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Accounting and Finance 47 (2007) 423–446

E.E. CarsonCarson andand N.N. Fargher/AccountingFargher/Accounting andand FinanceFinance 4747 (2007)(2007) xxx–xxxxxx–xxx

ORIGINAL ARTICLES

BlackwellOxford,AAccounting0810-5391©JournalXXXCFIThe AuthorscompilationUKPublishingand Finance©Ltd2007 AFAANZ

Note on audit fee premiums to client size and industry specialization

Elizabeth Carson a , Neil Fargher b

a School of Accounting, University of New South Wales, Sydney, 2052, Australia b Department of Accounting & Finance, Macquarie University, Sydney, 2109, Australia

Abstract

This research note examines the impact of client size on the estimation of audit fee premiums in the Australian market for audit services. Previous research suggests that higher audit fees are expected for both larger clients and for industry specialization. We find that in the Australian market for audit services, the fee premium attributed to industry specialist audit firms is concentrated in the audit fees paid by the largest clients in each industry. One reason for higher fees paid by larger clients is the demand for additional audit services. We find higher fees for companies cross-listed on US exchanges. We also find that fee premiums to auditors that are city-industry leaders are strongly related to client size.

Key words : Audit fees; Auditing; Industry specialization

JEL classification : M42

doi : 10.1111/j.1467-629x.2007.00213.x

1. Introduction

This research note examines the association between client size and audit fee premiums. This topic is important in helping to understand the extent to which fee premiums attributable to auditor characteristics, such as industry specialization,

We gratefully acknowledge the use of data provided by the Centre for Audit and Assurance Research at the University of New South Wales, the Securities Industry Research Centre of Asia-Pacific (SIRCA) from Aspect Financial, the Faculty of Economics and Business, University of Sydney, and Allen Craswell. We appreciate the helpful suggestions from Asher Curtis, Chris Hogan, Rajib Doogar, Brian Mayhew, Renee Radich, Peter Roebuck, Roger Simnett, Mike Stein, Stephen Taylor, Stuart Turley, Arnie Wright, Mike Wilkins, participants at the American Accounting Association (AAA) Auditing Section meeting 2004, the International Symposium on Audit Research 2004, the AAA Annual meeting 2004, and at workshops at the University of Connecticut, Boston College and Northeastern University.

Received 21 December 2005; accepted 29 September 2006 by Gary Monroe (Deputy Editor).

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can be distinguished from fee premiums attributable to client characteristics, such as client size. Prior studies of industry specialization have observed that the results for tests of industry specialization are sensitive to test specification with respect to client size. Craswell et al. (1995) report that the industry specialist premium only occurs for auditees in the top half of the sample based on auditee total assets. Ferguson and Stokes (2002) and Ferguson et al. (2003) report that the premium for industry specialists increases as client size increases. As client size can proxy for client characteristics influencing the scope and complexity of an audit, the present study examines client size as a determinant of audit fee premiums. Specifically, we investigate whether specialist auditors obtain a fee premium for clients of all sizes. As large clients pay higher fees, and auditors of larger clients are designated as the industry specialist, the research question of interest is whether specialist auditors earn fee premiums for audits of small- and medium-size clients. We find that the national industry specialist premium documented by Ferguson et al. (2003) is found only in the highest quintile of client size. The fee premium to industry-specialist auditors is not significantly different from zero for the lower and middle quintiles of clients based on total assets. The fee premium to city-industry lead auditors (Ferguson et al. , 2003) is also strongly related to client size. The present study contributes to the prior literature by documenting the sensitivity of premiums to industry specialization with respect to client size. Although this sensitivity is noted in the seminal research, it is frequently not cited by subsequent papers assuming a positive association between specialization and fees. In examining this sensitivity, we also document three potentially omitted variables in fee models using Australian data: cross-listing on a US exchange, location of the client head office and client bargaining power. Of particular importance is the need to control for larger client demand for assurance services related to US cross-listing when estimating fee models using Australian data.

2. Previous research

The general audit fee model common to most of the studies in the literature represents audit fees as a function of client size, client complexity, client and auditor risk, and audit quality (e.g. Craswell and Francis, 1999). Early research in this paradigm (e.g. Simunic, 1980; Francis, 1984; Francis and Stokes, 1986; Palmrose, 1986; Francis and Simon, 1987) makes it clear that client size is a significant issue with respect to the overall fee model being estimated. Speci- fically, the fee premium to auditors is expected to be different depending on the market segment in which the auditor is competing, where market segment is based on client size. Recent studies that have considered the role of client size include Reynolds and Francis (2001), who find no evidence that Big Five auditors report more

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favourably for larger clients, and Chung and Kallapur (2003), who find no support for the contention that important clients have higher abnormal accruals. Sullivan (2000) finds that following the Big Eight to Big Six mergers there is evidence of reduced marginal costs of auditing large clients as measured by patterns of client switches following the mergers. DeFond et al. (2000) find that the fee premium to Big Six industry specialist is robust across the spectrum of company size in the Hong Kong market. Prior studies of industry specialization using Australian data have observed that the results for tests of industry specialization are sensitive to test specifica- tion with respect to client size. Craswell et al. (1995) report that the industry specialist premium only occurs for larger auditees, where large is defined as being in the top half of the sample based on auditee total assets . Craswell et al. (1995) argue that larger-sized companies in general have greater agency prob- lems and, hence, are more likely to benefit from the additional audit quality of a Big Eight industry specialist. Ferguson et al. (2003) also report that the industry specialist premium increases as client size increases. Recent research also shows evidence consistent with demand for industry specialist auditors from Australian companies with characteristics that are likely to be associated with client size. Chen et al. (2005) find that companies with an audit committee and companies with a higher proportion of non-executive directors are more likely to be audited by an industry specialist. Ferguson et al. (2003, 2006) provide evidence that national rankings are ‘driven by’ city-industry leaders. In a small market like Australia with few large cities, there is the distinct potential that conditioning on industry and city is identifying the largest, more complex audit clients. Using data from the larger US market, Francis et al. (2005) find evidence of audit fee premiums being associated with joint national and city specialist auditors. Francis et al. (2005) argue that the results are generally consistent for the upper and lower halves of their sample by client size; however, they also note that the estimated premium for joint national–city leadership is 22 per cent for larger clients and only 7 per cent for smaller clients (Francis et al. , 2005). Therefore, in our study, we invest- igate the concentration of the observed fee premiums with respect to client size for both national-level and city-level industry specialists.

