Audit pricing

Journal of International Accounting, Auditing and Taxation 18 (2009) 6072

Contents lists available at ScienceDirect

Journal of International Accounting,Auditing and Taxation

Audit pricing and auditor industry specialization in an emergingmarket: Evidence from China

Kun Wang , Sewon O, Zahid IqbalDepartment of Accounting & Finance, Texas Southern University, Houston, Texas 77004, United States

a r t i c l e i n f o

Keywords:Audit feeBig 4 rmsIndustry specializationEmerging market

a b s t r a c t

In this paper we examine the determinants of audit fees by focusing on auditor industryspecialization and second tier auditors in the Chinese market. We nd evidence of Big4 premiums for brand name as well as industry specialization in both the statutory andsupplementarymarket. Big 4 industry specialists earn additional premiums in the statutorymarket as compared to non-industry specialists. We also nd that market expansion didnot provide the second tier auditors any price advantage. These auditors increased theirmarket share mainly in the mid- and small-sized clienteles. Moreover, industry experiencedeveloped by the second tier rmsmay have helped themgain economyof scale and reduceservice fees. This may be their strategy to win future clients that seek low-priced audits.

Published by Elsevier Inc.

1. Introduction

Audit pricing and its association with market competitiveness and auditor industry specialization is of primary interestto regulators and users of nancial statements (DeFond, Francis, &Wong, 2000; Ferguson, Francis, & Stokes, 2003;Mayhew&Wilkins, 2003).Muchof the research todate has focusedondeveloped economies, e.g., U.S., Australia, Canada, andHongKong.Evidence on audit pricing is scarce for developing countries, including China, which is potentially one of the worlds largestaudit markets. The purpose of this study is two-fold. First, we examine whether audit pricing in China can be explained byconventional variables aswell as variables specic to the Chinese auditmarket. Second, we explorewhether auditor industryspecialization exists, and to what extent such industry specialization affects audit fees in the Chinese setting.

The audit market in China is different from that of developed countries in several ways. First, competition among auditorsis more pronounced in China due to active participation of small- and mid-sized CPA rms and low concentration of Big 4auditors (Li, Song, & Wong, 2005; Wang & Claiborne, 2008). Consequently, oligopolistic pricing of auditing services is eitherabsent or minimal in China. Second, Chinese auditors usually operate only in the local market due to stronger geographicalinuences in selection of audit rms. Thus, it is not essential that the rm-wide expertise be separated from the ofce-level expertise when examining audit fees in China, a problem that has been encountered by prior studies on developedcountries.1 Finally, consulting fees, which account for only a small portion of audit rms revenue in China, will not be likelyto contaminate data used in our audit pricing models.

Corresponding author. Tel.: +1 713 313 7710; fax: +1 713 3137722.E-mail addresses: [email protected] (K. Wang), [email protected] (S. O), iqbal [email protected] (Z. Iqbal).

1 Prior studies provide inconclusive results on the effect of auditor industry specialization on audit fees. For example, Craswell, Francis, & Taylor (1995)found audit fee premium for industry specialized auditors in Australia in 1987, but Ferguson and Stokes (2002) found no such fee premium in 1998. In lightof these mixed ndings, Ferguson et al. (2003) studied auditors rm-wide and ofce-level industry specialization in Australia. They found that the marketperception and pricing of industry expertise in Australia is primarily based on ofce-level industry leadership in city-specic audit markets rather thannation-wide expertise. These results explain the mixed evidence on the impact of auditors industry expertise on audit pricing.

1061-9518/$ see front matter. Published by Elsevier Inc.doi:10.1016/j.intaccaudtax.2008.12.006

K. Wang et al. / Journal of International Accounting, Auditing and Taxation 18 (2009) 6072 61

Our study contributes to the literature on audit pricing in an emerging economy such as China in two important respects.First, our empirical tests use data from 2005 and 2006, capturing the effects of regulatory and institutional changes that havebeen undertaken in Chinas audit market since early 2000s. For example, further privatization of state-owned enterprisesand more overseas listings of Chinese rms are fostering both the supply of and demand for high quality auditors. Thisresult is in contrast to the evidence offered by two prior studies that the Chinese market was characterized by a lack ofdemand for quality audit services from controlling shareholders and managers (Chen, Su, & Wu, 2007; DeFond, Wong, & Li,2000). These studies used data before 2003. In addition to the Big 4 audit rms, second tier international auditors, includingHorwath International Inc. and BDO, have gained market share through mergers and partnerships with local CPA rms inthis period (Wang et al., 2008). Therefore, further investigation of audit pricing in this new segmented audit market in Chinais warranted. Two prior studies reported inconsistent results on the association between auditor size and audit pricing inChina (Chen et al., 2007; Li et al., 2005).

Second, and more importantly, our study examines audit pricing by focusing on auditor industry specialization in theChinese market. Prior studies (e.g., Chen et al., 2007) assumed that Chinese CPAs have not developed any clear auditorindustry expertise and thus ignored the role of auditor industry specialization in audit pricing. This assumption is weak asevidenced by the recent restructuring and marketing efforts around industry specializations by audit rms in China. Thebusiness focus on industry expertise is especially apparent for the Big 4 rms from the way they promote themselves ontheir web pages. For example, the KPMG website states:

At KPMG, we understand that each industry has its own issues, opportunities and special challenges. Through edu-cation, industry-focused training, and years of rst-hand experience, our professionals have gained an in-depthunderstanding of a range of key industries and the issues faced by each.

