title: Auditor Switch, Audit Fees, and Audit Quality: Evidence from the ASX 500 Firms
Creators: name: Mirzay Fashami, Ashkan
Publisher: name: Griffith University
Year: 2020
Subjects: subject: low-balling
subject: Australian Securities Exchange
subject: ASX
subject: non-audit services
subject: audit quality

description: This thesis is comprised of two studies. The first study investigates the incidence and magnitude of low-balling in the Australian Securities Exchange (ASX) top 500 firms. In auditing, low-balling refers to the provision of audit services below their actual costs during the early years of an audit engagement (DeAngelo, 1981a). Indeed, low-balling is the ‘bait to catch’ for non-audit services or continuity of office. It has been the focus of regulatory bodies, practitioners, and academics because of its potential adverse influence on auditor independence and audit quality (Levin, 2002; Ramsay, 2001; SEC, 2000; Sewon &amp; Wang, 2012; U.S. Senate, 2002). This study is primarily motivated by the non-trivial presence of auditor switch even within the ASX 500 firms. For example, there were 282 instances of auditor switch among the ASX top 500 firms between 2006 and 2016. This amounts to roughly 5% of ASX 500 firms switching their auditors every year. An auditor switch potentially creates an opportunity for a fee discounting in the first year of engagement, which in turn can raise questions about audit quality. Given the availability of audit fees data, the Australian setting offers an excellent opportunity to investigate whether auditor switches influence audit fees. The first study is motivated by increased attention on corporate governance and boards’ monitoring roles since the global financial crisis (Claessens, Dell’Ariccia, Igan, &amp; Laeven, 2010; Erkens, Hung, &amp; Matos, 2012; Goldin &amp; Vogel, 2010; Woods, 2010; Xu, Carson, Fargher, &amp; Jiang, 2013). Moreover, the ASX Corporate Governance Council issued ‘if not, why not’ type governance standards for public listed companies in 2003 (ASX, 2003). These standards oblige companies to publicly disclose their reasons to not comply with a Council recommendation. ASX Listing Rules mandate ASX top 300 companies to establish an audit committee and to provide a summary of their audit committee charters (ASX Corporate Governance Council, 2014, p. 22). It is recommended that the committee comments on the provision of NAS (ASX Corporate Governance Council, 2014, p. 22). Audit committees oversee the selection, remuneration, and dismissal of auditors. Hence, the new regulatory environment in Australia is likely to influence auditor switch and potentially any relation between auditor switch and audit fees. Furthermore, recent Australian studies on the relation between auditor switch and audit fees have focused on audit partner rotation (Ferguson, Lam, &amp; Ma, 2017; Grosse, Ma, &amp; Scott, 2018; Stewart, Kent, &amp; Routledge, 2015). This study extends prior Australian studies by examining audit firm switches rather than partner switches. Although there are concerns regarding the influence of low-balling on auditor independence (Huang, Raghunandan, Huang, &amp; Chiou, 2015; PCAOB, 2011), prior evidence suggests that low-balling is widely practised (DeAngelo, 1981a; Velte, 2012; Velte &amp; Azibi, 2015). Moreover, in terms of motives for low-balling, DeAngelo (1981a) and Dye (1991) provide two opposing low-balling theories. DeAngelo (1981a) suggests that the initial fee is discounted in every setting, whereas Dye (1991) posits that public disclosure of fees prevents fee discounting. Thus, Australia provides a unique setting to analyse low-balling theories, as it requires public disclosure of audit and non-audit fees data (Craswell &amp; Francis, 1999). Following prior studies, this study employs a parsimonious model that captures the most significant drivers of audit fees, including auditor switch (variable of interest). This study estimates its audit fees model using both ordinary least squares (OLS) regression and a random-effects technique. The first study examines audit fees data of ASX 500 companies from 2006 to 2016, based on their market capitalisation on 30 June 2016. This study compares the first year's audit fees and total fees of the incumbent auditor against the last fee charged by the former auditor to calculate fee discounting. An audit fee estimation model regresses fees against some variables that are either positively or negatively related to them based on evidence in the extant literature (Hay, Knechel, &amp; Wong, 2006). Audit fees are regressed on a set of control variables, namely: the size of an auditee’s revenue (Iyer &amp; Iyer, 1996; Maher, Tiessen, Colson, &amp; Broman, 1992), audit