Description
Abstract
This paper provides a review of the extensive
contributions made to the audit pricing
literature by researchers utilizing Australian
data. Recent United States [hereafter US]
regulatory requirements under the Sarbanes
Oxley Act (Section 102) have mandated
disclosure of audit fees. As such this is a useful
occasion to review the existing Australian audit
pricing research, since the audit fee disclosure
advantage once enjoyed by Australian
researchers has now effectively dissipated.
Beginning with the origins and genesis of audit
pricing research in Australia, this review then
discusses the key contributions to the literature
over time.
Accounting Research Journal
A Review of Australian Audit Pricing Literature
Andrew Ferguson
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To cite this document:
Andrew Ferguson, (2005),"A Review of Australian Audit Pricing Literature", Accounting Research J ournal, Vol. 18 Iss 2 pp.
54 - 62
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Albert L. Nagy, (2014),"Audit partner specialization and audit fees", Managerial Auditing J ournal, Vol. 29 Iss 6 pp. 513-526http://dx.doi.org/10.1108/MAJ -11-2013-0966
Mai Dao, Trung Pham, (2014),"Audit tenure, auditor specialization and audit report lag", Managerial Auditing J ournal, Vol. 29
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ACCOUNTING RESEARCH JOURNAL VOLUME 18 NO 2 (2005)
54
A Review of Australian Audit Pricing
Literature
Andrew Ferguson
School of Accounting
University of New South Wales
Abstract
This paper provides a review of the extensive
contributions made to the audit pricing
literature by researchers utilizing Australian
data. Recent United States [hereafter US]
regulatory requirements under the Sarbanes
Oxley Act (Section 102) have mandated
disclosure of audit fees. As such this is a useful
occasion to review the existing Australian audit
pricing research, since the audit fee disclosure
advantage once enjoyed by Australian
researchers has now effectively dissipated.
Beginning with the origins and genesis of audit
pricing research in Australia, this review then
discusses the key contributions to the literature
over time. It concludes with some brief
discussion of potential research directions.
1. Introduction
Australian researchers have for many years
been at the forefront of the audit pricing
literature. This situation has in large part
resulted from the public disclosure of
audit fee data in the annual reports of listed
Australian companies. Since audit fees have
not been disclosed in the US until 2002,
Australian researchers have held a comparative
advantage over their US counterparts, who
were previously forced to acquire data through
survey methods, or by direct approach to the
accounting firms themselves. Both these
methods have proved unreliable in terms of
data supply on an ongoing basis, and thus
constrained US research output in this area.
The post-Enron disclosure regime in the US
now provides for similar audit fee disclosure to
Keywords: Audit pricing, Audit quality, Auditor industry
specialization
Acknowledgment: An anonymous referee is thanked for
suggestions.
that mandated in AASB 101.
1
Since the
Australian audit fee data source advantage has
now dissipated, this appears to be a useful
occasion to review the existing Australian audit
pricing evidence, and to suggest some possible
future directions for Australian researchers.
The review is also timely in light of recent
regulatory interest in the public accounting
profession including The Panel on Audit
Effectiveness (2000) and the Sarbanes-Oxley
Act (2002) in the US, and the Ramsay Report
(2001) and the CLERP Audit Reform and
Corporate Disclosure Act (2004) in Australia.
Regulatory interest has seen the practise of
auditing placed under the microscope.
The review is structured as follows: In the
Section 2, the origins of the audit pricing model
and the theory of audit quality are discussed.
Section 3 includes a review of the ‘early’
Australian literature focussed on product
differentiation and pricing premiums for large
audit firms. Section 4 examines pricing
premiums for the industry specialist auditors.
Section 5 extends discussion in Section 4 and
overviews recent literature on industry
1 It is noted that AASB 101, consistent with provisions in
the Corporate Law Economic Reform Program
[hereafter CLERP] Audit Reform and Corporate
Disclosure Act 24
th
June 2004, requires enhanced
disclosure of monetary payments to auditors for
differing types of non-audit services such as tax,
consulting, IT, audit related, and accounting and due
diligence. This is significant since the Sarbanes Oxley
Act (2002) Section 201 effectively prohibits an auditor
from performing all other types of non-audit services
apart from tax in the US. Thus, the allowance of the
auditor to (i) perform, and for the client to (ii) disclose
differing types of non-audit services in Australia
maintains an interesting non-audit fee advantage for
Australian researchers. Implications of this enhanced
disclosure are discussed further in the Section 6.2
‘Auditor Independence’ where possible future research
directions are discussed.
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A Review of Australian Audit Pricing Literature
55
specialist premiums at the local office level.
Finally in Sections 6.1 – 6.3 some possible
future research directions are briefly discussed.
2. Origins of the audit pricing model
Simunic (1980) provides the theoretical
underpinning for the most often applied audit
fee model used in economics of auditing
research. For the auditee, Simunic suggests that
an audit functions as a type of insurance, the
benefits of which arise from liability avoidance
to financial statement users (shareholders,
creditors) in the event of litigation. This
theoretical approach also explains the relative
demand for internal versus external auditing.
Simunic argues that a substitution effect occurs
between internal and external auditing,
dependent on the relative strength of the
client’s internal controls.
From the supply perspective, the key
determinants of audit prices are those factors
deemed to contribute to an auditors’ potential
loss exposure arising from such litigation. To
identify these drivers of potential auditor loss
exposure, Simunic (1980) adopted an inductive
research approach. Discussions were held with
representatives of large audit firms, and also
providers of professional liability insurance.
2
From these discussions, a number of factors
were identified as supply side determinants of
loss exposure. These included (a) the size
of the auditee, (b) the complexity of the
auditee’s operations, (c) the risk of the
auditee’s operations, and (d) the industry of the
auditee. The empirical proxies developed by
Simunic for each determinant form the basis of
the audit fee model, applied in the majority of
subsequent audit pricing studies both in
Australia and abroad.
Whilst Simunic (1980) is credited with the
theoretical development of the audit fee
model, the paper also makes major empirical
contributions. A key empirical issue addressed
in the study is whether assumptions of price
competition in the audit market are valid
following the merger activity that saw the
2 Throughout this paper, the term large auditors merely
refers to any combination of Big 8, Big 6 or Big 5
auditors, whilst the term small auditors refers to the
non-Big 8, non-Big 6 or non-Big 5 auditors
respectively.
formation of the Big 8.
3
To examine this issue,
Simunic partitions the sample based on client
size, with the assumption of price competition
in the market for small audits providing
a benchmark for comparison with the
increasingly concentrated market for larger
client audits. The results indicate no significant
differences in the auditor type (large versus
small) co-efficients across the two sub-samples,
indicating the assumption of price competition
throughout the market cannot be rejected. In
addition, negative co-efficients on the large
audit firm indicator variable across the full
sample is argued to be a function of economies
of scale benefits to larger auditors. This is
suggestive of larger auditors charging lower
fees, although this finding has not been
replicated in subsequent audit pricing studies.
Structural issues raised in Simunic (1980)
would influence later audit pricing research in
Australia.
The other key theory contribution impacting
subsequent Australian audit pricing studies was
DeAngelo (1981).
4
DeAngelo developed the
theoretical basis for the existence of audit
quality, and its relationship with auditor size.
DeAngelo defined audit quality as:
(a) the probability that an auditor will discover
a breach in the client’s accounting system,
and
(b) the probability that this breach will be
reported.
DeAngelo (1981) provides two supply side
arguments supporting a relationship between
auditor quality and auditor size. First, large
auditors make significant investments in audit
technologies, undertake more rigorous staff
3 Such concerns about consolidation amongst accounting
firms and their dominance in the market for large client
audits are documented in the Subcommittee on Reports
(1976) commonly referred to as ‘The Metcalf Report’.
