Impact of Control Risks on Audit Fees - Research Paper Example

EXECUTIVE SUMMARY

This research examines the relationship between control risk and the determination of audit risk premiums and fixing audit fees. The research examines a broad array of secondary sources to determine the dominant elements and features of audit risk definition and how this influences audit fees.

The findings indicate that the main determinants of audit fees are legal liability, size of the audit, previous relationships with the client and market variables. The audit risk premium is almost always defined by the volume of work to be done in a given audit and this is based on control risk. Internal controls and their effectiveness in producing financial statements free of material errors is important and this influences the fees of most audit firms.

Empirical studies identify that audit control risk buildup includes abnormal accruals and earnings management. And this is vital in defining the volume of efforts and risk exposure that could lead to lawsuits which could be detrimental to a firm. A further study of audit fees over different years show that in the first year, most audit firms do not factor in control risks when fixing audit fees. This shows a trend of lowballing which is as low as 25% less than subsequent audits. Some writers attribute this difference to the fact that subsequent audits are based on realistic evaluation of control risks and integrating it to the risk premium.

Other studies show a direct link between control risk and audit risk premiums. This is because control risk determines the volume of work to be done and this has major impacts on audit activities and the effort to be integrated into the audit. However, there is evidence that other variables not considered to be part of the control risk play a role in the fixing of audit fees. This include reputation of the audit firm, relationship with the auditee and demand and supply variables.

INTRODUCTION

External auditors are required to exhibit an extremely high level of professionalism in their actions. This is because they are to provide an opinion about financial statements prepared by the directors. This is designed to be an objective opinion based on the facts of the previous year. This is safeguarded by the fact that audit work is to be done within a context of high professional ethics.

Technically, external auditors are providing a service to the shareholders of the company and other users who rely on the financial statement by delivering a view that is independent. However, in most situations, directors of companies have a lot of influence in determining the company auditors. In spite of this, audit reports are directed primarily at shareholders and other regulators particularly the Security and Exchange Commission (SEC) post-2001.

In spite of all the demands and expectations for independence and objectivity, there is an issue with the way audit fees affect the various risks of audits. By default, audit fees are determined by negotiations between the audit firm and the audit client and are finalized before the audit commences. In most companies, corporate governance rules require the audit committee, constituted by independent non-executive directors to determine the audit fee.

There have been numerous issues and problems with audit fees and other important and vital variables. For instance, there is a question of how well audit fees complement the audit risk. Will an auditor charge more if the audit risk is higher? What is the justification for this? The Post-Enron corporate world has sought to eliminate all matters and situations that could potentially lead to major problems and issues relating to directors controlling and unduly influencing auditors. Thus some fundamental questions arise in relation to how audit fees are defined and how responsive they are to realistic issues and risks relating to the actual audit and the audit documents.

RESEARCH AIMS & OBJECTIVES

The aim of the research is to determine the audit fee risk factors directly attributable to control risks. In order to attain this end, the following objectives will be explored:

• A critical analysis and review of the general determinants of audit fees;
• An evaluation of the internal control risks and their impacts on audit engagements;
• An assessment of the impact of internal control risks on audit fees;
• A determination of the audit fee risk premium.

RESEARCH STRUCTURE

This research will be conducted in four stages. The next stage of this research is a literature review which will involve an evaluation of fundamental theories and concepts related to the most important concepts of auditing and how audit fees are determined. The literature review will be followed by a methodology which will determine a structured approach and procedure through which data will be collected and analyzed to draw conclusions. The third phase of the research will present core findings. This study will be qualitative in outlook and will require the utilization of secondary sources like books, journals and other reports that show major trends of audit engagements and audit fee determination in the United States. Finally, the findings will be critiqued and theories will be formulated to answer the research questions.

LITERATURE REVIEW

This section of the dissertation will critique groundbreaking definitions and theories that are relevant and necessary for the completion of the entire research. In the broad sense, a risk is “the threat that an action or event will adversely affect an organization’s ability to achieve its objectives and execute its strategies successfully”. This means that a risk can affect any event and make the event lose its significance and goals. This should be forecast and necessary measures must be taken to ensure that such events or risks do not occur in the operations and activities of an organization.

