FURTHER EVIDENCE ON THE DETERMINANTS OF AUDIT FEES OF ENERGY FIRMS

Petroleum Accounting and Financial Management Journal, Fall 2003 by Wilson, Thomas E Jr

The nature of the market for audit services of energy firms has long been an area of interest to accounting researchers and government regulators. One area of research focus has been the amount charged by public accounting firms to conduct the required annual audits of energy companies. Although previous studies have examined factors affecting audit fees, inquiry in this area has been hampered by the lack of publicly available information about audit fees for specific companies. Prior researchers have often had to rely on survey data or on estimates of audit fees. However, recent regulatory actions permit examination of this audit issue facing energy concerns. The securities and Exchange Commission (SEC) has moved to require that publicly held companies disclose the fees paid to their external auditors for auditing and other services in their annual proxy statements. This paper employs energy company data filed with the sec to examine some determinants of the fees paid to their external auditors.

Selected Prior Research

Perhaps the one client characteristic that most directly influences audit fees is firm size. If nothing else, the greater volume of transactions to be examined would be expected to require additional audit time and effort. Not surprisingly, numerous prior studies have demonstrated that the audit fees paid by large client firms are greater than the fees paid by small client firms (e.g., Menon and Williams [2001] and Firth [1997]).

Other studies of audit fees have focused on the issues of audit complexity and audit risk. Logically, client firms presenting higher levels of audit difficulty or posing increased risks will likely pay higher audit fees. One measure of audit complexity is the number of subsidiaries a company has. As Pong and Whittington (1994, p. 1076) note, "(m)ore subsidiaries imply a greater amount of work in consolidation and eliminating intra-group transactions." The extra audit work involved would reasonably be expected to result in higher audit fees. Prior research has yielded mixed results regarding this issue. Menon and Williams (2001) examined audit fees over time and found a consistently significant positive association between audit fees and the square root of the number of corporate subsidiaries for the period 1980 to 1997. Pong and Whittington (1994) examined a sample of firms in the United Kingdom and also found a positive relation. However, Firth (1997) found no significant impact when the variable was tested using a sample of Norwegian firms.

In addition to size and organizational structure, certain accounts are often perceived as more complex than others. Firth (1997, p. 512) notes that "... inventories and accounts receivable are thought to require more audit work than many other types of assets because of their volume, their ability to 'be manipulated', and their exposure to fraud." Once again, however, prior research has yielded mixed results. Turpen (1995, p. 54), in a summary of previous research, flatly states that ". . . large diversified companies with extensive receivables and inventories . . . pay higher fees." However Firth (1997) examined inventories and receivables separately and found no significant relation for either one. Menon and Williams (2001 ) find that higher levels of inventories and receivables as a percentage of total assets are consistently and significantly associated with higher audit fees over an extended period of time. Further uncertainty is provided by their finding that, although still significant, the strength of the relationship between inventories and receivables and audit fees has been decreasing over time.

Another client characteristic commonly associated with audit fees is the risk posed by the client to the auditor. High risk audit engagements may expose the auditor to greater legal liability or to a loss of reputation from the negative publicity associated with a risky client. Wilson and Grimlund (1990) document the impact of a loss of reputation on an audit firm's ability to attract new clients or retain existing clients. Auditors may demand higher fees from such clients as a premium for accepting the added risk or may charge higher fees to reflect the additional audit work required to reduce such risks to an acceptable level.

Prior research has employed variables which are linked to firm financial difficulties to proxy for audit risk. Firth (1997, p. 513) notes that such variables are "... associated with companies who enter bankruptcy or financial distress and investors and creditors, who consequently suffer losses, may sue the auditors to recoup those losses." Turpen's (1995) summary of the literature reports that financially troubled clients pay higher audit fees. However, neither Firth (1997) nor Walker and Casterella (2000) found evidence that firms losing money were charged higher audit fees.

Firm leverage is also commonly employed as a surrogate for audit risk. Higher degrees of leverage, whether expressed as debt to equity or debt to assets, are often assumed to be correlated with higher audit fees. Firth ( 1997) found a positive, although insignificant, relation between leverage and audit fees. Menon and Williams (2001) found that leverage was significantly correlated with audit fees in only four of the 18 years they studied. However their results for those four years revealed a negative relation between leverage and audit risk. Clearly, the results from prior research for this variable are mixed.