3. Client size, industry specialization and fee premiums

The client size and auditor specialization explanations for audit fees both predict a fee premium for the industry specialist on the largest audits in the industry. However, the difference is with respect to whether fee premiums are earned by the specialist auditor for audits other than the largest clients that dominate the industry. If the audit fee premium is attached to the industry specialist auditor, then we would expect the premium to attach to all audits undertaken by that specialist auditor in that industry. If these premiums are attached only to audits of the largest clients in an industry, then we would not

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expect to observe significant fee premiums for audits beyond the premiums earned for audits of the largest clients. To the extent that the largest clients endogenously choose the auditor best suited to their business, client size and industry specialist are inherently related and cannot be separated. However, empirical evidence can provide a basis for understanding the extent of specialist audit fee premiums across clients of varying size and the ability of the specialist to earn a fee premium beyond the premium earned from the largest clients. There is evidence that differences in client size are related to audit fees. Mayhew and Wilkins (2003) find that audit firms that possess significantly higher market share than their competitors earn higher audit fees. Audit firms with higher market share also typically have a higher proportion of the larger clients. In contrast, Casterella et al. (2004) examine client bargaining power where power is measured as each client’s sales relative to the sales to all clients in the industry audited by the company’s auditor. They find that audit fees are lower as the client size increases relative to their auditor’s industry clientele. Consistent with prior studies, we do not have sufficient data to directly exam- ine the quantity or nature of assurance services demanded by specific clients. However, we can attempt to carefully model the relation between the client attributes and audit fees, and then consider the incremental fees attributable to industry specialization for clients of differing size. Overall, in considering the relation between client size and industry specialization, there are at least three aspects of client size that can be considered: absolute client size, client size within industry and client size relative to other clients. With respect to absolute client size, we consider two aspects of the associ- ation between client size and audit fees. The audit fee model is generally well specified. However, it is known from prior research that the coefficient on log of assets varies with client size (Bell et al. , 1994). Therefore, we consider non- linearity in the relation between audit fees and client size. Palmrose (1986) observes that if larger clients require more audit services than smaller clients, then we would expect that these large clients pay relatively higher fees per dol- lar of size relative to smaller clients. To examine possible sources of increased demand for audit services from larger clients, we identified companies cross- listed on a US exchange as a client characteristic correlated with client size and likely to increase the scope and complexity of audit procedures required by large clients. 1 With respect to size within industry we focus on the premium to industry specialization to clients of varying size. We empirically examine the extent to

1 From an econometric perspective, cross-listing could be considered an omitted variable from a typical audit fee model, but only to the extent that size and other variables do not fully capture the variation in fees attributable to the need to provide assurance on the reconciliation to US GAAP and other issues relating to dual listing status.

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which the audit fee premium attached to the industry specialist auditor is earned across clients of varying size. Casterella et al. (2004) argue that relative client size within industry results in clients having greater bargaining power and that, ceteris paribus, this will result in lower audit fees. In contrast, Mayhew and Wilkins (2003) argue that the client can only bargain for a lower fee where the auditor has not successfully differentiated itself from competitors. They find evidence that audit firms that have successfully differentiated themselves earn a fee premium. This evidence is consistent with the successfully differentiated audit firm retaining a stronger bargaining position with their clients. To the extent that larger clients have larger reputational capital at risk, and tend to select a differentiated leading auditor in the industry, we would expect higher fee premiums (Mayhew and Wilkins, 2003). We include a measure for client bargaining power as measured by Casterella et al. (2004); however, based on the prior research using US data the premium predicted is ambiguous. We specifically consider the following aspects of client size in audit fee models: (i) additional variables to capture non-linearity in the client size to fee relation; (ii) an additional variable to capture variation in fees arising from large client demand for additional audit services associated with size (cross- listing on a US stock exchange); (iii) a variable to control for client bargaining power (POWER); and (iv) interaction variables to capture the variation in fee premium to industry specialization across clients of varying size.

4. Sample

4.1. Sample selection

For comparability to Ferguson et al. (2003), the sample comprises audit engagements in Australia for the fiscal year 1998. It should be noted that the Price waterhouse Coopers and Lybrand merger occurred in late 1997 and potentially impacts the industry reputation and pricing during this period. However, to address the issue of the sensitivity of the results to the year selected, we have also estimated the models for 1999 and 2004, and reported the results as sensitivity analysis. The 1998 and 1999 samples are drawn from the Who Audits Australia data- base that contains audit fees and non-audit services fees data for the population of Australian listed companies. The 2004 sample is drawn from the University of New South Wales audit fee database. The audit fee data were then matched to the Aspect database of financial statement information. The data were reviewed for reasonableness and identified errors corrected by reference to annual reports. Only observations with all available data, matching total assets on both databases, and two prior years of financial statement information were included. We further excluded companies with financial periods of other than 12 months (including one large company – WMC), companies reporting in a foreign currency and audits where the audit office is outside Australia. All

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monetary units are in Australian dollars. For the city-level analysis, audit fees are examined for companies headquartered in the five largest Australian cities:

Adelaide, Brisbane, Melbourne, Perth and Sydney. We refer to the ‘Big Six’ auditors because of the use of fiscal year end 1998 data in which the firm Coopers and Lybrand was noted to be still issuing audit opinions. We have not redefined five Coopers and Lybrand audits as Price water- house Coopers because of the problematic issue of treating a lower market share auditor as an industry leader by arbitrary reclassification. 2 Between 1999 and 2004 the primary industry code used by the Australian Stock Exchange (ASX) was redefined. This creates an interesting problem for researchers. We have used the new Global Industry Classification Standard (GICS) industry codes for 2004 as any reputation effect based on industry would arguably be better measured by the industry codes actually in use. For 2004, industry is measured as the four digit GICS code. Two industries with fewer than 10 companies audited by Big Four auditors were included in larger industry groupings at the three digit level (GICS 3030 is included with 3020, and GICS 4530 is included with 4520). This resulted in 18 distinct non-financial industry groupings. Despite the lack of direct comparability between the 1998 and 2004 industry groupings, the results for 2004 are generally consistent with those for 1998.

5. Empirical model

We use as a basis for our analysis the audit fee model from Ferguson et al. (2003). We then extend the basic model to capture variations in the association between client characteristics and fee premium. We specifically consider the following aspects of client size: (i) allow the coefficient on client size to vary by quintile of total assets; (ii) include an additional variable to capture variation in fees arising from larger clients cross-listing on US markets; (iii) a variable to control for client bargaining power ( POWER ); and (iv) interaction variables to capture the variation in fee premium to industry specialization across clients of varying size.

