Audit Pricing in China and Pakistan: A Comparative Review of Audit Practices

Younas, Zahid Irshad; Velte, Patrick; Ashfaq, Khadija Article Audit Pricing in China and Pakistan: A Comparative Review of Audit Practices Journal of Accounting and Management Information Systems (JAMIS) Provided in Cooperation with: The Bucharest University of Economic Studies Suggested Citation: Younas, Zahid Irshad; Velte, Patrick; Ashfaq, Khadija (2014) : Audit Pricing in China and Pakistan: A Comparative Review of Audit Practices, Journal of Accounting and Management Information Systems (JAMIS), ISSN 2559-6004, Bucharest University of Economic Studies, Bucharest, Vol. 13, Iss. 1, pp. 98-110 This Version is available at: https://hdl.handle.net/10419/310549 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by/4.0/ Accounting and Management Information Systems Vol. 13, No. 1, pp. 98–110, 2014 Audit pricing in China and Pakistan: a comparative review of audit practices Zahid Irshad Younasa, 1 , Patrick Velteband Khadija Ashfaqc a,c GC University Lahore, Pakistan;bLeuphana University, Lueneburg, Germany Abstract: The purpose of this study is to investigate the firm-level factors effect on the audit pricing in China and Pakistan. For this purpose, we used the panel data of 160 firms of each country of study for the period from 2005 to 2011. First, we run the combined model for two countries and observed that complexity of business transaction is the only variable contributing positively and significantly in audit pricing of both countries. Then, for comparative review, we segregated the data of each country and run separate model. The results of separate models show that, in the case of Pakistan auditors mainly consider complexity of business transactions and client risk while pricing their engagement as an auditor. However, in the case of China the auditors only consider the Big 4 audit firm effect as a reputational tool while pricing their audit activity. The auditors in China totally ignore the client risk and complexity of business transactions which may be problematic for their auditing firm in future. The study concludes that audit pricing in Pakistan is more rational in comparison to China. Keywords: audit pricing, corporate governance, client risk, big 4 audit firms, audit quality JEL codes: M41, M42 1. Introduction External audit has a main affect on the reliability and availability of financial information. The SECP (Securities and Exchange Commission of Pakistan) in Pakistan and the CSRC (China Securities and Regulatory Commission) in China 1 Corresponding author:Zahid Irshad Younas, Lecturer, Department of Economics GC University Lahore. 1-Katchehry Road Lower Mall Lahore.Tel:+923349954677; Email address: [email protected]. Audit pricing in China and Pakistan: a comparative review of audit practices Vol. 13, No. 1 99 require each company to submit the audited financial statements at the end of the financial year. No one can deny the importance of financial statements because they are the fundamental source of financial information of any corporation; may be used by the stakeholders and analysts to test the financial health of corporations. Audited financial statements provide trust and faith to financial analysts and investors about the validity of financial statements (Simunic, 1980). External audit requires an independent opinion by auditors, about the validity of representation made by management, on its financial statements. For this independent audit opinion the auditor evaluates accounting procedure, methods and different estimations used by the management in financial reports. In addition, audit also involves transaction testing, observing and interviewing the clients, evaluating the internal control measures and checking the movement of physical inventory within the corporation. Because of the compulsory annual audit requirement of SECP and CSRC and the amount and nature of audit work required to be performed by auditors, audit fee is a substantial expenditure in total expenditure of firm. Moreover, independent audit improves the credibility of financial information and ease the access of audited corporations to the capital markets. However, whether independent audit will play its role or not, depends on the quality of audit services being provided. In order to observe the quality of audit services, audit fee is the basic research variable. As audit price incorporate the risk attach with audit engagement, so, on the one side it is sensitive to strategic decision of any corporation while on the other side it helps auditor in understanding and evaluating their liability. The purpose of audit engagement is to perform the services and issue an independent opinion on the validity of financial statements. The process of giving an opinion about the reliability of financial statements involves a high degree of risk. The auditor is answerable to regulators and stakeholders for his audit performance. The inherent risk in audit is that material misstatement may exist in the financial accounting and auditor fails to detect it and thus may issue an unqualified report. However, if auditor conducts the audit in accordance with International Financial Reporting Standards (IFRS) he will not be liable for any misstatement in financial statements. But if he does not follow the IFRS and fails to detect any fraudulent misrepresentation and users of these financial statements face damages due to it, then the auditor must be held responsible for those damages. For example, Arthur