The cost of audit qualifications: the role of non-audit services

The Cost of Audit Qualifications: The Role of NonAudit Services K. A. Houghton C. A. Jubb

This study argues that the incremental audit production costs associated with issuing a qualified opinion are difficult for public accounting firms to recoup through audit fees alone. It proposes that audit production costs associated with qualifications may be recouped through non-audit service (NAS) fees in addition to audit fees. Further, it proposes that such recoupment follows a differential timing pattern. Audit fees, because of their more constrained nature, are more likely to be elevated as a consequence of qualification presence in the year subsequent to the qualification. On the other hand, NAS fees, by virtue of their very nature and more flexible billing opportunities provided, are likely to be so affected in the year concurrent with the qualification. The research is based on Australian data, as there are few jurisdictions in the world that require disclosure of both audit and non-audit fees. Using a sample of 270 companies, a significant and positive association is found between the presence of an audit qualification and significantly higher fees paid. This relationship holds both in the case of an audit qualification contemporaneous with the fee charged, and of one occurring in the year preceding the disclosed fee(s). The effect on audit fees, however, occurs only on a lagged opinion basis, while the effect on NAS fees occurs only on a concurrent opinion basis. © 1999 Elsevier Science Inc. All rights reserved. Key Words: Audit Fees; Non-Audit Service Fees; Market for Audit Services; Audit Qualification

INTRODUCTION A substantial amount of research in much of the Western world has examined the determinants of audit fees (e.g., Butterworth & Houghton, 1995; Francis

K. A. Houghton 4482.

●

University of Melbourne, Parkville, Victoria, Australia; Phone: ⫹61 03 9344

Journal of International Accounting, Auditing & Taxation, 8(2):215–240 ISSN: 1061-9518 Copyright © 1999 by Elsevier Science Inc. All rights of reproduction in any form reserved.

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& Simon, 1987; Simunic, 1980). Almost invariably, these audit fee models have considered the content of the audit opinion key to fee level paid, and, in general, the significance of the qualification variable has been established. The theoretical importance of the audit opinion as a basis of audit fees resides in both (1) the differential audit risk, and (2) the audit effort, argued to accompany a qualified audit opinion. Such explanations apply in all audit markets, although the relative importance of the two may differ. Chan, Ezzamel, and Gwilliam (1993) report that interviews with audit firm partners reveal that auditee risk is perceived to have an important impact on levels of audit fees. This study argues that additional costs to the auditor arising from the decision to issue an audit qualification are not necessarily recouped through the audit fee alone. In situations where an incumbent auditor provides non-audit services (NAS) to the client, NAS fees for those services also are likely to play a role in the auditor’s cost-recoupment strategy. For example, with high litigation risk in the US, differential audit risk may be the more powerful explanation for additional fees, whereas in a market like Malaysia, where litigation against auditors is almost unheard of, cost associated with the additional work required for qualification is a more likely explanation. The specific role played by the auditor may reflect legitimate or “attachable” NAS service costs that arise in association with a more complex audit. It is argued in this paper that additional fees, either NAS or audit fees, are more likely to be billed to a client in receipt of a qualified opinion than one receiving an unqualified opinion. We further argue that the public accounting firms may make use of NAS fees as a means of relieving market constraints imposed by factors such as audit fee tendering and fixed audit fee billing. Since audit production costs are likely to be higher for auditees in receipt of qualifications, and since the likelihood of issuing a qualified opinion is not always easy to predict ex ante (Anderson, Francis, & Stokes, 1993), audit cost recoupment is likely to be more problematic in situations involving qualified opinions than in those involving unqualified opinions. Further, this paper proposes that a timing differential will arise in connection with recoupment of incremental audit firm costs associated with an audit qualification. Because of the greater likelihood of billing constraints for audit services (compared to NAS) and the ex ante difficulty of predicting when such additional costs might be relevant, it is likely that for audit fees, such production costs are recouped in the year subsequent to the qualification. If, on the other hand, recoupment of such production costs is approached using the NAS fee, the timing is likely to be concurrent with the year of qualification because of the flexibility argued to be associated with non-audit services.1 If evidence is consistent with the hypothesized directional relationship, an audit qualification may have direct costly consequences, of which shareholders, directors, managers, consumers, and regulators are insufficiently aware. Directors

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who insist on a particular accounting policy with which the auditor disagrees must be made fully aware of the costs associated with such a decision.2 Additionally, examining the relationship between fees and qualifications is likely to aid general understanding of the market for audit services. This understanding is of importance to both the consumers and providers of audit services, and to those attempting to regulate that market. In particular, this study has the potential to further our understanding regarding the presence, extent, and timing of the relationship between audit and NAS fees, as well as between audit qualifications and both types of fee.

THEORY

AND

DEVELOPMENT

OF

HYPOTHESES

Audit fee models have been used in research in many parts of both the Western and developing worlds, and they have frequently recognized the role that audit qualifications play in the explanation of fees paid to public accounting firms (e.g., Simunic, 1980). The theoretical rationale for this association is twofold, involving considerations of audit risk and audit effort. The next section discusses these two considerations. Audit Qualifications and Audit Risk That a higher audit risk is associated with a qualification stems from the fact that a qualified opinion may indicate the existence of uncertainty, financial or otherwise, surrounding the auditee (Dopuch, Holthausen, & Leftwich, 1987). Additionally, the circumstances giving rise to the qualification may, in themselves, increase the risk of litigation against the auditor (Palmrose, 1986; Lys & Watts, 1994; Simunic & Stein, 1996). For instance, financial distress increases: (a) chances for errors (Kreutzfield & Wallace, 1986); (b) incentives for management manipulation (DeAngelo, DeAngelo, & Skinner, 1994; Kinney & McDaniel, 1989; Schwartz, 1982); (c) auditor/client disagreements (DeFond & Jiambalvo, 1994; Dhaliwal, Schatzberg, & Trombley, 1993; Fisher & Fisher 1993); (d) the likelihood of non-routine management changes (Pourciau, 1993; Schwartz & Menon, 1985); and (e) delays in the timeliness of filing auditor change notifications (Schwartz & Soo, 1995). Since it is more likely that an auditor’s practice will be damaged through involvement with a particular auditee if the stakeholders in that auditee have suffered economic loss (Kaplan, 1987; Pratt & Stice, 1994; St. Pierre & Anderson, 1984; Stice, 1991), an audit resulting in qualification generally is perceived to be accompanied by a higher risk profile than that resulting in an unqualified opinion (Simunic, 1980). In the presence of a competitive market for audit services then, it is reasonable to argue that an auditor will charge a higher premium for a client associated with higher audit risk (Simunic & Stein, 1996).3

