furthermore, a relative older study by Menon and Williams (1994) posits that meeting frequency serves as a good indicator of audit committees’ diligence, and it has been negatively associated with the likelihood of fraud (Beasley et al., 2000). This implies that audit committees that meet frequently can proactively and positively influence audit coverage during the various stages of the audit (Abbott et al., 2003). On the other side, controversially, according to Vafeas (1999) larger audit committees could also lead to inefficient governance, thus yielding more frequent audit committee meetings. A recent study by Sharma et al. (2009) confirms this, finding evidence that audit committees with greater diligence are negatively related with audit committees’ independence. Moreover, in contrast to Abbott et al. (2003), they find a positive relationship between audit committee diligence and financial misreporting, financial expertize and audit committees’ independence.

The fourth characteristic of an active audit committee is its size. Research suggests that a larger audit committee is more likely to enhance its status and power within an organization, and demand higher audit quality (Kalbers and Fogarty, 1993). Moreover, Zaman et al. (2012) suggest that larger audit committees will be more likely to discover potential irregularities, since it has access to greater recourses, which helps the committee to improve the amount of oversight. Therefore, a larger audit committee is expected to be more effective in fulfilling its monitoring role, through enhanced status and increased resources. 2.3.1 Audit Committees’ Influence on Audit Fees and Earnings Management

Comparatively older studies have examined the association between the existence of an audit committee and audit fees (Collier and Gregory, 1996; O’Sullivan, 1999). More recent studies have investigated the association between the effectiveness, rather than just the existence, of an audit committee and audit fees, presenting contradictory results. Zaman et al. (2012) confirm this in their study stating that the effectiveness of an audit committee and their impact on audit fees is not well understood. They add, if an audit committee seeks to enhance audit quality, the impact could be an increase in audit fees, as greater audit effort is demanded. On the other hand, if the existence of an effective audit committee enhances the quality and strength of the internal control mechanism, a reduction of fees would be expected. 16

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Existing literature has indicated that the audit committee can potentially take three actions related to the external auditor, which might result in a higher level of audit assurance or scope (Abbott et al., 2003). First, audit committee members can attempt to persuade management to select a more knowledgeable auditor with greater reputation. Abbott and Parker (2001) find that companies that consist of all non-executive independent members and have greater diligence are more likely to select one of the bigger audit firms. As confirmed by literature, BIG4 auditors deliver higher quality audits, subsequently leading to higher audit fees (Lustgarten, 2006). Second, the audit committee can demand a greater quantity of audit effort from the incumbent auditor (Simunic and Stein, 1996). Increasing the scale of audit scope, according to DeZoort (1997) will enhance the audit quality and associated audit fees. The last mean by which an audit committee can impact the level of audit coverage is mitigating managements’ threat to replace the auditor (Knapp, 1987). Knapp (1987) adds that the determination of the audit planning often involves negotiations between auditors and managers. Managers could have incentives to cut costs and force the auditors to reduce the scope of the audit. An audit committee could potentially shield the auditor against the negotiation pressure to complete the audit in a smaller time frame, which is being carried out on the auditor. Consistently, Abbott et al. (2003) argue that an effective audit committee shifts the balance of power, from the management, in the auditors’ favour.

Carcello et al. (2002) find that audit fees are positively associated with measures of board effectiveness, i.e. independence, diligence and expertize. Based on a survey of 401 Australia companies, Goodwin and Kent (2006) found that higher audit fees are associated with the existence of an audit committee, more frequent audit committee meetings and the use of internal audits. Additionally, Felix et al. (2001) suggest that a strong internal audit function, as a result of an effective audit committee mechanism, serves as a substitute for the external audit. Assuming this, initial audit fees discounting should me more intense, i.e. lower initial audit fees, leading to more earnings management. On the other hand, Zaman et al.’s (2012) findings show a positive relationship between the effectiveness of an audit committee and demanded external audit effort, thus audit fees. Assuming this, as an effective audit committee will lead to higher audit fees, the amount of initial audit fees discounting should be less intense, i.e. a decreased tendency to reduce audit fees, leading to lower auditor independence and more chances for managers to intervene in financial reporting. However, prior research has found more evidence for the second assumption. Furthermore, prior literature has solely focussed on the effect of an effective audit committee on audit fees, and on audit quality, separately. To my knowledge, there is no debate in existing literature about a 17

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possible moderating effect of an effective audit committee on the practice of low-balling and earnings management. Hence, I hypothesize:

H3: An effective audit committee weakens the relationship between initial audit fees discounting and earnings management.