Interestingly, consolidation concerns have once again
been raised in Sarbanes – Oxley Act (2002), where a
separate inquiry was held in to market concentration and
its effects.
4 Discussion of the audit quality literature is necessarily
limited in this review, and readers should consider the
rich literature residing outside ‘economics based’
studies in the form of the behavioral literature. In
addition, it is also acknowledged that there are
contextual issues raised in the literature such as the
implications of audit switching on audit pricing that
could easily be the subject of a separate review.
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ACCOUNTING RESEARCH JOURNAL VOLUME 18 NO 2 (2005)
56
training, and have higher expenditures on
promotion and advertising.
5
Such investments
give rise to greater reputation capital, which is
reflected in higher partner capital contributions.
Second, DeAngelo suggests implicit benefits of
audit incumbency produce incentives for large
auditors to provide higher quality audits.
Benefits of incumbency include the elimination
of client specific start up costs incurred by
auditors as they ‘get to know’ new clients. On
the demand side, clients are faced with
switching costs (principally search costs)
incurred when changing auditors. As a result of
the existence of these ‘joint costs’, a bilateral
monopoly exists, and the larger the auditors’
client base, the larger the quasi rents at stake
should the auditor produce a poor quality audit.
The auditor quality – size relationship posited
by DeAngelo, and competition issues raised in
Simunic (1980) would motivate much of the
subsequent Australian audit pricing research.
3. Early Australian research:
Product differentiation and pricing
premiums for large audit firms
Following Simunic (1980) and DeAngelo
(1981), the early research literature using
Australian data namely Francis (1984), and
Francis and Stokes (1986) sought to examine
whether product differentiation might be a
factor in audit pricing. Francis (1984) develops
theoretical arguments for client demand for
higher quality audits based on agency theory.
The agency theory argument suggests that
shareholders impose tighter monitoring on
those managers who are viewed as being more
opportunistic, or on firms that suffer from
higher perceived or real agency costs. If tighter
monitoring is demanded by shareholders, one
solution would be to choose a higher quality
auditor.
Francis (1984) argues that if audit quality is
not homogeneous, the implicit assumption of
collusive behaviour where concentration of
audit firms is high is incorrect. The reason is
smaller auditors might choose not to invest to
build the necessary reputation to service larger
clients. This will account for the high
concentration of audit firms in the large client
5 Higher expenditure on promotion and advertising is
likely to lead to greater perceived audit quality.
market segment, rather than smaller auditors
being ‘forced out’. In addition, since large
auditors supply higher quality audits, they will
also supply higher priced audits, given
differentiated demand and a competitive
market. These assertions form the basis of the
empirical tests undertaken. Francis (1984)
specifies the audit pricing model as follows:
LAF = b
0
+ b
1
LTA + b
2
SUB + b
3
CATA
+ b
4
QUICK + b
5
DE + b
6
ROI
+ b
7
OPINION + b
8
YE + b
9
LOSS
+ b
10
AUDITOR + e
where:
LAF = natural log of audit fees,
LTA = natural log of total assets,
SUB = square root of the number of
subsidiaries,
CATA = ratio of current assets to total
assets,
QUICK = ratio of current assets (less
inventories) to current liabilities,
DE = ratio of long-term debt to total
assets,
ROI = ratio of earnings before interest
and tax to total assets,
OPINION = indicator variable, 1 = qualified
audit report,
YE = indicator variable, 1 = non-June
30
th
year end,
LOSS = indicator variable, 1=loss in any
of the past three years,
AUDITOR = indicator variable, 1=Big 8
auditor
e = error term assumed to have
normal OLS regression
properties.
Francis (1984) selects a sample of 150
Australian listed companies over each year
from 1974 to 1978 (30 per year), and runs the
above ordinary least squares regression model
in pooled cross section. After deleting 14
financial institutions, the remaining sample is
split on median total assets, and the test run in
both the large and small client segments. The
results indicate no structural differences
between the two models, with the sign of the
auditor indicator positive and significant in
both cases. This indicates higher audit fees to
the Big 8 in both the large and small segments,
consistent with assertions of product
differentiation to the Big 8. Since competition
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A Review of Australian Audit Pricing Literature
57
is the maintained assumption in the small client
segment, the consistency of price premiums to
the Big 8 across the two segments is not
suggestive of collusive or monopolistic pricing
by large auditors.
Francis and Stokes (1986) revisit the
competition issue, and argue that the differing
empirical results (in terms of fee premium
existence) between Simunic (1980) and Francis
(1984) could be due to respective differences in
auditee size across the two studies. By selecting
a bigger sample of large and small companies,
Francis and Stokes sought to provide further
evidence on the competition issue. Using the
same pricing model as Francis (1984), Francis
and Stokes find price premiums to the Big 8 in
the small client segment, but no Big 8 premium
in the large client segment. This is interpreted
as evidence of product differentiation to the Big
8 in the small client market. In the large
client segment, the failure to identify Big 8
premiums is interpreted as the co-existence
of Big 8 product differentiation, along with
diseconomies of scale to the non-Big 8 for
large client audits. The diseconomies are
argued to force up prices of the small auditors,
offsetting product differentiation premiums to
the large auditors, resulting in no observed Big
8 premium.
4. Pricing premiums for industry
specialist auditors
One of the most widely cited papers in the
audit pricing literature is Craswell, Francis and
Taylor (1995) [hereafter CFT]. CFT examine
Simunic (1980)’s assertions that the pricing of
audits may differ according to the industry of
the auditee. CFT suggest that company and
industry specific factors result in cross
sectional differences in monitoring demand,
including demand for industry specialists. CFT
argue that the supply of higher quality auditors
in the form of industry specialists is merely a
response to clients who demand higher quality
monitoring as a function of their increased
agency costs. Thus the demand for quality-
differentiated audits – both brand name audits
and industry specialist audits – is grounded in
agency theory (CFT, p. 299). This differential
demand for auditing leads auditors to
undertake investments enabling the supply of
differentiated audit quality in the form of Big
8/non-Big 8 differentiation, and within Big 8
differentiation through industry specialization.
If Big 8 auditors make these investments,
they will require a normal rate of return on
those investments (CFT, p. 301). This should
be reflected in higher fees for large compared
to small auditors and higher fees for specialist
large auditors compared to non-specialists.
CFT utilize a sizeable sample of 1484 ASX
listed companies from 1987, and apply a cross
sectional OLS regression model. The pricing
model applied is the same as Francis (1984)
with two slight modifications. First, the
variable ‘Foreign’, (which is the proportion of
subsidiaries that are foreign subsidiaries), is
included as a further complexity control.
Second, in addition to a Big 8/nonBig 8
indicator, another test variable coded ‘1’ for
industry specialist Big 8 auditor and coded ‘0’
for a non-specialist Big 8 auditor is included in
the model.
On top of a brand name premium, CFT
find a 34% premium to auditor industry
specialists. CFT’s findings raise two interesting
issues in terms of their interpretation and
generalisability. First, an important point to
note is that specialists were defined as those
auditors holding a 10% market share of either
clients or fees in ‘specialist’ industries.
However, the presence of the fee premium at
the 10% share is not replicated for a tighter
definition of specialist at the 20% level. CFT
suggest some caution in interpreting their
result, as it may be a product of a data artefact.
It also raises the issue of whether the presence
of economies of scale ‘kick-in’ at somewhere
between the 10% and 20% market share
level, mitigating any product differentiation
premiums at the higher market share threshold.
