The Development Of External Audit Accounting Essay

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This study aims at determining the factors concerning the level of audit fees paid by companies to their auditors. At the offset all the likely factors relating to the level of audit fees were identified through a literature survey. These factors were categorised into three groups, namely size, complexity, and risk. The relative importance of these factors was determined both empirically and statistically.

Preliminary readings were done in order to identify if the most important factors collected through the literature were suitable for further inclusion in the final analysis. The research is based on quantitative data derived from financials and annual reports of the companies. The research will also include data derived from stock exchange publications, journals and articles which will qualify to the relevance of the study. In carrying out the statistical analysis, the Multiple Regression model would be defined while other tests would be used to calculate the significance and robustness of the model.

The research identifies the company size (in terms of total assets and quick ratio), its complexity (in terms of number of subsidiaries held) and the risk (in terms of long terms debt to total assets and ratio of current assets to total assets) which are the major objective determinants of audit fees.

The research demonstrated on how external auditing practices, competition in the audit market, risks involved with audit work and regulatory requirements in the geographical segment of Sri Lanka and has provided an insight to the relationship on factors which would determine the audit fees. In addition, the statistical analysis revealed that the factors total assets which determined the size of the client and number of subsidiaries which determined the complexity were the most significant predictors of audit fees.

Table of Contents

Index of Tables

Index of Figures


An overview to the development of external audit

Following recent collapses in the corporate world that have caused a ripple effect on the economies in most developed countries, the intensity with which we need to consider proper auditing practices and the focus on promoting a culture of "Good Corporate Governance" have increased significantly. To this effect several measures have been introduced globally to ensure that companies contribute positively to its stakeholders, community, economy and the country. However there is a large area of concern that is yet to be addressed.

The Colombo Stock Exchange experienced huge growth in the aftermath of the war and saw major listings of privately held companies. From a strategic stand point this significant growth and expansion in the capital market has led to potential foreign direct investment of listed companies. In the wake of these developments it is important that the market and listed companies be regulated and proactive action be taken to avoid any kind of unwarranted situation.

To this effect the Securities and Exchange Commission of Sri Lanka, having recognised how important the role of the external auditor especially to listed companies, which come within its jurisdiction and which are required to maintain complete and accurate financial reports on a continuing basis, has determined key criteria to be adopted in selecting their external auditors and also in providing guidance to these companies on managing conflicts of interest, which may be prejudicial to the company and its stakeholders. The external audit function and audit fees are of interest to both the legal authorities and the professional accounting bodies.

The external audit services and fees paid by listed companies to the designated auditors are of much interest to both companies and auditors and companies are required to have their accounts audited by external audit firms, as per the regulations of the Colombo Stock Exchange.

From the companies' perspective the fees paid to the auditors must be reasonable and should be justified to both shareholders and directors. In this view audit firms need to provide such services and want to ensure that the fees they charge are capable of providing a satisfactory service. It is equally important to address the concerns of companies, auditors, the general public and shareholders, in particular that the audit fee is not set of such a level - either too high or too low - which may undermine confidence in the audit opinion.

This study focuses on the identification of the factors that enter into the determination of audit fees, factors which may affect directly the time of the audit work or indirectly the level of audit fees. Given the importance of having an accurate external audit, it is emphasised that the factors affecting the audit fees should be appropriately identified at its best, in order to provide an audit service at a competitive rate and in higher quality.

The research aims to demonstrate the significance of external audit for the listed companies in the geographical segment of Sri Lanka and will provide an insight to the relationship regarding factors which would determine audit fees.

Addressing the research problem

The importance of external audit pricing has continued to be an area of uncertainty over the years. Despite the Securities and Exchange Commission, Colombo Stock Exchange have developed certain guidelines for appointing external auditors for the listed companies that come under their jurisdiction, understanding the determinants and the factors that influence external audit fees is an area, where minimal research has been done.

The turbulence of the financial landscape, tension between shareholders, directors and the management have given rise to many complications in quality of auditing and good corporate governance.

The main motivation for undertaking this study is to understand how external audit pricing is arrived at and its applicability in the Sri Lankan context. Besides the researchers' interest, only a limited effort has been done in this sphere and the researcher hopes to provide insight on audit pricing for randomly selected listed companies on the Colombo Stock Exchange.

Research motives

The main objectives of the research are:

To determine the impact of firm size in determination of audit fees in the listed companies of the Colombo Stock Exchange.

To determine the impact of the significance of risk in determination of audit fees in the listed companies of the Colombo Stock Exchange.

To determine the impact of firm complexity in determination of audit fees in the listed companies of the Colombo Stock Exchange.

Contributions of the study

This research charts an unexplored area of the financial auditing landscape in the Sri Lankan context. Only a limited amount of research has been done to understand the audit fee process and its relevance for the listed companies on the Colombo Stock Exchange. Given the accelerated growth, introduction of new laws and good governance, the researcher feels that this research would help to bridge the gap in providing valuable insight into the determination of audit fees. The contribution of this research can be used to test the existing model across a wide range of listed companies across diverse industries and compositions. This will thus enable the future research to be based on the fundamentals of this thesis and to develop more accurate models based on the situational context.

Structure of the research

The thesis is structured in the following manner aimed at achieving the research objectives.

Chapter One: Introduction

This includes an introduction to the diverse business landscapes of Sri Lanka via focus on the listed companies. It includes the regulatory framework which governs them, the nature of the market for audit services and identifies the intent for research and its main objectives.

Chapter Two: Background to the Research

This chapter sets the stage and reviews the financial market in Sri Lanka and discusses the audit market with special emphasis on the Big 4 audit firms. The demand and supply of companies and the general audit practices used by companies are discussed later. The background to the research further explains the regulations on external audits while highlighting both professional and legislative guidelines. Some estimation of the external audit fees, secondly, its composition and services offered will also be discussed.

