Discussion Paper No. 135
IDENTIFYING THE DETERMINANTS OF
AUDIT FEES,
IN A POST J-SOX SCENARIO

Gaku UENO, PhD

2019/11/19

TOHOKU MANAGEMENT & ACCOUNTING RESEARCH GROUP
Discussion Paper

GRADUATE SCHOOL OF ECONOMICS AND

MANAGEMENT TOHOKU UNIVERSITY

27-1 KAWAUCHI, AOBA-KU, SENDAI,
980-8576 JAPANIDENTIFYING THE DETERMINANTS OF AUDIT FEES,
IN A POST J-SOX SCENARIO
Gaku Ueno, PhD

IDENTIFYING THE DETERMINANTS OF AUDIT FEES,
IN A POST J-SOX SCENARIO

Gaku Ueno, PhD

ABSTRACT
Research on the determinants of audit fees has mostly focused on the U.S. and other countries.
The Japanese Institute of Certified Public Accountants (JICPA) eliminated standard auditing
fees in April 2004, leading to intense competition among audit firms. However, previous
studies conducted in the U.S. and some European countries suggest that oligopolistic
conditions exist. These studies also show that audit firms add additional inspection costs tothe audit fees, when estimating further audit risks. This study aims to empirically confirm
whether Japanese audit firm charge similar fees or if the auditors’ effort is reflected in audit
fees. This study focuses on audit quality because firms cannot cover the cost of conducting anaudit in competitive scenario with low fees, leading to a decline in audit quality. To examine
the scenario after the enactment of the Financial Instruments and Exchange Act, commonlyreferred as the Japanese Sarbanes-Oxley (hereafter, J-SOX), this study uses variables that
estimate internal control risks and corporate governance risks. In conclusion, this study
confirms that Japanese audit firms conduct risk adjustment activities.

Keywords: audit fee, internal control, corporate governanceJEL classification: M42, M48

1. Introduction
Research has identified audit fee problems as the most important issue for theestimation of suitable audit fees.
The monetary relationship between auditors and audit clients is a characteristic ofauditing systems issues (Takada 2009). Audit and non-audit fees paid by clients express theirconnections making for the auditing. Using data from audit and non-audit fees, many studies
examine whether the independence of auditors is impaired. Recent studies estimate theappearance of independence from the earnings response coefficient (ERC), cost of capital,
shareholder activism, credit rating, rate of return of bonds, and so on(e.g., Francis and Ke
2006, Higgs and Skants 2006, Krishnan et al. 2005, Khurana and Raman 2006). The
independence of mental attitude is estimated by the contents of the audit opinion, andabnormal accounting accruals are proxies for the quality of disclosure statements (e.g.,
DeFond et al. 2002, Geiger and Rama 2003, Li 2009). These empirical studies wereconducted to observe whether economic engagements between auditors and their clients
impair the auditors’ independence. Studies in the 1980s considered the many factors andproxies as determinants of audit fees. Simunic (1980) famously used regression models foranalysis in which audit fee determinants are divided into the following parts: size,
complexities of operation, and risks to which auditors are exposed. In Japan, Yazawa (2009)and other researchers analyzed audit fees determinants (Kansanin Kansahoshu Kenkyukai

2012 (Japanese)).
The focus of this study is to recognize the risks that auditors are exposed to and theeffect of risk adjustment on audit fees. The proxies of size and complexity have been
analyzed sufficiently in prior studies, while this study adopts the proxies of the effect ofinternal control disclosure (J-SOX) and corporate governance in regression models. This
study examines whether the special inspection cost of audit is linked to audit fees .
How do we estimate the appropriate proxy for risk when an auditor and client enter
into an audit contract? This study considers the internal control risk and the effect of internal
control disclosure. Following Simunic (1980), many studies use the proxy of litigation risks
because material misstatemen such as inherent risks and control risks are connected tolitigation risks in the U.S. In Japan, however, there are few instances of stakeholders filinglawsuits against companies because of audit issues. We aim to confirm whether these risks
are accounted for in the audit fees and the auditors’ efforts. The following section includes aliterature review of prior studies, and the hypotheses are discussed in section three. The
research design is explained in section four, followed by the results. Finally, the last section
offers the conclusion and implications.
2. Prior studies
In this section, a review of previous studies on audit pricing and internal control isconducted.

