Litigation Risk and Audit Pricing: The Role of Public Equity. Brad Badertscher University of Notre Dame

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1 Litigation Risk and Audit Pricing: The Role of Public Equity Brad Badertscher University of Notre Dame Bjorn N. Jorgensen University of Colorado Boulder Sharon Katz Columbia University William Kinney * University of Texas at Austin January 3, 2013 ABSTRACT: Does de facto audit litigation risk arising from regulatory and market factors for U.S. public equity firms affect audit pricing? The answer is important for evaluating efficiency of regulatory regime design and for understanding audit production economics. For U.S. firms with publicly-traded debt, we hold constant the regulatory regime, including issuer reporting mandates and auditor responsibilities, but partition those with public equity and otherwise similar private equity firms and thus vary market factors and de facto litigation risk. In crosssection, we find that public equity firms fees are 16% to 25% higher than private firms. Results are consistent with higher audit litigation risk arising from public equity ownership due to readily available equity prices to quantify potential damage claims imposing substantial incremental audit fees. Time-series comparisons for firms that change ownership status yield qualitatively similar fee decreases for going-private firms and significantly larger fee increases for goingpublic firms. * Corresponding Author: Department of Accounting, McCombs School of Business, The University of Texas at Austin, 1 University Station, Office: CBA 3.226, Austin, TX Phone: (512) Fax: (512) william.kinney@mccombs.utexas.edu. Keywords: public firms, private firms, ownership structure, audit fees, litigation risk JEL classification: M41, M42, M44 Data Availability: Data are available from sources identified in the paper. We are grateful for constructive comments by Dain Donelson, Jim Fuehrmeyer, Katherine Gunny, Menon Krishnagopal, and Mike Wilkins, and seminar participants at Temple University, the 2011 AAA Annual Meeting, University of Colorado Boulder, and the 2012 AAA Midyear Auditing meeting (discussant Paul Chaney). We would like to thank Ryan Sheenan for research assistance and the Mendoza College of Business for financial support.

2 1. INTRODUCTION In concept, audit fees for a financial statement audit cover audit production cost including normal profit and the present value of the auditor s expected damages arising from the audited financial statements (Simunic [1980]). In application, these components interact as differential audit effort affects the risk of undetected material misstatement and thus the possible magnitudes and related likelihoods of damages to the auditor. 1 One source of private litigation, alleged audit firm violation of federal securities acts, may involve class actions and substantial legal defense costs, damage payments and damage to audit firms reputations, as well as bankruptcy declarations (Seetharaman et al. [2002], DeFond and Francis [2005], CAQ [2008]). 2 Litigation damages to audit firms vary by type of professional service with 78% of damage payments related to audits of firms with publicly traded equity, 16% to audits of private equity firms (including firms with private equity and public debt), and 6% to non-audit services. 3 For potential damages, 94% of the aggregate is attributable to public firm audits, 5% to private firm audits, and 1% to non-audit services. 4 Prior research also finds that lawsuits are more frequent and yield larger damage awards for public firm clients than for private firm clients that are not subject to SEC filing requirements (St. Pierre and Anderson [1984]; Lys and Watts [1994]). 1 Simunic and Stein [1996] note that the effects of ownership structure, auditor effort, and risk premium, need to be disentangled before it is possible to conclude whether or not audits are properly priced in the face of higher litigation. 2 The Center for Audit Quality (CAQ [2008]) reports that, from 1996 to 2007, private litigation payments by Big Four U.S. audit firms for 362 cases totaled $5.66 billion, and 147 claims for damages of $100 million or more for the same period can be conservatively aggregated at $201 billion (e.g., the 37 claims between $100 million and $250 million alleging public company audit defects are valued at $100 million each). In contrast, aggregate U.S. audit revenue of the same four firms that was $13.5 billion (Accounting Today, Special Supplement, 2010). 3 In this paper, the terms public, private, publicly-held, and privately-held refer to whether a firm s equity is publiclytraded on an organized capital market. For ease of exposition, we refer to firms with private equity and public debt as private firms while firms with public equity and public debt are referred to as public firms. 4 According the Stanford Law School Securities Class Action Clearinghouse ( which maintains an index of filings of 3,280 issuers that have been named in federal class action securities fraud lawsuits since passage of the Private Securities Litigation Reform Act of 1995 (PSLRA), 96% of all federal class action fraud lawsuits were filed against issuers with publicly traded equity. Private firms with publicly-traded debt and their auditors are also subject to federal class action lawsuits (e.g., Stanford securities class action clearinghouse, Nyack Hospital, Docket number: 02-CV-03283). 1

3 In addition to federal statutory provisions, various state contract and tort laws provide for different rights of plaintiffs based on ownership structure and the market environment may also play a role. The high relative liquidity and ownership dispersion of public firms (Katz [2009]) means that more public equity investors may be harmed by defective audited financial statements and may facilitate class action lawsuits. In addition, readily observable stock price declines for public equity firms may facilitate initiation of class actions due to the ease with which potential damages from substandard audits can be quantified. For example, in discussing audit litigation, a knowledgeable defense attorney has said a stock price decline of 20 percent or more just about guarantees you ll be hit by a suit... (as cited by Rivlin [1996], p. 58). As to the role of stock price declines in initiating litigation, Jones and Weingram [1996] find that the proportion of shares traded, market capitalization, and share price declines all contribute to litigation exposure. 5 More recently, Lowry and Shu [2002] find that potential litigation costs for initial public offering (IPO) firms are substantial, with settlement payments averaging 11% of total proceeds raised from the IPO. They also document that, among IPO firms, those with higher litigation risk underprice their offerings more and that more underpricing lowers expected litigation costs. Finally, as to specific firms, Lockyer [2008], Shore [2007], Wiles [1998], and Chase [1988] each provide evidence of a securities lawsuit brought against a firm as the result of a decrease in their stock price. The concentration of realized damage payments and potential damages for audits of companies with publically traded equity raises the question of whether audit fees reflect audit firms higher exposure to litigation risk and if so, to what extent is the difference due to extant audited financial reporting regulatory structure in comparison to ownership factors, including the availability of stock 5 The PSLRA was aimed at reducing opportunistic lawsuits, often filed within days of a stock price drop. While the PSLRA changed some of the ground rules for commencing and prosecuting such lawsuits, it did not diminish the volume of lawsuit appreciably (Giuffra [1999]) but rather shifted the lawsuits to the state courts (Rosen [2009], Post [2012]). 2

4 prices to quantify investor losses due to audited financial statement information. The answers are important for understanding the economics of audit services by scholars, audit firms, legislators and regulators interested in regulatory mechanism design for efficient delivery of assurance services to inform investors as well as analysts and those charged with governance. In this study, we analyze audit fees of U.S.-domiciled firms with publicly-traded debt over the period 2000 to 2009 partitioned on whether a firm s equity is public or private. Due to their publiclytraded debt, all firms in our sample are subject to SEC financial reporting regulations and are therefore required to file financial statements with the SEC in accordance with Sections 13 and 15(d) of the Securities Exchange Act of 1934 (see Katz [2009] and Givoly et al. [2010]). 6 Our research design allows examination of both levels and changes in audit fees across different ownership structures and hence exposure to litigation risk, while controlling for or holding constant other firm characteristics, including the public debt, legal environment, and SEC financial reporting and audit requirements. We conduct pooled cross-sectional tests of audit fee levels for public debt firms that maintain their private equity or public equity structure throughout the period of data availability (we refer to these as steady-state or non-transition firms). In addition to analyzing fees of private firms relative to public firms in cross-section, we also estimate the effect of inter-temporal change in ownership structure for two samples of transition firms: (i) firms with public debt and private equity that become firms with public debt and public equity, and (ii) firms with public debt and public equity that become firms with public debt and private equity. This difference-in-differences design holds other firm specific effects constant to allow examination of how audit fees change as the firm transitions between public equity and private equity ownership. 6 In particular, [u]nder the 1934 Act auditors must prove they acted in good faith (i.e., not grossly negligent, fraudulent or constructively fraudulent) (Venkataraman et al. [2008], p. 1317). 3

