Auditing-416 Academic Research Case-Seminar 4

Auditing-416

Academic Research Case-Seminar 4

Japan’s big 3 firms’ response to clients’ business risk: greater audit effort or higher audit fees?

a. What is the issue being addressed in the paper?

This study focuses on the Big 3 audit firms in Japan: Azsa, ShinNihon, and Tohmatsu, and examines how the audit firms respond to client business ricks.

Companies face varying levels of business risk resulting from factors related to the internal and external environments in which it operates, such as industry conditions, related regulations, management integrity, and internal controls. Auditors need to assess a client’s business risk, because higher business risk generally leads to higher risk of material misstatements in financial statements. According to Japanese auditing standards, auditors should address the assessed risks of material misstatements at the financial statement level through overarching responses such as increasing the number of audit staff, using experts, and securing appropriate audit hours (i.e., by increasing audit effort).

Consistent with increased interest in business risk reporting, since the fiscal year ending March 2004, Japanese listed companies have been required to disclose information regarding their business risk in their annual reports. This risk information is intended to enable financial statement users to assess a company’s business risk.

Thus, auditors must be aware of clients’ business risk disclosed in annual reports and be sure that all risk items that they think should be disclosed are actually disclosed. Using the data as measures of clients’ business risk identified and assessed by auditors, this study examines whether and how auditors respond to business risk: by researching the effects of clients’ business risk on audit efforts, the effect of clients’ business risk on audit fees, and how the Big Three Japanese audit firms respond to clients’ higher business risk.

b. What are the findings of the paper?

Effect of clients’ business risk on audit effort: Research on audit planning using data obtained from actual working papers found that audit planning is responsive to various client risks, whereas relationships between auditors’ risk assessments and audit planning are not strong. However, that fraud risk and other overall client risks have significant effects on audit planning, that the risk of clients manipulating their earnings affects both planned, audit hours and billing rates, particularly for clients with higher corporate governance risk. Examined audits after the business risk audit approach was adopted and found that auditors allocated more audit resources in response to assessed auditor business risk. These findings suggest that if auditors relate client business risk to auditor business risk, they will increase audit effort in response to the risk.

Also, if a client had a higher level of short-term accruals (i.e., greater earnings management), auditors allocated more audit effort in terms of audit hours and a mix of grade of labor, which provides further evidence of auditors responding to client risk by increasing audit effort.

Based on the findings of these prior studies and the audit risk model adopted by the current auditing standards that requires auditors to respond to clients’ business risk by increasing audit effort, the first hypothesis is stated as follows: H1: The Big 3 Japanese audit firms respond to clients’ higher business risk by increasing audit effort.

Effect of clients’ business risk on audit fees: JICPA issued guidelines for determining audit fees that adopt the “time charge” approach, whereby fees are determined as a function of audit hours and rates charged on an hourly basis. Hourly rates are calculated for each staff rank based on total salaries and total hours. Thus, audit fees will be higher if more audit hours are necessary and / or if higher rates are charged. The findings imply that two approaches exist regarding how auditors respond to higher client risk: (1) increasing audit effort (e.g., increasing total audit hours or assigning more experienced staff to the audit team), and (2) charging a higher hourly rate without increasing the audit effort (a risk premium). Although the auditing standards require auditors to increase their effort when faced with a client’s higher business risk, the approach that an audit firm actually adopts is an empirical question.

Based on these findings, it may be reasonable behavior for an audit firm to charge a premium to compensate for client business risk. The second hypothesis is formally stated as follows: H2: The Big 3 Japanese audit firms respond to clients’ higher business risk by charging a risk premium.

Big Three Japanese audit firms respond to clients’ higher business risk: How auditors respond to clients’ business risk can depend on two factors: (1) an auditor-related factor and (2) a client-related factor. First factor: The auditors effectively integrated business risk assessments with their assessment of the risk of material misstatement only when they were trained to use a strategic-systems approach, and the information analyzed was provided in a format consistent with the approach. Their results imply that auditors adopting a different audit methodology vary in their response to clients’ business risk.

Second factor: The auditors respond to clients’ business risk (i.e., the client-related factor) relates to client characteristics such as size, complexity, and riskiness, and the relationship between an audit firm and its clients. For example, an audit firm whose clients are smaller, less complex, and financially less risky may not respond to clients’ business risk by charging a risk premium because the firm considers that this does not lead to higher auditor business risk. Moreover, if a client has more power over an audit firm, the firm may not be able to charge a risk premium even if the client’s business risk is high.

Based on these findings, the Big 3 Japanese firms vary in certain aspects, such as client size, complexity, riskiness, industry specialization, and power relationships with clients. These finding simply that auditors’ responses to clients’ business risk can differ and can depend on their relationship with the clients. These discussions lead to our third hypothesis, as follows: H3: Responses to clients’ business risk differ among the Big 3 Japanese audit firms.

c. Why is this paper important to auditors, and what are the implications of this paper for the auditing profession?

The purpose of the current study is to examine the importance of business risk reporting. The reporting is a mandatory process of disclosure, and the auditor is required to mention any material inconsistency between the information and the audited financial statements. In addition, auditing standards require that if an auditor identifies a risk that has not been identified by the company’s risk assessment process. However, if the auditor is skeptical and believes that the risk assessment should be identified, then the auditor should investigate why the process failed to ascertain the risk. Therefore, it is pertinent that auditors must be aware of clients’ business risk disclosed in annual reports, and confirm that all risk information they think should be disclosed, is actually acknowledged.