A second issue is the location of the
observed premium. The premium in CFT is
found for clients in ‘specialist’ industries; with
specialist industries defined using the Craswell
and Taylor (1991) methodology. For an
industry to be defined as a specialist industry as
per Craswell and Taylor, it must have a
minimum of 30 companies. The choice of this
threshold appears arbitrary. These issues are
examined further by Ferguson and Stokes
(2002).
Ferguson and Stokes (2002) [hereafter FS]
investigate audit pricing evidence following the
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ACCOUNTING RESEARCH JOURNAL VOLUME 18 NO 2 (2005)
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CFT study. Their analysis incorporates audit
pricing implications following the 1989 audit
firm mergers forming the Big 6, and also
around the 1997 Price Waterhouse and Coopers
& Lybrand merger precipitating the formation
of the Big 5. FS pose the following two
questions; Do brand name premiums persist
following the two rounds of merger activity
after CFT? Do industry specialist premiums
persist after the same two rounds of merger
activity? To test these issues using a more
recent sample, audit fee and other necessary
data from hardcopy annual reports and other
sources for the years 1990, 1992, 1994, 1998
were acquired. The brand name and specialist
hypotheses are re-examined using similar
market share based definitions of specialization
as CFT. Additional market share sensitivities
are also tested in light of the merger activity,
and associated concentration effects.
The results documented in FS indicate that
the general brand name distinction between
large and small auditors is present. Second,
consistent with the prior CFT findings, when
tests of specialist premiums at various levels of
market share are undertaken, they produce only
mixed results. For example, FS tests of
specialist premiums using either fees or clients
at the 10% and 20% cut-offs, are observed in
only two out of four years. As a final test, the
logic of the auditor quality/industry specialist
argument is extended through tests for the
existence of premiums paid to auditor industry
leaders. Industry leadership is arguably more
unequivocal and unambiguous signal of
reputation than tests based on the arbitrary
market share categories first adopted in CFT.
6
Results of the tests of industry leadership
identify a change in the strength of the audit
industry leader co-efficients over time. In
earlier years (1990 – 1992), evidence of audit
6 A number of anecdotal reports, as well as the marketing
literature, discuss the reputation value of a ‘leadership
position’. For example, Hellofs and Jacobsen (1999)
cite efforts by Ford to maintain the market share
required to be the top-selling car in the US They
suggest:
“To be able to advertise “Taurus – America’s Best-
Selling Car Again,” Ford resorted to offering
$1000 rebates for the Taurus to protect its lead
over Honda’s Accord as the number-one-selling
car in the United States” (Naughton 1997).
industry leader premiums is reported. However,
by 1994, this premium has weakened to the
extent that when tests are run in specialist
industries, no evidence of leader premiums is
found. By 1998, no evidence of leader
premiums is present in either tests within
specialist industries or in tests across all
industries. However, the extent to which the
weakening of leadership premiums may be due
to economies of scale benefits is hard to
determine.
Two further findings in FS are noteworthy.
First, sensitivity tests show that when non-audit
service fees are added to the dependent
variable, the leadership premiums where
observed, disappear. This indicates that audit
pricing may be sensitive to potential non-audit
service revenues.
7
Second, in years when
leadership premiums are observed, when each
individual auditor is excluded one at a time, the
exclusion of KPMG results in no premium
being observed.
8
This suggests that leadership
fee premiums are sensitive to non-audit fees
and possibly individual auditor brand name
effects.
In summary, the weakening of reported
leadership premiums by 1994, and subsequent
disappearance by 1998 raises further issues
about the nature and existence of audit fee
premiums. One question that remained
unanswered in FS is whether the premium is
more likely to occur at the local office level, as
opposed to firm – wide or nationally.
9
This
question is considered by Ferguson, Francis
and Stokes (2003) [hereafter FFS (2003)].
7 These tests are consistent with those run by CFT p316
‘Jointness of audit and nonaudit fees’.
8 Interestingly, Gramling and Stone (2001) cite prior
studies suggesting that KPMG was the first Big 5
auditor to implement organizational restructuring along
industry service lines.
9 A caveat on this test is that there is no way of knowing
if only the top ranked firm earns a premium. If more
than one firm in an industry is perceived by the market
as holding a specialization, then this approach will
misclassify some specialists as non-specialists, and thus
weaken the design and statistical tests.
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A Review of Australian Audit Pricing Literature
59
5. Industry specialist premiums at
the local office level
FFS (2003) extend the investigation by FS of
large audit firm product differentiation. FFS
consider two contrasting ways of typifying the
operations of Big 5 accounting firms.
10
First
they consider the ‘firm-wide’ perspective,
where the operations of the Big 5 are viewed
on an aggregated or national level. Under this
view little differentiation is likely to exist
across individual offices and in terms of audit
pricing, a firm-wide measure of expertise is
appropriate. In contrast, under the ‘office level’
perspective, each office within the network
retains local idiosyncrasies. Since the audit
contract is conducted, administered and most
commonly signed-off on office specific
letterhead, it is argued that the local office level
constitutes an appropriate unit of analysis in its
own right. Under the office-level perspective,
expertise resides in human capital and
experience of staff in each office. Thus a
localised measure is relevant to capture
industry expertise in audit pricing.
FFS (2003) examine industry leading and
second ranked auditors both nationally and
locally, to counter any misspecification that
might result from industry expertise residing
outside the leading firm. The evidence
indicates that auditors who are one of the top
two ranked firm’s nationally and also local
industry leaders, enjoy 24% higher fees.
However, where the top two ranked firms
nationally are not the local industry leader, no
fee premiums are earned. Thus, FFS (2003)
conclude that an auditor must hold joint city-
level and national industry leadership to
generate premiums for industry expertise. This
implies the absence of any positive network
externality across offices.
Investigation of fee determination at the
local office level is extended further by
Ferguson, Francis and Stokes (2005) [hereafter
FFS (2005)]. FFS (2005) examine whether
results in FFS (2003) might be confounded by
the presence of city-specific overall market
leadership effects. FFS (2005) reaffirm that
joint local and national auditor expertise is
10 This approach is motivated by a prior study, Francis,
Stokes and Anderson (1999) who used US data.
valued by audit clients. In addition, they find
evidence that overall city-specific market
leadership also matters in fee determination,
although at weaker significance levels. Their
results highlight the importance of both city-
specific industry leadership, and city-specific
overall leadership in differentiating auditors.
6. Possible research directions
This review has focussed on the significant
contribution made by audit pricing studies
based on Australian audit fee data over the last
two decades. This period corresponds with the
competitive advantage in the form of audit fee
data availability Australian researchers have
enjoyed vis-a-vis those in the US. A ‘level
playing field’ with regard to audit fee
disclosure raises the question of the likely
direction of future Australian enquiry.
Fortunately the dynamic state of market
structure, coupled with regulatory interest in
accounting firms point to continuing
opportunities. Whilst current US studies are
likely to be directed at least in part by issues
raised in the prior Australian empirical
research, there will be an ongoing role for
Australian research effort in replication of US
audit pricing studies. The international interest
in such replication style papers will rest on the
importance to the literature of out of US sample
evidence. In addition to replications, the
following areas come to mind as possible
future research areas and constitute by no
means an exhaustive list.
6.1 Consolidation issues
Regulatory concerns about heightened
concentration in the market for audit services
represents something of an ‘old chestnut’, and
arguably first motivated Simunic (1980). Today
however, it remains an important issue facing
the profession as regulators across the globe
continue to express concerns about
concentration and its impact on competition.
