Audit Fees for Initial Audit Engagements Before and After SOX

8/12/2019 Audit Fees for Initial Audit Engagements Before and After SOX

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172 Huang, Raghunandan, and Rama

Auditing: A Journal of Practice & Theory May 2009American Accounting Association

much less likely to be prevalent, if at all, in the post-SOX period (Brown 2002; Banham2003).

Prior research has analytically and empirically examined issues related to pricing ofinitial-year audits. DeAngelo (1981) suggests that incumbent auditors earn quasi-rents from

clients due to the start-up costs (incurred by both auditors and clients) associated with newaudits; such quasi-rents lead to lowballing of initial-year audit fees. Initial-year audits typ-ically involve substantial additional effort from the auditor (Flanigan 2002; Turner 2002b),and to the extent the extra start-up costs are not passed along to the client in the form ofadditional fees, the extra costs may be viewed as an investment by the auditor, who expectsfuture returns on such investment.1 This forms the basis for concerns expressed about theimpact of lowballing on auditor independence, since an auditor who is concerned aboutfuture returns on an investment would be presumably more likely to go along with a clientin order to maintain the auditor-client relationship (Geiger and Raghunandan 2002). Forexample, a former chief accountant of the SEC noted in SOX-related congressional hearingsthat auditors propose a lower fee in the first year of an audit relationship in order to gain

the account, and this has a negative impact on the quality of the first-year audit (Turner2002a). If the additional costs associated with an initial audit are not billed to the client,then the auditor may be tempted to cut back on the work, which then could lead to a lower-quality audit in the initial year (Glater 2002; Hirsch 2002).

Lowballing (pricing below cost) of audit fees itself cannot be directly evaluated withoutknowledge of auditors costs. Nevertheless, many prior papers have examined if there is aninitial-year audit fee discount, since such a fee reduction makes it more likely that there islowballing. In the U.S. audit market, prior research has documented the existence of initial-year audit fee discounts (Simon and Francis 1988; Ettredge and Greenberg 1990). Craswelland Francis (1999) suggest that the existence of a price discount shown in prior studies

could be due to the absence of public disclosures of audit fees (the SEC mandated suchdisclosures only for proxy statements filed on or after February 5, 2001); using Aus-tralian data, Craswell and Francis (1999) are unable to find a price discount for withinsame-tier audit switches. However, Sankaraguruswamy and Whisenant (2005) documentthat even after public disclosure of fees, there was price discounting for initial-year auditengagements in the U.S. Ghosh and Lustgarten (2006) show that while there were initial-year audit fee discounts for same-tier switches involving the non-Big 4 clients in each yearfrom 2001 to 2003, such discounts for Big 4 clients disappeared by 2003.

Given the significant changes in the auditing profession following the enactment ofSOX, we examine if initial-year audit fee discounts persist in the post-SOX period. Thereare at least five reasons to expect that audit fee discounting for a new client would be less

likely in the post-SOX period.First, it is likely that audit firms business models, cost structures, and pricing decisions

would have significantly changed post-SOX. Specifically, in the post-SOX period audit firmsare much more likely to have priced auditing as a stand-alone service (in light of SOXs

1 Initial-year extra costs are sunk costs, and economic theory suggests that such costs should be irrelevant, butprior research in organizational behavior (e.g., Staw 1976; Staw and Ross 1987) shows that people do not ignoresuch costs.


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Audit Fees for Initial Audit Engagements Before and After SOX 173


restrictions related to nonaudit services); this implies that auditors would be less likely tolowball audit fees in order to obtain the clients nonaudit service contracts.2

Second, if audit firms became more conservative in the period after SOX (Bryan-Low2003), then it is likely that the fee changes following auditor changes would be different

before and after SOX. If auditor changes are viewed with suspicion by financial statementusers, and if problems are more likely to occur in initial audits (Glater 2002), then thechanged environment of auditing in the post-SOX era suggests that fee discounts followingauditor changes would be less likely to be observed in the post-SOX period than in thepre-SOX period.

Third, Section 301 of SOX changed the location of authority for selecting the externalauditor. Prior to SOX, company management selected the auditor and negotiated the auditfees with varying degrees of involvement by the audit committee. Given managers focuson cost control, audit fees were subject to downward pressure. However, Section 301 ofSOX states that the audit committee shall be directly responsible for the appointment,compensation, and oversight of the auditor. The incentives of audit committee members

are quite different from those of management, particularly in the post-SOX period. Auditcommittee members can be expected to be more concerned about their reputation andmaking sure that the auditors did not miss anything in the audit; this in turn changes thedynamics of audit fee negotiations, and hence lowballing is less likely to occur in the post-SOX period.

