The Association between Audit Committee Characteristics and Audit ...

AUDITING: A JOURNAL OF PRACTICE & THEORY Vol. 22, No. 2 September 2003 pp. 17–32

The Association between Audit Committee Characteristics and Audit Fees Lawrence J. Abbott, Susan Parker, Gary F. Peters, and K. Raghunandan SUMMARY: This study examines the association between audit committee characteristics and audit fees, using data gathered under the recent SEC fee disclosure rules. We hypothesize that audit fees will be positively associated with audit committee independence, financial expertise, and meeting frequency. We examine a sample of 492 nonregulated, Big 5-audited firms that filed proxy statements with the SEC in the period from February 5, 2001 to June 30, 2001. We find that audit committee independence (defined as an audit committee comprised entirely of outside, independent directors) and financial expertise (defined as an audit committee containing at least one member with financial expertise) are significantly, positively associated with audit fees. This is in contrast to the findings of Carcello et al. (2002a), who find that audit committee characteristics are not significant in the presence of board-related variables. Meeting frequency (defined as an audit committee that meets at least four times annually) was not associated with higher audit fees at conventional levels. This evidence is consistent with audit committees taking actions within their span of control to ensure a higher level of audit coverage. Keywords: audit committee; audit fees. Data Availability: All data obtained from publicly available sources.

INTRODUCTION he role of the audit committee in corporate governance is a subject of increasing regulatory interest. In recent years, the Securities and Exchange Commission (SEC), the Public Oversight Board (POB 1993) and the National Association of Corporate Directors (NACD 2000) have stressed the role of the audit committee in providing active oversight of the financial reporting process and in monitoring the relationship between a firm’s management and its external auditor.

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Lawrence J. Abbott is an Assistant Professor at the University of Memphis, Susan Parker is an Assistant Professor at Santa Clara University, Gary F. Peters is an Assistant Professor at the University of Arkansas, and K. Raghunandan is a Professor at Florida International University. The authors thank workshop participants at the University of Arkansas and the University of Georgia for helpful comments. We are also grateful to two anonymous reviewers, Audrey Gramling, Arnie Wright, and William Messier for their helpful suggestions. Professor Parker gratefully acknowledges the financial support of the Dean Witter Foundation and the Ernst and Young Accounting Faculty Research Fellowship.

Submitted: October 2001 Accepted: December 2002

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Auditing, September 2003

Such concerns resulted in the Blue Ribbon Committee’s report, Improving the Effectiveness of Corporate Audit Committees (BRC 1999). A number of the BRC’s recommendations have been incorporated into SEC and exchange-listing regulation. The Committee’s report (BRC 1999) included recommendations concerning audit committee composition and activities, including a recommendation that the audit committee oversee and review all economic relationships between the external auditors and management.1 In this paper, we examine the association between certain audit committee characteristics and one economic aspect of the auditor-management relationship, namely, audit fees. In particular, we hypothesize that specific audit committee characteristics (i.e., independence, financial expertise, and meeting frequency) are associated with higher audit fees. Our hypotheses are based upon two premises. First, prior research finds that audit committees can take actions within their span of control that may result in outcomes associated with a higher level of audit quality, such as increased going-concern modifications for distressed firms (Carcello and Neal 2000) and the selection of industry specialist auditors (Abbott and Parker 2000, 2001). Since reviewing the preliminary audit program and the results thereof is a primary audit committee responsibility (DeZoort 1997; BRC 1999), this suggests that audit committees can influence the level of audit coverage. To this end, it follows that an audit committee seeking a higher level of audit assurance could demand a greater level of audit coverage resulting in higher audit fees, given the auditor’s wealth-maximization function. Second, prior research suggests that certain audit committee characteristics critically impact the execution of audit committee duties (Carcello and Neal 2000; Raghunandan et al. 2001). These two premises generate separate hypotheses that test the association between three key audit committee characteristics—independence, expertise, and meeting frequency—and audit fees. To examine our hypotheses, we collect audit fee data for 492 nonregulated, Big 5-audited firms that filed annual proxy statements with the SEC between February 5, 2001 and June 30, 2001. Consistent with our hypotheses, we find that audit committee independence (defined as committees comprised solely of independent directors) and expertise (defined as committees that include at least one director with financial expertise per BRC recommendations) are significantly, positively associated with audit fees. Our measure of meeting frequency (a threshold of four meetings per year) was not significantly associated with audit fees. We interpret our findings as indicating a relation between these audit committee characteristics and a demand for increased audit coverage, reflected in higher fees. However, our findings are also consistent with certain audit committee characteristics leading to an increase in bargaining power for the auditor and a concomitant increase in fees with no change in audit coverage or quality. Our tests cannot distinguish between these two alternatives. Our findings contrast with those of Carcello et al. (2002a), who find that audit committee characteristics lose significance when board characteristics are included. Two possible explanations for this difference in findings are changes in the regulatory environment during the middle and late 1990s and differences in the degree of variation in audit committee characteristics in the samples utilized. The rest of this paper is organized as follows. The next section discusses the background and develops our research questions. This is followed by discussions of method and results. The paper ends with a summary and conclusions.