2.4 Research Delineation and Framework

1

1 Figure 1 presents an overview of this study’s structure. A more in-depth elaboration of the methodology,

i.e. the dashed lines, will be discussed in section 4.

Measured by Relationship H2: (-) Influence H3: (-) Audit Committee Effectiveness, measure by independence, size, expertise and diligence Measured by Measured by Discretionary Accrual Initial Audit Fees

Discounting Management Earnings

Audit Committee

H1: (+)

Difference estimated LAF and LAF for initial audit

engagements Pre-Global Financial Crisis era Global Financial Crisis era 18

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3. Data Selection

The following section discusses the data selection process, which is presented in Table 1. The Wharton Research Data Services is a service combining several reputable databases primarily used in accounting research, and hence is the most extensive publically available source of mainly US corporate data. Mainly, three databases have been availed of to collect data for the measurement of the used variables: initial audit fees discounting, audit quality and audit committee effectiveness, respectively AuditAnalytics, COMPUSTAT North America and RiskMetrics. However, variables required for the measurement of the effectiveness of the audit committee, i.e. hypothesis 3, were not entirely present. In order to complete all necessary data, the remaining required data has been collected manually, through company websites, i.e. the corporate governance chapter of annual reports.

Table 1 shows this study’s sample selection process. The panel set consists of 423 and 248 firms that changed auditor and meet this study’s applicable criteria, for the years 2005 and 2009, respectively. I begin with 1,660 and 2,030 firms that are have data available in the COMPUSTAT database and have audit fees data available in AuditAnalytics. Subsequently, I availed of the RiskMetrics database to conduct the additional analysis, leading to the elimination of 370 observations due to data unavailability.

Of the 1660 (2009) and 2030 (2005) initial firm-year observations, 47 and 223 were eliminated due to data unavailability, i.e. not every firm-year observation consisted of all necessary data to measure the variables, for 2005 and 2009, respectively. Furthermore, consistent with several prior studies, I exclude financial and trust firms, since prior research has shown that determinants of audit fees are unique for such institutions (Simunic, 1980; Firth and Lau, 2004). The aforementioned elimination consisted of 321 and 351 firm year observations related to firms with Standard Industrial Codes-codes between 6000 and 7000, for 2005 and 2009, respectively. Since I expect audit fee determinants for firms going public are unique, I exclude 41 and 30 firms involved in initial public offerings (IPO), for 2005 and 2009, respectively. This is consistent with the findings of Willenborg (1999), arguing the importance of an insurance-based demand for IPO audits, whereas even in the lower segment of the IPO-market, transaction size helps explain the association between auditor choice and under-pricing. Therefore transaction size is an important determinant of auditor compensation for start-up companies, i.e. IPO-firms. Consistent with Wahad and Zain (2013) I exclude 26 firms and 37 firms that switched auditors due to mergers between auditors and former Arthur Andersen clients, since motives for these firms for auditor switching differ, for 2005 and 2009,

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respectively. This is being clarified by McMeeking et al. (2007), providing evidence that auditees are likely to pay higher audit fees if their auditor merges with a larger counterpart. Moreover, I expect that there is a possibility that former Arthur Anderson clients have less intense fees cutting offers, as they were forced to find a new auditor, and therefore are likely to have less fee bargaining power (Lustgarten, 2006). Furthermore, I also eliminate 425 and 101 observations, for 2005 and 2009 respectively, for firms that record negative equity, since I expect auditor switches for these firms could be the result of overall costs cutting (Wahad and Zain, 2013). Prior research has shown that auditor resignations differ significantly from client dismissal of auditors (Krishnan and Krishnan, 1997; Shu, 2000). In addition, I expect firms switching auditor as result of auditor resignation will be more likely to accept an auditor with a higher initial audit engagement fee in order to retrieve public trust. This is consistent with legitimacy theory, which posits that businesses are bound by the social contract by which the firms agree to perform socially desired actions, in return for approval of business’ objective. Consequently, I eliminate 689 and 193 firms switching auditor due to auditor resignation, hence, this study only focuses on client dismissal of auditors, for 2005 and 2009, respectively. Lastly, consistent with Huang et al. (2009), in order to ensure that results are not driven by small denominator related issues, I eliminate 159 and 363 firms with less than $25,000 audit fees for the observed years, for 2005 and 2009, respectively.