5 Our results across both non-transition firms and transition firms provide consistent evidence that relative to public firms, private firms pay substantially lower audit fees. For cross-sectional tests of non-transition firms, we find that public firms pay audit fees that are 16% to 25% higher than private firms and both statistically and economically significant. For inter-temporal tests of a change in ownership status, we find that audit fees are significantly higher (increase by 74%) when a firm goes public and significantly lower (decrease by 16%) when a firm goes private. These inter-temporal change estimates are consistent with a greater liability loss component embedded in audit fees for public firms relative to private firms and suggest that audit firms may include a pure litigation risk premium for going public firms. 7 Our results are robust to controlling for the Sarbanes-Oxley Act (SOX 2002) section 404(b) that may differentially affect private equity firms with public debt, after controlling for firm characteristics such as leverage, occurrence of losses, size, and audit quality. We further control for auditors effort by including the length of the 10-K and utilizing each firm as its own control. Finally, we mitigate the role that self-selection might play by conducting both propensity score matching and Heckman s [1979] sample selection correction procedure. Taken together, these results imply that the ownership status of an audit client significantly affects audit pricing through audit litigation. Our study makes several contributions to the existing literature. First, in contrast to prior research (e.g. Seethataman et al. [2002], Venkataraman et al. [2008], and Choi et al. [2009]), our unique sample of privately-held firms with publicly-traded debt that are subject to mandatory SEC filings isolates how public equity and litigation risk directly affect audit pricing, controlling for filing, disclosure and auditing requirements, the existence of public debt, and audit effort. Second, we are able to quantify the audit fee premium due to higher litigation risk for private firms as suggested by 7 Cornerstone Research suggests that class action litigation exposure to IPO firms is highest in the first few years and decreases over time as companies mature and stock price volatility decreases (Cornerstone Research [2010]). 4

6 others (Simunic and Stein [1996], Bell et al. [2001], London Economics [2006]) Third, even though private equity firms constitute 99 percent of U.S. companies (AICPA [2004]; Katz [2009]), and make up a significant portion of the audit services market (Chaney et al. [2004]; Minnis [2011]), little is known about audited financial reporting by U.S. private equity firms (Ball and Shivakumar [2005]; Allee and Yohn [2009]; Cassar [2009], Badertscher et al. [2011]). 8 Finally, our tests of firms that transition from private to public and from public to private are the first to document that audit fees are significantly altered during the period surrounding going-public and going-private transactions further corroborate our main finding that ownership status affects audit litigation risk and audit pricing. The remainder of this paper is organized as follows. Section 2 discusses the bases for our research questions regarding audit fees based on structure and environment, while section 3 describes our research design and sample, including descriptive statistics. Section 4 provides our cross-section and time-series estimation results and robustness tests and section 5 concludes. 2. AUDIT LITIGATION RISK AND FEES: RESEARCH QUESTIONS Audit firms may react to higher audit litigation risk by raising fees to cover cost of increased audit production effort in an attempt to reduce the likelihood of material misstatement or by adding a risk premium to help cover possible future litigation costs (Palmrose [1986]; Simon and Francis [1988]; Pratt and Stice [1994]; Simunic and Stein [1996]). Prior research has isolated aspects of the relation of regulatory structure on audit litigation and audit fees, but has been unable to hold constant firm characteristics and regulatory reporting and audit requirements. In concept, higher litigation risk and thus higher audit fees might be expected for public firms audits as compared to private firms, because public firms market liquidity and ownership dispersion are higher (Katz [2009]) so more equity investors may be harmed by misrepresentation in audited 8 Hope and Langli [2010] and Hope et al. [2012) test auditor independence and audit effort in various agency settings for private firms in Norway, which are characterized by low litigation environment, and hence not appropriate to directly test for litigation risk; the results are not easily generalized to the U.S. 5

7 financial statements. The 2008 CAQ report suggests increasing difficulties for audit firms in dealing with potential liability from equity market capitalization declines of audit clients because potential damages in securities class action typically begin with a decline in large market capitalization associated with an alleged misrepresentation. Also, leading insurers of audits of smaller audit firms (e.g., Aon Corporation) consider public vs. private ownership status of audit clients as an important factor in determining an audit firm s litigation risk (CAQ [2008]). As a result, one would expect audit fees to be higher for public firms than for private firms. In contrast, higher audit fees might be expected for private equity firms, as Bell et al. [2001] and London Economics [2006] document that despite higher business risk for the auditor, audit firms are not likely to be able to pass on the full cost due to public market price competition. Private firms also have potentially greater business risk due to higher levels of debt and higher frequency of losses (O Keefe et al. [1994]; Simunic and Stein [1996], Seetharaman et al. [2002]; Choi et al. [2009]). Furthermore, audited financial statements may play a more important monitoring role for private firms because they lack a market base measure of firm value, have less vulnerability to takeovers, and less disclosure of non-accounting information (Lennox [2005]). Finally, higher ownership concentration among private firms (Katz [2009]) could lead to higher private equity litigation risk from large and more sophisticated shareholders, thereby increasing audit fees for private firms. 9 Recent studies conduct cross-country research to identify the effect of different regulatory regimes on audit fees and effort. Seetharaman et al. [2002] report higher audit fees paid by U.K. firms that are cross-listed in the U.S., consistent with the increased liability and litigation costs in the U.S. Choi et al. [2009] extend this research to 14 countries and document that auditors charge higher fees for firms that are cross-listed in countries with stronger legal regimes than they do for non-cross-listed 9 In contrast, differences in agency conflicts stemming from more concentrated ownership and controlling shareholders may reduce auditors independence in private firms (Hope and Langli [2010], Coffee [2001, 2005]) and hence, may reduce auditor effort and yield lower audit fees (Hope et al. [2012]). 6

8 firms. Choi et al. [2009] interpret their results as supporting the theory that audit fee premiums are associated with increased legal liability and not with increased audit complexity. 10 In contrast to cross-country research, Venkataraman et al. [2008] utilize a litigation and regulatory regime change during an IPO to examine the relationship between auditor exposure to legal liability, audit quality, and audit fees. They utilize 142 IPOs between 2000 and 2002 to compare the financial and associated audit fees for the two years prior to the IPO ( pre-ipo ), in accordance to prospectus filings, which are subject to the Securities Act of 1933, to the year of IPO ( post-ipo ), in which firms report filings under the Securities Exchange Act Venkataraman et al. [2008] find that auditors provide higher quality (measured by lower abnormal accruals) and receive higher audit fees for the pre-ipo audits under the Securities Act of 1933 due to their exposure to higher litigation risk. 11 Our study complements and extends Venkataraman et al. [2008] by examining a sample of firms that have identical reporting requirements across two different ownership structures. 12 Since Venkataraman et al. s [2008] results focus on the period of change in regulation regime, their results cannot easily be generalized to the comparison of private equity firms with public debt versus public equity firms with public debt, who are subject to identical reporting regulation regimes. Four other studies are more direct in their comparison of public and private equity. First, in contrast to archival 10 Skinner and Srinivasan [2012] find that, while audit fees in Japan are low compared to those in the U.S., cross-listed Japanese firms pay significantly higher audit fees than comparable U.S. firms, which they interpret as supporting the idea that audit quality in Japan is generally lower than in the U.S. Furthermore, in cross-country studies, factors other than litigation risk, such as cross-country differences in audit competition, relative bargaining power of auditors and clients, and audit quality levels could explain audit pricing differences (Sankaraguruswamy and Whisenant [2009]) and to the extent that the results based on samples consisting of foreign companies generalize to U.S. firms is not clear due to differences in these countries reporting regimes (Givoly et al. [2010]). 11 The authors acknowledge that auditors responsibilities are higher for IPO engagements and hence can lead to higher fees, but proxy for the portion associated with the litigation risk by utilizing the existence of audit committee, the change in auditors, the S-1 filings, the number of amendments to S-1 registration, and the log of gross proceeds. 12 Other related studies focus on specific attributes of the IPO process. Beatty [1993], for a sample of 1,191 IPO firms between 1982 and 1984, reports a positive relation between non-underwriting expenses, as a proxy for audit fees, and three ex-post measures of litigation risk: delisting, bankruptcy and lawsuits. Willenborg [1999] shows that IPO audit fees increase with the IPO proceeds, since these proceeds stand for the upper limit on damages, and associated with their insurance role. 7

