Project Number – 2020B05

2020B05 – An analysis of the effect of mandatory fees disclosure on subsequent period fees and audit quality

What?

The aim of our study is twofold. The first purpose is to investigate which effect mandatory fee disclosure has on subsequent period audit pricing. To this end, we will replicate the study by Francis and Wang (2005) which report that the disclosure of fees results in greater audit pricing precision and reduces the variance in audit fees across clients. According to the authors a reduction in information asymmetry concerning fees between auditors and clients allows overcharged clients to demand lower fees and auditors of undercharged clients to demand higher fees. Interestingly, clients seem to gain relatively more bargaining power than auditors on average.Relatedly, the second objective of this project is to go beyond the effect of mandatory fee disclosure on audit pricing, and also focus on the effect on audit quality. To this end, we will, in a second step, partially replicate the study by Chen et al. (2019) to examine whether fee adjustments in periods subsequent to the regulatory implementation of mandatory fee disclosure affect audit quality. We infer audit quality by three widely used proxies: (i) discretionary accruals, (ii) the propensity to issue going-concern opinions, and (iii) the incidence of small profits. Using multiple measures ‘provides a more comprehensive understanding of the effect on audit quality’ (DeFond and Zhang 2014, 291).

Why?

Over the past few decades, regulators across the globe have required companies to disclose in the financial statements both audit and non-audit fees billed by the auditor. Regulators were particularly concerned that economic bonding due to the level of fees received from an audited company or the provision of non-audit services may impair auditor’s independence. The overall purpose of this proposed project is to obtain a better understanding of the complex consequences of mandatory fee disclosure. Regulators believe that public disclosure of audit and non-audit fees is essential in preserving auditor independence and ensuring audit quality (European Commission 2006; SEC 2000). Accordingly, during the last few decades mandatory fee disclosure was implemented in many countries, such as the United States, Australia and the EU countries. We seek to identify the actual consequences in terms of audit pricing and audit quality in the context of mandated fee disclosure. By doing so, we assess whether the regulator’s goals of ensuring high-quality audits is achieved.

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The effect of mandatory fee disclosure on subsequent audit pricing and audit quality

This literature review synthesizes the current body of academic research on mandatory fee disclosure, with a focus on its effect on audit pricing and audit quality. While extant studies demonstrate that public fee disclosure has an impact on subsequent audit pricing, evidence on its impact on audit quality is inconclusive. Most research cited relies on archival data from listed firms in Asia and the US which leaves gaps in our understanding of the impact of mandatory fee disclosure in audit markets dominated by privately held firms. Private companies, however, constitute world-wide the majority of companies. Specifically, in continental European countries, such as the Dutch audit market, private companies make up over 99 percent of audited companies. Because private firms differ from listed firms on a number of important dimensions (e.g., exposure to market forces, nature of agency conflicts, information environment, it is ex ante unclear whether results from listed firms are generalizable to private firms. As part of the FAR Replication Program, our project aims to address this research gap: by replicating existing studies that investigate the impact of mandatory fee disclosure in the context of listed companies, our FAR replication project explores the actual consequences of the mandatory disclosure of fees on audit pricing and audit quality in the Dutch audit market, which is predominantly composed of private firms. To do so, we formulate several research questions that will be studied throughout our FAR replication project. Further, we elaborate on the methodology that we will employ and our anticipated contribution. Our review offers valuable insights for academics, regulators, and practitioners interested in the consequences of mandatory fee disclosure on audit pricing and quality. Specifically, our study contributes to the academic literature examining the real effects of disclosures. Regulators should be interested in our findings in case there are consequences, whether intended or unintended, to audit pricing and audit quality. With respect to practical implications, our study provides an analysis on the potential increased bargaining power after the regulatory implementation of mandatory fee disclosure.

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The effect of mandatory fee disclosure on subsequent audit pricing and audit quality

In line with the EU Statutory Audit Directive (2006/43/EC), the Dutch legislation has required large companies to disclose audit and non-audit fees in their financial statements since 2008. The objective of this mandatory fee disclosure was to safeguard the independence of auditors and to ensure the quality of their audits. By making information about the level of fees and scope of work performed publicly available, stakeholders have a better understanding of the company-auditor relationship and, hence, are better able to assess whether auditor’s independence is impaired. However, practitioners and professional bodies have raised concerns that fee disclosure may also result in downward pressure on fees, as clients gain more bargaining power. This could potentially lead to a decrease in the quality of audit services as the auditor might no longer be able to perform sufficient and/or adequate audit procedures. Despite these concerns, there is only limited research available on the effects of mandatory fee disclosure. The limited research, moreover, mainly focuses on listed firms in Asia and the US. The effect of fee disclosure in European markets which are dominated by private firms, like the Netherlands, remains however largely unknown. As part of the FAR Replication Program, our project aims to address this research gap: by replicating existing studies that investigate the impact of mandatory fee disclosure in the context of listed companies, our FAR replication project explores the actual consequences of the mandatory disclosure of fees on audit pricing and audit quality in the Dutch audit market, which is predominantly composed of private firms. Our goal is to uncover the benefits as well as the potential drawbacks of mandatory fee disclosure.

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