The KPMG website goes on to list six broad industry specializations: consumer markets, nancial services, industrialmarkets, information, communications and entertainment, property and infrastructure, and private equity. Industry focus isalso evident in the reorganization of Chinese local CPA rms in an effort to achieve competitive advantage over foreign rms(Peoples Daily, 2006). Furthermore, Chinese regulators are also encouraging Chinese CPA rms to diversify their servicesand develop a multi-layer industry structure. These developments in industry experiences will have a profound impact notonly on the Chinese audit market, but on the U.S. and global markets. Our study is, therefore, expected to shed light on thedevelopment of industry specialization in a rapidly growing auditmarket in China. To our knowledge, no study has examinedthe relation between industry specialization and audit fee in a developing economy such as Chinawhere competition amongthe auditors is relatively high.

We examine determinants of audit pricing relevant in developed markets as well as in transitional Chinese market. Ourresults indicate Big 4 auditors earn fee premiums for general brand name and industry specialization in both the statutoryand supplementary audit market. We also nd audit fees charged by Big 4 industry specialists are 139% higher than those ofnon-specialists in the more competitive statutory market. These ndings represent signicant changes from earlier studiesthat report Big 4 rms only earn fee premiums in the less competitive supplementary market (Chen et al., 2007). It alsoimplies auditor reputation is gaining increasing importance in Chinas nancial market as an effective mechanism to reduceagency cost and signal rm value.

In addition, second tier international auditors (i.e., Horwath International Inc. and BDO) do not earn price premiums foreither general brand name or industry specialization despite their increasedmarket share inmid- and small-sized clienteles.This may be an indication that second tier auditors increase their market share as a basis for production economies of scalewhich in turn, results in lower fees than other non-Big 4 rms. Another explanation for the increased market share is thatthese rms take smaller protmargins or cut corners on the audit. Consistentwith DeFond, Francis, et al. (2000) andDeFond,Wong, et al. (2000), our overall results suggest that the Big 4 industry specialization premium is not due simply to industryspecialization, but is in fact conditional on specialist accounting rms already having Big 4 brand name cachet.

Our study is of primary interest to regulators and nancial statement users who are concerned with the market con-centration of large auditors and audit quality in developing audit markets. Our results will also help audit rms price theirservices according to the different characteristics of their clients. This result is especially true for the Big 4 auditors that areleveraging heavily on the fast growing markets in China. Lastly, companies will benet from our study in assessing the costsand benets of selecting audit rms.

The remainder of the paper is structured as follows. The next section offers background information about the auditmarket in China and reviews prior literature. Section 3 explains sample selection and data collection. Empirical results andanalysis are provided in Section 4. The nal section presents conclusions and limitations.

2. Background and prior literature

2.1. Background

Until the late 1970s, China operated a planned economic system under which an enterprise was either state-owned orcollectively owned. Both types of enterprise were run directly by the government, with little room for market mechanisms.As such, there was no need for independent accounting and auditing until the early 1980s when the economic reform andopening of the economywere adopted by the government. In the early stage of reform, Chinas audit rmswere only allowed

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to serve business entities with a foreign afliation. The emergence of direct nancing for the state-owned enterprises inthe form of share issuance to domestic individual investors in the mid-1980s, however, led to an emerging demand forindependent audit information. Partially in response to such a need, the Chinese Institute of Certied Public Accountants(CICPA)wasestablished in1989, and theShanghai StockExchangeandShenzhenStockExchangewereestablished in1990and1991, respectively. The twomarkets have expanded steadily and provide direct incentives and pressures for market-orientednancial disclosure.2

The secondmajor change in Chinas audit market resulted from the issuance of publicly traded shares to foreign investorsand the rapid growth since 1992 of foreign-invested enterprises in the economy. In response to the information needs offoreign investors, thedemand for highquality audits has increaseddramatically from that time. As a result, foreign accountingrmswere allowed to establish joint ventures with local practitioners to perform nancial statement audits. Until the end of1999, there were three types of audit rms in China: government-sponsored audit rms, university-sponsored audit rms,and auditors in joint venture with overseas audit rms. A auditor rm of a region (especially relevant to government- anduniversity-sponsored auditors) usually has strong and close linkswith the local government and businesses of that region. Inorder to facilitate the economic reform and introducemarket mechanism in the audit market, the Ministry of Finance (MOF)requested all government- and university-sponsored audit rms to disafliate from their sponsors starting from year 2000.From that time, all audit rms operated independently as partnerships or limited corporations. At the end of February 2007,there were 1446 accounting/auditing rms across the country.3

Chinas publicly listed rms are the most sought-after clients of Chinas audit rms. Most listed rms are former SOEswith the government (both central and local) holding a certain percentage of shares. This market is not, however, open to allaudit rms. The MOF and China Securities Regulatory Commission (CSRC) require that listed rms be audited by speciallydesignated audit rms,4 which is a unique feature of the Chinese audit market. By the end of March 2007, only 73 CPA rmswere qualied to audit publicly traded rms.5

Publicly listed companies that issue only domestic shares (A-shares) are required to undertake a statutory audit byany qualied audit rms in accordance with Chinese GAAP. The B-share companies with foreign investments are requiredto undergo a supplementary audit that follows the International Financial Reporting Standards (IFRS), in addition to thestatutory audit.6 The statutory audit market has low entrance barriers and is highly competitive, while the supplementarymarket is dominated by the Big 4 rms because of Chinas regulatory preference for large foreign auditors. The differentnature of these two audit markets in China provides a useful institutional setting for studying the developing strategy ofaudit rms (especially the second-tier international auditors) and determinants of audit fees.

2.2. Research hypotheses

In contrast to the audit market in developed economies, Chinas audit market is competitive rather than oligopolistic (Liet al., 2005; Wang et al., 2008). According to Li et al., during the period 20012003, the top 10 audit rms in China auditedonly 30% of the listed rms, generated about 40% of their revenue and the top four audit rms in China audited only 14% ofthe listed rms, generated about 27% of their revenue. In comparison, the audit markets for the publicly listed rms in theU.S., U.K., Canada, and Hong Kong are dominated by the Big 8/5/4 rms. The big audit rms in these countries audited morethan 80% of the listed rms, which provided more than 97% of their revenue.