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It is possible to argue that the act of qualifying reduces litigation risk to the auditor since it represents an acknowledgment of financial statement problems for the audit period just passed (Carcello & Palmrose, 1994). A qualification is unlikely, however, to diminish litigation risk related to prior periods and may in fact do the opposite, serving as a signal that problems existed prior to their explicit recognition through the qualified opinion (see Carcello & Palmrose, 1994; Lys & Watts, 1994). Generally, audit fee model studies that include audit opinion as a measure of risk find a positive association between a qualification and audit fees (Butterworth & Houghton, 1995; Craswell, Francis, & Taylor, 1995; Francis & Simon, 1987; Francis & Stokes, 1986; Palmrose, 1986; Simon & Francis, 1988; Simunic, 1980)4 although this finding is not universal (e.g., Anderson & Zeghal, 1994; Balachandran & Simon, 1993; Eichenseher, 1995; Francis, 1984; Low, Tan, & Koh, 1990; Simon, 1985; Turpen, 1990). Chan et al. (1993) report that interviews with audit firm partners reveal that auditee risk5 is perceived to have a significant impact on audit fee levels. Pratt and Stice (1994) find that partners and managers adjust fees for the client characteristics determined by Stice (1991) to be predictive of litigation. Yet Wallace (1989) finds that audit fees are not sufficiently sensitive or adjusted in relation to differential client risk. Similarly, Hill, Ramsay, and Simon (1994) find evidence of insufficient risk adjustment in fees for savings and loan clients (Simunic & Stein, 1996). It is argued here that a possible reason for such conflicting findings in the literature is the timing of the recognition of audit risk as reflected in the content of the audit opinion. For example, an audit qualification in year t0 may not be reflected fully in the audit fee for that same period.6 It is possible that an auditor is unable to assess completely the audit risk reflected in an audit qualification until period t1 — the audit period immediately succeeding the issuance of the qualified audit opinion. Stein, Simunic, and O’Keefe (1994), in a survey of self-reported staff production times at one of the Big Six, find that the content of the auditor’s opinion has no effect on either audit production hours reported or audit fees, for either industrial or financial clients. Yet the audit delay literature provides evidence that qualifications are associated with delay in both reporting earnings and release of the audit report, as well as positing that additional audit effort and auditor/client negotiations surrounding a qualification are reasons for this result (e.g., Ashton, Willingham, & Elliott, 1987; Bamber, Bamber, & Schoderbeck, 1993; Carslaw & Kaplan, 1991; Whittred, 1980; Williams & Dirsmith, 1988). While the final decision to not qualify similarly might involve increased audit effort and negotiation, it is to be expected that qualifications are associated with incremental audit production costs. In part, the ability to charge for the high level of audit risk associated with an audit qualification depends on the nature of the contract between the auditor and client. Where the contract specifies a fixed fee, the likelihood of that fee

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reflecting contemporaneously the elevated level of audit risk is low. This type of contract has potential implications for the relationship between audit qualification and audit effort; however, while Palmrose (1989) finds evidence of lower fees for fixed-fee engagements, she notes “. . . that neither type of contract is of a single form” (p. 489). Some fixed-fee contracts are subject to adjustment for changed or unexpected circumstances. Audit Qualifications and Audit Effort The second reason why audit qualifications may be associated with higher audit fee levels arises from the process by which audit qualifications are issued. The accounting profession in Australia and elsewhere argues that fees should be based on the time taken to execute the work deemed to be required.7 An audit qualification invariably adds more billable hours to the audit process. This is because qualifications tend to require the accumulation of a greater amount of evidence to achieve the auditor’s desired level of assurance (Palmrose, 1986). If one assumes that the audit fees charged are, in part, a function of the hours of audit work accumulated, an audit engagement ending in a qualified audit opinion is likely to yield a higher fee than one that ends in an unqualified opinion. Timing Considerations The previous section argued that, because an audit qualification increases a client’s audit risk and is likely to require additional effort, the audit fee is likely to rise for a company given a qualified opinion. It is expected that this relationship will often hold, whether the qualification is contemporaneous with the relevant fee or precedes it. In a situation where there is no fixed-fee contract and the audit fee is charged on the basis of hours worked, then an auditee subject to a qualified audit opinion in period to is likely to face a higher audit fee for that year. Similarly, an auditor commencing an audit for a client that has previously received a qualification is likely to plan and execute an audit program with higher levels of testing than would be conducted for a client with a previously unqualified audit opinion. Therefore, for both the current and preceding year audit qualifications, the client is more, rather than less, likely to have an elevated audit fee. Because of explicit contractual obligations or implicit assumptions about the audit fees chargeable, however, it is possible that fee elevation may not be observable in the accounting period to which the audit qualification relates. That is, the ability to charge the auditee a fee relating to the qualification may be constrained for legal, practical, and professional reasons, thereby delaying any fee recoupment until the next (and perhaps subsequent to that) accounting period(s). Thus, the presence of an elevated fee may be less likely when measured contem-

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poraneously with the qualification than when the fee is lagged relative to the audit opinion in question. Fees to Public Accounting Firms: Non-Audit Service (NAS) Fees The previous section argued that fees paid to public accountants increase as a consequence of receipt of an audit qualification. It is proposed here, however, that such an elevated fee may not be reflected in the audit fee alone. In cases where the incumbent auditor provides concurrent NAS, the potential exists for NAS fees to reflect also, meritoriously or otherwise, fees connected with the audit function, for two reasons. First, incumbent auditors may experience difficulties in allocating fees accurately to each service, since joint product synergies can flow in either and, on occasion, both directions. NAS provided by consultants familiar with auditing should assist the auditor because it is more likely that auditable systems will be suggested (and implemented) by such consultants (Abdel– khalik, 1990). Similarly, the familiarity with client systems gained during the audit can potentially spillover into the NAS provided. Several studies have found evidence of knowledge spillovers in the joint provision of NAS and audit (e.g., Simon, 1985; Simunic, 1984; Turpen, 1990). In a finding that casts doubt on the existence of knowledge spillovers, however, Palmrose (1986) found that for both incumbent and non-incumbent auditors, there was a positive relationship between audit fees and NAS. She speculated that higher audit fees paid by clients who also purchase NAS may be explained by additional audit effort. Davis, Ricchiute, and Trompeter (1993), using actual billing records, found that additional audit effort is required for audits of clients who also purchase NAS. Those authors argue that this finding does not necessarily imply the nonexistence of knowledge spillovers; instead, it may be that savings from production efficiencies may have been passed on to clients. They also speculate that NAS may lead to greater audit requirements through greater financial complexity associated with consultants’ suggestions (e.g., leasing rather than borrowing). Another line of argument, however, suggests that NAS fees may be misclassified (Solomon, 1990). Solomon argues that compensation incentives exist for audit partners to arbitrarily classify fees as audit or non-audit. Barkess and Simnett (1994), in a test of presence versus extent of NAS purchased in association with the audit fee, discount this argument. Butterworth and Houghton (1995), searching for evidence of price cutting on initial audit engagements, find evidence of NAS fee and audit fee cross-subsidization where an audit is performed as an initial engagement. Further, it is argued here that the fee for the NAS component of an incumbent audit firm’s portfolio of tasks is less price-sensitive and less constrained to increase than the audit fee because, by its nature, it is less likely to be subject to tender or a fixed-fee billing arrangement. In addition, while the audit fee may be

