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Study Of Audit Fees Levels Accounting Essay

INTRODUCTION

The audit serves as a vital tool of economy and plays an important role in the reliability, truthfulness and fairness of financial statements of a company. In most cases there are not the owners those who look after they daily management of their business, they employ a team of qualified staff to do it. This management team is responsible for the information provided through financial statements; from which the owners get the information of the affairs of business. According to "Agency Theory" (Jensen and Meckling 1978), which explains relationship between 'principals' (owner or shareholders) and 'agent' (company's executive), where the principal delegates an agent to perform the work, it is needed a third party to judge or to express their opinion about the accuracy and fairness of the financial statement.

As seen, the role of auditor between 'principals' and 'agent' is to ensure the shareholders of the fairness of financial statement. However, there are not only the owners interested for an audit report but it is also in the interest of third parties like: banks, government, clients and any individual who wants to have an idea about the company performance.

Audit helps to enhance the reliably of the financial reporting which is very important for a healthy functioning of markets to the benefit of business, investors, creditors, employees and other stakeholders.

Moreover, it has been a big debate on the choice in the UK audit market. A special attention is given to the medium-sized companies for the role that they play in the economy and wellness of the country. Previous studies confirms that the Big Four audit firms - Deloitte & Touche, Ernst & Young, KPMG and PricewaterhouseCoopers - supply audit services to most large companies.

However, it is important to carry research into this field for understanding 'What are the Determinants of audit fees in the medium-sized companies.

AIM AND OBJECTIVES

AIM

The aim of this study is to determine the Audit Fees levels in medium-sized firms on the basis of firm characteristics from two perspectives, namely Corporate Governance and Firm Size.

OBJECTIVES:

  1. The first way to reach the objective of this aim is using a set of exploratory and null hypothesis asses the determinants of audit fees.
  2. Characterise firms on the basis of Corporate Governance Quality using prescribed Corporate Governance characteristics and dichotomises between strong and weak Corporate Governance.
  3. Determine audit fees on the basis of firm size.
  4. Collect and analyse data using SPSS software on the basis empirical models developed to test the hypothesis.
  5. Theory and philosophical framework

    The researcher is influenced by the positivistic research paradigm and the ontological reality of knowledge having a deterministic and singular reality.

    Since this research has a quantitative nature and involves testing hypothesis using empirical models, the proposed research will use a deductive approach, hence involves theory testing. 

    LITERATURE REVIEW

    This part of proposed research discusses previous research investigates that are undertaken in terms of audit fees. Beginning with a number of studies have examined the market for auditing services in specific countries.

    In his research, Simunic found that the main determinants of audit fees are; total assets, inventories, turnover and receivables.

    A general conceptual model that has been used as a representation of the audit market has been expressed in the following form

    Audit Fee =f [client complexity; competition; audit bid factors; quality]

    In this time some research studies are done in UK on this field. Main researchers are; Taylor and Baker (1981), Gwilliam (1993), and Ezzamel, Gwilliam, and Holland (1996), and Pong and Turley (1997).

    Other studies in this field made by Department of Trade and Industry (DTI) and Financial Reporting Council (FRC) will also be taken into consideration during this study.

    Chan's (1993) work is rather similar with this study but it was undertakin in terms of audit fees for United Kingdom Quoted Companies in a different time and therefore the data are different. However the way of collecting them is almost the same.

    The majority of these earlier studies have served to establish the association between audit fees and variables related to auditee size, risk, and complexity. According to Pong and Turley (1997), the audit charged fee is composed of two groups of factors that may affect price of audit fee. These two groups are: the characteristics of auditee and the characteristics of the auditor.

    Auditee characteristics: Some of the most unique and directly related with audit fees.

    Auditee size

    .