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The BRC recommended that audit committee charters specify that the outside auditor is ultimately accountable to the board of directors and the audit committee, which has the ultimate authority and responsibility to select, evaluate, and, where appropriate, replace the outside auditor. The substance of a number of BRC recommendations is included in the Sarbanes-Oxley Act of 2002, which requires audit committees to be responsible for the appointment, compensation, and oversight of the external auditor and to preapprove most permitted nonaudit services.

Auditing: A Journal of Practice & Theory, September 2003

Abbott, Parker, Peters, and Raghunandan

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BACKGROUND AND HYPOTHESES The Audit Committee’s Role in the Audit Scope Negotiation Process Prior research indicates that audit committees can potentially take three actions related to the external auditor that may result in a higher level of audit assurance or coverage. First, committee members can attempt to persuade management to select a more knowledgeable auditor with greater reputation. In this regard, Abbott and Parker (2001) find that companies with audit committees comprised entirely of independent directors that meet at least twice annually are more likely to select a (then) Big 6 auditor when switching auditors. In this study, we hold auditor quality (i.e., Big 5 versus non-Big 5) constant through the exclusion of non-Big 5 firms. Second, the audit committee can demand a greater quantity of audit effort from the existing external auditor (Simunic and Stein 1996). If greater effort (i.e., an enhanced audit scope) is associated with increased quality, then the audit committee’s efforts will be associated with increased quality. DeZoort (1997) provides evidence of audit committee involvement with external audit tasks, noting that audit committee members generally believe the review of the external auditor’s work to be a primary audit committee duty. Both the POB (1993) and BRC (1999) recommend that audit committees discuss the audit scope and plan with the auditor, providing a check on the adequacy of audit coverage. Carcello et al. (2002b) find that 85 percent of audit committee reports or charters disclose that the committee reviews the scope of the auditor’s proposed audit plan. The following excerpt from Kimberly-Clark Corporation’s 2001 proxy statement illustrates a typical audit committee disclosure with respect to the review of the external auditor’s proposed scope: The Audit Committee will meet with the Corporation’s principal independent auditor and management to review the scope of the proposed annual audit (and related quarterly reviews), the audit procedures to be followed and, at the conclusion of the audit, review the audit findings including any comments or recommendations of the Corporation’s principal independent auditor. (Kimberly-Clark Corporation)

These results and disclosures suggest that audit committees can directly influence the level of audit scope provided by the external auditor. The third, indirect means by which an audit committee can impact the level of audit coverage is by mitigating management’s threat to replace the auditor (Knapp 1985). Carcello and Neal (2000, 2003) show that independent audit committees mitigate management’s dismissal threats during a highly contentious situation involving management and the auditor: the going-concern modification decision. They find that: (1) financially distressed firms with independent audit committees are more likely to receive a going-concern modification, and (2) auditors who issue initial going-concern modifications are less likely to be terminated when the audit committee is comprised entirely of independent directors. Similarly, the determination of audit plan/scope often involves negotiations between the auditor and management, given that management may have incentives to minimize audit fees (Knapp 1985; Emby and Davidson 1998). Given these negotiations, an audit committee can potentially shield the auditor from management pressure to complete the audit quickly, accept management representations without adequate corroborating evidence or limit audit scope, thus shifting the balance of power in the auditor’s favor.2 Carcello et al. (2002a) have also addressed the question of the relation between audit committee characteristics and audit fees. They find, using data from 1992–1993, that audit committee characteristics (independence, expertise, and meeting frequency) are not associated with audit fees when 2

Discussions held by the authors with Big 5 audit partners affirm that external auditors currently experience a range of involvement with the audit committee both in terms of audit scope demanded and committee support for the auditors in management disputes. These conversations are consistent with increased audit committee involvement with the audit process.