Fourth, the failure of Arthur Andersen following its indictment by the U.S. Departmentof Justice in 2002 led to a more concentrated audit market. The U.S. General AccountingOffices (2003) study on consolidation of public accounting firms provides evidence aboutthe heightened concentration in many industries following the demise of Andersen. Theincreased concentration following Andersens demise also changes the dynamics of audit

pricing, and has the potential to reduce the lowballing of audit fees.Fifth, the requirements related to Section 404 of SOX imposed significant additionaldemands on manpower resources of audit firms. Both anecdotal evidence in the media andprior research suggest that there were substantial increases in audit fees in 2003 and 2004(Gullapalli 2005; Raghunandan and Rama 2006). A significant part of such higher auditfees is attributable to the substantially higher audit effort during 2004 in the context ofimplementing Section 404 of SOX (cf., Ernst & Young 2005; KPMG 2005). Section 404thus presented the audit firms with a new mandated source of revenue, so there is less ofan incentive for audit firms to cut back on audit fees for new clients. In addition, therequirements of SOX 404 could lead to significantly more audit work for initial-year en-gagements; this in turn would result in disappearance of the initial-year fee discount and,

possibly, an initial-year fee premium. Many news reports and prior research indicate thatthe large audit firms were much more likely to drop existing clients in the post-SOX period(Bryan-Low 2003; Byrnes 2003; Plitch and Wei 2004; Rama and Read 2006); if audit firms

2 For example, an executive from a smaller public accounting firm notes that his firm was shut out of marketingnonaudit services to publicly traded companies because the national accounting firms would lowball the auditwith the goal of selling their pricier nonaudit services. Now that [after SOX] cross-selling is prohibited, theplaying field has leveled (Banham 2003). The leveling of the playing field also suggests that the larger auditfirms would no longer lowball audit fees in order to obtain the more lucrative nonaudit service contracts.


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were actively dropping existing clients, then it is unlikely they would lowball audit fees inorder to acquire new clients.3

In summary, there are multiple reasons to expect that there would not be lowballing ofaudit fees in the post-SOX period. We empirically test this conjecture by comparing audit

fees for new clients in 2001 and 2006.The audit market witnessed unprecedented changes during the period from 2002 to2004, including the enactment of SOX in 2002, the implementation of SOX by the SEC in2003, and SOX Section 404s requirement for internal control reporting for fiscal yearsending on or after November 15, 2004 (for accelerated filers). Hence, a valid investigationof fee cutting for initial-year audits requires that audit fee levels stabilize at the new (andhigher) levels in the post-SOX period. Given the changes from 2002 to 2004, we use auditorchanges during 2006 to examine audit fees in the post-SOX period.4

For the pre-SOX period, we can investigate only one yearnamely, 2001. This isbecause under FRR No. 56 (SEC 2000), SEC registrants were required to publicly disclosefee data in proxy statements filed with the SEC on or after February 5, 2001. Further, while

FRR No. 68 (SEC 2003) requires fee disclosure for two fiscal years, FRR No. 56 onlyrequired fee data for the latest fiscal year. Since we directly calculate changes in audit feesas a part of our analyses, we require fee data for two fiscal years: the first year with thenew auditor and the last year with the old auditor. Hence, we examine auditor changesduring 2001 for the pre-SOX period.

Prior research (Krishnan and Krishnan 1997; Raghunandan and Rama 1999; Shu 2000;Whisenant et al. 2003) shows that auditor resignations differ significantly from client dis-missals of auditors. Our sample includes very few instances of auditor resignations withavailable data in 2001; the sample-size problem becomes particularly acute when we par-tition based on the type of the predecessor and successor auditor. Consequently, in this

paper we only examine auditor changes involving client dismissals.5

Prior research has consistently shown a Big 46 audit fee premium and quality differ-ences using a variety of metrics (Simunic 2005). Hence, it is likely that fee changes fol-lowing auditor changes will vary with the type of predecessor and successor auditors. Also,our sample includes very few instances of auditor changes involving a non-Big 4 prede-cessor and a Big 4 successor. Hence, in our analyses we separately examine auditor switcheswithin the Big 4 and non-Big 4.

Consistent with the approach used in prior studies, we measure the initial-year auditfee discount relative to continuing clients by including an indicator variable for initial-yearaudits in a multiple regression model that has the natural logarithm of audit fees as thedependent variable. We find that in the Big 4 client sample, initial-year audit clients received

3 A reviewer notes that Danos and Eichenseher (1986) find that supplier concentration is a result of client regu-lation and of audit firms seeking scale economies. Given the numerous changes in the post-SOX era, one mightexpect greater incentives to lowball given the added benefits of scale to the Big 4 in the face of increased clientregulation. Ultimately, whether the Big 4 continue to lowball in the post-SOX era is an empirical question, andthis paper provides some relevant empirical evidence on this issue.

4 We also investigate auditor changes in 2005 and, except in one instance as noted in footnote 15, obtain quali-tatively similar results with the 2005 sample.

5 Rama and Read (2006) show univariate results indicating that audit fees increased significantly for clients witha resignation by a Big 4 predecessor in 2003, but not in 2001. Their sample sizes are only 21 and 54 for 2001and 2003, respectively.

6 Prior research related to a Big N fee premium has examined periods when there were the Big 8, Big 6 or Big5 audit firms. For the sake of expositional convenience, we refer to the Big 4 even though the pre-SOX periodexamined in this study had the Big 5.


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a fee discount of about 24 percent in 2001; in contrast, initial-year audit clients paid apremiumof about 16 percent in 2006. In the non-Big 4 client sample, we do not observeany significant initial-year fee discount or premium in either 2001 or 2006.