2.1 Audit pricing studies
Simunic (1980) suggests that the cost of an audit depends on resources consumed byauditors and clients in addition to the cost of conducting the audit. Simunic analyzes thedeterminants of the cost of resources and the factor cost, which attribute to the differentiationof the audit fee. Simunic was the first to suggest the model of determinants of the audit fee.
The observable audit cost (i.e., the audit fee) has a positive significant relationship to theauditors’ exposure to losses (the increase of inherent risks) and the amount of observable
losses (the size and complexities of audit clients’ companies).
Craswell et al. (1995) analyzes the relationships between brand name, expertise, andaudit fees. They followed the step suggested by Simunic and constructed the model for audit
fees by including brand reputation as a proxy. The results demonstrate that the audit fees of
the Big 8 audit firms are 34% higher than others. It was also determined that the fees of thenon-specialist Big 8 firms are 22% higher than that of other non-specialist firms. In addition,
the specialist Big 8 firms earn a 16 % higher audit fee than the non-specialist Big8 firms.
Choi et al. (2010) define abnormal audit fees and they analyze the relationshipbetween abnormal audit fee and discretionary accruals. They assumed discretionary accruals
to be an audit quality issue and they estimated the discretionary accruals by utilizing themodified Jones model. They suggest that the relationship between positive discretionary
accruals and abnormal audit fees has negative significance. This signifies that an abnormallylow audit quality corresponds to abnormally high audit fees.
In Japan, Kasai (2009) analyzed Choi’s framework with Japanese data and received
significant results in the relationship between discretionary accruals and abnormal audit fees.
2.2 Auditor’s independence
Simunic (1984) examined the relationship between consulting, auditing and auditor’s
independence if the auditor provides both the consulting and the auditing service.

If thesame auditor is conducting the audit and consulting the firm, it impacts negatively on theauditors’ brand image if there is a proven failure in consulting. Simunic declares that in
auditing studies, the auditor’s independence is likely to be seen as ambiguous. However,supplying both services may affect both the independence of appearance and mental attitude.
Specifically, consulting as a non-auditing service affects the companies’ external (market
reaction) and internal control situations. Many studies have examined audit firms that provide
both services in the U.S., Japan, and some other countries. Simunic suggested the following
results as the initial findings. One is that the client pays a higher total fee if it engages thesame auditor as the consultant. Secondly, if an audit firm performs as auditor and consultant,they provide a more efficient service, rendering the simultaneous service desirable.
Hoitash et al.(2005) describe the change in the relationship between discretionary
accruals and abnormal audit fees after the enactment of the Sarbanes-Oxley Act (hereafter,
SOX). They suggest that discretionary accruals are significantly related to abnormal audit

fees before SOX but are ambiguous after its enactment. They insist that abnormal audit fees
affect discretionary accruals as a proxy of audit quality, and SOX impairs these relationships.
They estimated the independence of mental attitude by discretionary accruals and suggest a
relationship between independence of mental attitude and audit fees.
2.3 Material Weakness
Hoitash et al.(2008) investigates the relationship among material weakness,significant deficiency, and audit fees. Companies that have insufficient internal control
information based on the stipulation of Section 302 of SOX pay higher fees than companies
that report based on SOX404. They insist that companies that declare information
insufficiency pay higher fee because of risk adjustment.
Hogan and Wilkins (2008) investigated the adjustment of the audit risk approach inthe context of audit fees. The studies conducted before Hogan and Wilkins (2008)
documented ambiguous results and were limited to one audit firm or one industry. They
regarded the individual condition of managers or auditors. Hogan and Wilkins referred tothese before conducting their study, which examines the audit fees charged when acompany’s auditors document the internal control weaknesses. The study controls for factors
such as inherent risks and information risks. This study concluded that companies thatdeclared weak internal controls paid higher fees.
Ashbaugh et al. (2008) described the relationship between the effects of internalcontrol weakness disclosure and the quality of accruals. Initially, they noted that low quality
accruals were accompanied by the declaration of the information of internal control weakness.
Second, they determined if companies with internal control weakness disclosure haveabnormally high or low accounting accruals. Third, they determined that if the companies
that needed to declare internal control weakness revised their findings in the next year, theaccruals recovered. Fourth, they detected that auditors’ opinions were related significantly to
accounting accruals. Hence, the U.S. data confirms that accounting accruals and internal
control weakness have a significant relationship.
3. Hypothesis
3.1 Audit situation after the collapse of Chuo-Aoyama and Misuzu
The Japanese audit environment was drastically affected by the Kanebo window
dressing scandal resulting in the 2006 failure of the Chuo-Aoyama auditing firm (a memberof PricewaterhouseCooopers). This was followed by the 2007 dissolution of Misuzu, thename under which Cho-Aoyama resumed operation. After these scandals, the determinants ofaudit fees changed significantly, and it is now impossible to determine how a firm willconduct an audit. The environment affects the competition between auditing firms, leading to
new methods of gaining clients.
In addition, the audit fees paid by clients increases drastically because of theimplementation of quarterly reviews and internal control reports (Kansanin Kannsahoshu