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measures of board characteristics are present. We believe that both the public and regulatory bodies have come to regard the audit committee as the primary focus for financial monitoring (POB 1993; BRC 1999; NACD 2000) in the period since 1993. In addition, changes in the regulatory environment suggest a different measure of audit committee expertise than that used in Carcello et al. (2002a). Their measure of expertise is the number of other public company directorships held. While this measure certainly captures some aspects of director knowledge and experience, regulation has focused on whether directors have experienced specific managerial roles or have specific professional credentials (BRC 1999). The Carcello et al. (2002a) variable may also inadvertently measure the time pressures faced by the director when multiple directorships are held. The expertise measure chosen may affect the audit committee results. Characteristics of Audit Committee Effectiveness As described in the prior section, an audit committee can impact audit coverage by exercising its decision rights and executing its corporate governance responsibilities. Currently, all firms listed on the NYSE or NASDAQ/AMEX are required to maintain an audit committee. Prior research has shown, however, that key audit committee characteristics—rather than the mere presence of an audit committee—critically impact the audit committee’s ability to effectively execute its duties (Abbott and Parker 2000, 2001; Beasley et al. 2000; Carcello and Neal 2003; Raghunandan et al. 2001). Consistent with prior literature, we focus on audit committee independence, expertise, and meeting frequency. Independence Independent audit committee members, as outside directors, may view the directorate as a means of enhancing their reputations as experts in decision control (Fama and Jensen 1983). Audit committee service may increase the directors’ reputational capital, but it also may exacerbate the reputational damage should a financial misstatement occur. Furthermore, in cases of financial misstatement, outside nonaudit committee directors can potentially subrogate their director liability to audit committee members by asserting reliance on the audit committee for issues such as the adequacy of the firm’s financial reporting and relationship with its external auditor (Reinstein et al. 1984).3 Since audit quality is generally defined as the joint probability of the auditor detecting and reporting a material financial misstatement (DeAngelo 1981), it is reasonable to expect that independent audit committees prefer a higher level of audit quality. As previously noted, a higher level of audit coverage from the existing external auditor—which may result in improved detection of financial misstatement—can be obtained through increases in audit scope. A number of studies have explored the association of audit committee independence with financial reporting outcomes and with the relationship with the external auditor. Beasley et al. (2000) find that companies committing financial-statement fraud have less independent committees than a no-fraud industry benchmark. Carcello and Neal (2000) find that financially distressed firms with independent audit committees are more likely to receive going-concern opinions. Abbott et al. (2003) find that firms with audit committees that are independent, meet frequently, and which have an expert present are less likely to experience a restatement of earnings. These results suggest that audit committee independence, expertise, and meeting frequency improve the financial reporting process. The results of Beasley et al. (2000), Carcello and Neal (2000, 2003) and Abbott et al. (2003) rely upon an assertion that audit committees independent of management do not have a personal and/ or economic dependence on management. Thus, an independent audit committee may be more 3

Even if the audit committee director is effectively shielded from personal financial liability by insurance or indemnification, he or she faces the costs in time of mounting a defense (Sahlman 1990).



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willing to disagree with management on a variety of issues (Baysinger and Butler 1985). During the review of the audit program and results thereof, an independent audit committee may demand expanded audit scope in order to avoid being associated with a financial misstatement and preserve reputational capital. The committee may also demand (or support the auditor’s demand for) additional audit procedures beyond the initial audit plan for areas that subsequently reveal greater amounts of contention, uncertainty, or risk. This suggests that independent audit committee directors demand greater levels of audit assurance and potentially provide stronger support for auditors during scope negotiations with management. This ultimately may result in higher audit fees, leading in our first hypothesis, stated in alternative form: H1: There is a positive association between audit fees and audit committee independence. Expertise The POB (1993) states that the “effectiveness of the audit committee is affected, first and foremost, by the expertise of members of audit committees in the areas of accounting and financial reporting, internal controls and auditing.” Audit committee members, however, come from a wide variety of backgrounds and may not have the experience or technical knowledge needed for effective accounting and auditing oversight (Kalbers and Fogarty 1993). Knowledgeable audit committees are better equipped to understand auditor judgments and discern the substance of disagreements between management and the external auditor (DeZoort 1998; DeZoort and Salterio 2001). The assertion that effective audit committees must contain members who possess ample financial experience is consistent with previous research on audit committee expertise.4 Knapp (1987) finds that auditors were less likely to refer a complex auditing issue to an audit committee that was perceived as not being knowledgeable about the issue. DeZoort (1998) finds that audit committee members with internal control experience made judgments more similar to auditors than those audit committee members without such experience. DeZoort and Salterio (2001) posit that audit committee members with more experience are more likely to understand and sympathize with the risks the external auditor faces. These results suggest that audit committee members who possess financial expertise provide additional support for external auditors when discussing or negotiating auditing issues and/or audit scope with management. Such expertise allows audit committee members to better understand the auditing issues, risks, and the audit procedures proposed to address these issues and risks. These results lead us to expect a positive association between audit fees and audit committee expertise, leading to our second hypothesis, stated in alternative form: H2: There is a positive association between audit fees and audit committee expertise. Meeting Frequency The BRC report (1999) noted, as did the Treadway Commission (1987), that the audit committee should have direct communication channels with the external auditor to discuss and review specific issues as appropriate. Regular meetings between the audit committee and external auditor make it more likely that the audit committee will remain informed and knowledgeable about relevant accounting and auditing issues (BRC 1999; NACD 2000; Raghunandan et al. 2001). Menon and Williams (1994) posit that meeting frequency is a signal about audit committee diligence. Furthermore, the NACD (2000) recently suggested a rule of thumb of four half-day audit committee 4

In this paper, we use the term “expertise” consistent with the BRC report, which states “expertise signifies past employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background” (emphasis added).


