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Managerial Auditing Journal
Audit fee determinants: the plural nature of risk

C.A. JubbK.A. HoughtonS. Butterworth
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Audit fee determinants: the plural nature of risk
C.A. Jubb, K.A. Houghton and S. Butterworth The University of Melbourne,

Parkville, Australia
Addresses concerns regarding perceptions and measurement of risk and the resultant
confusion relating to understanding of the market for
audit services. Examines the
theoretical justification for a
plural approach to dealing
with risk in audit fee
models. Reviews the relevant
literature and undertakes a
factor analysis of 229 Western Australian firms in search
of evidence of plurality.
Argues for recognition of the
idea that risk in the audit
context is composed of two
separate but related concepts: audit risk and business
risk.
The authors gratefully

acknowledge the helpful
comments of an anonymous
reviewer, participants at
workshops at Deakin, Auckland and Monash Universities, the University of Melbourne, Murdoch University
and the Australian National
University. The comments of
Russell Craig and Greg
Shailer (both of the ANU),
Peter Schelluch and Grant
Gay (both of Monash University) and Alan Davidson
(Murdoch University) are
particularly appreciated.

11/3 [1996] 2540
MCB University Press
[ISSN 0268-6902]
Introduction
Understanding the operation of the audit
market is of importance to both the
consumers and providers of audit services,
and those attempting to regulate that market.
Properly specified models of the determinants of audit fees, such as those introduced
by Simunic[1] and others, are one of the most
powerful means by which this market can be
analysed.
To date, most of these models have posited
theoretically and supported empirically the
view that there is a positive relationship
between some concept of risk and audit
fees[1-15]: that is to say, as audit risk increases
so too does the fee charged by the auditor for
audit services to the auditee. However, the
audit risk concept has been ill-defined in the
relevant literature. As a result, major differences have existed between researchers as to
perceptions of risk and the way in which it
has been measured. Such confusion makes it
difficult to compare the various audit fee
models across studies and introduces a
degree of confusion into our understanding of
the market for audit services.
This paper aims to address these concerns.
Specifically, it argues that the audit fee literature should recognize the theoretical auditing literature which notes that risk, in the
audit context (not necessarily identical to the
notion of risk often used in the finance literature) is composed of two distinct but related
concepts; audit risk and business risk.
This paper examines the theoretical justification for a plural approach to dealing with
risk in audit fee models. It reviews the
literature to determine the theoretical justification for, and operationalization of, the most
frequently utilized risk measures. Factor
analysis of selected audit fee determinants is
then undertaken on a sample of 229 listed
companies in search of evidence of this plurality. Comparison is made between the labels
(audit and business) applied by
researchers to these various measures and
the factor analysed loadings. Finally, an audit
fee model adopting variables based on the
results of factor analysis is tested empirically.
The next section reviews the relevant literature and develops the research question to
be tested empirically. The subsequent

sections contain a description of the data and
methodology to be used in this study and the
penultimate section presents the empirical
findings. The final section contains conclusions, implications for both theory and practice and proposals for further research.
Literature review
There is now a substantial and growing literature concerned with the multivariate modelling of audit fees. Many of these studies contain common variables, including measures
for size, complexity and risk. Several constructs and measures have been used to operationalize each of these variables, however,
for reasons already noted (and developed
below) the present study focuses on the risk
variable alone.
Definitions
It is commonly accepted within the relevant
literature that, in any audit engagement,
there are two forms of risk which are relevant
to the auditor (see for example [16-18]). One of
these generally is labelled business risk.
This is the risk related to the business of
managing the audit firm and is defined as
the probability that an auditor will suffer loss
or injury in his professional practice[19,
p. 60]. Such loss or injury may arise through
law suits against the auditor, sanctions
imposed by external regulators, diminution
of the auditors professional reputation, possible loss of clients, time and costs incurred
in defending the auditors position and nonrealization of audit fees[19,20].
The second form of risk is labelled audit
risk. Audit risk is the likelihood that an
auditor will render an inappropriate opinion
on an auditees financial statements[21]. It is
generally accepted within both the professional and scholarly literature to be a function of a joint probability, multiplicative[22]
model involving a further set of components
of risk known generally as the audit risk
model.
Despite acceptance of this model as a planning tool within the professional literature
([23-25] in Australia, [26-28] in the USA, [29] in
[ 25 ]
C.A. Jubb, K.A. Houghton and

S. Butterworth
Audit fee determinants: the
plural nature of risk

11/3 [1996] 2540
[ 26 ]
Canada, and [30] in the UK) there is little

accompanying guidance on its implementation[31] and continuing controversy and
criticism are associated with its implementation[32-42]. Contributions to the scholarly
literature which seek to better specify the
model[35,43-45] (see [45,46] for evaluation of
the combined effect of the extentensions
proposed to the model by the first three of
these authors) have not yet had an impact on
the professional literature. Thus the measurement of audit risk by auditors is not
without difficulty, even presuming the components making up the audit risk model can
be assessed accurately. The researchers task
in attempting to examine issues involving
risk is made even more difficult by the
proprietary nature of assessments of audit
risk and its underlying components.
A major component of business risk for
audit firms is client specific audit risk
itself[16] and so, as audit risk increases so
too does business risk[20]. This is because
the auditors business risk is closely
related to one of the components in the audit
risk model: the auditees inherent risk[31].
This close relationship is brought about
because factors which bear on one of the risks
may affect the other also[47,48]. Yet, auditor
business risk encompasses a wider concept
than the auditee audit risk transmitted
through inherent risk alone. It incorporates
the risk that users will view the opinion as
incorrect even when it was, in fact, appropriate[47]. Indeed it can be argued that business
risk can arise whether or not audit risk is
present[18]. Business risk includes auditorcentred factors (e.g. the risk of unanticipated
legal liability after merging with another
firm), as well as client-centred factors (e.g.
client industry, management style, etc.). This
phenomenon is recognized by Simunic and
Stein[49] who assert that, as an auditor generally will have a portfolio of auditees, the
potential risk and return to an auditor of any
one audit engagement must be assessed in
terms of its impact on the potential returns to
the auditor from that portfolio.
Further, it is argued that while business
and audit risk to some extent overlap, there
are also situations in which each is
distinct[50]. Consider the case where an audit
has been conducted with competence and
diligence. Due to circumstances outside the
control or anticipation of the auditor the
company fails and, consistent with common
practice, the auditors are cited in litigation
by both former shareholders and creditors of
the company. The litigation, whether successful or not, will involve costs borne by the
auditor, in part or whole, including both legal
cost and potential negative reputation effects.
It is argued that these costs will give rise to

the auditor seeking to recoup and cover such
costs and anticipated further costs of a similar nature, by way of the pricing of audit
engagements.
The next section discusses how these conceptually distinct, but overlapping,
constructs of audit risk and business risk
have been treated theoretically and operationalized in the audit fee modelling literature.
Approaches to capturing risk

