Audit fee premium: The potential effect of King III

Abstract

In the wake of corporate scandals at world-renowned companies such as Enron (in 2001) and WorldCom (in 2002), public confidence in the role of the auditing profession was eroded. Consequently, in the United States, the Sarbanes-Oxley Act of 2002 (SOX) introduced a raft of mandatory corporate governance initiatives; in the United Kingdom measures included expanding the role of the Financial Reporting Council, the updating of the Combined Code in 2003 and the 2005 Company Law Reform Act; while in France, the Financial Security introduced provisions which were deemed to be very similar to SOX. In South Africa, corporate reforms included the introduction of the King I to III codes of corporate governance, the Companies Act No.71 of 2008 and the Auditing Profession Act No. 26 of 2005. In particular, King III introduced the concept of integrated reporting (IR) which recommends that companies report holistically on both financial and sustainability (economic, social and environmental) issues. In contrast to SOX, however, the application of King III is voluntary, operating on an ‘apply or explain’ basis. The introduction of SOX was postulated to have increased compliance costs and created fee opportunities for the audit profession, giving rise to questions as to whether or not the introduction of IR in King III had introduced similar opportunities for the auditing profession in South Africa, resulting in audit firms charging an audit fee premium¹.

In this study, multiple regression analysis was conducted on two sets of models to test two hypotheses: (i) that the BIG4² audit firms potentially charged an audit fee premium in response to the recommendations of King III on IR, and (ii) that audit fees are related to non-audit service fees. Results of the research do not show any evidence to suggest that the advent of King III was related to audit fee premiums, yet a strong relationship was found between audit³ and non-audit service fees⁴. Further, certain of the BIG4 audit firms were found to obtain an audit fee premium. The findings of this study add a South African dimension to the existing body of knowledge on the relationships between audit fees and governance initiatives in this context.

Keywords:

• Corporate Governance
• Accounting
• Auditing
• King III

JEL Classification:

• M400 Accounting and Auditing: General

Notes

1. Audit fee premium: the difference between what a client with an incumbent BIGX audit firm would pay and an equivalent non-BIGX audit firm (Chaney, Jeter & Shivakumar, 2004)

2. BIG4 refers to the four biggest audit firms in South Africa, namely PricewaterhouseCoopers, KPMG, Ernst & Young and Deloitte.

3. Audit fees: the fees that are charged by external auditors for carrying out the statutory annual audit of the financial statements of an organisation.

4. Non-audit service fees: any fees other than audit fees and include fees for services such as tax compliance, tax advice, tax planning, mergers and acquisitions and corporate governance.

5. SOX required public companies in the USA to file annual reports with the Securities and Exchange Commission (SEC), and auditors were required to attest to the accuracy of management assessments contained therein as well as evaluating the effectiveness of internal controls.

6. The United States term equivalent to the accountancy profession in the United Kingdom. Accountancy is the profession of an accountant to keep, audit and inspect the financial records of entities and to prepare financial and tax records (The Free Dictionary, 2012). So, whenever the term is used in this study, it is with reference to the broader definition which encompasses both the preparation of and the auditing of financial statements.

7. The letter X in BIGX denotes the number of audit firms regarded as big at different time frames. This group was once known as the ‘Big8’, and was reduced to the ‘Big6’ and then Big5’ by a series of mergers. The ‘Big5’ became the ‘Big4’ after the demise of Arthur Andersen in 2002, following its involvement in the Enron scandal (https://en.wikipedia.org/wiki/Big_Four_%28audit_firms%29).

8. According to the American Institute of Certified Public Accountants (AICPA) in 1992, the ‘expectation gap’ could be defined as the difference between what the public and financial statement users believe auditors are responsible for and what auditors themselves believe to be their responsibilities.

9. An acronym for the Johannesburg Stock Exchange.