Audit risk is viewed as “the risk of giving an inappropriate audit opinion on the fair presentation of an organization’s financial statements”. Audit risk is made up of three types of risks – inherent risks, control risks and detection risk. Inherent risk is the likelihood of material misstatements occurring in a given audit client’s activities due to error or fraud and this is done before considering the controls imposed by the audit client.

Control risks “reflect the possibility that the client’s system of control will allow erroneous items to be recorded and not detected in the ordinary course of processing”. This refers to the loopholes in the internal controls that are in place in the client’s firm and activities.

Detection risk is the risk that the procedures employed by the auditor will not detect a material misstatement. For all practical intents and purpose, detection of material misstatements is the fundamental duty of the auditor in an audit engagement. Therefore, the detection risk is the biggest and most direct risk that could derail the entire audit process and render it ineffective.

The general audit equation is that:

Audit Risk = Inherent Risk x Control Risk x Detection Risk

OR

AR = IR x CR x DR

Therefore an audit risk is defined by multiplying all the three forms of risks – inherent risk, control risk and detection risk. This leads to the identification of the level of effort that the auditor must utilize in formulating or designing the audit.

Detection Risk is futuristic and important in identifying the level of audit effort. The other two types of audit risk – Inherent Risk and Control Risk are historic. It is based on the nature of the system used to gather the financial information or that influenced the gathering of financial information in the period under review. Therefore, it can be solved and reviewed in order to draw a logical conclusion of the level of effort to be put into the detection. Therefore, the Detection Risk is an estimation that is conducted after evaluating and assessing the Inherent and Control Risks. Therefore, in modifying the equation we can say that:

DR = AR / [IR x CR]

This implies that detection risk is a function of the entire audit risk, divided by inherent risk and control risk combined. This implies that the Audit Risk is set by estimation. However, the auditor can assess the Inherent Risk and Control Risk and from there, deduce the Detection Risk.

Detection risk seem to have an inverse relationship with Inherent and Control Risk. This is because in situations where there is a lot of Inherent Risk and Control Risk, the auditor is required by default to increase effort. On the other hand, when there is a lower level of Inherent and Control risk, the audit effort is decreased. The increase in effort in a situation of high Inherent and Control Risk implies that there is a lower Detection Risk. This is because detection risk is reduced by the high effort since increasing the audit activities will make it difficult for risks to go unnoticed. On the other hand, when there is a low Inherent Risk and a low Control Risk, audit detection activities is likely to be lower because less will be done so Detection Risk is higher.

Figure 1: Relationship between Inherent/Control Risk, Audit Effort and Detection Risk

Figure 1 above shows how inherent and control risks generally influence audit effort. And this in turn, shows the extent to which detection could occur. And how detection risk is increased or decreased. The figure shows that where inherent and control risks are high, the audit effort is significantly increased. And this in turn, reduces the detection risk significantly. On the other hand, when the inherent and control risks are low, the audit effort is reduced. And this increases the detection risk.

In practice, there are some efforts towards the mitigation of audit risks. The following pointers are identified to be the most important elements for reducing audit risks;

• Careful audit planning;
• Representation letters from management;
• Adequate audit malpractice insurance

Audit fees are determined by a number of relevant variables and factors that are strongly linked to the issue of audit risk. This preliminary literature review brought to the fore, many different pointers and processes in the determination of audit fees amongst firms.

The first and most fundamental aspect of determining audit fee is the size of the audit firm. This is linked to the volume of work and the turnover and the activities that occurred within the activities of the auditee’s firm. There are many elements of audit risk that is reflected by the size of the audit firm. Thus, a lot of inferences can be made on the basis of what the audit client does and how the audit risk is skewed and determined by the auditee’s size.

There is also a question of the legal liability that comes with an audit engagement and this is important because it shows the level of risk that an audit firm is exposed to and its implications. Where the legal liability is large, it implies that there is the need for more effort and more activities to be conducted to deal with audit risks and its related processes. However, there are audit risk premiums that are charged on the basis of what the legal risk in a given audit entails.

There are also issues with relationships with the audit client which determines audit fees. The procedure is one that shows that when an audit firm provides other services permitted by law, there is a general trend to reduce costs of audits. On the other hand, when a firm is purely providing an external audit, they are likely to charge more.