Auditor business risk vs auditee
business risk
Accepting theoretically that the risk variable in audit fee models has a plural nature is
insufficient alone. If it can be empirically
ascertained that both dimensions exist, then
measures which adequately capture both
auditee audit risk and auditor business
risk need to be invoked. Neither aspect is
easy to measure as both are unable to be
observed directly. Data in relation to the audit
firm is particularly difficult to gather since
financial statements are not publicly available for partnership structures. Thus,
although it is auditor business risk which
is one of the variables of interest in this study,
it is extremely difficult, if not impossible, to
capture this other than through auditee
related measures (see [1, p. 173]). No audit fee
study has attempted to achieve a direct measure of auditor business risk. Hence, in the
discussion which follows, business risk,
unless otherwise specified, relates to auditee
business risk as a proxy for auditor business risk (some may argue that it is, in fact,
auditee risk which is at issue here since there
is no effective portfolio of clients and the
addition of a risky client will add to overall
risk anyway).
Conceptual treatment of risk in the

literature
It is not clear from the audit fee literature
(see Table I) that the two aspects relating to
the risk construct argued to exist have been
acknowledged adequately. Two early studies[1,2] show some recognition of the multidimensional nature of risk. However, it is
not clear from those two studies that the partitioning between business and audit
risk is well developed.
Since this early work, some authors have
written in terms of business risk but used
measures labelled by others as audit risk,
and vice versa (e.g. [7,10]). Other authors have
failed to specify the nature of the risk concept being invoked (e.g. [9]). Despite these
differences in the theoretical specification of
risk, the variables used to operationalize
**
NS
NS
***
**
***
***
+
NS
NS
NS
**
***
NS
**
***
***
**
+
NS
NS
NS
NS
***
**
NS
***
NS
NS
NS
ROI
or ROE
NS
NS
NS
NS
Quick
or current
ratio
**
***
***
NS
NS
**
NS
Debt
ratio
NS
NS
**
NS
NS
Loss in
last three
years
NS
NS
**
**
Variability
Current
in
Unsystematic
cost
profitability
risk
accounting
***
Ownership
***
Ins. co
rating
Notes: Not included; *** Significant at the p = 0.01 level; ** Significant at the p = 0.05 level; * Significant at the p = 0.10 level; NS Included but not significant; + Included but regression results
not reported
Simunic[1]
Francis[2]
Firth[3]
Simon[4]
Palmrose[5]
Francis and
Stokes[6]
Francis and
Simon[7]
Simon and
Francis[8]
Chung and
Lindsay[9]
Ettredge and
Greenberg[52]
Low et al.[11]
Turpen[10]
Maher et al[55]
Gist[12]
Chan et al[13]
Pearson and
Trompeter[15]
Anderson and
Zeghal[14]
Butterworth and
Houghton[56]
Study
Audit
opinion

11/3 [1996] 2540
Inventories
receivables
total assets
Table I
The operationalization of risk in audit fee studies

S. Butterworth
[ 27 ]

S. Butterworth

11/3 [1996] 2540
[ 28 ]
risk, the variables used to operationalize

whichever concept is used, often overlap.
In Simunics seminal work, development of
the argument regarding potential audit fee
determinants revolves around what he terms
variability in loss exposure across audit
engagements [1, p. 171]. While not specifically mentioning business risk, several of
Simunics measures for risk (loss in last
three years, net income/total assets and audit
opinion) are discussed in relation to auditee
financial distress. He argues the need to
include control variables for differences in
the assessed loss-sharing ratio (between auditor and auditee) [1, pp. 171, 173]. It is reasonable to believe that Simunics intention was
to control for business risk through these
measures since he uses them as a surrogate
for auditor financial distress.
As well as the implicit adoption of business risk as an audit fee determinant,
Simunic mentions audit risk specifically
and points out that inventories and receivables are risky balance sheet components
requiring specific auditing procedures (confirmation and observation) [1, p. 173]. Thus,
it would seem that Simunic, although not
stating so explicitly, invokes both here identified risk concepts in his measures of risk.
The first published study to follow
Simunic[1] was Francis[2]. In this Australian
replication, three additional control variables were included: quick ratio, equity-debt
ratio and month of year end. Francis hypothesizes that the first two of these are associated
with the auditors loss exposure or audit
risk. The argument assumes that auditee
financial risk relating to debt also affects
audit risk. Specifically, ... a small quick
ratio and equity-debt ratio should be associated with higher financial and audit risk than
a large quick asset ratio and equity-debt
ratio [2, p. 140]. Francis, like Simunic, recognizes two types of risk, makes explicit only
audit risk; and includes measures which
can be said to encompass both concepts.
(Francis[2] uses audit opinion current assets/
total assets, return on investment, quick asset
ratio, debt ratio, and loss in last three years to
measure risk. The present writers argue
that the first two of these relate to audit
risk and the remainder to business risk.)
The importance of the multi-dimensional
nature of risk appears to have been lost in
subsequent studies. For example, taking the
studies chronologically, Firths[3] discussion
focuses on only audit risk. Simon[4] does
not discuss the risk construct in any way.
Palmrose[5] notes the construct without
attempting to unravel its multi-dimensional
nature. Francis and Stokes[6] rely heavily on
the measures used in Francis[2] and write
only of audit risk[51]. Francis and Simon

[7] mention audit risk alone. Simon and
Francis[8] and Chung and Lindsay[9] do not
discuss risk. Turpen[10] and Ettredge and
Greenberg[52], on the other hand, specifically
mention their measures as relating to audit
risk. Similarly, Low et al.[11] discuss only
audit risk and explicitly mention that all
their measures relate to this aspect of risk,
even though several of them are arguably
more akin to business risk[53]. Gist[12,54]
and Anderson and Zeghal[14] do not explicitly mention either category of risk. Maher et
al.[55], and Butterworth and Houghton[56] do
not discuss risk at all. Chan et al.[13] introduce a new term operating risk, which it
can be argued is synonymous with business
risk as well as explicitly acknowledging
audit risk.
Thus, analysis of these audit fee studies
demonstrates that the definition of risk has
not been well addressed and much confusion
exists within the empirical literature. The
confusion commenced with Simunic[1] who,
although recognizing the necessity for measures encompassing both audit risk and
business risk, did not make explicit the
theoretical and empirical need for their differentiation. Perhaps it is not surprising then
that subsequent researchers (with the exception of Francis[2] and possibly Chan et al.[13])
have tended to discuss risk generically, if
indeed it is discussed at all, labelling all measures of risk, sometimes erroneously, as
audit risk. In addition, over time there has
been a tendency towards more parsimonious
audit fee models which are prone to omission
of one or other of the two risk concepts (e.g.
[4]).
Operationalization of risk in the

literature
A wide variety of measures have been used in
previous audit fee research to operationalize
risk in the context of auditing. Table I synthesizes this literature in relation to risk
measures. It can be seen that two measures
dominate: audit qualification and the ratio
of inventories and receivables to total assets
outnumber the next most frequently used
measures (leverage, return on investment
and loss history), by two to one (11 uses to
five). The question remains though as to
whether these typically used measures adequately capture the risk construct.
The purpose of this study is twofold. First,
to determine empirically which measure(s)
capture either or both of the risk dimensions identified theoretically above. Second,
to test the proposed superiority of an audit
fee model which incorporates both aspects of
risk using the measures so identified.