Kenkyukai, 2012).
3.2 Developing the hypothesis
Based on previous Japanese studies, we note the significant relationships between
audit fees and clients’ size, complexity, and specific risks. This study suggests a hypothesis toverify whether auditors incorporate the special inspection cost into the audit fees byconsidering the internal control risks and governance risks in addition to inherent risks,leverage, and, profitability. We also determine if audit fees are affected by internal control
risks and governance risks by using a regression of residual audit fees considering clients’size, complexity, and specific risks that may include the internal control risks and governancerisks. The residual audit fees are considered as abnormal audit fees information from Kasai(2009) and Fujiwara (2011). In addition to these analyses, this study adds variables to
examine the efforts of auditors after they perceive the risks of financial distress or internal
controls in the regression model.
For an extensive analysis, it is essential use the delta of audit fees as the dependent
variable in the regression model, but this study uses the stock variable of audit fees as the firststep.
I suggest the hypotheses stated below.
H1: Auditing firms receive the audit fees according to the client’s internal control condition.
H2: Auditing firms receive abnormal audit fees in accordance with the client’s internalcontrol framework.
4. Research design
4.1 Regression model
For the inspection of hypothesis H1, this study analyzes the regression model as stated below,

𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿

𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠, 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶, 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟(𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑟𝑟𝑟𝑟),= 𝑓𝑓 �
�
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟(𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒), 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
That is,

LNAuditFee =∝0 ＋ ∝1 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿＋ ∝2 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿＋ ∝3 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹+∝4 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿＋ ∝5 𝑅𝑅𝑅𝑅𝑅𝑅 +∝6 𝑆𝑆𝐺𝐺𝐺𝐺 +∝7 𝐶𝐶𝐺𝐺𝐺𝐺 +∝8 𝐿𝐿𝐿𝐿𝐿𝐿 +∝9 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅+∝10 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺ℎ𝑆𝑆𝑆𝑆𝑆𝑆 +∝11 𝑅𝑅𝑅𝑅𝑅𝑅 +∝12 𝐵𝐵𝐵𝐵𝐵𝐵4 +∝13 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿+∝14 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴1𝑠𝑠𝑠𝑠＋ ∝15 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴2𝑛𝑛𝑛𝑛+∝16 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹＋ ∝17 𝑅𝑅𝑅𝑅𝑅𝑅 +∝18 𝑆𝑆𝑀𝑀𝑀𝑀＋ ∝19 𝐶𝐶𝑀𝑀𝑀𝑀+∝20 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 +∝21 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 +∝22 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆+∝ 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖+∝ 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦+∝ 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 + 𝜀𝜀

In order to examine hypothesis H2, this study analyzes the following regression model toestimate abnormal audit fees:
LNAuditFee =∝0 ＋ ∝1 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿＋ ∝2 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿＋ ∝3 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹+∝4 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿＋ ∝5 𝑅𝑅𝑅𝑅𝑅𝑅 +∝6 𝑆𝑆𝐺𝐺𝐺𝐺 +∝7 𝐶𝐶𝐶𝐶𝐶𝐶 +∝8 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 +∝9 𝐿𝐿𝐿𝐿𝐿𝐿+∝10 𝑅𝑅𝑅𝑅𝑅𝑅 +∝11 𝐵𝐵𝐵𝐵𝐵𝐵4 +∝12 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺ℎ𝑆𝑆𝑆𝑆𝑆𝑆 +∝13 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿+∝ 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖+∝ 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦+∝ 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 + 𝜀𝜀

