Substantive or symbolic compliance with regulation, audit fees and audit quality

Abstract

We examine whether Audit Fee Regulation (AFR) enhances auditors’ bargaining power in setting audit fees, consequently leading to superior quality audit services using the Iranian audit environment. We posit two hypotheses of “symbolic” and “substance” compliance. We find that neither audit fees nor audit quality has increased in the post-AFR era, supporting the symbolic hypothesis. The results are robust to several sensitivity tests, including difference-in-difference analysis. Contrary to the regulator’s expectation, our findings suggest that arbitrarily stimulating suppliers’ incentives without considering the priority and importance of demand-side incentives in a compliance-driven audit market and the flexibility to bypass the regulation result in symbolic (de jure) compliance with the regulation. We provide policy, practice, and research implications by suggesting that positive intended consequences of regulations in a compliance-driven audit market can be achieved when the regulation is robust with less latitude for discretion symbolic compliance.

Appendices

Appendix A: Evidence from interviews

To address the economic significance of our results and examine whether audit firms comply with AFR and whether that ‘symbolic compliance’ is actually used by Iranian auditors, we gathered additional evidence from two different sources. The first source was that we referred to the disciplinary sentences of the IACPA against its members and did not find sentences in relation to non-compliance with AFR.²³ In the second and most important step, we conducted short interviews with fifteen partners of audit firms. In these interviews, we ask three general questions; first, do audit firms comply with AFR? If not, we would ask the second and third questions, why do audit firms not comply with AFR? and how do audit firms bypass AFR without avoiding IACPA’s penalties?

Most of the interviewed partners state that they cannot comply substantially with AFR in the emerging audit market of Iran. Regarding the second question, the five main and frequent reasons for non-compliance with AFR include (1) intense competition in the audit market; (2) the lack of demand for quality audit services; (3) the poor economic situation of the country; (4) less precise counterparts’ quality control; and (5) significant available rooms in AFR. Furthermore, in the highly competitive audit market, if audit firms comply with AFR in determining their audit fees, there would be a high probability of losing clients. For instance, one of the partners states the following:

“In a market where client firms are maintained or transferred between the audit firms through intermediaries, by paying commissions to them, all the efforts of the audit firms are focused on maintaining their clients and there is competition among the audit firms for paying a higher percentage of commissions to the intermediaries.”

In addition, since in the Iranian audit market, the main purpose of the client firms is to recruit the auditor to comply with legal requirements, there is less incentive to demand quality audit services. Therefore, client firms prefer to perform this requirement by paying the least audit fee. For instance, one of the partners about the rooms in AFR states the following:

“AFR contains fundamental shortcomings and drawbacks, and the regulation suffers from the lack of clear guides to determine budgeted audit hours based on the client size.”

Regarding the third question, they came up with different ways to symbolically comply with the regulation. As mentioned, the most common strategy is calculating the audit fee from the bottom up. For instance, one of the partners states the following:

“After the final agreement of the audit fee with the client, the audit firms proceed to the inverse calculation of the audit fee.”

Taken together, the evidence from the interviews suggests that the audit fee, instead of being initially estimated in compliance with the regulation, is determined from the agreement between the auditor and the client. According to this strategy, the best way to bypass the regulation is to manipulate the budgeted hours. Another way used to symbolic compliance with AFR is that a number of audit firms, after determining audit fees based on the regulation and paying the fee by the client, return a part of the fee to the client’s accounts under various headings. Finally, according to the third strategy, the audit fee is determined in a way that it is not too minimum to seem like a case of non-compliance with AFR; then, they do not pay a part of the fee at all and record it in the account payable, and eventually, it may be applied as stagnant debts.²² The additional evidence provided by the interviews not only incorporates field data and results into our archival research (see Soltes 2014) but also supports the main findings, the non-efficiency of AFR and the ‘symbolic compliance’ view employed by the present study to explain why AFR is not effective in practice.

Appendix B: Definition of Variables

Variable	Measurement
AudFee	The natural logarithm of total audit fees
AudFail	1 if the audit opinion is unqualified in the prior year but financial statements were restated in the current year to correct the last year errors, and 0 otherwise
AudOpn	1 if the audit opinion is qualified and 0 for unqualified audit opinion
AbsDisAcc	Absolute discretionary accruals, as measured by the model developed by Kothari et al. (2005)
AFR	1 for period of Audit Fees Regulation (2016–2018), 0 otherwise
Switch	1 if auditor switched, 0 otherwise
NQtoQ	1 when the audit opinion is qualified for the current year, but not for the prior year
QtoNQ	1 when the audit opinion is unqualified for the current year, but not for prior year
Size	Natural logarithm of a firm’s assets at the beginning of the year
Lev	Debt-to-asset ratio of a firm at the beginning of the year
InvRec	Proportion of inventory and receivables to total assets
Liq	Ratio of total current assets to total current debts
ROA	The return on assets
LtoNL	1 when a client reports a loss for the prior year, but not for the current year
NLtoL	1 when a client reports a loss for the current year, but not for the prior year
FirstRank	1 if the auditor is a private TAF and ranked as “First” (first-ranked), and 0 if it is other TAF ranked such as “Second”, “Third” and “Fourth” (non-first-ranked);
StOwn	1 if more than 50 percent of a firm’s share is owned by the state- or semi-state-owned firms, 0 otherwise
TSE	1 if a client firm is listed in Tehran Stock Exchange, 0 otherwise
Sub	1 if a firm has a subsidiary or subsidiaries, 0 otherwise
Busy	1 if the fiscal year-end of a firm is 20 March, 0 otherwise
Age	Natural log of the number of years from the establishment of a client firm
ConOwn	Percent of a firm’s outstanding shares that are owned by the largest shareholder
Aturn	Asset turnover, computed as sales divided by total assets
Issue	1 if a firm issued common or preferred stocks, 0 otherwise
OCF	Cash flow from operation deflated by total assets
SG	One-year growth rate in sales
Disclose	1 if a client firm discloses audit fees, 0 otherwise
Δ Management	1 if chief executive officer or board of directors’ of a client firm have changes to prior year, 0 otherwise
Post_AFR	1 for period of Audit Fees Regulation (2016–2018), 0 otherwise
Δ AudFee	Inflation-adjusted changes in current year audit fees relative to the previous years
AbAuditFee	Residuals from audit fee regression model (Model 1) as a cross-sectional model in yearly-basis
EM-DD	Absolute discretionary accruals, as measured by the model developed by Dechow and Dechiv (2002)
AQPN	The number of audit qualification paragraphs in an audit report
YearDum	Dummies for fiscal years
IndustryDum	Dummies for 16 industry groups