The effect of control risk, audit firm size and auditor change on audit fees : an empirical study in New Zealand

Abstract

Concerns about the rising costs of external audit services in the 1970's prompted a series of research studies in an attempt to provide more understanding of the fee setting process and of the behaviour of the audit market. Earlier research studies developed audit fee models to identify variables explaining the variations in the level of audit fees. The development of audit fee models enables subsequent research studies to examine the market behaviour of external audit services.

A number of studies in the literature focused on examining the competitiveness of the audit market. The market of external audit services may be monopolised by the Big 6 international audit firms if there is a lack of competition. On the other hand, if the market is highly competitive, auditors may reduce their audit fees in order to obtain new audit clients. Both monopoly pricing and price cutting behaviour are socially undesirable since the former allows the Big 6 auditors to charge an unreasonable monopoly rent while the latter may result in sub-standard audits.

The fundamental purpose of this study is to provide better understanding of the market behaviour of external audit services in a New Zealand setting. Three objectives are set out to achieve such goal. The first objective is to extend the audit fee model by introducing variables not tested in previous studies. The variables are related to control risk and are expected to have a negative relationship with audit fees. The second objective is to examine whether the New Zealand audit market is competitive, by studying the effect of audit firm size on audit fees, while the third objective is to investigate whether price cutting occurred in cases of auditor change in this country.

The sample included in this study was 135 listed companies. Data were obtained from annual reports of the sample companies, The New Zealand Stock Exchange Security Code and Description List, the members handbook 1994/95 published by The Institute of Internal Auditors of New Zealand and the New Zealand Company Register 1995.

The results of data analysis fail to identify a negative relationship between control risk variables and audit fees. On the contrary, two of the three control risk variables are found to have significant positive association with audit fees.

With respect to the effect of audit firm size on audit fees, the results reported in this thesis also indicate that the New Zealand audit market is competitive. The Big 6 audit firms charge a premium for product differentiation and better reputation.

The last finding of this study suggests that pricing cutting does not exist in cases of auditor change. On the contrary, the audit fees for initial audit engagements are found to be significantly higher than subsequent audits.