Using the above residual 𝜀𝜀 as AbAuditFee, we define the abnormal audit fees and analyze
the regression as stated below:

AbAuditFee =∝0 +∝1 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴1𝑠𝑠𝑠𝑠＋ ∝2 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴2𝑛𝑛𝑛𝑛+∝3 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹＋ ∝4 𝑅𝑅𝑅𝑅𝑅𝑅 +∝5 𝑆𝑆𝑆𝑆𝑆𝑆+∝6 𝐶𝐶𝐶𝐶𝐶𝐶 +∝7 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵+∝8 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 +∝9 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆+∝ 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑦𝑦+∝ 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 + 𝜀𝜀

4.2 Independent variableThis study considers the following six factors when consulting the regression model:(1)Clients’ size of operation(2)Clients’ complexity of operation(3)Clients’ specific risks(3-1) Inherent risk and financial distress risk
(3-1-1) Risk variables(3-1-2) Auditor effort after perceiving of financial distress risk
(3-2) Leverage(3-3) Profitability(4) Auditor size(5) Clients’ internal control risk
(5-1) Auditor’s effort after their perceiving internal control risk
(5-2) Clients’ management risk
(6)Clients’ governance risk
Factors 1~4 are discussed in studies from Simunic (1980), Craswell et al. (1995), and Choi etal. (2010)
This study adds to the findings regarding the efforts of auditors after perceiving the risks
based on the prior research analysis. The variables RGC, SGC, CGC, RMW, SMW, andCMW(all are defined in the Appendix) are the proxies of the effort of auditors.
This study separates internal control risk into auditor’s effort after perceiving internal
control risk (5-1), management risk (5-2). In previous studies, clients’ size, complexity, andspecific risk were included in the estimation model.
In this study the internal control risk is considered in the regression model along withclients’ size, complexity, and specific risks. According to the Committee of Sponsoring
Organization of Treadway Commission’s (COSO) internal control-integrated framework(COSO 1992, COSO 1994 and this citation is referred to Japanese translations of COSO 1992
and 1994 by Toba, Hatta, and Takada 1996), it has necessary for us to carefully consider thefollowing situations:
・Change in operating environment
・New executives and employees
・New and refined information systems
・Rapid Growth・New techniques
・New product lines, products, and operations
・Foreign businessIn this framework, governance risk variables are used in the analysis to describe thestatus of the environment change in the operation. Management risk variables such asswitching auditors and managers flexibility are used to capture the risk of new executives
and employees. The ratio of foreign sales to total sales is used to capture the risk of foreignbusiness but this is considered a variable of the complexity of operations.
The hypothesis on management risk and the auditor’s effort after perceiving internal
control risk is explained. The higher the gain from managers’ switching, the higher is the
management risk. As a result, auditors will require higher audit fees. On the other hand, there
are very few instances of auditor switching in the Japanese market since it is considered veryrisky. Auditor switching is usually indicative of many internal control problems. This resultsin risk adjustment, possibly affecting audit fees. However, some studies that analyze therelationship between audit fees and auditor switching suggest that auditor switching is afactor of low-balling (discounting audit fees). This study aims to confirm whether auditor
switching is indeed a risk factor. The auditor’s efforts after perceiving internal control risk arepresented by material weakness data. If auditors declare material weakness, audit fees
become higher than other conditions. However, in the low litigation countries such as Japan,
there are few cases in which auditors require “hush money” from clients. This study suggeststhat some risk adjustment activities are a direct results risk perception. This study supposesthat auditors gain more tasks after their declaration or perception of material weakness
compared to other conditions. As previously stated, this study set the dummy variables as,
RMW, SMW and CMW (As the same types of dummy variables, this study set RGC, SGC,