11
For example in a recent Australian Federal
Treasury policy paper it is suggested:
‘In short, just 10 firms service nearly 80 per cent of
the market. The remainder is spread across firms
that audit less than three listed clients. With such
11 For example, regulatory bodies in the US have raised
recent concerns about the effects of increasing
concentration amongst large audit firms through
Sarbanes Oxley (2002).
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ACCOUNTING RESEARCH JOURNAL VOLUME 18 NO 2 (2005)
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concentration, companies face a restricted pool of
audit firms with experience in auditing listed
companies. Where one of the major audit firms is
providing non-audit services to a company, the
pool of possible providers of audit services may be
even more limited. Choice would be further
restricted if a company did not wish to contract
audit services from a firm that audited a major
competitor’
12
Since the collapse of Arthur Andersen and
its subsequent merger with the Ernst & Young
in Australia, the number of top-tier competitors
both in Australia and internationally has been
reduced to four. Regulatory interest regarding
aspects of concentration and competition in the
audit market is being fuelled by the perceived
profitability of the Big 4. A number of
anecdotal reports are consistent with this
assertion.
13
Consequently, research examining
potential for collusive behaviour and indicators
of collusion such as industry profitability
appear to be of interest. A point to note is that
US fee disclosure does not extend back prior to
the demise of Arthur Andersen in 2001, so any
study examining fee effects prior to and after
this event will benefit from data outside the US.
6.2 Auditor independence
Independence concerns arising from joint
supply of audit and non-audit services have
been heightened by recent corporate collapses.
Early Australian evidence on this issue is
provided by Barkess and Simnett (1994) who
also examine the determinants of non-audit
service fees. Barkess and Simnett identify no
relationship between audit qualifications and
non-audit service fees. Wines (1994) also
examines auditor supply of non-audit services
and propensity to modify audit opinions, and
finds that auditors sourcing more non-audit
services from clients are more likely to provide
a clean opinion. More recently Craswell
(1999) finds that non-audit services do not pose
independence threats. Thus the bulk of
Australian evidence does not indicate
independence threats through non-audit service
provision.
In terms of further effort in this area,
researchers might consider that recent audit
12 CLERP Paper No.9: Proposals for Reform – Corporate
Disclosure. Part 3: The market for audit services.
13 See for example ‘Big Four, Big Worries’ BRW
10.04.03, and ‘Bloodied but Rich’ Business Week
03.06.02 pp. 74 – 75.
firm restructuring has seen consulting divisions
spun-off, which arguably resolves some of the
perceived independence threat. Consequently,
research effort on non-audit services using
Australian data will most likely evolve
more along the lines of recent US literature
such as Whisenant, Sankaraguruswamy and
Raghunandan (2003). This study examines
whether audit and non-audit services fees are
simultaneously determined. This approach has
not been replicated in Australia, and given the
non-audit services sensitivity results reported in
FS, joint determination represents an attractive
research question to be applied to Australian
data.
As observed in Footnote 1, research
questions involving non-audit services will also
be encouraged by enhanced non-audit fee
disclosure emanating from the CLERP Audit
Reform and Corporate Disclosure Act (2004).
This requires a breakdown of amounts paid to
auditors for different types of non-audit
services such as tax, consulting, IT, audit
related, accounting and due diligence to be
provided in notes to the financial accounts.
Interesting questions such as the relationship
between the magnitude of certain types of non-
audit services and audit fees remain under-
researched. Such research questions using
Australian non-audit fee disclosure will have
the added attractiveness due to the effective US
prohibition of all non-audit services apart from
tax under Section 201 of the Sarbanes Oxley
Act (2002). Thus whilst the US now has
comparable audit fee disclosure to Australia,
we maintain a disclosure advantage in terms of
non-audit fees.
6.3 Measurement Issues
A final suggestion relates to the potential for
improvements in the audit quality proxies
adopted in audit pricing studies. Gramling and
Stone (2001) contains a useful summary
including discussion of problems relating to
measurement of industry expertise. Gramling
and Stone list the three methods typically
adopted in the literature including: (1) industry
market share as a proxy for industry expertise,
(2) percentage of an audit firm’s revenue in an
industry relative to total revenue across all
industries and (3) specialist measures based on
self proclaimed industry specialization on
accounting firm web-sites. Each of these
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A Review of Australian Audit Pricing Literature
61
measures of industry specialisation has
potentially serious problems. For example,
using audit fees to construct market share
metrics to define specialisation or industry
leadership creates a potential endogeneity
problem, since the dependent variable is a log
of audit fees. This highlights a more general
problem faced by researchers in the economics
of auditing field which is the development of
valid measures of the audit quality construct.
One approach might be to make use of
capital market assessments to validate existing
audit quality measures. An example using
Australian data is Ferguson and Matolcsy
(2004), who examine audit quality measures in
a post-earnings announcement drift context.
14
Ferguson and Matolcsy examine large versus
small audit firm, industry specialist, and auditor
industry leader dummies - the same audit
quality metrics applied in FS. Interestingly,
Ferguson and Matolcsy find differing capital
market reaction when partitions are undertaken
within the Big 6/5 auditors themselves. This
result is not unsurprising given FS report that
the industry specialist premium disappeared
when KPMG was excluded from the sample,
implying that specialist premiums were
impacted by individual auditor brand name
effects.
Two points emerge from Ferguson and
Matolcsy (2004). First, it is likely that audit
pricing research will be increasingly directed at
identifying differences within the Big 4 as
opposed to simple comparisons of large and
small auditors. Second, novel ways of
validating and assessing audit quality metrics
are likely to be of interest to the both
practitioners and researchers alike.
References
Barkess, L., and R. Simnett. (1994), ‘The provision of other
services by auditors: Independence and pricing issues’,
Accounting and Business Research, vol. 24, pp. 99-108.
Craswell, A. (1999), ‘Does the provision of non-audit
service impair independence?’, International Journal
of Auditing, vol. 3, pp. 29-40.
14 Another recent example of applying audit quality
metrics in a capital market setting is Stevenson-Clarke
and Hodgson (2004) who examine Audit Quality and
both earnings and cash response co-efficients. They find
that the use of a Big 5 auditor enhances the perceived
credibility of reported earnings for industrial companies,
but not mining firms.
Craswell, A., and S. Taylor. (1991), ‘The market structure
of auditing in Australia: The role of industry
specialization’, Research in Accounting Regulation,
vol. 5, pp. 55-77.
Craswell, A., J. Francis, and S. Taylor. (1995), ‘Auditor
brand name reputations and industry specializations’,
Journal of Accounting and Economics, vol. 20 (3), pp.
297-322.
DeAngelo, L. (1981), ‘Auditor size and auditor quality’,
Journal of Accounting and Economics, vol. 3 (3), pp.
183-199.
Ferguson, A. and Z. Matolcsy. (2004), ‘Audit quality and
post earnings announcement drift’, Asia Pacific
Journal of Accounting and Economics, vol. 11 (2), pp.
121-137.
Ferguson, A., J. Francis and D. Stokes. (2003), ‘The effects
of firm-wide and office level industry expertise on
audit pricing’, The Accounting Review, vol. 78 (2), pp.
429-448.
Ferguson, A., J. Francis and D. Stokes. (2005), ‘What
matters in audit pricing – Industry specialization or
overall market leadership?’, Accounting and Finance,
Forthcoming.
Ferguson, A. and D. Stokes. (2002), ‘Brand name audit,
industry specialization and leadership premiums post
the Big 6 and Big 8 mergers’, Contemporary
Accounting Research, vol. 19 (1), pp. 77-110.
