dao et al - 2012 - shareholder voting on auditor selection, audit fees, and audit quality

THE ACCOUNTING REVIEW American Accounting Association Vol. 87, No. 1 DOI: 10.2308/accr-10159 2012 pp. 149–171 Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality Mai Dao University of Toledo K. Raghunandan Dasaratha V. Rama Florida International University ABSTRACT: The Advisory Committee on the Auditing Profession (ACAP), formed by the U.S. Department of the Treasury, has recommended that all public companies be required to have shareholder ratification of auditor selection. Using data from 1,382 firms for the year ending December 31, 2006, we find that audit fees are higher in firms with shareholder voting on auditor ratification. We also find that firms that started having a shareholder vote pay higher fees than firms that stopped having a shareholder vote. In the second part of our study, we find that in firms with shareholder voting on auditor selection (1) subsequent restatements are less likely and (2) abnormal accruals are lower.OurfindingsareconsistentwiththeexperimentalresultsinMayhewandPike (2004),andprovideempiricalgroundingforthedebateaboutmandatingshareholder voting on auditor selection. Keywords: auditor selection; shareholder voting; audit fees; audit quality. I. INTRODUCTION T he objective of this study is to examine the association between shareholder involvement in auditor selection and (1) audit fees and (2) audit quality. Motivation for this study comes from the U.S. Department of the Treasury’s (DoT 2008) Advisory Committee on the Auditing Profession (ACAP), which recently recommended that all public companies must have an annual shareholder ratification of the external auditor. The ACAP (DoT 2008, VIII:20) justified this recommendation by stating that that the annual submission of auditor selection for ratification enhances ‘‘competition in the audit industry.’’ The ACAP did not provide any empirical evidence in support of the above recommendation, and research related to shareholder involvement in auditor selection is sparse. We gratefully acknowledge many useful comments and suggestions from Steve Kachelmeier (senior editor) and two anonymous reviewers. We thank Abhijit Barua, Vishal Munsif, and Paul Tanyi for help with data collection and analysis. Editor’s note: Accepted by Steven Kachelmeier. Submitted: October 2009 Accepted: June 2011 Published Online: August 2011 149 The ACAP did not elaborate on exactly what benefits would accrue from any increased competition among auditors. However, the traditional view of the courts, legislators, and regulators has been that competition in any sector leads to higher quality and lower price (U.S. Supreme Court 1978; Federal Trade Commission 2003). In contrast, economic theory suggests that the joint effect of competition on price and quality is not uniform; the effect of increased competition on price and quality will depend on the relative elasticities of price and quality (Dranove and Satterthwaite 1992; Kranton 2003). Even within the context of professional services, prior studies examining different types of services have shown divergent results about the joint effects of enhanced competition on price and quality (Kwoka 1984; Haas-Wilson 1986; Rizzo and Zeckhauser 1992; Kessler and McClellan 2000). While the ACAP recommends shareholder voting on auditor selection based on arguments about increased competition, the same recommendation can be arrived at by using a governance and accountability framework. We argue that any arrangement that strengthens the role of the shareholders in auditor selection also changes the incentives of the auditors and strengthens auditor independence. The Sarbanes-Oxley Act (SOX, U.S. House of Representatives 2002) made audit committees formally responsible for the selection and compensation of the external auditor; however, evidence indicates that even in the post-SOX era, managers exercise significant control over the hiring and firing of auditors (KPMG 2004; Cohen et al. 2010). If managers retain significant influence over auditor selection, then auditors will be more likely to go along with the preferences of managers (Saul 1996). Hence, institutional arrangements that strengthen the role of shareholders in auditor selection will also strengthen auditor independence. Mayhew and Pike (2004) examine, in a laboratory market setting, the effects of alternative auditor hiring rules on competition in the audit market. They find that, in their experimental setting, investor involvement in auditor selection leads to both higher audit quality and an increase in audit fees. Mayhew and Pike (2004, 820) note that ‘‘further research into the institutional structures that promote audit committee independence or produce the types of incentives for auditor independence documented in our investor selection treatments is clearly warranted.’’ The ACAP recommendation represents a step in the direction toward increased shareholder involvement in auditor selection. Saul (1996, 135) suggests that having shareholder ratification of the auditor is ‘‘more than a symbolic act’’ in the context of strengthening auditor independence. Accordingly, our objective is to empirically examine the association between shareholder involvement in auditor selection and both audit fees and audit quality, using archival data. To the extent that increased shareholder involvement in auditor selection alters the governance and accountability dynamics between auditors, management, and shareholders, we find that shareholder voting on auditor selection leads to both higher audit fees and better audit quality. We use data from a sample of 1,382 companies included in the 2006 edition of the Board Analyst database. We find that audit fees are higher in firms that submitted auditor selection for a shareholder vote, after controlling for other factors associated with audit fees. This finding is inconsistent with the argument generally advanced by legislators, regulators, and the judiciary, but is consistent with the experimental evidence in Mayhew and Pike (2004). As noted by Hermalin and Weisbach (2003), endogeneity is a pervasive problem in any governance-related archival-empirical research. For example, it is possible that the same factors that are associated with some firms voluntarily having a shareholder vote on auditor selection, since such a vote is not currently legally required, are also associated with higher audit fees. We perform a Hausman test of endogeneity between audit fees and shareholder voting on auditor selection, and find that there is support for the two being endogenous. Accordingly, we perform two-stage regression analysis and find that the positive relationship between shareholder involvement in auditor selection and audit fees persists. 150 Dao, Raghunandan, and Rama The Accounting Review January 2012 We also perform a different type of test, relying on changes in firms’ policies relating to shareholder voting on auditor ratification. Specifically, we focus on firms that changed from not having a shareholder vote on auditor selection in 2005 to having such a vote in 2006, and vice versa. Because auditor-selection-related issues are supposed to be the prerogative of the audit committee after SOX, we require that the firms selected for such change analyses do not have a change in the composition of the audit committee. With this additional restriction, we have 54 firms that newly initiated an auditor ratification vote in 2006 and 45 firms that stopped having an auditor ratification vote in 2006, and did not have a change in the membership of the audit committee. For this subset of 99 firms, we perform the audit fee regression in the ‘‘changes’’ form. We find that the indicator variable measuring change in auditor ratification policy is positive and significant, indicating that firms that initiated an auditor ratification vote paid higher audit fees compared to firms that stopped having an auditor ratification vote. While audit pricing is directly observable, audit quality is a more difficult construct. The quantity or quality of audit work is not directly observable, so researchers have used different measures for audit quality. In this study, we use subsequent restatements as our measure for audit quality. A restatement implies that the previously filed financial statements are unreliable and, hence, the presence (or absence) of a restatement can be viewed as a direct measure of audit quality. We restrict our analysis to restatements with a negative effect on financial statements. We find that firms with a shareholder vote on auditor ratification during 2006 were less likely to have a subsequent restatement of fiscal year 2006 financial statements. Hennes et al. (2008) point out that not all restatements are the same, and suggest using stock price reactions as a direct measure of problem restatements. Accordingly, we further restrict our analysis to subsequent restatements that also had a negative stock price reaction. With this analysis we also find that firms with a shareholder vote on auditor ratification were less likely to have a later restatement that elicits a negative market reaction. As with audit fees, we conduct Hausman tests of endogeneity but cannot reject the hypothesis of exogeneity between subsequent restatements and shareholder involvement in auditor selection. Unlike with audit fees, we do not perform the analyses with only the subset of firms changing auditor ratification policies because only four firms from each of the change groups had a subsequent restatement. As additional analysis, we use clients’ abnormal accruals as another measure of audit quality. Although using accruals measures as a proxy for audit quality is subject to many limitations (Ball 2009), previous studies have used clients’ abnormal accruals as a measure of audit quality given the paucity of observable measures related to audit quality (e.g., DeFond and Subramanyam 1998; Francis and Krishnan 1999). Following this tradition, we examine the association between shareholder voting on auditor selection and abnormal accruals. We find that performance-matched abnormal current accruals are lower in firms that submit auditor selection for shareholder ratification. A Hausman test indicates the presence of endogeneity, but the association between shareholder