Furthermore, the kind of market variables that exist at a given time plays a role in the determination of audit fees. Like all other industries, the audit industry is influenced by the principles of demand and supply. This is because there is a competitive element to bidding for audit engagements. And in this process, there is the risk that some people and some parties are likely to demand certain fees based on what other firms charge.

The discussions in this section have led to the identification of a pattern that shows some of the fundamental elements of audit fee determination. To this end, the following hypotheses can be put forward:

• Audit control risks determine audit risk premiums;
• Audit risk premiums play a role in defining audit fees.

This implies that audit control risk defines audit risk premiums which in turn provide information about the audit fees. This hypothesis is going to be subjected to further testing in the next stage of this research and findings will show important trends and processes that defines audit risk.

METHODOLOGY

The research for this project will be a qualitative research. The fundamental end is to identify the relationship between the three variables – audit control risks, audit risk premiums and audit fees. The three ideas and concepts are to be examined and reviewed on the basis of previous empirical studies that have been conducted in the research.

Data Collection

Data for this exercise will be collected from peer reviewed academic journals that have studied the relationship between two or all three variables of the research. This will include the identification of relevant pointers and linkages that define the way and manner in which the audit risk is built up in relation to audit risk premium and control risks.

The peer-reviewed journals will be chosen from popular databases and their methodologies and approaches will be used as a means of determining the core and most fundamental findings. The studies will show major trends and procedures that were carried out and this will be used as basis for the acceptance or rejection of the relationship between the variables as were studied in the relevant research.

Databases will be searched and evaluated significantly for journals and other articles which show empirical and real studies relating to the audit industry. This will be done by presenting various patterns and trends that were found in dominant databases in the United States and around the world.

The sample will be taken mainly from studies conducted in the United States. However, where appropriate, studies outside the United States will be used as basis for the identification of trends and possibilities that could be generalized and applied for the United States audit and accounting industry.

Data Analysis

Findings will be aggregated and interpreted. They will be reviewed in relation to how well they enforce or reject the hypothesis. This will include the evaluation of the study that was conducted and the main conclusions drawn in the empirical peer-reviewed studies. The patterns and dominant trends will be shown and presented as an explanation for the reality in fixing audit fees for various audit engagements.

Theorization

The findings will be analyzed and reviewed in relation to whether they support or reject the hypothesis that there is a link between audit control risk, audit risk premium and audit fee determination. This will be used as a basis to prove or disprove the variables and how they work together to define a pattern of predictability of audit fee determination amongst American audit firms and audit firms in other major nations around the world.

FINDINGS & DISCUSSIONS

The fieldwork culminated in the examination and critique of some peer-reviewed accounting sources. In all, there was a query of the words “DETERMINANTS OF AUDIT FEE” and “AUDIT FEE CONTROL RISK”. These two queries were made in the EBSCOhost using the Athens log in. In the search on EBSCOhost yielded 20,400 results for DETERMINANTS OF AUDIT FEE and 27,300 results for AUDIT FEE CONTROL RISK. This included the searches into related external and other internal websites that were relevant to the entire search questions and requirements.

The abstracts of the top 100 journals were critiqued for both of the searches. Out of this, 20 of the most relevant sources were downloaded and printed. They were studied further and 7 of them were identified to be of direct relevance to the research question. They were evaluated and applied to the fundamental research questions

Models for the Determination of Audit Fees

There have been numerous approaches and models for the estimation of audit fees in the industry. Most of them have sought to identify the main factors that build up the cost of audits and how auditors value their audits to their clients. Several studies have been done into this. And one of them, by Pong and Whittington (1994). In their study, “Two additional audit cost variables were collected. Pre-tax profits, P, was used as a possible audit risk variable, although, as discussed earlier, this could also be an ability to pay variable.” identifies eight core pointers that are important and vital in defining what auditors charge their clients:

• Total Asset
• Sales
• Profit
• Time trend
• Complexity
• Auditor change
• Debtor and stock level
• Membership of the Big 8

A regression analysis of the variables show that auditee size is the most important variable. This implies that auditee’s size plays a leading role in showing which amounts should be charged in a given audit. The writers stated that “we found some evidence to support our suggestion that size could be measured in two dimensions, assets and sales, but this was not robust to model specification. An asset measure (either total assets or stocks plus debtors) always had a significant influence on audit fees, and in our modified and extended models sales had a negligible independent influence. There was fairly strong evidence for economies of scale with respect to auditee size” .