committee size (Vafeas &amp; Waegelein, 2007), audit committee independence (Lee &amp; Mande, 2005), audit committee expertise (Abbott, Parker, Peters, &amp; Raghunandan, 2003b), auditor quality (Choi, Kim, Kim, &amp; Zang, 2010), audit opinion (Simunic, 1980), provision of non-audit services (Simon, 1985; Simunic, 1984), leverage (Choi, Kim, Liu, &amp; Simunic, 2008), inventory (Gul, Chen, &amp; Tsui, 2003), receivables (Gul et al., 2003; Singh, Woodliff, Sultana, &amp; Newby, 2014), auditor switch in the first year after a switch (Garsombke &amp; Armitage, 1993), return on assets ratio (ROA) (Huang, Raghunandan, &amp; Rama, 2009), and quick ratio (Singh et al., 2014). The total fees model also considers NAFRATIO (the ratio of an auditee’s nonaudit to audit fees) (Hay et al., 2006; Whisenant, Sankaraguruswamy, &amp; Raghunandan, 2003) and Loss (1 if an auditee has a bottom-line loss, else 0) (Desir, Casterella, &amp; Kokina, 2013) as two additional control variables that are likely to influence total fees. The remaining control variables are as per the audit fees model. The data are obtained from ASX, Connect 4, Morningstar, and companies’ annual reports. The first study shows that of the 282 instances of auditor switch among the ASX top 500 firms between 2006 and 2016, 155 (55%) switches were to Big Four, and 127 (45%) switches were to non-Big Four. There is evidence that companies switch more frequently from non-Big Fours to Big Fours than they do from Big Fours to non-Big Fours. Results based on multivariate analysis suggest that auditor switch does not affect either audit fees or total fees. Thus, in the sample of ASX top 500 firms throughout 2006- 2016, there is no evidence of low-balling associated with auditor switch. Moreover, an auditee size is the most significant determinant of its audit and total fees. Findings are robust to various robustness checks, namely: heteroscedasticity; multicollinearity; exclusion of audit committee expertise, quick ratio, and mid-tier audit firms; different switching sub-categories, random-effects model, audit fees change model, total fees change model. Between the two competing theories of low-balling, the results are more consistent with Dye (1991) than with DeAngelo (1981a). This finding is potentially due to the public disclosure of audit and non-audit fees in Australia. The first study also examines the relationship between the audit committee and audit fees. Results show that audit committee existence is not associated with audit fees. However, audit committee quality, measured by audit committee size, independence, and expertise, is positively associated with audit fees. This finding is because a high-quality audit committee demands higher audit effort and quality, leading to higher audit fees. In contrast, audit committee quality is not associated with audit fees in case of an auditor switch. This result is because public disclosure of audit fees deters auditors from discounting their initial audit fees in Australia. The first study has several contributions. First, it provides recent evidence of the price efficiency of the audit market in Australia. Results suggest that auditor switch does not lead to a significant fee reduction in the initial audit engagement in the sample of ASX top 500 firms. To the extent audit fees reflect audit quality (DeFond &amp; Zhang, 2014; Ireland &amp; Lennox, 2002), this study is likely to enhance users’ confidence in the audit reports of the ASX top 500 firms in Australia. Second, the first study provides recent evidence that the Australian audit market is increasingly being concentrated in the hands of the Big Fours with more firms switching from non-Big Fours to Big Fours. Such concentration of the audit market could be the result of several factors, including increased audit complexity over time, demand for higher audit quality over time, and competitive advantages of the Big Four auditors over non-Big Fours. Third, although the rotation of audit firms is not mandatory in Australia, many of the ASX top 500 listed companies switched their audit firms throughout the 2006-2016 period. The results of the first study support the argument that a low-balling outlaw is not necessary for Australia. Fourth, this study shows that public fee disclosure can prevent low-balling practices, supporting Dye (1991) theory. The second study of this thesis examines the influence of non-audit services (NAS) on audit quality in Australia. Auditors are more likely to report their discoveries if their litigation and reputation losses are higher than the benefits associated with their NAS (Hong-jo, Choi, &amp; Cheung, 2017). Hence, popular media frequently question the potential implications of NAS