9 studies, Palmrose [1986] collected survey data for a sample of 361 audits between 1980 and 1981 where 25% of the firms were privately held with no public debt and therefore not required to comply with SEC reporting and audit requirements. Palmrose finds that public firms had higher audit fees. This finding, however, can be also attributed to the different reporting requirements and effort by auditors and is not solely tied to litigation and business risk. Second, the client acceptance decision literature finds that audit firms consider public status as a business risk of auditor reputation loss (Palmrose [1986]; Bell et al. [2002]; Johnstone and Bedard [2003, 2004]). The role of auditors and therefore the pricing of audit fees in private firms may also differ from public firms. Finally, Chaney et al. [2004] investigated audit pricing among U.K. private firms and document that private firms choose the lowest-cost auditor available. Further, they find that Big 5 audit firms are not able to charge a premium to private firms. 13 Given the prior research, it is not clear whether and to what extent the role of public equity and the attendant regulatory and market environments play in the pricing of audit fees. We pose three empirical questions based on regulatory reporting and audit regimes and other things equal: Q1 Are audit fees significantly different for public vs. private equity firms? Q2 Does going public significantly increase audit fees? Q3 Does going private significantly reduce audit fees? We will address all three questions using a single sampling frame of U.S. firms with public debt. 3. RESEARCH DESIGN, SAMPLE, AND DESCRIPTIVE STATISTICS 3.1 Research Design Because their debt is publicly-traded, private equity firms with publicly-traded debt must file on Form 10-K audited financial statements with the SEC, even though their equity is privately-held. 13 Both the Norway and the U.K. settings are characterized by much lower litigation environment and hence are less generalizable to the U.S. (Seetharaman et al. [2002], Hope and Langli [2010], and Hope et al. [2012]). 8

10 We use the population of publicly-traded debt firms in a research design that enables us to hold constant SEC filings, disclosure requirements, and basic audit requirements, but vary the ownership structure of the audit client and hence exposure to the audit firm s litigation risk. We address Q1 by comparing audit fees of private equity and public debt firms that maintain their private equity status with otherwise similar firms having public equity and public debt. In particular we compare, in crosssection, our sample of non-transition or steady-state private firms to all public firms with public debt as well as to a matched sample of firms with publicly-traded debt and equity based on industry, year, leverage, abnormal accruals, sales, assets, and foreign operations. To address Q2 and Q3, we estimate the audit fee effect of inter-temporal change in ownership structure as private equity firms transition to public firms (going-public transactions), and as public firms transition to private firms (going-private transactions). This difference-in-differences design holds firm effects constant and allows examination of how audit fees change as firms change ownership status. Figure 1 illustrates the sample frame and sample selection process and includes the corresponding Tables and Figures showing results. [PLACE FIGURE 1 HERE] 3.2 Sample Selection To establish our sampling frame, we follow Katz [2009] and Givoly et al. [2010] and select all firm-year observations on Compustat in any of the ten years from 2000 through 2009 that satisfy the following criteria: (1) the firm s stock price at fiscal year-end is unavailable (i.e., SEC filings are available, but not year-end stock price); (2) the firm has total debt as well as total annual revenues exceeding $1 million; (3) the firm is a domestic company; (4) the firm is not a subsidiary of another public firm; and (5) the firm is not a financial institution or in a regulated industry (SIC codes and ). 9

11 To ensure that our initial sample includes only private firms with public debt, we examine each firm and remove firms with only historical prospectus information, firms with public equity, firms lacking required financial statement data, firms involved in bankruptcy proceedings, foreign-domiciled firms, and firms that lack audit fee data on Audit Analytics. Details are provided in Table 1 and Figure 1. The resulting initial sample consists of 229 private firms (772 private firm-years) with public debt between 2000 and For Q1 analyses we limit our sample to steady-state (non-transition) firms that remain private during the sample period. This limitation generates a sample of 162 firms with 628 firm-year observations. We compare this sample of private firms to the frame of public firms with public debt and to a matched sample of public firms with public debt. Following Givoly et al. [2010], we establish the presence of public debt in a given year based on one of the following indications: (1) the availability of S&P senior debt ranking (Compustat item SPLTICRM), (2) the existence of debt debentures (DD), or (3) the issuance of public debt (according to the Mergent Fixed Income Securities database (FISD) and Thomson Reuter SDC database, prior to the observation year with a maturity date beyond the observation year). Applying the above criteria generates a final sample of distinct public equity firms with publicly-traded debt (1,950 firms and 11,322 firm-year observations). Some characteristics that affect private versus public ownership choice may also affect audit fees, so we develop a propensity score to obtain a matched sample. In particular, we first match public firms in the same industry (three-digit SIC code) and fiscal year as the private firms. We then create propensity scores derived from a PROBIT model that include control variables that significantly differ between the two groups: leverage (LEV), abnormal accruals (ABNACC), size (both total sales and ASSETS), and foreign operations (MNC). We then match each public firm, one-to-one, with a private firm with the closest propensity score, without replacement (for further discussion see Angrist and 10

12 Pischke [2009]). This matching procedure ensures that our results are not driven by such differences as growth, size, earnings quality or leverage between public and private firms. As a result of this matching process, both samples include 427 firm-year observations. [PLACE TABLE 1 HERE] For the Q2 and Q3 analyses we limit the initial sample of private firms to those firms that transition between private equity and public equity ownership during the sample period and hence have both private and public ownership phases. This limitation generates a sample of 67 firms with 391 firm-year observations, of which 245 are public and 144 are private (the 245 public firm-year observations were added to the initial private firm-year sample). In order to maximize subsample size, when audit fee data are not available on Audit Analytics, we hand-collected the data from proxy statements (or 10-K filings if not disclosed in proxy statements). As indicated in Table 1, the final sample consists of 45 firms (144 public and 93 private firm-years) that transition from private to public and 22 firms (101 public and 51 private firm-years) that transition from public to private. 3.3 Descriptive Statistics for Public and Private Firm-Years Table 2, Panel A presents descriptive statistics for our sample of private firms with public debt, that remain private, as compared to all public equity firms with pubic debt. Both means and medians of AUDIT (AUDIT_S) are statistically smaller for private firms as compared to public firm. Where AUDIT is the natural log of audit fees and AUDIT_S is the audit fees converted into millions of dollars and scaled by total assets. The AUDIT_S results indicate that private firm exhibit significantly lower audit fees relative to public firm by 33% ( / ) on average. We find no statistical difference in audit-related fees between public and private firms, but we do find evidence that the mean amount of total fees is significantly lower for private firms. 11

13 The statistics for leverage indicate that private firm have significantly higher leverage ratios (mean LEV is 0.70 vs. 0.31) than public firm, and private firms are more likely to report net current year losses (LOSS). Private firms exhibit significantly lower total assets, number of business segments, and foreign operations (ASSET, SEG, MNC) compared to public firms. Private firms also have lower word count on the 10-K filings (WORDCT). Fewer private firms operate in litigious industries (LIT), are audited by Big 4 auditors (91% and 93% for private firms and public firms, respectively), and were involved in class-lawsuit action (POST_LS), but more private firms change auditors (AUD_TO). Regarding SOX 404(b) audits internal controls that were required for larger public equity firms beginning in late 2004, the overall rate of application by private firm auditors for our ten year period is 4% versus 53% for public firms and fewer private firms report internal control weaknesses (M_WEAK). Finally, Panel A suggests that private firms exhibit lower abnormal accruals (ABNACC) relative to public firms, which is consistent with results in Givoly et al. [2010]. In sum, the results in Table 2, Panel A suggest the importance of controlling for client and audit firm characteristics, as well as for other factors that may affect audit litigation risk when comparing the audit fees of public and private firms. [PLACE TABLE 2 HERE] Table 2, Panel B presents the Pearson and Spearman correlation tables for our variables of interest. Consistent with public firms having higher audit fees, both the Pearson and Spearman correlations between an indicator variable for a public firm-year (PUBLIC) and AUDIT are positive and significant. In addition, PUBLIC is positively related to AUDIT fees, TOTAL fees, multinational corporations (MNC), number of operating business segments (SEG), fewer loss years (LOSS), lower leverage (LEV), higher assets (ASSETS), abnormal accruals (ABNACC), involvement in class actions 12