5.1. Industry specialist auditors

For comparability to prior research, we follow the methodology of Ferguson et al. (2003) in designating the first and second ranked auditors, based on the proportion of industry audit fees, as the specialist auditors ( SPECIALIST ). We extend the analysis to consider alternate measures of specialization in auditor reputation, such as the auditor that is the leader in both the industry nationally and the city office (Ferguson et al. , 2003; Francis et al. , 2005). The city-industry

2 Ferguson et al. (2003) refer to Big Five audits and treatment of these observations is not reported.

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leader indicator variable takes the value of 1 when the auditor is the number one auditor, based on proportion of audit fees, in the city and 1 of the top 2 firms nationally ( CITYIL ).

5.2. Non-linearity in the client size to audit fee relation

Prior research indicates that the coefficient on log of assets varies with client size (Bell et al. , 1994). We model this aspect by inclusion of indicator variables for each quintile by total assets to partially capture the effect of client size on audit fees. We interact an indicator variable for the quintile of total assets with the log of total assets. This allows the coefficient on log of total assets to vary with client size. 3

5.3. Large client demand for assurance services: US cross-listing

To examine possible sources of increased demand for audit services from larger clients, we identified companies required to complete reconciliations between US Generally Accepted Accounting Principles (GAAP) and Australian GAAP. To examine this possible source of relatively higher fees for large clients, we include an indicator variable ( ADR ) for companies with Level II or Level III American Depository Receipts (ADR). An ADR is a dollar-denominated negotiable certificate that represents ownership of shares in a non-US company. ADRs were identified from the JPMorgan database with an effective date prior to the end of the 1999 financial year. Level II and Level III ADRs are required to com- plete reconciliations between US GAAP and Australian GAAP, and file audited financial statements with the US Securities and Exchange Commission. For the 1998 sample, 13 of the 24 largest clients in the 24 industry categories have ADRs.

5.4. Specialist premiums earned on clients of differing size

Finally, we partition the specialist premium by clients of different size. We report the results using quintiles of total assets. We calculate the quintile of firm size within the sample of Big Six clients and interact an indicator variable for the largest quintile, medium quintiles and small quintile with the indicator variable for audit by a specialist auditor. Similar results are obtained using deciles with slightly stronger reductions in the specialist premium when deciles are used. When size within industry is used, the empirical relations suggest that the association is stronger between fee premiums and size within industry than between absolute size and the fee premium.

3 We also allowed both intercept and slope to vary with the quintile of total assets. The results are generally consistent with those reported, although the combinations of intercept and slope for each quintile varied less systematically. The inferences for the industry specialist premium are not altered.

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5.5. Relative client size

Relative client size is measured following Casterella et al. (2004). POWER is measured for each company as the natural log of company sales divided by the sum of logged sales for all firms in the industry audited by the company’s auditor. Because of missing sales data available for 2004 from Aspect, total revenue is used for sales in 2004.

5.6. Client size and measures of office level industry expertise

Ferguson et al. (2003) find that the premium to industry expertise in Australia is driven by industry leadership at a city level. In the city-level analysis, we include an additional control for variation in city-level costs. As audit practices in major cities (Sydney and Melbourne) are more likely to have higher over- heads than practices in smaller cities (Adelaide and Perth), it is necessary to control for the higher cost of audit production in these cities. As the major audit cost driver is labour, we use the annual salary cost for an experienced auditor in each of the major cities from Hays Personnel Services for the relevant year. Higher salaries are reported for Sydney and Melbourne relative to the other capital cities. Audits outside the major capital cities are allocated the salary cost for Adelaide. Although we recognize that an audit production cost would not be expected to enter linearly into a production cost function, we use the linear approximation as a parsimonious model allowing comparison to prior research.

5.7. Model

The resulting ordinary least squares regression model for examining the impact of size not conditioned on industry is specified as follows (ignoring the company subscript):

LAF = α + ∑ q = 1,5 β 1, q ( δ q * LTA ) + β 2 LSUB + β 3 CATA + β 4 QUICK

+ β 5 DE + β 6 ROI + β 7 FOREIGN + β 8 OPINION + β 9 YE

+ β 10 LOSS + β 11 ADR + β 12 POWER + β 13 SPECIALIST*LARGE

+ β 14 SPECIALIST*MEDIUM + β 15 SPECIALIST*SMALL + ε,

(1)

where LAF is the natural log of total audit fees paid to the auditor ($A thousands); δ q is an indicator variable for each quintile of client size to allow the slope to vary with client size; LTA is the natural log of total assets ($A millions); LSUB is the natural log of the number of subsidiaries; CATA is the ratio of current assets to total assets; QUICK is the ratio of current assets less inventories to current liabilities; DE is the ratio of long-term debt to total assets; ROI is the ratio of earnings before interest and tax to total assets; FOREIGN is the proportion of subsidiaries that represent foreign operations; OPINION is an

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indicator variable with a value of 1 for a qualified or modified opinion; YE is an indicator variable with a value of 1 for non-June fiscal year end; LOSS is an indicator variable with a value of 1 for a loss in any of the last 3 years; ADR is an indicator variable taking the value 1 where the client is cross-listed on a US exchange as a Level II or Level III ADR; POWER is a measure of client bargaining power relative to the auditor’s total clientele in the industry as measured by the natural log of company sales, divided by the sum of logged sales for all firms in the industry audited by the company’s auditor; SPECIALIST is an indicator variable with a value of 1 for the first and second ranked auditor in the industry based on proportion of industry audit fees; SPECIALIST *LARGE is an indicator variable for the two specialist auditors in the industry interacted with a value of 1 if the client is in the largest quintile of clients based on total assets and 0 otherwise; SPECIALIST*MEDIUM is an indicator variable for the two specialist auditors in the industry interacted with a value of 1 if the client is in quintile 2, 3 or 4 of clients based on total assets and 0 otherwise; SPECIALIST*SMALL is an indicator variable for the two specialist auditors in the industry interacted with a value of 1 if the client is in the smallest quintile of clients based on total assets and 0 otherwise; and ε = an error term.

5.8. Descriptive statistics

Table 1 reports descriptive statistics for the sample of firms with Big Six auditors. As in Craswell et al. (1995) and Ferguson et al. (2003), to avoid the confounding effect of brand name on audit fees, the regression models are estimated only for the firms having Big Six auditors in fiscal year 1998. We also exclude the financial services and property development industries (ASX industry codes 16, 17, 19 and 20; GICS codes starting with 40) because of their dissimilar nature relative to other industries (Fields et al.,

2004).

As is common in studies using Australian data, there is a broad variation in client size. Consistent with previous research the distributions of the client size, subsidiaries and audit fee variables are highly skewed. To reduce the impact of outliers on the residuals, the natural log of size (total assets), log of subsidiaries and the natural log of audit fees are used in the subsequent analysis. To reduce the impact of outliers on the distribution of the regression residuals, the QUICK, DE and ROI variables are winsorized (consistent with Ferguson et al., 2003) at the 5 per cent level. Table 2 reports the Spearman correlations between audit fees, client size, auditor and client characteristics. Indicator variables used for industry specialist (SPECIALIST) and city-industry specialist (CITYIL) are all significantly positively correlated with both audit fees and client size. Of interest to this study is whether industry specialist auditors still earn higher fees after controlling for any higher fees earned on the largest audits.