Chapter Three: Literature Review

An introduction and development to auditing from a global perspective, prior researches conducted in the South Asian and Sri Lankan context, the identification of factors affecting the level of audit fees and designing of the audit fee model would be discussed, thus providing an overall review of both historic and contemporary literature.

Chapter Four: Theoretical Framework

Deals with the theoretical framework and aims at discussing the general theories aligned with the research problem. In particular this chapter emphasises the Agency theory, Stewardship theory and the Stakeholder theory.

Chapter Five: Research Methodology and Hypotheses

This chapter illustrates the research philosophy which represents the research design, process, types and the approach. The development of the hypotheses is then discussed along with the appropriate empirical model including the defined independent variables (i.e size, complexity and risk). The analytical procedure will be then explained.

Chapter Six: Findings

Presents the results and discussion of the statistical analysis i.e., it discusses the findings of the preliminary statistical procedures. It also presents comparison between the results of the empirical study and the statistical analysis.

Chapter Seven: Research Conclusions & Recommendations

This chapter summarises the research results and provides research recommendations. It also goes on to explain the limitations of the research and goes on to explain the avenues for further research.



The intention of this chapter is to set the stage and review the financial market in Sri Lanka and to discuss the audit market with special emphasis on the Big 4 audit firms. The demand and supply of companies and the general audit practices used by companies are discussed later. The background to the research further explains the regulations on external audits while highlighting both professional and legislative guidelines. Some features of the external audit fees are discussed subsequently.

Financial market in Sri Lanka

Sri Lanka's financial system continues to remain stable and resilient underpinned by strong domestic economic growth in the face of increased risks from the global macro-financial environment. This stability is instrumental in creating a favourable environment for depositors and investors, while encouraging financial institutions and markets to function effectively and efficiently, promoting investment and economic growth. Financial system stability requires a stable financial and economic environment within an effective regulatory framework and a safe and robust payment and settlement system.

The local financial landscape can be divided into the Money Market and the Capital Market respectively. The Money Market where short-term interest- bearing assets with maturities of less than one year, such as treasury bills, commercial paper, and certificates of deposits are traded and facilitate the liquidity management in the economy. The Capital Market on the other hand is the market for trading in assets for maturities longer than one year, such as treasury bonds, private debt securities (bonds and debentures) and equities (shares). Its purpose is to facilitate the raising of long-term funds.

The Financial Market can be also be classified according to instruments, such as the debt market and the equity market.

The debt market is also known as the Fixed Income Securities Market and its segments are the Government Securities Market (treasury bills and bonds) and the Private Debt Securities Market (commercial paper, private bonds and debentures).

The financial system consists of the Central Bank, as the apex financial institution, regulatory authority, financial institution, a payment and settlement system and a legal framework. The financial system carries out the vital financial intermediation function of borrowing from surplus units and lending to deficit units.

The Central Bank through its conduct of monetary policy influences the different segments of the Financial Market in varying degrees. The Central Bank's policy interest rates have the greatest impact on a segment of the Money Market called the inter-bank call money market and a segment of the Fixed Income Securities Market, i.e. the Government Securities Market. The Central Bank may also intervene in the inter-bank Foreign Exchange Market, which is closely connected to the Money Market.

One of the most important functions of the financial system is to ensure safety and efficiency in payments and security transactions. Financial infrastructure refers to the different systems that provide for the execution of both large-value and small-value payments. Payment and settlement systems enable the transfer of money in the accounts of financial institutions to settle financial obligations between individuals and institutions. (Financial System Stability Review - Central Bank 2011)

Audit market in Sri Lanka

With Sri Lanka's convergence to International Financial Reporting Standards (IFRS), a major role must be played by the Institute of Chartered Accountants of Sri Lanka (CA, Sri Lanka), which is the country's sole authority in formulating Accounting and Auditing Standards.

The Sri Lankan audit landscape is mainly dominated by the Big 3 audit firms which are Pricewaterhouse Coopers, Ernst & Young and KMPG. These audit giants account for the majority of audit services across the listed companies.

In addition to these major players BDO Partners, B. R. De Silva & Company, Amerasekera & Company, SMJS Associates, De Zoysa Associates, R N Associates, Nandimuttu & Co, Ranwatta & Co are some of the other auditing firms that compete in the general audit industry of Sri Lanka. These players mostly are involved in auditing companies that are not listed on the Colombo Stock Exchange.

The game of Big 4 & Non Big 4 audit firms

When analysing the audit landscape from an international context the Big 4 are known as the four largest international professional services networks in accountancy and professional services, which handle the vast majority of audits for publicly traded companies as well as many private companies.

The Big 4 are sometimes referred to as the "Final Four" due to the widely held perception that competition regulators are unlikely to allow further concentration of the accounting industry and that other firms will never be able to compete with the Big 4 for top-end work, as there is a market perception that they are not credible as auditors or advisors to the largest corporations.

However in Sri Lanka it is noted that Deloitte Touche Tohmatsu is not a prominent player and only the other three audit firms are significant within the industry. The stability, credibility and global presence that these companies offer are in fact substantial. In a Sri Lankan context these companies have an edge and become a formidable contender for almost all the listed companies.