The above method leads to an indirect estimation of the audit fee discount in the initial

year of an audit engagement. We also directly calculate the change in audit fee followingan auditor change by comparing the fees paid before and after auditor changes, in the pre-and post-SOX periods. We find that 62 (50) percent of the clients moving from one Big 4(non-Big 4) auditor to another Big 4 (non-Big 4) auditor paid lower audit fees to thesuccessor auditor than to the predecessor auditor; in 2006, only 38 (49) percent of clientsswitching within the Big 4 (non-Big 4) paid lower audit fees to the successor auditor. Ourregression analyses with changes in audit fees as the dependent variable (with changes inthe levels of other variables as the control variables) confirms the finding that clients movingfrom one Big 4 to another Big 4 auditor experienced a fee decline in 2001. Results fromthe non-Big 4 sample indicate that there is a significant initial-year fee discount in 2001and 2006.

Overall, the results suggest that audit fee discounts for initial-year audit engagementsare much less likely in the post-SOX period than in the pre-SOX period for Big 4 clients;in fact, we observe a significant initial-year audit fee premium for Big 4 clients in 2006.In a recent study, Ghosh and Lustgarten (2006) find that there was a Big 4 price discountfor initial-year audit engagements in 2001 but not in 2003. Taken together, the results fromthe two studies suggest that the initial-year audit fee patterns for the Big 4 changed grad-ually from 2001 to 2006, with the discount disappearing in 20022003 and a premiumappearing in 20052006. The results should be of interest to clients, auditors, and regula-tors, given the concerns expressed by regulators and legislators about the adverse conse-quences associated with initial-year audit fee discounts. A secondary finding of our study

is that the Big 4 are less likely to serve as a successor auditor following an auditor changein 20052006 than in 2001. Overall, our findings reinforce suggestions that the Big 4 firmshave become more conservative in the post-SOX period.

METHODTable 1 shows our sample selection process. We begin with 5,418 and 7,626 observa-

tions that are in the Compustat database and have fee data available in the Audit Analyticsdatabase for fiscal years ending in 2001 and 2006, respectively.

The auditing environment was in a significant state of flux late in the year in both 2001and 2004. For example, the Enron bankruptcy occurred in November 2001, and congres-

sional hearings started almost immediately about the role of Enrons auditor (Andersen) inthe failure of Enron; since it is likely that such legislative actions would have an impacton auditors actions, comparisons may be difficult between firms with fiscal year-ends inearly 2001 and December 2001. Similarly, Section 404 of SOX became applicable foraccelerated filers with fiscal year-ends on or after November 15, 2004, and auditors andothers have noted that there was a steep learning curve associated with Section 404. Hence,it is not appropriate to compare firms that have a fiscal year-end after November 15, 2006(2005) with firms that have a fiscal year-end earlier in 2006 (2005), since the former typefirms would be in the third (second) year of their Section 404 audit while the latter would


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TABLE 1

Sample Description

Panel A: Sample Selection

2001 2006

Compustat observations (firm-years) with fee data in AuditAnalytics 5,418 7,626

Less: Fiscal year end other than December 31 1,677 2,747

Less: Missing fee data for prior year or audit fee 0 401 48

Less: SIC 6000 1,484 2,104

Less: Foreign firms 26 430

Less: Variable data missing in Compustat 125 282

Less: Audit Fee less than $25,000 14 23

Total 1,691 1,992

Panel B: Types of Auditor Changes in 2001 and 2006

OldAuditor

New Auditor

Auditor Changes in 2001

ClientDismissal

AuditorResignation

Auditor Changes in 2006

ClientDismissal

AuditorResignation

B4 NB4 B4 NB4 B4 NB4 B4 NB4

B4 53 21 3 3 39 50 4 5

NB4 12 10 0 1 7 57 1 43

Panel C: Auditor Dismissals (within Big 4 and non-Big 4) by Industry

By Industry: Defined by SIC Code 2001 2006Mining and Construction (10001999, except 13001399) 3 3

Food (20002111) 0 2

Textiles and Printing / Publishing (22002799) 2 0

Chemicals (28002824, 28402899) 3 1

Pharmaceuticals (28302836) 1 11

Extractive (13001399, 29002999) 6 13

Durable manufacturers (30003999, except 35703579 and 36703679) 22 26

Transportations (40004899) 11 12

Utilities (49004999) 4 8

Retail (50005999) 7 12Computers (35703579 and 36703679) 2 7

Others (0000999) 2 1

Total 63 96

Panel C considers only those dismissals that occurred from one Big 4 firm to another or from a non-Big 4 firmto another (i.e., we exclude observations across types, from a Big 4 to a non-Big 4 or vice versa). Only suchdismissals are used in the rest of our analyses.


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be in the second (first) year of their Section 404 audit.7 Consequently, we restrict theanalysis to firms with a December 31 fiscal year-end.8

As part of our analyses, we calculate changes in audit fees (fees paid in the first yearwith the new auditor less the fees paid in the last year with the predecessor auditor). Hence,

to ensure that the sample size is uniform for all our analyses, we delete firms without feedata for the prior year. Since financial and service firms have unique characteristics andsince such firms are typically excluded in prior audit fee studies (e.g., Huang et al. 2007),we drop 1,484 and 2,104 observations related to firms with SIC codes higher than 6000from 2001 and 2006, respectively. Since some of the SOX requirements were not applicablefor foreign firms in 2005, we delete 26 and 430 observations related to foreign firms in2001 and 2006, respectively. We then exclude 125 and 282 observations missing financialdata in 2001 and 2006, respectively. Finally, to ensure that results (especially those relatedto change analyses) are not driven by small-denominator-related issues, we delete 14 and23 firms with audit fees less than $25,000 from the 2001 and 2006 samples, respectively.9

Thus, our sample includes 1,691 and 1,992 observations for 2001 and 2006, respectively.