S. Butterworth

11/3 [1996] 2540
Audit qualification
At a theoretical level it is unclear which of
the two aspects of risk the audit qualification is likely to capture. On one hand, it can
be argued that a qualification increases auditor business risk. This follows for two reasons. First, it may indicate the existence of
financial or other uncertainty surrounding
the auditee[57]. This may lead the audit firm
to suffer damage as a result of being involved
in that audit[1]. Second, it may indicate the
necessity for additional audit work. Palmrose
argues that qualifications require the
accumulation of a greater amount of evidence
to achieve the auditors desired level of assurance. In addition, circumstances that give
rise to modifications may signal the need to
increase the desired level of assurance
because of the increased risk of adverse
actions against the auditor [5, p. 100].
On the other hand, it can be argued that a
qualification helps to protect the auditor from
a charge of negligence and so reduces auditor
business risk. Nothing seems to raise the
ire of shareholders and regulators as much as
an unqualified audit opinion followed soon
thereafter by auditee collapse. It can be
argued that a qualification takes the surprise out of such a phenomenon and reduces
the chance that an auditor will be involved in
subsequent litigation.
Another view sees qualification not as a
business risk measure at all but rather as
an audit risk measure. This is because of
its link with the definition of audit risk
used in the professional and scholarly literature in terms of the risk of giving an inappropriate opinion (see for example [23,33]).
Thus, the exact nature of the qualification
measure when used as a proxy for risk is
unclear, although it is testable empirically.
Proportion of inventory and receivables to
total assets. Simunic was the first to recognize inventory and receivables as risky
balance sheet assets, in that they require
specific auditing procedures and even then
may not be well audited since their valuation
requires a forecast of future events [1, p. 173].
Since these items generally represent a material portion of the balance sheet they usually
warrant substantial audit effort and the risk
of a material misstatement being missed by
the auditor is higher than for other accounts.
It is argued here that the proportion of inventory and receivables to total assets measurement is a proxy for audit risk .
The use of this variable in audit fee studies
creates problems in that it could be a proxy
for (and highly correlated with) auditee complexity. This is so because when the auditee
becomes more complex and its operations
more dispersed, it may be harder for the audi-
tees central management to maintain adequate control over inventory and debtors.
Therefore, as complexity increases, so too
could the value of this ratio. Firth[3] used
such a ratio to control for auditee complexity
in his study and Simon and Francis[8] found
a significant positive correlation between this
variable and their complexity variable. On
the other hand, although not directly relevant
since inventory plus receivables over total
assets was not included, Taylor and Baker[58]
in a factor analysis of a variety of variables
affecting audit fees (but not explicitly including risk) found that the number of subsidiaries as a measure of complexity did not
load on the same factor as either current
assets or total assets. (Wallace[18] also factor
analyses a number of variables she argues to
be related to risk. However, none of the
variables included here form part of that
analysis.)
Thus the ratio of an auditees receivables
and/or inventories to the auditees total
assets has received overlapping use in the
literature and its suitability as a measure of
risk (especially in studies which concurrently measure complexity) can be
questioned. Once again, the question as to
which construct this measure relates (business risk, audit risk or complexity) is
empirically testable[59,60].
Leverage, return on investment, loss history
and liquidity. It is argued that these measures
generally are associated with the potential
for, or actual level of, auditee financial distress. As such they are likely to be proxies for
auditee business risk and hence (indirectly)
auditor business risk[1, p. 173]. This
approach is justified on the basis that an
auditors practice, generally, is vulnerable to
damage through involvement with a particular auditee if the stakeholders in that auditee
have suffered economic loss[61-63]. Such
economic loss is more likely to arise when the
auditee is in financial distress or experiences
failure. In addition, the tendency for
distressed companies to experience more
financial statement errors[64], window
dress financial reports[65] and be associated
with greater non-routine management
turnover[66] can be argued to lead to a
greater likelihood of audit failure and hence
involvement in audit-related litigation[67].
The link between auditee financial distress
and audit fees is strengthened by findings of
an association between financial distress and
auditor switching[68,69] since audit fees have
been found to be a factor influencing auditor
switching in several studies (e.g. [69,70]).
Despite the link between business risk
and auditee distress it is observed that, to
date, only univariate measures of financial
[ 29 ]

S. Butterworth
11/3 [1996] 2540
distress have been employed in audit pricing

studies. However, multivariate measures,
such as the discriminant model utilized in
Altman[71] and Zmijewski[72], are generally
acknowledged as superior predictors of financial distress[73]. In addition, there have been
calls within related auditing literature to
develop a measure that captures characteristics of both failing and non-failing firms[68].
Why the confusion?
The reason for the confusion relating to the

risk construct and the use of varying risk
measures may be that audit fee models have,
some might argue, generally been developed
in the absence of a rigorous theoretical
framework[11]. Therefore, it may be possible
to develop more appropriate measures of
risk in the audit fee model context by more
closely defining this construct and partitioning it between the two components noted
above.
The audit literature relating to risk is not
of great help in resolving the issues. It tends
to concentrate either on criticism of the
adopted algebraic formulation of the concept,
or an investigation of how auditors implement the model in practice. Little effort has
been devoted to determining the relationship
between audit risk and audit exposure
arising from acceptance of a particular
engagement or portfolio of engagements.
Review and focus of the present study

To summarize, it is argued that research on
audit fee modelling has acknowledged the
relevance of risk but not its multi-dimensional nature. Leaving aside the theoretically
indeterminate qualification variable, since
as previously noted, it is difficult to categorize, many studies have incorporated both the
alleged audit and business aspects of
risk (e.g. [1,2,6,9,10,11,13]). However, one
might argue that, at least for some, the plural
nature of risk may have been captured more
by accident than by design.
The purpose of this study is to categorize
the most commonly used risk measures in
auditing as to business risk or audit risk
and then to propose and test a fee model
which includes variables appropriate to each
risk aspect. The research question is
prompted by three factors. First, confusion
within the literature. Second, the existence of
studies in which variable measurement
(again leaving aside the theoretically indeterminate qualification variable) is relevant to
either audit risk (e.g. [55]) or business
risk (e.g. [5,12]), but not both. Third, the
recent tendency towards parsimony in audit
fee models.
[ 30 ]
No published study (with perhaps the

exception of Simunic[1]) makes clear the role
that each form of risk might play in audit
fee modelling. Further, even in studies which
measure both concepts of risk, no fee study
has previously taken advantage of incorporating a multivariate measure (such as a ztype model score) for business risk. (Stice
[63] uses a z score in analysing financial
and market factors associated with auditor
litigation.)
This study both posits and empirically
verifies that, despite acknowledged overlap,
audit risk and business risk are separate
dimensions of risk which should both be
included as independent variables in audit
fee models[74]. It seeks to clarify which of the
commonly utilized measures of risk belong
in either, or both, category(ies). An audit fee
model is then developed which incorporates
both aspects of risk and the proposed superiority of this model is tested.
Data
The data used in this study come from the
1988 Annual Reports of 433 Western
Australian-headquartered companies maintained by the (then) Department of Corporate
Affairs in Perth, Western Australia (now the
Western Australian Division of the
Australian Securities Commission). These
data represent the (then) complete population
of publicly listed companies within the jurisdiction of that body. From this population the
data selection process yielded 229 companies
as shown in Table II.
Companies for which complete data were
unavailable were omitted. Financial Services
sector companies were also omitted. This
industry sector previously has been signalled
as characteristically different from other
industry sectors due to the nature of its asset
base[75]. Some previous audit fee studies
similarly omit this sector from the sample
examined (e.g. [1,3,56]). Palmrose[5] reported
that this sector gave rise to a fee model with
coefficients different from the remainder of
her sample.
Mining companies constituted the largest
industry sector within the sample (61 per
cent), with other companies distributed
across remaining industry groupings in proportions varying from 1-12 per cent. Table III
shows the distribution of companies in the
sample across industry groups while Table IV
gives descriptive details for the mining and
non-mining categories and the total group of
companies.
Mining companies, on average, demonstrate approximately half the average total

S. Butterworth
Table II
Data relating to publicly-listed companies in
jurisdiction of Department of Corporate Affairs,
Perth (1988)

11/3 [1996] 2540
Number of valid cases

Total companies on file
433
349
The company had filed its

1988 annual report and it
had been processed by the
regulators at the time of
data collection
Financial
characteristics
Inventory ($m)
Companies still active

(neither failed in 1988
nor dormant)
305
293
The companys auditors,

and audit fee charged could
be determined for both 1987
and 1988
268
Companies where industry

classification on file and not
a financial institution/financial
service company
229
Table III
Summary of sample coverage by industry
Total
sample
R&D high-tech
R&D others
Retail
Manufacturing
Consultancy
Leisure and
tourism
Construction
Mining
(extractive)
Transport
Health
8
7
28
26
8
(4)
(3)
(12)
(11)
(4)
5
1
(2)
(0)
140
2
4
(61)
(1)
(2)
Total
229
Note: Figures in parentheses = percentages
level of assets of the sample as a whole

with inventories much lower than for nonmining companies . The only significant
difference between mining and non-mining
companies relates to leverage, as would be
anticipated given the extant finance literature. Mining companies exhibit significantly
lower levels of gearing than non-mining
companies.
1
2
3
4
Total Mining Nonmean mean mining Diff.a
n = 229 n = 140 n = 89 2 vs 3
5.5
1.0
12.6
ns
Receivables ($m)
8.3
5.9
12.1
ns
Total assets ($m)
102.4
50.3
182.7
ns
Inventory+receivables/ 0.11
0.06
0.18
ns
Total assets (SD)
Information on the companys

subsidiaries/organizational
complexity was determinable
Stock exchange
industry
classification
Table IV
Descriptive statistics company attributes
(0.15) (0.10) (0.17)
Total liabilities
61.0
20.4
123.6
ns
Leverage (TL/TA)
37%
17%
68%
0.000
Operating revenue ($m) 70.3
33.7
126.5
ns
Operating profit ($m)
2.0
0.9
3.7
ns
Adult opinion
Total
(%)
Percentage
qualified (1988)
31.9
27.9
38.2 0.109
Percentage
qualified (1987)
28.4
21.4
39.3 0.005
Percentage
qualification (1988)
3.9
1.4
7.7
Major qualification
(1987)
7.4
1.4
16.5 0.000
NonMining mining Diff.b