Fiscal Year


Pricewaterhouse Coopers




United Kingdom

Deloitte Touche Tohmatsu




United States

Ernst & Young




United Kingdom






Table : Financials of the Big 4 Audit Firms

Reference: Company Financials (PWC 2011, E&Y2011, KMPG 2011, Deloitte 2011)

Demand and Supply

In terms of geography, the American region accounts for a 40% and declining share of global combined revenues. From 2010 to 2011 however, the American region had a strong performance growth of 9.9%. Europe has 44% of combined firm revenues and increased 5.4% from 2010 to 2011, growing the slowest due to regional uncertainty. Asian revenues have more than doubled from $7 billion in 2004 to $17 billion in 2011, and grew a spectacular 17.4% from 2010 to 2011.(The 2011 Big Four Firm Performance Analysis)

According to statistics indicated in the Big 4 Performance analysis report 2011 the Big 4 firms cumulatively employ more than 650,000 staff globally, with a total of 35,000 partners overseeing a steep pyramid of about 490,000 professionals. It also indicates that the net employment increased by 36,000 from 2010 to 2011. This gives an indication of how significant these companies are and to what extent they dominate the entire audit landscape.

Regulations on external auditing

The Board of a listed company should establish formal and transparent arrangements for considering how they should select and apply accounting policies, financial reporting and internal control principles and maintaining an appropriate relationship with the Company's Auditors. Once this is finalised a listed company should obtain the services of a professional audit firm. To this effect the company must reach out to the framework on Sri Lankan Auditing standards. The Companies Act of 2007 also has a series of regulations that need to be adhered to when selecting and commissioning the services or an external auditor. This is also applicable in the event of changing the existing audit firm.

Listed companies are required to comply with Sri Lankan Accounting Standards when preparing audited financial statements which are included in their Annual Report. However, the Listing Rules of the Colombo Stock Exchange require the Annual Report to include some additional information.

The Annual Report, as defined by the Colombo Stock Exchange Listing Rules, must include the audited financial statements of the Company, Director's report and the disclosures required by rule 7.6 of the Listing Rules and must be circulated to shareholders before the expiry of five (5) months from the end of the financial year.

This is one of the main considerations that the listed companies must meet in order to comply with the requirements mandated by the Securities and Exchange Commission and the Colombo Stock Exchange.

Professional guidelines

The Sri Lankan Auditing Standards are based on the International Standards on Auditing (ISA) published by the International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC), with slight modifications to meet local conditions and needs. It sets out the basic principles and related practices and procedures that apply to audits of financial statements. Hence compliance with the Sri Lankan Auditing Standards ensures compliance in all material respects with the International Standards on Auditing.

Under the Act (Sri Lanka Accounting & Auditing Standards Act No. 15 of 1995), compliance with these Standards is compulsory when carrying out the audits of entities specified in the said Act. This Act not only places the responsibility of complying with these Standards on the Auditors alone, but also places a corresponding responsibility on the entity's management to take all reasonable steps to ensure that these Standards are complied with in the conduct of the audits of their accounts.

Legislative guidelines

When analysing the legislative framework for the listed companies, it is the responsibility of the audit committees of listed companies to determine the audit process both internal and external. Audit committee responsibilities in companies are to be greatly enhanced according to the Sri Lanka branch of the Association of Chartered Certified Accountants which will create an additional layer of governance and accountability. This will ensure that appointing audit firms to conduct external audits will now rest in the hands of these audit committees which will monitor and provide transparency to the audit process.

Steps are taken to ensure that all listed companies provide information publicly on auditor independence. Auditors should also provide more detailed information about the fees earned by auditors for non-audit services and publish annual reports of the audit committee's work including risk management and internal control reviews. This has enabled more transparency into the legislation and audit procedures.

In the wake of significant discrepancies in corporate disclosures in listed companies it is important to note that auditors only give an opinion of the true and fair view of the financial statements taken as a whole, in terms of materiality, which is termed as a reasonable assurance and not an absolute assurance, in accordance with the international accounting standards.

Features of external audit services

An external audit is a review of the financial statements or reports of an entity, usually a government or business, by someone not affiliated with the company or agency. External audits play a major role in the financial oversight of businesses and governments because they are conducted by outside individuals and therefore provide an unbiased opinion. External audits are commonly performed at regular intervals by businesses, and are typically required yearly by law for governments.

External audits are performed to verify that the financial statements of an entity are correctly presented with a true and fair view. They do not involve an actual accounting of a business' or company's financial accounts, but rather external audits are an independent review of financial documents provided to the party, that carries out the audit.

For a private-sector business, an external audit will typically include a review of the company's quarterly or monthly financial reports as well as statements on revenues and expenditures to ensure they are correctly tabulated and reported. For governments, an external audit will include a review of the budget, the allocation of funds and the actual expenses to ensure the budgeted revenues and expenses were correctly compiled and used.

An external audit will feature a report outlining the auditor's findings. This will generally be a summary of the overall validity of the financial statements and documents as presented by the company or government which is usually presented as the Statement of Auditors in the Annual Reports. Should the external auditor uncover discrepancies between the statements presented by the company and his findings, these will be noted in the report as well. The audit will often include financial suggestions for the entity as ways to improve its overall financial standing and accounting practices.

The more important feature of an external audit is the conclusion of the auditor. A favourable conclusion is unbiased evidence that the entity is reporting financial data correctly while a negative conclusion is a red flag for poor accounting practices.


The stability of the financial market in Sri Lanka is a key driver of economic growth and sustenance. Similarly the capital markets provide a gateway for foreign investment and stimulate growth trajectories. The Sri Lankan Auditing Standards board and the Institute of Charted Accountants are the top governing bodies that ensure good practices and transparency in the industry.

In summary it was revealed that in Sri Lanka a majority of the listed companies prefer to seek the services of three of the Big4 audit firms, namely, Ernst & Young, KMPG and Pricewaterhouse Coopers. There are some smaller audit firms that are not so significant in providing services to the listed companies. This chapter discusses the regulations on external audits while stressing the importance of both professional and legislative guidelines. Estimation of the external audit fees, its composition and services offered have been discussed from a Sri Lankan perspective.