We expect audit fee changes following auditor changes to vary with the type of pre-decessor and successor auditor. In addition, prior research also shows that client-initiateddismissals and auditor-initiated resignations must be examined separately in studies of au-ditor changes (e.g., Krishnan and Krishnan 1997; Raghunandan and Rama 1999; Shu 2000;Whisenant et al. 2003). Thus, we first partition the sample using the following variables:time period (pre- or post-SOX), type of change (dismissal or resignation), predecessorauditor (Big 4 or non-Big 4) and successor auditor (Big 4 or non-Big 4).

Several interesting observations can be made related to the data in Panel B of Table1. First, resignations are more likely in 2006 than in 2001; auditor resignations accountfor only seven out of 103 (7 percent) auditor changes in the 2001 sample, but account for

53 of 206 (26 percent) auditor changes in 20052006.10

Second, there are very few instancesof a Big 4 firms serving as a successor following the resignation of a predecessor. Oursample includes only one instance of a Big 4 successor after an auditor resignation by anon-Big 4 firm.

Third, the likelihood of a Big 4 successor following a client dismissal is lower in20052006 than in 2001. The data show that a Big 4 auditor served as a successor followinganother Big 4 auditors dismissal in 53 of 74 instances (72 percent) in 2001; however, a

7 There are many nonaccelerated filers in our sample; however, it is likely that the work associated with SOX404 for accelerated filers would have affected the manpower associated with all SEC audits.

8 Note that even with this restriction, there is a bias againstfinding any reduction in initial-year fee discounting

in 2001 if audit fees for clients with a December 31, 2001, fiscal year-end were higher than expected in theaftermath of last-minute changes in the audit effort due to Enrons failure in November 2001 and Andersensproblems beginning January 2002. Conversely, to the extent there was a steep learning curve effect related toSection 404 audits, the fees for fiscal 2006 can be expected to be lower than the fees for fiscal 2005, resultingin a bias forfinding significant initial-year fee reductions. Nevertheless, such biases should affect both new andexisting clients; this is one reason why we use a fee-levels regression that includes new and existing clients aswell as analyses (descriptive and a change regression) based on audit fee changes. Also, as noted later, as partof our sensitivity tests we delete observations with an adverse internal control report, but the inferences arequalitatively similar with the reduced sample.

9 As part of our sensitivity tests, we also eliminated all firms with audit fees with less than $100,000. Our resultsare substantively similar with this alternative cutoff.

10 In FRR No. 68, the SEC (2003) changed the audit fee disclosure rules, requiring firms to disclose details aboutfees paid to the auditor in 10-K filings if the registrant did not file a proxy. Prior to FRR No. 68, the SEC onlyrequired fee disclosures in proxy statements, and many small registrants did not always file a proxy. The greater

availability of fee data from smaller SEC registrants may partially explain the higher proportion of resignationsin 2006 in our sample.


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Big 4 auditor was the successor in only 39 of 89 instances (44 percent) of a clientsdismissing a predecessor Big 4 auditor in 2006. Considering instances of a non-Big 4predecessor being dismissed, a Big 4 firm served as the successor in 12 of 22 changes(55 percent) in 2001; in 2006, this proportion had dropped to 11 percent (seven of 64).

This suggests that the Big 4 have become more selective in accepting new clients (or, thatthe non-Big 4 are much more aggressive in accepting new clients) in the post-SOX periodthan in prior periods; however, more detailed analysis (including consideration of clientcharacteristics) is necessary before concluding that the Big 4 are more conservative inclient selection in the post-SOX period.

Since the data indicate that some of the resignation cells have very few observations,in our multiple regression analyses we focus only on client dismissals. Based on priorresearch (e.g., Simunic 1980; Francis and Wang 2005; Raghunandan and Rama 2006), weuse the following regression model to examine the factors associated with initial-year dis-counting of audit fees following auditor dismissals:

LnAF LnTA RECINV SQSEG FOREIGN LIQ1 2 3 4 5

DA ROA GC LOSS MW RESTATE6 7 8 9 10 11

NAFRATIO INITIAL . (1)12 13

The variables are defined as follows:

LnAF natural logarithm of audit fees;LnTA natural logarithm of total assets;

RECINV percentage of total assets in receivables and inventories;SQSEG square root of number of business segments reported on Compustat;

FOREIGN 1 if foreign segments reported, else 0;LIQ current ratio;DA debt-to-assets ratio;

ROA return on assets;GC 1 if audit report is modified for going concern, else 0;

LOSS 1 if there is a bottom-line loss, else 0;MW 1 if there is a material weakness in internal controls, else 0;

RESTATE 1 if there is a restatement in the current or prior year, else 0;NAFRATIO ratio of nonaudit fees to audit fees; and

INITIAL 1 if initial-year audit, else 0.