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meetings per year. These recommendations and findings suggest that: (1) meeting frequency is an important component of audit committee effectiveness, and (2) meeting frequency is often used as a proxy for audit committee diligence. Finally, the BRC contends that for an audit committee to be effective, it is necessary for audit committee directors to expend one of their most valuable resources, time, in executing their duties. Recent research supports the importance of audit committee meeting frequency. Beasley et al. (2000) find that audit committees of fraud firms met less often than audit committees of a nonfraud industry benchmark. Abbott et al. (2003) find that firms whose audit committees meet at least four times annually are less likely to have restated their audited financial statements. The results of prior research and the recommendations of the BRC and NACD suggest that audit committees that meet frequently are more likely to be informed of current auditing issues and more diligent in the discharge of their duties. This implies that audit committees that meet frequently can proactively and positively influence audit coverage during the various stages of the audit. This generates our third hypothesis, stated in the alternative form: H3: There is a positive association between audit fees and audit committee meeting frequency. It is important to note that we address the association between audit committee characteristics and audit fees from the demand side, as do Carcello et al. (2002a), who find that stronger boards are associated with increased audit fees. However, an alternative view is that an effective audit committee may be viewed by the auditor as improving the overall control environment, thus reducing the auditor’s control risk and the resulting amount of audit work deemed necessary (Tsui et al. 2001). Thus, the association between audit committee characteristics and audit fees remains an empirical issue, and consequently we report two-sided p-values in our results section. METHOD Regression Model Prior audit fee research has generally used variables serving as proxies for auditee size, complexity, and audit risk in its analyses. Following prior research (Francis and Simon 1987; Simon and Francis 1988), we expect audit fees to be positively associated with the natural log of total assets (LNTA), receivable and inventory intensity (RECINV), square root of the number of subsidiaries (SQSUBS), proportion of foreign subsidiaries (FORGN), and whether the audit opinion is modified (OPIN). We control for these factors in our analysis. Prior research has also documented an association between board characteristics and audit fees. Carcello et al. (2002a), using data from Fortune 1000 companies, find that board characteristics are associated with audit fees. Hence, we also include variables drawn from Carcello et al. (2002a) measuring board composition, board meeting frequency, and board expertise as control factors. We measure board composition (BDCOMP) and activity (BDMEET) using the proportion of nonemployees on the full board and the number of board meetings held in the sample year, respectively.5 As in Carcello et al. (2002a), board expertise (BDEXP) is the average number of outside directorships in other firms held by outside directors. Our explanatory variables of interest relate to audit committee characteristics. As noted previously, the SEC, BRC, and others have emphasized the importance of having solely independent directors on the audit committee, and thus we code ACOUT as “1” when the audit committee is comprised entirely of independent directors, and “0” otherwise. 5

We also use an alternative measure of board composition by focusing on the percentage of independent (i.e., nongray, nonemployee) directors. Results with this alternative definition are substantively similar to those reported in the paper.



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The BRC recommends that the audit committee include at least one member with accounting or finance expertise. The BRC report provides specific guidance as to the professional backgrounds likely to result in an appropriate level of expertise. In particular, the BRC states that accounting or financial management expertise may be demonstrated by employment experience in finance or accounting, a CPA or comparable experience, or a position as a CEO or other senior officer with financial oversight responsibilities. Each audit committee member’s current and prior work experiences were reviewed per the annual proxy statement disclosures. We code ACEXP as “1”’ when the audit committee contains at least one member with financial expertise (per the BRC recommendation), and “0” otherwise. The Treadway Commission (1987), the POB (1993), NACD (2000) and the BRC (1999) have emphasized that audit committees should have an adequate number of meetings each year. Based on sample charters included in the BRC report, the BRC’s recommendation for review of interim, quarterly financial reports and a specific NACD recommendation of four meetings per year, we code ACMEET as “1”’ for an audit committee that meets at least four times during the year, and “0” otherwise.6 Thus, we use the following cross-sectional regression model to examine the association between audit committee characteristics and audit fees: LNAFEE where:

= β0 + β1LNTA+ β2RECINV + β 3SQSUBS + β4FORGN + β 5OPIN + β6BDCOMP + β7BDEXP + β8 BDMEET +β9 ACOUT + β10ACEXP + β11ACMEET + ε, LNAFEE = LNTA = RECINV = SQSUBS = FORGN = OPIN = BDCOMP = BDEXP = BDMEET = ACOUT = ACEXP =

natural log of audit fees; natural log of sample firm’s total assets; proportion of total assets in accounts receivable and inventory; square root of the number of consolidated subsidiaries; proportion of foreign subsidiaries to total subsidiaries; 1 if a modified audit opinion is issued, 0 otherwise; percent of nonemployee directors on the board of directors; average number of outside directorships in other firms held by outside directors; number of board meetings in the sample year; 1 if the audit committee had solely independent directors, 0 otherwise; 1 if the audit committee had a member with accounting or finance expertise, 0 otherwise; and ACMEET = 1 if the audit committee met four or more times in the sample year; 0 otherwise.