14 suits (POST_LS), greater number of words in their 10K (WORDCT), lower auditor turnover (AUD_TO), and more likely to apply section 404(b) of SOX. Univariate results for private firms relative to the propensity matched sample of publiclytraded firms with public debt are in Table 2, Panel C. The results indicate that private firms have lower audit fees and total fees, but higher audit-related fees. By construction of the matching process, private firms significantly differ from public firms across fewer firm characteristics, all with lower economic significance, including leverage (LEV, 56% and 48%, respectively). In the matched sample, more private firms are audited by Big 4 auditors than public firms (BIGAUD, 92% and 84%, respectively) which would mitigate our findings, subject to less audit turnover (AUD_TO), class action litigation (POST_LS), section 404 (SOX404) audits, and report fewer material internal weaknesses (M_WEAK). 4. ESTIMATION RESULTS AND ROBUSTNESS TESTS Model: Our basic regression specification for both our Q1 cross section and Q2 and Q3 inter-temporal analyses is the following: FEES i,t = α 0 + α 1 PUBLIC i,t + α 2 INVREC i,t + α 3 ASSETS_GR i,t + α 4 BIGAUD i,t + α 5 SEG i,t + α 6 MNC i,t + α 7 LIT i,t + α 8 LOSS i,t + α 9 LEV i,t + α 10 ASSETS i,t + α 11 ABNACC i,t + α 12 POST_LS i,t + α 13 AUD_TO i,t + α 14 WORDCT i,t + α 15 SOX404 i,t + α 16 M_WEAK i,t + Σ t α t YEAR t + Σ k α k INDUS i + ε i,t, (1) where the dependent variable, FEES, represents the natural logarithm of audit firm fees. 14 We include an indicator variable, PUBLIC, which equals one for public equity and public debt firms, and zero 14 Our main focus is audit fees (AUDIT), but we also examine audit fees plus audit-related fees (AUDIT+AUDIT_RELATED) and total fees (TOTAL) to provide additional evidence on the role that ownership structure and litigation risk has on fees paid to the audit firm as Schmidt [2012] notes an association of non-audit fees with litigation risk and settlements. 13

15 otherwise. If public firms are subject to higher audit fees, then the coefficient on PUBLIC should be positive. See the Appendix for a detailed definition of each variable included in equation (1). We also include variables to control for factors that affect audit fees, as documented by prior research, including both client firm characteristics as well as characteristics of the audit firm. Growth in assets (ASSET_GR) is associated with litigation risk due to significant changes in transaction cycles and overburden on client s financial control. We include a number of control variables for the firm s complexity, including the fraction of assets in inventories and receivables (INVREC), the number of operating business segments (SEG), and indicator variable for foreign operations (MNC). Our final complexity measure is the number of words in the 10-K (WORDCT). Prior research by Loughran and McDonald [2011] suggest that the number of words in a 10-K proxies for the complexity of the firm. Auditor type (BIGAUD) can reflect greater expertise and hence command higher audit fees and can have fee implications as to audit effort as well as audit pricing. Section 404(b) of the Sarbanes-Oxley Act (SOX) presents a substantial audit requirement that differentially affects public equity firms after Specifically, SOX 404(b) requires independent audits of internal controls over financial reporting for larger public equity firms (firms with greater than $75 million in public float) and some private firms chose to have such audits. Given the documented audit costs of section 404(b) (Iliev [2010] and Kinney and Shapardson [2011]) and to ensure that section 404(b) type audits are not driving our results, we include an indicator variable (SOX404) if the audit firm conducted an internal control audit. 15 Prior research also suggests that firms with material weaknesses in internal control have complex operations, higher accounting risk, financial stress, and poorer accounting quality (Ashbaugh-Skaife et al. [2007]; Doyle et al. [2007]). Hence, we identify firms with ineffective internal controls (M_WEAK). 15 Private firms, including those with public debt, are not subject to SOX 404(b). However, our results suggest that approximately 11% of private firms with public debt voluntarily adopt SOX 404(b). 14

16 Loss (LOSS), and leverage (LEV) are proxies for the financial strength of the client firms and client-specific litigation risks borne by the auditors. The litigious industry-based indicator variable (LIT), as in Francis et al. [1994], controls for any auditors fee premium for more litigious industries. Similarly, to control for the potential of increased audit fees due to securities class action lawsuits we include an indicator variable (POST_LS) that equals one if the client firm was involved in a classaction lawsuit in year t-1, according to the Stanford class action clearinghouse database. The natural logarithm of total assets (ASSETS) is used as a proxy for the client firm size. We further include year (YEAR) and industry (INDUS) fixed-effects, which have not been tabulated, to control for fundamental differences in audit fees that may exist across years and industries. For Q2 and Q3 analyses, we also include in equation (1) indicator variables for the year of IPO (YEAR_IPO) and the year of going private (FIRSTYEAR_PRV) when examining firms that transition between private equity and public equity ownership. These event timing indicator variables isolate specific corporate events that increase the litigation risk and effort required by the auditors. Heninger [2001] reports that the risk of auditor litigation is positively associated with abnormal accruals. In addition, Venkataraman et al. [2008], who use abnormal accruals as a proxy for audit quality, 16 document that an increase in litigation risk increases both the audit fees and the audit quality. Therefore, to the extent which our firms exhibit different abnormal accruals between ownership phases, we need to control for it. Ball and Shivakumar [2005] and Givoly et al. [2010] find that public firms recognize losses in a more timely manner and engage in more earnings management than private firms. Thus, we control for both timely loss recognition and abnormal accruals by including ABNACC. ABNACC is the amount of abnormal accruals after controlling for conservatism (see Ball and Shivakumar [2006] and the Appendix for detailed discussions of the computation of 16 Abnormal accruals were commonly used in prior literature as a proxy for audit quality (see Becker et al. [1998], Francis and Krishnan [1999], Frankel et al. [2002], Myers et al. [2003], Sankaraguruswamy and Whisenant [2009]). 15

17 ABNACC). Finally, as a result of prior research by Maher et al. [1992] who document that audit fees increase when a firm changes auditors, we include an auditor turnover indicator variable for the firms that change auditors (AUD_TO). 17 Q1 Results: Cross-section Comparison of Private Firms with Public Firms We present the Q1 steady-state regression results for tests of audit fees for public and private firms in Table 3 (for the full sample) and Table 4 (for the propensity matched sample). The first column of each table exhibits the application of equation (1) to explore the impact that ownership structure has on audit fees (AUDIT) after considering the effect of litigation risk factors. The results indicate that public firms exhibit higher audit fees than private firms, after controlling for important client firm and audit firm characteristics. The estimated coefficient on PUBLIC is (0.223) and significant (t-statistic = (4.678)), consistent with audit fees being 16% (25%) higher due to the higher litigation risk. 18 Similarly, AUDIT+AUDIT_RELATED fees and TOTAL fees are significantly higher for the public year observations. [PLACE TABLE 3 and TABLE 4 HERE] Most control variables in Tables 3 and 4 are significant and in the direction consistent with a positive association of audit litigation risk and fees. The coefficients on the fraction of assets in inventories and receivables (INVREC), client firm size (ASSET), foreign operations (MNC), number of operating business segments (SEG), and word count (WORDCT), each of which proxies for required effort by the audit firm, are significantly positive. In contrast to our expectations confirmed by our univariate analyses in Table 2, Panel B, asset growth (ASSET_GR) is significantly negative. 19 The coefficient on leverage (LEV) is significantly positive, indicating that financial weakness of the 17 In an untabulated analysis we further control for sales growth, profitability (ROA), volatility of sales, volatility of ROA, tangible assets, R&D intensity, and CAPEX, while results remain qualitatively similar the benefit to R-square is marginal. 18 Since PUBLIC is an indicator variable and the dependent variable is the natural logarithm of audit fees, the calculation of the percentage increase in fees for public firms as compared to private firms is e = in Table Similar results are documented in Hope and Langli [2010] and Hope et al. [2012], but in a lower litigation setting. 16