    The most consistent result in al previous research has been that auditee size is far most significant explanatory variable in determining audit fees. Most of this studies have have used 'Total Assets' as a measure of size. Total assets measure may vary significantly between otherwise similar companies because of difference in the age profile of assets or because of accounting policy chosen. Chan (1993) rejects Total Assets as a measurement of auditee size, arguing that another problem of using this figure is that there may be a linkage and interaction with complexity variables of type which incorporate total assets directly in their calculation. On his research "Determinants of Audit Fees for Quoted UK Companies" has used 'Turnover' figure to describe the auditee size. However, even though turnover measures may abstract from problems associated with accounting policy, he argues that turnover may be a better explanatory variable. Different from, other researchers have used 'Total Assets' and 'Turnover' figure as measurement of the size of the company being audited. For Total Assets figure as much higher it is as much more the auditor must collect information for the assets existence and their fair value reported to financial statements. The same way even for the turnover figure of the auditee, as higher it is, as higher the efforts required by auditor to ascertain and ensure the figures.

    In the auditor's production function, economies of scale, explain that larger companies will have a good internal control procedures suggest that the relationship between auditee size and audit fee is likely to be a decreasing function of auditee size.

    Auditee complexity

    Complexity costs will be a reflection of nature of the business of the auditee, its location, the quality of internal control, the amount of unusual transactions etc. Other studies have included the number of subsidiaries, the number of industries in which the company participates, the number of different company locations and variables relating to asset composition. A group with a great number of subsidiaries might pay a higher audit fee than a single company of comparable size. There are costs related with the audit of separate financial statements each of which has to comply with a variety of statutory and professional requirements for revelation. Therefore it is likely that the level of audit work will increase with the level of auditee complexity.

    Auditee risk

    There would be an association between audit risk and audit fees if taking into consideration the widespread prevalence of risk model methodology in the audit process (Turley and Cooper, 1991). These researchers have concluded that audit risk is a significant factor in determining the extent of necessary audit work and in outcome the amount of fee charged.

    Audit risk, which reflects the nature of the business of the company and the control environment instituted by the company too, is difficult to determine a measurement directly.  Previous studies have given a great attention to the balance sheet measures of risk; liquidity ratios and gearing ratios etc. Thus, it is expected to be a direct relationship between the audit fees and auditee risk.

    Auditee profitability

    The conclusions of the previous studies are divided as to whether there might be any relationship between the level of profitability and the amount of audit fee.

    Auditor characteristics

    Auditor size

    For a long time the debate whether the fee charged by auditor has any relationship with the auditor size have been going on. In previous studies a significant focus of attention has been on whether there are identifiable differences between fee charged by Big Eight Audit Firms and those charged by Non-Big Eight Audit Firms (Chan 1993). Some researchers have concluded that there are no price differences between Big 8 and Non-Big 8 auditors (Simunic 1980) and Firth (1985) found that auditor size was not significant in audit market in the USA. These findings were rejected latter on by Palmrose (1986a), Francis and Stokes (1986) that they founded that Big 8 prices were higher than Non-Big 8. Francis (1984) and Francis and Stokes (1986) recorded similar results for the Australian market. In the United Kingdom Chan, Ezzamel and Gwilliam (1993) and Pong and Whittington (1994) reported the existence of a Big Eight premium, but no differentiation was made between large and small auditees in these studies.

    Since 1989, and one major scandal involving Arthur Andersen in 2002, have reduced the number of major accountancy firms from eight to four. The Big-four are the four largest accountancy firms. They are: Pricewaterhousecooper, Deloitte Touche, Ernst & Young and KPMG.

    In his study Chan (1993) interviewed some partners from large audit firms. The results have suggested that Big 6 existed if they were compared with small audit firms but not compared with medium size audit firms.  

    Lowballing

    Lowballing occurs when an auditor or an auditing company reduces the quote of the initial fee hoping to attract a new audit client and recoup this 'loss' in next years. This phenomenon is much more evident in the case of audit of the large companies. This happens because the fee charged by auditors to large companies is a high one.

    Non-audit services

    Income from consultancy and other non-audit services represents a large amount of income of audit/accountancy firms. Auditors usually provide numerous services to complement their audit work. Such services include accountancy and bookkeeping assistance, legal assistance, management consultancy services, personnel recruitment, corporate finance advice and tax advice (Moizer, 1997). In a previous study done by Accountancy Age in 1995, the consultancy services income, in the top fifteen accounting firms of that time, was higher than that from audit services.

