The Effects of Internal Control Quality and Its Changes on Audit Fees Hong-juan JI

Transcription

1 2017 2nd International Conference on Modern Economic Development and Environment Protection (ICMED 2017) ISBN: The Effects of Internal Control Quality and Its Changes on Audit Fees Hong-juan JI School of Economics and Management, Nanjing University of Science and Technology, Nanjing, Jiangsu, China Keywords: Internal Control, Audit Fees, Separation Between Control and Ownership, Property Rights. Abstract. This paper mainly investigates whether and how internal control quality and its changes make effect on audit fees. The results show that firms with worse internal control have higher audit fees. Furthermore, improving the internal control quality will not reduce the audit fees. But the deterioration of the internal control will increase the audit fees significantly. In addition, the paper finds that the separation between control and ownership can enhance the negative relationship between the deterioration of the internal control and audit fees to some extent, and compared with the non state-owned firms, this negative relationship will be weaken in the state-owned firms. 1. Introduction Audit fee is the price of audit services provided by external auditors. It has significant relationship with the independence and quality of audit services. Since early 20 th century, scholars have studied the influence factors of audit fees. In order to strengthen internal control and protect the interests of investors, the United States Congress enacted the SOX. The expensive execution costs of the SOX have triggered a heated debate on costs and benefits. As one of the costs of the implementation of the SOX, audit fees have attracted the attention of the theoretical and practical fields. Scholars have begun to consider the relationship between internal control and audit fees. For the study of internal control and audit fees, foreign scholars mainly propose two perspectives: substitution theory and complementary theory. Substitution theory holds that auditors will reduce audit resources and audit fees when auditees have higher internal control quality [1-3]. Complementary theory believes that in order to effectively supervise the implementation of internal control, the governance layer of the firms with higher internal control quality will actively require auditors to expand the audit scope, and hire the accounting firms with high-quality services [4]. These accounting firms tend to have reputation premium and the expansion of the scopes will increase audit costs. In addition, some scholars have explored the relationship between the internal control and audit fees from a dynamic perspective. Some scholars found that the remediation of the internal control weaknesses did not significantly reduce the audit fees [2,5,6]. Munsif et al. found that in the case of accelerated filers remediating auditees pay lower fees compared to auditees continuing to report internal control problems [7]. The current researches mainly focus on the firms with internal control weaknesses. No one has studied the overall relationships between the internal control and the audit fees. The paper adopts the internal control index from the DIB to investigate the relationships between internal control quality and the audit fees, and explore whether and how the audit fees vary with the changes of internal control quality. The paper finds that the internal control quality has negative relationship with audit fees. The deterioration of the internal control will make the audit fees increased significantly, but the improvement of the internal control does not make the audit fees significantly reduced. To some extent, the separation of control and ownership can enhance the negative relationship between the deterioration of the internal control and audit fees. And compared with the non state-owned firms, this negative relationship will be weaken in the state-owned firms. 34

