Auditing standards and audit fees

Professional due care requires that auditors comply with professional standards and rules, including auditing standards. Non-compliance with auditing standards is an important determinant of audit failure that significantly increases the auditor’s loss exposure.

Therefore, auditing standards have a significant impact on auditors’ behavior, including audit service pricing.

Doogar et al. (2010) use the replacement of Auditing Standard No. 2 (AS2) with Auditing Standard No. 5 (AS5) as a natural experiment to test how auditing standards affect audit efficiency and effectiveness and audit fees. AS2 and AS5 both specify standards for audits of internal controls over financial reporting, an antifraud measure mandated by Section 404 of the Sarbanes-Oxley Act of 2002. AS2 was established in 2004 and AS5 was developed in 2007 as a replacement for AS2. The key differences between AS5 and AS2 are summarized by Cox (2007b) under four major areas:

1. The new standard is shorter, less prescriptive, and easier to read.

AS5 was about half as long as AS2, imposed significantly fewer mandatory requirements, and was designed to focus auditor attention on risk and materiality. Some of the inefficiencies allegedly stemming from the more-prescriptive approach embodied in AS2 could be avoided.

2. AS5 makes the audit scalable—so it can change to fit the size and complexity of any company.

AS5 explains that for audits of smaller and less complex companies, the auditor can appropriately reduce the amount of internal control testing.

3. The new standard directs auditors to focus on what matters most and eliminates unnecessary procedures from the audit.

AS5 allows auditors to pay attention to areas that present the highest risk, such as the financial statement close process and controls designed to prevent fraud by management.

4. AS5 includes a principles-based approach to determining when and to what extent the auditor can use the work of others.

AS5 allows auditors to use professional judgment rather than simply follow prescribed procedures. Relative to AS2, AS5 prescribes a more flexible, top-down, risk-based audit approach and encourages auditors to incorporate their professional judgments about auditee risk of material misstatement, particularly fraud risk, in determining the extent of audit procedures. At the same time, the greater flexibilities may cause two potential problems: First, it may provide them an opportunity to shirk using the pretense of judgment. Second, it may make the audit of the internal controls more demanding for the auditors and they may not be up to the task.

Using a sample of 3,023 U.S.-based Big-4 accelerated filer auditees, Doogar et al. (2010) find that during the AS5 period, higher-fraud-risk auditees pay higher fees (by about 11%) than do lower-fraud-risk auditees. By contrast, AS2 fees do not exhibit systematic association with auditee fraud risk. They conclude that AS5 appears to have met the regulatory goal of better directing audit resources to higher-fraud-risk settings.

They also find AS5 fees to be lower (by about 4%) than AS2 benchmarks and the decline in AS5 fees is not reflective of a pre-existing trend. AS5 appears, on average, to reduce audit fees. They further find that, relative to AS2 benchmarks, AS5 fees for higher-fraud-risk auditees increase (by about 5%). Lower-fraud-risk auditees, by contrast, experience an 8% year-to-year decline during this period. This finding is consistent with auditors improving audit effectiveness (and thus audit quality) by reallocating audit labor savings from lower-fraud-risk engagements to higher-fraud-risk engagements.