The research implied that auditors should accentuate clients’ business and fraud risks, by adhering to the auditing standards to increase their effort when clients’ business risk is high, and the primary findings indicate that the Big 3 firms respond to clients’ higher business risk by increasing audit effort. Therefore, the study’s data measure are the best publicly available proxies for audit effort and clients business risk. The study contributes to the literature by investigating both audit fees and audit effort through a single analysis, which will further improve the quality and value, of the pertinence of business risk reporting for the Japanese audit profession.

d. Describe the research mythology used as a basis for the conclusions.

The research method included dependent variables and data, and sample selection. And, the researchers tested the 3 hypotheses using two research approaches. SEM and OLS regression. As a primary analysis, we adopted the SEM approach because it allows us to simultaneously assess the relationships among clients’ business risk, audit fees, and audit effort. Using SEM, it is possible to examine the indirect effect of the clients’ business risk on audit fees via audit effort (H1) and the direct effect on audit fees (H2). SEM is a combination of statistical techniques such as factor analysis, path analysis, and regression analysis, and provides a useful and powerful method for analyzing complicated relationships among variables, where a dependent variable in one relationship is an independent variable in another relationship. Such complicated relationships cannot be analyzed simultaneously by other multivariate statistical techniques.

To examine H3, researchers adopted a multiple-sample modeling approach wherein a model is fit simultaneously to sample data from different populations. They specified three samples for clients of each Big 3 firm. The coefficient of the path from Business Risk to Effort is expected to be positive (H1). In addition, if the Big 3 Japanese audit firms respond to clients’ higher business risk by charging a risk premium, the coefficient of the path from Business Risk to ln Fee should be positive (H2). Finally, given that the Big 3 Japanese audit firms’ responses to clients’ business risk are expected to vary (H3), we expect that the significant path coefficients in the model are different among the three samples.

SEN Results: In summary, Azsa and ShinNihon increase audit effort and charge a risk premium for audits with higher business risk. In contrast, Tohmatsu responds to clients’ business risk only by increasing audit effort. In addition, the strength of the relationships between clients’ business risk and audit effort/fees varies among the firms. These differences among the Big 3 firms may reflect each firm’s audit methodology, risk preference, and the intended audit quality to be attained. Or, they may be attributable to the differences in client characteristics.

The researchers’ next approach is the OLS regressions as a corroborative analysis of the effect of clients’ business risk on audit fees and audit effort. First, to examine the effect on fees, the researchers adopted a regression equation similar to that used by many previous studies. The equation study is BRisk. BRisk is the number of business risk items disclosed in a client’s annual report. This variable is of primary interest to our study. In addition, to examine differences among the Big 3 firms, we included dummy variables in the model to represent specific firms (AuditfirmDummy) and their interactions with Brisk (AuditfirmDummy*BRisk).14 To control audit effort, we include lnTeam, which is the natural log of the total number of CPAs (excluding engagement partners), junior accountants, and other staff (i.e.,CPA + OtherStaff). The coefficient of this variable is expected to be positive.

OLS Results: In summary, Azsa has larger clients with more power over the firm, whereas Tohmatsu’s clients are smaller and financially less risky, and the firm’s market share in industries is lower. ShinNihon conducted more initial audits in 2007 and its market share in industries is the highest. These differences in client characteristics may affect how the Big 3 firms respond to clients’ business risk.

Also, the researchers implemented descriptive statistics for audit fees and effort related variables, clients’ business risk related variables, and control variables included in the analyses for each Big 3 firm. The researchers conducted t-tests for variables (or chi-square tests for indicator variables) to examine whether any difference exists among the Big 3 firms.

Chi-square tests Results: The Model fit statistics in Table 4 indicate that the fit of our model is good.16 First, the chi-square statistic is 158.538 with 75 degrees of freedom (p-value < 0.001). Although the chi-square statistic indicates that the null hypothesis has been rejected, this statistic is sensitive to sample size. Given the size of our sample, this result is not surprising.

Supporting the Hypothesis: Tohmatsu responds to clients’ business risk by increasing audit effort without charging a risk premium. These results provide supportive evidence for H1. Azsa, and ShinNihon respond to an increase audit effort and charge a risk premium for audits with higher business risk-support, the results provide supportive evidence for H1 and H2. And, the results indicate that the Big 3 Japanese audit firms respond differently to clients’ business risk, thus supporting H3.

e. Describe any limitations of the research.

The research findings excluded companies in finance-related industries (i.e., banking, securities, insurance, and other financial businesses) because these industries are highly regulated and their audit pricing differs substantially from other industries (143 observations were excluded), excluded 48 observations for which necessary data were unavailable, Japanese auditing standards provide no guidance on what auditors should do to identify a risk that a client has failed to identify, the sample comprises only audits conducted in 2007 and does not include audits conducted in 2008 or later because the audit of listed companies’ internal control was introduced in 2008 in Japan and is likely to have resulted in a substantial structural change in the Japanese audit market.

Also, while interpreting the results of this study, other limitations should be considered. The researchers adopted the number of audit team members as a proxy for audit effort. In doing so, they assumed that the average audit hours per person at a particular level of staff (i.e., CPAs or other staff) are the same across all engagements in a particular audit firm. If this is not the case, audit team size may be an inappropriate proxy for audit effort. Moreover, by using narrative risk information disclosed in an annual report as a measure of clients’ business risk, this study does not consider managers’ incentives to disclose business risk. If managers discretionarily and opportunistically disclose information on business risk, the information may not necessarily reflect the actual level of business risk that the auditors assessed.

Reference:

Kim, H., & Fukukawa, H. (2013). Japan’s Big 3 Firms’ Response to Clients’ Business Risk: Greater Audit Effort or Higher Audit Fees?. International Journal Of Auditing, 17(2), 190-212. doi:10.1111/j.1099-1123.2012.00464.x