The first nine variables in the model above are fairly standard and follow well-established audit fee models. We include MWbased on submissions to the SEC (2005) byeach of the Big 4 auditors that fees would be significantly higher for firms with internalcontrol problems, as well as recent evidence in Raghunandan and Rama (2006) that auditfees are higher by about 43 percent for firms with adverse SOX 404 internal control reports.Similarly, we include RESTATE because it is likely that audit fees would be higher forfirms that have had to recently restate their financial statements.11 We include NAFRATIObecause the recent limits imposed by the SEC on the provision of certain types of nonaudit

11 More generally, the three variables indicating special situationsGC, MWand RESTATEalso account for thefact that in bad cases, the new auditor may charge a premium to be persuaded to take the client.


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services after SOX may change the pricing of audit services. Finally, INITIALis our variableof interest.

We also directly calculate the change in audit fees for each firm. The fee-change mea-sure is the difference in audit fees between the 2001 (2006) and 2000 (2005) fiscal years.

We then use the following changes regression in addition to the levels regressionnoted above:

DLnAF DLnTA DRECINV DSQSEG DFOREIGN1 2 3 4

DLIQ DDA DROA DGC DLOSS5 6 7 8 9

DMW DRESTATE DNAFRATIO10 11 12

DINITIAL . (2)13

The variables that begin with D measure the difference in values of the variables between

the current year (2001 or 2006) and the preceding year (2000 or 2005).We obtain data about auditor changes, audit and nonaudit fees, internal control opinions,and restatements from the Audit Analytics database. All other data are obtained from theCompustat database. We winsorize continuous variables at the 1st and 99th percentiles; thisis done to reduce the influence of extreme observations.12

RESULTSTable 2 provides descriptive data about the 2001 and 2006 auditor change samples. A

noticeable difference between the pre- and post-SOX periods is that the mean and medianaudit fees for 2006 are much higher than the corresponding numbers for 2001. The differ-ences can be attributed to a variety of reasons, including (1) the higher levels of audit effort

and risk premium in the post-SOX period, (2) additional cost related to Section 404 auditwork, and (3) the changes in the definition of audit fees by the SEC (2003).13 Notsurprisingly, given the nonaudit-related changes following SOX, the NAFRATIO is muchlower in 2006 than in 2001. The data also indicate that restatements are more prevalent inthe 2006 sample than in the 2001 sample; this is a reflection of the well-documentedincrease in the number of restatements found in the general population in the post-SOXperiod (e.g., FEI 2005).

Table 3 presents the results from the fee-levels regression discussed earlier. Given thewell-documented differences between Big 4 and non-Big 4 auditors (Simunic 2005), weperform the regressions separately for Big 4 and non-Big 4 auditors. The Big 4 (non-Big

4) samples include only those clients that either continued with a Big 4 (non-Big 4) auditoror switched from one Big 4 (non-Big 4) auditor to another Big 4 (non-Big 4) auditor. TheBig 4 regressions have higher explanatory power than the non-Big 4 regressions in both2001 and 2006. This can perhaps be attributed to the fact that the Big 4 audit both largeand small clients, while the size range of clients audited by the non-Big 4 is smaller; thisin turn results in lower variation in the audit fees for the non-Big 4 sample, in turn yieldinglower explanatory power for the regression.

12 While we do not present a correlation matrix, none of the VIF scores exceeds 2.0, suggesting that multicollin-earity is not a problem. As part of our sensitivity analyses, we also winsorizedDAand ROAso that the maximumabsolute value is 1.0; the results with this approach remain quite similar to the results presented in this paper.

13 The SEC (2003) moved some types of fees from the audit-related services fees category to the audit feescategory. The differences in definition suggest that the 2001 and 2006 audit fees cannot be directly compared;however, we are interested not in the direct comparisons between 2001 and 2006 audit fees but rather in thedifferences in fees between the old and new auditor in the respective regimes then in place in 2001 and 2006.


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TABLE 2

Descriptive Statistics

Panel A: 2001 SampleContinuing Clients (n 1,588)

TA AF-New AF-Old RECINV SQSEG FOREIGN LIQ DA ROA GC LO

Mean 2380.54 0.62 0.58 0.25 1.36 0.50 3.18 0.52 0.14 0.07 0Std. Dev. 6345.34 1.34 1.64 0.20 0.48 0.50 3.52 0.31 0.40 0.26 0

25thpercentile

57.33 0.11 0.10 0.08 1.00 0.00 1.19 0.28 0.16 0.00 0

Median 246.20 0.22 0.19 0.21 1.00 0.00 1.93 0.53 0.00 0.00 0

75thpercentile

1230.93 0.53 0.48 0.36 1.73 1.00 3.68 0.69 0.05 0.00 1

Panel B: 2001 SampleDismissal Clients (n 63)

TA AF-new AF-old RECINV SQSEG FOREIGN LIQ DA ROA GC LO

Mean 1972.15 0.47 0.48 0.28 1.32 0.46 2.30 0.62 0.25 0.08 0

Std. Dev. 5441.00 1.36 1.44 0.22 0.44 0.50 2.94 0.50 0.60 0.27 0

25thpercentile

26.20 0.09 0.09 0.07 1.00 0.00 0.99 0.33 0.43 0.00 0

Median 155.50 0.18 0.19 0.23 1.00 0.00 1.39 0.46 0.00 0.00 1

75thpercentile

915.60 0.29 0.33 0.46 1.73 1.00 2.48 0.73 0.04 0.00 1

Panel C: 2006 SampleContinuing Clients (n 1,786)


