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Review of Quantitative Finance and Accounting

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28.08.2020 | Original Research

Do failed auditors receive lower audit fees from continuing engagements?

verfasst von: Kam-Wah Lai, Ferdinand A. Gul

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 3/2021

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Abstract

This study investigates whether a failed auditor suffers from reduced audit fees from clients who continue to employ him and whether the reduced audit fees are more pronounced when the failed auditor is not a market leader. The subject audit firm Deloitte Touche Tohmatsu (Deloitte), Hong Kong, issued a clean audit opinion to a client on its 1997 financial statements which were subsequently found to have accounting errors because of fraud and other irregularities by KPMG. Consequently, Deloitte resigned from the engagement and withdrew its audit report for the client. Results show that Deloitte had more negative change in audit fees than other auditors after the event, and the reduced audit fees were more pronounced when Deloitte was not the market leader. Additional tests suggest that Deloitte did not reduce its audit quality after the event.

Vorheriger Artikel At what life-cycle stage does the auditors’ going concern report add value?

Nächster Artikel The effect of distracted audit committee members on earnings quality

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The first form of economic loss may not always take place as clients may not find changing auditors possible or economically feasible. However, see also note 18 and Table 10 in the Appendix for evidence that the subject audit firm Deloitte Touche Tohmatsu did appear to have suffered from the loss of clients and audit fees from auditor switch over the event period.

ChuoAoyama was split into two firms following its suspension by regulator: (a) a reconstituted ChuoAoyama named as Misuzu Audit Corporation and (b) a new firm named as PwC Aarata. Misuzu was shortly closed down following another accounting scandal. PwC Aarata survived. However, it is the suspension of ChuoAoyama that forced clients to change auditor.

Deloitte & Touche is known as Deloitte Touche Tohmatsu in Hong Kong.

In supplementary tests (results are available from the authors), it is found that Deloitte’s clients suffered from negative security returns when Deloitte resigned from the engagement and withdrew its audit report. In addition, the lower returns on those dates were associated with some characteristics of the clients that were related to investors’ concern for audit quality (e.g., client size, existence of a reported loss and leverage).

Even in the case of Andersen, only those more visible clients dismissed Andersen early (Barton 2005) while some others would like to hold on until later (see Gately 2002).

In Hong Kong, the ethical codes of the Hong Kong Institute of Certified Public Accountants have such a prohibition.

In cases like Andersen or ChuoAoyama where the failed auditor is suspended or even banned from public practice shortly afterwards, clients’ inertia does not prevent them from searching for a new auditor because they must get a new incumbent anyway. In places such as Hong Kong where regulatory forces are weak, clients may prefer retaining the failed auditor to avoid switching costs, and penalizing it through reduced audit fees.

A notable case involves Anthony Wu, the then chairman of Ernst and Young in China business, who was a member of the executive committee of an audit client of Ernst and Young. The HKICPA took 2 years to decide whether the case required disciplinary investigation, and another two and a half years to finish the investigation (see Winn 2014).

All amounts are in Hong Kong dollars unless stated otherwise.

The fraud perpetuated in Guangnan and its subsidiaries involved the use of faked transactions to obtain letters of credit from banks (see Bradford 2002). Trading companies were set up to supply goods to subsidiaries of Guangnan. Such goods, however, did not exist and the transactions were supported by forged documents. Credit obtained from banks was used to boost profit margin and pay for the fictitious purchases. The total amount involved was $1.8 billion, representing 36% of Guangnan’s market capitalisation as at December 31, 1997. Fifteen people including senior managers of Guangnan were convicted for serving 2 to 10 years’ imprisonment. However, some of the suspects, including Guan Sun, the chairman of Guangnan, had fled Hong Kong and were wanted.

On May 27, 1999, KPMG, as the succeeding auditor, issued its audit report for the year ended December 31, 1998, for Guangnan. It made reference to exceptional losses in the accounts of Guangnan amounting to $3521 million, $1067 million of which occurred in 1998 and $2543 million occurred before 1998. Due to the lack of information, Guangnan was unable to further quantify reliably how much of the $2543 million losses related to 1997 and how much was prior to 1997. However, the opinion of KPMG was that losses prior to 1997 should exceed $1079.3 million, which was the finding of the special audit previously done by KPMG as the financial restructuring adviser. Consequently, Guangnan could not restate the year 1997 financial statements and KPMG disclaimed its opinion on the results of Guangnan for 1998.

From the KPMG’s announcement to the decision of the Court of Appeal, more than 100 news reports were made by the two English business newspapers, major Chinese newspapers and other journals. In addition, during the same period, there was no other reported adverse news concerning Deloitte that might confound the effect of the tarnished reputation of Deloitte on its clients’ audit fees.

A possibly omitted variable in model (2) is non-audit fees which are not required to be disclosed by companies in Hong Kong. However, Whisenant et al. (2003) show that audit fees and non-audit fees are unrelated after controlling for factors that could jointly determine audit and non-audit fees. More importantly, their results also show that the inferences of other determinants of audit fees are not substantially affected.

While a leader may earn higher audit fees than a non-leader in a year (Ferguson et al. 2003), it may not increase its audit fees over time more than a non-leader. Thus, the sign of the coefficient of NLEADER is not predictable.

As in prior research (e.g., Whisenant et al. 2003), the finance industry is excluded because of the lack of comparability of many of the ratios in the audit fee model for financial firms with other firms. In addition, Simunic (1980) reports that his audit fee model is sensitive to the inclusion of utility firms.

Annual reports of all listed companies are made commercially available by the HKSE.

The HKSE makes a note to the effect. The companies involved may be in liquidation, suspended for trading or recently listed in the year.

Table 10 in the “Appendix” shows the composition of clients that changed auditors in 1999. All these clients were audited by Big 5 auditors in 1998. Deloitte lost the largest number of clients (i.e., 11) in 1999 with total audit fees of $17.887 million in 1998. It was followed by the three firms Coopers & Lybrand, Price Waterhouse and PwC (the former two merged in July 1998 to become the latter). Hence, Deloitte suffered the most from the event. The net gain or loss in clients from these auditor changes shows that Coopers & Lybrand, Price Waterhouse and PwC had the largest loss in number and was followed by Deloitte. However, the loss of clients by the three firms may be due to auditor–client realignment following their merger. Therefore, it appears that Deloitte did suffer from a net loss of clients because of the event.

As Coopers & Lybrand merged with Price Waterhouse to form PwC in July 1998, observations for clients with either Coopers & Lybrand or Price Waterhouse as the auditor in 1998 and PwC in 1999 are regarded as continuing engagements.

For brevity, the definitions of these variables are not shown because they can be easily derived from the related variables in panel A of Table 1.

The results also hold for a change model of report lag.

The Jones’ (1991) model omits the term CHREC from model (5) in the “Appendix”.

The thresholds used to define a small profit or small positive change in profit are sample-specific (see Beatty et al. 2002).

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Titel: Do failed auditors receive lower audit fees from continuing engagements?
verfasst von: Kam-Wah Lai
Ferdinand A. Gul
Publikationsdatum: 28.08.2020
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 3/2021
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-020-00922-9

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