The Effects of Auditor Change on Audit Fees: Empirical Evidence from Japan

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ABSTRACT

This paper investigates whether initial audit fees are discounted by audit firms in Japan in periods in which audit fees are mandatory disclosures. This study is motivated by two competing theories of initial audit engagement pricing. DeAngelo (1981) argues that incumbent auditors derive cost advantages from technological advantages and switching costs that arise from clients and that auditors bid for the rights to earn quasi-rents during incumbency by discounting initial audit engagements. However, Dye (1991) argues that public disclosure of audit fees provides information to investors regarding the auditor-client economic bond created by quasi-rents. Through my study, I find no evidence of audit fee discounting in Japan. The results of my study support Dye's (1991) conclusion that public disclosure of audit fees precludes initial engagement discounting and auditor independence problems arising from this discounting. Additionally, my research sample includes clients of the Japanese audit firm Chuo Aoyama. Because the Japanese Financial Services Agency had ordered this audit firm to suspend audit engagements in 2006 (related to the Kanebo scandal), these clients had mandatorily switched to other audit firms. This is a very rare case of auditor change; thus, my research contributes to auditor rotation studies in relation to this aspect.

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INTRODUCTION

This paper examines initial engagement audit pricing in Japan. Several prior researches investigate the discounting of initial audit engagement fees in the audit markets of the United States, the United Kingdom, and Australia. That is, previous researches have focused on commonwealth countries; only Machida (2007) has focused on the Japanese audit market. However, this research has several limitations, one of which is that it does not conduct a multivariate analysis of initial audit engagement fees. Therefore, I conduct a multivariate analysis of initial audit engagement pricing in the Japanese audit setting.

Recently, a great number of accounting and auditing scandals have taken place in the United States. For example, Arthur Andersen, which once was one of the "Big Five" accounting firms in the United States, collapsed in 2002 due to the Enron scandal. Similarly, one of Japan's large accounting firms, Chuo Aoyama or Misuzu collapsed in 2007 due to the Kanebou audit failures. Recent instances of auditors failing to detect questionable accounting practices have increased researchers' and regulators' concern with auditor independence. Regulators in the United States and Japan are anxious about auditors' fee-setting practices that could have a potential impact on auditor independence. The practice of setting audit fees below cost on initial engagements has been the subject of many studies because of its impact on auditor independence (DeAngelo, 1981; Magee & Tseng, 1990; Craswell & Francis, 1999; Sankaraguruswamy & Whisenant, 2005; Ghosh & Lustgarten, 2006; Machida, 2007; Machida, 2009).

Regulators in the United States believe that fee cutting on initial audit engagements impairs auditor independence because the audit firm must recover losses on the initial audit from future audit fees. This creates an incentive on the part of the auditor in the continued existence of the client. For example, the American Institute of Certified Public Accountants (AICPA) Commission on Auditor's Responsibilities states that fee discounting impairs auditor independence in the same manner as does an unpaid audit bill from a prior engagement (AICPA, 1 978, p. 1 2 1 ). DeAngelo (1981) quotes the report of the Commission on Auditors' Responsibilities (Cohen Commission), which debates that fee discounting impairs auditor independence. The Accounting Series Release (ASR) no. 250 issued by the Securities and Exchange Commission (SEC) in 1978 called for public disclosure when audit fees are significantly less than the expected direct cost. …