on audit quality (Kahn, 2002; Solomon, 2002). A significant audit failure that is associated with the provision of NAS initiates a regulatory response (Schmidt, 2012). For example, a key motivation of Ramsay (2001) to provide a report regarding the independence of auditors was the rise of NAS provided by large accounting firms in Australia (Ramsay, 2001, p. 6). Thus, there are theoretical reasons to believe that the provision of NAS will lead to reduced audit quality. Most prior studies that investigated the association between NAS and audit quality were undertaken in the United States (U.S.) setting, where evidence was mixed (Blay &amp; Geiger, 2013; Church, Jenkins, McCracken, Roush, &amp; Stanley, 2014; Knechel &amp; Sharma, 2012; Prawitt, Sharp, &amp; Wood, 2012). The second study is primarily motivated by the limitations of prior studies in this area, especially the U.S. studies. Specifically, previous U.S. studies potentially suffered from the self-selection bias, as before 2001, listed firms in the U.S. were not required to publicly disclose the amount and nature of the fees to their auditors (Dickins &amp; Higgs, 2005). Moreover, although the SOX mandated the public disclosure of fees paid to auditors, it has banned U.S. listed firms from acquiring particular NAS (such as actuarial services) from their auditors (Dickins &amp; Higgs, 2005). Second, unlike the U.S., Australia permits auditors to provide NAS. However, all NAS require prior approval of the audit committee and subsequent disclosure of the paid fees (Patel &amp; Prasad, 2013). Further, ASX Listing Rules mandate ASX 300 companies to have an audit committee. It is recommended that the committee comments on the provision of NAS (ASX Corporate Governance Council, 2014, p. 22). Hence, the new regulatory environment in Australia is likely to influence audit quality and potentially any relation between NAS and audit quality. Finally, there is limited evidence in Australia on the link between NAS and audit quality. Most prior studies regarding NAS and audit quality in Australia predated CLERP 9 (Craswell, Stokes, &amp; Laughton, 2002; Gul, Tsui, &amp; Dhaliwal, 2006; Ruddock, Taylor, &amp; Taylor, 2006). The second study focuses on two widely used measures of audit quality: auditor’s propensity to issue a going-concern audit opinion and discretionary accruals to address the hypothesis that the provision of NAS impairs audit quality in Australia. This study uses a logistic regression for its going-concern audit opinion model as its dependent variable is binary (DeFond &amp; Zhang, 2014). However, it uses the OLS regression technique for its discretionary accruals model as its dependent variable is continuous. The experimental variables of the second study are LnNon-auditFees (natural log of an auditee’s non-audit fees in dollar value) and NASTF (the ratio of an auditee’s non-audit to total fee) for both going-concern audit opinion and discretionary accruals models. The second study uses the sample of ASX top 500 companies throughout 2006-2016. Results support the second study’s hypothesis that NAS impair audit quality. This study contributes to the current debate regarding the relationship between NAS and audit quality. Findings of this study are essential to standard setters (such as AUASB). Findings of this study suggest that the current regulatory environment does not appear to safeguard enough audit quality in Australia. Thus, proposals to regulate NAS to a greater extent may be necessary as current NAS practice deteriorates audit quality. Specifically, this study shows that economic and social bonding of NAS may encourage auditors to sacrifice their independence and reduce their audit quality. Furthermore, the findings have important policy implications for other Anglo-American countries (e.g., the UK) because of the similarities of their regulatory setting with Australia. However, additional analysis suggests that providing NAS to clients can compromise audit quality of some auditors (such as Deloitte or Bentleys), supporting this study’s hypothesis. However, it does not impair audit quality of others (such as PWC or PKF), supporting prior studies that conclude NAS do not impair audit quality (Church et al., 2014; Knechel &amp; Sharma, 2012; Mitra, 2007; Reynolds, Deis Jr, &amp; Francis, 2004). Overall, further analysis suggests that a gain in audit efficiency and a decline in audit quality are both at play when auditors provide NAS to their clients. Thus, whether audit quality will improve or decline due to the provision of NAS depends on market characteristics and auditor characteristics. These results explain why there is mixed evidence in the literature when it comes to NAS and audit quality.