This relatively competitive nature of the Chinese audit market necessitates re-examination of the association betweenauditor size and audit fee in the Chinese setting. Two prior studies have looked at this issue. For example, Li et al. (2005)measured audit rm size using various continuous measures rather than dichotomous proxies (Big 4. vs. non-Big 4) andexamined the linear relationship between auditor size and audit quality (audit fees). Based on data from all publicly listedcompanies from 2001 to 2003, their test results showed larger audit rms are likely to issue modied opinions, suggestingthat large rms tend to maintain their reputations in a competitive environment. For size effects on audit fees, they foundlarger audit rms are more likely to charge signicantly higher fees. This result is likely to be due to higher audit qualityrather than economic rents created by monopolistic market power because audit rms are unlikely to exert substantialmonopolistic power in a relatively competitive market.

2 Currently, two types of shares are listed on the domestic exchanges: A- and B-share. A-share listings are offered only to domestic investors and aretransacted in Chinese currency (RMB). B-share listings are offered, primarily, to foreign investors and transacted in U.S. dollars (Shanghai) or Hong Kongdollars (Shenzhen). Until 2001, B-shares were only offered to foreign investors. Approximately 20% of A-share rms are also authorized to issue B-shares.Since its inception in 1991, the B-share market has attracted a considerable number of foreign investors. By the end of November 2006, there were 110issuers of B-shares with a total market capitalization of US $148.4 billion.

3 CICPA news release on February 12, 2007.4 According to the most recent regulation released by Ministry of Finance (MOF) on June 10, 2000, a qualied rm has to be established for at least 3

years, with capital of no less than RMB 2 millions for a limited liability rm and RMB 1 million for partnerships. The rm also needs to employ at least 20CPAs who are qualied to audit public rms and at least 40 CPAs under age 60. Furthermore, it must show a sales record of at least RMB 8 million in theprevious year and no violation of law in the previous 3 years.

5 CSRC news release on March 23, 2007.6 MOF and CSRC required all of the publicly listed companies in China to prepare their annual reports in accordance with IFRS from January 2007.


On the other hand, a recent study by Chen et al. (2007) on the 20002003 Chinese B-sharemarket argues the fee premiumcharged by large auditors is jointly determined by their reputation andmarket power. Which of the two factors has a greaterinuence in determining audit fees depends on the market demand for audit quality and the competitiveness of the market.For example, in Chinas statutory audit market where competition is ercely high and the demand for audit quality is low,large auditors do not have an advantage from their high quality service. Rather, they need to compete on price with otheraudit rms to retain clients. Consistent with their predictions, Chen et al. (2007) found that the Big 5 rms earn signicantfee premium in the less competitive supplementary market but not in the competitive statutory market. They conclude thataudit fee premium earned by the Big 5 rms in China is more likely related to their dominance than reputation in the auditmarket.

The mixed results from the two prior studies are likely due to different samples and research designs. Our data includesB-share companies similar to those used by Chen et al. (2007) but focuses on more recent reporting periods (i.e., years 2005and 2006). Table 1 provides market shares of our sample audit rms. Panel A shows that the market share of Big 4 rmsranges from 20 to 35% based on number of clients, and Panel B shows a 4568% market share of Big 4 rms based on clientstotal assets audited. This result conrms the Chinese audit market is competitive rather than oligopolistic (Li et al., 2005). Italso implies Big 4 rms service larger companies as compared to other auditors.

Notably, our data in Table 1 shows a steady increase of Big 4 market share in the statutory market as compared totheir average market shares (26.8%) reported in Chen et al. (2007). We interpret this trend as that Big 4 rms are gainingpopularity because further privatization of stated owned enterprises andmore overseas listings of Chinese rms are fosteringthe demand for high quality auditors even in the statutory market (Sun & Tobin, 2005). The increased market share, in turn,may deliver pricing advantages to Big 4 auditors when companies are willing to pay higher fees. Therefore, we expect theinsignicant association between auditor size and audit fee in the statutory market documented in Chen et al. (2007) willcease or reverse for our testing period, and our rst set of hypotheses predicts:

H1a. Big 4 audit rms are associated with fee premiums in the statutory audit market.

H1b. Big 4 audit rms are associated with fee premiums in the supplementary audit market.

An interesting phenomenon in Chinas audit market is the expansion of the second tier international auditors as a resultof mergers and partnerships with Chinese local CPA rms. For example, Horwath International Inc. (Horwath) has partneredwith seven local rms since 2001, including Shanghai Shulun Pan CPAs, one of the largest local CPA rms in China. Bycapturing the market shares of its new partners, Horwath became the largest audit rm measured by the number of clientsin the B-share market and audits more than 20% of all of the public companies listed on Stock Exchanges in China. Therefore,the role of the second tier auditors in China is an important market force that cannot be omitted in an audit fee study.

Due to the small market share of non-Big 4 audit rms in the developed market, there is a dearth of evidence on the linkbetween the reputation of second tier auditors and their fee levels. The impact of change in market position of second tierauditors on their pricing strategy, therefore, remains an empirical question to be explored in the Chinese setting. Followingthe argument of Chen et al. (2007) that audit pricing is drivenmostly by themarket dominance in the statutory auditmarket,we expect that second tier auditors may derive some fee advantage from their increased market power. However, this feeadvantage accrued from expandedmarket share may not be sustained in the supplementary market where brand name andaudit quality are the primary determinants of fee levels (i.e., fee premiums are related only to Big 4 reputation). Based onthese speculations, we state our second set of hypotheses as follows:

H2a. Second tier audit rms are associated with fee premiums in the statutory audit market.