(%)
(%) 2 vs 3
majorc
0.038
Notes:
a Two-tailed t-test
b 2 test
c Major here refers to adverse, except for and subject to
opinions. In the analysis, all qualifications were used
Methodology
The audit fee model takes the form of a multiple linear regression function as originally
developed by Simunic[1] and used extensively
in the literature (e.g. [4,7,8,56]):
FEEi = b0 + b1 AUDi + b2NASi + b3SIZEi
+ b4COMPi + b5RISKi +
where:
FEEi = Audit fee charged to auditee i
(log10)
AUDi = Size of auditee is auditor (Big 8
or non-Big 8)
NASi = Amount of non-audit services
provided to auditee i by its
auditor (log10)
SIZEi = Size of auditee i (log10)
COMPi = Complexity of auditee i (log)
RISKi = Risk to the auditor of auditee i.
(This is the variable of interest
and may be split into business
and audit risk, depending on
factor analysis results.)
[ 31 ]

S. Butterworth
11/3 [1996] 2540
= Error (assumed to have a

normal distribution and
constant variance).
Measurement of independent variables

Risk
Risk in its generic sense will be measured in

three ways. The first of the two, it is argued,
can be categorized as to either business or
audit risk respectively. The third is theoretically indeterminate as to category.
Z-type distress score (business risk). This
variable is operationalized utilizing a contemporary multivariate measure of financial
distress in the tradition of Altman[71], developed by Houghton and Smith[76] and more
fully described in Houghton[77]. (The exact
nature of this model and its parameters cannot be disclosed because of proprietary rights
held by the Western Australia Corporate
Affairs Commission (now the Australian
Securities Commission; see Houghton[77] for
a description of the model construction
process and the accounting information used
in the prediction of failure.) The
Houghton[77] distress score is calibrated so
that negative values represent distressed
companies and positive values represent
companies which are non-distressed. It is
anticipated that there should be an inverse
relationship between the distress score and
business risk. That is, the higher the distress score the healthier the company and the
lower should be the risk of financial distress
and hence business risk. (It is argued here
that using a measure to signal financial distress different from previous studies does not
detract from the purpose of this study. That is,
determine whether the plural nature of risk
has been adequately captured in those previous studies. Measures previously used have
been related to liquidity, profitability and
solvency, factors which are traditionally
encapsulated within distress score models.
Thus, it is argued, a distress score is a superior, but not different, measure of business
risk.)
Inventories + receivables/total assets (audit
risk). The balance sheet items inventories
and receivables as a fraction of total assets
are as taken from the sample companies
balance sheets as at 1988. This ratio is
expected to measure audit risk because of
its association with accounts which require
specific audit procedures[1] and the audit
effort involved in these risky balance sheet
accounts.
As found previously[3,8], Table V shows
this measure to be significantly correlated
with complexity. Factor analysis will help
determine whether it is aligned with risk
[ 32 ]
or complexity for the purposes of determining audit fees.

Audit opinion (indeterminate as to business or audit risk). It is not clear whether
the audit opinion coded 1 if qualified, 0 if
unqualified (qualification here refers to all
qualifications), relates to either or both of
audit and business risk. Even though
audit opinion type has previously been used
by some as a proxy for business risk (e.g.
[1,2]) it may be more correctly a measure of
audit risk (e.g. [56]). For instance, it can be
argued that, in a situation requiring audit
qualification, it is necessary to accumulate a
greater amount of evidence than would otherwise be the case to achieve the auditors
desired level of assurance or audit risk[78].
Similarly, the very factors which give rise to
the need for qualification may increase the
risk of adverse actions against the auditor[5].
Both a concurrent and lagged measure of
audit opinion was used since all but the most
recent, previous literature incorporating this
measure of risk has used a concurrent measure but Butterworth and Houghton[56]
found a lagged audit opinion to be superior in
predicting audit fees. This is likely to be
because the superior information possessed
by the auditor allows the signalling of, for
instance, significant uncertainties. Interestingly, Table V shows the lagged audit opinion
to be not as highly correlated with the distress score (r = 0.18) as is the concurrent
audit opinion (r = 0.29).
Other variables
The remaining variables were measured as
follows (with transformations as indicated) to
better meet the assumptions underlying
regression analysis:
Audit fee. The audit fee charged to auditees
is measured by the log10 of the dollar value
of audit fees paid by the firm to its auditor.
In Australia this dollar value must be disclosed by law. (See Schedule 5 to Australian
Corporations Regulations, cl. 27[79]). The
regulations also require that firms disclose
the dollar amount of other services (NAS)
purchased from the auditor. Since fees are
likely to vary at a decreasing rate with
increases in client size a log10 transformation is used.
Auditor size. As with other studies in this
field, auditor size is measured using a
dummy variable coded 1 if the auditor is a
member of the first tier of auditors (the Big
8, or, more recently the Big 6); otherwise
coded 0.
Provision of non-audit services. The log10 of
the dollar value of non-audit services purchased by the auditee from its auditor. As
with the audit fee, this amount must by law

S. Butterworth
Table V
Correlations between dependent and independent variables
Audit
fee
(log10)

11/3 [1996] 2540
Audit fee
(log10)
Size
(log10TA)
Complexity
(log10sub+1)
Big 8/non
Big 8
Non audit
fees (log10)
Distress
score
Opinion
(1987)
Opinion
(1988)
Inventory+
receivables/
total assets
Size
(log10)
Complexity Big 8/
(log10
non
sub + 1) Big 8
Non
audit fee Distress
(log10)
score
Opinion
(1987)
Inventory
Opinion receivables/
(1988) total assets
0.72**
0.69**
0.53**
0.35**
0.29**
0.26**
0.62**
0.55**
0.44**
0.31**
0.04
0.15*
0.13
0.01
0.01
0.02
0.16*
0.07
0.11
0.01
0.18**
0.07
0.23** 0.09
0.13
0.01
0.29**
0.37
0.05
0.31**
0.067
0.21**
0.01
0.44**
0.10
0.01
Notes:
* < 0.05
** < 0.01
be disclosed by the auditee. Simunic[1],
Simon[4] and Butterworth and
Houghton[56] have previously found this
variable to be significant. It captures the
possibility that the greater the amount of
non-audit services provided by the auditor,
the greater will be the potential spill-over
effects or the greater will be the potential
for audit fee/non-audit services fee tradeoffs, and the greater will be the effect on the
audit price.
Client size. Consistent with other researchers, (see for example [7]) the size of an
auditee is measured using the log10 of the
book value of the auditees total assets.
Client complexity. Most researchers in this
field have measured the complexity of an
auditee by using a continuous measure of
its organizational dispersion (the legal
form of the entity may be a relevant factor
here) such as the number of consolidated
subsidiaries in the auditees group of companies. The rationale behind this type of
measure is that the greater the dispersion
that is shown by a firms structure, the
more intricate and sophisticated become
the operational forms adopted by the
firm[58]. Consistent with this, the present
study uses the number of companies in the
auditees group (log 10 holding company
plus subsidiaries) as the measure for
complexity.
Results
The following section consists of two parts.
First, the results of an analysis to assess the
extent of the independence of the two risk
concepts are discussed. Second is an analysis
of multiple regression results arising from
inclusion in the model of both risk concepts. The following then discusses implications arising from this study and makes suggestions for future research.
Are business risk and audit risk

separate constructs?
Initially, factor analysis (principal components model with othogonal (varimax) rotation) was carried out on the determinants of
the audit fee model to identify the underlying
common dimensions and to determine
whether audit risk and business risk
represent separate constructs. Table VI
shows that each of the determinants attained
factor loadings greater than or equal to the
conventional criterion (a loading of 0.5). The
risk proxy variables were loaded within
independent (orthogonal) factors, confirming
that audit and business risk should each
be treated as separate variables in the audit
fee model.
As expected, thistress score represented
one factor and the ratio of inventory plus
[ 33 ]