This chapter largely deals with the vital point of current knowledge, extensive secondary research and publications related to the topic of the study. It classifies and elaborates on the concepts of introduction and development of external audit fees from a global perspective; prior researches conducted in the Sri Lankan and South Asian context and the identification of factors affecting eternal audit fees. The review is also an effort to understand the determinants of audit fees and hypotheses for an audit fee model for the listed companies in Sri Lanka.

Review of previous researches in relation to external audit fees and the determinants of such, influences a better understanding to provide a worthy foundation for this study. This section presents a generalised review of the studies on audit fee determinants in a globalised perspective.

External audit pricing and the factors which determine the audit fees have been a much debated topics throughout decades and various views have been identified based on initial researches during 1990's and 1980's.

The purpose of this review is to analyse literature on the audit landscape, thereby to assess the current understanding of the major themes relevant to addressing the research question of this thesis: What are the determinants of audit fees in the Sri Lankan context? There is an abundance of literature on determinants of audit fees, pertaining to what will be classified in this thesis as the audit fee model. However there is only a limited amount of literature available on audit fee research from a Sri Lankan organisation standpoint. Similarly it must be noted that audit fee determinants on listed companies in Sri Lanka are constantly evolving due to major changes in the business environment and how organisations do business.

Development of audit fee in a global perspective

During the last couple of decades the '' bubble burst and major corporate collapses took place; the reverberations from the events of 11 September 2001; the introduction of Sarbanes Oxley (SOX) requirements in 2002; the transition in 2005 to International Financial Reporting Standards (IFRS); auditing standards becoming legally enforceable in 2006 and being further 'clarified' in 2010; the 2008 Global Financial Crisis (GFC) causing financial distress on a scale not seen since the 1930s; a post-Global Financial Crisis debt crisis plaguing the United States and the European Union sum up the volatile global expanse. Sri Lanka however may not have been significantly impacted by world events, yet natural disasters like the Tsunami, a raging 30 year ethnic war which brought about unprecedented stock market activity and devaluation of the rupee calls for proper reform and financial regulation. The direction given in the Colombo Stock Exchange Annual report 2011-2012 shows that the monopolised activity witnessed on the Colombo Stock Exchange could have been better monitored and regulated leading to harmonious investments and foreign capital inflow. To this effect recommendations of the code of best practice on governance issued jointly by the Securities Exchange commission and the Institute of Charted Accountants of Sri Lanka have been set and listing rules have been revised in February 2012.

Globalisation and the resulting interdependencies in economies and supply chains, advances in technology, rapid population growth and increasing global consumption have significantly impacted on the quality, availability and price of resources, including water, food and energy. The need for a broader information set is clearly demonstrated by the small percentage of market value now represented by physical and financial assets - down to only 19 per cent in 2009 from 83 per cent in 1975. (The Global Reporting Initiative's G3.1 Sustainability Reporting Guidelines; Water Act 2007).

The remainder represents intangible factors, some of which are explained in financial statements, but most of which are not. The type of information needed to assess past and current performance and future prospects is much wider than is provided for by the existing financial-reporting model.

External reporting is now due for a wave of reforms. The International Integrated Reporting Council (IIRC) is developing an integrated reporting framework that will guide the development of external reporting over the coming decades. It has issued a discussion paper (IIRC, 2011) and intends to issue an exposure draft in 2012.

For auditors, these changes have increased the risk and complexity of auditing financial-statements and highlighted the importance of audit quality to market confidence. As the 'contracted regulators' of financial reporting, auditors have inevitably increased audit effort in response to these higher risks. One measure of greater risk is the increasing rate of corporate insolvencies.

To this effect Simunic (1980) initially developed a positive model in the market for audit in publicly listed companies with respect to the price competition and the study was mainly based on a sample of 397 observations.

The model identified three basic variables which are,

loss exposure variables represented by the total assets and the complexity in terms of decentralisation (Number of subsidiaries) and diversification

loss sharing variables represented by the ratio of net income to total assets, the loss incurred by the firm as a dummy variable and the opinion of a qualified auditor through a dummy variable

production function variable represented through the auditor tenure

The initial analysis on the whole sample scored an R squared value as 57% where he identified a nonlinear relationship between assets and audit fees. Therefore secondarily he used a square root transformation of assets variable in order to linearise the relationship between audit fees and assets.

Next he classified industries specified as utility firms and banking sector assigning them values 0 and 1 (dummy variables) and identified that the R squared value as 42%. In order to test the impact of size of the audit firm on audit fees he categorised the whole sample into two on the basis of sales size (Sales more than $125 and less than $125) and the R squared value was respectively 28% and 51%. He found that the variables counted for loss exposure are statistically significant in determining the audit fees. Despite identification of the determinants he also concluded that there is no monopoly pricing which leads big firms to enjoy economies of scale to charge lower fees.

The limitations of this study is that the data has been collected through questionnaires, a qualitative method and this gives rise to measurement errors, question of reliability of collected data and is also a moral hazard to empirical research analysis. The findings of the study are also limited to a particular time frame and therefore further studies have to be taken place with a wider span of time.

Elliot and Korpi (1978) undertook an empirical study with 60 manufacturing companies and 42 financial companies by collecting data through questionnaires to develop an audit fee model. They considered a number of factors, i.e. size of sales and assets of the companies, degree of complexity and applied the transformation of square root in order to linearize the relationship with the audit fees. Their model explained 94% and 84% of the audit fees variance for manufacturing and financial companies respectively which is statistically significant. However in order to test the accuracy of this model it is vital that a wider range of companies be covered ranging across diverse industries.

The findings of this study provide clarity around financial & manufacturing companies and can be used to specialise audit fee models that would be consistent only within these two industries.