H2b. Second tier audit rms are not associated with fee premiums in the supplementary audit market.

Another recent change in the market strategy of audit rms in China involves the emphasis on development of industryspecialization. In the western market, claims by Big 4 audit rms of increased or increasing levels of industry specializationimply that rmsperceive a net benet to specialization regardless ofwhether the benets come from increasedmarket share,prots, audit quality, or audit fees (Hogan & Jeter, 1999). On one hand, audit rms acquire a reputation as industry specialistsby developing industry-specic skills and expertise over and above normal auditor expertise. To the extent that Big 4/5/6rms invest in industry specialization, they require a return on this investment and, ceteris paribus, would be expected tocharge higher fees compared to non-specialists for audits in the related industries.

On the other hand, audit rms develop industry specialization by increasing their clienteles. As a result, specialistscould also achieve production economies of scale and become more efcient, lower-cost producers of audits. Under thesecircumstances, the specialist audit rms would presumably earn a prot premium (due to their lower marginal costs).However, because only fees not costs are observable, empirical models could show that industry specialization resultsin lower fees. To date, the empirical ndings from the U.S. market indicate that audit fee and industry specialization arepositively related, while the ndings from the Australian market are mixed (Craswell, Francis, & Taylor, 1995; Mayhew &Wilkins, 2003; Palmrose, 1986; Ward, Elder, & Kattelus, 1994).

In the Chinese market, industry specialization can have different implications for the pricing strategy of Big 4 rms andsecond tier auditors. As shown in Table 1, second tier rms leveragedmore onmid- and small-sized clients in the expansionof their market share and development of industry expertise. These companies are not very protable and are more likely tobe a clientele that simply demands the lowest-priced audit available. Therefore, we expect the benets derived from product

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Table 1Audit rm market share in Chinese B-Share market in 2005 and 2006.

2005 2006

The statutory audit market % The supplementary audit market % The statutory audit market % The supplementary audit market %

Panel A: audit rm market share based on number of clientsErnst & Young 5 4.59 5 4.59 6 5.71 4 3.81Deloitte & Touche 8 7.34 5 4.59 4 3.81 4 3.81KPMG Peat Marwick 2 3.67 6 5.50 2 1.90 4 3.81Price Waterhouse Coopers 11 10.09 22 20.18 10 9.52 21 20.00Total Big 4 rms 26 25.69 38 34.86 22 20.94 33 31.43

BDO 18 16.51 17 15.60 21 20.00 21 20.00Horwath 26 23.85 24 22.02 24 22.86 22 22.95Total second tier rms 44 40.36 41 37.62 45 42.86 43 42.95

Other CPA rms 34 31.20 22 20.18 34 32.38 22 20.95Total sample 109a 100.00 109 100.00 105a 100.00 105 100.00

2005 2006

The statutory audit market % The supplementary audit market % The statutory audit market % The supplementary audit market %

Panel B: audit rm market share based on clients total assets auditedErnst & Young 5.52 6.25 2.54 3.88Deloitte & Touche 15.92 7.75 16.52 7.76KPMG Peat Marwick 9.63 15.47 13.23 18.38Price Waterhouse Coopers 13.50 34.63 17.27 38.11Total Big 4 rms 44.57 64.10 49.56 68.13

BDO 11.59 10.41 10.50 9.55Horwath 15.08 12.23 11.04 7.38Total second tier rms 26.67 22.64 21.54 16.93

Other CPA rms 28.76 13.26 28.90 14.94Total sample 100.00 100.00 100.00 100.00

a The numbers are different from the total sample due to missing auditor data.


Table 2Industry representation of the sample rms.

Industry description Number of rms % of the sample

Agriculture 4 1.88Chemicals and allied products 5 2.35Conglomerates 4 1.88Construction 3 1.41Electronics 19 8.92Food and beverages 8 3.76Industrial and commercial machinery 65 30.52IT 7 3.29Mining and metal productions 14 6.57Paper and printing 4 1.88Pharmaceuticals 5 2.35Real estate 16 7.51Social services 10 4.69Textiles & apparel 18 8.45Transportation 15 7.04Utilities 8 3.76Wholesale and retail 8 3.76

Total sample B-share rms 213 100.00

economies will enable industry specialized second tier rms to lower audit fees in recruiting and retaining clients. As anadditional support for our expectation, DeFond, Francis, et al. (2000) and DeFond, Wong, et al. (2000) found a local auditrm that specialized in the property industry actually charged 31% lower fees than other local non-Big 6 rms in Hong Kong.Our third set of hypotheses predicts:

H3a. Industry specialized second tier audit rms are not associated with fee premiums in the statutory audit market.

H3b. Industry specialized second tier audit rms are not associatedwith fee premiums in the supplementary audit market.

The primary aim of Big 4 audit rms that already have brand name in place is to develop industry expertise by offeringdifferential service quality rather than lower audit cost. Prior evidence in the Hong Kongmarket indicates that Big 4 industryspecialists earn a premium of 29% over Big 6 non-specialists (DeFond, Francis, et al., 2000; DeFond, Wong, et al., 2000).Moreover, in the Chinese setting, market share of Big 4 rms resides in the largest companies that are more protable andwilling to pay higher fees for differentiated audit services. Therefore, we expect Big 4 auditors will charge higher prices tocompensate their investment on industry specialization in both the statutory and supplementary audit market, and our lastset of hypotheses states:

H4a. Industry specialized Big 4 audit rms are associated with fee premiums in the statutory audit market.

H4b. Industry specialized Big 4 audit rms are associated with fee premiums in the supplementary audit market.