Francis, J. (1984), ‘The effect of audit firm size on audit
prices: A study of the Australian market’, Journal of
Accounting and Economics, vol. 6 (2), pp. 133-151.
Francis, J., and D. Stokes. (1986), ‘Audit prices, product
differentiation, and scale economies: Further evidence
from the Australian audit market’, Journal of
Accounting Research, vol. 24 (2), pp. 383-393.
Francis, J., D. Stokes, and D. Anderson. (1999), ‘City
markets as a unit of analysis in audit research and the
re-examination of Big 6 market shares’, Abacus, vol.
35 (2), pp. 185-206.
Gramling, A.A., and D.N.Stone. (2001), ‘Audit firm
expertise: A review and synthesis of the archival
literature’, Journal of Accounting Literature, vol. 20
(1), pp. 1-29.
Hellofs, L.H., and R. Jacobson. (1999), ‘Market share and
customers’ perceptions of quality: When can firms
grow their way to higher versus lower quality?’,
Journal of Marketing, vol. 63, pp. 16-25.
Naughton, K. (1997), ‘Taurus may tumble from the top’,
BusinessWeek, January 20, p. 4.
Public Oversight Board, (2000), ‘The panel on audit
effectiveness final report’, September 6
th
, Stanford CT.
Ramsay, I. (2001), ‘The independence of Australian
company auditors: Review of current Australian
requirements and proposals for reform’, Report to the
minister for financial services and regulation, The
University of Melbourne.
Simunic, D. (1980), ‘The pricing of audit services: Theory
and evidence’, Journal of Accounting Research, vol. 18
(1), pp. 161-190.
Stevenson-Clarke, P., and A Hodgson. (2004), ‘Estimating
the value added by Big 8/6/5 auditors using linear and
nonlinear earnings and cash response coefficients’,
Accounting Research Journal, Forthcoming.
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ACCOUNTING RESEARCH JOURNAL VOLUME 18 NO 2 (2005)
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Subcommittee on Reports. (1976), ‘Accounting and
management of the commission on government
operations, United States Senate’, The Accounting
Establishment: A Staff Study, Washington D.C.,
Government Printing Office.
Whisenant, S., S. Sanaraguruswamy and K. Raghunandan.
(2003), ‘Evidence on the joint determination of Audit
and non-audit fees’, Journal of Accounting Research,
vol. 41 (4), pp. 721-744.
Wines, G., (1994), ‘Auditor independence, audit
qualifications and the provision of non-audit services:
A note’, Accounting and Finance, May, pp. 75-86.
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This article has been cited by:
1. Effiezal Aswadi Abdul Wahab, Mazlina Mat Zain, Kieran James, Hasnah Haron. 2009.
Institutional investors, political connection and audit quality in Malaysia. Accounting Research
Journal 22:2, 167-195. [Abstract] [Full Text] [PDF]
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doc_176479622.pdf
Abstract
This paper provides a review of the extensive
contributions made to the audit pricing
literature by researchers utilizing Australian
data. Recent United States [hereafter US]
regulatory requirements under the Sarbanes
Oxley Act (Section 102) have mandated
disclosure of audit fees. As such this is a useful
occasion to review the existing Australian audit
pricing research, since the audit fee disclosure
advantage once enjoyed by Australian
researchers has now effectively dissipated.
Beginning with the origins and genesis of audit
pricing research in Australia, this review then
discusses the key contributions to the literature
over time.
Accounting Research Journal
A Review of Australian Audit Pricing Literature
Andrew Ferguson
Article information:
To cite this document:
Andrew Ferguson, (2005),"A Review of Australian Audit Pricing Literature", Accounting Research J ournal, Vol. 18 Iss 2 pp.
54 - 62
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ACCOUNTING RESEARCH JOURNAL VOLUME 18 NO 2 (2005)
54
A Review of Australian Audit Pricing
Literature
Andrew Ferguson
School of Accounting
University of New South Wales
Abstract
This paper provides a review of the extensive
contributions made to the audit pricing
literature by researchers utilizing Australian
data. Recent United States [hereafter US]
regulatory requirements under the Sarbanes
Oxley Act (Section 102) have mandated
disclosure of audit fees. As such this is a useful
occasion to review the existing Australian audit
pricing research, since the audit fee disclosure
advantage once enjoyed by Australian
researchers has now effectively dissipated.
Beginning with the origins and genesis of audit
pricing research in Australia, this review then
discusses the key contributions to the literature
over time. It concludes with some brief
discussion of potential research directions.
1. Introduction
Australian researchers have for many years
been at the forefront of the audit pricing
literature. This situation has in large part
resulted from the public disclosure of
audit fee data in the annual reports of listed
Australian companies. Since audit fees have
not been disclosed in the US until 2002,
Australian researchers have held a comparative
advantage over their US counterparts, who
were previously forced to acquire data through
survey methods, or by direct approach to the
accounting firms themselves. Both these
methods have proved unreliable in terms of
data supply on an ongoing basis, and thus
constrained US research output in this area.
The post-Enron disclosure regime in the US
now provides for similar audit fee disclosure to
Keywords: Audit pricing, Audit quality, Auditor industry
specialization
Acknowledgment: An anonymous referee is thanked for
suggestions.
that mandated in AASB 101.
1
Since the
Australian audit fee data source advantage has
now dissipated, this appears to be a useful
occasion to review the existing Australian audit
pricing evidence, and to suggest some possible
future directions for Australian researchers.
The review is also timely in light of recent
regulatory interest in the public accounting
profession including The Panel on Audit
Effectiveness (2000) and the Sarbanes-Oxley
Act (2002) in the US, and the Ramsay Report
(2001) and the CLERP Audit Reform and
Corporate Disclosure Act (2004) in Australia.
Regulatory interest has seen the practise of
auditing placed under the microscope.
The review is structured as follows: In the
Section 2, the origins of the audit pricing model
and the theory of audit quality are discussed.
Section 3 includes a review of the ‘early’
Australian literature focussed on product
differentiation and pricing premiums for large
audit firms. Section 4 examines pricing
premiums for the industry specialist auditors.
Section 5 extends discussion in Section 4 and
overviews recent literature on industry
1 It is noted that AASB 101, consistent with provisions in
the Corporate Law Economic Reform Program
[hereafter CLERP] Audit Reform and Corporate
Disclosure Act 24
th
June 2004, requires enhanced
disclosure of monetary payments to auditors for
differing types of non-audit services such as tax,
consulting, IT, audit related, and accounting and due
diligence. This is significant since the Sarbanes Oxley
Act (2002) Section 201 effectively prohibits an auditor
from performing all other types of non-audit services
apart from tax in the US. Thus, the allowance of the
auditor to (i) perform, and for the client to (ii) disclose
differing types of non-audit services in Australia
maintains an interesting non-audit fee advantage for
Australian researchers. Implications of this enhanced
disclosure are discussed further in the Section 6.2
‘Auditor Independence’ where possible future research
directions are discussed.
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A Review of Australian Audit Pricing Literature
55
specialist premiums at the local office level.
Finally in Sections 6.1 – 6.3 some possible
future research directions are briefly discussed.
2. Origins of the audit pricing model
Simunic (1980) provides the theoretical
underpinning for the most often applied audit
fee model used in economics of auditing
research. For the auditee, Simunic suggests that
an audit functions as a type of insurance, the
benefits of which arise from liability avoidance
to financial statement users (shareholders,
creditors) in the event of litigation. This
theoretical approach also explains the relative
demand for internal versus external auditing.
Simunic argues that a substitution effect occurs
between internal and external auditing,
dependent on the relative strength of the
client’s internal controls.