voting and accruals quality persists after controlling for endogeneity. In summary, we examine an issue that is currently of interest to regulators and the accounting profession but lacks relevant archival evidence. Research methods involve trade-offs, and the benefit of an experimental setting such as the one used by Mayhew and Pike (2004) is that it enables researchers to control and manipulate factors of research interest while ignoring other external factors that are present in the real-world setting. Conversely, the benefits from archival research are the use of more natural settings that currently exist and greater external validity. Ideally, results from multiple methods should complement each other and there is greater confidence in the inferences when different research methods yield the same basic findings. The results from our archival tests validate the experimental results of Mayhew and Pike (2004) in a closely related setting—that increased shareholder involvement in auditor selection leads to an Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality 151 The Accounting Review January 2012 increase in both audit fees and quality—but are inconsistent with the traditional arguments of legislators, regulators, and the judiciary in the U.S. that enhanced competition will lead to lower prices and higher quality. Section II discusses the background. This is followed by a description of hypotheses, research method, data, and discussion of results related to the two issues examined in this study: audit fees in Section III and audit quality in Section IV. Section V concludes with a summary and discussion. II. BACKGROUND Shareholder Voting: Competition Perspective Even when there were eight large international auditing firms, legislators had expressed concerns about the (lack of) competition in the audit market (U.S. Senate 1976, 1977; U.S. House of Representatives 1985). Such concerns have become more pronounced as the Big 8 have now become the Big 4 since 2002. For example, Section 701 of SOX mandates the General Accounting Office (GAO) to study and report back to Congress about the concentration of the audit market and the problems resulting from limited competition among public accounting firms. The GAO (2003, Highlights) concluded that ‘‘the significant changes that have occurred in the profession may have implications for competition and public company choice, especially in certain industries, in the future. ’’ In a follow-up report, the GAO (2008, Highlights) stated that ‘‘the loss of another large firm would further reduce large companies’ auditor choice and could affect audit fee competitiveness.’’ Thus, it is clear that the extent of competition in the market for audit services for public companies (and the resultant impact on fees) continues to be an issue of significant interest to legislators and regulators. Such concerns led to the U.S. Department of the Treasury forming, in October 2007, an Advisory Committee on the Auditing Profession (ACAP). The ACAP held a series of meetings during 2007 and 2008, and issued a report in October 2008, proposing six recommendations related to concentration and competition in the audit market. Recommendation #5 suggests the adoption of ‘‘annual shareholder ratification of public company auditors by all public companies ’’ and notes as follows (DoT 2008, VIII:20–21): The Committee believes shareholder ratification of auditor selection through the annual meeting and proxy process can enhance the audit committee’s oversight to ensure that the auditor is suitable for the company’s size and financial reporting needs. This may enhance competition in the audit industry The Committee also urges exchange self-regulatory organizations to adopt such a requirement as a listing standard. Competition, Price, and Quality From an economic perspective, increased competition generally leads to higher quality and/or lower price. However, if price and quality are jointly determined, then the effect of increased competition on price and quality is not clear-cut; the effects of increased competition on price and quality will depend on the relative elasticities of price and quality (Dranove and Satterthwaite 1992; Kranton 2003). Nevertheless, the U.S. Supreme Court (1978, 695) noted in a case brought by the National Society of Professional Engineers: ‘‘The Sherman Act reflects a legislative judgment that ultimately competition will produce not only lower prices, but also better goods and services The assumption that competition is the best method of allocating resources in a free market recognizes that all elements of a bargain—quality, service, safety, and durability—and not just the immediate cost, are favorably affected by the free opportunity to select among alternative offers.’’ Similarly, the Federal Trade Commission (2003, 1) states that ‘‘vigorous competition forces producers to 152 Dao, Raghunandan, and Rama The Accounting Review January 2012 minimize costs and prices and to increase quality.’’ Thus, the legislative, judicial, and executive views appear to be that increased competition will lead to lower prices and higher quality. Empirical evidence on the joint effects of competition on price and quality is sparse and mixed (Kranton 2003; Kallapur et al. 2009). Prior research shows that, when the ban on advertising was removed (i.e., competition increased), the price of optometric services declined without an adverse impact on quality (Kwoka 1984; Haas-Wilson 1986). However, in the case of physicians’ services, the removal of the ban on advertising led to higher prices and an increase in at least some measures of quality (Rizzo and Zeckhauser 1992). Similarly, Kessler and McClellan (2000) show that in the case of hospitals, prior to 1991, higher levels of competition led to both higher costs and improved quality. 1 Shareholder Voting: Governance and Accountability Perspective While the ACAP recommendation is based on the effects of increased competition, there is an alternative perspective that is useful in the context of shareholder voting on auditor ratification. Until the enactment of SOX, client management was responsible for selecting the auditor. Under Section 301 of SOX, audit committees are directly responsible for the appointment, compensation, and oversight of the auditor. Accordingly, Section 301 of SOX is a recognition of the governance and accountability perspective of auditor selection. Specifically, if management is responsible for hiring or firing the auditor and negotiating the audit fee, then it is more likely that the auditor will go along with the wishes of management (Saul 1996). Mayhew and Pike (2004, 798) note that the auditor’s ‘‘financial dependence on the client depends heavily on the client’s ability to hire and fire the auditor. As a result, the control over hiring and firing the auditor serves as the core incentive for auditors to maintain or compromise their independence.’’ By removing the authority to hire and fire the auditor from management, and vesting such authority with representatives of shareholders, Section 301 of SOX sought to shift the locus of power in the auditor-manager relationship—and thereby enhance auditor independence. However, as noted by Mayhew and Pike (2004), in many companies, the board of directors is dominated by management. This enables management to retain significant influence over auditor- related decisions, including the hiring and firing of auditors. In these circumstances, auditors’ natural response is to be more likely to go along with managements’ preferred accounting choices. Along these lines, a survey of audit committee directors and executives by KPMG (2004, 5) found that, even after SOX, ‘‘69 percent of respondents said the chief executive officer or the chief financial officer had the most influence over the compensation of the external auditor, and only 27 percent thought the audit committee had the most influence.’’ In a later study based on interviews with 30 audit partners and managers from the Big 4 firms, Cohen et al. (2010, 752) report that ‘‘management continues to be seen as a major corporate governance actor and, contrary to the intent of SOX, often the driving force behind auditor appointments and terminations.’’ The ACAP noted that, even though SOX gives the audit committees the responsibilities related to the appointment and compensation by the auditor, shareholders should have a say in auditor selection and that ‘‘ratification allows shareholders to voice a view on the audit committee’s work, including the reasonableness of audit fees and apparent conflicts of interest ’’ (DoT 2008, VIII:20). Thus, shareholder voting on auditor ratification, while perhaps not as effective as direct shareholder selection of the auditor, is a step toward increasing the role of shareholders in the auditor selection process. Reflecting this view, shareholder activists have continued to press companies to let 1 This is the so-called ‘‘Medical Arms Race’’ hypothesis, and this logic has been used by the courts in litigation involving hospital mergers. See, for example, U.S. vs. Carilion Health System, 892 F 2d 1042. Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality 153 The Accounting Review January 2012 shareholders vote on auditor selection because this is considered to be a good corporate governance practice (Krishnan and Ye 2005; Institutional Shareholder Services [ISS] 2007a, 2007b). Support for this governance-and-accountability-based perspective comes from the actions of the Financial Reporting Council (FRC) in the United Kingdom. The FRC established the Market Participants Group (MPG) in October 2006 to provide advice on ‘‘possible actions that market participants could take to mitigate the risks arising from the characteristics of the market for audit services to public interest entities in the United Kingdom ’’ (FRC 2006, 1). The MPG issued its report in October 2007 with a set of recommendations; Recommendation #8 notes that the FRC should amend the rules ‘‘to include a requirement for the provision of information relevant to the auditor re-selection decision,’’ while Recommendation #10 states that ‘‘investor groups, corporate representatives, firms, and the FRC should promote good practices for shareholder engagement on auditor appointment and re-appointments ’’ (FRC 2007, 10). The