3. Sample and research design

3.1. Sample

Our sample includes all 109 Chinese listed companies that issued both A- and B-shares in years 2005 and 2006. We handcollected audit fee and nancial data from each companys annual report published by the Shanghai and Shenzhen StockExchanges. The data for total audit fee are available for 213 rm years of which 107 rm years belong to the statutory auditmarket and 106 rm years belong to the supplementary audit market. The industry breakdown of our sample is reported inTable 2. In the sample, 30.52% are industrial and commercial machinery rms, 8.92% are electronics rms, 8.45% are textileand apparel rms, and 7.04% are transportation rms. The remaining 45.07% of the sample is from 14 other sectors.

3.2. Research design

Using a standard audit fee model (Chen et al., 2007; Craswell & Francis, 1999; Mayhew &Wilkins, 2003), we examine thedeterminants of audit pricing after controlling for the effects of client size, audit complexity, and auditorclient risk sharing.To test for differential audit pricing based on our hypotheses, experimental variables for Big 4 rms, second tier auditors,and industry specialists are added to the audit fee model. We estimate the OLS regression model as follows:

AUDFEE = b0 + b1ASSETS + b2INVREC + b3SUB + b4LOSS + b5OPINION + b6TENURE+b7FOREIGNSH + b8FL CONTROL + b9BIG4 + e (1)


AUDFEE = b0 + b1ASSETS + b2INVREC + b3SUB + b4LOSS + b5OPINION + b6TENURE+b7FOREIGNSH + b8FL CONTROL + b9BIG4TIER2 + e (2)

AUDFEE = b0 + b1ASSETS + b2INVREC + b3SUB + b4LOSS + b5OPINION + b6TENURE+b7FOREIGNSH + b8FL CONTROL + b9TIER2 + b10BIG4 + e (3)

AUDFEE = b0 + b1ASSETS + b2INVREC + b3SUB + b4LOSS + b5OPINION + b6TENURE + b7FOREIGNSH+b8FL CONTROL + b9TIER2NSPEC + b10TIER2SPEC + b11BIG4NSPEC + b12BIG4SPEC + e (4)

where AUDFEE=natural log of total audit fee; ASSETS=natural log of total assets; INVREC= (accounts receiv-ables + inventory)/total assets; SUB= square root of number of consolidated subsidiaries; LOSS= indicator variable (1 if lossreported in current year, 0 otherwise); OPINION= indicator variable (1 if modied opinion, 0 otherwise); TENURE=naturallog of auditors tenure in years; FOREIGNSH=percentage of B-shares (i.e., foreign shares); FL CONTROL= shares of top 10foreign shareholders/Shares of the largest shareholder; BIG4= indicator variable (1 if a Big 4 audit rm is used, 0 otherwise);BIG4TIER2= indicator variable (1 if the auditor is a Big 4 rm or BDO or Horwath, 0 otherwise); TIER2= indicator variable(1 if the second tier auditor is BDO or Horwath, 0 otherwise); TIER2NSPEC= indicator variable (1 if the Tier 2 rm is not anindustry specialist, 0 otherwise); TIER2SPEC= indicator variable (1 if the Tier 2 rm is an industry specialist, 0 otherwise);BIG4NSPEC= indicator variable (1 if the Big 4 rm is not an industry specialist, 0 otherwise); BIG4SPEC= indicator variable(1 if the Big 4 rm is an industry specialist, 0 otherwise); e=error term with a normal distribution.

Model (1), which tests H1, will provide a baseline comparison with the results of other studies and document whetherthe Chinese audit market pays a premium to the Big 4 auditors. Models (2) and (3) are used to test H2 and examine whethersecond tier auditors (namely BDO and Horwath) can earn a fee premium due to recent expansion of their market share. Toseparate the effect of auditor industry specialization from auditors general brand name, we construct model (4) to examineH3 and H4. Specically, in model (4), we include indicator variables of industry specialists for both second tier and Big 4audit rms.

With respect to the control variables, ASSETS is a proxy for client size, INVREC is a proxy for audit risk, and SUB is a proxy foraudit complexity. We expect positive relationships between audit fee and client size, audit risk, and audit complexity sincehigher values of these variables increase the workload and riskiness of the audit work. LOSS is a proxy for rm protabilityand audit rms would require higher fees if the company suffered losses. The association between audit fee and OPINIONis inconclusive in the developed audit market (Craswell et al., 1995; Craswell & Francis, 1999). In the Chinese setting, wepredict a negative coefcient on OPINION because Chen et al. (2007) found companies receiving modied opinions tend tobe smaller, poor nancial performers, and unable to pay higher fees.

We are unclear about the sign of TENURE because prior literature recognizes two opposing effects on audit fees fromauditor tenure. On one hand, auditors with longer tenure tend to extract higher fees (i.e., future quasi-rents) from clients torecover losses incurred due to low-balling. On the other hand, longer tenure enhances auditors understanding of the clients,enabling auditors to design efcient audit procedures and enjoy cost savings.

Finally, FOREIGNSH and FL-CONTROL are two control variables developed by Chen et al. (2007) in the emerging Chi-nese B-Share market. FOREIGNSH controls for the possibility that foreign investors may have a greater demand for qualityaudits, and we expect a positive relation between audit fee and FOREIGNSH. FL-CONTROL captures differences in agencycosts in terms of the relative monitoring power of foreign investors over the largest shareholders that could affect theaudit fee. Increased monitoring power on the part of foreign investors is expected to reduce agency costs and reduce auditfees.