    Simunic (1984) found that the purchase of management advisory services from the auditor was associated with a significant increase in audit fees. Another evidence for a positive relationship between audit fees and non-audit services was also provided by Palmrose (1986). She suggested that non-audit services might require greater audit effort.

    Auditor location

    On his study Chan (1993) found that another explanatory variable which might contribute to the audit fee is audit location. Audit fees are affected by the coordination and complexity of the engagement. Palmrose (1986) argues that one important aspect of the coordination and complexity is the number of different client locations requiring on-site visits by the auditors.

    METHODOLOGY

    This section will describe the way that the study will be undertaken. Different set of data are required for the purpose of this study, hence this part of research also will describe the variables.

    First of all it is needed the definition of the medium-sized companies to ensure the selection criteria. According to Companies Act 2006 (Amended accounts and reports regulations 2008 No.393) a company is classified as medium-size if it meets at least two of the following criteria:

    • Turnover of not more than £25.9 million
    • Number of employees between 50 and 250
    • Balance sheet total of not more than £12.9 million

    Pricing model

    To control for variables that might affect audit fees, the following variables will be included to the model: total assets, turnover, inventories, locations and auditee industry.

    Audit Fees

    The audit fee amount is the most important data required. As this figure is going to be the independent variable of this study, it should include only the fee charged in respect of audit work. Therefore this figure will not include any other services provided by the same auditor. Because of the target population of this study is quoted companies, the audit fee figure is obtainable from financial statements.

    Total Assets

    Although audit fees service may not increase linearly with auditee size, clearly bigger auditees will purchase more services than smaller auditees. Auditors are expected to spend much effort and time in a company with a great figure of total assets than in a company with a small figure of total assets. Following previous pricing studies using cross-sectional data, I will use 'total assets' to measure size of auditee and will be correlated with the audit fee charged too.

    Turnover

    Turnover figure is another way to measure the size of auditee. Although the relationship between audit fees and turnover figure may not be perfectly linear in nature, it is anticipated that the higher the turnover figure the higher would be the audit fee charged. The turnover figure will also be linked with audit fee.

    Inventories

    Inventories include raw materials, work-in-process goods and completed finished goods that are considered to bethe portion of a business's assets that are ready or will be readyfor sale. An inventory represents one of the mostimportant assets thatmost businesses possess, because the turnover of inventoryrepresentsone of theprimary sources ofrevenuegenerationand subsequent earnings for the company's shareholders/owners. The auditors have to investigate the outdated stocks and this also adds the amount of time and effort by auditor, hence it is an important figure which will be regressed against the audit fees.

    Locations

    As discussed in auditor characteristics section, coordination and complexity of the engagement might strongly affect audit fees. For this study the log of the number of locations will be used in the regressions.

    Big Four or Non-Big four Auditor

    Tests of the effect of audit firm size on fees charged typically divide suppliers into Big Four and Non-Big Four firms. Since audit quality is difficult to examine, it is not possible to be categoric about the reason for any Big Four premium. Size of the audit firm (Big Four/Non-Big four) may play a considerable role in the determination of audit fees, although previous studies have not shown consistent results in this context. The information about the size of auditor will be known from the client's auditor name.

    Provision of additional services

    Some different researchers argue that may be lower to attract the client for more non-audit services. However, some others argue that provision of non-audit services to an auditee may indicate that the client has problems in his systems and consequently the audit fee is expected to be higher. As the target population of this study is quoted companies, the non-audit fee is reachable from the financial statements.

    Y= α + β 1 * X 1 + β 2 * X 2 + β 3 *X 3 + ε

    Where: Y=the dependent variable (audit fees)

                 α = the intercept coefficient

                 β1 = the coefficient for the independent variable X1

                       X1 = the independent variable

                 ε = the error term of the regression model

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