Sample Selection SEC rules requiring the disclosure of audit and nonaudit fees became effective for proxies filed on or after February 5, 2001. We first examined all proxies filed with the SEC between February 5, 2001 and March 23, 2001 for which there was a corresponding fiscal year-end 10-K available by March 23, 2001. This resulted in an initial sample of 262 firms. To expand the sample size, we then selected a random sample of 250 firms filing proxy statements from March 24, 2001 to June 30, 2001, and which met our additional criteria.7 Since mutual funds and other financial registrants have 6

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We use dichotomous variables for the measures of audit committee independence, expertise, and meeting frequency because of specific BRC or NACD recommendations concerning entirely independent audit committees, the presence of at least one audit committee director with accounting or financial management expertise, and at least four audit committee meetings per year. In contrast, no board of directors has solely outside directors. Further, there are no rules or “good practice guidelines” that suggest an optimal number of board members with accounting or financial management expertise or optimal number of board meetings. Thus, consistent with Carcello et al. (2002a), we use continuous measures for board characteristic variables. Univariate comparisons between the two sample subperiods (February 5–March 23 and March 24–June 30) do not reveal any significant differences between the two groups.


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unique operating and reporting characteristics, we excluded such registrants from our sample. We also restrict the analysis to clients of the Big 5 audit firms. This enables us to obtain a more homogeneous sample. After deleting 20 firms that either had an IPO in 2000 or had missing variables, 492 companies remained in our sample.8 Table 1 provides descriptive data about the sample. The mean (median) total assets for the companies in our sample are $6,094 million ($623.4 million). The mean (median) audit fee paid is $917,700 ($343,500). With respect to our board composition, expertise and diligence variables, we find that 68 percent of overall board members are nonemployees, the average board holds just under 7 meetings per year, and the average board member holds an additional 1.34 outside directorships. Seventy-five percent of the companies in the sample had audit committees that were composed entirely of outsiders, 80 percent had at least one financial expert (using the BRC guidelines) and 59 percent of the committees held four or more meetings in the sample year. Only 40 percent of our sample companies met all three audit committee criteria simultaneously (not reported), suggesting that despite the BRC’s efforts and the resulting regulatory focus on audit committee functions, many companies fell short of meeting recommendations during the sample period. Table 2 provides information on the Pearson pair-wise correlations between our explanatory variables. All of the remaining independent variables are correlated with the natural log of total assets (LNTA), with the exception of the proportion of foreign subsidiaries (FORGN ) and audit committee independence (ACOUT). Among the other independent variables, audit committee independence (ACOUT) and board composition (BDCOMP) exhibit the largest correlation at 0.39 and no other correlation exceeds 0.22. A review of regression diagnostics (discussed in the next section) does not indicate problems from multicollinearity. RESULTS Regression Results Table 3 provides the results from a regression where the dependent variable is the log of the audit fee. The overall model is significant (F-statistic = 146.4, p < .0001), and, consistent with prior research, the model’s explanatory power is quite high (adjusted R2 = .77). The coefficients for LNTA, RECINV, and SQSUBS are all positive and significant, whereas the coefficient estimates for FORGN and OPIN are in the predicted direction, but insignificant. In terms of board characteristics, the coefficient estimates for BDMEET and BDCOMP are positive and significant (t = 2.31 and 1.75, respectively). Our results for board expertise (BDEXP) were insignificant. These results are consistent, in part, with those of Carcello et al. (2002a), using a sample from a later time period and fee data that are publicly disclosed in proxy statements. Considering the variables of interest, the coefficients for ACOUT and ACEXP are positive and significant (t = 2.39 and 1.74, respectively), indicating that audit fees are higher in companies where the audit committee has: (1) solely independent members, and (2) at least one member with accounting or finance expertise. The coefficient for ACMEET is positive, but is not significant at conventional levels (t = 1.37). 9 8 9

We deleted firms in the first year of public trading because we expect firms to require an initial period of time post-IPO to appoint an audit committee and effectively transfer functions to the committee. We performed a number of diagnostics on the regression reported in Table 3, including investigation of outliers (discussed further in the “Sensitivity Analysis” section). In terms of multicollinearity, we performed two sets of tests. First, variance inflation factor (VIF) scores revealed no problems with multicollinearity (all scores < 2). Second, per Belsley et al. (1980), we calculated condition indices. The maximum calculated condition index was 6.78. According to Belsley et al. (1980), a condition index of 5–10 indicates weak dependencies and a condition index of 30–100 indicates moderateto-strong relations among the independent variables. Therefore, it appears that multicollinearity is not a problem. With respect to heteroscedasticity, we performed the Breuch-Pagan test, which failed to reject the null of homoscedasticity, suggesting that heteroscedasticity has not interfered with our OLS regressions. Finally, plotting our residuals did not suggest a nonnormal distribution. Therefore, it appears that the assumptions underlying OLS regression have been satisfied.