3.3. Summary statistics

Table 3 presents descriptive statistics for the Chinese B-share rms that have audit fee data available for the statutoryand supplementary audit markets (213 rm years in total). In the statutory and supplementary audit markets, the mean andmedian total assets (ASSETS) are RMB 5021 (5066) million and RMB 2605 (2636) million, respectively. Themean andmediantotal audit fee (AUDFEE) charged by the audit rms in these two markets are RMB 703.8 (668.34) thousand and RMB 550(512.5) thousand, respectively. The data also show that accounts receivables and inventory (INVREC) are about 24% of totalassets and that sample rms have, on average, 14 consolidated subsidiaries (SUB). As indicated by LOSS, about 16% of the rmsexperienced nancial loss. During the sample period, 15% of their companies received modied opinions (OPINION), and thetenure period for engaged auditors (TENURE) is roughly 6.5 (5.5) years in the statutory (supplementary) market. Finally, totalshares owned by foreign investors are roughly 35% (FOREIGNSH), and total shares held by top 10 foreign investors are around43% of the shares owned by the largest shareholder (FL-CONTROL).

In Table 3, we also present data on audit fees for ve levels of auditor quality in the statutory and supplementary auditmarkets. At the lowest quality level, rms use non-Big 4 and non-second tier auditors; at the second quality level, rms usesecond tier non-industry specialized auditors; at the third level, rms use second tier industry specialist auditors; at thefourth level, rms use Big 4 auditors who are not industry specialists; and at the top quality level, rms use the Big 4 auditors

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Table 3Summary statistics for the audit fee model.

Variables Total sample(N=107)

Non-Big 4 auditors(N=49)

Tier 2 non-industryspecialists (N=34)

Tier 2 industryspecialists (N=7)

Big 4 non-industryspecialists (N=6)

Big 4 industryspecialists (N=11)

Mean Median Mean Mean Mean Mean Mean

Panel A: the statutory audit marketAUDFEE (000) 703.80 550.00 503.47 553.47 522.57 979.64 2,835.17ASSETS (000) 5,021,062 2,605,366 4,174,086.90 2,774,148.12 2,887,624.57 6,040,861.45 25,149,759.67INVREC 0.24 0.18 0.22 0.27 0.16 0.32 0.19SUB 13.82 9.00 9.80 14.44 12.43 13.64 43.67LOSS 0.16 0.00 0.14 0.29 0.00 0.00 0.00OPINION 0.15 0.00 0.22 0.11 0.00 0.00 0.00TENURE 6.55 5.50 6.15 6.85 7.42 8.09 4.00FOREIGNSH % 35.51 34.62 35.69 36.56 34.21 35.93 28.86FL CONTROL % 43.00 9.00 43.00 39.00 29.00 48.00 66.00BIG4 0.16 0.00 0.00 0.00 0.00 1.00 1.00TIER2 0.38 0.00 0.00 1.00 1.00 0.00 0.00

Variables Total sample(N=106)

Non-Big 4 auditors(N=31)

Tier 2 non-industryspecialists (N=29)

Tier 2 industryspecialists (N=5)

Big 4 non-industryspecialists (N=16)

Big 4 industryspecialists (N=25)

Mean Median Mean Mean Mean Mean Mean

Panel B: the supplementary audit marketAUDFEE (000) 668.34 512.50 384.42 449.41 448.00 867.73 1,190.82ASSETS (000) 5,065,874.712 635,761.00 2,109,536.55 2,045,164.62 2,221,262.00 5,342,251.06 12,942,879.54INVREC 0.24 0.19 0.23 0.29 0.18 0.30 0.17SUB 13.89 9.00 7.87 14.14 12.00 10.88 23.50LOSS 0.16 0.00 0.23 0.28 0.00 0.00 0.00OPINION 0.14 0.00 0.29 0.17 0.00 0.00 0.00TENURE 5.53 5.00 3.10 3.76 4.20 7.87 9.54FOREIGNSH % 35.27 34.33 33.81 37.70 36.73 36.97 32.80FL CONTROL % 42.00 8.00 50.00 31.00 32.00 45.00 65.00BIG4 0.39 0.00 0.00 0.00 0.00 1.00 1.00TIER2 0.32 0.00 0.00 1.00 1.00 0.00 0.00


Table 4Audit rm industry specialization in the Chinese B-share market.

Audit rms The supplementary audit market The statutory audit market

Industries Mean audit market share % Industries Mean audit market share %

Ernst & Young Information technology 30 Information technology 30

Deloitte & Touche Papers and printing 88.62 Metals and non-metals 40.3Social services 49.75 Social services 49.75

Papers and printing 88.62Utilities 46.69

KPMG Peat Marwick Electronics 42.51 Real estate 50.56Metals and non-metals 40.3 Electronics 37.89Real estate 50.56

Price Waterhouse Coopers Social services 33.83 Food and beverages 47.76Machinery 52.64 Textiles & apparel 44.29Textiles & apparel 65.51 Machinery 42.56Food and beverages 47.76 Social services 33.83Transportation 61.21Utilities 86.19Wholesale and retail 73.58

BDO Agriculture 51.7 Food and beverages 33.79Conglomerates 67.76 Pharmaceuticals 55.18Pharmaceuticals 55.18 Conglomerates 67.76

Horwath Pharmaceuticals 44.53 Agriculture 48.3Construction 71.67 Mining 80.44Information technology 61.46 Pharmaceuticals 44.53

Construction 71.67Information technology 61.46Petrochemicals 53.94

who are industry specialists. Our industry specialization measure is derived from prior studies (Casterella, Francis, Lewis,& Walker, 2004; DeFond, Francis, et al., 2000; DeFond, Wong, et al., 2000; Ferguson et al., 2003), capturing audit rms thathave more than 30% of the market share in each industry (two-digit SIC codes).7 Each auditors market share is based on theclients total assets.8

For second tier audit rms, we do not nd signicant differences in client size and audit fees between industry specializedauditors and non-industry specialists based onmean andmedian values (onlymean values are reported). Compared to rmshiring local CPA rms, second tier audit rms actually have smaller clients and charge lower audit fees. These results suggestsecond tier auditors rely on small- and mid-sized clients to expand their market, and their motivation to develop industryexpertise is to lower rather than increase price.