2 2. Theoretical Analysis and Research Hypothesis 2.1 Internal control quality and audit fees The audit pricing model proposed by Simunic divides the audit fees into two main parts: Audit Fee = Audit cost + Risk premium [8].Where audit cost is the resource cost; risk premium is the compensation for the potential loss of auditors. According to the risk-oriented auditing, auditors need to assess the risk of auditees and understand the internal control, and then plan further audit procedures. The audit pricing model shows the impact path of internal control on audit fees. Firstly, the internal control quality has greatly affected the investment of audit resources. Because of the information asymmetry, auditors tend to make audit fees based on the internal control. The perfect internal control effectively inhibits the opportunistic behavior of the managers, and then improves the accuracy and reliability of financial data [9]. So auditors will reduce the substantive procedures, and take more control tests. And thereby reduce the audit costs. Because of the grasp of more information, poor internal control gives managers more changes to seek personal gain. It will increase the earnings management [10], reduce the accounting conservatism and the financial information quality [9,11]. So auditors tend to invest more audit resources to ensure the quality of auditing. In addition, for firms with poor internal control quality, auditors need to spend more time discussing with managers [1], which will increase audit fees. Secondly, internal control quality affects the risk premium. The insurance theory believes that auditing has insurance value. The auditees transfer part of the risk to the auditors through the audit fees. In order to compensate for the loss of reputation and liability caused by the potential litigation risk, auditors will charge the risk premium. In the firms with poor internal control, financial reporting problems cannot be found timely [12], and the risks of management fraud rise. So auditors have to increase audit costs to reduce the risk, and increase the risk premium to compensate for the potential losses. On the contrary, good internal control can not only reduce the misstatement risk caused by negligence, but also reduce the risk of management fraud. So through the theoretical analysis, this paper proposes the following hypothesis: H1: Internal control quality is negatively related to audit fees. 2.2 The changes of internal control quality and audit fees At present, some scholars have already explored the impact of the remediation of internal control weaknesses on audit fees, namely the internal control quality from bad to good. But no one has studied the impact of the changes from good to poor. The disclosure of internal control weaknesses will bring a series of negative effects to the firms, such as more financing constraints and financing costs, more attention from the external regulators [13,14]. Under both internal and external pressures, managers will actively take measures to correct the deficiencies. With the improvement of internal control, insider trading behavior and the earnings management will be reduced [9,10], and the quality of financial reporting will be improved [12]. So auditors will reduce investment and audit fees. However, previous studies show that the remediation of internal control weaknesses will not reduce audit fees quickly and significantly. Compared with the firms that didn t disclose internal control weaknesses, audit fees of these firms are still higher [2,5,15]. Firstly, based on the principle of prudence, auditors will expand the scope to test the effectiveness of internal control when firms have corrected the weaknesses [2]. Secondly, auditors will require more risk premium to reduce the potential risk. In addition, the audit fees have downward price stickiness [16]. So the improvement of the internal control will not lead to a significant decline in audit fees. When the internal control quality decline, internal control risk will increase. Auditors will take more substantive tests, and spend more time communicating with these firms. So audit fees will increase when the internal control quality deteriorates. Moreover, the separation between control and ownership, the property rights and the bargaining power of the auditees also affect the audit fees. When the separation between ownership and control is high, the agency conflicts between actual controllers and small shareholders increase. Because auditing can effectively reduce the conflicts, these firms tend to hire the accounting firms with great 35

3 quality [17]. The separation also decreases the quality of financial statements [18], which will increase the audit risk. And this will eventually be reflected in the increase of audit cost and risk premium. Compared with the non state-owned firms, state-owned firms are more likely to get the support from the state. Considering the social impacts of these firms, regulators tend to treat these firms with a lighter attitude of leniency when they have illegal actions. So the audit risk of state-owned firms is smaller. When the auditees are important to the auditors, auditors will not significantly increase audit fees to avoid the loss of customers, even if the internal control quality decline. Based on the theoretical analysis, this paper proposes the following hypotheses: H2: Auditors will reduce the audit fees when the internal control quality rises, and increase the audit fees when the internal control quality declines. The impact of the deterioration of internal control quality on audit fees is larger than the impact of the improvement. H3: The separation between control and ownership can enhance the negative relationship between the deterioration of the internal control and audit fees. The bargaining power of customers can mitigate the negative relationship. Compared with the non state-owned firms, the negative relationship will be mitigated in the state-owned firms. 3. Research Method 3.1 Research design This paper studies the impacts of internal control quality and its changes on audit fees. And further explore the influence of bargaining power of customers, the separation between control and ownership and the property rights on the relationship between internal control quality and audit fees. In order to test H1, the paper builds the following regression model: lnfee, =β +β lnici, + Control, +ε, (1) The paper predicts that coefficient β is less than 0. In order to test H2, the paper adds a dummy variable in the model (1) to measure the change direction of the internal control quality [16]. The model is as follows: lnfee, =β +β lnici, +β D, +β lnici, D, + Control, +ε, (2) If coefficient β is less than 0, the audit fees decline as the internal control quality improved. The range of the decrease of audit fees caused by the improvement of internal control quality is lower than the increase of audit fees caused by the deterioration of internal control quality if coefficient β is less than 0. The range of the decrease of audit fees caused by the improvement of internal control quality is higher than the increase of audit fees caused by the deterioration of internal control quality if coefficient β is more than 0. The paper further consider the regulatory effects of the separation between control and ownership, the property rights and the bargaining power of customers on the relationship between the changes of internal control quality and audit fees. The model is as follows: lnfee, =β +β lnici, +β D, +β lnici, D, +β SOC, +β lnici, SOC, + β lnici, D, SOC, +β CI, +β lnici, CI, +β lnici, D, CI, +β State, + β lnici, State, +β lnici, D, State, + Control, +ε, (3) The paper predicts that β is smaller than 0, β larger than 0, and β larger than 0. In order to make the empirical results more accurate, the paper controls some variables related to the auditees and the accounting firms. All variables are defined in table 1. Table 1. Definition of Variables. Variable symbol Variable name Description lnfee Audit fee Natural log of audit fees lnfee Changes of audit fee lnfee, - lnfee, lnici Internal control quality Natural log of internal control index from the DIB 36

