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The purpose of this study is to test whether the realization rate on audit engagements increases with auditor tenure in competitive markets, suggesting the presence of…
The purpose of this study is to test whether the realization rate on audit engagements increases with auditor tenure in competitive markets, suggesting the presence of initial audit lowballing.
Using regression analysis, we test this hypothesis with fee- and cost-related data from a sample of local governments audited by a single audit firm. Based on representations of the firm, we classify the audit market for the 127 cities, counties and school districts in our sample as competitive and the audit market for the 93 special district audits as non-competitive.
As hypothesized, we find that in the competitive market, the realization rate on audit engagements increases with auditor tenure but does not do so in the non-competitive audit market.
We cannot identify the specific engagements which were subject to a competitive bidding process, so we rely on the auditor’s representation of competitiveness by entity type.
To our knowledge, the central prediction of audit pricing models that the auditor’s realization rate increases with auditor tenure has not been tested in real audit markets because proprietary cost data are rarely available. Testing this prediction is the primary contribution of this paper.
Firm management has an incentive to improve credit ratings to enjoy the reputational and financial benefits associated with higher credit ratings. In this study, the…
Firm management has an incentive to improve credit ratings to enjoy the reputational and financial benefits associated with higher credit ratings. In this study, the authors question whether audit effort in hours can be considered incrementally increasing with credit ratings. Based on legitimacy theory, the authors conjecture that firms with higher credit ratings will demand higher levels of audit effort to signal audit and financial quality compared to firms with higher levels of credit risk.
The authors conduct empirical tests using a sample of Korean-listed firms using a sample period covering 2001–2015.
The results show that firms with higher credit ratings demand higher audit effort in hours compared to client firms with lower credit ratings. The authors interpret that firms with higher ratings (lower risk) demand higher levels of audit effort in hours to reduce information asymmetry and to demonstrate that financial reporting systems are robust based on audit effort signaling audit quality. The authors also interpret that firms with lower credit ratings do not have incentives to signal similar audit quality. The authors also capture the “Big4 auditor expertise” effect by demonstrating that client firms audited by nonBig4 auditors demand additional audit effort with increasing credit rating compared to Big4 clients.
Audit effort is considered a signal of firm risk in the literature. This study’s results show evidence that audit effort is inversely related to firm risk.
The results show that audit hour information is informative and likely managed by firm stakeholders. Internationally, it is not possible to capture the audit demand of clients because listing audit hours on financial statements is not a rule. Given that audit hours can be considered informative, the authors believe that legislators could consider implementing a policy to mandate that audit hours be recorded on international annual reports to enhance transparency.
South Korea is one of few countries to list audit effort on annual reports. Therefore, the link between audit effort and credit ratings is unique in South Korea because it is one of few countries in which market participants likely monitor audit effort.