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Panel A: Sample selection

Initial Continuing Initial Continuing Compustat observations with fee data in AuditAnalytics 2,030 14,278 1,660 16,835

Less: SIC > 6000 < 7000 321 1,296 351 1,452

Less: Not USA 64 243 122 90

Less: Audit Fees < $25,000 159 583 363 618

Less: Auditor Mergers 26 - 37

-Less: Negative Equity Firms 425 1,498 101 1,689

Less: IPO Firms 41 438 30 397

Less: Auditor Resigned 566 - 193

-Less: Unavailable data 47 4,921 240 7,984

381 5,210 223 4,605

Panel B1: Auditor distribution by # of Observations

Initial Continuing Initial Continuing BIG4

Ernst & Young 36 1,033 23 947

KPMG 30 717 14 587

Deloitte & Touche 27 821 20 708

PWC 35 915 15 731 Non-BIG4 Grand Thornton 42 215 16 226 BDO Seidman 29 194 12 159 Others 181 1,315 121 1,247 380 5,210 221 4,605

Panel B2: Auditor distribution by % of Sample

Initial Continuing Initial Continuing BIG4

Ernst & Young 9.4 19.8 10.4 20.5

KPMG 7.9 13.8 6.3 12.8

Deloitte & Touche 7.1 15.8 9 15.4

PWC 9.2 17.6 6.8 15.9 Non-BIG 4 Grand Thornton 11 4.1 7.2 4.9 BDO Seidman 7.6 3.7 5.4 3.5 Others 47.8 25.2 54.9 27 100 100 100 100 2005 2009 2005 2009 TABLE 1 Sample Description:

Distribution of Firm-Year Observations by Industry

2005 2009

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4. Methodology

This study primarily examines the causal relationship between, on the one hand the practice of low-balling, and on the other hand audit quality, in a quantitative manner. Data is obtained from US listed companies, for experimental years 2005 and 2009. In order to investigate hypothesis 1, I will use data of year 2009, i.e. during financial crisis. Hypothesis 2 will be examined using data from the fiscal years of 2005 and 2009, i.e. pre- and during the financial crisis, in order to make the comparison. Hypothesis 3 will be examined by testing the effectiveness of a firms’ audit committee in investigating whether this either weakens or strengthens the relationship between low-balling and audit quality.

4.1 Initial Audit Fees Discounting

In order to test hypothesis 1, this study uses two models to capture the amount of low-balling, namely (1) the self-selection equation, and (2) the underlying audit fee model.

Panel C: Auditor Dismissals by Industry Defined by Two-Digit SIC by # of Observations

Obs. %

Sample Obs. % Sample Obs. % Sample Obs. % Sample

Mining and Construction (1000–1999, except

1300–1399) 8 2.1 201 3.9 4 1.8 218 4.73

Food (2000-2111) 8 2.1 114 2.2 5 2.2 112 2.43

Textiles and Painting/Publishing (2200-2799) 14 3.7 207 4 13 5.8 162 3.52

Chemicals (2800-2824, 2840-2899) 13 3.4 140 2.7 5 2.2 139 3.02

Pharmaceuticals (2830-2836) 22 5.8 426 8.2 22 9.9 387 8.40

Extractive (1300–1399, 2900–2999) 23 6 245 4.7 8 3.6 259 5.62

Durable manufacturers (3000–3999, except

3570–3579 and 3670–3679) 100 26.2 1148 22 63 28.3 969 21.04 Transportations (4000–4899) 29 7.6 385 7.4 18 8.1 337 7.32 Utilities (4900–4999) 11 2.9 254 4.9 2 0.9 244 5.30 Retail (5000–5999) 40 10.5 472 9.1 20 9 404 8.77 Computers (3570–3579 and 3670–3679) 28 7.3 320 6 12 5.4 305 6.62 Others (000–0999) 84 24.5 1298 24.9 51 22.8 1069 23.21 380 100 5,210 100 223 100 4,605 100 TABLE 1 (continued) 2009

Initial Continuing Initial Continuing

2005

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4.1.1 Self-Selection Bias (1)

Recent studies using audit pricing models have questioned whether companies self-select their auditors, since this could introduce self-self-selection bias into the audit fee regression estimations and affect the audit fee premium estimates used (Hamilton et al., 2008). To clarify, fee premiums estimates are often used as the basis for making inferences about market competition. Several studies have found that auditor choice is likely to be endogenous, i.e. the choice for an auditor is driven without outside intervention, and treating auditor choice as an exogenous variable may affect the analysis’ results (Ireland and Lennox, 2002; Chaney et al., 2004; Hamilton et al., 2008). To overcome this issue, consistent with Wooldridge (2002) and Greene (2003), I will use a two-step treatment effects model to determine whether selectivity bias is an issue in this setting. Consistent with Wahad & Zain (2013), this study’s first step in addressing the selection model involves using a probit regression analysis to determine the likelihood of selecting a BIG4 auditor, and to calculate the inverse mills ratio (IMR) to be included in the audit fee model. Wahad and Zain (2013) developed an auditor choice model, which is quite similar to the model developed by Hamilton et al. (2008). However, they added a subset of variables from the audit fee model, as well as the variable of (OPINION(t-1)) which represents the prior fiscal years’ auditor opinion. This study adapts the aforementioned self-selection model developed by Wahad and Zain (2013). Furthermore, consistent with Lustgarten and Ghosh (2006), I add an industry dummy variable to test whether fee cutting is a competitive response, as argued by studies such as DeAngelo (1981) and Chan (1999). The results of this probit-regression analysis are subsequently incorporated in the regression of model (2).