4 lnici Changes of internal control quality lnici, - lnici, The separation between control and The control proportion of actual controller ownership SOC ownership proportion The importance of the auditee=total assets of aditee CI The importance of the auditee total assets of all auditees of one accounting firm State Property rights It is equal to 1 if the auditee is state-owned firm, else 0. D Dummy variable It is equal to 1 if lnici<0, else 0. lnasset Asset size Natural log of total assets of auditee. Foreign Foreign operations It is equal to 1 if converted difference in foreign currency statements is not equal to 0, else 0. Age The age of auditee The age of the listed company. ROA Average return on total assets Net profit 2 (total assets at the beginning of the period + total assets at the end of the period) DA Asset-liability ratio Total liabilities total assets CR Current ratio Current assets current liabilities Rec Proportion of receivables Total receivables total assets Inv Proportion of inventory Total inventory total assets Cata Proportion of current assets Current assets total assets Loss Operating losses It is equal to 1 if auditee operated at a loss, else 0. DFL Financial leverage (net profits + income taxes expense + financial costs) (net profits + income taxes expense) AT Total assets turnover Income average total assets Growth Sales growth rate (Income in period t Income in period t+1)-1 MO Managerial ownership The number of management holding Total capital stock TOP1 Largest shareholder holding ratio The number of the first shareholder holding Total capital stock INDR Independent directors ratio The number of independent directors Number of board members Dual Combined title of board chair and It is equal to 1 if chairman and general manager hold a CEO concurrent post, else 0. Switch Change accounting firm It is equal to 1 if the auditee changes accounting firms, else 0. MS Market share of the accounting firm Income of one accounting firm in period t-1 income of all accounting firms in period t-1. Big4 Big4 It is equal to 1 if the auditor is one of the Big4, else 0. Big10 Top local ten accounting firms It is equal to 1 if the auditor is one of the top local ten accounting firms, else 0. CPI CPI Consumer price index Year Year A dummy indicator for year Industry Industry A dummy indicator for industry. Prov Province The region the auditee belongs to. 3.2 Sample selection In order to shed light on the hypotheses, the study takes listed companies from Shanghai and Shenzhen stock exchange as research objects for the period 2010 to The information and data included in this paper is from CSMAR, RESSET and the official website of China Certified Public Accountants Association. In this research, samples are processed as follows: (1) exclude listed companies under special treatment; (2) exclude financial firms; (3) exclude the companies that have IPO during the sample period; (4) exclude the companies whose continuous observations of internal control index and audit fees are less than two years. All continuous variables are winsorized at the 1st and 99 th percentiles. Excel 2007 and Stata14.0 are used in data processing. 37