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seen by directors and shareholders as simple, compliance-type work, NAS fees are more “value adding.” The fact that one is a “necessary evil” and the other may be seen as adding to shareholder wealth also contributes to the notion that NAS is less price-sensitive than are audit fees. If it is accepted that audit and NAS fees are interrelated and that NAS fees are able to be “managed,” it is expected that NAS fees will reflect the impact of an audit qualification. For the NAS fee, however, the expectation is that the increase will be reflected in the time period concurrent with the qualification rather than in the year subsequent. The above discussion gives rise to the following hypotheses: H1:

All other things being equal, audit qualifications will give rise to significantly higher total (audit plus NAS) fees paid to auditors.

H2:

Audit qualifications significantly affect audit fees in the year subsequent to the qualification.

H3:

Audit qualifications significantly affect NAS fees in the year concurrent with the qualification.

While these hypotheses and the theory that underpins them may be equally applicable to many audit markets around the world, it is only in a few countries that these issues can be investigated to any extent. The only site known to the present writers, where both audit and NAS fee data is readily available, is Australia.

FOCUS

OF

STUDY

AND

METHODOLOGY

The focus of the present study is to examine whether increased audit fees arising as a result of an audit qualification are reflected in either audit or NAS fees, or both, and the timing of any such reflections, ceteris paribus. We test this by examining the presence of an audit qualification relative to both the contemporaneous and lagged audit fee, for both the NAS fee and total (audit plus NAS) fee. While it is hypothesized that audit qualifications influence fees paid to the auditor, previous studies (e.g., Firth, 1985; Francis, 1984; Francis & Simon, 1987; Simunic, 1980) have shown that several additional variables are also significant. Amongst these variables are auditee risk, auditee size, auditee complexity, auditee industry, and auditor size. Each of these variables is discussed in turn. These variables need to be controlled so the effect of the hypothesized variable “audit qualification” is not confounded. Many audit fee studies use the variable of interest here, “audit qualification,” to operationalize auditee risk (e.g., Francis & Stokes, 1986; Maher et al., 1992; Simunic, 1980). Jubb, Houghton, and Butterworth (1996) argue that this measure

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proxies for client “business risk,” and that it is necessary to also capture “audit risk” by incorporating a second measure of risk. The ratio of inventory-plusreceivables to total assets, they argue, captures this second dimension of risk by proxying for risky or hard-to-audit assets. Like audit qualification, it is a measure that has been used frequently in previous literature (e.g., Chung & Lindsay, 1988; Francis & Simon, 1987; Simon, 1985), often concurrently with audit qualification. Auditee size is expected to influence fees because as the auditee increases in size, it is likely that the auditor will need to perform more work to ensure adequate tests of control and substantive testing. The rate of increase in fees is likely to decrease with size because the larger the auditee, the easier it is for the auditor to achieve economies of scale in the production function (Firth, 1985), the savings from which may be passed on to the client. Additionally, sample sizes involved in audit testing increase at a decreasing rate (Simunic, 1980). Auditee size has been found consistently to be a significant determinant of audit fees. Auditee complexity is another variable that consistently gives evidence of significance in audit fee modeling studies (e.g., Butterworth & Houghton, 1995; Taylor & Baker, 1981). It is to be expected that the more complex the client, the more time the audit manager must spend coordinating the audit function and the greater the difficulty of performing the audit duties. Thus, increasing client complexity is likely to be more demanding in terms of audit resources and result in a higher fee. This function may also increase at a decreasing rate (see Palmrose, 1986). In previous fee studies, auditee industry category has received mixed results as to significance. The rationale behind its possible influence lies in likely differential audit risk profiles across industry groupings (Palmrose, 1986; Simunic, 1980), and there have been calls within the literature to develop industrycontextual audit fee models (Low et al., 1990). It can be argued that any industry effect should be reflected through other variables already captured in the model (e.g., inventory plus receivables/total assets). The industry itself, however, is a significant explanatory variable in some studies (e.g., Anderson & Zeghal, 1994; Butterworth & Houghton, 1995; Gerrard, Houghton, & Woodliff, 1994; Low et al., 1990; Palmrose, 1986). In addition, the deliberate omission of particular industry sectors from some studies because of their potential to be “nonrepresentative” (e.g., Firth, 1985; Simunic, 1980), along with the findings regarding supply segmentation along industry specialist lines (Craswell & Taylor, 1991; Ritson, Jubb, & Houghton, 1997) all justify this variable’s separate inclusion in the present study. Many previous studies have shown that auditor size is an important determinant of fees. Possibly this is because larger auditors can achieve economies of scale in their production function, the savings from which may be passed on to clients (Firth, 1985). Alternatively, it may be that larger auditors deliver higher quality audits since they conceivably have more to lose from a market perception of poor quality (De Angelo, 1981).