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Table 1 Descriptive statistics for sample of Big Six audits of non-financial Australian companies

Sample

Operating companies with Big Six Auditors

1998

1999

2004

N = 558

N = 543

N = 611

Variable

Mean

SD

Mean

Mean

Audit fees ($A thousand) Log of audit fees (LAF) Total assets ($A million) Log of total assets (LTA) Number of subsidiaries Log of subsidiaries (LSUB) CATA QUICK DE ROI FOREIGN CITYCOST POWER Categorical variables OPINION YE LOSS ADR NATIONAL #1 or #2 (SPECIALIST) CITY #1 AUDITOR AND INDUSTRY #1 or 2 AUDITOR (CITYIL)

241.21

736.40

273.04

318.182

4.13

1.46

4.24

4.58

658.85

3359.70

708.68

773.09

10.80

2.25

10.93

10.91

20.28

53.27

21.75

21.86

0.51

4.54

0.52

0.75

0.38

0.25

0.40

0.45

4.11

8.41

3.41

4.44

0.16

0.16

0.16

0.13

– 0.11

0.32

–0.07

–0.09

0.21

0.27

0.20

0.23

46.47

4.53

46.54

60.58

0.17

0.18

0.12

0.11

13%

12%

13%

23%

23%

22%

66%

64%

61%

9%

9%

7%

57%

57%

61%

28%

29%

31%

Sample excludes banks, financial and property segments (industry codes 16, 17, 19, and 20 for 1998 and 1999; GICS code 40 for 2004). LAF is log of total audit fees paid to the auditor ($A thousands); LTA is log of total assets ($A thousands); LSUB is the log of the number of subsidiaries; CATA is the ratio of current assets to total assets; QUICK is the ratio of current assets less inventories to total assets; DE is the ratio of long-term debt to total assets; ROI is the ratio of earnings before interest and tax to total assets; FOREIGN is the proportion of subsidiaries that represent foreign operations; OPINION is an indicator variable with a value of 1 for a modified orqualified opinion; YE is an indicator variable with a value of 1 for non-June fiscal year end; LOSS is an indicator variable with a value of 1 for a loss in any of the last 3 years; CITYCOST is the use the annual salary cost for an experienced auditor in each of the major cities from Hays Personnel Services; ADR is an indicator variable taking the value 1 if the firm is cross-listed as an American Depository Receipt; POWER is a measure of client bargaining power relative to the auditor’s total clientele in the industry as measured by the natural log of company sales, divided by the sum of logged sales for all firms in the industry audited by the company’s auditor; SPECIALIST is an indicator variable with 1 if the client is audited by the specialist auditor in the industry, where specialist auditor is identified as the two auditors with the largest market share based on the highest proportion of industry audit fees; and CITYIL is an indicator variable with 1 if the company is audited by the number one auditor in the industry and the city, and number one or two in the industry nationwide based on total audit fees. SD, standard deviation.

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Table 2 Non-parametric correlations between variables

Variable

SPECIALIST

LAF

LTA

LSUB

CATA

QUICK

DE

ROI

FOREIGN

OPIN

LOSS

ADR

POWER

CITYCOST

SPECIALIST

1.00

LAF

0.13

1.00

LTA

0.12

0.86

1.00

LSUB

0.14

0.80

0.69

1.00

CATA

0.02

0.10

–0.04

0.08

1.00

QUICK

0.01

–0.34

–0.29

–0.26

0.25

1.00

DE

0.06

0.59

0.62

0.48

– 0.13

–0.30

1.00

ROI

0.07

0.51

0.57

0.33

0.15

–0.21

0.37

1.00

FOREIGN

0.07

0.42

0.29

0.53

0.06

–0.07

0.16

0.09

1.00

OPINION

–0.11

–0.19

–0.26

–0.11

–0.17

–0.11

–0.18

–0.35

0.03

1.00

LOSS

–0.09

–0.50

–0.52

–0.41

–0.09

0.21

–0.35

–0.60

–0.17

0.26

1.00

ADR

0.05

0.21

0.22

0.22

–0.08

–0.02

0.12

–0.02

0.15

–0.01

–0.05

1.00

POWER

– 0.09

0.52

0.53

0.41

0.13

–0.25

0.39

0.43

0.13

–0.15

–0.40

0.07

1.00

CITYCOST

0.05

0.33

0.25

0.19

0.08

–0.08

0.12

0.17

0.06

–0.09

–0.07

0.02

0.20

1.00

CITYIL

0.55

0.25

0.24

0.22

0.06

–0.05

0.14

0.15

0.07

–0.13

–0.16

0.17

0.04

0.11

All correlations greater than 0.10 are significant at the 0.01 level. LAF is log of total audit fees paid to the auditor ($A thousands); LTA is log of total assets ($A thousands); LSUB is the log of the number of subsidiaries; CATA is the ratio of current assets to total assets; QUICK is the ratio of current assets less inventories to total assets; DE is the ratio of long-term debt to total assets; ROI is the ratio of earnings before interest and tax to total assets; FOREIGN is the proportion of subsidiaries that represent foreign operations; OPINION is an indicator variable with a value of 1 for a modified or qualified opinion; LOSS is an indicator variable with a value of 1 for a loss in any of the last 3 years; ADR is an indicator variable taking the value 1 if the firm is cross-listed as an American Depository Receipt; POWER is a measure of client bargaining power relative to the auditor’s total clientele in the industry as measured by the natural log of company sales, divided by the sum of logged sales for all firms in the industry audited by the company’s auditor; CITYCOST is the use the annual salary cost for an experienced auditor in each of the major cities from Hays Personnel Services; and CITYIL is an indicator variable with 1 if the company is audited by the number one auditor in the industry and the city, and number one or two in the industry nationwide based upon total audit fees.