18 client firm and higher litigation risk could lead to higher audit fees. Similarly, losses (LOSS) are positively correlated with audit fees. Increase in litigation risk as capture by class actions suits (POST_LS) and weakness in internal control (M_WEAK) are positively correlated with audit fees. As further expected, big auditors charge higher audit fees (BIGAUD), however, change in auditors (AUD_TO) is negatively associated with audit fees. Especially relevant to consideration of the structure of audited financial reporting is the audit pricing effect of SOX 404(b) audits as private equity firms are exempt from internal control audits. Consistent with the literature documenting higher audit fees due to applying internal control audits under section 404(b) of SOX (Iliev 2010), the estimated coefficient on SOX404 is statistically significant and positive (or 49% increase in audit fees) for our full sample and (or 98%) for our propensity matched sample. The latter coefficient is noteworthy in that it corresponds with other estimates that incremental audit fee are typically doubled when smaller public companies first apply SOX 404(b) (e.g., see Kinney and Shepardson [2011]). 20 The regression results found in Tables 3 and 4 for our three forms of audit firm fees indicate that public firms have higher AUDIT fees as well as higher AUDIT+AUDIT_RELATED fees and TOTAL fees relative to a sample of private firms. In addition, the estimated coefficients on PUBLIC are statistically significant and economically important for all three forms of audit firm fees. Q2 and Q3: Audit Fees around Going-Private and Going-Public Events Descriptive statistics and audit firm fees for firms that transition between private and public equity Prior research documents that organization structure changes such as going public and going private can affect earnings quality in time periods surrounding those transactions. For example, Ball and Shivakumar [2008] and Katz [2009] provide evidence that private firms alter their 20 By implication, a private firm that were to become a public accelerated filer would face two compounding effects on its audit fees, the 16% (or 25%) added audit fees related to PUBLIC as well as 49% (or 98%) added audit fees due to audit effort related to SOX

19 earnings quality several years before public stock exchange listings, in anticipation of increased scrutiny by regulators and public investors. Thus, we examine whether audit firms adjust their fees in the periods surrounding going-private and going-public transactions. Such changes in audit fees could be the consequence of anticipated changes in stock ownership concentration, financial reporting pressures, reliance on more or less debt financing, earnings quality, and overall audit litigation risk. More specifically, Venkataraman et al. [2008] document that, in the years prior to an IPO, when their (but not our) firms are subject to the Securities Act of 1933, auditors are associated with lower abnormal accruals. Auditors also receive higher audit fees for their additional responsibilities and higher audit litigation risk under the 1933 Act, relative to the IPO year, when firms file audited reports subject to the Securities Exchange Act of These findings imply that their pre-ipo private firms without public debt may pay higher audit fees than their public firms during the IPO year. In contrast, we expect the changes in audit fees in the periods surrounding the going-private and going-public transactions to reflect the broader differences in audit fees that we document for public and private firms. However, we have no predictions for how quickly the changes will occur. Thus, we examine two years before and two years after the going-private and going-public transactions. Figure 2, Panel A, presents the mean values for different audit firm fees in the two years preceding and the two years after a public firm is taken private. The plots of mean AUDIT fees suggest a substantial decrease in AUDIT fees in the year after the going-private transaction. In contrast, mean TOTAL fees (which are affected by non-audit fees as well) increase in the year preceding the going-private transaction, due mainly to increases in tax-related fees, and then decrease in both the year of going private and the first year after the going-private transaction. These results are 18

20 consistent with the decline in audit fees during the private ownership phase and with an increased demand for non-audit services before such going-private transactions. [PLACE FIGURE 2 HERE] Figure 2, Panel B, presents audit and total fees for a matched sample of public firms that do not transition to private equity ownership. The match is conducted in year t-1 and the matched sample remains constant throughout the time period. The match is based on the same fiscal year, industry (3- digit SIC code), and closest propensity score match, where propensity score match is based on leverage, abnormal accruals, sales, assets, and foreign operations. The average percentage change in audit fees from year t-1 to t+1 for the transition sample is -30.3% while the average change in audit fees over the sample period for the non-transition matched sample is +15.3%. The difference in percentage change in audit fees is -45.6% which is statistically significant at the 1% level (t-stat = -4.15). The results provide additional support that public equity ownership significantly affects audit fees at the time audit litigation risk declines. Figure 3, Panel A, presents similar charts for our measures of fees as firms with public debt go public with their equity. This figure is centered on the two years preceding and the two years after a private firm goes public. The plots of mean AUDIT fees suggest a substantial and monotonic increase in audit fees beginning one year before the IPO until one year after the IPO. These results are consistent with the increase in audit fees during the public ownership transition phase. 21 In contrast, mean TOTAL fees increase in the year preceding the going-public transaction (again due primarily to tax-related services fees) and begins to decline to the pre-ipo level in the year after the IPO, consistent 21 These results, however, may appear inconsistent with the findings of Venkataraman et al. [2008], who document that the audit fees in the two years prior to the IPO are higher than the fees in the year of IPO. While Venkataraman et al. [2008] focus on pure private firms that go public through an IPO without prior SEC filings; private firms in our sample already submitted audited financial reports with the SEC prior to the IPO. Therefore, we can expect lower auditor effort and exposure to litigation risk in our setting where private firms previously submitted audited SEC filings. 19

21 with an increased need for non-audit-services (e.g., compliance with SOX) as well as tax-fees consultation before such going-public transactions (Badertscher et al. [2011]). 22 [PLACE FIGURE 3 HERE] Analogous to Panel B of Figure 2, Figure 3, Panel B, presents the results for a matched sample of private firms that do not transition to public equity ownership (see Figure 3 for a description of the matching procedure). Interestingly, the average percentage change in audit fees from year t-1 to t+1 for the transition sample is +75.4%, while the average change in audit fees for the non-transition matched sample is +14.9%. The difference in percentage change is +60.5%, which is statistically significant at the 1% level (t-stat = 5.88). Taken together, the patterns of audit fees exhibited in Figures 2 and 3 are consistent with an increase in litigation risk during the public phase, with systematically increasing audit fees charged by audit firms. Estimation results for firms that transition between private and public equity Table 5, Panel A, reports descriptive statistics for our sample public debt firms that transition from private to public ownership of equity. Both means and medians of AUDIT and TOTAL are statistically smaller for the private firm years as compared to public firm years. In addition, private firm-years exhibit significant lower natural logarithm of assets, class action lawsuits, submission according to section 404, and frequency of internal control weaknesses (ASSET, POST_LS, SOX404, and M_WEAK) as compared to public-firm-years. Furthermore, loss and leverage (LOSS and LEV) are significantly higher for private firm-years. [PLACE TABLE 5 HERE] Consistent with the results in Tables 2 through 4, the results in Table 5, Panel B also indicates that public years exhibit higher audit fees than private years of the same firms, after controlling for 22 The inversely related change in tax and audit fees is noteworthy with respect to factors affecting audit litigation risk as Schmidt [2012] documents that audit litigants act as if non-audit services compromise auditor independence and audit quality. 20

22 important client firm and audit firm characteristics. The coefficient on PUBLIC is and significant (t-statistic = 3.704), consistent with higher audit fees due to the higher litigation risk. The log transformation of the coefficient on PUBLIC represents a 74% premium relative to fees charged to private firms, once the firm goes public. Similarly, TOTAL fees in the third column remain significantly higher for public years and represent a 39% premium relative to total fees for public firms. In addition to the control variables used in the previous tables, we also control for the year of IPO (e.g., Venkataraman et al. 2008). In contrast to the results presented in Tables 2-4 that used much larger samples, only a few control variables remain significant, but remain similar overall. In particular, the SOX404 coefficient (0.158) is significantly positive at the 0.10 level and consistent with a 17% increase. This may indicate that firms going public had better internal controls on average than firms that did not go public. Table 6, Panel A, reports descriptive statistics for our sample of public debt firms that transition from public to private equity ownership. The Panel A results are qualitative similar to those reported in Panel A of Tables 2 and 5. While the difference between the AUDIT fees for public and private years is not as large relative to the full sample in Table 2, Panel A, both the mean and median fees are statistically lower for the private firm years. Also consistent with the results in Panel A of Tables 2 and 5, we find no difference in AUDIT_RELATED for the two samples. In contrast, the mean for the total fees is significantly indistinguishable between the two samples. The regression results in Table 6, Panel B indicate that public years exhibit higher audit fees than private years of the same firms, after controlling for important client firm and audit firm characteristics. The coefficient on PUBLIC is and significant (t-statistic = 1.804), consistent with significantly higher audit fees due to the higher litigation risk. The log transformation of the coefficient on PUBLIC represents a 16% premium relative to fees charged to private firms. Similarly, 21