The data on the levels of auditor quality for Big 4 rms, however, indicate that the Big 4 audit rms have more engagedclients in the supplementary audit market than in the statutory market (41=16+25 vs. 17=6+11). Also, in both markets,industry specialized Big 4 auditors are associated with the largest clients. Moreover, audit fee at least on a univariate basis is signicantly higher for auditors that specialize in industries than for auditors that are in the other levels (i.e., Big 4auditors that do not specialize and non-Big 4 auditors). These ndings are generally consistent with previous research thatdocuments industry specialized Big 4 rms provide differentiated service to their clients and, as a result, earn fee premiums(Mayhew & Wilkins, 2003).

Further in Table 4, we report audit rms that are dened as industry specialists that have at least 30% market share intheir respective industries. The results indicate that Price Waterhouse Coopers has broader industry experience than theother Big 4 auditors in the statutory and supplementary market, followed by Horwath and Deloitte & Touche.

7 To measure audit rm specialization based on total assets, we use the method employed by Hogan and Jeter (1999). In particular, each audit rmsmarket share is calculated, per year, as the sum of the square root of assets of all rms that it audited in a given two-digit SIC code divided by the sum ofthe square root of assets across all COMPUSTAT rms in the same two-digit SIC code. The following equation describes the measure:

MSik =

Jikj=1

Aijk

Iki=1Jik

j=1

Aijk

where i= an index of audit rms; j= an index of client rms; k= an index of client industries; Ik =number of audit rms in industry k; and Jik = the numberof clients served by audit rm i industry k.The IPO literature has adopted the use of square root of the assets as a better measure of auditor industry concentration than the untransformed measure.

8 Following prior studies (Ferguson et al., 2003; Mayhew &Wilkins, 2003), we tried using 10% and 20% thresholds to dene industry specialized auditorsbased on their market share percentage. However, the distributions of audit fees and clients in the Chinese market make these criteria impractical. Whenapplied, these criteria result in over 80% of the clients in the ve largest industries being audited by the specialists.


Table 5Regression results for the statutory audit market.

Expected signs Model (1) Model (2) Model (3) Model (4)

F-statistics 3.66 3.08 3.31 2.84Signicance 0.00 0.00 0.00 0.00Adjusted R2 0.20 0.17 0.19 0.19Independent variables*

Intercept ? 3.02 2.04 2.92 3.172.23** 1.53*** 2.13** 2.32**

ASSETS + 0.2 0.28 0.21 0.172.17** 3.11* 2.21** 1.78***

INVREC + 0.000009 0.00001 0.000009 0.000011.89*** 2.40** 1.90*** 2.54**

SUB + 0.01 0.002 0.001 0.0090.20 0.03 0.02 0.16

LOSS + 0.41 0.20 0.30 0.291.45*** 0.68 1.04 1.00

OPINION + 0.48 0.35 0.45 0.511.56*** 1.14 1.44*** 1.61***

TENURE ? 0.05 0.005 0.04 0.080.44 0.03 0.35 0.64

FOREIGNSH + 0.01 0.007 0.01 0.010.90 0.63 0.91 1.10

FL-CONTROL 0.04 0.01 0.03 0.060.21 0.07 0.16 0.28

BIG4 + 0.71 0.782.45** 2.50**

BIG4TIER2 ? 0.291.40

TIER2 ? 0.140.62

TIER2NSPEC ? 0.170.73

TIER2SPEC 0.040.10

BIG4NSPEC 0.641.83***

BIG4SPEC + 1.192.34**

* Indicate signicance at the 0.01 level.** Indicate signicance at the 0.05 level.*** Indicate signicance at the 0.10 level.

4. Empirical results and analysis

In this section, we present the multivariable test results for our hypotheses in the statutory audit market and thesupplementary market.

4.1. The statutory audit market

The regression results of the audit fee models for the statutory audit market are given in Table 5. The F-statistics aresignicant at p


Weusemodels (2) and (3) to test H2a, an examination of fee premiums associatedwith second tier auditors due to recentexpansion of their market shares. In model (2), we create a new dummy variable (BIG4TIER2) by combining Horwath andBDO with the Big 4 rms. The dummy variable (BIG4TIER2) has a value of 1 if the auditor is Horwath, BDO, or Big 4 rm, 0otherwise. The results show that the coefcient of BIG4TIER2 (0.29) is positive but not signicant (t=1.4, p=0.17), indicatingthat audit fees cannot be explained by this larger group of auditors. As a further test, we separate TIER2 and BIG4 in model(3) along with other control variables. The results show that the TIER2 coefcient of 0.14 is not signicant (t=0.62, p=0.54),but the coefcient of 0.78 for BIG4 is positive and signicant (t=2.5, p=0.01). In sum, these results do not support H2a,suggesting that second tier CPA rms do not price their services signicantly higher than other local audit rms even withincreased number of clients in the relatively competitive statutory audit market.

Prior research argues that the Big 4 auditors earn fee premiums because clients value their general brand name as wellas differential service quality such as industry expertise. We use model (4) to test H3a and H4a in an attempt to separatethe effect of auditor industry specialization from the general brand name for Big 4 and second tier audit rms. We nd thecoefcients for TIER2NSPEC and TIER2SPEC are positive and negative, respectively, but both insignicant. This result indicatessecond tier auditors do not earn higher fees due to industry specialized knowledge. Rather, industry specialization may givethem the advantage of product economies and lower audit costs so that they can reduce audit prices, an effective strategyto attract and retain clients when competing with other local rms.9 Therefore, H3a is supported.