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6. Results

6.1. Client size and audit fees

We initially document specification issues regarding the association between client size and audit fees in Australian audit fee data. Table 3 documents the influence of scale on the Studentized residuals for a typical fee model. We estimate typical fee models, excluding the industry specialist variable, for each quintile of client size and calculate the Studentized residual for each observa- tion. As the Studentized residual is expected to be normally distributed (Easton and Sommers, 2003), we count the number of observations with the absolute value of Studentized residuals greater than 1.96 and compare the frequency of Studentized residuals across size quintiles. In Panel A of Table 3, the median absolute value of the Studentized residual ranges from 0.538 for quintile 3 of client size to 0.832 for quintile 1. The mean and median absolute value for the largest client quintile, quintile 1, is the largest with a value of 0.973. The proportion of observations greater than 1.96 is less than 5 per cent of the sample indicating that the audit fee model is generally well specified. However, the extreme observations are clustered in the largest and smallest client quintiles. All the observations with Studentized residuals greater than 1.96 are in the extreme quintiles. The extreme observa- tions represent 3.6 and 5.4 per cent in the small and large client quintiles, respectively. There are no extreme observations in quintiles 2 through 4. Furthermore, while less than 5 per cent of the observations are potentially influential, 16 per cent of the largest clients in each industry and 17 per cent of the second largest clients in each industry have Studentized residuals greater than 1.96. (For 1999, not reported, 20 per cent of the largest clients and 17 per cent of the second largest clients have Studentized residuals greater than 1.96.) The large clients in each industry are overrepresented in the potentially influential observations. After deleting any potentially influential observations (with absolute value of the Studentized residuals greater than 1.96), we consider the pattern in the coeffi- cient on log of total assets when audit fee models are estimated on subsamples of clients by size quintile. The results are reported in Panel B of Table 3. The coefficients on log of total assets increase with client size. Large audit clients pay more per dollar of assets than small audit clients. The coefficient on size is no longer monotonically increasing across size quintiles, but varies depending on the size of the intercept estimated for the model. Panel B of Table 3 also reports the same data reported sorted by industry-size quintile; that is, the quintile of size of total assets within industry. In this case, the coefficient on size is monotonically increasing, suggesting that size within industry is a deter- minant of audit fees. To provide further evidence of the difference between audit fee model coefficients for small and large client segments, we divided the sample into

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Table 3 Client size effects on residuals and coefficients in standard audit fee models

Panel A: Client size effects in Studentized residuals: 1998 Data a

 

Mean of

Median of

absolute

absolute

Proportion extreme observations (5% level) b %

 
 

Mean of

value of

value of

Median of

total assets

Studentized

Studentized

Studentized

Variable

($A million)

residuals

residuals

residuals

Size quintile 1 Size quintile 2 Size quintile 3 Size quintile 4 Size quintile 5

3078.420

0.973

0.832

3.604

0.387

169.798

0.695

0.612

0

–0.084

44.530

0.702

0.538

0

–0.287

13.755

0.757

0.667

0

–0.145

3.501

0.812

0.667

5.405

0.302

Panel B: The association between client size and audit fees by quintile of client size after removing potentially influential observations c

Variable

Mean of total assets ($A million)

Intercept α

Coefficient on log of total assets: β 1

(1)

Rank on client total assets Size quintile 1 Size quintile 2 Size quintile 3 Size quintile 4 Size quintile 5 Rank on size within industry Size quintile 1 Size quintile 2 Size quintile 3 Size quintile 4 Size quintile 5

 

3010.941

–3.737

0.646

162.991

–1.841

0.478

44.337

–5.363

0.835

13.703

–0.879

0.436

3.635

–1.386

0.362

(2)

 

2298.216

–3.888

0.671

644.629

–2.970

0.596

320.023

–2.638

0.591

71.428

–1.863

0.533

13.922

–1.602

0.469

a Studentized residuals from the basic audit fee model excluding industry specialist auditor. The sample excludes audits of financial and property trusts (industry codes 16, 17, 19, and 20). Model: LAF = α + β 1 LTA + β 2 LSUB + β 3 CATA + β 4 QUICK + β 5 DE + β 6 ROI + β 7 FOREIGN + β 8 OPINION + β 9 YE + β 10 LOSS + ε. LAF is log of total audit fees paid to the auditor ($A thousands); LTA is log of total assets ($A thousand); LSUB is the log of the number of subsidiaries; CATA is the ratio of current assets to total assets; QUICK is the ratio of current assets less inventories to total assets; DE is the ratio of long-term debt to total assets; ROI is the ratio of earnings before interest and tax to total assets; FOREIGN is the proportion of subsidiaries that represent foreign operations; OPINION is an indicator variable with a value of 1 for a modified or qualified opinion; YE is an indicator variable with a value of 1 for non-June fiscal year end; and LOSS is an indicator variable with a value of 1 for a loss in any of the last 3 years. b Proportion of extreme observations is proportion of quintile observations with the absolute value of Studentized residuals greater than 1.96. c This table reports coefficients for fee models estimated on subsamples partitioned by client size excluding all potentially influential observations identified as observations with the absolute value of Studentized residuals greater than 1.96.

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client segments below and above the median size (not reported). We can reject the hypotheses that the coefficients on total assets, number of subsidiaries, current ratio, quick ratio, and number of foreign subsidiaries in the large client subsample are equal to the value of the coefficients in the small client subsample. The coefficient on the log of total assets is 51 per cent higher for the large client sample than for the small client sample. Overall, the results so far suggest that the audit fee model is reasonably well specified; however, there are distinct patterns in the association between client size and audit fees in the extreme client size quintiles. The observations that potentially have significant influence are clustered in the quintiles for the smallest and largest companies. As prior research does not exclude these observations, and exclusion would remove the largest clients in each industry from the sample, we use the full sample in the subsequent analysis but we allow the intercepts and slopes to vary with client size.

6.2. The impact of client size on industry specialist fee premiums

Table 4 estimates fee models with variables capturing the various aspects of client size predicted to impact fees. Column 3 provides results for a basic fee model with an indicator variable for the two largest industry specialist auditors based on market share for comparison with prior research. The model is well specified with an adjusted R 2 of 83.2 per cent. The coefficient on specialist is positive and significant (coefficient 0.12, t = 2.26). Column 4 of Table 4 includes the additional variables allowing the coefficient on log of total assets to vary with client size. Consistent with the results from Table 3, there is a ‘U-shaped’ pattern in the coefficients with slightly higher coefficients for the largest and smallest clients. The differences between coeffi- cients are not statistically significant; however, even small differences when multiplied by log of total assets predict significantly different fees in the extreme quintiles. The indicator variable for cross-listing in the USA is positive and significant (coefficient 0.22, t = 2.27). With respect to potential client bargaining power, the coefficient is positive and significant (coefficient 0.33, t = 2.78). This is consistent with the view that clients that are relatively large in their industry tend to choose an auditor that has successfully differentiated themselves from their competitors and, hence, retains strong bargaining power with the client. We do not find any evidence of the clients that are relatively larger in the industry obtaining any fee discount. The coefficient on specialist remains positive and significant (coefficient 0.12, t = 2.30) similar to the initial model estimate. Column 5 of Table 4 partitions the specialist premium by quintile of client size. The premium to specialization for the largest quintile of clients is 0.28 compared to 0.08 for the middle quintiles and 0.11 for the smallest quintiles. The coefficient on specialization is significant for the largest clients but not significant for the majority of clients. A hypothesis of equal coefficients for