Anderson (the audit firm of Enron) was failed to follow the International Standards on Auditing (ISA) and was held responsible for the damages which further lead to the dissolution of Enron. Because the audit fee cannot be adjusted after disclosure of material misstatement in financial statements, the auditor can minimize its loss by incorporating this inherent loss in his audit fee. Accounting and Management Information Systems Vol. 13, No. 1 100 Both regulator and academia in western countries gave a considerable attention to audit fee and conducted an extensive research on it in past. Simunic(1980) developed a model to find whether 8 big audit firms charged higher audit fee as compare to the other firms. Many researchers, in western countries, conducted the research on the factors which affect audit fee. They obtained new insights but their conclusions are not justifiable for countries like China and Pakistan. Because, both of the economies are not market driven economies and regulatory measures on governance of audit firm especially in China is under review to improve the quality of audit and protection of auditing firms. Our study considers the firm level characteristics like complexity of business transaction to increase the protection of auditing firms in China and Pakistan. However, the previous studies of Ferguson et al. (2006) address the issue of audit pricing in China but failed to incorporate the complexity of business transactions, our study fills this gape by considering the complexity of business transaction as a major determinant of audit pricing at micro level in China. Our results also show in a comparative manner that audit firms in China are failed to incorporate it in their audit pricing policy as compare to the audit firms of Pakistan. By considering audit fee as a basic criterion of audit quality services, the regulatory bodies in China and Pakistan has recently started setting the criterion for charging the audit fee. Regulatory bodies incorporate all the relevant factors in setting the audit fee. In order to access which factors affect audit fee in Pakistan and China, it is essential to know about three pillars i.e. regulatory bodies, auditor and auditee. Because of the late reforms in audit industry and slow process of privatization in both economies, audit industry remained unattractive and no proper study is available on determination of audit pricing. Taylor and Simon (1999) have already conducted the research on audit market of Pakistan and explored the country level characteristics in order to detect the determinant of audit fee. But after the research period of their study, the audit market of Pakistan has subject to new different rules, which are very important in determining the audit fee. Thus, the results and conclusion of Taylor and Simon (1999) are not justified in new audit environment of Pakistan. Moreover, that study was based on macro factors but our study is centered on firm level characteristics contributing towards the audit fee of an auditor. Our study seems to be a contribution in the existing literature available on audit pricing in Pakistan, because it uses the recent data of firms, which incorporates all regulatory measure introduced by ICAP (Institute of Chartered Accountancy of Pakistan), SECP in Pakistan, and CSRC in China. Audit pricing in China and Pakistan: a comparative review of audit practices Vol. 13, No. 1 101 2. Literature review Meshari and Al-Harshani (2008) focus on the determinants of audit fee in Kuwait. Their findings strongly confirm that the audit fee in Kuwait is positively related with audit client size (total assets) and profitability of audit client. This study also suggests inverse relation between audit fees and firm liquidity ratio, uses as a measurement of client risk. Nevertheless, they could not find any significant relation of audit fees with the number of audit locations visited the client’s debt to equity ratio, and the audit firm size due to the different attributes of audit market as compared to large and more developed countries. Choi et al. (2011) examine the role of a firm’s earnings quality in determining audit fees. Empirically, they develop seven parameters to capture the firm’s earnings quality i.e. accrual quality, earnings persistence, predictability, smoothness, value relevance, timeliness and conservatism. They use them as proxies for overall accounting quality. The study sample consists of 2376 publically listed firms in USA. The study shows that auditors charge higher audit fee to firms with less desirable attributes of earnings, as compare to client-firms with more favorable earnings quality. The analysis also explains that the auditors give more weight to the earnings quality induced by the economic fundamentals (innate sources) than by management choices (discretionary sources) in evaluating risk, which in turn is reflected in audit fee. In addition, the study documents weak evidence on the association of audit fees and earnings attributes for client of Big 4 audit firms, as compared to clients of non-Big 4 audit firms. Pop and Iosivan (2008) report the determinants of the external audit fees in Romania. The study uses the data of 60 firms from 2004 to 2006. The results suggest the significant relation of audit fees with client size, client complexity and size of audit firm. Cantoni et al. (2011) investigate the determinants of audit fees in charity sector of U.K. For this purpose, the study uses the data of 119 largest charitable institutions of U.K. This