CHAPTER 2
Soltani (2007) defined Audit fees as the costs associated with an auditor performing an audit to form an opinion on whether a client's overall financial statements are prepared, in all material respects, in accordance with generally accepted accounting principles (GAAP). Simunic (1980) defined audit fees as a product of unit price and quantity of audit services provided by audit firms on demand by the management of audited company.
Chow (1982) observed that the demand for audit services arises in a firm either due to contracting or institutional requirements. Earlier literature finds the managers desire to reduce agency cost as a main determinant of audit fees. DeAngelo (1981) and Watts & Zimmerman (1983) considered the provision of audited financial statements under contracting between management-shareholder as a cost effective contractual response to agency cost. However, the later literature suggests a number of variables that cover corporate needs, good corporate governance and litigation costs. The audit firms determine the audit fees of a firm based on different factors like the company size, complexity of the business and factors that contribute to different aspects of audit risk etc.
Corporate governance and audit fees
The information gap created as a result of the separation of corporate ownership from management necessitated the demand for forms of control and monitoring both internally and externally. Monitoring & control is done internally through the board of directors and externally through the report of the external auditors as well as through the market for control. Soltani (2007) states that corporate governance is related to the monitoring function of the board of directors and the audit committee. Corporate governance ensures reliable financial reporting of a firm by management. Various corporate governance measures related to auditing minimizes the chances of disclosure of financial restatements to protect the company against negative effects.
Quality of corporate governance structure has an effect on the audit fees of a firm through control risk estimation by its auditor. The strong corporate governance structure signaled reduced inherent risk of the firm hence the amount paid to the external auditor will be lowers. Griffin et al. (2008) state that corporate governance can have both audit fees increasing and decreasing effects. On one side, Better governance measures increase the audit cost of the firm. On the other side, they also enhance the quality of financial reporting and internal control which results in reduced audit fees and audit risk.
Corporate governance quality influences the audit fees in various ways. Cohen & Hanno (2000) examine the influence of corporate governance quality on client- acceptance process. Their findings state that auditors more likely accept a client that has high corporate governance quality. In the presence of high corporate governance quality, Bell et al., (2001) find reduction in substantive testing at audit planning stage. This reduction leads to condensed audit hours and reduced audit fee.
Corporate Governance and auditing in Pakistan
Determinants of Audit Fees
There are various determinants of audit fees in a firm. Earlier studies suggest that the size of the firm, complexity of the audit and the risk associated with the audit are main determinant of the audit fee in a firm. Most of the earlier studies identified size, complexity of operations, industry and operational risks as significant factors that affect the audit fees of a firm. Audit firms usually charge more audit fees from firms which have large size, audit is complex and audit risk is higher. The following discussion is based on these variables.
Audit Committees
Audit Committees are sub committees of the board. Abbott et al. (2003) mentioned in their study that Securities and Exchange Commission (SEC), the Public Oversight Board (POB 1993) and the National Association of Corporate Directors (NACD 2000) emphasized the role of audit committee. According to them, audit committee provides active supervision of the financial reporting process and also monitors the relationship between a firm's management and its external auditor. Hence, the audit committee plays an important role in the determination of audit fees.
In the presence of audit committees, management cannot influence the auditor to approve questionable accounting practices. In the case of earning manipulation, audit committee can support auditor and question management. Audit committees usually take three types of action for the assurance of higher level of audit quality. First, committee members can convince management for the selection of an auditor with greater reputation and more knowledge. Secondly Simunic & Stein (1996) state that the audit committee can also demand bigger audit effort from the existing auditors of the firm. Third, audit committee through indirect means influence the level of audit coverage by extenuating threats to replace the auditor (Knapp, 1985).
The introduction of corporate governance codes has required the auditors to look into various factors like audit committee independence, audit committee expertise, audit committee size etc. for evaluation of their audit risk and audit fees. Audit committee members convince management for the appointment of auditors with appropriate knowledge and higher reputation. They can also demand greater audit effort from the external auditors. Goodwin-Stewart and Kent (2006) in their study on Australian firms with higher audit fees observe that these firms are mostly expected to have an audit committee and stronger internal control measures. On the other hand, Bedard et al. (2004) suggest that strong audit committee may results in reduced auditor's workload that leads to reduced audit fees of the firm.
Characteristics of Audit Committees
Krishnan and Visvanathan (2006) examine that auditor's price the efficacy of the audit committee by relating it to the control risk and thus, on the whole audit risk. They observe a negative association between audit pricing and financial expertise of audit committee members. Furthermore, they also observe that there is no significant relation between audit fees and financial expertise for firms with weak governance arrangements. The lack of significant relationship between non-financial expertise and audit fees advocate the view that auditors perceive that only financial expertise significantly contributes to the audit committee's effectiveness.
Abbott et al. (2003) find a positive relationship of audit committee independence and financial expertise with audit fees, but not between audit committee diligence and audit fees. The findings of Abbott et al. are up to certain extent supported by the findings of Carcello et al. (2002). The difference is due to changes in regulatory environment and the late 1990s variations in audit committee characteristics. Vafeas and Waegelein (2007) suggest that audit committee characteristics such as size, member expertise and member independence are positively related with audit fees. They argue that audit committees bring into line the external auditing in monitoring management.
Rainsbury et al. (2009) in their study on New Zealand firms for the year 2001 in the pre-SOX period examined no significant association between the characteristics of effective audit committee and audit fees.
Executive Compensation
Executive compensation in the firm usually refers to the general form of base salary and incentives of CEO or top executives. Executive managers are the individuals who manage the affairs of the firm. Shareholder and bondholders pay an attractive salary package to these executives for ensuring the protection of their investment and returns on their investments. Since the ownership is separate from management, these managers may have conflicting interest with shareholders. Agency theory provides a framework for reducing the conflict of interest among the managers and shareholders. Jensen and Meckling (1976) provide examples of monitoring/bonding contracts that mitigate the manager-shareholder conflicts. Kannan (2009) state the reason of board of director's interest in the association between audit fees and CEO compensation contracts. He proposed that results of this association may influence the compensation committees' plan of future compensation agreements.
Executives Incentive Based Compensation and audit fees
Executives incentive based compensation can be of short term or long term. The payments of these incentives are either made in the form of cash or in kind of stock options. Vafeas & Waegelein (2007) state that well-structured compensation contracts not only provide managers with an incentive to execute their monitoring function well but also act as a alternate for monitoring services provided by external auditors. Incentives in CEO compensation are basically planned for minimizing the agency conflicts between managers and shareholders. These compensation plans will results in agency cost reductions and shareholder wealth maximization.
Conversely, Executive incentive programs enhance the risk of earnings manipulation by management. Healy (1985) and Holthausen (1995) document that bonuses influence managerial accounting and reporting processes by encouraging managers to manipulate earnings in order to earn their bonuses. Furthermore, these incentive pay are costly to the firm as the cost of financial statement restatement or fraud claim also increases. These incentive based schemes raise the potential audit risk. For the evaluation of this risk, auditors appoint skilled personnel that lead to increase in audit fees for firms.
Vafeas and Waegelein (2007) in their study on the association between audit committees, compensation incentives, and corporate audit fees state that board of directors prefer external auditors of higher quality that charge high fees. This is done to control management from unnecessary earning manipulation to increase their compensation. Wysocki (2010) find a positive and significant association between CEO total compensation and audit fees.
