Japan's Big 3 Firms' Response to Clients' Business Risk: Greater Audit Effort or Higher Audit Fees?

Abstract

This study examines whether and how the Big 3 audit firms in Japan respond to clients' business risk and whether their responses vary. Two possible approaches to addressing clients' higher business risk are increasing audit effort (e.g., increasing total audit hours or assigning more experienced staff to the audit team) and charging a risk premium to cover possible future losses without increasing audit effort. Although the auditing standards and audit fee determination guidelines issued by the Japanese audit profession apparently assume that an auditor chooses the first approach to respond to clients' high business risk, the approach adopted by each Big 3 firm is an empirical issue. By analyzing data on audits conducted by the Big 3 Japanese firms using structural equation modeling and ordinary least squares regression, we find that responses to clients' higher business risk vary among the firms. While two of the firms increase audit effort and charge a risk premium for audits with higher business risk, the third firm responds to clients' business risk only by increasing audit effort. In addition, the strength of the relationships between clients' business risk and audit effort/fees varies among the firms.

What If There Were Three? Audit Pricing within the Big 4 and the PricewaterhouseCoopers' Premium in the Australian Audit Market

“…We note that if one of the Big 4 audit firms can charge a fee premium (or pass on a fee discount), it would be suggestive of price competition (e.g., Simunic, ; Balachandran & Simon, ). By considering competition, we extend a recent paper by Kim and Fukukawa () who find that the ‘Big 3’ audit firms in Japan respond to business risk via increased effort or risk premiums, but do not directly consider whether there is price competition in the Japanese audit market.…”

“Problem” directors and audit fees

“…Bell, Doogar, and Solomon () also found that riskier clients have significantly higher billing rates from auditors. Hackenbrack and Knechel (), Johnstone and Bedard (), Pratt and Stice (), O'Keefe, Simunic, and Stein (), Beaulieu (), and Kim and Fukukawa () documented similar results. However, none of these studies consider audit risks emanating from questionable board composition.…”

International Perspectives on Accounting and Corporate Behavior

“…Kim and Fukukawa (2013) investigated what determines the level of business risk disclosure of Japanese companies. Thus, determinants of business risk disclosure are somewhat different from those of other information.…”

“…Firms with high risk disclosure carry greater business risks (Campbell et al 2012;Kim and Fukukawa 2013), and the market discounts their associated revision number because of the higher risk level. Firms with high risk disclosure carry greater business risks (Campbell et al 2012;Kim and Fukukawa 2013), and the market discounts their associated revision number because of the higher risk level.…”