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437

Table 4 Audit fee premiums and client size

 

Expanded model to allow fees to vary with size

Expanded model to allow specialist premium to vary by client size 1998

Expanded

Expanded model 2004 sample revised GICS industries

 

Premiums to

model 1999

industry specialist

sample

Year:

(2)

(3)

(4)

(5)

(6)

(7)

INTERCEPT LTA LTA*QUINTILE 1 (large) LTA*QUINTILE 2 LTA*QUINTILE 3 LTA*QUINTILE 4 LTA*QUINTILE 5 (small) LSUB CATA QUICK DE ROI FOREIGN OPINION YE LOSS ADR POWER SPECIALIST SPECIALIST and LARGE SIZE QUINTILE 1 SPECIALIST and MEDIUM SIZE QUINTILES 2–4

(.)

–1.86 (8.88)

–1.22 (3.08)

–1.15 (2.90)

–1.04 (2.50)

–0.34 (0.91)

(+)

0.51 (28.98)***

 

0.46 (15.78)***

0.45 (14.72)***

0.44 (14.13)***

0.42 (15.26)***

0.44 (13.21)***

0.44 (13.08)***

0.42 (12.01)***

0.39 (12.68)***

0.43 (11.61)***

0.42 (11.46)***

0.40 (10.60)***

0.39 (11.53)***

0.43 (10.49)***

0.42 (10.31)***

0.40 (9.49)***

0.38 (10.11)***

0.45 (9.53)***

0.45 (9.22)***

0.41 (8.43)***

0.40 (9.33)***

(+)

0.04 (5.24)***

0.04 (5.64)***

0.04 (5.67)***

0.03 (4.47)***

0.03 (5.27)***

(+)

0.80 (7.25)***

0.82 (7.44)***

0.82 (7.38)***

0.89 (8.50)***

0.91 (9.14)***

(–)

–0.02 (4.76)***

–0.01 (5.40)***

–0.02 (5.40)***

–0.02 (5.46)***

–0.03 (9.76)***

(+)

0.36 (1.86)

0.32 (1.72)

0.33 (1.75)**

0.58 (3.29)***

0.54 (2.71)***

(–)

–0.52 (5.10)***

–0.36 (3.49)***

–0.35 (3.38)***

–0.19 (1.79)**

–0.27 (2.35)***

(+)

0.60 (5.82)***

0.56 (5.64)***

0.55 (5.54)***

0.76 (7.75)***

0.11 (2.19)**

(+)

0.07 (0.83)

0.09 (1.12)

0.09 (1.08)

0.13 (1.64)

0.09 (1.11)

(–)

0.11 (1.82)

0.09 (1.55)

0.09 (1.44)

0.03 (0.32)

0.07 (1.30)

(–)

–0.18 (2.70)***

–0.15 (2.32)***

–0.14 (2.24)***

–0.02 (0.30)

–0.01 (0.18)

(+)

0.22 (2.27)**

0.21 (2.18)**

0.25 (2.74)***

0.26 (2.64)***

(+/–)

0.44 (3.05)***

0.45 (3.05)***

0.41 (3.01)***

0.24 (1.03)

(+)

0.12 (2.26)**

0.12 (2.30)**

(+)

0.28 (2.18)**

0.23

(1.84)**

0.31

(2.66)***

(n

= 77)

(n

= 75)

(n

= 86)

(+)

0.08 (1.26)

0.16

(2.55)***

0.12

(1.92)**

(n

= 179)

(n

= 178)

(n

= 217)

438

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2007 AFAANZ

Table 4

(continued)

 

Expanded model to allow fees to vary with size

Expanded model to allow specialist premium to vary by client size 1998

Expanded

Expanded model 2004 sample revised GICS industries

 

Premiums to

model 1999

industry specialist

sample

Year:

(2)

(3)

(4)

(5)

(6)

(7)

SPECIALIST and SMALL SIZE QUINTILE 5

(+)

0.11 (0.94) (n = 62)

0.12 (1.10) (n = 57)

0.02 (0.19) (n = 72)

N

558

558

558

543

611

Adjusted R 2 (%)

 

83.2

84.3

84.3

84.9

82.5

*** and ** indicate significance at the 1 and 5 per cent levels (one-tailed), respectively. LTA is log of total assets ($A thousand); LSUB is the log of the number of subsidiaries; CATA is the ratio of current assets to total assets; QUICK is the ratio of current assets less inventories to total assets; DE is the ratio of long- term debt to total assets; ROI is the ratio of earnings before interest and tax to total assets; FOREIGN is the proportion of subsidiaries that represent foreign operations; OPINION is an indicator variable with a value of 1 for a qualified opinion; YE is an indicator variable with a value of 1 for non-June fiscal year end; LOSS is an indicator variable with a value of 1 for a loss in any of the last 3 years; ADR is an indicator variable taking the value 1 if the firm is cross-listed as an American Depository Receipt; POWER is a measure of client bargaining power relative to the auditor’s total clientele in the industry as measured by the natural log of company sales, divided by the sum of logged sales for all firms in the industry audited by the company’s auditor; and SPECIALIST is an indicator variable with 1 if the client is audited by the specialist auditor in the industry, where specialist auditor is identified as the two auditors with the largest market share based on the highest proportion of industry audit fees.

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the largest size quintiles of clients and for size quintiles 2–4 cannot, however, be rejected at an alpha level of 1 per cent (F = 1.81, p = 0.18) due to large standard errors for this test. Overall, the results suggest that the typical audit fee model using Australian data needs to include an indicator variable for cross-listing to capture the demand for increased audit services by this group of large clients. Furthermore, the premium to specialization appears to be clustered in the fees paid by the largest clients. This confirms the seminal research in the area but also documents the extent to which fee premiums to specialization are conditional on client size.