MPG report noted that the recommendations were ‘‘directed at improving the accountability of boards for their auditor selection decisions’’ (FRC 2007, 10). Finally, we interviewed three audit partners from three of the Big 4 audit firms and a subcommittee chair of the ACAP about shareholder involvement in auditor selection. Of the audit partners, one is a regional managing partner, the second is an office managing partner of a large metropolitan office, and the third is a regional leader for audit practice. Two of the audit partners and the ACAP member noted that shareholder voting on auditor selection led to slightly higher risks for the auditor. To paraphrase, the partners and the ACAP member noted that ‘‘everyone expects the auditor to receive 98 or 99 percent approval from the shareholders, so even if you get 90 or 95 percent approval, there are bound to be questions from the audit committee; in addition, even if remote, there is a non-zero probability of a significant proportion of shareholders voting against the auditor.’’ Two partners also discussed anecdotal evidence about Ernst & Young, which had 38 percent of Sprint shareholders voting against ratification in 2003, resulting in unfavorable media coverage. 2 To the extent that perceptions affect auditors’ judgments and actions, we can expect both audit quality and price to be higher when there is a shareholder ratification vote on auditor selection. III. SHAREHOLDER VOTING AND AUDIT FEES Regulators in the U.S. and U.K. are considering recommendations to require all public companies to have a shareholder vote on auditor selection. Some recent studies have examined issues related to shareholder ratification of the auditor, including characteristics of firms submitting auditor selection for a shareholder vote (Krishnan and Ye 2005) and the determinants of shareholder votes for ratification (e.g., Raghunandan 2003; Hermanson et al. 2009). However, there is little archival evidence related to the effect of having a shareholder vote on price and/or quality in the market for audit services. This study seeks to fill this void, given the calls from regulators to require companies to have such a shareholder vote. As noted earlier, the experimental evidence in Mayhew and Pike (2004) and the governance/ accountability perspective suggest that shareholder voting on auditor selection leads to higher audit fees and improved audit quality. Nevertheless, given the paucity of evidence on this issue, and given the stated opinions of the judiciary and the executive that increased competition is expected to result in lower price and better quality, we do not make a directional prediction for our first hypothesis. Formally stated, our first hypothesis is: H1 (null form): There is no association between shareholder involvement in auditor selection and audit fees. 2 Following the shareholder vote, Ernst & Young was replaced as the auditor for Sprint. 154 Dao, Raghunandan, and Rama The Accounting Review January 2012 Model We use the following regression model to test H1: LogðAuditFeesÞ¼a 0 þ a 1 Ã LogðTotalAssetsÞþa 2 Ã InvRecTA þa 3 Ã SqrtSegments þa 4 Ã Foreign þa 5 Ã CurrentRatio þa 6 Ã Leverage þa 7 Ã ROA þa 8 Ã GC þa 9 Ã ICW þa 10 Ã Big4 þa 11 Ã Initial þa 12 Ã VOTE þerror: ð1Þ The variables are defined as follows: Log(AuditFees) ¼ natural logarithm of audit fees; Log(TotalAssets) ¼ natural logarithm of total assets; InvRecTA ¼ ratio of assets in inventory plus accounts receivable to total assets; SqrtSegments ¼ square root of the number of business segments; Foreign ¼ 1 if foreign income is reported, 0 otherwise; CurrentRatio ¼ ratio of current assets to current liabilities; Leverage ¼ ratio of total liabilities to total assets; ROA ¼ ratio of income before extraordinary items to total assets; GC ¼ 1 if the firm receives a going-concern modified opinion, 0 otherwise; ICW ¼ 1 if the firm has an adverse SOX 404 opinion, 0 otherwise; Big4 ¼ 1 if the auditor is a Big 4 audit firm, 0 otherwise; Initial ¼ 1 if the audit engagement is a first- or second-year audit, 0 otherwise; VOTE ¼1 if the firm submits auditor selection for shareholder ratification vote, 0 otherwise. 3 Starting from Simunic (1980), prior research has used various measures related to client size, complexity, and risk as control variables in audit fee models. We use the same audit fee model as in Raghunandan and Rama (2006). Following a long tradition in the auditing literature, we use the log transformed audit fees, Log(AuditFees), as the dependent variable. Log(TotalAssets) is employed to measure client size, and we expect the coefficient of Log(TotalAssets) to be positive. Three variables—InvRecTA, SqrtSegments, and Foreign—proxy for client complexity, and we expect positive coefficients for these three variables. Five variables, CurrentRatio, ROA, Leverage, GC, and ICW, control for client financial condition and internal control; the coefficients of CurrentRatio and ROA are expected to be negative, while the coefficients of Leverage, GC, and ICW are expected to be positive. A large body of literature has shown that there is a Big N audit fee premium, so we include Big4 and expect the coefficient of