study concludes that the charity‘s size, risk and non-audit service are the major factors that determine the audit fee. Contrary to Beattie et al. (2001), they do not find any significant relationship between audit fees and organizational complexity. In addition, the study also confirms that amount of audit fees is positively associated with non-audit services fees, the presence of an audit fee premium between big 4 and non-big 4 auditors and the experience of auditor. Fields et al. (2004) observe audit pricing of 277 banks in U.S. This study modifies the audit pricing model for manufacturing firms by introducing measures of risk and complexity that are more appropriate for banks. The study incorporates variables that deal directly with the regulatory structure; include ratios related to Accounting and Management Information Systems Vol. 13, No. 1 102 deposits, commercial loans, mortgage loans and charge-offs for nonperforming loans, which are special to the banking industry. The purpose is to develop an audit pricing model that can explain audit fees and investigate the consistency of government regulations with the variables used by accounting firms to price audits. Fields et al. (2004)conclude that banks with more transactions accounts, fewer securities as a percentage of total assets, lower levels of efficiency, and higher degrees of credit risk, charge higher audit fee. Taylor and Simon (1999) collect the fee observations of 20 countries in a single sample. They assert that benefit of collecting fee observations from differing countries provides an opportunity to include variables such as litigation and regulation, which vary across countries but not within a given country. However, this research is centered on “macro” determinants of audit fees. The results indicate that litigation pressures, institutional traditions of increased disclosure, and increased regulation put upward pressures on audit fees. 3. Methodology 3.1. Data and data sources Our analysis is based on consolidated data from 2005 to 2011 of 160 companies of both countries listed on KSE (Karachi Stock Exchange) in the case of Pakistan, and on Shanghai Stock Exchange in the case of China. For our research need and homogeneity purpose, we ignored the firms from financial sector and only focused on manufacturing sector for this study. In the case of Pakistan, information on all variables is obtained from annual reports of each company. For China the data on audit fee is obtained from Chinese CSMAR data base and the data on other firm specific financial variables is obtained from Chinese RESSET financial data base. However, for compatibility purpose, all variables are converted in US dollar to remove the currency differences between two countries. 3.2. Model of the study As discussed before, in many developed and developing countries, many studies exist that explain the structure of audit fees. For this purpose, a large number of variables have been used in previous studies. We focus on those variables, which have a vital role in strategic decision of corporations of both countries and have a sound theoretical and empirical relationship with audit fee as well. In both countries it is very important to know how its corporate structure and results of operations effect audit fee. The model seeks to develop a link of audit fee with corporate size, profitability, complexity of operations, risk, liquidity position and presence of audit committee. Audit pricing in China and Pakistan: a comparative review of audit practices Vol. 13, No. 1 103 It is mostly said that auditors spend more time and efforts to check and verify the quality of financial statements of their large sized clients, which are involved in a variety of business operations and also operate a large number of business assets. Previous studies have also explained corporate size as an important determinant of audit fees (Joshi & Al-Bastaki, 2000; Langendijik, 1997; Pong & Whittington, 1994; Simon et al., 1986; Taylor & Baker, 1981).In this study, we expect a positive relation between audit fees and client size because auditors conduct a detailed auditing procedure by applying substance testing and adequate amount of compliance to their large clients. We use natural logarithm of total assets as the indicator of size. Different measures have been adopted in previous studies to measure the complexity of business operations. Some previous studies, such as Taylor and Baker (1981), Langendijik (1997), Joshi and Al-Bastaki (2000), Collier and Gregory (1996) have used variables namely foreign operations and number of subsidies/branches to measure complexity of a firm. Other studies like Chan et al.(1993), Peel and Clatworthy (2001), Naser et al.