6.3. Client size and measures of office level industry expertise

Table 5 provides a similar fee analysis using an audit fee model with an indicator variable for the city-industry leader (Ferguson et al., 2003). Only audits in the five largest metropolitan areas are included in this analysis. The city-industry leader variable takes the value of 1 when the auditor is the number one auditor in the city and one of the top two firms nationally (CITYIL). Three partitions of the city-industry lead auditor variable are also included in the analysis partitioning the specialization measures by client size quintiles. The indicator variables take the value of 1 if the auditor is a city-industry leader (CITYIL) and the client is in the highest quintile of the full sample by total assets, quintiles 2 to 4, or quintile 5, respectively. Column 3 of Table 5 reports the coefficients for a basic fee model. The coefficient on city cost is positive and significant. Audits where the head office of the client is in a higher-cost city have higher fees than audits of clients with head offices in lower-cost cities. The premium on the city-industry leader in is 0.16, which is a little lower than Ferguson et al. (2003) but still a very large premium. Column 4 allows the coefficient on total assets to vary with client size, includes the indicator variable for cross-listing in the USA and allows the city-industry premium to vary with client size. Consistent with the industry-level analysis the coefficient on cross-listing in the USA (ADR) is large and significant (coefficient 0.19, t = 2.06). The coefficient on the city-industry leader indicator variable remains positive and significant (coefficient 0.33, t = 2.78). As for industry the coefficient on industry special- ization for clients in quintiles 2–4 is not significantly different from 0. As discussed below, the coefficient on the medium quintiles is, however, signific- antly greater than 0 for 1999 and 2004. The pattern of coefficients and the resulting inferences are generally consistent with those reported for national industry-level analysis.

7. Sensitivity analysis and further discussion

In this section, we consider the sensitivity of our results to the period exam- ined and alternate definitions of industry specialist (Gramling and Stone, 2001).

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Table 5 Fee premiums to city-industry leaders

 

Premiums to

Expanded model to allow specialist premium to vary by client size 1998

Expanded

Expanded model

city-industry

model

2004 revised

specialist

1999

GICS industries

Year:

(2)

(3)

(4)

(5)

(6)

INTERCEPT

(.)

–3.41 (10.75)

–2.86 (6.11)

–2.28 (4.65)

–1.02 (2.03)

LTA (Average coefficient in columns 4, 5, 6)

(+)

0.48(27.32)***

0.43 (11.84)***

0.39(10.56)***

0.37(10.84)***

LSUB

(+)

0.04 (5.32)***

0.04 (5.73)***

0.02 (4.66)***

0.03 (5.04)***

CATA

(+)

0.74 (6.83)***

0.77 (7.10)***

0.81 (7.72)***

0.88 (8.72)***

QUICK

(–)

–0.02 (4.99)***

–0.02 (5.58)***

–0.02 (5.11)***

–0.03 (9.55)***

DE

(+)

0.42 (2.21)**

0.40 (2.16)**

0.63 (3.60)***

0.54 (2.71)***

ROI

(–)

–0.57 (5.70)***

–0.40 (3.98)***

–0.23 (2.14)***

–0.24 (2.15)**

FOREIGN

(+)

0.62 (6.16)***

0.58 (5.94)***

0.76 (7.75)***

0.09 (1.78)**

OPINION

(+)

0.05 (0.65)

0.08 (0.94)

0.16 (1.99)**

0.09 (1.13)

YE

(–)

0.06 (0.98)

0.04 (0.67)

–0.03 (0.63)

0.09 (1.47)

LOSS

(–)

–0.22 (3.42)***

–0.20 (3.11)***

–0.04 (0.70)

–0.06 (0.85)

CITYCOST

(+)

0.04 (6.71)***

0.04 (6.75)***

0.03 (5.31)***

0.02 (2.95)***

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441

 

Premiums to

Expanded

Expanded model

city-industry

Expanded model to allow specialist premium

model

1999

 

2004 revised

specialist

to vary by client size 1998

GICS industries

Year:

(2)

(3)

(4)

(5)

(6)

ADR

(+)

0.19 (2.06)**

0.22 (2.41)***

 

0.25 (2.56)***

POWER

(+/–)

0.37 (2.53)***

0.36 (2.60)***

0.08 (0.33)

CITYIL

(+)

0.16 (2.48)***

CITYIL and LARGE

(+)

0.33 (2.78)***

0.40

(3.33)***

0.52

(4.57)***

SIZE QUINTILE 1

(n

= 46)

(n

= 46)

(n

= 58)

CITYIL and MEDIUM

(.)

0.12 (1.51)

0.22

(2.76)***

0.16

(2.19)**

SIZE QUINTILES 2–4

(n

= 88)

(n

= 80)

(n

= 99)

CITYIL and SMALL SIZE QUINTILE 5

(.)

0.05 (0.33)

0.17

(1.24)

0.18

(1.47)

 

(n

= 18)

(n

= 20)

(n

= 30)

NATIONAL 1 or 2 but not CITY 1

0.08 (1.29)

0.08 (1.34)

0.10 (1.59)

0.09 (1.45)

CITY 1 not NATIONAL 1 or 2

0.08 (0.77)

0.08 (0.84)

0.06 (0.69)

0.26 (2.13)**

N

546

546

526

 

594

 

Adjusted R 2 (%)

84.3

85.3

 

85.6

83.1

*** and ** denote significance at the 1 and 5 per cent levels (one tailed), respectively. LTA is log of total assets ($A thousand); LSUB is the log of the number of subsidiaries; CATA is the ratio of current assets to total assets; QUICK is the ratio of current assets less inventories to total assets; DE is the ratio of long- term debt to total assets; ROI is the ratio of earnings before interest and tax to total assets; FOREIGN is the proportion of subsidiaries that represent foreign operations; OPINION is an indicator variable with a value of 1 for a qualified opinion; YE is an indicator variable with a value of 1 for non-June fiscal year end; LOSS is an indicator variable with a value of 1 for a loss in any of the last 3 years; CITYCOST is the use the annual salary cost for an experienced auditor in each of the major cities from Hays Personnel Services; ADR is an indicator variable taking the value 1 if the firm is cross-listed as an American Depository Receipt; POWER is a measure of client bargaining power relative to the auditor’s total clientele in the industry as measured by the natural log of company sales, divided by the sum of logged sales for all firms in the industry audited by the company’s auditor; and CITYIL is an indicator variable with 1 if the company is audited by the number one auditor in the industry and the city, and number one or two in the industry nationwide based on total audit fees.

442 E. Carson and N. Fargher/Accounting and Finance 47 (2007) 423–446

We specifically expect that definitions of industry specialist will affect the estima- tion of relations between client size, identification of the industry specialist, and the resulting measures of fee premiums.