The second most important variable is Complexity of Audit is most important variable for charges. Complexity is viewed “as measured by number of subsidiaries, always had a positive and statistically significant effect on audit fees.”. The complexity of an audit is a direct function of the control risks of an audit. This is because the audit risks are fundamental in defining the level of effort that will be invested into a particular audit. Therefore, if the control risks are high, the audit will become more complicated.

This shows that control risks are important as they define the complexity of the audit and are also influenced by the size of the firm. This is because when the auditee is a large corporation, the control risks are going to be multiplied and the implications and complexities for the auditor is likely to be increased.

Risks of Audit Complications, Control Risk and Audit Fee determination

There are some other researcher who conducted empirical research into the specific complications that are linked to control risks and how this affect the determination of audit fees. They came up with different conclusions and the journals reviewed showed some of the dominant and fundamental trends in the findings they came up with.

A study indicated that abnormal accruals are main element of audit risk in most national and city engagements. This study examined different auditees in cities and in larger multinational settings. The findings showed that the main booster of control risk is steeped in abnormal accruals.

Accrual complications are high in city-level and national entities and can be investigated through more demanding and more complicated methods. They state that “…the evidence is that differential Big 4 industry expertise is primarily the joint result of the expertise of national and office-based professionals, captured and distributed more broadly throughout the firm and within their offices.”.

In international engagements, there could be further complications and this could keep the auditor stuck for a longer period of time. Thus, there is the need to charge for the audit in a way that will compensate for these different difficulties. They go further to state that “Industry auditor specialists have incentives to protect their reputation against potentially harmful litigation by expressing more conservative audit opinions. They do so by stricter tolerance of their client’s accruals management, and by issuing more going-concern opinions.”.

There is a critical need for checking the pre-tax accruals lead to determination of prices amongst most Big-Four audit companies. This is a common pattern in audits and this drives up the prices in the big four audit firms in almost all parts of America – KPMG, Price Waterhouse Coopers, Ernst and Young and Deloitte. Thus, other smaller audit firms continue to modify their ways and systems to bridge this gap.

Additionally, earnings management lead to major risks of audit delays and this is a critical factor in determining audit effort and audit fees. Audit delays are often covered in defining fees and earning quality becomes a major aspect of defining these prices.

“Results reported in the paper are consistent with abnormal audit delays being significantly associated with poor earnings quality. The information about earnings quality contained in abnormal audit delays is incremental to the information conveyed by delays in releasing earnings reports. When the market values a dollar of reported earnings, it appears to discount the valuation by the extent of abnormal audit delay. This discounting is present even after controlling for the negative signaling about earnings quality conveyed by earnings report delays. These results are important for understanding the mechanism of the audit process.”. This therefore shows that the malicious attempts of managers to hide processes provide a major problem to auditors. However, this might be related more to detection risks as opposed to control risks.

Some authorities attribute earnings management to control risk since the directors are required under corporate governance to set up controls to avoid these. On the other hand, many view this as a function of detection risk since the auditors have the duty of identifying the main causes of these earnings management things and reporting them.

Evidence shows that some entities have extremely high control risks and it will be detrimental for auditor not to factor it into defining the fees for an audit. Johnson and Xie studied US manufacturing companies that have foreign exchange contracts, interest rate contracts and commodities contracts (2015). These firms have inherent risks that are almost always not properly compensated for in terms of control risks in audits

A firm will need more than one senior partner to handle such contracts to audit them properly. Therefore, the control risk that comes up with these complicated audits must be factored into the cost of audit and audit risk premium because it will be negligent and irresponsible not to do so.

Lowballing and Control Risk in Audit Fee Determination

In order to critique the impact of control risk, one important thing that many of the empirical studies identified is that there is a trend of lowballing which has a direct link to audit risk and its impact on audit pricing. It is identified that low-balling is common in seeking new jobs, but after that, audit control risk becomes an argument for increasing prices as it is used as a popular excuse for increasing audit effort requirements. Some of these researchers identified that lowballing almost always comes with some explanation linked to control risks.