The self-selection equation, i.e. model (1), is as following:

= + + _ +

+ INVTA + + + + +

+ +

(1) 4.1.2 Audit Fee Model (2)

The second step is the assessment of the audit fees, using the underlying audit fee model. The model employed for this purpose captures the primary fee determinants, as derived from several (recent) studies (Hamilton et al., 2008). Within this audit fee model the dependent variable is the natural logarithm of audit fees, which is common in audit fees studies (Gul,

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2006). Consistent with Wahad and Zain (2013), I used audit fees as the dependent variable, since this research setting is interested in capturing the extent of auditor investigations. For the sake of clarification, it is reasonable to assume that more audit investigations will require more audit hours and/or the use of more specialized audit staff, leading to higher audit fees (O’Sullivan, 2000). Moreover, O’Sullivan (2000) adds that the use of audit fees to proxy for audit quality is appropriate, as actual delivered audit quality is unobservable on a straightforward manner.

The audit fee model, i.e. model (2), is as following:

= + + + +

+ INVTA + + + + +

+ + + + +

(2) 4.1.3 Control Variables

Consistent with the meta-analysis conducted by Hay et al. (2006), and for the sake of simplicity, I subdivide the control variables into three categories, being client attributes, auditor attributes and engagement attributes.

The client attributes consist of size, complexity, inherent risk, profitability, leverage and industry. I use the natural logarithm of assets, i.e. LNASSETS to proxy for the size of a company. I posit that the larger a firm is, the more complex and time-consuming the audit, and subsequently the audit fee. Consistent with Hay et al. (2006), I use a direct measure of complexity; a dummy variable, i.e. DISC_OP, that takes the value of 1 when a firm reports either discontinued operations or extraordinary items, 0 otherwise. Inherent risk is proxied by

RECVTA; accounts receivables scaled by total assets, and INVTA; inventory scaled by total

assets. LIQUID, the relationship between current assets and current liabilities (working capital ratio), serves as a proxy to control for liquidity. Consistent with Lustgarten (2006), I use (1) the return on assets, i.e. ROA, and (2) LOSS; a dummy variable that takes the value of 1 when a firm reports a loss in the previous year, as my proxies for firms’ profitability. Lastly, consistent with Wahab and Zain (2013), I use LEV as a proxy for leverage; the ratio of long-term debt and total assets.

The engagement attributes consist of two variables, being a dummy variable (YE) that takes the value of 1 when a firm report from 31th of December to 31th of May, and an indicator variable (OPINION) to proxy for the auditor opinion (Hay et al., 2006).

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The variables used in model (1) and model (2) are defined as follows:

Variable Definition

NLAF Natural logarithm of audit fees

INITIAL Dummy variable, 1 if a firm switches from auditor, 0 otherwise

LNASSETS Natural logarithm of total assets

DISC_OP Dummy variable, 1 if a firm reports discontinued operation or extraordinary items

RECTVA Accounts receivables scaled by total assets

INVTA Inventory scaled by total assets

LIQUID Current assets to current liabilities

ROA Net income divided by average total assets

LOSS Dummy variable, 1 if a firm incurred a loss in the last fiscal year

LEV Total long term debt to total assets

YE Dummy variable, 1 for firms whose fiscal year

ends between 31th of December and 31th of March

OPINION Dummy variable, 1 for qualified opinion

IMR Inverse mills ratio

INDUSTRY Industry dummy, 1 when firms is in manufacturing (SIC codes 20-39), in utility (SIC codes 40-49), or financial industry (SIC codes 60-69)

While several prior low-balling papers have only applied an audit fee model, in order to test the robustness of the model, in this research the self-selection equation, i.e. model (1), has been incorporated. The coefficient outcomes of the variables INITIAL2005 and INITIAL2009 in the

NLAF regression model will indicate the level of fees cutting.

