Audit Pricing, Accruals and Firm Value: A Legal OriginsPerspective

Audit Pricing, Accruals and Firm Value: A Legal Origins Perspective Jun Zhan, Ph.D. in Business Administration Concordia University, 2012 Relying on an conceptual approach that mixes economics and law, La Porta, Lopez-de-Silanes, Shleifer and Vishny (1997, 1998) and La Porta, Lopez-de-Silanes and Shleifer (2008) document that legal rules and regulations protecting investors vary systematically among legal origins and related institutions. They further argue and show that such differences do affect various economic outcomes. Relying of the ground-breaking work of LLSV, many studies find extensive evidence on how a country`s legal system affects, among other things, its capital market development, the governance of firms and the properties of accounting information. In that context, the quality of external auditing, which does encompass the pricing of such services, are widely perceived to underlie capital market development, corporate governance and accounting information. However, prior empirical research pays scant attention to the interface between country-level legal systems or macro-economic factors and audit pricing. Thus, whether and how audit pricing is influenced by a country’s legal system remain open questions. Hence, this dissertation purports to shed further light on the pricing of audit services and on the effect of such pricing on the quality of financial reporting, as proxied by accounting accruals, across different legal regimes. I measure accruals as either total accruals or discretionary accruals. In addition, I adopt multiple measures to proxy for a country’s legal institutions, such as rules of law, strength of legal enforcement and investor protection. Using a sample of 23,398 observations on audit fees from 13 countries for the period 1996-2006, I find the following results. Firstly, I find that audit fees are associated with higher accruals across countries. Additional analysis reveals that the fees-accruals association is more likely to be driven by the “Risk pricing” argument, which argues that auditors charge higher fees to compensate for additional engagement risks that are reflected in higher accruals. Secondly, I find that a country’s legal regime plays a significant role in audit pricing. Specifically, the positive fees-accruals association is more pronounced for firms from weak legal environments. In the next stage of analysis, I proceed to investigate the impact of large audit fees on investors’ perceived audit independence. I find a significant positive association between audit fees and a firm`s Tobin’s Q, and this association is more pronounced under weak legal environment than under strong legal environment. I further test whether excessive audit fees help to predict future profitability or not. My analyses show that audit fees are significantly and positively associated with CFO of next year. These results suggest that abnormally large audit fees are priced by the stock market because they help predict a firm’s future profitability, thus providing valuable information to investors. Overall, my findings lead to the conclusion that auditors charge higher fees to clients with larger accruals for risk-pricing purposes. My analyses do not suggest that such large fees compromise auditor independence. Moreover, the evidence suggests that legal institutions play critical roles in terms of accrual choices and of audit pricing.