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Finally, NAS fees have been found to both influence audit fees (Butterworth & Houghton, 1995; Simon, 1985; Turpen, 1990) and be influenced by audit fees (Barkess & Simnett, 1994). This may be because of audit fee/NAS fee tradeoffs (Solomon, 1990) or because of the potential spillover effects (Abdel– khalik, 1990; Palmrose, 1986; Simunic, 1984) that arise when an incumbent auditor performs either service for a client. Measurement of Variables The following describes the measurement procedure used for each of the hypothesis, control, and dependent variables. Dependent Variables Audit Fees. The measurement is log10 of the dollar value of the audit fees reported in the 1988 financial reports of the sample companies. Unlike in previous U.S. studies, these data are public information by virtue of the regulated minimum disclosure rules of the Australian Companies Act, 1988 (now the Australian Corporations Law). Measurement is therefore likely to be both reliable and not subject to significant error. Non-Audit Service Fees. The measurement is log10 of the dollar value of the NAS fees reported in the 1988 Accounting Reports of the sample companies. Like audit fees, these data are public information in Australia and are required to be separated into fees attributable to the auditor and fees attributable to other service providers. Total Fees. The measurement is log10 of the dollar value of the total of the two previous categories: audit plus NAS fees. Independent Variables Separate regressions are to be processed using as the hypothesis variable the lagged and concurrent audit opinion, respectively: Variable of Interest: Audit Opinion (Lagged). This variable is coded 1 where the auditor has issued to the auditee a qualified audit opinion (of any type) in the year preceding the audit fee measurement; otherwise 0. Variable of Interest: Audit Opinion (Concurrent). This variable is coded 1 where the auditor has issued to the auditee a qualified audit opinion (of any type) in the year concurrent to the audit fee measurement, otherwise, 0.

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Control Variables Auditee Size. This measure is of reported total assets of the auditee measured contemporaneously with the audit fees. That is to say, reported 1988 total assets of the auditee is the measure employed. Because audit fees can be expected to increase at a decreasing rate as auditee size increases, the specific measure used here is a log10 transformation of the total assets of the auditee. Auditee Complexity. Consistent with some of the existing literature (e.g., Butterworth & Houghton, 1995), the measure of auditee complexity here is taken as the number of legal entities within the corporate group. That is to say, the number of subsidiaries within the group (plus one for the holding company). Again, because audit fees are likely to increase at a decreasing rate as auditee complexity increases, a log10 transformation is used. The measure of auditee complexity is contemporaneous with the audit fee. That is to say, the number of subsidiaries reported in 1988 is used as the basis of measurement.8 Audit Risk. The ratio of inventory and receivables to total assets is used as the measure for audit risk. This ratio is believed to capture risky or hard-to-audit assets that involve audit time and effort beyond that of other assets. Auditee Industry. Previous studies in this field have observed that auditee industry can have a significant influence on the level of audit fees. This variable is controlled using a dummy variable, coded 1 for companies designated as mining or extractive industry companies; otherwise, 0. Auditor Size. This is measured as 1 if the auditor comes from the “first tier” (i.e., Big Eight at that time, now Big Six) group of auditors; otherwise, this is coded 0. The Model The above variables, together with the variable of interest, “audit qualification,” are incorporated into multiple regressions of the following form, substituting respectively audit fee and NAS fee as the dependent variable instead of total fees, and incorporating both lagged and contemporaneous audit opinion measures: TOTFEE i ⫽ b 0 ⫹ b 1 AUDQUAL i ⫹ b 2 SIZE i ⫹ b 3 COMP i ⫹ b 4 AUDRISK i b 5 IND i ⫹ b 6 AUD i where: TOTFEEi ⫽ Audit plus NAS fee charged to auditee i (log10); AUDQUALi ⫽ Audit Opinion (contemporaneous or year preceding);

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SIZEi ⫽ Size of auditee i (log10); COMPi ⫽ Complexity of auditee i (log10); AUDRISKi ⫽ (Inventory ⫹ Receivables)/Total Assets INDi ⫽ Industry Sector (Mining/Non-Mining); AUDi ⫽ Size of auditee i’s auditor (Big Eight or Non-Big Eight); ␮ ⫽ Error (assumed to have a normal distribution and constant variance). Data The data used in this study come from two successive years of Annual Reports of the populations of companies under the regulatory supervision of the (then) Department of Corporate Affairs in Perth, Western Australia (now the Western Australian Division of the Australian Securities and Investment Commission). These data comprise 433 companies for the years 1987 and 1988. From this population the data selection process yielded 270 companies as follows: Valid Number of Cases (1) (2) (3)

Total companies on file Companies still active (neither failed nor dormant) Companies had filed a current annual report which had been processed by the regulators at the time of data collection (4) All information relating to independent variables was determinable (5) Companies for whom auditor, audit fee and NAS fee could be determined

433 349 305 293 270

This is the most recent complete set of data available from the regulatory source noted above. While other more recent data sources are available, the data set used provided detailed information of high integrity.

RESULTS Descriptive Statistics Table 1 shows the industry breakdown of the companies in the data set. As can be observed, a high proportion (52%) of the companies come from the extractive industry. Table 2 shows that a relatively low proportion of companies from the mining industry have received qualified audit reports: both in respect of substantive (i.e., subject to, adverse) and minor (i.e., except for a minor issue) audit qualifications. The analysis that follows is based on all forms of audit qualification (re-analysis using only substantial qualifications produced similar results.)

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TABLE 1

Sample Coverage Industry Stock Exchange Industry R & D - Hi-Tech R & D - Others Retail Manufacturing Consultancy Property Investment Investment - Others Financial Services Leisure & Tourism Construction Mining (Extractive) Transport Health Farming TOTAL

Sample Classification 8 (3%) 7 (3%) 28 (10%) 26 (10%) 8 (3%) 9 (3%) 21 (8%) 9 (3%) 5 (2%) 1 (0%) 140 (52%) 2 (1%) 4 (2%) 2 (1%) 270

As noted above, the mining industry is significantly less costly to audit than non-mining companies (Butterworth & Houghton, 1995). This is to be expected, given average mining company size (as measured by total assets) compared to non-mining companies (Table 2); the nature of their inventory; and the governing accounting standard (AASB 1022, 1989), which arguably allows wide discretion in the expense-versus-capitalize decision surrounding exploration and development expenditures.9 Table 3 displays the correlations between the variables. As expected, there is a high correlation between Auditee Size and Complexity and between Auditee Size and all measures of Fee. Audit Qualifications and Total (Audit Plus Non-Audit) Fees The analysis focusing on Hypothesis 1, the impact of audit qualifications on total fees, can be found in Table 4. Results are reported for the full sample and the mining/non-mining subsamples because of the high proportion of mining companies in the sample. For the full sample of companies, the relationship between both the lagged (i.e., one year prior to the audit opinion) and contemporaneous (same year as the audit opinion) measures of audit opinion show a significant, positive association (p ⫽ .040 and p ⫽ .015, respectively) with the variability in audit fees. That is, as hypothesized, an audit qualification in one year gives rise to a significantly higher total fee in both the concurrent and next accounting period. Thus, ceteris paribus, an audit client is likely to pay significantly higher fees to the auditor when an audit qualification is issued than when an unqualified opinion is given.

