Abstract
The present study examines the empirical relationship between ownership characteristics and audit fees. The basic premise is that the level of ownership sophistication and the extent to which ownership is large and substantial impact the effectiveness of stockholder monitoring on corporate affairs including the financial reporting process. Furthermore, high managerial ownership firms may experience a decline in agency problems in financial reporting due to a decrease in managerial propensity to misreport financial results. By employing a cross-sectional least squares regression analysis for a sample of 358 New York Stock Exchange-listed firms audited by the Big Five auditors, we find evidence of a significantly positive relationship between diffused institutional stock ownership (i.e., having less than 5% individual shareholding) and audit fees, and a significantly negative relationship between institutional blockholder ownership (i.e., having 5% or more individual shareholding) and audit fees. Finally, we document that managerial stock ownership is negatively associated with audit fees. We do not, however, find evidence of any relationship between noninstitutional blockholder ownership (with at least 5% individual stock ownership) and audit fees. The study's main results hold in various specification tests including when the effects of board-related and audit committee variables are factored in the analysis. Based on the observed relationship between the ownership variables and audit fees, we suggest that the ownership characteristics of a firm as a part of its governance mechanism constitute an important determinant of audit fees.
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Notes
The demand for audit services and for quality-differentiated auditing is seen to be the efficient resolution of costly contracting problems (Watts and Zimmerman, 1986).
Inherent risk indicates the probability that financial statements contain material misstatements prior to the audit (Simunic and Stein, 1996). Greater inherent risk always has the potential for heightened audit risk (risk that some material misstatements may remain undetected during the course of audit).
Cohen et al. (2002) argue that in the presence of strong governance, audit firms could reduce sample sizes to be covered by an audit (e.g., the number of locations to be visited for inventory valuations) and the extent of costly substantive checking, which leads to lower audit investment and audit fees. Further, Whittington and Pany (2005) suggest that in response to low assessed control risk auditors reduce the level of substantive testing.
As defined by the Securities and Exchange Commission in Rule 13-f, institutional investors are entities such as bank trusts, insurance companies, mutual funds, and pension funds that invest funds on behalf of others and manage at least $100 million in equity. Entities such as arbitrageurs, brokerage houses, and companies holding stock for their own portfolio (as opposed to their pension funds) are not considered institutional investors by the SEC and are not required to disclose their equity investments. Institutional shareholders are often characterized as the sophisticated ownership group in various research contexts (e.g., Bushee, 1998; Utama and Cready, 1997; El-Gazzar, 1998; Duggal and Millar, 1999; Bartov et al., 2000; Wahal and McConnell, 2000; Balsam et al., 2002; Chung et al., 2002; Mitra and Cready, 2005). The use of institutional stock ownership as a sophistication variable is well established in accounting and finance research. The studies using such a variable look into the aggregate effects of institutional owners in the context of a specific economic circumstance or a research situation.
Reynolds and Francis (2001) suggest that reputation protection and litigation risk dominate auditor's reporting behavior.
Simunic and Stein (1996) suggest that total audit costs include a “resource cost and an expected liability loss component.” Resource cost increases with an increase in audit effort, and the proportion of liability loss component (ex-ante risk premium) increases with an increase in probable ex-post litigation loss liability. Auditors respond to higher audit risk by investing more in the audit and/or by charging a risk premium. Cohen et al. (2002) argue that consistent with the risk-driven audit approach (espoused by SAS No. 47, AICPA, 1983), as an audit firm evaluates audit strategy based on business process and business risk, corporate governance impacts audit planning and staff allocation decisions. Increase in risk induces audit firms to assign more experienced professional staff to a particular engagement, leading to greater audit investment and audit fees. Similarly, in response to lower risk, auditors tend to decrease their engagement efforts as a safeguard against possible audit failure.
In the audit planning stage, auditors assess the probability of misstatements contained in a client's financial statements and the effectiveness of internal control in the financial accounting process to prevent or detect such misstatements and then adjust the audit procedures to minimize the overall audit risk. Audit risk is a function of inherent risk of material misstatements, control risk that a client's internal control system may not prevent or detect such misstatements on a timely basis, and detection risk that auditors will fail to detect the misstatements with their audit procedures. The greater the inherent risk, ceteris paribus, the more resources the auditor will have to engage in an audit to reduce the detection risk and, therefore, the audit risk to an acceptable level (Gul and Tsui, 1998). Inherent risk of material misstatements varies with the nature of accounts. In general, assertions with high inherent risk are: difficult to audit transactions or balances; complex calculations; difficult accounting issues; significant judgment by management; and valuations that vary significantly based on economic factors (Whittington and Pany, 2005). In the face of high audit risk, auditors may also include a risk premium in the quoted fees to cover future litigation loss liability that may arise from probable audit failure.
