Mandatory audit fee disclosure and price competition in the private client segment of the Belgian audit market

Abstract

This study empirically examines whether mandatory audit fee disclosure affects audit pricing and price competition in the private client segment of the Belgian audit market. We expect price competition between auditors to intensify after mandatory public disclosure of audit fees because transparency of audit fee information is likely to increase client bargaining power and/or increase competitive pressure. Using a data set including both pre- and post-disclosure audit fees of private clients, we observe that subsequent to mandatory disclosure of audit fees, clients with positive (negative) abnormal audit fees experience a downward (upward) fee adjustment. Consistent with increased price competition following mandatory audit fee disclosure, clients with negative abnormal audit fees are better able to mitigate the upward fee adjustment if they have higher bargaining power or have an auditor facing stronger competitive pressure. These effects are largest in the initial disclosure year, suggesting anticipatory price adjusting behavior by audit firms.

Introduction

The objective of this paper is to empirically examine whether mandatory public disclosure of audit fees affects audit pricing and price competition in the private client segment of the Belgian audit market. First, we explore whether mandatory audit fee disclosure affects subsequent audit pricing. Second and more importantly, we aim to gain insights into the effect of mandatory audit fee disclosure on the relationships between clients and their auditor, as well as between auditors and their competitors. Specifically, we explore whether and how client bargaining power and competitive pressure between auditors influence the effect of mandatory audit fee disclosure on subsequent audit fees.

In some countries, such as the United Kingdom (Companies Act, 1967) and Australia (Uniform Companies Act of 1961–1962), mandatory disclosure of audit fees already exists for several decades, whereas it has only been established in the last two decades in many other countries, such as the United States (US) (US Securities and Exchange Commission (SEC)), 2000), and the European Union (EU) (for example, Germany (BilReG, 2004) and Belgium (Royal Decree, 2007)). In the aftermath of various accounting scandals (e.g., Enron, Lernout & Hauspie, WorldCom), the introduction of audit fee disclosure regulation was mainly triggered by concerns about auditor independence arising from incumbent auditors providing both audit and non-audit services. While mandatory fee disclosure provides information with regard to fees paid to the auditor and the scope of services provided by auditors to their clients, it is also likely to increase competitive pricing in the audit market. Anecdotal evidence suggests that auditors did not encourage the mandatory disclosure of the actual values of audit and non-audit fees, but rather favored mandatory disclosure of the ratio of audit over non-audit fees (or the ratio of non-audit over audit fees).¹ Specifically, the concern was that mandatory disclosure of (non-)audit fees would lead to higher pressure on audit fees in addition to the provision of information about the client-auditor relationship.² In this study, we consider the effect of mandatory audit fee disclosure on price competition in the audit market. Hence, results from our study may help elucidate the role of publicly available information in the pricing of audit services and competitiveness of the audit market and are, therefore, of interest to scholars, regulators, and policy makers.

Francis and Wang (2005) are the first addressing the impact of mandatory audit fee disclosure on subsequent audit pricing. Their evidence suggests that public audit fee disclosure in the US improved the precision of audit pricing (less variance in audit fees) and that audit fees have been adjusted downward to a greater extent for “overcharged” clients than adjusted upward for “undercharged” clients. More recently, Su and Wu (2017) obtain similar results in the Chinese audit market. We add to these studies in two important ways.

Firstly, Francis and Wang (2005) and Su and Wu (2017) conclude that public disclosure of audit fees gave clients increased bargaining power over auditors based on the observation that in the period subsequent to the disclosure regulation, audit fees were adjusted downward to a greater extent for clients with positive abnormal audit fees than adjusted upward for clients with negative abnormal audit fees. However, Francis and Wang (2005) and Su and Wu (2017) do not explicitly test the impact of client and auditor bargaining power in their analysis. We extend their analysis by including measures for client bargaining power and competitive pressure on auditor bargaining power to assess how these factors affect adjustments in audit pricing following the mandatory public disclosure of audit fees.

Secondly, Francis and Wang (2005) and Su and Wu (2017) focus on public client information and consequently, the impact of mandatory audit fee disclosure regulation on audit pricing and price competition is yet unexplored in the private client segment of the audit market. We believe that examining this issue in the private segment of the audit market is relevant for several reasons. As argued by Langli and Svanström (2014), research focusing on public clients may not be generalizable across the entire audit market since the audit setting of the private client segment differs from the public client segment. The private client segment of the audit market does not only include clients in need of a high-quality auditor (i.e., quality-seeking clients) but also clients looking for the cheapest auditor only to fulfill legal audit requirements (i.e., price-seeking clients) (Chaney, Jeter, & Shivakumar, 2004; Willekens & Achmadi, 2003). Therefore, prior studies often assume that price competition, rather than quality competition, prevails in the private client segment of the audit market because of its low concentration (see e.g., Simunic, 1980). As a result, audit fee adjustments resulting from mandatory audit fee disclosure might differ for private clients relative to public clients. While a downward fee adjustment (which is in favor of the private client) might be easy to accept, an upward fee adjustment might be more difficult to negotiate in this more price competitive segment of the audit market.

In addition, private firms are of economic importance as they represent the majority of the EU economy and the EU market for audit services. Small and medium-sized companies represent more than 99 percent of European companies and are also considered to be the backbone of European economy (Federation of European Accountants, 2016; Vanstraelen & Schelleman, 2017). In Belgium, the private client segment of the audit market is predominant. Studying audit pricing in the Belgian audit market, Van Caneghem (2010) reports that 99 percent of his sample are private firms and this accounts for about 94 percent of the total audit fees charged by Belgian auditors. As argued by Vanstraelen and Schelleman (2017), research on the external audit of private firms is much more limited than that of public firms and, thus, additional studies using private client information are needed to extend the auditing literature. For these reasons, the private client segment of the (Belgian) audit market provides a relevant setting to explore the issue under study.

We use a data set that includes both pre- and post-disclosure audit fee data, which enables us to investigate the impact of mandatory audit fee disclosure regulation on audit pricing and price competition in both the period surrounding as well as the period after the implementation of the requirement. Based on a balanced sample of 18,939 firm-year observations (relating to 6,313 unique clients) from both before (the year 2004) and after (the year 2010) mandatory disclosure, our analyses indicate an overall increase in audit fees over this seven-year time span.

However, from the point that disclosure becomes mandatory (i.e., 2007 and onwards), clients with a positive abnormal audit fee³ are able to negotiate a downward fee adjustment, irrespective of their bargaining power (i.e., importance in the auditor’s portfolio) or competitive pressure that the auditor faces from its closest competitors. Clients with a negative abnormal audit fee face an upward fee adjustment during the same time period, but they are better able to mitigate the upward fee adjustment if they have higher client bargaining power or if their auditor faces higher competitive pressure. These effects are largest in the initial disclosure year, which suggests anticipatory price adjusting behavior by auditors. That is, because mandatory public disclosure of audit fees was announced before the actual requirement came into effect (cf. Section 4.1 Audit fee disclosure regulation), audit firms may have anticipated the potential public disclosure of audit fees in their pricing. In sum, while mandatory fee disclosure was enforced to provide insight into the client-auditor relationship and to enhance auditor independence, this study provides evidence of another consequence, that enhanced competitive pricing in the private client segment of the audit market.

The remainder of the paper is organized as follows. In Section 2, we present previous literature on mandatory audit fee disclosure. In Section 3, we develop our hypotheses with regard to client and auditor bargaining power. In Section 4, we discuss the institutional setting. We discuss our research design in Sections 5 and 6 presents our results, including additional and sensitivity analyses. Finally, in Section7, we discuss the conclusions and limitations of this study.