Turning to the Big 4 audit rms, we nd the coefcients on industry specialist variable (BIG4SPEC) and non-industryspecialist (BIG4NSPEC) are both positive and statistically signicant (p


Table 6Regression results for the supplementary audit market.

Expected signs Model (1) Model (2) Model (3) Model (4)

F-statistics 8.96 7.99 8.03 6.55Signicance 0.00 0.00 0.00 0.00Adjusted R2 0.43 0.40 0.43 0.41Independent variables*

Intercept ? 1.82 0.80 1.85 1.851.79*** 0.86 1.82*** 1.77***

ASSETS + 0.27 0.34 0.27 0.273.97* 5.46* 3.89* 3.78*

INVREC + 0.00001 0.00001 0.00001 0.000013.12* 3.86* 3.01* 3.1*

SUB + 0.006 0.02 0.003 0.0020.16 0.49 0.07 0.06

LOSS ? 0.03 0.07 0.03 0.040.17 0.34 0.17 0.221

OPINION 0.43 0.39 0.41 0.422.09** 1.83*** 2.00** 2.97***

TENURE + 0.10 0.01 0.11 0.100.81 0.11 0.89 0.84

FOREIGNSH + 0.02 0.01 0.01 0.012.79*** 1.86*** 1.82***

FL-CONTROL + 0.14 0.09 0.13 0.131.02 0.34 0.92 0.88

BIG4 ? 0.50 0.562.48** 2.39**

BIG4TIER2 ? 0.191.12

TIER2 ? 0.10 0.510.56 2.70***

TIER2NSPEC ? 0.110.60

TIER2SPEC 0.030.08

BIG4NSPEC 0.572.24**

BIG4SPEC 0.551.96***

* Indicate signicance at the 0.01 level.** Indicate signicance at the 0.05 level.*** Indicate signicance at the 0.10 level.

4.3. Sensitivity analysis

We performed sensitivity analyses to test the robustness of our results based on model (1), (3), and (4) specications inTables 5 and 6. We demonstrate the robustness for a wide range of sample selection and model specication issues.

First, we re-estimated the audit models using two new specications of industry specialization. We re-classied an auditrm as a specialist if it audited the highest number of clients or if it is the top leader in that industry. The regression resultsunder these new specications are similar to our earlier ndings. Second, to examine if any one of the Big 4 auditing rmsimpacts our ndings, we re-estimate the models by dropping that rm from the regressions. We nd that no single Big 4rm inuences our results.

Finally, it is quite possible that the largest industry in our sample, namely themachinery industry comprising of 28% of thesamplerms, impacts the regression results. To control for industry inuence,we include an indicator variable (MACHINERY),which has a value of 1 if a rm is in the machinery industry, 0 otherwise. Not reported, for all three models the coefcientsfor MACHINERY are signicantly negative in both the statutory audit market and the supplementary market, indicating theaverage audit fee is lower for clients in the machinery industry. The direction and magnitude of the coefcients for generalBig 4 brand name and the industry specialization variables remain unchanged. In addition, the R2s increased slightly aftercontrolling the industry effect and the coefcients for other variables are comparable to the main ndings.

5. Conclusions and limitations

This study investigates the audit market in Chinas transitional economy using data from annual reports prepared bypublicly traded companies that issued both domestic and foreign shares. We examine variables that explain audit fees inthe developed market economies as well as variables unique to the Chinese economy. The results support our expectationsthat audit fees in China are responsive to certain systematic inuences. Specically, we nd evidence of Big 4 premiums for


brand name as well as industry specialization in both the statutory and supplementary market. In addition, Big 4 industryspecialists can earn additional premiums in the statutory market as compared to non-industry specialists. We also nd thestrategy of expansion in China by the second tier audit rms did not provide them any price advantage. These audit rmsincreased their market share mainly in the mid- and small-sized clienteles. However, industry experience developed by thesecond tier rms may help them to gain economies of scale and reduce service fees. This may be an important strategy forthem to win future clients that seek low-priced audits.

Our study indicates that audit pricing in the Chinese economy has special features. The results can help enhance under-standing of the audit markets in China and in similar developing countries. Firms can price their auditing services accordingto our empirical results on the determinants of audit fee. Also, the second tier audit rms need to improve audit quality andindustry expertise rather than market power in order to earn fee premiums.

There are several limitations and extensions of this study which can be addressed in future research. First, our studyfocuses on the audit market where rms issue both domestic and foreign shares. A concern is that the industry expertiseof auditors specic to this market segment may not represent the entire audit market and potential selection bias mayimpact our results. This concern especially involves local and second tier audit rms as Big 4 auditors have very small marketshare in companies that only issue domestic shares. Consequently, future studies can use an expanded sample of all publiccompanies that issue domestic shares to retest the audit fee models. Second, like most previous studies, this study hasexamined only a couple of specications for industry specialization. Future studies can check the robustness of our ndingsusing other measures of industry expertise developed in the literature. Finally, since both audit rms and public companiesin the Chinese environment have unique features, such as the stronger government and regional/geographical inuences inthe selection of audit rms, our ndings may not be generalized to other audit markets. Replications of audit fee models inother national settings warrant potential research extensions of this paper.

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Audit pricing and auditor industry specialization in an emerging market: Evidence from ChinaIntroductionBackground and prior literatureBackgroundResearch hypotheses

Sample and research designSampleResearch designSummary statistics

Empirical results and analysisThe statutory audit marketThe supplementary audit marketSensitivity analysis

Conclusions and limitationsReferences

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Audit pricing