Most first audit engagements are secured by lowballing and the audit fee is increased in future on the basis of control risks which are cited as reason for increasing prices. “Substantial variance in fee cuts was evident. For a subsample of 163 firms, percentage fee cuts were regressed against variables proxying for the client's financial condition, the change in the auditors' relative cost advantage or disadvantage in auditing a given client, the change in auditor class (if any), the number of auditors bidding on the engagement,”.

Ettredge a’nd Greenberg studied 387 firms that increased prices after the first year over a 4-year period and they found that most of them most of them reduced their first year fees by 23% - 25%.

The study showed that most of the first audits disregard audit condition and control risk in first engagement but in subsequent audits, they increase prices to reflect control risk. This leads to a 25% increase in audit fee which shows some degree of addition and integration of audit risk premium.

Direct Adjustments in Audit Risk Premium in Respect to Audit Control Risks

Study by Jiang and Son (2015) shows that there is a direct evidence of the need to adjust audit fees in proportion to audit control risks. This is because audit risks reflect audit risk premium and control risk is the most significant risk. They observed that firms have tolerable audit risk levels and when it is identified that the control risk systems are not effective, the risk increases and the risk premium is increased in a corresponding manner. Their findings state that:

“Employing a changes analysis approach, we find strong evidence of auditors responding to increased control risk by charging fees above the cost of conducting additional audits. This suggests that auditors adjust risk premiums as well as audit procedures in face of increasing control risk. In further analysis, we find some evidence that changes in risk premiums are also associated with changes in the severity of the underlying internal control problems.”.

Another related study undertook regression analysis of size and financial position and control risk its impact on audit fees. The study identified that auditor firms integrate a fee element that compensates for audit litigation risks and also for the level of effort that must be invested into projects. This shows a direct relationship between audit fees and audit control risks. This relationship is one that increases with audit risk and leads to many major position changes.

However, the Swanson model of fixing risk premium per audit in relation to control risks has a limitation – in that the findings show that audit risk premium and control risks are not easily quantifiable. Therefore, it is apparent that some other variables which cannot be determined off-head come to play where audit premium is being fixed. This shows a fundamental part of insurance risk premium definition which might be problematic.

CONCLUSIONS

The study indicates that there are some general determinants of audit fees. This include legal liability, size of the audit firm, relationship with the client and market variable. These pointers come together to define the audit fees and this is in turn, a part of defining audit risk premium. Audit risk is in three part, inherent risk, control risk and detection risk. From all the processes, it appears that control risk is the most central and most relevant form of risk. And if properly handled, detection risk loses its relevance in many ways and forms.

The research identifies that audit risk premium is influenced by many variables, most of which are linked to control risk. The main elements of defining audit risk premium is about the auditee’s size and the complexity of audit. Complexity of audit is almost always based on control risks. The most typical elements of control risks include the possibility for abnormal accruals, earnings management and other negative practices that leads to risks of fraud and error in the financial statement. In most cases, these control risks must be compensated for by more effort in dealing with them and this leads to delays in audits and more risk exposure for legal action against the auditor.

Another aspect of the determination of the relevance of control risk in determining the cost of an audit is found in the frequency of lowballing in first audits. Most first audits are quoted at a price far lower than the subsequent audits. This is explained by some researchers to be something that has a strong connection and linkage to the elements of control risk. This is because most audit firms charge about 25% less in their first audit. And they justify it by stating that there are control risks that are relevant.

There are other direct studies that have also shown that control risk is a major determinant of audit risk premium. This include the fact that audit risks are directly influenced by the level of work and effort necessary to work especially if there are major control risks and other inherent risks that compound these control risks.

However, the findings show that control risk is not the only variable in determining audit risk and audit fees. There are some risks like detection risk which could lead to delays and major legal claims against an audit firm. There are also risks of earning management which does not fall under the normal ambit of control risks but under the classification of detection risks. Also, other variables that cannot be quantified easily, like demand and supply and relationship with client as well as reputation are important in defining the audit fees charged by an auditor.