S. Butterworth
Table VI
Factor analysis (varimax rotation) of variables: auditor and auditee characteristics, audit qualification, distress and inventory + receivables/total assets

11/3 [1996] 2540
Independent
variable
Size
(log10TA)
Non-audit
fees (log10)
Complexity
(log10sub+1)
Big 8/non Big 8
(dummy)
Audit opinion
(1987)
Audit opinion
(1988)
Distress score
Inventory+
receivables/
total assets
Panel A
concurrent
opinion
Panel B
lagged
opinion
Panel C
concurrent
opinion
Factors
Factors
Factors
0.81
0.80
0.79
0.78
0.78
0.79
0.65
0.68
0.66
0.66
0.66
0.65
0.56
0.78
0.81
0.50
0.71
0.81
0.65
0.87
0.92
0.82
0.82
Notes: Variables measures: Size = log10 book value of auditees total assets. Non-audit service fees (NAS) = log10 of
dollar value of NAS provided. Complexity = log10 of subsidaries + 1. Auditor size = dummy coded 1 if auditor is in the Big
8. Audit opinion 1987 (1988) = all audit qualifications received in 1987 (1988). Distress score = Z-type score.
Inventory + receivables/total assets = book value of auditees inventory and net receivables/book value of total assets
receivables over total assets represented a
second factor. The concurrent audit qualification, not able to be predicted as to risk
category, loaded with the distress score. Thus
it seems that the presence of an audit qualification represents a business risk to the
auditor rather than a protection against such
risk. Interestingly, a lagged audit qualification loaded almost equally to both the audit
risk and business risk categories. It would
seem logical that the lagged opinion, when
qualified, influences fees ex ante through both
anticipation of additional audit effort and as
a litigation litmus. These findings imply that
the theoretical equivocation as to the exact
nature of the risk which qualification
measures is, at least partly, justified.
All other variables (Big 8/non Big 8, NAS,
size and complexity) loaded on a further
factor. This is to be expected since they all, to
some extent, proxy for size and are significantly correlated (Table V). It is interesting to
note that the complexity measure loaded
separately from the risky balance sheet
measure, despite the correlation between
these two measures in this ( r = 0.31) and
previous studies (e.g. [8]).
The result confirms the confusion in the
literature. If risk is discussed in audit fee
studies, generally it has been labelled audit
[ 34 ]
risk [3,6,7,11,52]. Yet, almost all studies use

audit qualification[80], a business risk
measure according to this analysis, as one of
the variables. Thus it would seem that,
although most studies do capture the plurality of risk, this situation has occurred fortuitously rather than as a result of sound
methodological design.
The audit fee model

In light of the results from the factor analysis,
the audit fee model can be respecified as:
FEEi = b0 + b1 AUDi + b2NASi + b3SIZEi
+ b4COMPi + b5 AUDRISKi
+ b6DISTRESSi + b7AUDQUALi +
where all variables except RISK are as previously defined (in the section on other variables) and:
AUDRISKi = Audit risk to the auditor of
auditee i
DISTRESSi = Distress score of auditee i
AUDQUALi = Status of audit opinion
(clean vs qualified) a
dummy variable with the
value 1 if the report was
qualified, 0 otherwise.
Table VII reports regression results for the
model using the entire sample of 229 companies. Results are reported for regressions
6.728
1.994
4.326
5.638
6.044
Complexity
(subsidaries + 1)
(log10)
Big 8/non Big 8

(dummy)
Non-audit fees
(log10)
Audit opinion
(1988)
Audit opinion
(1987)
Distress score
Inventory +
receivables/
total assets
Constant
0.000
0.000
0.000
0.047
0.000
0.000
Significance
level
0.000
0.082
0.285
0.000
0.066
0.000
0.000
Significance
level
73.61 73.03
91.84 124.48
0.000 0.000
4.856
1.747
1.071
4.534
1.845
8.546
8.214
0.000
0.000
0.077
0.163
0.002
0.374
0.000
0.000
Significance
level
70.73 74.12
92.83 94.26
0.000 0.000
6.443
5.746
1.778
1.401
3.838
2.095
6.884
9.776
C1
Audit and
business risk
(concurrent)
6.044
5.638
4.326
1.994
6.728
9.397
0.000
0.000
0.000
0.047
0.000
0.000
Significance
level
A2
Audit risk
only (opinion
lagged)
5.341
1.660
2.870
4.539
2.038
8.674
8.629
0.000
0.098
0.004
0.000
0.043
0.000
0.000
Significance
level
B2
Business risk
only (opinion
lagged)
6.744
5.480
1.822
2.517
3.945
2.203
7.060
10.036
0.000
0.000
0.070
0.013
0.000
0.029
0.000
0.000
Significance
level
C2
Audit and
business risk
(lagged)
Notes: Variable measures: Audit fees = log10 of published audit fees. Size = log10 book value of auditees total assets. NAS = log10 of dollar value of NAS provided. Complexity = log10 of subsideries +
1. Auditor size = dummy coded 1 if auditor is in the Big 8. Audit opinion = dummy coded 1 if auditee receives an audit qualification in 1987(1988) distress score + z typescore. Audit risk = inventory
+ receivables/total assets.
73.03 70.60
124.48 88.83
0.000 0.000
9.397
Size
(log10 TA)
R2 (%) (Adj.)
F
Significance
Independent
variable
B1
Business risk
only (opinion
concurrent)

11/3 [1996] 2540
A1
Audit risk
only (opinion
concurrent)
Table VII
Regression of size, complexity, auditor size, non-audit fees and risk on audit fees

S. Butterworth
[ 35 ]

S. Butterworth

11/3 [1996] 2540
using each of a concurrent and lagged audit

opinion. This is because audit fee studies, in
the main, have used a concurrent opinion,
however, Butterworth and Houghton[53]
found a lagged opinion to be a more powerful
explanator of fees. Control variables are significant at p < 0.05 across both the concurrent
and lagged analyses with the exception of the
auditor size variable when business risk
and both risk measures are used and opinion
is on a concurrent basis [columns B1 ( p =
0.066) and C1 ( p = 0.374). Interestingly, the
concurrent opinion is not significant whether
used in conjunction with the other business
risk measure, distress (column B1, concurrent, p = 0.285), or audit risk (column C1,
concurrent, p = 0.163). However, once a lagged
opinion is incorporated in the model, the
qualification becomes highly significant, both
when used with distress (column B2, lagged,
p = 0.004) and when combined with audit
risk (column C2 lagged, p = 0.013). This superiority of a lagged opinion as a determinant
of audit fees confirms the findings of Butterworth and Houghton[56].
As anticipated, the sign of the distress
variable is negative. However, it is only
weakly significant in its relationship to audit
fees (column B1, concurrent, p = 0.082). When
the model includes both risk concepts and
uses a lagged opinion the significance
improves slightly (p = 0.070)[81]. As might be
expected, given results from the existing
literature, audit risk (inventory + receivables/total assets) is highly significant
(p = 0.000) both with the business risk
measures (columns C1 and C2, concurrent
and lagged) and without (columns B1 and B2,
concurrent and lagged).
Thus, as earlier theorized, there is support
for incorporating both the business and
audit risk aspects of the construct in audit
fee modelling studies; both demonstrate significance, although to differing degrees.
Importantly, the inclusion of both types of
risk also enhances the level of explained
variable, especially if a lagged audit opinion
measure is used. Business risk used alone
(columns B1 and B2, concurrent and lagged)
does not seem to provide as much explanatory power as audit risk (inventories and
receivables/total assets) used alone (columns
A1 and A2). However, the optimal adjusted R2
in this study is achieved when audit and
business risk measures are used in combination, using a lagged measure for opinion
(column C2, lagged: Adjusted R2 = 74.12 per
cent).
Conclusion and implications