7.1. Sensitivity to period examined

We chose the 1998 year to facilitate comparison with research by Ferguson et al. (2003). To examine the robustness of the results to the period examined, we re-estimated the results using equivalent data for 1999 and for 2004. In 1999, for the base model, the coefficient on specialist is positive and significant (coefficient 0.17, t = 3.16). Consistent with the results for 1998, there is a ‘U- shaped’ pattern in the coefficients when the coefficient is allowed to vary by quintile of total assets. For the complete model (reported in column 6 of Table 4), the coefficient on the indicator variable for cross-listing in the USA is positive and significant (coefficient 0.25, t = 2.74). The premium to specializa- tion for the largest quintile is 0.23 compared to 0.16 for the middle quintiles and 0.12 for the smallest quintile. The coefficient for the interaction between specialist premium and medium size of client is significantly greater than 0; however, there is a consistent decline in premium between the largest clients and the medium size of client. Overall, the results are consistent with those reported using the 1998 data. With the demise of Arthur Andersen, there has been a further concentration of suppliers of audit services. To establish whether our results are generalizable to this period, we re-estimate our models for 2004. For the base model, reported in column 7 of Table 4, the ADR variable continues to be positive and signi- ficant (coefficient of 0.26, t = 2.64). We also find evidence of premiums to national specialist for the largest quintile of clients (0.31, t = 2.66), which decline across the medium and small quintiles. In column 6 of Table 5, we report a similar pattern of results for city-industry leaders. Overall, we find evid- ence that the pattern of premiums to specialization for large firms is robust to time period despite the significant change in industry designations adopted by the ASX before 2004. However, in the post-Arthur Andersen market, we no longer find support for a higher fee paid by relatively large clients in an industry as we found in earlier periods. For 2004, we do find a premium to the city, but not national leader (0.26, t = 2.13) that appears to clustered in industry groupings for GICS code 1510 (materials) and GICS code 3020 (food) where larger industry groupings than previously result in some large companies employing city leading but not industry leading auditors. However, we have not partitioned this group by client size because of the small number of companies involved.

7.2. Number of clients in the industry

A concern in use of the market share measure of specialization in prior liter- ature is the intuition that an industry must have a minimum number of clients

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in an industry for an auditor to be designated a specialist in that industry. Although Ferguson et al. (2003) assign specialists in all industries, earlier research by Craswell and Taylor (1991) and Craswell et al. (1995) were careful in only identifying specialists in industries with greater than 30 observations and only identifying auditors as specialists where the auditor has a threshold of 10 per cent of market share on either the number of clients or the percentage of total audit fees. Replicating our models on the nine industries that previous research has identified as having industry premiums (01–04, 07, 09, 11, 13 and 19), we find similar results to those reported. Influential observations are clustered in the largest and smallest quintiles by asset size. For the full model (column 5 of Table 4), fee premiums to specialization are found for ADR (coefficient 0.21, t = 2.18). The premiums to specialization for the large, medium and small clients were 0.28, 0.08 and 0.11, respectively. Replicating our models on the 7 industries that previous research has identified as having industry premiums and that have 30 clients in our sample (1, 2, 4, 9, 11, 13 and 19), we again find results consistent with those reported above.

7.3. Number of auditors in the industry and identifying a specialist

Seminal research on specialization (e.g. Craswell et al., 1995) examines a market with eight large international audit firms. Given the small number of auditors in the current market we consider the ability of the typical methodology to distinguish between alternate explanations for specialist fee premiums. To determine whether the fee premium attributed to specialization can also be explained by client attributes, we examine the observed fee premium when clients are assigned to five auditors at random. That is, we randomize clients within industry with respect to the reputation of the auditor selected. We ini- tially allocated all clients to five auditors using a random draw from a uniform distribution. The industry specialist auditor is then identified based on the high- est share of audit fees in an industry and the basic fee model estimated (as per column 3 of Table 4). We repeated this procedure 1000 times. The mean coeffi- cient on the industry specialist auditor is 0.12 with a range of 0.06 to 0.19. The largest clients in each industry pay fee premiums in the Australian market, and whichever auditor has these clients is designated the industry specialist and receives an apparent fee premium. Fee premiums of the magnitude typically observed for industry specialist auditor can be explained by the fee premiums paid by the largest clients, and whether this premium is due to industry special- ization or other client attributes requires additional information not typically available in this type of study. As a further sensitivity, we also re-estimated the regressions reported as Table 4 removing clients from one auditor from each estimation. For 1998, only the test of the significance of the coefficient on the ADR variable is not signific- ant when KPMG is excluded (KPMG audits 13 of 49 clients with ADRs in 1998). The coefficient on the SPECIALIST and LARGE SIZE QUINTILE 1

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interaction is also not significant when Price waterhouse Coopers clients are excluded (166 clients are excluded from the sample). However, the coefficients are consistently in the direction of those reported and most statistical inferences are consistent with those reported.

8. Conclusion

Previous research suggests that industry specialist auditors earn higher fees. Previous research has also found that, in the Australian environment, higher fees are concentrated in clients of larger size. This research attempts to provide further insight into the association between the client characteristic of size and audit fee premiums. Premiums to national industry specialists are concentrated in the fees paid by the largest clients in each industry. The premium to industry specialist auditors is not significantly different from 0 for the middle and smaller quintiles of clients based on total assets. The findings are consistent with auditor specialization only benefiting large clients. Another possible explanation is that the client characteristics of large clients impact audit fees and the auditors of the largest clients are designated the industry specialist. Given the differences in apparent premiums to large and medium clients it appears important to partition the specialist premium by client size, or to report results by subsamples partitioned by client size (e.g. above and below the median). Given the strong relationship between client size and audit fees, and that audit fees do not vary strictly linearly with client size, we suggest that it is important to examine the robustness of any observed fee premium across clients of varying size. We document a variable that can be considered an omitted variable in typical audit fee models. Companies that are cross-listed on US exchanges pay higher audit fees. As these large companies have more complex filing requirements it is to be expected that they pay higher audit fees. The premium to this factor is large relative to premiums attributed to industry specialization and should be considered in audit fee models using Australian data. We also document three smaller effects. There is non-linearity in the asso- ciation between client size and audit fees. For the period examined, both smaller and larger clients tend to pay higher audit fees. We also observe that audit costs vary by the city of the client head office. Clients located in higher-cost cities pay higher audit fees. We also find evidence that clients that are large relative to their industry paid higher fees in the earlier years of our sample period. We find no evidence consistent with larger clients being able to negotiate lower audit fees. The issue of fee premiums paid by large clients is of particular concern because of the possible explanation that there is a potentially less competi- tive segment for ‘large’ auditees that is dominated by a few large audit firms (Simunic, 1980; Francis and Stokes, 1986). In the USA, the Sarbanes–Oxley Act explicitly refers to the reduction in the number of firms capable of providing

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audit services to large businesses (Sarbanes–Oxley Act, US Congress, 2002, section 701). This paper highlights the higher fees received from larger clients in each industry with indirect implications for the importance of these clients to the auditor and auditor independence. However, we find evidence consistent with a higher demand for more complex accounting and auditing issues from these clients that needs to be considered before attributing fee premiums to a lack of competitive pressure. Because of the changes observed in the audit market, future research could also consider these issues in a dynamic market setting with a declining pool of large auditors available to audit large companies.

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