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TABLE 1 Descriptive Data for Final Sample of 492 Firms Panel A: Descriptive Statistics for Continuous Variables Variable Name

Mean

Median

Standard Deviation

25th percentile

75th percentile

AUDFEE (in $000s) ASSETS ($millions) RECINV SQSUBS FORGN BDCOMP BDEXP BDMEET

917.7 6,094 0.2719 4.2927 0.1671 0.6823 1.3437 6.9471

343.5 623.4 0.2583 2.5474 0.1200 0.7200 1.0695 6.0000

1,680.6 27,410 0.1981 4.2417 0.3412 0.1798 2.1085 3.4749

142.5 116 0.1131 0.0000 0.0825 0.5700 0.3967 5.0000

850.2 2,886 0.3781 5.7448 0.2500 0.8300 1.8569 9.0000

Panel B: Mean, Median, and Frequencies for Dichotomous Variables Variable Name

Mean

Median

OPIN ACOUT ACEXP ACMEET

0.1219 0.7541 0.8049 0.5915

0.0000 1.0000 1.0000 1.0000

AUDFEE ASSETS RECINV SQSUBS FORGN OPIN BDCOMP BDEXP BDMEET ACOUT ACEXP

Number of Firms Number of Firms Coded “1” Coded“0” 60 371 396 291

432 121 96 201

= = = = = = = = = = =

total audit fees (in $000s); total assets (in $millions); proportion of total assets in accounts receivable and inventory; square root of the number of consolidated subsidiaries; proportion of foreign subsidiaries to total subsidiaries; 1 if a modified audit opinion is issued, 0 otherwise; percent of nonemployee directors on the board of directors; average number of outside directorships in other firms held by outside directors; number of board meetings in the sample year; 1 if the audit committee had solely independent directors, 0 otherwise; 1 if the audit committee included a member with accounting or finance expertise, 0 otherwise; and ACMEET = 1 if the audit committee met four or more times in the sample year, 0 otherwise.


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TABLE 2 Pearson Pair-Wise Correlations Variable Name

LNAFEE

LNAFEE

1.00 0.00

LNTA RECINV SQSUBS

LNTA

0.78 0.01 1.00 0.00

RECINV

SQSUBS

–0.04 0.29 –0.11 0.01 1.00 0.00

0.18 0.05 0.35 0.01 –0.05 0.27 1.00 0.00

FORGN OPIN BDCOMP BDEXP BDMEET

FORGN

0.11 0.01 0.04 0.33 0.10 0.02 –0.09 0.14 1.00 0.00

OPIN

–0.10 0.01 –0.09 0.02 –0.06 0.28 –0.04 0.35 –0.04 0.35 1.00 0.00

BDCOMP

BDEXP

BDMEET

ACOUT

ACEXP

ACMEET

0.41 0.01 0.35 0.01 –0.08 0.33 0.14 0.56 0.06 0.18 –0.01 0.99 1.00 0.00

0.56 0.01 0.23 0.01 –0.05 0.23 0.16 0.15 –0.03 0.46 –0.03 0.45 –0.03 0.42 1.00 0.00

0.24 0.10 0.23 0.01 –0.12 0.49 0.11 0.05 0.03 0.47 0.03 0.45 0.15 0.01 0.09 0.05 1.00 0.00

0.16 0.01 0.07 0.12 –0.06 0.17 0.06 0.17 0.02 0.69 –0.04 0.30 0.39 0.01 –0.04 0.13 0.02 0.66 1.00 0.00

0.27 0.01 0.23 0.01 0.04 0.39 0.12 0.08 –0.10 0.27 0.01 0.81 0.22 0.01 0.13 0.04 0.03 0.41 0.06 0.15 1.00 0.00

0.29 0.01 0.25 0.01 –0.05 0.25 0.09 0.11 –0.02 0.75 –0.03 0.48 0.14 0.01 0.08 0.05 0.17 0.01 0.14 0.01 0.10 0.08 1.00 0.00

ACOUT ACEXP ACMEET p-values listed below correlation coefficients. = = = = = = = = = = = =

natural log of audit fees; natural log of total assets; proportion of total assets in accounts receivable and inventory; square root of the number of consolidated subsidiaries; proportion of foreign subsidiaries to total subsidiaries; 1 if a modified audit opinion is issued, 0 otherwise; percent of nonemployee directors on the board of directors; average number of outside directorships in other firms held by outside directors; number of board meetings in the sample year; 1 if the audit committee had solely independent directors, 0 otherwise; 1 if the audit committee included a member with accounting or finance expertise, 0 otherwise; and 1 if the audit committee met four or more times in the sample year, 0 otherwise.