this variable to be positive. Prior research also suggests that audit fees are discounted for initial years of audit engagements (e.g., Simon and Francis 1988; Whisenant et al. 2003); however, recent research suggests that initial audit engagements have an audit fee premium in the post-SOX period (Huang et al. 2009), so we include Initial in the model but do not make a prediction about the sign of the coefficient. The independent variable of interest is VOTE. The governance/accountability perspective and experimental results of Mayhew and Pike (2004) suggest that the coefficient of VOTE should be positive. Data We start our sample with all U.S. companies that are included in the 2006 version of Corporate Library’s Board Analyst database. As part of our analyses of audit quality, we examine subsequent restatements; since it takes some time before restatements are discovered and disclosed, using data 3 Continuous variables (used in this and any subsequent regression) are winsorized at the 1st and 99th percentiles. Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality 155 The Accounting Review January 2012 from fiscal year 2006 enables us to examine subsequent restatements over a three-year period (until the end of 2009). Section 404 of SOX first became applicable for fiscal years ending on or after November 15, 2004, and auditors have noted that there has been a steep learning curve related to audits in the post-Section 404 period. Hence, we restrict the analysis to the 2,084 companies with fiscal years ending December 31, 2006. 4 Consistent with prior research related to audit fees and because firms in financial sectors have different financial statement reporting formats (and are subject to additional regulations), we exclude 602 firms with SIC codes from 6000–6999. We obtain data about audit fees, audit opinions, and auditor changes from the Audit Analytics database, while financial data are from the Compustat database and 10-K filings available on the SEC’s website. We manually collect data about submission of auditor selection for shareholder ratification voting from proxy filings available on the SEC’s website. After eliminating 100 observations with missing data, our final sample includes 1,382 firms. Descriptive Statistics Panel A of Table 1 provides descriptive statistics about the variables used in the audit fee regression model. The mean (median) audit fees for the sample firms are $2.86 ($1.53) million. The mean and median values for the control variables are generally in line with those found in other studies (e.g., Ghosh and Lustgarten 2006; Raghunandan and Rama 2006) that examine audit fees in the post- SOX period. 5 Seventy-five percent of the sample firms submitted auditor selection for shareholder ratification in 2006. As seen in Panels B and C of Table 1, firms that submitted auditor selection for shareholder ratification tend to be larger, are more likely to be audited by a Big 4 auditor, and are less likely to have adverse Section 404 reports, going-concern modified audit reports, or auditor changes. We test for multicollinearity between the independent variables by examining the correlation matrix (untabulated). We find that all of the bivariate correlations are less than 0.50. We also find that the variance inflation factors for the variables in the regression model are all less than 2.0, indicating that multicollinearity does not cause problems with our inferences. Audit Fee Regression Results Table 2 presents the regression results for the model with Log(AuditFees) as the dependent variable. The overall model is significant, and the adjusted R 2 of 71 percent is in line with prior audit fee studies. All control variables in the model (except for Leverage and Initial) are significant and have the expected coefficient signs. The variable of interest, VOTE, is positive and significant (p , 0.05). The magnitude of the coefficient of VOTE is 0.085, indicating that companies 4 There are two reasons why we restrict the analysis to clients with a 12/31 fiscal year-end. First, the Big 4 firms noted in submissions to the SEC in 2005 and 2006 that SOX 404-related work had a significant impact on audit fees and that there is a steep learning curve effect for SOX 404-related work; hence, a firm with a 12/31/2006 fiscal year-end would be in the initial phase of the third year of SOX 404 work, while a firm with a 2/28/2006 (6/30/ 2007) fiscal year-end would still be in the second year (later phase of the third year) cycle of SOX 404. We do not want to contaminate our sample by mixing firms that would have been in different stages of the learning curve. The second reason relates to the change from AS 2 to AS 5; the PCAOB approved the change in May 2007 to use a more top-down approach, and this had a pronounced effect on audit work and fees; the PCAOB provided permission for immediate application of the standard. 