Mean 3167.75 1.98 1.87 0.23 1.27 0.45 3.07 0.58 0.12 0.06 0

Std. Dev. 7387.18 3.37 3.30 0.19 0.39 0.50 3.15 0.55 0.55 0.25 025th

percentile72.00 0.34 0.31 0.07 1.00 0.00 1.26 0.30 0.07 0.00 0

Median 437.40 0.88 0.76 0.18 1.00 0.00 2.00 0.52 0.03 0.00 0

75thpercentile

2091.13 2.08 1.98 0.34 1.41 1.00 3.52 0.70 0.08 0.00 1


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TABLE 2 (continued)

Panel D: 2006 SampleDismissal Clients (n 96)


Mean 1527.47 1.19 1.27 0.24 1.20 0.31 3.12 0.83 0.46 0.26 0

Std. Dev. 4347.46 2.33 2.67 0.23 0.37 0.47 4.22 1.02 1.07 0.44 0

25thpercentile

11.45 0.11 0.11 0.05 1.00 0.00 0.82 0.33 0.46 0.00 0

Median 104.65 0.37 0.41 0.17 1.00 0.00 1.54 0.59 0.02 0.00 1

75thpercentile

853.18 1.25 1.15 0.40 1.41 1.00 3.24 0.91 0.05 1.00 1

This table presents descriptive statistics for the 2001 and 2006 samples examined in this study.

Variable Definitions:TA total assets at year-end;

AF-new audit fees paid for fiscal 2001 or 2006, as appropriate;AF-old audit fees paid for fiscal 2000 or 2005, as appropriate;

RECINV percentage of total assets in receivables and inventories;SQSEG square-root of number of business segments reported on Compustat;

FOREIGN 1 if foreign segments reported, else 0;LIQ current ratio;DA debt-to-asset ratio;

ROA return-on-assets;GC 1 if audit report is modified for going concern, else 0;

LOSS 1 if net income is negative, else 0;MW 1 if there is a material weakness in internal controls, else 0;

RESTATE

1 if there is a restatement in the current or prior year, else 0; andNAFRATIO ratio of nonaudit fees to audit fees.


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TABLE 3

Audit Fee Regression Results

Variable

Big 4 Clients

2001

Coeff. p-value

2006

Coeff. p-value

N

2001

Coeff. p-va

Intercept 2.485 .01 3.537 .01 3.770 .0

LnTA .481 .01 .477 .01 .418 .0

RECINV .901 .01 .895 .01 .491 .0

SQSEG .166 .01 .248 .01 .036 .6

FOREIGN .342 .01 .380 .01 .307 .0

LIQ .018 .01 .005 .52 .011 .4

DA .091 .11 .026 .70 .050 .7

ROA .366 .01 .391 .01 .189 .0

GC .247 .01 .316 .01 .294 .0

LOSS .039 .24 .155 .01 .150 .0

MW .213 .01

NAFRATIO .033 .01 .215 .01 .091 .

RESTATE .175 .02 .100 .07 .324 .0

INITIAL .268 .01 .149 .10 .005 .9

N 1,472;F stat. 460.4;

p .001;2Adj. R .789.

N 1,367;F stat. 283.1;

p .001;2Adj. R .729.

N 179;F stat. 26.9;

p .001;2Adj. R .636.


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TABLE 3 (continued)

This table presents the results from regressions with the natural logarithm of audit fees as the dependent variable.All p-values are two-tailed.The 2001 and 2006 samples include firms that either continued with a Big 4 (non-Big 4) auditor or dismissed the incumbent different Big 4 (non-Big 4) auditor, respectively.

Variable Definitions:LnTA natural logarithm of total assets;

RECINV percentage of total assets in receivables and inventories;

SQSEG square-root of number of business segments reported on Compustat;FOREIGN 1 if foreign segments reported, else 0;

LIQ current ratio;DA debt-to-asset ratio;

ROA return-on-assets;GC 1 if audit report is modified for going concern, else 0;

LOSS 1 net income is negative, else 0;MW 1 if there is a material weakness in internal controls, else 0;

RESTATE 1 if there is a restatement in the current or prior year, else 0;NAFRATIO ratio of nonaudit fees to audit fees;

INITIAL 1 if new audit client, else 0.


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The coefficients on the control variables are generally significant with the expectedsigns. Considering the variable of interest, INITIAL, in the Big 4 sample, it is negative andsignificant in the 2001 regression. The magnitude of the coefficient, 0.268, indicates thatthe initial-year audit fee discount is about 24 percent. In contrast, the coefficient ofINITIAL

is positive and significant in the 2006 regression; the magnitude of the coefficient, 0.149,indicates that the initial-year clients pay a premium of around 16 percent in 2006. However,in the two non-Big 4 regressions,INITIALis not significant in either regression. The resultsreinforce the view that fee changes for initial-year audits need to be examined separatelyfor Big 4 and non-Big 4 auditors.