23 AUDIT+AUDIT_RELATED and TOTAL fees remain higher and statistically significant for public years. [PLACE TABLE 6 HERE] Taken together, the results in Tables 2-6 and Figures 2 and 3 consistently suggest that public firms, whose audit firms are subject to greater litigation risk, pay significantly larger audit fees after controlling for additional complexity and other client and audit firm characteristics. Robustness Tests To mitigate concerns about endogeneity or self selection of ownership structure, our first robustness test includes a control variable, the inverse Mills ratio (INV_MILLS) from the first stage of the Heckman [1979] sample selection correction procedure, to correct for possible self selection and associated with the decision for a firm to be publicly- vs. privately-held. In the first stage, we estimate the following probit regression, which predicts whether firm-year observations are publicly-held (PUBLIC): PUBLIC j,t = β 0 + β 1 FIRM_AGE j,t + β 2 INVREC j,t + β 3 ASSETS_GR j,t + β 4 BIGAUD j,t + β 5 SEG j,t + β 6 MNC j,t + β 7 LIT j,t + β 8 LOSS j,t + β 9 LEV j,t + β 10 ASSETS j,t + β 11 ABNACC j,t + β 12 POST_LS j,t + β 13 AUD_TO j,t + β 14 WORDCT j,t + β 15 SOX404 j,t + β 16 M_WEAK j,t + Σ t β t YEAR t + Σ k β k INDUS j + ε j,t (2) where equation (2) is based on models of public and private ownership as in Ball and Shivakumar [2005] and Givoly et al. [2010]. FIRM_AGE is measured as the number of years since first firm s appearance on Compustat. 23 See the Appendix for a detailed definition of all other variables included in the first stage equation (2). We compute INV_MILLS for each firm-year observation based on the estimated coefficients for equation (2), and then include that variable in equation (1), the second stage 23 FIRM_AGE is the so-called exclusion restriction variable suggested by Givoly et al. [2010], which does not appear in the second stage regression. This variable has no expected direct impact on audit fees in the second-stage equation (1) while it is an important determinant of public equity selection (the likelihood of a firm to go public increases with the passage of time) in the first stage equation (2). See Lennox et al. [2012] for further discussion on the implementation of the Heckman [1979] two-stage procedure. 22

24 of the Heckman estimation procedure. 24 After including INV_MILLS in all of our regressions (untabulated), our primary inferences remain unchanged. 25 As to the effect of SOX 404(b) audits on audit fees, we note that although private firms are not subjected to SOX 404(b), 11 percent of private firms in our sample (25 out of 229) voluntarily engaged their audit firm to conduct SOX 404(b)-based internal control audits. This frequency is significantly lower than those of public firms in which the vast majority complied with section 404(b) of SOX. We estimated the effect of SOX404 in each of our regressions. To further mitigate concerns regarding the effect of section 404(b), we compare (1) public firms to private firms that both apply section 404(b), as well as (2) public to private firms that do not apply SOX 404(b). All results remain qualitatively similar. In addition, separation of each sample into two subsamples of before and after SOX (fiscal years 2004 and beyond) leads to similar results to those reported in the paper. As to transition periods and restructuring activities, we note that Figures 2 and 3 document dramatic audit fee shifts in the periods surrounding going-private and going-public transactions. Following Katz [2009], we expect that other organizational changes such as mergers and acquisitions and bankruptcy might also affect auditor effort and litigation risk, and hence, audit fees charges. To verify that major organizational changes do not substantially influence our results, we remove observations during the three years surrounding (one year before and after) each of these transactions. All results remain qualitatively similar. Corporate restructurings can further affect audit fees. In order to address this concern, we use several proxies for restructuring activities including the magnitude of discontinued operations, special items, involvement in mergers and acquisitions, and an indicator for whether assets increased or 24 We estimate the Heckman [1979] two-stage procedure using Lee s [1979] switching simultaneous equation (see Maddala [1983], Chapter 9). We obtain a 61 and 60 percent MacKelvey-Zavonia pseudo-r-squared, respectively, in the first-stage probit regressions, which validates the relevance of our chosen control variables. 25 Stolzenberg and Relles [1997] argue that if selection bias is moderate then the two-step estimation approach can make estimates worse. 23

25 decreased more than 50 percent in a single year. Untabulated analyses indicate that restructuring activities are similar across our comparison groups. Further, removing observations during restructuring periods produces qualitatively similar results. In addition, we considered audit firm changes as a driver of fee results. Eighteen of our private transition firms (27%) changed auditors during our sample period. Of those, 13 changed from a Big 4 to another Big 4, two changed from non-big 4 to another non-big 4 and three changed from Big 4 to non-big 4. As a robustness check we removed the 18 firms from our analysis and our results are quantitatively similar to those presented. For the non-transition sample we have 588 auditor turnovers, with 77% switching from Big 4 to another Big 4 and 23% switching from either non-big 4 to Big 4 or vice versa. As a robustness check, we removed the 588 firms from our analysis and our results are quantitatively similar to those presented. Finally, the prior literature introduces several analytical audit pricing models that suggest initial audit engagements are discounted or that the new auditor lowballs the incumbent auditor s fees. Due to transaction costs (switching and startup costs), such lowballing allow audit firms to realize higher fees and profits in subsequent years (DeAngelo [1981a]; Magee and Tseng [1990]; Dye [1991]; Kanodia and Mukherji, [1994]). Several studies document that such discounts existed in the U.S. before the public disclosure of audit fees (Simon and Francis [1988]; Ettredge and Greenberg [1990]; Turpen [1990]). Sankaraguruswamy and Whisenant [2009] further document that initial audit lowballing continues in the U.S. after the public disclosure of audit fees. 26 They also find no evidence that audit quality (measured by discretionary accruals) is related to that initial audit discount, despite the potential effect on litigation risk. While Sankaraguruswamy and Whisenant [2009] exclude observations from the year of IPO, we include the IPO year but control for transition period directly, such lowballing discount might still 26 These results, however, are in contrast to Craswell and Francis [1999], who did not find such a discount in the Australian market for initial audits of same-tier auditor changes. 24

26 affect our results, because audit fees paid by private firms may also capture a discount received by private firms prior to going public. Hence, we conducted our analyses separately on firms that go private, as well as private firms that remain private, where such lowballing discount is not predicted. While the higher audit fees of firms that are going public might be attributed to lowballing and discounted audit fees by the audit firms (e.g. DeAngelo [1981a], Dye [1991], and Sankaraguruswamy and Whisenant [2009]), our finding of a decrease in audit fees when firms are going private runs opposite to the lowballing explanation CONCLUSION This study investigates how litigation risk affects audit fees by comparing public and private firms. In particular, we examine whether audit fees are higher for public firms relative to private firms. Our results indicate that when firms have private equity they pay significantly lower audit fees than when they have publicly traded equity. The results hold for both subgroups of firms that transition from private to public and from public to private ownership structures. These results are consistent with auditors of public firms charging higher audit fees, despite similar required audit effort under SEC regulations, because they are subject to greater litigation risks arising from public equity ownership structure. This paper also demonstrates distinctive inter-temporal trends in audit firm fees around goingprivate and going-public transactions. We document a substantial decrease in audit fees around going-private transactions. This trend continues while firms are privately-held. The trend in audit fees around going-public transactions is virtually inverse to that for going-private transactions. Taken 27 We further test changes in audit fees for the eighteen firms who changed auditors during our sample period, and find no indication of lowballing discount. In particular, for those firms that changed from Big 4 to Big 4 during the year the firm went public, we document a significant increase in audit fees, see DeAngelo [1981b]. The decrease in the audit fees for the three firms that went from Big 4 to non-big 4 can be attributed to the audit firm s size, we further find no change in audit fees for the two firms that changed from non-big 4 to Big 4. 25