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227 TABLE 2

Descriptive Statistics Total Sample n ⫽ 270

Variable

Mean Std. Dev. $A000 46.99 192.49 27.01 105.53 74.00 291.08 92,525 617,225

Audit Fee ($A000) NAS Fee (A000) Total Fee ($A000) Total Assets ($AM)

Non Clean opinions (contemporaneous) Non Clean Opinions (lagged) Substantive* Qualifications (contemporaneous) Substantive* Qualifications (lagged) (Inv. ⫹ Rec)/ Total Assets Audited by Big Eight Firms

Mining Sub-Sample n ⫽ 140 Mean $A000 21.32 13.82 35.13 50,282

Std. Dev. 39.29 26.95 63.33 280,475

Non-Mining Sub-Sample n ⫽ 130 Mean $A000 74.65 41.21 115.85 138,018

Std. Dev. 272.23 148.48 411.05 840,020

Total Sample %

Mining Sample %

Non-Mining Sample %

31.5%

27.9%

35.4%

26.7%

21.4%

32.3%

4.8%

1.4%

8.5% 17% (Range 0–87%)

1.4% 8% (Range 0–58%)

61%

57%

8.54% 16.2% 26% (Range 0–87%) 65%

* Substantive qualifications here refers to ‘adverse,’ ‘subject to,’ and ‘except for’ qualifications.

This result does not hold at all, however, for mining companies and holds only for the concurrent opinion (p ⫽ .009) for non-mining companies. Audit Qualifications and Audit Fees The second hypothesis posits that the potential to elevate the audit fee associated with a qualification will be constrained in the year concurrent with the qualification but not so in the year subsequent. In order to test this hypothesis, the following regression model was used: AUDFEE i ⫽ b 0 ⫹ b 1 AUDQUAL i ⫹ b 2 SIZE i ⫹ b 3 COMP i ⫹ b 4 AUDRISK i ⫹ b 5 IND i ⫹ b 6 AUD i ⫹ b 7 NAS i ⫹ ␮ where: AUDFEEi ⫽ Audit fee charged to auditee i (log10); and all other variables are as specified in the model of total fees described above.

.93** .71** .36** .28** .64** ⫺.27** .01 .03 .36**

Audit Fee NAS Fee Auditee Size Risky Assets Complexity Industry Opinion (contemporaneous) Opinion (lagged) Auditor Size

Significance: * ⬍ 0.05, ** ⬍ 0.01

Total Fee

Variable .49** .73** .30** .68** ⫺.29** ⫺.04 .03 .34**

Audit Fee

.47** .09 .32** ⫺.07 .05 .04 ⫺.08

NAS Fee

.02 .53** ⫺.08 ⫺.20** ⫺.14* .26**

Auditee Size

.27** ⫺.49** .05 .10 .04

Risky Assets/TA

⫺.22** ⫺.05 ⫺.07 .24**

Complexity

⫺.08 ⫺.12* ⫺.08

Industry Group

Correlations Between Dependent and Independent Variables

TABLE 3

.44** ⫺.11

Opinion Contemporaneous

⫺.07

Opinion Lagged

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229 TABLE 4

Regression of Audit Opinion (Concurrent and Lagged), Auditee Size, Auditee Complexity, Auditor Size, Risky Assets and Auditee Industry (by Mining/NonMining Sub-Groups) on Total Fee

Dependent Variable: Total Fee Audit Opinion (lagged) Audit Opinion (contemporaneous) Auditee Size Auditee Complexity Auditor Size Risky Assets Industry Constant R Square (adj.) F Significance

Total Sample n ⫽ 270 T

Mining Companies n ⫽ 140

Non-Mining Companies n ⫽ 130

P-Value

T

P-Value

T

P-Value

.040

1.762

.080

1.429

.156

.015 .000 .000 .000 .003 .127 .000

0.354 8.220 2.698 2.461 2.296

.724 .000 .008 .015 .023

2.646 7.923 5.339 3.303 1.940

.009 .000 .000 .001 .055

2.066 2.460 11.809 6.110 4.363 2.985 ⫺1.531 16.553 65.6% 70.09 .000

17.092 .000 56.9% 31.56 .000

11.936 .000 67.3% 41.09 .000

Variable Measures: Total Fee ⫽ log10 of published audit plus non-audit service fee. Audit Opinion ⫽ dummy coded 1 if auditee receives an audit qualification in contemporaneous and/or lagged year respectively. Auditee Size ⫽ log10 book value of auditee’s total assets. Auditee Complexity ⫽ log10 of subsidiaries ⫹ 1. Auditor Size ⫽ dummy coded 1 if auditor is in the Big Eight. Risky Assets ⫽ (Inventory ⫹ Receivables)/Total Assets. Industry ⫽ dummy coded 1 if Mining.

The results are reported in Table 5, again on a total sample and industry sub-sample basis. As can be observed, for the total sample, the relationship between the lagged measure of audit opinion shows a highly significant, positive association with the variability in audit fees (p ⫽ .014). That is to say, an audit qualification in one year gives rise to a significantly higher audit fee in the next accounting period. Thus, ceteris paribus, an audit client is likely to experience a significantly higher audit fee in the year after an audit qualification is issued by the auditor than it would if an unqualified opinion were incorporated within the audit report. This result holds for the non-mining company subsample (p ⫽ .031) but not for the mining company group (p ⫽ .254). The control variables are all significant and in the expected direction. The relationship between the audit opinion and audit fees is insignificant when a contemporaneous measure of audit qualification is used. This result is consistent with four possible scenarios, each of which may be present to some degree: (a) auditors being unable (ex ante)10 to fully recognize the risk a particular client represents;11 (b) auditors being unable to contemporaneously recoup any

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TABLE 5

Regression of Audit Opinion (Concurrent and Lagged), Auditee Size, Auditor Size, Complexity, Non-Audit Service Fees, Risky Assets and Auditee Industry (by Mining and Non-Mining Sub-Samples) on Audit Fee

Dependent Variable: Audit Fee Audit Opinion (lagged) Audit Opinion (contemporaneous) Auditee Size Auditee Complexity Auditor Size NAS Fee Risky Assets Industry Constant R Square (adj.) F Significance

Total Sample n ⫽ 270 T 2.489

P-Value

Mining Companies n ⫽ 140 T

Non-Mining Companies n ⫽ 130

P-Value

T

P-Value

.014

1.146

.254

2.188

.031

0.464 .643 11.287 .000 7.307 .000 2.771 .006 2.674 .008 3.477 .001 ⫺2.234 .026 19.760 .000 71.0% 78.67 .000