Fee ChangesDirect Calculation

Table 4 provides data about the changes in audit fees following auditor dismissals,based on various partitions of the predecessor and successor auditor. First, the medianchange in audit fees is negative for all four predecessor-successor combinations in 2001;however, the mean values are positive in two of the cells.14 Overall, 62 of the 96 (65percent) clients experienced a fee decline in 2001 following the dismissal of the predecessor.Second, the median is negative for only one of the four cells in 20052006changesinvolving a Big 4 predecessor and a non-Big 4 successor; the mean change in fee percentis positive for all cells. Overall, 76 of the 153 (47 percent) clients experienced a fee declinein 20052006 following the dismissal of the predecessor. Considering the proportion ofclients with a fee reduction, a Chi-square test rejects the null hypothesis of no differencebetween the two periods (p .05).

Table 5 provides the results from the changes regressions (model 2); the regressionsare similar to those presented in Table 3, except that the dependent variable measures thechange in audit fees, while the control variables are changes in the respective variables. In

general, fee-change regressions have much lower explanatory power compared with fee-levels regressions (Francis and Wang 2005; Ferguson et al. 2006). Each of the four regres-sions in Table 5 is significant, although the explanatory powers are much lower thanthe corresponding regressions in Table 3. Considering the variable of interest, INITIAL,there is a significant initial-year audit fee discount in 2001 for Big 4 clients. However,INITIAL is positive but not significant in the 2006 regression.15 In the non-Big 4 regres-sions,INITIALis negative and significant in both years; this result differs from the inferencebased on the levels regression in Table 3 but is consistent with the Big 4 results and withthe univariate results shown in Table 4.

Additional AnalysesIndustry Effects

Panel C of Table 1 indicates that there are differences in the occurrences of auditordismissals in some industries in 2006 when compared with 2001. To ensure that the resultsare not being driven by firms in any particular industry, we perform the following analyses:We create 13 different subsamples by deleting firms in each of the 13 industries. We thenperform our fee levels and fee change regressions on these 13 subsamples. We find that in

14 We winsorize audit-fee-change percentages at 300 percent and 75 percent (to reflect changes in feesup anddownby a factor of 3).

15 The INITIALvariable is positive and significant in the regression with 2005 data. We conjecture that the higherinitial-year premium for 2005, when compared with 2006, arises because 2005 represents only the second yearof SOX 404, and hence the fee levels had not yet stabilized in the post-SOX period. If the learning curve relatedto SOX 404 was incomplete in 2005, we can expect that initial-year audits would entail greater audit effort andhence result in an initial-year premium.


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May2009

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ountingAssociation

TABLE 4

Descriptive Data about Changes in Audit Fees following Auditor Dismiss

OldAuditor

NewAuditor

2001

Number ofClients

Mean (Median)Change in Fee %

Proportion withFee Reduction

Number ofClients

MCh

Big 4 Big 4 53 3.0 (9.0) 62% (33 / 53) 39 Non-Big 4 21 17.1 (24.0) 76% (16 / 21) 50

Non-Big 4 Big 4 12 31.8 (9.0) 67% (8 / 12) 7

Non-Big 4 10 4.0 (4.0) 50% (5 / 10) 57

This table presents data about the changes in audit fees (measured as difference between fees paid in the first year with the supredecessor auditor) following client dismissals of the incumbent auditor in 2001 and 2006.


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May2009

AmericanAccou

ntingAssociation

TABLE 5

Audit Fee Change Regression Results

Variable

Big 4 Clients

2001

Coeff. p-value

2006

Coeff. p-value

N

2001

Coeff. p-v

Intercept .099 .01 .052 .01 .016

DLnTA .258 .01 .507 .01 .049

DRECINV .073 .55 .435 .05 1.177

DSQSEG .129 .01 .153 .16 .100

DFOREIGN .036 .25 .060 .35 .137

DLIQ .006 .07 .006 .38 .003

DDA .096 .09 .038 .63 .211

DROA .137 .01 .135 .09 .054

DGC .069 .02 .096 .16 .251 DLOSS .021 .19 .024 .40 .032

DMW .099 .01

DNAFRATIO .005 .11 .012 .68 .009

DRESTATE .040 .35 .040 .23 .007

INITIAL .196 .01 .040 .52 .279

n 1,472;F stat. 13.3;

p .001;2Adj. R .091.

n 1,367;F stat. 17.9;

p .001;2Adj. R .138.

n 179;F stat. 2.3;

p .009;2Adj. R .082.

This table presents the results from regressions with changes in the natural logarithm of audit fees as the dependent variable.All p-values are two-tailed.The 2001 and 2006 samples include firms that either continued with a Big 4 (non-Big 4) auditor or dismissed the incumbent different Big 4 (non-Big 4) auditor, respectively.The variables that begin with D measure the difference in values of the variables between the current year and the preceding yas in Table 3.


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every subsample, the basic inferences hold; namely, Big 4 firms offered a significant pricediscount for new clients in 2001 but not in 2006.

Matched-Pair Approach

We also perform a matched-pair test to ensure that the results are not being driven byany industry clustering effects. Since we have only 10 intra-non-Big 4 dismissals in 2001,we do not examine the non-Big 4 sample for 2001. We match each auditor dismissalobservation with a matched pair from the same year, industry, and size. We obtainedmatches for 41 (68) of the 53 (96) auditor dismissals in 2001 and 2006, respectively, onthe basis of four-digit SIC code; for an additional four (seven) and six (17) observations,we were able to match on the basis of three- and two-digit SIC codes, respectively; theother two (four) were matched on the basis of one-digit SIC code. We matched on the basisof total assets and took the control observation with the nearest size that had all availabledata.