LNAFEE LNTA RECINV SQSUBS FORGN OPIN BDCOMP BDEXP BDMEET ACOUT ACEXP ACMEET


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TABLE 3 Regression Results

LNAFEE = b 0 + b1 LNTA + b2RECINV + b3SQSUBS + b4 FORGN + b5OPIN + b 6BDCOMP + b7BDEXP + b8BDMEET + b9 ACOUT + b10ACEXP + b 11ACMEET + e Variable Name INTERCEPT LNTA RECINV SQSUBS FORGN OPIN BDCOMP BDEXP BDMEET ACOUT ACEXP ACMEET

Expected Sign + + + + + + + + + + +

n = 492 Adjusted R2 = 0.77

Parameter Estimate 5.60 0.48 0.68 0.01 0.02 0.12 0.34 –0.00 0.02 0.18 0.07 0.08

t-statistic 27.47 30.18 4.56 2.66 1.13 1.35 1.75 –0.07 2.31 2.39 1.74 1.37

Model F-stat = 146.4

p-value 0.000 0.000 0.000 0.008 0.257 0.177 0.081 0.946 0.021 0.018 0.082 0.173

p < .0001

Two-sided p-values are reported. LNAFEE = LNTA = RECINV = SQSUBS = FORGN = OPIN = BDCOMP = BDEXP = BDMEET = ACOUT = ACEXP = ACMEET =

natural log of audit fees; natural log of client’s total assets; proportion of total assets in accounts receivable and inventory; square root of the number of consolidated subsidiaries; proportion of foreign subsidiaries to total subsidiaries; 1 if a modified audit opinion is issued, 0 otherwise; percent of nonemployee directors on the board of directors; average number of outside directorships in other firms held by outside directors; number of board meetings in the sample year; 1 if the audit committee had solely independent directors, 0 otherwise; 1 if the audit committee had a member with accounting or finance expertise, 0 otherwise; and 1 if the audit committee met four or more times in the sample year, 0 otherwise.


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Our finding that both audit committee and board variables are positively and significantly associated with audit fees merits further discussion. As previously noted, Carcello et al. (2002a) find that the audit committee variables were not significant in explaining audit fees after controlling for board composition. We believe there are at least two possible explanations for the differences between our results. First, Carcello et al. (2002a) obtained their data based on a survey conducted in 1993 of the Fortune 1000 companies. The Fortune 1000 companies are larger than the overall population of SEC registrants, and prior papers have documented that size is associated with many issues related to corporate governance including audit committee characteristics. It is likely that larger firms exhibit less variation in audit committee characteristics than does the present sample. Further, survey-based data introduce potential concerns related to nonresponse bias. Second, in the period since 1993 the SEC has considerably expanded its regulatory focus on audit committees as evidenced by the creation of BRC and the Independence Standards Board (ISB). The SEC and others have called for not only greater audit committee oversight, but also greater disclosure of audit committee duties and responsibilities in the annual proxy statements. The expanded audit committee disclosures and increased regulatory focus on audit committees are likely to have strengthened the motivation of audit committees to act in a manner consistent with our hypotheses. Consequently, this result also suggests the BRC and ISB recommendations are at least somewhat effective in accomplishing their corporate governance intentions (BRC 1999; ISB 1999). Sensitivity Analyses Size, Alternative Test Variable Definitions, and Additional Variables We performed several tests to examine the influence of size on our results. First, we ran our regression model separately on small companies (total assets less than $200 million) and large companies (total assets greater than $200 million), and performed a Chow test. The Chow test Fstatistic was not significant, indicating that neither segment drives our results. Second, for each of the continuous variables, including LNTA, we deleted outlying observations (those outside two standard deviations from the median). Third, we truncated outlying observations to the 1 percent and 99 percent levels. Finally, following Simunic (1984), we also ran separate tests that deflated audit fees by the square root of total assets. In all cases, our results were qualitatively unchanged. We also used continuous versions of our ACOUT (the percentage of outsiders on the audit committee) and ACMEET (the number of audit committee meetings) variables. With this alternative specification, our results remained substantively similar. We also substituted the Carcello et al. (2002a) measure of expertise (the average number of other outside directorships held by outside audit committee directors) for our ACEXP variable. With this specification (not reported), both audit committee independence and expertise remained significant. We also tested whether the inclusion of additional variables such as leverage, return on assets, an indicator variable for recurring losses, current ratio, and an indicator variable for December 31 year-end firms significantly impacted our results (Gul and Tsui 2001). We find that current ratio and recurring loss are significantly and positively related to audit fees, but that our test variable results are not affected. Our results were also robust to including an indicator variable coded “1”’ if the CEO is also chairman of the board, “0” otherwise (Tsui et al. 2001). We checked whether the clients of any one of the audit firms influenced the results. We formed five separate subsamples by deleting the clients of each of the Big 5 firms. The regression results of such subsamples were substantively similar to the results reported in the paper, and the audit committee composition variables continued to remain significant in each regression. We also checked to see if our results are driven by the engagement of auditor industry specialists since Abbott and Parker (2000) find a positive relationship between engagement of an industry specialist and audit committee