5 4. Results 4.1 Descriptive Statistics Table 2. Descriptive Statistics. Variable N Mean Median Min Max S.D. lnfee lnici lnfee lnici D SOC CI State Table 2 shows the descriptive statistics of the main variables. The differences of audit fees of listed companies are large. Because the maximum score of internal control index is1000 points, the internal control quality of listed companies meet the basic requirements. Compared with the previous period, 55% samples internal control quality falls. The mean of lnfee is larger than 0, but the median is 0, which means less than half of the samples whose audit fees rise and the increasing degree is large. The standard deviation of SOC is large, but most of the samples SOC are small. The descriptive statistics of CI indicate that firms rely less on customers. More than half of the samples are state-owned firms. 4.2 Results of hypothesis tests Internal control quality and audit fees. Column 1 in the table 3 is the results of model 1. The coefficient of lnici (β1) is significantly negative (p<0.01), which means internal control quality is negatively related to audit fees. Auditors will take the effectiveness of the internal control into account when they negotiate the audit fees. Firms with great internal control will have high-quality information and less possibility of financial misstatement. So auditors will take more control tests, which will reduce audit cost and risk premium. So H1 has been verified. The changes of internal control quality and audit fees. The columns 2 to 7 examine the impacts of the changes of internal control quality on audit fees. Column 2 shows that the coefficient of lnici (β1) is negative, but not significant, which indicates that the audit fees do not respond quickly to the changes of internal control quality. Column 3 is the results of model 2. It shows that the coefficient of lnici (β1) is positive, but not significant. The coefficient of D lnici (β3) is negative and statistically significant (p<0.1). The results in column 2 and 3 indicate that when the internal control quality decreases by 1%, % increase in audit fees (β1+β3), but the increase in internal control quality is not make the audit fees significantly reduce, which verifies the H2 partially. The columns 4 to 7 further examine the influence of the separation between control and ownership, the importance of the auditee and the property rights. The results in columns 4 to 6 examine the individual effects of SOC, CI and State, respectively. The results show that the coefficient of SOC lnici D (β6) is significantly negative (p<0.05), the coefficient of CI lnici D (β9) is positive but not significant, and the coefficient of State lnici D (β12) is significantly positive (p<0.01). Column 7 shows the results of the joint test of SOC, CI and State. The results show that only the coefficient of State lnici D (β12) is significantly positive (p<0.01). The results in columns 4 to 7 suggest that when the internal control quality decline, the importance of auditee is not got enough consideration in pricing. The high separation between control and ownership can enhance the negative relationship between the deterioration of the internal control and audit fees to some extent. Compared with the non state-owned firms, this negative relationship will be weaken in the state-owned firm. So H3 is partially supported. 38

6 Table 3. Regression Results. Variable (1) (2) (3) (4) (5) (6) (7) lnici lnici D D lnici SOC SOC ln ICI SOC D lnici CI CI lnic I CI D l nici State State ln ICI State D lnici Control variables *** (-2.75) (-1.48) (0.69) (-0.18) (0.86) (1.31) (0.78) (0.81) (0.81) (0.81) (0.74) (0.75) * ** *** *** (-1.89) (-0.10) (-2.05) (-4.46) (-2.75) * * * (-1.94) (-1.83) (-1.90) (1.22) (0.90) ** (-2.19) (-1.47) * ** (-1.07) (1.71) (2.28) (-0.46) (-0.39) (0.63) (0.43) (-0.44) (0.93) (0.03) (-1.38) (-1.09) *** *** (4.06) (3.40) Control Control Control Control Control Control Control Cons *** (8.62) (-1.49) (-1.48) (-1.16) (-1.43) (-1.51) (-1.13) Year Control Prov Control Control Control Control Control Control - Industry N Adj_R *, **, *** Denote significant at the 0.1, 0.05, and 0.01 levels, respectively. T-values are in parentheses. 4.3 Robustness test Use the ratio of audit fee (ROF) to measure audit fees. ROF is the ratio of audit fees to total assets. ROF can more accurately reflect the influence of various factors on the audit pricing because of excluding the effect of assets [19]. The regression results show that besides the decrease of goodness-of-fit of the models, the rest of the results are basically consistent with the former. Exclude the samples changing accounting firms. Previous studies have shown that there are low balling phenomena in Chinese audit market. The paper excludes the samples changing accounting firms for robust test. The results are basically consistent with the former. Exclude the samples audited by Big4. Because of the brand effect and high quality services, audit fees of Big4 are obviously higher than local firms [20]. Therefore, the samples audited by Big4 are eliminated for robust test. The results show that no significant change is observed. 39

