Do failed auditors receive lower audit fees from continuing engagements?
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Do failed auditors receive lower audit fees from continuing engagements? Kam‑Wah Lai1 · Ferdinand A. Gul2
© Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract This study investigates whether a failed auditor suffers from reduced audit fees from cli‑ ents who continue to employ him and whether the reduced audit fees are more pronounced when the failed auditor is not a market leader. The subject audit firm Deloitte Touche Toh‑ matsu (Deloitte), Hong Kong, issued a clean audit opinion to a client on its 1997 finan‑ cial statements which were subsequently found to have accounting errors because of fraud and other irregularities by KPMG. Consequently, Deloitte resigned from the engagement and withdrew its audit report for the client. Results show that Deloitte had more negative change in audit fees than other auditors after the event, and the reduced audit fees were more pronounced when Deloitte was not the market leader. Additional tests suggest that Deloitte did not reduce its audit quality after the event. Keywords Audit fees · Audit failure · Continuing engagements · Auditor reputation · Clean opinions JEL Classification M42
1 Introduction Prior studies (e.g., Chaney et al. 2002; Krishnamurthy et al. 2006; Cahan et al. 2009; Numata and Takeda 2010; Dee et al. 2011) show that clients of auditors who fail to con‑ duct proper audits are likely to have negative stock returns around important event dates that adversely affect the auditors’ reputation. However, lower returns to common stocks are borne by failed auditors’ clients but not by failed auditors. If auditors induce economic losses on their clients because of their audit failure, then the failed auditors should also suf‑ fer an economic loss. DeAngelo (1981) suggests that the economic loss of failed auditors may take the form of either the loss of audit revenue from client dismissal or reduced audit fees from clients who retain the failed auditors. * Kam‑Wah Lai [email protected] 1
Department of Accounting and Banking, Chu Hai College of Higher Education, Tuen Mun, Hong Kong
2
Department of Accounting, Deakin University, Geelong, Australia
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K.-W. Lai, F. A. Gul
This paper examines the second form of economic loss suffered by failed auditors using an accounting scandal in Hong Kong.1 We first test whether audit fees of failed auditors from continuing engagements decrease after an alleged scandal relative to the audit fees of other auditors over the event period. We then draw on the literature on market leadership to test whether failed auditors’ reduced audit fees are more pronounced when they are not the market leader. This investigation is important because it sheds light on audit market discipline of failed auditors. In deciding the appropriate level of audit assurance to deliver, auditors consider the likely economic loss if they lose auditor independence and are dis‑ covered (Chung and Kallapur 2003). Concurrently, audit clients expect a certain level of audit assurance from auditors and pay
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