⫺0.198 7.871 4.327 2.444 1.856 0.918

.844 .000 .000 .016 .066 .360

0.994 7.899 5.525 1.413 1.884 3.096

.323 .000 .000 .161 .062 .003

14.895 .000 62.4% 33.18 .000

14.726 .000 72.1% 44.25 .000

Variable Measures: Audit Fee ⫽ log10 of published audit fee. Audit Opinion ⫽ dummy coded 1 if auditee receives an audit qualification in contemporaneous and/or lagged year respectively. Auditee Size ⫽ log10 book value of auditee’s total assets. Auditee Complexity ⫽ log10 of Subsidiaries ⫹ 1. Auditor Size ⫽ dummy coded 1 if auditor is in the Big Eight. Non-Audit Service Fee ⫽ log10 of published non-audit fee. Risky Assets ⫽ (Inventory ⫹ Receivables)/Total Assets. Industry ⫽ dummy coded 1 if Mining.

changes in costs; (c) auditors being unable to contemporaneously charge an audit fee premium for enhanced levels of risk; and (d) auditors classifying additional audit costs as NAS fees rather than as audit fees. It is not possible, within the confines of the present study, to discriminate between the first three of the four possible explanations. However, the fourth possibility is encompassed in the third hypothesis. It can be tested by examining the relationship between NAS and qualifications and comparing it to the one between total fees and qualifications. Audit Qualification and Non-Audit Service Fees In order to test for an association between an audit qualification and NAS fee, a model based on Barkess and Simnett (1994) and similar to that used in the previous section is used. In this instance, the NAS fee becomes the dependent variable, so that the model appears as follows:

The Cost of Audit Qualifications

231 TABLE 6

Regression of Audit Opinion (Concurrent and Lagged), Auditee Size, Auditee Complexity, Auditor Size, Risky Assets, and Auditee Industry (by Mining/NonMining Sub-Samples) on NAS Fee

Dependent Variable: Non-Audit Service Fee Audit Opinion (lagged) Audit Opinion (contemporaneous) Auditee Size Complexity Auditor Size Audit Fees Risky Assets Industry Constant R Square (adj.) F Significance

Total Sample n ⫽ 270 T 0.600

P-Value

Mining Companies n ⫽ 140 T

P-Value

Non-Mining Companies n ⫽ 130 T

P-Value

.549

1.330

.186

0.225

.822

2.031 .043 2.981 .003 ⫺0.507 .613 2.381 .018 2.674 .008 0.099 .921 1.358 .176 ⫺1.905 .058 24.1% 11.08 .000

0.314 1.496 ⫺1.222 0.696 1.856 1.928

.754 .137 .224 .487 .066 .056

1.919 2.202 0.108 2.649 1.884 ⫺0.564

.058 .030 .914 .009 .062 .574

⫺0.964 .337 15.7% 4.63 .000

⫺1.725 .087 33.3% 9.36 .000

Variable Measures: Non-Audit Service Fee ⫽ log10 of published non-audit service fee. Audit Opinion ⫽ dummy coded 1 if auditee receives an audit qualification in contemporaneous and/or lagged year respectively. Auditee Size ⫽ log10 book value of auditee’s total assets. Complexity ⫽ log10 of subsidiaries ⫹ 1. Auditor Size ⫽ dummy coded 1 if auditor is in the Big Eight. Audit Fee ⫽ log10 of published audit fee. Risky Assets ⫽ (Inventory ⫹ Receivables)/Total Assets. Industry ⫽ dummy coded 1 if Mining.

NASFEE i ⫽ b 0 ⫹ b 1 AUDQUAL i ⫹ b 2 SIZE i ⫹ b 3 COMP i ⫹ b 4 AUDRISK i ⫹ b 5 IND i ⫹ b 6 AUD i ⫹ b 7 AUDFEE i ⫹ ␮ where: NASFEEi ⫽ Non-audit service fee charged to auditee i (log10); and all other variables are as specified in the model of total fees and audit fees described above. Table 6 shows that, for the full sample, there is a significant and positive relationship between the NAS fee measured on a contemporaneous basis and a qualified audit opinion, but not for the lagged opinion (p ⫽ .043 and p ⫽ .549, respectively). This result is consistent with H3, which hypothesizes that the NAS fee will

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be used as a repository for charges associated with the additional audit effort expected to accompany a qualification. It is also consistent with a legitimate need for NAS in the year after the audit qualification. It is argued here that the reversal in relative significance of the contemporaneous versus lagged opinion when NAS fees (Table 6), rather than audit fees (Table 5) are examined is consistent with the greater likelihood that NAS is charged on a fee-for-service basis rather than a fixed-fee basis. The significance of the contemporaneous audit opinion when regressed on non-audit service fees supports the argument that NAS fees are being used as a repository for qualification-associated charges on a contemporaneous basis. An alternative explanation remains that whatever is causing the qualification problem also gives rise to the demand for additional, substitute, consulting services as well as, or perhaps instead of, additional audit effort. Initial Audit Qualifications and Fees In order to examine the impact on fees of initial versus recurring qualifications, further analysis utilizing data on first time audit qualifications for each of the years was carried out.12 Results are reported in Table 7 on a total fee, audit fee, and NAS fee basis. The results reflect again the tendency of an audit qualification to be reflected in higher contemporaneous NAS fees (p ⫽ .040) and higher lagged audit fees (p ⫽ .002). Audit Qualifications and Auditor Switching The above findings give rise to a potential, alternative rationale for auditor switching following an audit qualification: auditees may seek to switch auditors after receiving an audit qualification to avoid an increase in the audit cost (or to “punish” the audit firm that has imposed higher costs), rather than to avoid a potential further qualification (or punish an audit firm for giving a qualification). Previous studies that have examined the relationship between auditor switching and audit fees give conflicting evidence. For instance, Burton and Roberts (1967), Simunic (1980), Chung and Lindsay (1988), Francis (1984), Palmrose (1986) and Butterworth and Houghton (1995) find no association between the two, but Bedingfield and Loeb (1974), Eichenseher and Shields (1983), Francis and Simon (1987), Simon and Francis (1988), Turpen (1990) and Ettredge and Greenberg (1990) do find an association. This study provides a possible explanation for these conflicting results. If qualifications motivate switching behavior because of their fee impact, then it is not necessary that a subsequent auditor cut the fee to secure the audit. If the auditee expects the incumbent to recoup next period, fees unable to be billed in the current period (because of audit contract type or the potential to load NAS fees13), then the client is better off financially with a new auditor who charges a