Briston and Perks (1977) estimated the total audit fees paid by all the 592,243 companies; 3,555 listed companies & 589,688 unlisted companies, ranked by turnover registered in England, Scotland, and Wales to be around £200 million comprising £109.70 million for the listed companies plus £90.0 million for the unlisted companies for 1975 / 1976, and £250 million during 1977. They used the average of the audit fees as a percentage of turnovers (i.e., 0.1 %.) to estimate the total audit fees. Their study indicated that the proportion of audit fees to turnover decreases as the company's size increases e.g., audit fees as a percentage of turnover was 0.1 for the companies with total turnover £2.2 billion, and it decreases to 0.04% for the companies with total turnover £69 billion.

Fanning (1978) also estimated the total audit fees of limited companies in the U.K. including the top 100 quoted companies by market value, 500 other quoted companies, and 300,000 unlisted companies in 1976 / 1977 to be £416 million comprising of £54.42 million for the top 100 companies, £212.85 million for the other 500, and £148.75 million for the 300,000 unlisted companies. Additionally the estimated audit fees for 1978 was about £450 million assuming a continuing trend in fees increases between 15% and 30%. The increasing risks, complexity and costs of financial-statement audits would suggest substantial increases in audit fees, particularly post 2008 period.

These models give an indication that the size of a company in terms of turnover is a critical component that needs to be considered. However it may not provide enough clarity to determine that higher turnovers alone are inversely proportional to the audit fees charged. Further research areas could be performed to analyse the companies across industries and in terms of market capitalisation and other financial ratios.

Taylor and Baker (1981) carried out a study with 126 manufacturing companies in the UK and found that square root transformation of data improves the relationship between dependent (audit fees) and independent variables. As a data reduction technique they applied factor analysis and identified the most viable measures of size and complexity are total assets and number of subsidiaries respectively. The developed audit fee model has explained 79% of the variation in the audit fee which is treated as highly significant.

A cross country study has been done by Wayman and Bavishi (1983) in determining the factors in 640 companies across four countries; India, Malaysia, United Kingdom and Australia. The size of the company, multi-nationality, size of the audit firm and financial close month were treated as the independent variable whereas audit fees; the dependent variable of their regression model. The explanation of the variable of the audit fees were explained as 69%, 51%, 88% and 49% respectively in Australia, India, Malaysia and UK. They found an inverse relationship between audit fees and the size of company common to all four countries. This study goes on to support the inverse relationship between size and audit fees. The countries however are geographically dispersed and may not provide a holistic view on the audit research. Further areas for research would be to analyse a more specific geographical area such as in specified regions (ie: European region, South Asian region) and develop the audit fee model.

Chan et al. (1993) assumes as a fact that a high insider ownership mitigates agency conflict between manager and shareholders. Using an initial sample of 985 UK listed companies that they divided in two sub-samples (big firms vs. non big firms), Chan et al. shows that insider ownership is negatively associated to audit fees for the whole sample and for the sub-sample of big firms. However, the results are non-significant for the small firms sub-sample.

Using the same argument as Chan et al. (1993) on a sample of Norwegian firms, Firth (1997) finds a non-significant relation between insider ownership concentration and audit fees. In France, Piot (2001) finds a non-significant relation between insider ownership and the choice of big audit firm (audit quality). Finally, Niemi (2005) tests Chan et al.'s (1993) model on Finnish firms and finds a non-significant relation between audit fees and the measure of the combined managerial and non-managerial ownership concentration (i.e. insiders). Then, the author explains these mixed results by the fact that managerial and non-managerial ownership concentration should have opposite effects on audit fees. After having distinguished between firms that are controlled by the management, by a foreign holding or by the state, he finds (1) a significantly negative relation between audit fees and management control of the firm; (2) a positive relation between audit fees and state control and foreign holding control.

The author acknowledges the selection bias in that the countries selected, all have strong "european" ties, "thus they may not reflect a varied set of international audit fee pricing practices". It is acknowledged that, although prior literature indicates some consensus on the variables chosen, other variables had also been identified which could further explain audit fees. They deserve credit for their efforts, although the evidence is by no means clear as to whether selection of other variables would have produced any more powerful explanatory model(s). The results are generally positive and significant, across countries and firms, although the level of applicability varied from between country and firm. The researcher considered this showed consistency in the model across ranges of firms and countries however may not hold true for Asia centric countries.

Fan and Wong (2005) study audit fees determinants in Asia, where family ownership is high and investors are less protected. They test whether auditors ask for an additional premium to their clients when agency conflicts are high. The authors find a positive relation between audit fees and ownership concentration and explain that auditors assume a higher risk to audit those firms. Previous research therefore presents mixed evidence of the impact of agency conflicts on the supply of audit services and points out the necessity to consider the distinction between managerial and controlling shareholders ownership.

Hay et al (2006) summarises the large body of audit fees determinants research using a meta-analysis and conclude that the results on the relation between ownership structure and audit fees are mixed. Previous studies focused mainly on the impact of insider ownership (defined as both manager and controlling shareholders) on audit fees.

Prior researches in the Sri Lankan & South Asian context

Sri Lanka is considered an appropriate focus for the current study because it is a developing country, has largely converged its accounting and auditing standards to International Financial Reporting Standards (IFRS) and International Standards on Auditing (ISA) equivalents, respectively, and has acknowledged the issues associated with Fair Value Accounting (FVA).

In terms of background to the auditing landscape in Sri Lanka the Institute of Chartered Accountants of Sri Lanka (ICASL) sports a membership of over 3,500 members and was constituted by the Act No. 23 of Parliament in 1959. It is the sole body authorised under the Sri Lanka Accounting and Auditing Standards Act No. 15 of 1995 to issue both Sri Lankan Accounting Standards (SLAS) and Sri Lankan Auditing Standards (SLAuS). Under the latter Act, compliance with SLAS is compulsory for "specified business enterprises", while SLAuS must be applied for audits of entities specified in the Act. As noted in the Introduction, ICASL has issued a range of standards which prescribe FVA for particular assets and liabilities.