This study examines component parts of the
construct risk and related measures associ-
[ 36 ]
ated with risk in the audit fee modelling

literature. It argues that, theoretically, business risk and audit risk are separate
(albeit related) concepts which should both be
included in audit fee models; empirical evidence confirms this view. Further, empirical
evidence clarifies which of the most
frequently used measures of risk relate to
each category. A model incorporating both
risk measures is then used in a regression
analysis of the audit fees associated with 229
Western Australian companies.
Factor analysis results show that financial
distress and audit qualification should be
labelled as business risk measures and
inventories plus receivables over total
assets should be labelled as an audit risk
measure.
Thus it would seem that most previous
audit fee studies (see Table I) adequately
capture the plural nature of risk. However,
the recent trend towards more parsimonious
models (e.g. [10,55,56]) is a concern. Researchers need to take care not to eliminate
variables to the extent that one or other of the
risk dimensions is also eliminated from
audit fee models, so rendering their model
underspecified.
Contrary to expectations, the distress variable proved to be only weakly significant as a
determinant of audit fees. A possible explanation lies in the possibility that auditors may
charge lower fees to distressed clients.
Wallace argues that low fee realization rates
exist among troubled clients and that a
client with liquidity problems will often
increase fee pressures, resulting in lower fees
in the presence of what is likely to be a higher
audit risk [18, p. 4]. Interviews with audit
firm partners conducted by Chan et al.[13] in
their study of audit fee determinants confirm
this latter possibility. Those authors further
argue that to the extent that distressed
clients exhibit low profitability (or indeed
losses) this would imply a negative relationship between audit fees and profitability [13,
p. 782].
While it is important to note the validity of
both types of risk, examination of the
results of studies that incorporate variables
covering both types of risk (see Table I)
suggest some degree of instability in the level
of importance of risk in the explanation of
audit fees. Thornton and Moore in their analytical, descriptive model of determinants of
audit fees similarly observe this phenomenon
[82, p. 342] as do Chan et al.[13, p. 765]. Why, in
studies which incorporate measures to
accommodate both risk concepts, are the
business risk measure(s) clearly significant
sometimes and the audit risk measure not
[11,13] and vice versa[4,9]? One might hypoth-

S. Butterworth

11/3 [1996] 2540
esize that, in part, this differing level of

importance of the two types of risk reflects
different industry groupings within sample
companies used in the studies.
Several studies have found an association
between audit fees and industry type (e.g. [1,5,
11]). This might arise because of the differing
nature of regulation in different industries
[5], or because of different risk levels associated with particular industries[1]. This
association has prompted some researchers
[5,11,52,55,56] to include a variable controlling
for industry. To date, mixed results as to significance have been reported. For example
Simunic[1] found that his sample was sensitive to industry effects. Francis[2] omitted
banks from his sample because he found
associated fees for them to be significantly
different; however, other tests for differential
industry effects in that study did not prove
significant. Palmrose[83] and Wallace[18]
provide evidence that audit fees may be
affected by industry.
More recently, Low et al.[11] in their examination of the Singaporean audit services
market found an overall model of audit fees to
be a poor fit and argued that the heterogeneity of industries was the cause. The authors
found that a refinement of the overall allindustry model into six distinct industrial
models resulted in superior models as predictors of audit fees.
Thus, despite acknowledgment in the literature that industry plays a role in audit fee
determinants, the limited evidence available
regarding the significance of industry is
mixed and inconclusive. In view of Simunics
comment that ... loss exposure may well vary
with the industry(ies) in which an auditee
operates [1, p. 173] and, in view of the mixed
findings regarding the significance of audit
and business risk in studies which utilize
measures of both, it seems plausible that
there may be an association between industry
and risk. Examination of this issue, and
especially of the value of using a multivariate
model developed distress score as a measure
of risk, awaits further research using data
more representative of various industry
groupings.
This study suffers from several limitations.
First, it did not include all the measures of
risk that have been used in previous literature (see Table I) and so other measures may
more successfully capture the plural nature
of risk than measures used here. Second, the
time period (1987-1988) may mean that data
have been unduly influenced by the October
1987 stock market crash. Third, the dominance of mining companies in the Western
Australian company population may cause
difficulty in generalizing from these results.
It remains for future research to replicate

this study using samples of companies from
other locations and other (and possibly
longer) time periods so as to determine
whether the results reported here are sample
specific, or are generalizable to other locations and time periods.
Notes and references

1 Simunic, D.A., The pricing of audit services:
theory and evidence, Journal of Accounting
Research, Vol. 6, 1980, pp. 329-43.
2 Francis, J.R., The effect of audit firm size on
audit prices: a study of the Australian market,
Journal of Accounting and Economics, Vol. 6,
1984, pp. 133-51.
3 Firth, M., An analysis of audit fees and their
determinants in New Zealand, Auditing: A
Journal of Practice and Theory, Vol. 4, Spring
1985, pp. 23-37.
4 Simon, D.T., The audit services market: additional empirical evidence, Auditing: A Journal of Practice and Theory, Vol. 5, Autumn 1985,
pp. 71-8.
5 Palmrose, Z.V., Audit fees and auditor size:
further evidence, Journal of Accounting
Research, Vol. 24, Spring 1986, pp. 97-110.
6 Francis, J.R. and Stokes, D.J., Audit prices,
product differentiation and scale economies:
further evidence from the Australian market,
Journal of Accounting Research, Vol. 24,
Autumn 1986, pp. 383-93.
7 Francis, J.R. and Simon, D.T., A test of audit
pricing in the small-client segment of the US
audit market, The Accounting Review, Vol. 62,
January 1987, pp. 145-57.
8 Simon, D.T. and Francis, J.R., The effects of
auditor change on audit fees: tests of price
cutting and price recovery, The Accounting
Review, April 1988, pp. 255-69.
9 Chung, D.Y. and Lindsay, W.D., The pricing of
audit services: the Canadian perspective,
Contemporary Accounting Research, Vol. 5,
1988, pp. 19-46.
10 Turpen, R.A., Differential pricing on auditors initial engagements: further evidence,
Auditing: A Journal of Practice & Theory,
Spring 1990, pp. 60-76.
11 Low, L., Tan, P.H. and Koh, H., The determination of audit fees: an analysis in the Singapore
context, Journal of Business Finance and
Accounting, Vol. 17, Spring 1990, pp. 285-95.
12 Gist, W., Explaining variability in external
audit fees, Accounting and Business Research,
Vol. 23 No. 89, 1992, pp. 79-84.
13 Chan, P., Ezzamel, M. and Gwilliam, D., Determinants of audit fees for quoted UK companies, Journal of Business Finance and
Accounting, November 1993, pp. 765-86.
14 Anderson, T. and Zeghal, D., The pricing of
audit services: further evidence from the
Canadian market, Accounting and Business
Research, Vol. 24 No. 95, pp. 195-207.
[ 37 ]