5 We also compared our firms with the overall Compustat population (after excluding foreign firms and firms in financial sectors). In terms of industry, when we use the 12 industry groups based on Professor French’s (http://mba.tuck. dartmouth.edu/pages/faculty/ken.french/data_library.html) classification, our sample has fewer firms in the ‘‘wholesale, retail, and some services’’ category (5.9 percent in our sample versus 10.4 percent in Compustat). However, 75 percent of the sample firms from this sector had a shareholder ratification of the auditor—identical to the proportion for the rest of the sample. Firm size in our sample is, however, larger than in the Compustat population (e.g., average total assets are $1.00 billion for our sample compared to $199 million for the Compustat sample). 156 Dao, Raghunandan, and Rama The Accounting Review January 2012 TABLE 1 Descriptive Data (n ¼ 1,382) Panel A: Sample Statistics Variable Mean Standard Deviation 25th Percentile Median 75th Percentile Audit Fees ($000) 2,863.05 3,969.04 805.22 1,528.92 2,996.57 Log(Audit Fees) 14.31 1.00 13.60 14.24 14.91 Log(TotalAssets) 20.88 1.66 19.67 20.73 22.01 InvRecTA 0.22 0.17 0.08 0.18 0.32 SqrtSegments 1.44 0.53 1.00 1.00 2.00 Foreign 0.29 0.45 0.00 0.00 1.00 CurrentRatio 2.64 2.38 1.25 1.87 3.07 ROA 0.01 0.18 0.01 0.05 0.09 Leverage 0.53 0.27 0.34 0.53 0.68 GC 0.02 0.14 0.00 0.00 0.00 ICW 0.09 0.28 0.00 0.00 0.00 Big4 0.90 0.30 1.00 1.00 1.00 Initial 0.15 0.35 0.00 0.00 0.00 VOTE 0.75 0.43 0.00 1.00 1.00 Panel B: Comparison of Subsamples Partitioned by VOTE: Mean (Median) of Continuous Variables Used in the Audit Fee Regression Model VOTE ¼ 0 (n ¼ 346) VOTE ¼ 1 (n ¼ 1,036) p-value for t-test (Mann-Whitney U test) Log(TotalAssets) 20.49 21.02 ,0.01 (20.39) (20.93) (,0.01) InvRecTA 0.23 0.21 0.07 (0.20) (0.17) (0.10) SqrtSegments 1.48 1.43 0.14 (1.41) (1.00) (0.06) CurrentRatio 2.54 2.67 0.39 (1.89) (1.86) (0.65) ROA 0.01 0.01 0.85 (0.05) (0.04) (0.86) Leverage 0.53 0.54 0.74 (0.51) (0.53) (0.30) Panel C: Comparison of Subsamples Partitioned by VOTE: Proportion with Value of 1 for Discrete Variables Used in the Audit Fee Regression Model VOTE ¼ 0 (n ¼ 346) VOTE ¼ 1 (n ¼ 1,036) p-value (Chi-square test) Foreign 0.29 0.29 0.98 GC 0.05 0.01 ,0.01 ICW 0.13 0.07 ,0.01 Big4 0.84 0.93 ,0.01 Initial 0.23 0.12 ,0.01 The p-values are two-tailed. (continued on next page) Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality 157 The Accounting Review January 2012 submitting auditor selection for shareholder ratification pay, on average, 9 percent higher audit fees. This result is consistent with the evidence in Mayhew and Pike (2004) that increased shareholder involvement in auditor selection is associated with higher audit fees. Further Analyses: Endogeneity Hermalin and Weisbach (2003) note that almost all research related to corporate governance is subject to the problems associated with endogeneity. Thus, it is possible that the same factors that are associated with greater shareholder involvement in auditor selection are also associated with higher audit fees. Krishnan and Ye (2005) find that audit committee characteristics are associated with the likelihood of shareholder voting on auditor ratification. Prior research also shows that good corporate governance is associated with higher audit fees (e.g., Carcello et al. 2002), possibly due to the demand for higher quality or quantity of monitoring by auditors. To the extent that good corporate governance—such as, an audit committee with a greater number or proportion of accounting experts—is associated with both greater shareholder involvement in auditor selection and higher audit fees, the association documented earlier could reflect the same underlying governance characteristics. Hence, we perform the following two-stage analysis. In the first stage, in addition to the audit fee model discussed above, we use the following PROBIT regression model: VOTE ¼ c 0 þ b 1 Ã LogðTotalAssetsÞþb 2 Ã ACExpert þ b 3 Ã DirectorVote þb 4 Ã Return þ b 5 Ã CEOCHR þb 6 Ã InsiderOwn þb 7 Ã Big4 þb 8 Ã Initial þerror: ð2Þ The variables VOTE, Log(TotalAssets), Big4, and Initial are as defined earlier. Other variables are defined as in Krishnan and Ye (2005), as follows: ACExpert ¼ proportion of audit committee directors who are accounting or auditing experts; DirectorVote ¼ minimum percent of votes against the election of a director in the prior year; Return ¼ prior-year common stock return minus the mean of two-digit SIC’s common stock return for the prior year; CEOCHR ¼ 1 if the CEO is also the Chair of the Board of Directors, 0 otherwise; InsiderOwn ¼ proportion of common stock held by officers and directors. TABLE 1 (continued) This table provides descriptive statistics about variables used in the audit fee model. The sample includes 1,382 firms that (1) are in the 2006 edition of the Corporate Library database, (2) are U.S. firms, (3) have a December 31 fiscal year-end, (4) are in nonfinancial industries, and (5) have required data. Variable Definitions: Log(TotalAssets) ¼ natural logarithm of total assets; InvRecTA ¼ ratio of assets in inventory plus accounts receivable to total assets; SqrtSegments ¼ square root of the number of business segments; Foreign ¼ 1 if foreign income is reported, 0 otherwise; CurrentRatio ¼ ratio of current assets to current liabilities; ROA ¼ratio of income before extraordinary items to total assets; Leverage ¼ ratio of total liabilities to total assets; GC ¼ 1 if the firm receives a going-concern modified opinion, 0 otherwise; ICW ¼ 1 if the firm has an adverse SOX 404 opinion, 0 otherwise; Big4 ¼ 1 if the auditor is a Big 4 audit firm, 0 otherwise; Initial ¼ 1 if the audit engagement is a first- or second-year audit, 0 otherwise; and VOTE ¼ 1 if the firm submits auditor selection for ratification vote, 0 otherwise. 