Despite a few high-profile corporate failures, which have generated discussions by stakeholders with regard to the auditors' role, there have been no legal cases or other punitive sanctions against auditors. Sri Lanka has had few high-profile corporate failures. In the wake of the collapse of several finance companies in the late 80s and early 90s, the Government of Sri Lanka established the Presidential Commission on Finance and Banking to investigate the causes of such failures and to recommend measures for strengthening the country's financial sector arrangements. The Commission stressed the need for adoption and enforcement of accounting and auditing standards for establishing a high-quality corporate financial reporting regime. Furthermore, the Commission recommended better performance of responsibilities by auditors in preventing such failures. Even with these measures, as recent as 2003, there was a failure of a savings and development bank in Sri Lanka. Despite such failures, there have been no legal actions or other administrative measures taken against auditors according to the report on the "Observance of standards & codes" (ROSC) Sri Lanka 2004.

Prior research done on the Sri Lankan context was not available, however from a Commonwealth and South Asian context particularly, the literature includes researches set in Bangladesh (Karim & Moizer, 1996), Singapore (Low et al, 1990), Singapore and Malaysia (Poitras et al, 1995), Singapore, Malaysia and Hong Kong (Simon et al, 1992), India (Dugar et al, 1995) and Pakistan (Ahmed & Goyal, 2005).

Poitras et al (1995) selected a sample of 50 companies by largest capitalization as at December 31, 1991 listed on the Stock Exchange of Singapore (SES). These companies had operations mainly in Singapore and Malaysia. Based mainly on the Simunic (1980) model, with adjustments for local conditions and the introduction of few more variables such as audit fees/total assets, and found find mixed results in their study. However the Pearson's correlation analysis suggests audit fee, as the dependent variable is correlated to audit size and tenure. Singapore exhibits the presence of Big six premium but the results are mixed with an adjusted R square of the empirical model of 92%, with major volatility in audit pricing being observed at due mostly at industry level and on time series basis, the intercept indicates both negative and positive.

The research by Ahmed & Goyal (2005) illuminates a weakly-researched issue as to how auditors charge for their services by empirically examining audit fee determinants in three emerging economies in South Asia. Using 1998 data from 118 Bangladeshi, 219 Indian and 229 Pakistani firms, the results show that size of reporting entity, multinational affiliation and size of audit firm are the three most important determinants across the three countries. They find no significant relationship between audit fee and a firm's financial situation and auditee complexity. Additionally, no significant relations were found between audit fees and the firm's financial condition and auditee complexity. The results of this study provide useful insights into the role of contracting cost variables and auditors' billing practices in comparative and emerging economies in general, and South Asia in particular.

Naser & Nuseibih (2007) studied the structure of audit fees in Jordan using traditional measures of determination such as size and complexity. In line with prior research, these authors find similarity in their findings with core determinants being both size and complexity in Jordan. In much the same geography, Al-Shammari et al (2008) studied the determinants of audit fees in Kuwait. This would provide clarity on the determinants that impact audit fees from a Middle Eastern perspective. This study is in line with the audit variables that are used and size and complexity are critically analyzed for all intents and purposes.

Simon et al (1986) found similar results similar to previous research in India. Again, Size and Complexity were key determinants of audit fees. They determined that audit fees in India are determined primarily by audit size, complexity and risk. They also suggest that bigger firms with dispersed shareholding are increasingly demanding Big 4 auditors - thus perhaps mitigating agency conflicts - as the majority of "large" shareholders are still "families" who have controlling interests in the firms. They also suggest that while audit premia is not evident in their research, auditors may charge higher fees than Non-Big 4 firms through setting lower qualification levels. This suggests that firms with lower agency issues deploy the services of Big 4 auditors more than firms with a high degree of agency problems. Later research by Dugar et al (1995) is of relevance. This research is consistent with the concept of including the analysis of the big 4 audit firms as a variable to understand its relationship to determine the audit fee model.

Identification of factors affecting the level of audit fees

Hobgood and Sciarrino (1972) predicted factors through responses for a survey conducted in 155 Canadian companies. These were identified as, size and caliber of the audit firm staff, scope of the audit, size of the client and comparison of audit fees paid by other companies similar in size and industry.

Morgan (1973 and 1974) respectively studied on the objective and subjective factors which influences in determining the audit fees and he established that time is the main objective element whereas value of the service to the client and difficulty of engagement as the subjective elements. Zweig (1978) specified that the value of the service be the basic element of the fee determination.

Flesher and Loroosh (1980) recognized nine factors in determining the audit fees through a survey of randomly selected 232 CPAs which are;

• Time spent on the task

• Cost of the service rendered

• Ability of client to pay

• Value of the service rendered

• Customary fees

• Legal limitations

• Established client (status)

• Fixed fees

• Urgency for work to be completed

Concluding the survey, time, cost and the value of the service to the client were identified as the most important factors and others were treated as less important by the respondents.

One distinctive feature in the case of Bangladesh in 2007 is that there are formally no Big Four firms with an established presence in the country, as in India and Pakistan, even though the population of Bangladesh is around 147.4 million. Consequently, Karim & Moizer (1996) in their research set in Bangladesh, used as a proxy for Big Four firms, local audit forms with links to international audit firms. In their study of determinants of audit fees in Bangladesh, Karim and Moizer attempted to determine the factors towards explaining the audit services market in the Country and state that "audit is a buyer's market". Their study suggests a limited Big Six premium effect; however they do state that audit size, audit risk and audit complexity form the foundations for audit price. This research focuses on the big 4 audit firms in the local context to understand their relationship to the model.


Finally a conclusion will be drawn identifying the key points addressed, the conflicts in the literature and the areas this study will address. The main objective would be to understand the determinants for external audit in the listed companies and thereby to understand the development of an ideal audit fee model.