S. Butterworth

11/3 [1996] 2540
[ 38 ]
15 Pearson, T. and Trompeter, G., Competition in

the market for audit services: the effect of
supplier concentration on audit fees, Contemporary Accounting Research, Summer 1994,
pp. 115-35.
16 Mock, T.J. and Vertinsky, I., Risk Assessment in
Accounting and Auditing, Research Monograph, The Canadian Certified General
Accountants Research Foundation, Vancouver, 1985.
17 Kaplan, S., An examination of the effects of
environment and explicit internal control on
planned audit hours, Auditing: A Journal of
Practice and Theory, Autumn 1985, pp. 12-25.
18 Wallace, W., Are audit fees sufficiently risk
adjusted?, Advances in Accounting, Supplement 1, 1989, pp. 3-38.
19 Brumfield, C.A., Elliott, R.K. and Jacobson,
P.D., Business risk and the audit process,
Journal of Accountancy, April 1983, pp. 60-8.
20 Holstrum, G.L. and Kirtland, J.L., Audit risk
model: a framework for current practice and
future research, in Schultz, J.Jr and Brown,
C.E. (Eds), Symposium on Auditing Research V,
University of Illinois, Urbana-Champaign, IL,
1983.
21 Warren, C.S., Audit risk, Journal of Accountancy, August 1979, pp. 66-74.
22 Audit risk is specified generally in the form:
AR = IR CR DR, where AR = audit risk,
the risk that auditors may express inappropriate opinions on financial information that
is materially misstated[23, p. 10], IR = inherent risk, the susceptibility of an account
balance or class of transactions to misstatement that could be material, individually or
when aggregated with misstatements in other
balances or classes, assuming that there were
no related internal controls. It is a function of
an entitys business and its environment and
the nature of the account balance or class of
transactions.[23, p. 27; 24], CR = control risk,
the risk that misstatement will not be
prevented or detected on a timely basis by the
system of internal control.[23, p. 15] and DR =
detection risk, the risk that auditors procedures will not detect a misstatement that
exists in an account balance or class of transactions [23, p. 16].
AUP 24, [25, p. 5] notes that the multiplicative
model expresses the general relationship of
audit risk to the individual risk components.
The model is not intended to be a mathematical formula including all factors that may
influence the determination of individual risk
components.
23 Auditing Practice Statement (AUP) 27, Materiality and Audit Risk, Australian Accounting
Research Foundation, Melbourne, February
1986.
24 American Institute of Certified Public Accountants (AICPA), Statement on Auditing Standards No. 47: Audit Risk and Materiality in
Conducting an Audit, (SAS No. 47), AICPA,
New York, NY, 1983.
25 Auditing Practice Statement (AUP) 24, Audit

Sampling, Australian Accounting Research
Foundation, June 1985.
26 Auditing Practice Statement (AUP) 30, Inherent and Control Risk Assessments and Their
Impact on Substantive Procedures, Australian
Accounting Research Foundation, July 1990.
27 American Institute of Certified Public Accountants (AICPA), Statement on Auditing Standards No. 39: Audit Sampling, (SAS No. 39),
AICPA, New York, NY, 1983.
28 American Institute of Certified Public Accountants (AICPA), Statement on Auditing Standards No. 55: Considerations of the Internal
Control Structure in a Financial Statement
Audit, (SAS No. 55), AICPA, New York, NY,
1988.
29 Canadian Institute of Chartered Accountants
(CICA), Extent of Audit Testing (EAT) Study,
CICA, Toronto, 1980.
30 Auditing Practices Committee, Audit Sampling, ICAEW, London, 1987.
31 Dirsmith, M.W. and Haskins, M.E., Inherent
risk assessment and audit firm technology: a
contrast in world theories, Accounting,
Organisations and Society, Vol. 16 No. 1, 1991,
pp. 61-90.
32 In particular, attention has been drawn to the
assumed independence of the components,
when it has been argued interdependencies
exist, for instance between the assessment of
inherent risk and control risk[33]; the need to
apply the model at both a financial statement
level and transaction or account level when
clearly the model is not developed to this level
of detail[33]; the tendency of the model to
understate audit risk[34-36]; the apparent
inconsistencies induced by application of the
model in practice[37,38]; the presumption of
equal weighting attributable to each risk component across all audit situations[39]; the
models neglect of the potential interactions
between auditor and auditee[40, 41] and underspecification of the model[35, 42].
33 Cushing, B.E. and Loebbecke, J.K., Analytical
approaches to audit risk: a survey and analysis, Auditing: A Journal of Practice & Theory,
Vol. 3, Autumn 1983, pp. 23-41.
34 Kinney, W.R. Jr, A note on compounding probabilities in auditing, Auditing: A Journal of
Practice & Theory, Vol. 2 No. 2, Spring 1983,
pp. 13-22.
35 Kinney, W.R. Jr, Achieved audit risk and the
audit outcome space, Auditing: A Journal of
Practice & Theory, Vol. 8, Supplement, 1989,
pp. 67-97.
36 Huss, H.F. and Jacobs, F.A., Risk containment: exploring auditor decisions in the
engagement process, Auditing: A Journal of
Practice and Theory, Vol. 10 No. 2, Autumn
1991, pp. 16-32.
37 Jiambalvo, J. and Waller, W., Decomposition
and assessments of audit risk, Auditing: A
Journal of Practice & Theory, Vol. 3 No. 2,
Spring 1984, pp. 80-8.

S. Butterworth

11/3 [1996] 2540
38 Daniel, S.J., Some empirical evidence about

the assessment of audit risk in practice,
Auditing: A Journal of Practice & Theory, Vol. 7
No. 2, Spring 1988, pp. 174-81.
39 Strawser, J.R., Examination of the effect of
risk model components on perceived audit
risk, Auditing: A Journal of Practice &
Theory, Vol. 10 No. 1, Spring 1991, pp. 126-35.
40 Fellingham, J.C. and Newman, D.P., Strategic
considerations in auditing, The Accounting
Review, October 1985, pp. 634-50.
41 Shibano, T., Assessing audit risk from errors
and irregularities, Journal of Accounting
Research, Vol. 28, Supplement, 1990, pp. 110-40.
42 Leslie, D.A., An analysis of the audit framework focusing on inherent risk and the role of
statistical sampling in compliance testing,
Auditing Symposium VII, Lawrence: Touche
Ross/University of Kansas, 1984, pp. 89-125.
43 Aldersley, S.J., Discussion of achieved audit
risk and the audit outcome space, Auditing: A
Journal of Practice & Theory, Supplement,
1989, pp. 85-97.
44 Sennetti, J.T., Toward a more consistent
model for audit risk, Auditing: A Journal of
Practice & Theory, Spring 1990, pp. 103-12.
45 Woodhead, A.D., Audit risk modelling, Managerial Auditing Journal, Vol. 7 No. 5, 1992,
pp. 3-7.
46 Skerratt, L.C.L., Modelling audit risk,
British Accounting Review, Vol. 24, 1992,
pp. 119-37.
47 Colbert, J.L., Understanding the relationship
between business risk and inherent risk,
Managerial Auditing Journal, Vol. 6 No. 3,
1991, pp. 4-7.
48 Colbert[47, pp. 4-5] lists the following as factors
affecting business and inherent risk which are
identical to: economy in which the client operates; client industry; clients financial position; number and complexity of applicable
regulations; number and complexity of reporting requirements; rate of turnover of management and board of directors; and history of
audit adjustments. In addition, a number of
other factors listed are not identical for both
types of risk but are related: for instance,
managerial experience which Colbert identifies as a business risk factor is related to quality of management which is identified as an
inherent risk factor.
49 Simunic, D.A. and Stein, M.T., Audit risk in a
client portfolio context, Contemporary
Accounting Research, Vol. 6 No. 2-I, Spring 1990,
pp. 329-43.
50 Colbert[47, p. 7] identifies the following differences between business and inherent risk:
business risk is assessed at the overall financial statement level while inherent risk is
applied to the individual account balance or
class of transactions; inherent risk is independent of audit risk, whereas business risk
affects the auditors judgement of audit risk at
the financial-statement level which, in turn,
affects planned audit risk for individual audit
51
52
53
54
55
56
57
58
59
60
61
62
areas; business risk is not included in the