27 together, our results provide consistent cross-sectional and inter-temporal evidence that audit litigation risk affects the amount of fees charged by audit firms. Our results are also consistent with ownership structure playing an important role in the pricing of audit fees. Specifically, we show that audit fees are on average 16% to 25% higher for public firms relative to private firms. To our knowledge, this is the first U.S. study to compare the audit fees of firms with different ownership structures and to document the magnitude of the premium charge for public firms. Our study should be of interest to auditors, regulators, insurance companies, and investors who are interested in the role that litigation risk plays in the pricing of audits, and to researchers who are interested in the impact of ownership structure on audit fee pricing. In addition, our investigation into the audit pricing of public and private firms should be of interest to the Center for Audit Quality as further evidence on the link between ownership structure, litigation risk and audit fees. 26

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34 Measures of Audit Fees: AUDIT AUDIT_RELATED TOTAL AUDIT_S AUDIT_RELATED_S TOTAL_S APPENDIX Variable Measurement = Firm i s natural logarithm of audit fees (Audit Analytics AUDIT_FEES) which consists of all fees necessary to perform the audit or review in accordance with Generally Accepted Auditing Standards. This category also may include services that generally only the independent accountant reasonably can provide, such as comfort letters, statutory audits, attest services, consents, and assistance with and review of documents filed with the SEC. = Firm i s natural logarithm of audit fees (Audit Analytics AUDIT_RELATED_FEES) which include assurance and related services (e.g., due diligence services) that traditionally are performed by the independent accountant. More specifically, these services would include, among others: employee benefit plan audits, due diligence related to mergers and acquisitions, accounting consultations and audits in connection with acquisitions, internal control reviews, attest services that are not required by statute or regulation and consultation concerning financial accounting and reporting standards = Firm i s natural logarithm of total fees (TOTAL_FEES) which is the sum of audit fees and total non audit fees. = Firm i s audit-related fees (AUDIT_FEES) converted into millions of dollars and divided by total assets (Compustat AT). = Firm i s audit fees (AUDIT_RELATED_FEES) converted into millions of dollars and divided by total assets (AT). = Firm i s total fees (TOTAL_FEES) converted into millions of dollars and divided by total assets (AT). Public Firm Indicator Variables: PUBLIC = 1 when the firm has publicly-traded equity and publicly-traded debt and 0 otherwise. ABNACC Control Variables and Other Variables of Interest: = Firm i s abnormal total accruals in year t derived from the modified crosssectional Jones [1991] model. To estimate the model yearly by two-digit SIC code, we require that at least 10 observations be available. The regression is: TACC j,t / TAj, t 1 = a 1 *[1 / TA j, t 1 ] + a 2 *[(ΔREV j, t ΔTR j, t )/TAj, t 1 ] + a 3 *[PPE j, t / TAj, t 1 ] where: TACC is total accruals for firm j in year t, which is defined as income before extraordinary items (IBC) minus net cash flow from operating activities, adjusted to extraordinary items and discontinued operations (OANCF - XIDOC). To control for the asymmetric recognition of gains and losses, the modified Jones model is augmented with the following independent variables: cash flow from operations in year t (CF t ), a dummy variable set to 1 if CF t <1 and 0 otherwise (DCF t ), and an interactive variable, CF t DCF t (as suggested by Ball and Shivakumar [2006]). CF t is defined as cash from operations in year t adjusted for extraordinary items and discontinued operations (OANCF - XIDOC). 33

35 ASSETS = Natural logarithm of the total assets (AT) for firm i, at the end of year t. ASSET_GR = Firm i s total assets growth, where total assets growth is total assets (AT) at the end of year t minus total assets at the beginning of year t divided by total assets at the beginning of year t. AUD_TO BIGAUD M_WEAK INVREC LIT LEV LOSS MNC POST_LS SEG WORDCT YEAR_IPO FIRSTYEAR_PRV SOX404 = 1 if the firm changed auditors in year t and 0 otherwise. = 1 if a Big 4 audit firm, and zero otherwise (AU). = 1 if the audit firm s report indicates the firm has ineffective internal controls in year t and 0 otherwise. = Firm i s inventory (INVT) and receivables (RECT), divided by total assets. = 1 if SIC is , , , , or (biotechnology, computers, electronics or retailing); and zero otherwise (Francis et al. 1994). = Firm i s leverage in year t, measured as total debt (DLTT + DLC) divided by total assets (AT). = 1 if firm i reports a loss, where loss is net income before extraordinary items (IBC) and zero otherwise. = 1 if firm s foreign pre-tax income (PIFO) or foreign income taxes (TXFO) is positive or negative and zero otherwise. = 1 if the firm-year is after the firm was involved in a class-action lawsuit according to the Stanford class action clearinghouse database and zero otherwise. = Number of business segments (BUSSEG). = The number of words, in thousands, in the 10-K. = 1 if the firm-year is the first year the firm is public for firms that transition from private to public, and zero otherwise. = 1 if the firm-year is the first year the firm is private for firms that transition from public to private, and zero otherwise. =1 if according to Audit Analytics the firm s auditor APPLIEDthe requirements of section 404(b) of the Sarbanes-Oxley Act and zero otherwise. Σ j INDUS = 1 if firm i is in industry j in year t, based on three-digit SIC codes, and zero otherwise. Σ j YEAR = 1 if firm i is in year j, and zero otherwise. All continuous variables are winsorized at the 1st and 99th percentiles 34

36 TABLE 1 Sample Selection Sample Selection Procedures for Private Firms with Public Debt ( ) No. of Firm-Years No. of Firms Potential private firms with public debt (Compustat) a 3,390 1,072 Eliminate firms that: Do not have historical (non-prospectus) data b (1,327) (576) Are public firms (113) (26) Are subsidiaries of public firms (92) (22) Are involved in bankruptcy proceedings (56) (16) Are foreign firms or subsidiaries of foreign firms (218) (81) Other c (127) (15) Subtotal of private firms with public debt 1, Eliminate firms that : Are cooperatives, LPs, or government-owned (78) (13) Subtotal of private firms with public debt 1, Eliminate firms that : Are missing required Compustat data (83) (12) Are missing Audit Analytics data d (524) (82) Total Sample of private firms with public debt Sample of steady-state (non-transition) private firms with public debt e Sample of steady-state (non-transition) private firms with public debt-propensity score matched f Sample of private firms that transition from private to public g Sample of private firms that transition from public to private h a The sample of potential private firms with public debt consists of all firm-year observations on Compustat in any year from that satisfy the following criteria: (1) the firm s stock price at fiscal year-end is unavailable; (2) the firm has total debt as well as total revenues exceeding $1 million; (3) the firm is a domestic company; (4) the firm is not a subsidiary of another public firm; and (5) the firm is not a financial institution or in a regulated industry (SIC codes and ). b Compustat reports three years of historical information for public firms that file for initial public offering. This financial information is taken from the prospectus. c Other includes observations of the same firm with different names, firms that have joint ventures and partnerships with public firms, firms that are public spin-offs, and holding companies of public firms. d We hand-collected audit data information only for those private firms that are missing information on Audit Analytics and have both private firms-years and public firm-years. e The corresponding sample of public equity firms with public debt has 11,322 firm-years and 1,950 firms. f The propensity score matched procedure results in 427 firm-years and 147 firms with public equity and public debt. g The 45 transition firms that move from private to public equity ownership have 93 private and 144 public firm-years. h The 22 transition firms that move from public to private equity ownership have 51 private and 101 public firm-years. 35