The exploratory nature and limited scope of this research points to a range of related further research. It would be useful to build on this study by widening the range of research into audit fee models from this research, and develop more qualitative determinants, as appropriate. This would create a balanced approach that would perfect the outcome of determining audit fees.

Having regard to the previous researches done on designing the audit fee model this research attempts to demonstrate relationships between variables that would represent risk, size and complexity and related audit fees in the financial statements of the listed companies in the Colombo Stock Exchange.



This chapter describes the general theories aligned with the research. The research attempts to focus on the Agency theory, Stewardship theory and the Stakeholder theory which create a sound theoretical framework.

The Agency theory discusses the agency relationship and the issues that arise from the dilemma that the principal and agent, while nominally working toward the same goal, may not always share the same interests. The literature on Agency theory largely focuses on methods, systems and their consequences that align the interests of the principal and agent.

The Stewardship theory on the other hand is an alternative view of Agency theory, in which managers are assumed to act in their own self-interests at the expense of shareholders.

Stakeholder theory suggests that the purpose of a business is to create as much value as possible for stakeholders. According to Drucker (1990), today corporations have to balance their responsibilities towards society in which they function, while meeting the ever increasing demands of their stakeholders to be competitive in a global economy.

Agency Theory

The concept of Agency theory is a useful economic theory of accountability is defined as 'one in which one or more people (the principal) engage another person (the agent) to perform a service on their behalf which involves delegating some decision making authority to the agent' (Jensen & Meckling, 1976). Although this is primarily meant to be the relationship between the shareholders and directors, it has been also argued by Jenson & Meckling that there are other contracts which could be considered within an agency framework such as directors and other interest groups and such relates to understand the role of external auditors.

The delegation of authority involves the trust between the agent and the principal whereby the Agency theory takes a view that people cannot be trusted to act in the public good and in the interest of the shareholders. This gives rise to the need of monitoring and controlling of the performance of agents and therefore needs to put in place mechanisms such as the external audit to reinforce this trust.

External auditors do engage as agents but they are expected to be independent from the agents who manage the operations of a business and are expected to provide an objective, credible and independent opinion on the financial statements to the stakeholders including shareholders.

The problem of agent and principal arises as a result of separation of management and ownership in a large scale where the interests of parties diverge consequently. This is where the directors have the full control over the funds of shareholders and tend to be self-serving by maximising their own pockets. The agency theory had been tested upon the positive accounting theory in 1978 by Watts and Zimmerman and has identified the reasons as to why managers (agents) cook their own books.


When understanding the operating model of listed companies in Sri Lanka the most important basis of Agency theory is that the managers are usually motivated by their own personal gains and work to exploit their own personal interests rather than considering shareholders' interests and maximising shareholder value. For example, managers may be attracted to buying lavish offices, company cars and other extravagant items, since the cost is borne by the owners. However the concept of auditing and control carried out by a reputed audit firm will ensure that the operating model comes under proper scrutiny.

Thus, the key predicament indicated by Agency theory is ensuring that managers pursue the interests of shareholders and not only their own interests. Eisenhardt (1989, p. 58) explains that agency problems commence when "The goals of the principal and agent conflict and it is difficult and costly for the principal to verify what the agent is actually doing".

Controversy occurs because principals are unable to monitor the performance of agents (Jensen & Meckling 1976). The pursuit of self-interest increases costs to the firm, which could include the costs of the formation of contracts, loss due to decisions being taken by the agents and the costs of observing and controlling the actions of the agents. Leuz et al. (2003) assert that the effects of such behaviour ultimately reflect in the company earnings. It is now evident that the investment in an audit needs to be apportioned to ensure that the performance of the agents or managers is monitored and proper feedback is provided.


It is also important that the management has an incentive to manage the company's reported earnings in order to meet or beat earnings targets and, thus, to receive any bonuses that may be tied to the company's earnings (performance-related pay). This creates an information asymmetry in that managers can exercise the discretion they have on accruals, which in turn reduces the relevance and reliability of reported earnings, and the whole financial statements. Davidson et al. (2004) argues that when management provides inaccurate financial reporting information, it introduces earnings management as a type of agency cost. To counter this situation an internal audit may not be sufficient and the importance of an external audit must be conducted to understand the variances and changes that happen in the operating model of a company. The strict monitoring of managers by the principals or their representatives, such as the firm's board, is seen as fundamental to protecting shareholders' interest from being compromised when managers maximise their self-interest at the expense of the organisation's profitability.


In order to effectively limit agency costs caused by the separation of ownership and control, Fama and Jensen (1983b, p.309) propose that firms need a system that can separate decision management from decision control. This would limit agency costs by controlling the power of management and ensuring the proper consideration of shareholders' interests. It is clearly mentioned that the role of the external auditor is to reduce agency costs by cutting information asymmetry in financial reporting (Poit, 2001). This constitutes the importance of external audit and how it can positively impact the transparency in financial reporting.

Agency theory recognises external auditing as the most important monitoring mechanism because it controls conflicts of interest and diminishes agency costs. Watts and Zimmerman (1983) confirm that high quality external auditing will undermine the opportunistic behaviour cost (agency cost) introduced by management. 

These monitors act on behalf of the shareholders. As a result, high audit quality involving specialised independent auditors like the Big 4 audit firms can decrease opportunities for managers to pursue self-interest at the expense of owners and, thus, principals obtain more favourable returns. Hence the agency theory can be looked upon as a basis to develop theories for determining the relevance and composition of audit fees for companies public quoted companies in Sri Lanka.