and CGC).
In this section, I suggest governance risk variables. Corporate governance is usually
defined as the stockholders’ supervision of management. Standard and Poor’s (hereafter,S&P) suggested a comprehensive quantification method (Ashbaugh et al. 2006) with four
directionalities as detailed below:(1) Ownership structure and effect(2) Rights of stakeholders and their relationship to financial matters(3) Transparency and disclosure of financial matters(4) Board structure and processes
Since corporate governance is also included internal controls, its proxies are suggested
below.
(1) I capture the situations by SPECIFICST which is the ratio of specific stockholders to allstockholders.
(2) It is difficult to measure the proxies that tequnically express these situations in Japanesesamples. As the Ashbaugh et al. (2006) study, the G-score is used.
(3) I do not capture the situations because financial transparency does not directly affect theaudit. Financial transparency is suggested by abnormal current accruals, but it is difficult todecide whether the transparency is expressed by abnormal current accruals only.
(4) I capture the situations by BDOUTSIDE and BDSTOCK. BDOUTSIDE represents ratio

of outside board members to all board members and BDSTOCK represents ratio of shareboard members own.
4.4 Sample selection
I selected the samples as stated below:(1) Companies in the Japanese stock markets, excluding banks, insurance companies,
securities, and other financial institutions(2) Companies that do not undergo a joint audit(3) Companies that do not adopt U.S. SEC standards or IFRS
(4) Companies that do not change the fiscal term(5) Companies whose fiscal year-end is in March(6) Companies whose sample is available in the database
Financial data is obtained from the Nikkei NEEDS normal companies database (Nikkei
Media Marketing Inc.). Audit fees are obtained from the 2011 and 2012 White Book of
Auditor and Audit Fee of Japanese Companies (edited by Kansanin Kansahoshu Kenkyukai(Japanese)), corporate governance data is from Nikkei CGES (Nikkei Media Marketing Inc.),
and auditor switching data is from the timely disclosure of auditing information(from theTokyo Stock Exchange Group, Inc.) I limited the samples to firms whose fiscal years end in
March because audit firms’ policies on audit fees differ according to fiscal year ends.
5. Verification result5.1 Descriptive statistics
Please see the Table1. I use the outlier dummy variable to reject the data of Lev,
ROA, LIQUID, GrothSal, and RecInv data in the higher 100th percentile and the 1st
percentile.
[Place Table 1 here]
5.2 Result of regression
5.2.1 Hypothesis 1
Key findings are displayed in Table 2 to 4.
The results confirm that audit fees are determined by client size, complexity andfinancial distress risk, profitability and leverage. It also confirms that the relationshipbetween audit fees and material weakness data is significant. First, it is determined whether ththere is RMW, which means the auditor declares material weakness at t-1 and at t, the auditor
deletes material weakness. Regression results suggest that the recovery from material
weakness increases audit fees as the tasks of auditors to recover from material weakness
increase. Further auditors adjust the risks by requiring higher audit fees. Second, SMW isindicated, which means at t-1, the material weakness is declared and at t, the same declaration
is disclosed. The result of the estimation of coefficient is positively significant. The amountof standardized coefficient for RMW and SMW are almost level. Third, CMW is present,
meaning that at t-1, there was no declaration of material weakness and it is declared at t. The

result of the estimation of coefficient is positively significant. CMW’s standardized
coefficient is smaller than RMW and SMW. This suggests the efforts of auditors after
declaration of material weakness exists and the efforts of auditors are reflected in the audit
fees. The same structural results are displayed in RGC, SGC and CGC. RGC and SGC’scoefficients are positively significant and the standardized coefficient is almost level. On theother hand, CGC’s coefficient is insignificant, and standardized coefficient is much lower
than others. However, in 2011 data analysis, the ambiguous result comes out. This result
suggests that economic conditions or year specific conditions are needed to control in the
regression model.
Flexmanager’s coefficient is positively significant in all data and in the 2010 data
analysis. The flexibility of manager’s switching increases audit fees to a certain level. In theinternal control viewpoint, it can be said that the flexibility of manager switching is adeterminants of internal control risks.
Auditor SW 1st and 2nd provide ambiguous results. The hypothesis states thatJapanese auditing firms require fixed costs and conduct the risk adjustment for the first year,
and in auditors discount their fees in the second year. In some analyses however, thecoefficient of Auditor SW 1st is insignificant, and the coefficient of Auditor SW 2nd ispositively significant. In the second year, auditors charge more audit fees than in any otherperiod. This result implies that audit fees and auditor switching is not directly connected.