Among many things, O’Keefe et al. (1994), however, find no systematic evidence about the effect of the client's internal control on the level of the auditor's engagement effort.
Jiambalvo (1996) suggests that if managers want to manipulate reported earnings, they can choose from a number of manipulation methods, some involving operating, financing, and investment decisions and others involving pure accounting decisions. Examples are as follows:
Operating decisions: Delay or accelerate research and development expenditures; delay or accelerate maintenance expenditures; delay or accelerate sales.
Financing decisions: Early extinguishment of debts.
Investment decisions: Sales of securities or fixed assets to affect gain or loss.
Pure accounting decisions: Change in accounting principles; change in useful life of fixed assets; change in estimated residual value of fixed assets; change in policy about capitalization versus expensing certain costs; estimation of bad debt expenses; deferral of costs previously recognized as expenses; early or delayed recognition of revenues and expenses; classifying more indirect manufacturing costs as period expenses or classifying a greater number of overhead cost items as product costs though some of them qualify for period expenses.
Core (1995) argues that the presence of large blockholders of shares reduces the agency costs, since managers would be more inclined to act in the interest of such shareholders and would reduce the extent of fraudulent reporting through accounting manipulation to avoid litigation.
(1) GM's management made major policy changes less than three weeks after a threat was made by the Council of Institutional Investors (Hessel and Norman, 1992), a pension fund organization collectively owning over $1 trillion of assets and taking active part in the corporate governance. The co-chairperson of the council has made it clear that such pressure would continue when he said: “The Council members want to meet with CFOs to make sure that their opinions are considered when policies are formulated and to ensure that management feels accountable to someone outside the firm.” Moreover, a study by Opler and Sokobin (1995) on the activism of the Council of Institutional Investors provides evidence that the firms on the council's focus lists subsequently experienced significant improvements in operating profitability and share returns. Based on the results, Opler and Sokobin (1995) suggest that coordinated institutional activism creates shareholder wealth. Furthermore, McConnell and Servaes (1990) find evidence of a positive relationship between institutional ownership and firm value. They attribute the results to lower agency costs when the firm has a greater proportion of institutional ownership.
(2) Kane and Velury (2004) suggest that institutional investors influence management in two ways. First, as large suppliers of equity capital, they have enormous influence over a significant percentage of security trade, thereby directly impacting the market price of stock. This certainly gives them substantive leverage in negotiation with a firm's management. As large capital providers, they have significant power to alter a firm's cost of capital, a vital input in a firm's capital structure and a major component of firm valuation. Second, because of their large percentage shareholdings, institutional investors hold substantial voting rights that can be used to influence management's strategic decisions. Kane and Velury (2004) argue that mere potential to use voting power, as opposed to actual use, allows institutions to influence management.
In the 1990s, there was a wave of activism by large institutional investors such as CalPERS, Putnam Management, J.P. Morgan, and others. These institutions lobbied for the removal of CEOs at several large, poorly performing firms including Kodak, Westinghouse, IBM, Borden, American Express, and General Motors (Economist, 1993).
In an interview with investment managers from four different institutions, the managers emphasized that they spend much time and effort in information collection and in-house analysis to improve portfolio performance and to satisfy their fiduciary responsibilities (El-Gazzar, 1998). Several prior studies document the effect of institutional investors’ superior information processing abilities on equity valuations. Bartov et al. (2000) observe that institutional investors reduce the post-earnings announcement drift in stock prices, while Jiambalvo et al. (2002) document that the extent to which stock prices lead earnings is positively related to institutional stock ownership. With the increase in institutional stock ownership, stock prices tend to reflect a greater proportion of the information in future earnings relative to current earnings. These results indicate that an increase in institutional investment is associated with greater information dissemination, with a corresponding reduction of information asymmetry between managers and shareholders. Institutional monitoring is also deemed to improve the perceived credibility of reported earnings as reflected in an increased earnings response coefficient (Rajgopal and Venkatachalam, 1998).
We use two forms of institutional stock ownership, diffused and substantial. We define less than 5% individual shareholding as diffused stock ownership and 5% or more individual stock ownership as substantial. This 5% individual shareholding is based on the SEC's Rules 13D and 13G requiring that any person or group of persons who acquire a beneficial ownership of 5% or more of equity securities must file a schedule 13D or 13G (depending on the category of investors) reporting such acquisition together with certain other information. The 5% threshold level is also used to define substantial individual shareholding by prior research (e.g., Core et al., 1999; Eng and Mak, 2003). Investors having different levels of individual stock ownership have different abilities, resources, and incentives to monitor management actions. Therefore, it is more appropriate to examine the association between these two institutional ownership constructs and audit fees rather than using a single overall institutional stock ownership variable.