4.2 Audit Quality

The next step after capturing the amount of fee cutting at the initial audit engagement is to access whether this practice has increased the likelihood of managers managing their earnings, and thus audit quality. This study will make the comparison between the levels of audit quality, as proxied by earnings management in INITIAL = 1, i.e. the first year of audit engagement, and INITIAL = 0, i.e. the subsequent years after the initial auditor-client relationship.

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4.2.1 The Audit Quality Model

Following prior research, this study uses the level of discretionary accruals as the proxy for audit quality, since it provides an indication of management’s active intervention in reporting earnings (Johnson et al., 2002; Krishnan, 2003). However, Gul et al. (2013) argue that actual earnings management is unobservable on a direct manner. Therefore researchers have investigated two elements to capture earnings management and audit quality, being the choice of accounting methods and the managerial discretion in determining accounting accruals. According to DuCharme et al. (2004) accruals models to capture audit quality are preferred, since this approach captures the subtle income management techniques allegedly used to avoid detection of managerial discretion within reporting by outsiders. Gul et al. (2013) add that this approach not only captures the managerial choice of accounting policy, but rather the effect of recognition of revenues and expenditures, asset write-downs and changes in accounting estimates. In existing literature there are two approaches to deal with earnings management and audit quality. Relatively older studies (Healy, 1985; DeAngelo, 1981) proxy for audit quality using the total magnitude of accruals, while relatively more recent studies (Jones, 1991; Dechow, Sloan and Sweeny, 1995) use discretionary accruals as proxy for audit quality. The distinction between discretionary- and non-discretionary accruals is important, as in order to manage earnings managers use their discretion. Actual changes in a firms’ underlying economic performance will cause non-discretionary accruals to fluctuate, whereas managers’ ability to manipulate earnings will be accomplished using discretionary accruals. This discretion is solely reflected by discretionary accruals and consequently these discretionary accruals represent managerial intervention in financial reporting.

Dechow et al. (1995) proposed a modified version of the original Jones (1991) model to detect discretionary accruals. According to their findings this modified model provides the most powerful test of earnings management compared with earlier existing models like that of Healy (1985) and DeAngelo (1981) and the original Jones (1991) model. This model is designed to eliminate the conjectured tendency of the original Jones Model (1991) to measure discretionary accruals with error when discretion is exercised over revenue recognition (Gul and Tsui, 2000). Furthermore, I agree with Al-Thuneibat et al. (2010) in using the discretionary accruals to capture earnings management, not considering the non-discretionary accruals, as solely discretionary accruals can be controlled and influenced by managers.

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Based on the motives mentioned above, this study will use the Modified Jones Model (1995), as developed by Dechow et al. (1995), to capture the magnitude of discretionary accruals, hence, as proxy for audit quality.

According to the Modified Jones Model, the expected accruals are estimated from two equations, being equation (3), and equation (4). Ultimately, the magnitude of abnormal accruals is the difference between total accruals and expected total accruals.

4.2.2 Total Accruals (3)

Equitation (3) estimates the total accruals from the change in revenue, the level of property, plan and equipment, and the previous year’s operational performance (Riechelt and Wang, 2010):

= 0 1

1 + 1 + 2 +

(3)

The variables used in equation (3) are defined as follows:

Variable Definition

TA Total accruals (net income from continuing operations -/-

operating cash flow, for company i for year t divided by total assets at the end of year t – 1

Total assets for company i at the end of year t – 1

Change in revenue from prior year, company i for year t divided by total assets at the end of year t – 1

Gross property, plant and equipment for company i at the end of year t divided by total assets at the end of

year t – 1

Return on assets, measured by net income for company i for year t – 1 divided by average total assets for

year t – 1 Error term

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4.2.3 Expected Total Accruals (4) and Discretionary Accruals (5)

Equation (4) estimates the expected total accruals, using the coefficient estimates of equitation (3) with an adjustment for the change in accounts receivables, as proposed by Dechow et al. (1995):

= 0+ 1 1

1 + 1( ) + 2 +

(4) Variable Definition

ETAit Expected total accruals for company i in year t

Expected coefficient from equation (1)

REVit Change in accounts receivables from prior year, for

company i in year t

Finally, the discretionary accruals is the difference between equation (3) and (4): =

(5)

As has been mentioned above, the amount of DACC reflects the amount of abnormal i.e. discretionary accruals, and therefore serves as a proxy to measure managerial discretion i.e. intervention in financial earnings reporting. In order to measure hypothesis 1, I developed the following combined intervention model:

= + + + +

+ + BIG4 + + + 2009

+ ( 2009)

4.3 Audit committee effectiveness

The effectiveness of a firms’ audit committee will act as a mediator in order to investigate the extent to which an effective audit committee influences the relationship between initial audit fees cutting and audit quality.

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