From the supply perspective, the key
determinants of audit prices are those factors
deemed to contribute to an auditors’ potential
loss exposure arising from such litigation. To
identify these drivers of potential auditor loss
exposure, Simunic (1980) adopted an inductive
research approach. Discussions were held with
representatives of large audit firms, and also
providers of professional liability insurance.
2
From these discussions, a number of factors
were identified as supply side determinants of
loss exposure. These included (a) the size
of the auditee, (b) the complexity of the
auditee’s operations, (c) the risk of the
auditee’s operations, and (d) the industry of the
auditee. The empirical proxies developed by
Simunic for each determinant form the basis of
the audit fee model, applied in the majority of
subsequent audit pricing studies both in
Australia and abroad.
Whilst Simunic (1980) is credited with the
theoretical development of the audit fee
model, the paper also makes major empirical
contributions. A key empirical issue addressed
in the study is whether assumptions of price
competition in the audit market are valid
following the merger activity that saw the
2 Throughout this paper, the term large auditors merely
refers to any combination of Big 8, Big 6 or Big 5
auditors, whilst the term small auditors refers to the
non-Big 8, non-Big 6 or non-Big 5 auditors
respectively.
formation of the Big 8.
3
To examine this issue,
Simunic partitions the sample based on client
size, with the assumption of price competition
in the market for small audits providing
a benchmark for comparison with the
increasingly concentrated market for larger
client audits. The results indicate no significant
differences in the auditor type (large versus
small) co-efficients across the two sub-samples,
indicating the assumption of price competition
throughout the market cannot be rejected. In
addition, negative co-efficients on the large
audit firm indicator variable across the full
sample is argued to be a function of economies
of scale benefits to larger auditors. This is
suggestive of larger auditors charging lower
fees, although this finding has not been
replicated in subsequent audit pricing studies.
Structural issues raised in Simunic (1980)
would influence later audit pricing research in
Australia.
The other key theory contribution impacting
subsequent Australian audit pricing studies was
DeAngelo (1981).
4
DeAngelo developed the
theoretical basis for the existence of audit
quality, and its relationship with auditor size.
DeAngelo defined audit quality as:
(a) the probability that an auditor will discover
a breach in the client’s accounting system,
and
(b) the probability that this breach will be
reported.
DeAngelo (1981) provides two supply side
arguments supporting a relationship between
auditor quality and auditor size. First, large
auditors make significant investments in audit
technologies, undertake more rigorous staff
3 Such concerns about consolidation amongst accounting
firms and their dominance in the market for large client
audits are documented in the Subcommittee on Reports
(1976) commonly referred to as ‘The Metcalf Report’.
Interestingly, consolidation concerns have once again
been raised in Sarbanes – Oxley Act (2002), where a
separate inquiry was held in to market concentration and
its effects.
4 Discussion of the audit quality literature is necessarily
limited in this review, and readers should consider the
rich literature residing outside ‘economics based’
studies in the form of the behavioral literature. In
addition, it is also acknowledged that there are
contextual issues raised in the literature such as the
implications of audit switching on audit pricing that
could easily be the subject of a separate review.
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ACCOUNTING RESEARCH JOURNAL VOLUME 18 NO 2 (2005)
56
training, and have higher expenditures on
promotion and advertising.
5
Such investments
give rise to greater reputation capital, which is
reflected in higher partner capital contributions.
Second, DeAngelo suggests implicit benefits of
audit incumbency produce incentives for large
auditors to provide higher quality audits.
Benefits of incumbency include the elimination
of client specific start up costs incurred by
auditors as they ‘get to know’ new clients. On
the demand side, clients are faced with
switching costs (principally search costs)
incurred when changing auditors. As a result of
the existence of these ‘joint costs’, a bilateral
monopoly exists, and the larger the auditors’
client base, the larger the quasi rents at stake
should the auditor produce a poor quality audit.
The auditor quality – size relationship posited
by DeAngelo, and competition issues raised in
Simunic (1980) would motivate much of the
subsequent Australian audit pricing research.
3. Early Australian research:
Product differentiation and pricing
premiums for large audit firms
Following Simunic (1980) and DeAngelo
(1981), the early research literature using
Australian data namely Francis (1984), and
Francis and Stokes (1986) sought to examine
whether product differentiation might be a
factor in audit pricing. Francis (1984) develops
theoretical arguments for client demand for
higher quality audits based on agency theory.
The agency theory argument suggests that
shareholders impose tighter monitoring on
those managers who are viewed as being more
opportunistic, or on firms that suffer from
higher perceived or real agency costs. If tighter
monitoring is demanded by shareholders, one
solution would be to choose a higher quality
auditor.
Francis (1984) argues that if audit quality is
not homogeneous, the implicit assumption of
collusive behaviour where concentration of
audit firms is high is incorrect. The reason is
smaller auditors might choose not to invest to
build the necessary reputation to service larger
clients. This will account for the high
concentration of audit firms in the large client
5 Higher expenditure on promotion and advertising is
likely to lead to greater perceived audit quality.
market segment, rather than smaller auditors
being ‘forced out’. In addition, since large
auditors supply higher quality audits, they will
also supply higher priced audits, given
differentiated demand and a competitive
market. These assertions form the basis of the
empirical tests undertaken. Francis (1984)
specifies the audit pricing model as follows:
LAF = b
0
+ b
1
LTA + b
2
SUB + b
3
CATA
+ b
4
QUICK + b
5
DE + b
6
ROI
+ b
7
OPINION + b
8
YE + b
9
LOSS
+ b
10
AUDITOR + e
where:
LAF = natural log of audit fees,
LTA = natural log of total assets,
SUB = square root of the number of
subsidiaries,
CATA = ratio of current assets to total
assets,
QUICK = ratio of current assets (less
inventories) to current liabilities,
DE = ratio of long-term debt to total
assets,
ROI = ratio of earnings before interest
and tax to total assets,
OPINION = indicator variable, 1 = qualified
audit report,
YE = indicator variable, 1 = non-June
30
th
year end,
LOSS = indicator variable, 1=loss in any
of the past three years,
AUDITOR = indicator variable, 1=Big 8
auditor
e = error term assumed to have
normal OLS regression
properties.
Francis (1984) selects a sample of 150
Australian listed companies over each year
from 1974 to 1978 (30 per year), and runs the
above ordinary least squares regression model
in pooled cross section. After deleting 14
financial institutions, the remaining sample is
split on median total assets, and the test run in
both the large and small client segments. The
results indicate no structural differences
between the two models, with the sign of the
auditor indicator positive and significant in
both cases. This indicates higher audit fees to
the Big 8 in both the large and small segments,
consistent with assertions of product
differentiation to the Big 8. Since competition
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is the maintained assumption in the small client
segment, the consistency of price premiums to
the Big 8 across the two segments is not
suggestive of collusive or monopolistic pricing
by large auditors.
Francis and Stokes (1986) revisit the
competition issue, and argue that the differing
empirical results (in terms of fee premium
existence) between Simunic (1980) and Francis
(1984) could be due to respective differences in
auditee size across the two studies. By selecting
a bigger sample of large and small companies,
Francis and Stokes sought to provide further
evidence on the competition issue. Using the
same pricing model as Francis (1984), Francis
and Stokes find price premiums to the Big 8 in
the small client segment, but no Big 8 premium
in the large client segment. This is interpreted
as evidence of product differentiation to the Big
8 in the small client market. In the large
client segment, the failure to identify Big 8
premiums is interpreted as the co-existence
of Big 8 product differentiation, along with
diseconomies of scale to the non-Big 8 for
large client audits. The diseconomies are
argued to force up prices of the small auditors,
offsetting product differentiation premiums to
the large auditors, resulting in no observed Big
8 premium.