The Cost of Audit Qualifications

233 TABLE 7

Regression of Initial Audit Qualification (Concurrent and Lagged), Auditee Size, Auditee Complexity, Auditor Size, Risky Assets and Auditee Industry on Total, Audit, and NAS Fee (n ⴝ 270) Dependent Variable Total Fee T Initial Audit Qualification (lagged) Initial Audit Qualification (contemporaneous) Auditee Size Auditee Complexity Auditor Size NAS Fee Audit Fee Risky Assets Industry Constant R Square (adj.) F Significance

P-Value

Audit Fee T

P-Value

NAS Fee T

P-Value

3.432

.001

3.216

.002

1.280

.202

2.107 11.473 5.715 4.085

.036 .000 .000 .000

⫺0.304 10.909 7.226 2.601 2.908

.761 .000 .000 .001 .004

2.069 2.850 ⫺0.819 2.189

.040 .005 .414 .030

3.316 .001 ⫺1.537 .126 19.095 .000 64.9% 68.06 .000

3.652 .000 ⫺2.351 .020 20.134 .000 71.2% 79.48 .000

2.908 .004 0.273 0.785 1.402 .162 ⫺1.931 .055 23.5% 10.77 .000

Variable Measures: Total Fee Audit Fee NAS fee Audit Opinion

⫽ ⫽ ⫽ ⫽

Auditee Size Complexity Auditor Size Risky Assets Industry

⫽ ⫽ ⫽ ⫽ ⫽

log10 of published audit plus non-audit service fee. log10 of published audit fee. log10 of published non-audit service fee. dummy coded 1 if auditee receives an audit qualification in contemporaneous and/or lagged year respectively. log10 book value of auditee’s total assets. log10 of subsidiaries ⫹ 1. dummy coded 1 if auditor is in the Big 8. (Inventory ⫹ Receivables)/Total Assets. dummy coded 1 if Mining.

fee similar to that currently being paid. Remaining with the incumbent auditor will incur a fee rise, but changing can increase the likelihood that the fee (after taking into account switching costs), at the very least, remains comparable to that currently charged. Competition in the marketplace might mean that the fee actually drops, but under this scenario the switching client may be no worse off if it fails to do so. If, on the other hand, the audit contract type permits concurrent recoupment of additional costs associated with a qualification, and/or if the NAS fee can be boosted to so reflect, then switching behavior motivated solely to avoid such recoupment is not rational, although many other reasons remain for switching (see, for example, DeFond, 1992; Francis & Wilson, 1988; Krishnan, 1994; Williams, 1988). Thus, audit contract type, a variable that is extremely difficult to

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capture because of its confidential nature, may be an important omission from previous studies examining this issue. The finding in this study, that the degree of association between qualifications and audit versus NAS fees reverses in terms of contemporaneous and lagged measures of qualification, supports the proposition that audit contract type has the potential to influence audit and NAS fees in any one year. In order to provide evidence regarding this alternative auditor switching rationale, analysis involving the previously used regression models for “Total Fees,” “Audit Fees,” and “NAS Fees” was carried out, but this time, an interaction term “Auditor Change X Initial Audit Qualification” was included. The results are reported in Table 8. The interaction term is not significant for either audit (p ⫽ .929) or total fees (p ⫽ .076), and so this sample yields no evidence of switching after a prior qualification motivated by cost avoidance associated with the qualification. The sample, however, involved only nine cases where there was an initial audit qualification (from the 37 instances of auditor change). That is, testing on a larger sample fulfilling the requisite criteria remains a task for future research. There is, however, a positive and significant relationship between an initial qualification and change of auditor in connection with NAS fees (p ⫽ .050). This finding is consistent with that of Butterworth and Houghton (1995), who, using the complete population of auditor changes within virtually the same data set, concluded that switching either to gain access to NAS services, or recoupment of lowballing losses by audit firms through NAS growth, was occurring.

CONCLUSIONS

AND

IMPLICATIONS

Australia is an ideal site for audit market research, given that it is a large, developed market, and its regulators require audit and NAS fee data be made publicly available. It has been used as a site to examine theories not readily testable in other parts of the world. Because it has similarities to other western audit markets, research based on Australian data has been used to generalize to other jurisdictions and markets. Based on research in Australia and many other (predominantly) Western nations, the literature dealing with the association between audit fees and audit opinions has focused on a relationship where fees influence audit opinions. This study looks at the relationship in the opposite direction: where the audit opinion is presumed to influence audit fees but with timing differences. Consistent with the underlying theory that auditors seek to receive some return for taking on systematically high-risk clients (Simunic & Stein, 1987, 1996), and with the proposition that an auditee who is issued a qualified opinion requires a high level of audit effort, the present study shows that there is a significant, positive association between the issuance of a qualified audit opinion in one year and a

The Cost of Audit Qualifications

235 TABLE 8

Regression of Initial Audit Qualification (Concurrent and Lagged), Auditee Size, Auditee Complexity, Auditor Size, Risky Assets, Auditee Industry and Initial Audit Qualification ⴛ Auditor Change on Total, Audit, and NAS Fee (n ⴝ 270) Dependent Variable Total Fees T Initial Audit Qualification (lagged) Initial Audit Qualification (contemporaneous) Auditee Size Auditee Complexity Auditor Size NAS Fee (contemporaneous) Audit Fee Risky Assets Industry Initial Audit Qualification ⫻ Auditor Change Constant R Square (adj.) F Significance

P-Value

Audit Fee T

P-Value

NAS Fee T

P-Value

2.586

.010

2.984

.003

0.533

.595

2.164 11.652 5.545 4.054

.031 .000 .000 .000

⫺0.299 10.771 7.172 2.596

.765 .000 .000 .010

2.134 3.063 ⫺0.968 2.161

.034 .002 .334 .032

2.866

.005

3.646 ⫺2.347

.000 .020

2.866 0.329 1.379

.005 .743 .169

3.368 ⫺1.565

.001 .119

1.783 .076 19.261 .000 65.2% 60.48 .000

⫺0.089 0.929 19.993 .000 71.1% 70.37 .000

1.968 .050 ⫺1.771 .078 24.4% 10.18 .000

Variable Measures: Total Fee Audit Fee NAS fee Audit Opinion

⫽ ⫽ ⫽ ⫽

Auditee Size Complexity Auditor Size Risky Assets Industry

⫽ ⫽ ⫽ ⫽ ⫽

log10 of published audit plus non-audit service fee. log10 of published audit fee. log10 of published non-audit service fee. dummy coded 1 if auditee receives an audit qualification in contemporaneous and/ or lagged year respectively. log10 book value of auditee’s total assets. log10 of subsidiaries ⫹ 1. dummy coded 1 if auditor is in the Big Eight. (Inventory ⫹ Receivables)/Total Assets. dummy coded 1 if Mining.