In this respect, Opler and Sokobin (1995) argue that one way for institutional investors to exert pressure on a firm's management is to create a third-party monitoring organization. Such an organization can serve as a focal point for diffused investors and give such investors more credibility to challenge management. Their results support this view by showing that the firms on the focus list of the Council of Institutional Investors experienced significant increases in shareholder value. Furthermore, Black (1990) suggests that organized institutional shareholders can exercise significant clout at a fairly low cost as a result of economies of scale from their organized activism.
Kaplan and Minton (1994) suggest that blockholder ownership helps control agency problems. Beasley and Salterio (2001) propose that blockholders act as an alternative monitoring mechanism to the audit, thereby reducing the need for monitoring by the audit committee and, presumably, the degree of audit intensity demanded from the auditor. In another influential study, Dechow et al. (1996) observe that firms subject to the SEC's enforcement actions are less likely to have outside blockholders and more likely to have their board of directors dominated by management. They suggest that a firm's ownership structure impacts its earnings management decisions and sophisticated investors are more likely to expose such earnings manipulation in financial reporting.
According to Shleifer and Vishny (1986), the outside blockholders may also have representatives on the board of directors or have the potential power to influence the activities of the board of directors. The threat of dismissal of top managers is another method for alleviating the agency problem that arises because of the separation between ownership and control. The fear of antagonizing a few influential blockholders could encourage managers to act in the best interest of shareholders. Shleifer and Vishny (1986) refer to the ability of large shareholders to influence management as “jawboning.”
Beasley et al. (1999) suggest that shareholders often suffer significant losses in the wake of financial reporting problems.
Since the owners of most large U.S. corporations are separated from firm management, there is a possible incentive for managers to misreport financial results for opportunistic purposes (Jensen and Meckling, 1976; Watts and Zimmerman, 1986). Managers often engage in non-value-maximizing activities to increase their compensation and other perquisites, and/or participate in activities associated with management entrenchment (Shleifer and Vishny, 1989). The adverse effects of such non-value-maximizing activities can be masked by accounting manipulation (Christie and Zimmerman, 1994).
Gul et al. (2003) argue that in a high managerial ownership firm there is a greater probability that accruals are likely to be realized in the future, which implies that accrual adjustments are informationally driven rather than opportunistically driven when manager-shareholder interests are more closely aligned. This is consistent with the notion that managers whose interests are aligned with shareholders are more likely to report income that reflects the underlying economic value of the firm (Warfield et al., 1995). Moreover, McConnell and Servaes (1990) demonstrate that a higher proportion of insider ownership mitigates agency problems and improves firm value.
Tsui et al. (2001) demonstrate that a corporate board independent of the CEO is more effective in providing internal monitoring, which has the effect of reducing internal control risk and the level of audit fees, while Klein (2002) observes that boards independent of the CEO are more effective in monitoring the financial accounting process. Carcello et al. (2002) show that the audit fee has a positive relationship with the number of board meetings (a proxy for board diligence), board expertise, and the percentage of nonmanagement board members, while Abbott et al. (2003) document that audit committee independence and financial expertise (developed in terms of the Blue Ribbon Committee recommendations, Improving the Effectiveness of Corporate Audit Committees) are positively related to the level of audit fees. However, Abbott et al. (2003) find no evidence that audit committee diligence in terms of number of audit committee meetings is related to audit fees.
This is consistent with Carcello et al. (2002) and Abbott et al. (2003). Using firms audited only by Big Five auditors provides a uniform basis of evaluating the study's results because audit quality and brand name reputation (e.g., Craswell et al., 1995) differentially impact the level of audit fees charged by the Big Five and non-Big Five audit firms.
The SEC's rule (2000) requires that firms submitting their annual proxy statements on or after February 5, 2001 must separately disclose information relating to audit and nonaudit fees paid to their external auditors during the most recent fiscal year.
Various diagnostic tests, therefore, indicate that the model employed in the study is well specified. Variance inflation factors (VIF) and condition indices suggest that the influence of multicollinearity is of inconsequential magnitude. Normal probability plot does not indicate any nonnormality in the data distribution. In general, residual plots do not exhibit any systematic pattern of error distribution. When plotted against various independent variables of interest, the residuals are found to be randomly distributed with no pattern. Moreover, the influence statistics, Cook's D and DEFFITS do not indicate the presence of influential data points that might significantly affect our empirical findings.
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JEL Classification M42
Data availability: Data used for this study are obtained from publicly available sources described in the text.
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Mitra, S., Hossain, M. & Deis, D.R. The empirical relationship between ownership characteristics and audit fees. Rev Quant Finan Acc 28, 257–285 (2007). https://doi.org/10.1007/s11156-006-0014-7
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DOI: https://doi.org/10.1007/s11156-006-0014-7