4. Pricing premiums for industry
specialist auditors
One of the most widely cited papers in the
audit pricing literature is Craswell, Francis and
Taylor (1995) [hereafter CFT]. CFT examine
Simunic (1980)’s assertions that the pricing of
audits may differ according to the industry of
the auditee. CFT suggest that company and
industry specific factors result in cross
sectional differences in monitoring demand,
including demand for industry specialists. CFT
argue that the supply of higher quality auditors
in the form of industry specialists is merely a
response to clients who demand higher quality
monitoring as a function of their increased
agency costs. Thus the demand for quality-
differentiated audits – both brand name audits
and industry specialist audits – is grounded in
agency theory (CFT, p. 299). This differential
demand for auditing leads auditors to
undertake investments enabling the supply of
differentiated audit quality in the form of Big
8/non-Big 8 differentiation, and within Big 8
differentiation through industry specialization.
If Big 8 auditors make these investments,
they will require a normal rate of return on
those investments (CFT, p. 301). This should
be reflected in higher fees for large compared
to small auditors and higher fees for specialist
large auditors compared to non-specialists.
CFT utilize a sizeable sample of 1484 ASX
listed companies from 1987, and apply a cross
sectional OLS regression model. The pricing
model applied is the same as Francis (1984)
with two slight modifications. First, the
variable ‘Foreign’, (which is the proportion of
subsidiaries that are foreign subsidiaries), is
included as a further complexity control.
Second, in addition to a Big 8/nonBig 8
indicator, another test variable coded ‘1’ for
industry specialist Big 8 auditor and coded ‘0’
for a non-specialist Big 8 auditor is included in
the model.
On top of a brand name premium, CFT
find a 34% premium to auditor industry
specialists. CFT’s findings raise two interesting
issues in terms of their interpretation and
generalisability. First, an important point to
note is that specialists were defined as those
auditors holding a 10% market share of either
clients or fees in ‘specialist’ industries.
However, the presence of the fee premium at
the 10% share is not replicated for a tighter
definition of specialist at the 20% level. CFT
suggest some caution in interpreting their
result, as it may be a product of a data artefact.
It also raises the issue of whether the presence
of economies of scale ‘kick-in’ at somewhere
between the 10% and 20% market share
level, mitigating any product differentiation
premiums at the higher market share threshold.
A second issue is the location of the
observed premium. The premium in CFT is
found for clients in ‘specialist’ industries; with
specialist industries defined using the Craswell
and Taylor (1991) methodology. For an
industry to be defined as a specialist industry as
per Craswell and Taylor, it must have a
minimum of 30 companies. The choice of this
threshold appears arbitrary. These issues are
examined further by Ferguson and Stokes
(2002).
Ferguson and Stokes (2002) [hereafter FS]
investigate audit pricing evidence following the
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CFT study. Their analysis incorporates audit
pricing implications following the 1989 audit
firm mergers forming the Big 6, and also
around the 1997 Price Waterhouse and Coopers
& Lybrand merger precipitating the formation
of the Big 5. FS pose the following two
questions; Do brand name premiums persist
following the two rounds of merger activity
after CFT? Do industry specialist premiums
persist after the same two rounds of merger
activity? To test these issues using a more
recent sample, audit fee and other necessary
data from hardcopy annual reports and other
sources for the years 1990, 1992, 1994, 1998
were acquired. The brand name and specialist
hypotheses are re-examined using similar
market share based definitions of specialization
as CFT. Additional market share sensitivities
are also tested in light of the merger activity,
and associated concentration effects.
The results documented in FS indicate that
the general brand name distinction between
large and small auditors is present. Second,
consistent with the prior CFT findings, when
tests of specialist premiums at various levels of
market share are undertaken, they produce only
mixed results. For example, FS tests of
specialist premiums using either fees or clients
at the 10% and 20% cut-offs, are observed in
only two out of four years. As a final test, the
logic of the auditor quality/industry specialist
argument is extended through tests for the
existence of premiums paid to auditor industry
leaders. Industry leadership is arguably more
unequivocal and unambiguous signal of
reputation than tests based on the arbitrary
market share categories first adopted in CFT.
6
Results of the tests of industry leadership
identify a change in the strength of the audit
industry leader co-efficients over time. In
earlier years (1990 – 1992), evidence of audit
6 A number of anecdotal reports, as well as the marketing
literature, discuss the reputation value of a ‘leadership
position’. For example, Hellofs and Jacobsen (1999)
cite efforts by Ford to maintain the market share
required to be the top-selling car in the US They
suggest:
“To be able to advertise “Taurus – America’s Best-
Selling Car Again,” Ford resorted to offering
$1000 rebates for the Taurus to protect its lead
over Honda’s Accord as the number-one-selling
car in the United States” (Naughton 1997).
industry leader premiums is reported. However,
by 1994, this premium has weakened to the
extent that when tests are run in specialist
industries, no evidence of leader premiums is
found. By 1998, no evidence of leader
premiums is present in either tests within
specialist industries or in tests across all
industries. However, the extent to which the
weakening of leadership premiums may be due
to economies of scale benefits is hard to
determine.
Two further findings in FS are noteworthy.
First, sensitivity tests show that when non-audit
service fees are added to the dependent
variable, the leadership premiums where
observed, disappear. This indicates that audit
pricing may be sensitive to potential non-audit
service revenues.
7
Second, in years when
leadership premiums are observed, when each
individual auditor is excluded one at a time, the
exclusion of KPMG results in no premium
being observed.
8
This suggests that leadership
fee premiums are sensitive to non-audit fees
and possibly individual auditor brand name
effects.
In summary, the weakening of reported
leadership premiums by 1994, and subsequent
disappearance by 1998 raises further issues
about the nature and existence of audit fee
premiums. One question that remained
unanswered in FS is whether the premium is
more likely to occur at the local office level, as
opposed to firm – wide or nationally.
9
This
question is considered by Ferguson, Francis
and Stokes (2003) [hereafter FFS (2003)].
7 These tests are consistent with those run by CFT p316
‘Jointness of audit and nonaudit fees’.
8 Interestingly, Gramling and Stone (2001) cite prior
studies suggesting that KPMG was the first Big 5
auditor to implement organizational restructuring along
industry service lines.
9 A caveat on this test is that there is no way of knowing
if only the top ranked firm earns a premium. If more
than one firm in an industry is perceived by the market
as holding a specialization, then this approach will
misclassify some specialists as non-specialists, and thus
weaken the design and statistical tests.
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5. Industry specialist premiums at
the local office level
FFS (2003) extend the investigation by FS of
large audit firm product differentiation. FFS
consider two contrasting ways of typifying the
operations of Big 5 accounting firms.
10
First
they consider the ‘firm-wide’ perspective,
where the operations of the Big 5 are viewed
on an aggregated or national level. Under this
view little differentiation is likely to exist
across individual offices and in terms of audit
pricing, a firm-wide measure of expertise is
appropriate. In contrast, under the ‘office level’
perspective, each office within the network
retains local idiosyncrasies. Since the audit
contract is conducted, administered and most
commonly signed-off on office specific
letterhead, it is argued that the local office level
constitutes an appropriate unit of analysis in its
own right. Under the office-level perspective,
expertise resides in human capital and
experience of staff in each office. Thus a
localised measure is relevant to capture
industry expertise in audit pricing.
FFS (2003) examine industry leading and
second ranked auditors both nationally and
locally, to counter any misspecification that
might result from industry expertise residing
outside the leading firm. The evidence
indicates that auditors who are one of the top
two ranked firm’s nationally and also local
industry leaders, enjoy 24% higher fees.
