In this study, we investigate whether and to what extent country-level board reforms affect audit pricing decisions. We find audit fees are positively associated with board reforms. An increase in audit fees is more pronounced for firms that switched up to Big N auditors following board reforms. After board reforms, firms are less likely to issue restatements, and both analyst forecast accuracy and management forecast frequency increase, indicating improved audit quality and information transparency in the postreform period. Moreover, the positive relation between board reforms and audit fees is more evident for firms in countries that lack institutional governance mechanisms, captured by emerging capital markets, high political risk, weak governmental enforcement actions and low corporate governance quality. Overall, our findings broadly support the view that audit fees increase upon demand for better audit quality.
To date, most empirical research on board and audit committee independence has not explicitly separated the gross costs and benefits of reforms, but rather, has focused on the net impact to financial reporting outcomes, firm value and capital markets in assessing the merits (Fauver et al., 2017; Cohen et al., 2014; Klein, 2002; Palmrose et al., 2004; Hribar & Jenkins, 2004; Becker et al., 1998; Dhaliwal et al., 2010; Griffin et al., 2008; Tsui et al., 2001; Abbott et al., 2003). This empirical stream has provided valuable, yet mixed, findings: the net effect of board independence and a separate audit committee varies significantly across firms, industries and countries (Fauver et al., 2017). Such variations call for a better understanding of the specific nature of costs and benefits to determine the economic trade-off of board reforms. To respond to such a call, this study is able to quantify the direct statutory audit costs incurred by firms by examining the adoption of board reforms.
We focus on audit costs because the adoption of board reforms is likely to have a profound impact on audit time and effort to review clients’ financial statements. Therefore, audit fees represent a direct, observable and measurable cash outflow that may incorporate significant changes in the board structure and composition.1 The impact of board reforms on audit fees is twofold. On the one hand, a more effective board with independent directors may demand higher audit quality (greater assurance), which requires more audit effort, to protect their reputation and to avoid future legal liability.2 This is consistent with the theory that audit fee is an input-based audit quality measure and restatement is an output-based audit quality measure, according to DeFond and Zhang (2014). As a result, the demand for high audit quality may increase audit costs/fees by ensuring that auditors perform sufficient and appropriate audit procedures (Carcello et al., 2002; Abbott et al., 2003; Zhang & Yu, 2016) and thereby reducing the likelihood of future financial restatements, which supports quality demand hypothesis.3
One of the potential benefits of board reforms is to improve the process by which auditors are selected, retained and compensated. That raises an interesting question to accounting researchers and practitioners. To the best of our knowledge, this study is the first to test the association between board reforms and audit fees in a global setting. Due to different types and components of board reforms as well as country-level characteristics, prior studies provide mixed evidence as to whether such potential benefits of board reforms are being achieved. This study provides a comprehensive empirical analysis of the relation between a board reform’s efficacy and audit pricing decisions.