37 TABLE 2 Descriptive Statistics and Correlations for Steady-State Firms Panel A: Descriptive Statistics for Firm Characteristics for Steay-State (Non-Transition) Firms Private Firm-Years Public Firm-Years Difference Variable q1 mean median q3 std.dev. q1 mean median q3 std.dev. mean median AUDIT *** *** AUDIT_RELATED TOTAL *** *** AUDIT_S ** ** AUDIT_RELATED_S TOTAL_S * INVREC ASSET_GR BIGAUD ** 0.00 SEG *** *** MNC *** *** LIT *** 0.00 LOSS *** 0.00 LEV *** 0.39 *** ASSETS *** *** ABNACC *** ** POST_LS *** 0.00 AUD_TO *** 0.00 WORDCT *** *** SOX *** *** M_WEAK *** 0.00 Firm-Years ,322 *,**,*** indicates significance between the private and public firm-years at the 10%, 5%, and 1% level, respectively. Differences between means (medians) are tested for significance using a two-tailed t-test (two-tailed Wilcoxon signed rank test). All variables are as defined in the Appendix. 36

38 Panel B: Pearson (top) and Spearman (bottom) Correlations for Steady-State Firms PUBLIC AUDIT AUDIT_RELATED TOTAL AUDIT_S AUDIT_RELATED_S TOTAL_S INVREC ASSET_GR BIGAUD SEG MNC LIT LOSS LEV ASSETS ABNACC POST_LS AUD_TO WORDCT SOX M_WEAK Bold denotes significantly different from zero at the 5 percent levels or greater (two-tailed). 37

39 Panel C: Descriptive Statistics for the Propensity Matched Steady-State Sample Private Firm-Years Public Firms-Years Difference Variable q1 mean median q3 std.dev. q1 mean median q3 std.dev. mean median AUDIT *** *** AUDIT_RELATED ** 0.37 ** TOTAL *** *** AUDIT_S *** *** AUDIT_RELATED_S ** * TOTAL_S *** *** INVREC ASSET_GR BIGAUD ** 0.00 SEG MNC LIT LOSS LEV *** 0.13 *** ASSETS ABNACC POST_LS *** 0.00 AUD_TO ** 0.00 WORDCT SOX *** 0.00 M_WEAK *** 0.00 Firm-Years *,**,*** indicates significance between the private and public firm-years at the 10%, 5%, and 1% level, respectively. Differences between means (medians) are tested for significance using a two-tailed t-test (two-tailed Wilcoxon signed rank test). The propensity matching is based on the same fiscal year, industry (3-digit SIC code), and closest propensity score match, where propensity score match is based on leverage, abnormal accruals, sales, assets, and foreign operations. All variables are as defined in the Appendix. 38

40 TABLE 3 Results for Regressions of Audit and Total Audit Fees on a Public Firm-Year Indicator Variable and Other Control Variables Based on a Sample of Steady-State Public and Private Firms AUDIT AUDIT +AUDIT_RELATED TOTAL Coeff t-stat Coeff t-stat Coeff t-stat Intercept *** *** *** PUBLIC *** *** *** INVREC *** *** *** ASSET_GR *** *** *** BIGAUD *** *** *** SEG *** *** *** MNC *** *** *** LIT *** *** LOSS ** *** *** LEV *** *** *** ASSETS *** *** *** ABNACC ** ** ** POST_LS *** *** *** AUD_TO *** *** *** WORDCT *** *** *** SOX *** *** *** M_WEAK *** *** *** Adjusted R N 11,950 11,950 11,950 *,**,*** indicates significance at the 10%, 5%, and 1% level using a two-tailed t-test, respectively. Regressions include industry and year indicator variables, which have not been tabulated. This analysis is based on 628 private firm years (162 firms) and 11,322 public firm years (1,950 firms). The t-stats have been adjusted to control for the clustering by multiple firm observations. All variables are as defined in the Appendix. 39

41 TABLE 4 Regressions for a Sample of Steady-State Firms based on Propensity Matching AUDIT AUDIT +AUDIT_RELATED TOTAL Coeff t-stat Coeff t-stat Coeff t-stat Intercept *** *** *** PUBLIC *** *** *** INVREC *** *** *** ASSET_GR *** *** *** BIGAUD ** ** *** SEG *** *** *** MNC *** *** *** LIT *** *** *** LOSS * * * LEV *** *** *** ASSETS *** *** *** ABNACC POST_LS *** *** *** AUD_TO WORDCT *** *** *** SOX *** *** *** M_WEAK ** *** Adjusted R N *,**,*** indicates significance at the 10%, 5%, and 1% level using a two-tailed t-test, respectively. Regressions include industry and year indicator variables, which have not been tabulated. This analysis is based on 427 private firm years (112 firms) and 427 public firm years (147 firms). The t-stats have been adjusted to control for the clustering by multiple firm observations. All variables are as defined in the Appendix. 40

42 TABLE 5 Descriptive Statistics and Regression Analysis for Firms that Transition from Private to Public Equity Panel A: Descriptive Statistics for Firms that Transition from Private to Public Equity Private Firm-Years Public Firm-Years Difference Variable q1 mean median q3 std.dev. q1 mean median q3 std.dev. mean median AUDIT *** *** AUDIT_RELATED TOTAL *** *** AUDIT_S ** ** AUDIT_RELATED_S TOTAL_S * INVREC ASSET_GR BIGAUD SEG MNC LIT LOSS *** 1.00 *** LEV *** 0.22 *** ASSETS *** *** ABNACC POST_LS ** 0.00 AUD_TO WORDCT SOX *** *** M_WEAK ** 0.00 Firm-Years *,**,*** indicates significance at the 10%, 5%, and 1% level using a two-tailed t-test, respectively. Regressions include industry and year indicator variables, which have not been tabulated. The t-stats have been adjusted to control for the clustering by multiple firm observations. All variables are as defined in the Appendix. 41

43 Panel B: Regression Results for firms that Transition from Private to Public Equity AUDIT AUDIT +AUDIT_RELATED TOTAL Coeff t-stat Coeff t-stat Coeff t-stat Intercept *** *** *** PUBLIC *** ** ** INVREC ASSET_GR ** * BIGAUD SEG MNC *** *** *** LIT LOSS LEV ** * ASSETS *** *** *** ABNACC ** POST_LS AUD_TO WORDCT SOX * M_WEAK YEAR_IPO * * Adjusted R N *,**,*** indicates significance at the 10%, 5%, and 1% level using a two-tailed t-test, respectively. Regressions include industry and year indicator variables, which have not been tabulated. This analysis is based on 45 transition firms with 93 private firm years and 144 public firm years. The t-stats have been adjusted to control for the clustering by multiple firm observations. All variables are as defined in the Appendix. 42

44 TABLE 6 Descriptive Statistics and Regression Analysis for Firms that Transition from Public to Private Equity Panel A: Descriptive Statistics for Firms that Transition from Public to Private Equity Private Firm-Years Public Firm-Years Difference Variable q1 mean median q3 std.dev. q1 mean median q3 std.dev. mean median AUDIT * * AUDIT_RELATED TOTAL * AUDIT_S * AUDIT_RELATED_S TOTAL_S * * INVREC *** ** ASSET_GR ** * BIGAUD SEG MNC LIT LOSS *** 0.00 *** LEV *** 0.27 *** ASSETS ABNACC POST_LS AUD_TO * 0.00 WORDCT SOX M_WEAK Firm-Years *,**,*** indicates significance between the private and public firm-years at the 10%, 5%, and 1% level, respectively. Differences between means (medians) are tested for significance using a two-tailed t-test (two-tailed Wilcoxon signed rank test). All variables are as defined in the Appendix. 43

45 Panel B: Regression Results for firms that Transition from Public to Private Equity AUDIT AUDIT +AUDIT_RELATED TOTAL Coeff t-stat Coeff t-stat Coeff t-stat Intercept *** *** *** PUBLIC * * * INVREC ASSET_GR BIGAUD SEG *** ** * MNC ** LIT * LOSS LEV ASSETS *** *** *** ABNACC POST_LS AUD_TO *** * WORDCT SOX * * * M_WEAK ** ** FIRSTYEAR_PRV ** Adjusted R N *,**,*** indicates significance at the 10%, 5%, and 1% level using a two-tailed t-test, respectively. Regressions include industry and year indicator variables, which have not been tabulated. This analysis is based on 22 transition firms with 51 private firm years and 101 public firm years. The t-stats have been adjusted to control for the clustering by multiple firm observations. All variables are as defined in the Appendix. 44

46 45