Audit fees

Under the definition of Exchange Act, Rule 3b-7, the executive officers include registrant’s president, any vice president of the registrant in charge of a principle business unit, division, or function (such as sales, administration or finance), any other officer who performs a policy making function. For the third proposed amendment, auditors are required to perform procedures that include but not limited to (1) reading employment and compensation contracts and (2) reading proxy statements and other relevant company filings with the U.S. Securities and Exchange Commission (SEC) and other regulatory agencies that relate to the company’s financial relationships and transactions with its executive officers.

2.2.1Audit pricing

The determinants of audit fees on a competitive audit market were examined first by Simunic(1980),and later by several other researchers (e.g., Abbott, Parker, Peters,

8 PCAOB Release No. 2012-001, page 2, paragraph 4

9PCAOB Release No. 2012-001, Appendix 4, page A4-42

10 According to a May 2010 academic study that examined in detail SEC accounting and auditing enforcement releases from 1997 to 2008, the chief executive officer or chief financial officer was named in 89 percent of the enforcement actions involving fraudulent financial reporting. See M. Beasley, J.

Carcello, D. Hermanson, and T. Neal, “Fraudulent Financial Reporting 1998-2007 An Analysis of U.S.

Public Companies.”

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and Raghunanda, 2003; Carcello, Hermanson, Neal, and Riley Jr., 2002; Colsen, Maher, Broman, and Tiessen, 1988; Creswell, Francis, and Taylor, 1995; Davis, Ricchiute, and Trompeter, 1993; Hay, Knechel, and Wong, 2006). These studies indicate that audit fees are determined by the auditor’s efforts during the engagement, firm-specific factors and thelevel of auditor’s accepting audit risk. Audit risk is the risk of failing to detect and report a material accounting discrepancy.

On one hand, regulatory risk, litigation risk and reputation risk are three types of risk that determine the maximum overall audit risk an auditor is willing to accept.Regulatory risks, the risk of regulators investigating the firm and its auditor, are determined by firm-specific and non-firm-specific factors (Colsen et al., 1988).

Litigation risk refers to the risk of clients and auditors being sued by interested stakeholders (Simunic and Stein, 1996), and reputation risk is the possibility of future restatements and revelations of inadequate audits or auditor impropriety impairing auditor reputation and its value to future clients (Craswell et al., 1995). If the standard auditing procedures do not allow auditors to gather sufficient appropriate audit evidence to lower the audit risk to an acceptable level, auditors would charge higher audit fees to compensate for potential future loss including increased litigation risk (Simunic and Stein, 1996).

On the other hand,the audit risk is composed of the likelihood that environmental factors result in a material error before considering the quality of internal controls (inherent risk), the likelihood that the internal controls will not prevent or detect a material error (control risk), and the likelihood that the audit procedures will fail to detect a material accounting discrepancy (detection risk), since auditors design audits to reduce audit risk below a given level.

AR = IR × CR × DR

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Therefore, if the firm’s internal risk and/or control risk are higher than acceptable audit risk, the auditor can only decrease its detection risk and exert more effort, thus with higher audit fees.

To cover the extra costs incurred by exerting higher audit effort and /or allocating more professional staff, auditors charge larger fees for higher risk clients (Simunic and Stein, 1996). Auditors may also charge a risk premium fee beyond that needed to cover the extra costs incurred, to compensate for the additional risks assumed (Abbott et al., 2006). Prior literatures indicate that audit fees are larger in firms having higher inherent and /or control risk (Davis et al. 1993; O’Keefe, Simunic, and Stein, 1994; Gul and Tusi, 2001). The development of the brand name of auditors is argued to be costly, in turn, named auditors face higher reputation risk when facing audit failure, and therefore to increase audit fees (Craswell et at., 1995). It also shows a positive association between audit fees and litigation risk arising from a client’s financial reporting quality (Bédard and Johnston, 2004; Abbott et al. 2006).

2.2.2 Audit fees and the risk of misreporting

Prior studies have examined the association between the risk of client misreporting and audit fees. Studies indicate that auditors incorporate litigation risk by supplying higher audit effort or charging higher fees to clients with higher risk of misreporting.

Simunic and Stein (1996) conclude that the U.S. evidence is generally consistent with audit firms increasing their fees when facing the litigation risk higher than usual. Gul et al. (2003) find a positive association between earnings management and audit fees.

Bédardand Johnstone(2004) report that heightened earnings management risk increases planned audit effort and higher auditor billing rate. Hogan and Wilkins (2008) find that audit fees are higher for firms that disclose internal control deficiencies, suggesting that

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auditors either increase their effort or charge higher premiums for firms with increased control and information risks. Kim, Park and Wier (2012) show that audit fees are inversely related to the client’s reporting quality, since an increase in the probability of client misreporting increases the auditor’s litigation risk. The research of Vafeas and Waegelein (2007) also suggest that billing rates are greater for audit clients with greater earnings manipulating risk and corporate governance risk.

2.2.3 Determinants in audit fee model

There is a substantial literature on audit pricing with Simunic (1980) among the earliest to provide theoretical and empirical evidence on the determinants of audit fees.

These determinants may be broadly classified as client attributes, auditor attributes, and characteristics specific to the audit engagement (e.g. Gul, Chen, and Tsui, 2003;

Hay,Knechel, and Wong, 2006; Chen, Gul, Veeraraghavan, and Zolotoy, 2013).

Much research focuses on client attributes, finding that audit fees are increasing in the client size (e.g., Simunic, 1980), risk (e.g., Stice, 1991), and complexity (e.g., Hackenbrack and Knechel, 1997). Client size is usually proxied for the natural logarithm of total assets. Firm risk often includes audit opinion, operating loss, discretionary accruals, whether the firm belongs to high litigation industry, restatement, stock return volatility, leverage ratio, return on assets, the ratio of receivables and inventory to total assets, quick ratio, and so on. Firm complexity includes the number of business segments, the number of subsidiaries, whether engage in acquisition of merger, foreign sales percentage, growth rate in sales, market-to-book ratio, and so on. (e.g.

Chen et al., 2013; Gul, Chen, and Tsui, 2003; Goncharov, Riedl, and Sellhorn, 2013;

Chen, Srinidhi, Tsang, and Yu, 2012; Ho and Kang, 2013)

Look into the attributes of auditors, many studies consider the auditor quality,

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proxied for Big N or auditor specialization. Other characteristics include the auditor tenure, non-audit fees, and client’s fiscal year-end. Please look to Appendix 2-1 for detailed description of determinants in audit fee model by prior literatures.