Auditors do not consider the first and second years of an audit as risky.
The coefficient of BDOUTSIDE is insignificant. A higher ratio of outside members
to the board leads to an improvement in auditors’ independence decreasing the risk of audit
and reducing audit fees. However, this study suggests insignificant results in reference to the
hypothesis. In this paper, I interpret the results as stated below. An outside member institution
is not common in Japanese business culture, and their impact on the business is unclear. The
presence of outside members with unknown abilities and impact may be risky and institutions
may be uncomfortable feeling about outside members.
The coefficient of BDSTOCK is negatively significant. The results suggest that audit
fees are lower when board members own a high percentage of the company’s stocks, which
eliminates the fear that the board will act against management.
The coefficient of SPECIFICST is negatively significant. If a specific stockholder
has a high proportion of shares decision-making is faster. It is also possible to reduce internal
control risks and improve the independence of the auditor, resulting in lower audit fees.
[Place Table 2, Table 3, Table 4 here]
5.2.2 Hypothesis 2
The results of abnormal audit fees are provided in Table 5 below.This analysis
suggests the robustness of hypothesis 1 results from using the residuals controlled by
non-internal control risks and gaining audit tasks. The coefficients of RMW, SMW, CMW,BDSTOCK, SPECIFICST and AuditorSW2nd are significant, while the coefficients of theother variables are insignificant. Abnormal audit fee is used as a proxy of auditors’
independence. As Abnormally high audit fee is similarly related to material weakness, board
members’ shareholding and the ratio of specific stockholders as audit fees. This suggestion
express that robustness of key analyses are sufficient.
[Place Table 5 here]
5.2.3 other robustness check
High correlation
LNAsset and LNSubsidiary have high correlation(results not tabulated). I reject the
LNSubsidiary in the regression model, but the result of that is almost same as all variables
analysis (results not tabulated).
The difference of audit opinion
I analyze the regression model of the audit fee model in all variables including
OPINION, a dummy variable with a value of 1, if the auditors give an unqualified opinion
with no additional information; it is 0 in all other instance. This coefficient is significant
while the significance of the other variable does not change. Hence, the analysis issufficiently robust (results are not tabulated).
The difference of the rank data between raw data and data taking logarithm
I use rank data on Flexmanager, BDOUTSIDE, BDSTOCK and SPECIFICST in themain analysis. These raw data (not taking logarithm) are analyzed using a regression modeland generates results similar to the main results (results are not tabulated).
6. Conclusion and Implication
Based on the results of the analysis, this study confirms a relationship between audit
fees and the internal control factor. In this context, some researchers insist that auditors waive
their independence when internal control risks are increasing. This suggests that higher audit
fees are used as “hush money”. However, in low litigation countries like Japan, there are notmany cases in which auditors require audit fees as “hush money”. In almost cases in Japan,
the auditor’s effort after perceiving risks is reflected in audit fees. This study adds the risk
variables to effort variables.
In the results of this study, auditors require higher fees as they are taking a risk. Risk
adjustment is not considered fraud, but Japanese auditing firms add to the sense of urgency inthe intensely competitive environment after the elimination of the rules applicable to standard
audit fees. In addition, this study analyzed the relationship between auditor switching andaudit fees and identified auditor switching as a risk factor. Some U.S. studies identify theswitching of auditors as a low-balling factor. The result of this study suggests the ambiguous
result that auditor switching is not related to audit fees.
This study indicates that internal control reporting affects audit quality. Abnormallyhigh audit fees reduce solid independency. Since independence is connected to audit quality,we discuss the relationship between audit practice, audit fees, and audit quality.
Appendix
The variable definitions are stated below,
LNAuditFee: Logarithm of audit fees
Client size andClient complexity
LNAsset: Logarithm of total asset
LNsubsidiary: Logarithm of the number of subsidiary companies
ForeginSales: Foreign sales divided by total sales
Clients’ specific risk
Inherent risk
RecInv: (receivable + inventory)/total assets
GrothSal: Sales at t-1 term subtracted from Sales at t term then deflated by total asset.
Financial distress risk
Effort from perceiving financial distress risk
RGC: Equals 1 if auditors declared the company to be a going concern for the previous term.
All other instances equal 0
SGC: Equal 1 if auditors declared the company to be a going concern for the previous termand declare the company in the same condition. All other instances equal 0CGC: Equal 1 if auditors do not declare the company to be a going concern for present term,
but declare the company to be in the same condition for the present term, All other instanceequal 0.
Risk variable
Loss: Equal 1 if the company discloses a net loss. All other instance equal 0
LIQUID: Current assets divided by current liabilities
Leverage
Lev: Total liabilities divided by total assets
Profitability
ROA: Return on assets
Auditor size
Big4: Equal 1 if the audit firm is a members of the Big 4 auditing firm (Deloitte&