systematically higher level of audit plus NAS fees in both the same and subsequent year. This result has been found after controlling for several potentially confounding factors, including auditee size, auditee complexity, auditor size, and auditee industry. The study puts a different complexion on the relationship between fees to public accountants and the content of issued audit opinions. It shows, for example, that receiving an audit qualification bears costs beyond those to the auditee’s reputation and its standing in accounting-conscious financial markets. In addition to these possible effects, auditees receiving audit qualifications pay significantly higher fees (either for audit or NAS or the total of these) in the concurrent year

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and subsequent year to the qualification. This finding provides an alternative rationale for auditor switching following an audit qualification and suggests that the concern authorities hold with respect to opinion shopping may be misplaced. Thus, this finding is consistent with those studies that have failed to find evidence of opinion shopping where the more stringent test of examining the post-switch opinion is applied (e.g., Chow & Rice, 1982). Additionally, this study suggests that, in audit fee modeling, a lagged audit opinion may better explain audit fees than does a contemporaneous opinion. For NAS fee modeling, however, the reverse is true. Thus, while previous studies that examine the relationship between audit and NAS fees (e.g., Barkess & Simnett, 1994; Butterworth & Houghton, 1995; Simon, 1985; Simunic, 1984; Turpen, 1990) do not include both lagged and contemporaneous qualification measures as independent variables, for the theoretical reasons discussed above, future studies might do well to so do. Due to the timing differential in the relationship between audit and NAS fees and qualifications, the proposition that an audit qualification gives rise to a change in audit fees is more theoretically defensible than a change in audit fee affecting the likelihood of receiving an audit qualification. The evidence in this study is consistent with the possibility that, given the circumstance of a fixed fee or a client sensitive to audit fee levels, the auditor providing both audit and NAS may recoup (in part at least) costs associated with qualifying by concurrently increasing NAS fees. An alternative explanation is that the issuance of a qualified opinion gives rise to significant, additional, and substitutive consulting efforts. Under either scenario, some will argue that the results of this study provide even further incentive for management to negotiate and facilitate the adoption of accounting policies and practices that are regarded as satisfactory by the company’s auditor. This study is subject to a number of limitations. First, it includes only two measures of auditee risk, “audit qualification” and the proportion of risky assets, when several other measures exist and have been found previously to be significant. Second, the sample is confined to one geographic region of Australia and is heavily weighted toward the mining industry. Despite these limitations, the findings suggest that future investigations into switching behavior and the impact of audit contract type and client industry category may be worthwhile.

Acknowledgments: The authors gratefully acknowledge the helpful comments of Dan Simunic, University of British Columbia; Allen Craswell, University of Sydney; and Russell Craig, Australian National University. Also, participants at workshops at the Universities of Melbourne and Tasmania, the Australian National University, the Papua New Guinea University of Technology, and an Auditing Section Conference of the American Accounting Association.

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237

NOTES 1. 2.

3.

4.

5. 6. 7.

8.

9.

10.

11.

It is acknowledged here that recurrent NAS engagements provided by an incumbent audit firm, such as for tax and internal audit, may be as constrained as the audit fee itself. Since the period to which this study relates, the Australian State Companies Acts have been replaced by the nationally enforced Corporations Law. Initially, the Corporations Law mirrored the Companies Acts in that accounting standards did not have to be applied if so doing was considered to not render a true and fair view. In 1993, the Corporations Law was amended to remove the “true and fair override” [see S298(1)], thus making it more difficult for directors to fail to comply with pronouncements of the Australian Accounting Standards Board (AASB). Nevertheless, there remains the possibility of directors insisting on an accounting treatment encompassed within the AASBs but with which the auditor disagrees, preferring instead an alternative AASB-permitted treatment. Even in the presence of an adequate level of professional indemnity insurance, the deductible portion makes it likely that there is potentially some cash flow consequence to the auditor following successful litigation against the firm. In addition, there are indirect consequences, such as reputation effects. It is expected that some limit exists on the extent to which fees can be expected to reflect higher audit risk. A client may be regarded as so risky that an auditor will not accept the engagement at any realistic fee. Alternatively, an audit firm may accept clients (perhaps even to the extent of its complete client portfolio) falling within a particular band of risk category without a compensating fee adjustment. An audit qualification is only one possible aspect of auditee risk. [See Jubb et al. (1996) for a fuller discussion of what constitutes auditee risk.] It is assumed throughout this analysis that fees disclosed in any year relate to audit and non-audit work performed for that year. For example AUP 32 (published by the Australian Accounting Research Foundation, AARF), regarding charging for services, states, “The auditor should not enter into fee arrangements where independence might be, or be seen to be, compromised. The auditor should ensure that the fee for an audit is commensurate with the service provided . . . and reflects the time needed . . .” (Australian Accounting Research Foundation, 1992: 25). Client complexity is a difficult variable to operationalize. Most researchers have used a continuous measure of organizational dispersion, such as the number of domestic or foreign subsidiaries. The legal form of the entity may be relevant to organizational dispersion. The rationale behind these measures is that the greater the dispersion shown by a firm’s structure, the more sophisticated become the operational forms adopted by the firm (Taylor & Baker, 1981). It is acknowledged that this measure is likely to be highly correlated with client size but unlikely to be subject to measurement error. AASB 1022 (Australian Accounting Standards Board, 1989), Accounting for the Extractive Industries, permits costs arising from exploration and development to be carried forward in respect of an area of interest as long as they are expected to be recouped through either exploitation or sale (clauses .10 – .15). Big Six audit partners, in a survey of their perceptions of the usage and effects of fixed-fee billing arrangements, reported difficulty in estimating an adequate fixed fee (Margheim & Kelley, 1992). It is recognized that the audit risk associated with a new client is generally (ceteris paribus) higher than that associated with an existing client; thus, tenure may be a variable also needing to be controlled. Several audit fee studies have found tenure to be significant (Simon & Francis, 1988; Simunic, 1980; Turpen, 1990). Butterworth and Houghton (1995), however, using the same data set as in the current study, find no evidence of a price differential between initial and repeat engagements between the two years.

238 12. 13.

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Data were available to determine whether a lagged qualification was initial or recurring. Interestingly, both Burton and Roberts (1967) and Butterworth and Houghton (1995) find an association between NAS fees and switching.

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