audit risk model; business risk is affected by a
much broader base of interested parties (e.g.
users and their perceptions) than inherent
risk which is affected mainly by management;
and differences in the recognition given to
each in the professional literature.
Francis and Stokes[6] use audit opinion, inventory + receivables/total assets, return on
investment, quick asset ratio, debt ratio and
loss in last three years to measure risk. The
present writers argue that the first two of these
relate to audit risk and the remainder to
business risk.
Ettredge, M. and Greenberg, R., Determinants of fee cutting on initial audit engagements, Journal of Accounting Research,
Vol. 28, Spring 1990, pp. 198-210.
Low et al.[11] utilize loss in last three years,
contingent liabilities, long-term liabilities/
total funds in addition to receivables and
inventory/total assets and audit opinion.
Gist[12], however, does appear to differentiate
between financial distress and the uncertainty
signalled by a subject to opinion in a discussion of the measures used. Net income(loss)/
total assets, total long-term debt to total assets
and subject to audit opinion are used to
operationalize the construct.
Maher, M.W., Tiessen, P., Colson, R. and
Broman, A.J., Competition and audit fees,
The Accounting Review, January 1992,
pp. 199-211.
Butterworth, S. and Houghton, K., Auditor
switching and the pricing of audit services,
Journal of Business Finance and Accounting,
April 1995, pp. 323-44.
Dopuch, N., Holthausen, R.W. and Leftwich,
R.W., Predicting audit qualifications with
financial and market variables, The Accounting Review, July 1987, pp. 431-54.
Taylor, M.E. and Baker, R.L., An analysis of
the external audit fee, Accounting and Business Research, Winter 1981, pp. 55-60.
Similar difficulties arise out of Palmroses[5]
use of a publicly owned/non publicly owned
dummy variable to control for risk in her
audit fee study. The difficulty with this variable is that it is a possible proxy for size, as
only larger auditees are likely to be publicly
owned. Further, size is often correlated with
leverage[60] and leverage is related to financial
distress. However, in the context of this study
this is not an empirically testable question
since the full sample relates to publicly owned
companies.
Ball, R. and Foster, G., Corporate financial
reporting: a methodological review of empirical research, Journal of Accounting Research,
Vol. 20 (supplement), 1982, pp. 161-234.
St Pierre, K. and Anderson, J.A., An analysis
of the factors associated with law suits against
public accountants, The Accounting Review,
Vol. 59, April 1984, pp. 242-63.
Kaplan, R.L., Accountants liability and audit
failures: when the umpire strikes out, Jour-
[ 39 ]

S. Butterworth
63

11/3 [1996] 2540
64
65
66
67
68
69
70
71
72
73
74
[ 40 ]
nal of Accounting and Public Policy, Vol. 6

No. 1, Spring 1987, pp. 1-8.
Stice, J.D., Using financial and market information to identify pre-engagement factors
associated with lawsuits against auditors,
The Accounting Review, July 1991, pp. 516-33.
Kreutzfeldt, R. and Wallace, W., Error characteristics in audit populations: their profile and
relationships to environmental factors, Auditing: A Journal of Practice & Theory, Autumn
1986, pp. 20-43.
Kinney, W. and McDaniel, L., Characteristics
of firms correcting previously reported quarterly earnings, Journal of Accounting & Economics, Vol. 11 No. 1, February 1989, pp. 71-93.
Pourciau, S., Earnings management and
nonroutine executive changes, Journal of
Accounting and Economics, Vol. 16, 1993,
pp. 317-36.
Pratt, J. and Stice, J.D., The effects of client
characteristics on auditor litigation risk
judgements, required audit evidence, and
recommended audit fees, The Accounting
Review, October 1994, pp. 639-56.
Schwartz, K.B. and Menon, K., Auditor
switches by failing firms, The Accounting
Review, April 1985, pp. 248-61.
Haskins, M.E. and Williams, D.D., A contingent model of intra big eight auditor changes,
Auditing: A Journal of Practice and Theory,
Fall 1990, pp. 55-74.
Eichenseher, J.W. and Shields, D., The correlates of CPA-firm change for publicly-held
corporations, Auditing: A Journal of Practice
and Theory, Spring 1983, pp. 23-37.
Altman, E., Financial ratios, discriminant
analysis and the prediction of corporate bankruptcy, Journal of Finance, Vol. X, September
1968, pp. 589-609.
Zmijewski, M.E., Methodological issues
related to the estimation of financial distress
prediction models, Journal of Accounting
Research, Supplement, 1984, pp. 59-82.
Watts, R.L. and Zimmerman, J.L., Positive
Accounting Theory, Prentice-Hall, Englewood
Cliffs, NJ, 1986.
Indeed, as noted in Table VII, the correlation
between business risk and audit risk is
75
76
77
78
79
80
81
82
83
less that 0.18 (or just over 3 per cent of shared

variance given the proxies used).
Castagna, A.D. and Matolscy, Z.P., The prediction of corporate failure: testing the Australian
evidence, Australian Journal of Management,
June 1981, pp. 23-50.
Houghton, K.A. and Smith, M., In defence of
going-concern prediction models, Australian
Accountant, December 1992, pp. 23-9.
Houghton, K.A., Business failure: symptoms
and solutions, 1990 Annual Research Lecture,
Australian Society of Certified Practising
Accountants, Melbourne, 7 November 1990.
Arens, A.A., Loebbecke, J.K., Best, P.J. and
Shailer, G.E.P., Auditing in Australia: An Integrated Approach, 2nd ed., Prentice-Hall,
Sydney, 1990.
Attorney Generals Department, Australian
Corporations Legislation, (1989), Volumes 1
and 2, Butterworths, New South Wales, 1993.
The only studies which have not used qualification as a variable are Firth[3] (NZ), Chung
and Lindsay[9] (Canadian); Maher et al.[55]
(USA) and Chan et al.[13] (UK). Of these, the
first two exclude qualification as a measure for
institutional reasons related to the frequency
of qualification. Maher et al. and Chan et al. do
not discuss the reason for its omission.
Using business risk as a dummy variable (1
if distressed, 0 if healthy), rather than as a
continuous score variable, similarly demonstrates a weakly significant relationship in the
same direction, suggesting that the results are
robust.
Thornton, D.B. and Moore, G., Auditor choice
and audit fee determinants, Journal of Business Finance and Accounting, Vol. 20 No. 3,
April 1993, pp. 333-49.
Palmrose, Z.V., The pricing of audit services:
industry differences and other insights,
Proceedings of the 1983 De Paul University
Research Symposium, Chicago, IL, 1983, pp. 4784.
Further reading
Grobstein, M. and Craig, P.W., A risk analysis
approach to auditing, Auditing: A Journal of
Practice and Theory, Spring 1984, pp. 1-16.

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Managerial Auditing Journal

Audit fee determinants: the plural nature of risk

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Audit fee determinants: the plural nature of risk

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C.A. Jubb, K.A. Houghton and S. Butterworth The University of Melbourne,

The authors gratefully

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be tested empirically. The subsequent

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Canada, and [30] in the UK) there is little

It is argued that these costs will give rise to

Approaches to capturing risk

Conceptual treatment of risk in the

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C.A. Jubb, K.A. Houghton and

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risk, the variables used to operationalize

only of audit risk[51]. Francis and Simon

Operationalization of risk in the

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Managerial Auditing Journal

C.A. Jubb, K.A. Houghton and

distress have been employed in audit pricing

Why the confusion?

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The reason for the confusion relating to the

Review and focus of the present study

No published study (with perhaps the

C.A. Jubb, K.A. Houghton and

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Number of valid cases

The company had filed its

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Companies still active

The companys auditors,

Companies where industry

Note: Figures in parentheses = percentages

level of assets of the sample as a whole

Total assets ($m)

Total assets (SD)

Information on the companys

(0.15) (0.10) (0.17)

Operating revenue ($m) 70.3

Operating profit ($m)

NonMining mining Diff.b

C.A. Jubb, K.A. Houghton and

= Error (assumed to have a

Measurement of independent variables

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Risk in its generic sense will be measured in

or complexity for the purposes of determining audit fees.

C.A. Jubb, K.A. Houghton and

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