7 Change the measurement of control variables. The paper chooses the natural log of revenue for company size [21], replaces average return on total assets with average return on equity, and replaces TOP1 with H10. The results of robust test show that there is no substantial change. 5. Conclusions The paper explores the effect of internal control quality and its changes on audit fees. Different from previous studies, this paper does not limit the samples to firms with internal control weaknesses. It studies the overall relationships between the internal control and the audit fees and further considers the effects of the separation between control and ownership, property rights, and the importance of auditee. Through analysis, this paper draws the following conclusions: Firstly, internal control quality is negatively related to audit fees. Effective internal control can inhibit the opportunistic behavior of the managers, improve the reliability of financial information, reduce the possibility of material misstatement. Compared with the firms with poor internal control, auditors will reduce the audit resources, which will save the audit cost, reduce the risk premium. Secondly, compared with the previous internal control quality, the improvement of the internal control quality this year will not significantly reduce audit fees. But the deterioration of the internal control quality will significantly increase audit fees. Based on the principle of prudence, auditors usually do not enhance the trust of internal control, even if auditees have improved the internal control quality. In these firms, auditors still invest significant resources to reduce audit risk, and charge a higher risk premium to cover potential losses. However, the deterioration of the internal control quality can catch the auditors attention quickly, and is directly reflected in the increase of audit fees. Therefore, the poor internal control has a longer-lasting negative effect on firms. In order to reduce costs, companies should constantly improve the internal control. Thirdly, the separation between control and ownership can enhance the negative relationship between the deterioration of the internal control quality and audit fees to some extent. The effect of the importance of the auditees on this negative relationship is not obvious. Compared with the non state-owned firms, this negative relationship will be weakened in the state-owned firms. The higher separation between control and ownership exacerbates the agency conflicts between controlling shareholders and small shareholders. The deterioration of internal control quality brings more opportunities for controlling shareholders to rob the corporate wealth. So for the auditees with higher separation, auditors will be more cautious, and invest more resources to reduce the risk. When the internal control quality falls, the importance of the auditee does not significantly increase the bargaining power of the auditee. This shows that the accounting firms have absolutely dominant position in the price game. Compared with the non state-owned firms, state-owned firms are less likely to be punished by regulators and to have financial distress because of their special status, thus have smaller overall risk. Audit risk does not necessarily rise with the decline of internal control quality. So the negative relationship between the deterioration of the internal control quality and audit fees can be weakened in the state-owned firms. References [1] K. Raghunandan and D. V. Rama. SOX Section 404 Material Weakness Disclosures and Audit Fees [J]. Auditing: A Journal of Practice & Theory, 2006, 25 (1): [2] R. Hoitash, U. Hoitash and J. C. Bedard. Internal Control Quality and Audit Pricing under the Sarbanes-Oxley Act [J]. Auditing: A Journal of Practice & Theory, 2008, 27 (1): [3] D. M. Yang and T. Hu. Internal control, earnings management and audit opinions [J]. Auditing Research, 2010, 05: [4] D. Hay, W. R. Knechel and H. Ling. Evidence on the Impact of Internal Control and Corporate Governance on Audit Fees [J]. International Journal of Auditing, 2008, 12 (1):

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