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characteristics.10 The industry specialist variable was not significant and our results remain qualitatively unchanged.11 We also tested the sensitivity of our results to the inclusion of nonaudit fees. Evidence on the impact of nonaudit fees on audit fees remains mixed (Simunic 1984; Davis et al. 1993; Felix et al. 2001). Knowledge spillovers from the joint supply of audit and nonaudit services could lead to higher audit fees, depending on the price elasticity of the audit demand function (Simunic 1984). Alternatively, auditors may discount their audit fees in the hopes of providing higher-margin, nonaudit services (Felix et al. 2001). To address this issue, we also used a two-stage least squares regression to control for the potential endogeneity among audit fees, audit committee characteristics, and nonaudit fees. Our test variables continued to remain significant in the two-stage approach. SUMMARY AND CONCLUSIONS In 1994, the Public Oversight Board observed that in most companies “management selects or recommends auditors and changes in auditors, negotiates fees … and monitors the audit” (POB 1994). The BRC noted the POB’s comments and sought to strengthen the audit committee’s ability to monitor the management-auditor relationship. The BRC asserted that characteristics such as audit committee independence, expertise, and diligence could lead to better overall audit committee oversight. The BRC also recognized that audit committees must rely upon the external auditor and emphasized the importance of engaging the audit committee in all phases of the audit process. Specifically, the BRC (1999) stated that “the (audit) committee’s job is clearly one of oversight and monitoring, and in carrying out this job it acts in reliance on senior management and the outside auditors.” Subsequent adoption of many BRC recommendations by stock exchanges, legislation, and the SEC further focuses attention on the audit committee’s role in management of the audit process. In this paper, we examine the association between audit committee characteristics and audit fees. Our results, based on data obtained from 492 proxy statements filed with the SEC, indicate that audit committees consisting solely of independent directors and having at least one financial expert are associated with higher audit fees. Assuming that the increased audit fee is associated with a higher level of audit assurance, our results support the expectation of the BRC that greater independence and expertise of audit committees will lead to enhanced oversight of the management-auditor relationship. The SEC, BRC, and others have emphasized the need for financial expertise on the audit committee, but there is little empirical evidence about the association between audit committee expertise and the audit committee’s interaction with the external auditor. Our paper provides initial empirical evidence on the association between audit committee expertise and audit fees. Overall, our study provides additional insight into the interplay between the external auditor, the audit committee, and management in the financial reporting process.

10 11

We also acknowledge the mixed results in prior literature regarding the relation between audit fees and audit firm specialization. We used three measures of industry specialization. For a thorough review of industry specialization measures, see Gramling and Stone (2001). The first measure of auditor specialization was based upon market share, measured as the proportion of client sales in a particular industry audited by a specific auditor, as follows: Audit Specialization = Total Client Salesai / Total Industry Sales1. i = industry a = Audit Firm The second measure was a dichotomous measure that codes as a specialist the market share leader in each industry group and any other auditor within 15 percent of the market share (Abbott and Parker 2000, 2001). The third method of identifying industry specialization was based on a portfolio approach (Gramling et al. 2002; Krishnan 1999), which assumes that client size (measured by sales) proxies for the auditor revenues associated with that client in a specific industry. The third measure is therefore calculated as follows: Audit Specialization = Total Client Salesai / Total Sales of all Clientsa. i = industry a = Audit Firm We classified firms into 12 focus industry groups used by Franz et al. (1998) and Abbott and Parker (2000).


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Our results are consistent with audit committee characteristics impacting the demand for greater audit coverage. An alternative (but not mutually exclusive) explanation for our results is that effective audit committees could impact the negotiation of audit fees as well as scope (audit effort or coverage). Specifically, by reducing the overall threat of auditor dismissal, an audit committee could simultaneously strengthen (weaken) the auditor’s (client’s) relative bargaining position during audit fee negotiations. Consequently, this change in relative bargaining position could lead to higher audit fees even in the absence of increased audit scope. Future research incorporating actual audit hours and audit committee characteristics can shed additional light on which of the two explanations drives the higher audit fees documented in this paper. The corporate governance area has recently experienced an accelerated pace of regulatory change. Subsequent to the time period encompassed by this study, the Sarbanes-Oxley Act of 2002 was passed, providing for substantial changes to the corporate governance structures of public companies. Among these changes are more rigorous independence rules for audit committee members, a requirement for at least one member to possess financial expertise, restrictions on the provision of certain nonaudit services (NAS), and a requirement that the audit committee preapprove any nonproscribed NAS provided by the financial statement auditor. Some of these legislative provisions are similar in part to exchange-listing requirements that became effective June 14, 2001, which set standards for audit committee independence, financial literacy, and expertise. Even more recently, following the signing of Sarbanes-Oxley, the NYSE and NASDAQ/AMEX have proposed additional restrictions on (and qualifications for) audit committee membership and additional audit committee responsibilities, including mandated periodic meetings. It seems likely that variation in the characteristics commonly used by research in this area (expertise, independence, meeting frequency) will be diminished in the future. However, it is very likely that a consequence of these changes for public companies may be an increase in the effectiveness and scope of audit committee monitoring. If this is the case, future research in this area may emphasize subsequent changes in other corporate governance mechanisms that may be either complements or substitutes for audit committee activities. In addition, the focus of research in this area may shift to an exploration of audit committee processes and decision making.

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