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Impact of Market Structure on Audit Price and Quality

Background and motivation

Audit is a fundamental financial activity of all business organizations. Audit determines the financial position of an organization. Companies undertake audits annually. The regulatory bodies of most countries require companies to publicize their annual financial reports. The financial reports determine the investor’s investment decision. Therefore, it is vital to determine various factors that determine the audit of various companies. Audit companies may collaborate with companies to fleece the unsuspecting members of the public. The Enron scandal is a clear illustration of the role of audit companies in the financial malpractices of various companies. As of 2002, four firms (Big4) accounted for more than 90% of audit fees of public companies. Massive consolidation during the 1980s and 1990s is the major factor that reduced the number of audit companies. The reduction in the number of audit companies has a significant effect on audit quality and price. Audit helps in portraying the financial position of an organization. Therefore, audit quality may determine the investors’ investment decision (Schipper, 2007). Therefore, market concentration and market equality may have a significant impact on price and quality.

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The study strives to determine the effect of audit market equality on the audit price and quality. The researchers hypothesize that “audit supplier equality results in lower audit fees and greater audit quality at the national-industry level” (Dunn, Kohlbeck & Mayhew, 2013, p. 2).

Research Design Issues

Research designs determine the efficiency of scientific studies. The issue under investigation determines the most efficient research design. Most studies use structured questionnaires. Determining the level of equality is vital in the overall results of the study. The researchers used the Gini Metric to determine the level of market share equality. The Gini metric is more effective than the Herfidahl Index (HI) in determining the level of market share equality (Kallapur, Sankaraguruswamy & Zang, 2010). This increases the accuracy and relevance of the study.

Finding the right tool of measuring the market equality determines the accuracy of a study. It is vital for researchers to design the most efficient formulas that they would use to determine various parameters that would be helpful in the research. It is very hard for the findings of the researchers to be perfect. Therefore, researchers make several assumptions during the research. Intricate knowledge of the issues under investigation enables the researchers to make the right assumptions.

Theoretical or Statistical Issues

‘Audit fees’ is one of the inputs of the research. The researchers use the audit fee model that General Accounting Office (GAO) used in 2008. GAO’s audit fee model is one of the most efficient models. However, it has various limitations. Therefore, the dropped the ‘Separate auditor’ that was insignificant in the model. The researchers follow GAO’s predictions that “larger clients usually expect to get higher audit fees” (Dunn, Kohlbeck & Mayhew, 2013, p. 14). In some instances, businesses activities may not proceed according to the expectations of the management of the organization. Businesses may “incur losses, receive going concern opinions, restate their financial results, file notices of non-timely, or have their internal controls deemed ineffective” (Dunn, Kohlbeck & Mayhew, 2013, p. 14). The researchers expected these businesses to incur higher audit fees. The researchers used the above parameters in determining the audit fees that businesses may pay. The researchers focused on audit restatements. This limits the accuracy of their results.

The researchers also determine the effect of audit supplier equality on audit quality. They use restatements to determine the audit quality. However, the researchers could also have used ongoing concern opinions and earnings response coefficient in determining audit quality (Marciukaityte, Szewczyk & Varma, 2009).

Researchers should consider the findings of other studies in their research. Other studies show that large local offices have fewer restatements. Therefore, the researchers include this fact in their studies. Client characteristics determine the probability of restatement (Palmrose, Richardson & Scholz, 2004). Large organizations have large clients. These clients have complex accounting practices. Therefore, the researchers expect large organizations to have a higher probability of restatement. However, large organizations usually have highly developed accounting systems. These systems reduce the probability of restatements. Despite the existence of highly developed accounting systems in large organizations, the probability of restatements in these organizations is higher than in small firms. The Sarbanes-Oxley Act (2002) led to significant changes in accounting practices (Leone & Liu, 2010). Therefore, the researchers used a sample from 2004-2011. Using a sample from 2004 enables the researchers to avoid the effects of implementation of the legislation in 2003.

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Results

Gini index ranges from zero to one. High values of Gini index represent less equality in the industry. The researchers used the inverse of the Gini index to determine the equality index more efficiently. From the research, the national-industry GAO audit fee model ranged from 1.58 to 23.81. The high values indicate more equality. On the other hand, the mean national industry equality was 7.729. The research shows that there is a negative correlation between audit fees and national industry equality. Therefore, market equality leads to lower market fees. This supported the hypothesis of the researchers.

The sample from the research included firms in various industries. Finance and insurance accounted for 34.9% of the sample. Two manufacturing classifications accounted for 16.7% and 9.4% of the sample. The sample used is any research determines the accuracy and relevance of the research. Finance and insurance are some of the largest industries in the U.S. However, the research should have increased the percentage of manufacturing firms.

The researchers used various characteristics of the above firms in determining the audit fees. The coefficient for the Gini measure of the national industry market has a close relationship with audit fees. From the research, there was an inverse relationship between the coefficient and audit fees. This implies that equality reduces audit fees. This fulfills the hypothesis of the researchers that “audit fees decrease as audit supplier equality increases at the national-industry level” (Dunn, Kohlbeck & Mayhew, 2013, p. 21).