In the levels regressions with the Big 4 group, the coefficients of INITIAL in such

matched-pair approach are 0.281 and 0.188 in 2001 and 2006, respectively; both valuesare significant (p .10). In contrast, for the non-Big 4 group, the coefficient of INITIALis 0.001 in 2006 and is not significant at conventional levels. In the changes regressionswith the Big 4 group, the coefficients ofINITIAL are 0.200 in 2001 (p .10) and 0.064(p .47) in 2006, respectively. For the non-Big 4 group, the coefficient of INITIAL is0.190 (p .10) in 2006. In summary, results from the matched-pair approach reinforcethe findings from the main results presented earlier.

Internal Control QualityOur 2006 sample includes some firms that had an adverse internal control report for

2005. If a firm that changed auditors in 2006 had an adverse internal control reportin 2005, then it is likely that the audit fee would have been higher for fiscal 2005sothere may be a bias in favor of finding a fee reduction for fiscal 2006, particularly if thefirm had corrected the internal control problem early in 2006. Conversely, if a firm had anadverse internal control report for fiscal 2006 but a clean internal control report for fiscal2005, then there is a bias against finding a fee reduction in 2006. Hence, we delete firmsthat had an adverse internal control report and run the 2006 regressions. Our results withsuch reduced samples are substantively similar to those reported in Tables 3 and 5.

We have data about internal control quality only for the 2006 sample (after SOX 404became effective); we do not have internal control data for 2001.16 Assuming that internalcontrols did not suddenly deteriorate, we coded MW as 1 for clients that had a material

internal control weakness in 2004, and reperformed the regressions for 2001. With thisalternative approach, we find that our primary inferences remain similar; the coefficient ofINITIAL is negative and significant in both the levels and changes regressions for Big 4clients in 2001.

Fiscal Year-EndIn our analyses, we examine only firms with a December 31 fiscal year-end. We perform

sensitivity analyses as follows. Since SOX 404 was applicable for fiscal year-ends beginning

16 Firms changing auditors are required to indicate if there was a reportable event in the two years prior to theauditor change, and reliability of internal controls (as assessed by the auditor) is one of the items to be disclosedin the 8-K. However, prior to the implementation of SOX, such data can be obtained only for companies changingauditors. Note also that Section 302 of SOX, which requires disclosures about disclosure controls, becameapplicable only in August 2002 and hence is not applicable for our 2001 sample.


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in November 15, 2004 and since Enron entered bankruptcy in November 2001, we includeall firms with fiscal year-ends between November 15 and December 31. Results with suchexpanded samples are substantively similar to those reported in the paper.

SUMMARY AND CONCLUSIONSLegislators, regulators, and the media have expressed concerns about auditors dis-counting initial-year audit fees following an auditor change because of suggestions thatsuch discounting can have an adverse effect on audit quality. Many prior studies havedocumented the existence of an initial-year audit fee discount in the pre-SOX period. How-ever, for a variety of reasons (changes to auditors business models and increased conser-vatism of Big 4 auditors in the post-SOX period, SOX stripping managements ability tohire and negotiate the audit fee, changes in the audit market following Andersens failure,and resource constraints related to the new SOX 404 requirements) it is likely that initial-year audit fee discounts would be less likely in the post-SOX period than in prior years.

In this paper, we examine audit fees for clients changing auditors in 2001 and 2006.

We find that there is a significant initial-year audit fee discount in 2001 for clients of theBig 4 audit firms: The new clients pay, on average, about 24 percent less than continuingclients after controlling for factors expected to be associated with audit fees. In contrast,there is a significant premium for new Big 4 clients in 2006: Initial-year clients pay, onaverage, a premium of 16 percent more than continuing clients. Results from a changesmodel (with changes in audit fees as the dependent variable and changes in the levels ofthe control variables as the independent variables) confirm the findings that new Big 4clients had price discounts in 2001 but not in 2006. Thus the results suggest that concernsabout the initial-year discounting of audit fees are not supported by empirical evidence inthe post-SOX period, at least for the Big 4 auditors.

The results related to non-Big 4 clients are not consistent, with the changesbutnot levelsregressions indicating initial-year audit fee discounts in 2001 and 2006.Ghosh and Lustgarten (2006) examine audit fees during the period from 2000 to 2003 andshow that there was significant price discounting for initial audits by the non-Big 4 eachyear during 20012003. Overall, our results are consistent with the inference by Ghoshand Lustgarten (2006) that competition is more intense in the non-Big 4 segment of theaudit market in the post-SOX period. The differential results for the Big 4 and non-Big 4clients found in our study further reinforce the need to separately examine Big 4 and non-Big 4 clients in audit fee research in particular and auditing research in general.

Our findings also indicate that the Big 4 are much less likely to serve as a successorfollowing a client dismissal of the predecessor in 2005 than in 2001. The lower likelihood

of serving as a successor, coupled with the presence of an initial-year fee premium (asopposed to the initial-year fee discount that is observed in the pre-SOX period), supportssuggestions that the Big 4 have become more conservative with respect to their new clientacceptance and pricing decisions in the post-SOX period.

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Documents

Audit Fees for Initial Audit Engagements Before and After SOX