Stewardship Theory

Unlike the Agency theory, the Stewardship theory, based on a psychological and sociological approach, maintains that the interests of corporate executives (as stewards) are aligned with those of the organisation and its owners (Albrecht et al., 2004). The stewardship theorists focus on structures that empower and facilitate rather than monitor and control. They reject the highly individualistic model of Agency theory that promotes a suspicious "policeman's" attitude, assumes that principals and agents have different interests and sees agents as essentially self-serving and self-centred. This is a theory that contradicts and challenges to a certain extent the concept of external auditing for all intents and purposes of monitoring management and employees of firms. The theory also goes on to reject the view that principals need to invigilate the opportunistic agents by monitoring them and apply sanctions or incentives as means of control.

Stewardship theory takes an opposite perspective in suggesting that the agents are trustworthy and good stewards of the resources are entrusted to them, which makes monitoring unnecessary (Donaldson, 1990; Donaldson & Davis, 1994; Davis et al., 1997). Since managers are not opportunistic and act in the best interests of the owners, they should also be given autonomy based on trust, and this reduces the cost of monitoring and controlling their behaviour. This means that according to the Stewardship theory managers are considered loyal and their conduct does not need to be scrutinised. However Donaldson and Davis (1994, p. 51) observe, "organisational role-holders are conceived as being motivated by the need to achieve and exercise responsibility and authority, to gain satisfaction through effectively performing essentially challenging work, and to gain recognition from peers and bosses".

In most listed companies in Sri Lanka we see a significant proportion of dividend paying companies (i.e. Hayleys PLC, John Keels Holdings and etc.). From a Sri Lankan perspective a dividend paying company is considered stable and attractive to most investors. According to Stewardship theory, the behaviour of the steward is collective, because the steward seeks to achieve the organisation's goals (e.g. profitability). This, in turn, benefits the principals through the positive effects of profits on dividends and share prices (Davis et al. 1997). In most local companies managers believe that their interests are aligned with those of the firm's owners. Thus, Stewardship theory maintains that the optimum governance structures are those that enable effective coordination in the enterprise. The stewardship perspective sees directors, as well as managers, as stewards of the firm and thus likely to increase the shareholders' wealth. Davis et al. (1997) posit that stewards gain greater satisfaction from achieving organisational goals than through pursuit of their own goals.

Davis et al. (1997) argue that achieving organisational success also satisfies the personal needs of the stewards. Thus, the stewardship theory considers that managers' decisions are also influenced by non-financial motives, such as need for achievement and recognition, the intrinsic satisfaction of successful performance, and respect for authority and the work ethic. However it is interesting to analyse, if this would be more prominent as opposed to the financial incentives a manager would visualise. This may well contradict the Stewardship theory in the Sri Lankan context.

However, according to this theory, it makes sense for corporate governance to be based on the view that the directors, on behalf of stakeholders, want to be good stewards of the corporate assets, and there is no conflict of interest or opportunistic behaviour at the expense of stakeholders. They work diligently to gain high levels of corporate profit and shareholder return. These concepts have been documented in organisational studies, such as in Muth and Donaldson (1998). To this effect the importance of an audit procedure may seem far-fetched and the value proposition may not be as clear, if this theory were to be considered.


When understanding the impact of the Stewardship theory from a level of the board, it considers the board of directors as an instrument of assistance to a steward chief executive officer rather than a controlling mechanism (Albrecht et al., 2004). It also considers that management is less likely to practice earnings management. However, the problem lies in the extent to which the management aspires to attain a good corporate performance. This could also take a turn where chief executive officers' may aspire for personal incentives & benefits over broader shareholder expectations. From the stewardship theory perspective, a firm's superior performance is linked to the board having a majority of executive directors since these directors understand the business better than outside directors, and can therefore make superior decisions (Donaldson, 1990; Donaldson & Davis, 1994).

Also important to note is the concept of duality of the board chair, that is the same person holding the position of chair and chief executive, is viewed favorably since, it is argued, it leads to better performance by the firm due to clear and unified leadership (Donaldson & Davis, 1994; Davis, et al., 1997). Bhagat and Black (1999) find that firms with boards consisting of a higher number of outside directors (representing the Agency theory perspective) perform worse than firms with fewer outside directors.

The concept of identifying key people and drivers is common in most local companies. This enables a selected bunch of mangers to take on more responsibility and authority to drive a firm towards success. Davis et al. (1997) suggest that key managers identified within the firm leads to a personal relationship with success or failure of the firm. Daily et al. (2003) argue that managers and directors also want to protect their reputations as expert decision makers. As a result, managers run the firm in a manner that amplifies financial performance, including shareholder returns, as the firms' performance impacts directly on perception of their individual performance. 


The Stewardship theory goes on to argue that the effective control held by professional managers empowers them to maximise the firm's performance and corporate profits. Consequently, boards that are dominated by executive directors are preferable because of their expertise and knowledge, access to essential information and commitment to the firm. Several studies support the view that managers make superior decisions because they possess more and better information (e.g. Boyd, 1995). In the listed companies a committee is appointed to make decisions of the audit practices both internal and external. This would mean that the committee would be a cross section of managers, directors and the board who would collectively take decisions on behalf of the audit practice within the company and ensure best practice.

In summary, the Stewardship theory argues that the responsibility and authority of executive managers provides a better focus on company objectives, leadership and implementation of operational decisions, leading to more effective corporate governance and corporation. Donaldson & Davis (1994) contend that the Stewardship theory remains the theoretical foundation for better regulation and legislation in corporate governance. Muth and Donaldson (1998) compare the predictions of Agency theory with those of Stewardship theory and find support for the latter as a good model of reality. The question of how important this this theory is for determining external audit is somewhat unclear. Yet it adds a basis from which external audit is to be determined in the context of the audit practice and good governance.

Stakeholder Theory

The stakeholder theory revolves around the concepts that managers should on the one hand manage the corporation for the benefit of its stakeholders in order to ensure their rights and the participation in decision making and on the other hand the management must act as the stockholder's agent to ensure the survival of the firm to safeguard the long term stakes