158 Dao, Raghunandan, and Rama The Accounting Review January 2012 [...]... outcomes, and organizational performance The Accounting Review 82 (4): 963–1008 The Accounting Review January 2012 Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality 171 Mayhew, B W., and J E Pike 2004 Does investor selection of auditors enhance auditor independence? The Accounting Review 79 (3): 797–822 Raghunandan, K 2003 Nonaudit services and shareholder ratification of auditors Auditing:... that shareholder selection of the auditor is also associated with better quality audits Specifically, Mayhew and Pike (2004) show that average auditor effort is The Accounting Review January 2012 Dao, Raghunandan, and Rama 162 TABLE 4 Shareholder Voting on Auditor Ratification and Subsequent Restatements Panel A: Shareholder Voting and Subsequent Restatements Subsequent Restatement Shareholder Voting. .. accruals as the proxy for audit quality (e.g., Becker et al 1998; DeFond and Subramanyam 1998; Francis and Krishnan 1999) Following this line of research, we use performance-matched discretionary accruals as an alternative proxy for audit quality and examine the association between shareholder involvement in auditor selection and client abnormal accruals We follow the same approach as in Geiger and. .. ratification policies For such analyses, as in Geiger and North (2006), we use changes in discretionary accruals as the dependent variable; the control variables are also measured in changes form, and the variable of The Accounting Review January 2012 Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality 167 TABLE 5 Abnormal Accruals Regression Analysis Panel A: Descriptive Data for Abnormal... Review January 2012 Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality 169 than expected proportion of shareholders do not vote to ratify the auditor) , then it is likely that auditors would spend extra effort and be more cautious in negotiations with the client The additional costs associated with the extra effort would likely be passed along to the client and lead to higher audit fees;... issuing common and preferred stock and long-term debt)/average total assets; and VOTE ¼ 1 if the firm submits auditor selection for ratification vote, 0 otherwise higher, and auditor independence violations are lower, when there is shareholder involvement in auditor selection Economic theory suggests that enhanced competition can also have an effect on the quality of a product, so another implication from... the ACAP’s suggestion (that shareholder involvement in auditor selection will lead to enhanced competition) is that shareholder voting should be associated with higher quality audits Further, the governance and accountability perspective suggests that greater shareholder involvement in auditor selection should strengthen auditor independence and lead to improved audit quality Audit quality is not directly... we find that audit fees are about 9 percent higher for firms that have shareholder voting on auditor ratification Our results continue to hold after we control for potential endogeneity between audit fees and shareholder voting on auditor selection When we restrict the analysis to firms that changed their auditor ratification policy in 2006 and did not have a change in the composition of the audit committee,... regression is particularly appropriate for audit fees because, in general, last year’s audit fees predicts well this year’s audit fees; for example, in our sample a regression of last year’s fees on this year’s fees yields a regression coefficient of 0.91 The Accounting Review January 2012 Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality 161 TABLE 3 Audit Fee Change Regression Results... firms that started auditor ratification pay higher audit fees than firms that stopped auditor ratification in 2006 We also examine the association between shareholder voting and audit quality We find that firms with a shareholder vote on auditor ratification are less likely to have subsequent restatements that have a negative effect on financial statements Our results hold when we restrict the analysis to restatements . involvement in auditor selection leads to an Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality 151 The Accounting Review January 2012 increase in both audit fees and quality but. ,0.01 Initial 0.23 0.12 ,0.01 The p-values are two-tailed. (continued on next page) Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality 157 The Accounting Review January 2012 submitting. are lower.OurfindingsareconsistentwiththeexperimentalresultsinMayhewandPike (2004),andprovideempiricalgroundingforthedebateaboutmandatingshareholder voting on auditor selection. Keywords: auditor selection; shareholder voting; audit fees; audit quality. I. INTRODUCTION T he