(2007) employed the measures inventory/total assets and accounts receivables/total assets to determine the complexity. In this study we use balance sheet composition ratios to estimate the complexity, due to ease in availability of data. Inventory and accounts receivables are two main assets which are very time and effort consuming. It is because complex nature of receivables and a wide range of inventory attached with variable cost. So, auditors spend a lot of time and efforts on them and demand higher audit fees. Profitability of any business refers to efficient utilization of its assets and human resources. Simunic (1980), Joshi and Al-Bastaki (2000) and Wallace (1984) conclude in their studies that audit fees and profitability have a significant relationship. However, other studies, such as Francis and Simon (1987) and Chan et al. (1993) could not find any significant link. Successful corporations optimally utilize their assets in order to gain high returns. Usually, higher profitable firms purchase expensive audit service because profitability requires careful scrutiny of testing for revenues and expenses recognition which are very time demanding in nature. So, we expect positive relation between audit fee and profitability. Here, return on assets (ROA) is used to indicate firm’s profitability. Client risk is also an important factor that can highly influences audit fees. Previous studies show no adequate measure of client risk. Due to fall of Enron, WorldCom and an immense increase in lawsuits against auditors on issuing unqualified opinion on misstated financial statements, this factor is playing a vital role in determining audit fees. Therefore, auditors charge higher audit fees against high audit risk. In this study, debt ratio is used as an indicator of client risk. Accounting and Management Information Systems Vol. 13, No. 1 104 Liquidity ratio basically measures the ability of a firm to meet its current obligations. Liquidity ratio is measured by the current assets of a company divided by its current obligations. Liquidity ratio is very useful for those stakeholders who are interested in the life of the business, such as creditors, shareholders etc. Different points of views are available about the relationship between audit fees and liquidity ratio. Some suggest that companies with better liquidity ratio prefer to spend more resources on audit fees. Companies with good liquidity position are interested in rigorous testing of their current assets as they have a significant effect in day-to-day business. However, others say that better liquidity ratio refers the low level of audit risk and also require less effort and time by external auditors. So, audit fees and liquidity ratio is inversely related. But in this study we assume a positive significant relation between audit fees and liquidity ratio. It is very difficult to explain the exact relation between audit committees and audit fee because audit committees react in two ways. Firstly (demand side) the presence of audit committees does not compromise on low quality of external audit and pay higher amount of audit fee to improve the audit quality by increasing the hours and efforts of audit (Collier & Gregory, 1996). Secondly (supply side) involvement of audit committees in fortifying internal control reduces the level of audit risk which pushes the auditors to reduce the amount of audit fees (Collier & Gregory, 1996). Effective audit committee reduces the fear of auditor’s dismissal and raises the bargaining power of auditor to increase audit fee, thus it shows a positive relationship between audit fees and audit committees (Abbott et al., 2003).Therefore, we assume the demand side of audit committee here and expect the positive relation between audit fee and the implementation of audit committees. As discussed before, the audit committee demands higher quality of audit services. Some studies also presented the evidence that the services of big 4 auditors are much better than non-big 4 (Bedard& Johnstone,1998; Francis & Krishnan, 1999). To achieve this target, the audit committee prefers to conduct audit from big 4 audit firms. Prior studies of Choi et al.(2008), Craswell et al. (1995) and Simunic and Stein (1996) also conclude that big 4 auditors charge higher price of audit fee for better quality of audit. Since big 4 auditors are very conscious about the reputation of their services quality in the market, they adjust their procedures of audit according to the changes in firms operations and demand higher audit fees. Insofar, this study expects positive relationship between audit fee and big 4 audit firm. As a summary, the following model is developed to observe the determinants of audit fee in Pakistan and China: t,it,it,it,i t,it,it,it,i AUCBigCOMPLIQ RISPROSZFeeln 7654 321 4  Audit pricing in China and Pakistan: a comparative review of audit practices Vol. 13, No. 1 105 with ti Fee , ln =Natural log of audit fee. ti SZ, = Firm size: measured as natural log of total assets; positive sign expected. ti PRO , = Profitability of firm: captured by Return on Assets (ROA); positive sign expected. ti RIS , = Client risk: captured by debt ratio of firm; positive sign expected. ti LIQ , = Liquidity: captured by current ratio; positive sign expected. ti COMP, = Business Complexity: measured by the sum of ratio of inventory to total assets and ratio of account receivables to total assets; positive sign expected. ti Big , 4 =big four audit firm: dummy of 1, otherwise 0; positive sign expected. ti AUC , = Presence of an audit committee; dummy of 1, otherwise 0; positive sign expected. In this study first we run the combine model for both countries to find the determinants of audit fee and then we segregated the firms and run separate model to see the determinants of audit fee at country level. The next segment of study deals with the results of study. 4. Results The results of descriptive statistics and correlation matrix are shown in table 1 and table 2 respectively. Table 1. Descriptive statistics Variables Mean Median Maximum Minimum Std. Dev. AUC 0.850 0.999 1.000 0.000 0.358 BIG4 0.493 0.000 1.000 0.000 0.501 RIS 0.982 1.000 5.980 -4.586 0.962 LIQ 14.998 0.995 916.203 0.0527 104.212 PRO 2.35 0.125926 7.05 -3.786 4.07 SZ 22.212 20.094 25.263 11.699 23.019 COMP 196.638 1.629 9388.738 -1.014 727.632