From the research, the mean of the city market equality was 5.615. This value was lower than the mean of the national industry equality. This indicates that there was lower market equality in city markets. This is due to the narrower market definition in city markets. Most of the firms that made up the sample that the researchers used for the city market analysis were from New York. Approximately 6,000 firms were from New York. It is a fact that New York is one of the major economic centers of the U.S. However, this does not warrant the researchers to use approximately 6,000 firms from New York in the research. They should have used a lower number in the research.

Implications

Various factors determine the relevance of financial statements. It is a fact that financial statements do not include all assets of an organization. In addition, there is a raging debate on whether financial statements should provide historical costs or fair market values. Fair value adopts the Hicksian definition of income as a change in wealth. It is a fact that “change in fair value of net assets on the balance sheet yields income” (Penman, 2007, p. 33). Use of fair value enables the organization to have up-to-date financial information. In addition, fair value is largely unaffected by various factors that are specific to various entries in the financial statement. This enables fair value to provide unbiased financial information across various entries of the financial statement. This makes fair value provide the most accurate financial information.

However, debates on financial reports overlook the effect of market structure on the quality of the financial reports. Auditors are the most important parties in the formation of the financial reports of companies. The Enron scandal highlights the impact of auditors in the accuracy of financial reports (Hennes, Leone & Miller, 2008). In the scandal, senior executives of Enron collaborated with the auditor, Arthur Andersen, in falsifying the financial reports of the company. The Enron scandal necessitated the U.S. government to enact the Sarbanes-Oxley Act. This legislation made it difficult for organizations to engage in financial malpractice (Gray & Manson, 2007). However, organizations may provide wrong financial information without their knowledge. The market structure may determine the quality of audit reports.

The findings of the research would help in determining the quality of financial reports in relation to the market structure. The research shows that equality reduces audit fees of industries in national markets. In the national market, competition among the Big4 increases reduces audit fees. In the city market, equality increases audit fees. The research found that the equality levels of city markets were low. The low level of equality of city markets is due to the few number of Big4 in these markets. The Big4 usually compete with other smaller audit firms.

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Companies usually make restatements if their financial reports are not complete or truthful. The restatements may be voluntary or forced. Restatements may have a negative effect on the investor confidence (Srinivasan, 2005). The research considered both the income-reducing and income-increasing restatements of the national-industry and city markets. Restatement model variables have additional data requirements. This necessitated the researchers to reduce the sample they used in determining the coefficient of market equality. From the research is clear that the probability of restatement in the national-industry market “decreases as audit supplier equality increases” (Dunn, Kohlbeck & Mayhew, 2013, p. 21). The reverse is true in the city market. The results from this research show the significant differences between the national-industry and city markets. Policy makers may use the findings of this research enacting legislation that would improve audit quality. The legislation should consider the market structure. In addition, the findings of the research may help policy makers to determine whether to liberalize the market. It is clear that market equality in in the national-industry.

Conclusion

Financial statements show the financial position of a company. Determination of the financial position helps the management in strategic planning. In addition, financial statements are the most important documents that help investors in making investment decisions (Francis & Schipper, 1999). The research highlights how the market structure affects audit price and quality. The research considers both the national-industry and city markets. The research shows that in the national industry, equality reduces audit price (Boone, Khurana & Raman, 2012). The reverse is true in the city industry. The research may help investors in determining the audit quality of an organization. In addition, it may help policy makers in designing policies that would improve audit quality. This would enable organizations to show their real financial position.

References

Boone, J., Khurana, I. & Raman, K. (2012). Audit market concentration and auditor tolerance for earnings management, Contemporary Accounting Research, 29(4), 1171-1203.

Dunn, K.A., Kohlbeck, M. & Mayhew, B.W. (2013). The impact of market structure on audit price and quality. Madison, WI: Wisconsin School of Business.

Francis, J. & Schipper, K. (1999). Have financial statements lost their relevance. Journal of Accounting Research, 37(2), 319-352.

Gray, I. & Manson, S. (2007). The audit process: Principles, practice and cases. Mason, OH: Cengage Learning.

Hennes, K., Leone, A. & Miller, B. (2008). The importance of distinguishing errors from irregularities in restatement research: The case of restatements and CEO/CFO turnover. The Accounting Review, 83(6), 1487-1519.

Kallapur, S., Sankaraguruswamy, S. & Zang, Y. (2010). Audit market concentration and audit quality. New Delhi: Indian School of Business.

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Leone, A. & Liu, M. (2010). Accounting irregularities and executive turnover in founder-managed firms. The Accounting Review, 85(1), 287-314.

Marciukaityte, D., Szewczyk, S.H. & Varma, R. (2009). Voluntary vs. forced financial restatements: The role of board independence. Financial Analysts Journal, 65(5), 1-15.

Palmrose, Z., Richardson, V. & Scholz, S. (2004). Determinants of market reactions to restatement announcements. Journal of Accounting and Economics, 37(1), 59-89.

Penman, S.H. (2007). Financial reporting quality: Is fair value a plus or a minus. Accounting & Business Research, 37(1), 33-44.

Schipper, K. (2007). Required disclosures in financial reports. The Accounting Review, 82(2), 301-326.

Srinivasan, S. (2005). Consequences of financial reporting failure for outside directors: Evidence from accounting restatements and audit committee members. Journal of Accounting Research, 43(2), 291-334.

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