Touche Tohmatsu LLP, Ernst & Young SinNihon LLC, KPMG AZSA LLC andPriceWaterhouceCoopers Arata LLP) All other equal 0.
Internal control risk
Effort from perceiving internal control risk
RMW: Equal 1 for the previous term if the auditors declare the material weakness and do
not declare for the present term. All others equal 0
SMW: For the both previous term and present term auditors declare the material

weakness=1. All others equal 0
CMW: Equal 1 for the previous term if the auditors do not declare material weakness andfor the present term they declare the material weakness. All others equal 0Management risk
Auditor SW1st : Equal 1 if auditors turn over on the current term. All others equal 0.
Auditor SW2nd : Equal 1 if auditors turn over on the previous term. All others equal 0.
FlexManager: This is ranked from 1 to 5 according to the frequency of manager turn over.
This study uses data taking logarithms (from Nikkei CGES).
Governance risk
BDOUTSIDE: According to the ratio of outside board members, BDOUTSIDE is ranked
from 1 to 5. This study uses data taking logarithms (from Nikkei CGES).
BDSTOCK: According to the ratio of shareholding board members, BDSTOCK is ranked
from 1 to 5. This study uses this data taking logarithms (from Nikkei CGES).
SPECIFICST: According to ratio of share owned by specific stockholders, SPECIFICST is
ranked from 1 to 5.This study uses data taking logarithms (from Nikkei CGES). Specificstockholder refers to the top ten block holders and extra stakeholders excluding unstableparts)
OthersOutliers: Dummy variables to exclude variables, such as, Lev, ROA, LIQID, RecInv, andGrothSal , which are lower than the 1st percentile and higher than the 99th percentile.
yeardummy: year dummy variableinddummy: industry dummy variable

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Aoyama Journal of Business 44(3) :227-256[Table 1] Descriptive Statistic (n=3834）
Maximum Minimum
LNAuditFee
1.946
6.522
LNSubsidiary
0.000
6.567
ForeignSales
0.000
0.996
LOSS
0.000
1.000
RGC
0.000
1.000
SGC
0.000
1.000
CGC
0.000
1.000
Lev
0.015
2.212
RecInv
0.001
0.927
GrothSal-0.857
5.046
Flexmanager
0.000
1.609
ROA
-79.600
68.160
Big 4
0.000
1.000
LIQID
0.114
58.451
RMW
0.000
1.000
SMW
0.000
1.000
CMW
0.000
1.000
AuditorSW1st
0.000
1.000
AuditorSW2nd 0.000
1.000
BDOUTSIDE
0.000
1.609
BDSTOCK
0.000
1.609
SPECIFICST
0.000
1.609

Average
3.623
2.059
0.155
0.190
0.007
0.014
0.003
0.510
0.330
-0.010
0.792
4.161
0.747
2.101
0.015
0.002
0.004
0.038
0.047
0.531
1.100
1.090

Standard Deviation
0.554
1.234
0.222
0.392
0.085
0.117
0.053
0.208
0.158
0.218
0.611
6.128
0.435
1.989
0.123
0.043
0.066
0.192
0.212
0.624
0.523
0.542