However, where the top two ranked firms
nationally are not the local industry leader, no
fee premiums are earned. Thus, FFS (2003)
conclude that an auditor must hold joint city-
level and national industry leadership to
generate premiums for industry expertise. This
implies the absence of any positive network
externality across offices.
Investigation of fee determination at the
local office level is extended further by
Ferguson, Francis and Stokes (2005) [hereafter
FFS (2005)]. FFS (2005) examine whether
results in FFS (2003) might be confounded by
the presence of city-specific overall market
leadership effects. FFS (2005) reaffirm that
joint local and national auditor expertise is
10 This approach is motivated by a prior study, Francis,
Stokes and Anderson (1999) who used US data.
valued by audit clients. In addition, they find
evidence that overall city-specific market
leadership also matters in fee determination,
although at weaker significance levels. Their
results highlight the importance of both city-
specific industry leadership, and city-specific
overall leadership in differentiating auditors.
6. Possible research directions
This review has focussed on the significant
contribution made by audit pricing studies
based on Australian audit fee data over the last
two decades. This period corresponds with the
competitive advantage in the form of audit fee
data availability Australian researchers have
enjoyed vis-a-vis those in the US. A ‘level
playing field’ with regard to audit fee
disclosure raises the question of the likely
direction of future Australian enquiry.
Fortunately the dynamic state of market
structure, coupled with regulatory interest in
accounting firms point to continuing
opportunities. Whilst current US studies are
likely to be directed at least in part by issues
raised in the prior Australian empirical
research, there will be an ongoing role for
Australian research effort in replication of US
audit pricing studies. The international interest
in such replication style papers will rest on the
importance to the literature of out of US sample
evidence. In addition to replications, the
following areas come to mind as possible
future research areas and constitute by no
means an exhaustive list.
6.1 Consolidation issues
Regulatory concerns about heightened
concentration in the market for audit services
represents something of an ‘old chestnut’, and
arguably first motivated Simunic (1980). Today
however, it remains an important issue facing
the profession as regulators across the globe
continue to express concerns about
concentration and its impact on competition.
11
For example in a recent Australian Federal
Treasury policy paper it is suggested:
‘In short, just 10 firms service nearly 80 per cent of
the market. The remainder is spread across firms
that audit less than three listed clients. With such
11 For example, regulatory bodies in the US have raised
recent concerns about the effects of increasing
concentration amongst large audit firms through
Sarbanes Oxley (2002).
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concentration, companies face a restricted pool of
audit firms with experience in auditing listed
companies. Where one of the major audit firms is
providing non-audit services to a company, the
pool of possible providers of audit services may be
even more limited. Choice would be further
restricted if a company did not wish to contract
audit services from a firm that audited a major
competitor’
12
Since the collapse of Arthur Andersen and
its subsequent merger with the Ernst & Young
in Australia, the number of top-tier competitors
both in Australia and internationally has been
reduced to four. Regulatory interest regarding
aspects of concentration and competition in the
audit market is being fuelled by the perceived
profitability of the Big 4. A number of
anecdotal reports are consistent with this
assertion.
13
Consequently, research examining
potential for collusive behaviour and indicators
of collusion such as industry profitability
appear to be of interest. A point to note is that
US fee disclosure does not extend back prior to
the demise of Arthur Andersen in 2001, so any
study examining fee effects prior to and after
this event will benefit from data outside the US.
6.2 Auditor independence
Independence concerns arising from joint
supply of audit and non-audit services have
been heightened by recent corporate collapses.
Early Australian evidence on this issue is
provided by Barkess and Simnett (1994) who
also examine the determinants of non-audit
service fees. Barkess and Simnett identify no
relationship between audit qualifications and
non-audit service fees. Wines (1994) also
examines auditor supply of non-audit services
and propensity to modify audit opinions, and
finds that auditors sourcing more non-audit
services from clients are more likely to provide
a clean opinion. More recently Craswell
(1999) finds that non-audit services do not pose
independence threats. Thus the bulk of
Australian evidence does not indicate
independence threats through non-audit service
provision.
In terms of further effort in this area,
researchers might consider that recent audit
12 CLERP Paper No.9: Proposals for Reform – Corporate
Disclosure. Part 3: The market for audit services.
13 See for example ‘Big Four, Big Worries’ BRW
10.04.03, and ‘Bloodied but Rich’ Business Week
03.06.02 pp. 74 – 75.
firm restructuring has seen consulting divisions
spun-off, which arguably resolves some of the
perceived independence threat. Consequently,
research effort on non-audit services using
Australian data will most likely evolve
more along the lines of recent US literature
such as Whisenant, Sankaraguruswamy and
Raghunandan (2003). This study examines
whether audit and non-audit services fees are
simultaneously determined. This approach has
not been replicated in Australia, and given the
non-audit services sensitivity results reported in
FS, joint determination represents an attractive
research question to be applied to Australian
data.
As observed in Footnote 1, research
questions involving non-audit services will also
be encouraged by enhanced non-audit fee
disclosure emanating from the CLERP Audit
Reform and Corporate Disclosure Act (2004).
This requires a breakdown of amounts paid to
auditors for different types of non-audit
services such as tax, consulting, IT, audit
related, accounting and due diligence to be
provided in notes to the financial accounts.
Interesting questions such as the relationship
between the magnitude of certain types of non-
audit services and audit fees remain under-
researched. Such research questions using
Australian non-audit fee disclosure will have
the added attractiveness due to the effective US
prohibition of all non-audit services apart from
tax under Section 201 of the Sarbanes Oxley
Act (2002). Thus whilst the US now has
comparable audit fee disclosure to Australia,
we maintain a disclosure advantage in terms of
non-audit fees.
6.3 Measurement Issues
A final suggestion relates to the potential for
improvements in the audit quality proxies
adopted in audit pricing studies. Gramling and
Stone (2001) contains a useful summary
including discussion of problems relating to
measurement of industry expertise. Gramling
and Stone list the three methods typically
adopted in the literature including: (1) industry
market share as a proxy for industry expertise,
(2) percentage of an audit firm’s revenue in an
industry relative to total revenue across all
industries and (3) specialist measures based on
self proclaimed industry specialization on
accounting firm web-sites. Each of these
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measures of industry specialisation has
potentially serious problems. For example,
using audit fees to construct market share
metrics to define specialisation or industry
leadership creates a potential endogeneity
problem, since the dependent variable is a log
of audit fees. This highlights a more general
problem faced by researchers in the economics
of auditing field which is the development of
valid measures of the audit quality construct.
One approach might be to make use of
capital market assessments to validate existing
audit quality measures. An example using
Australian data is Ferguson and Matolcsy
(2004), who examine audit quality measures in
a post-earnings announcement drift context.
14
Ferguson and Matolcsy examine large versus
small audit firm, industry specialist, and auditor
industry leader dummies - the same audit
quality metrics applied in FS. Interestingly,
Ferguson and Matolcsy find differing capital
market reaction when partitions are undertaken
within the Big 6/5 auditors themselves. This
result is not unsurprising given FS report that
the industry specialist premium disappeared
when KPMG was excluded from the sample,
implying that specialist premiums were
impacted by individual auditor brand name
effects.
Two points emerge from Ferguson and
Matolcsy (2004). First, it is likely that audit
pricing research will be increasingly directed at
identifying differences within the Big 4 as
opposed to simple comparisons of large and
small auditors. Second, novel ways of
validating and assessing audit quality metrics
are likely to be of interest to the both
practitioners and researchers alike.
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