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Abnormal audit fees and audit quality: initial evidence from the German audit market

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This study investigates the economic auditor–client dependency issue by examining the association between abnormal audit fee pricing and audit quality. Our study is the first to analyze this phenomenon empirically for the institutional setting of German IFRS firms by using a sample of 2,334 firm-year observations for the period from 2005 to 2010. Our empirical results demonstrate that positive abnormal audit fees are negatively associated with audit quality and imply that the audit fee premium is a significant indicator of compromised auditor independence due to economic auditor–client bonding. Audit fee discounts generally do not lead to a reduced audit effort, or respectively, audit quality is not impaired when client bargaining power is strong. The association of positive abnormal audit fees and audit quality is robust to different audit quality surrogates such as absolute discretionary accruals, financial restatements, and meeting or beating analysts’ earnings forecasts.

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  1. Please note that we are not able to measure audit effort directly. However, it is reasonable to assume that audit fees are positively correlated with, for example, the working hours of the auditor or the assignment of more experienced staff, both signaling greater effort (Asthana and Boone 2012; Blankley et al. 2012; Eshleman and Guo 2013).

  2. Also, we are not able to measure client bargaining power directly. However, and consistent with previous audit research studies, we do think that audit fee discounts are correlated with the clients’ ability to exercise bargaining power (Asthana and Boone 2012; Eshleman and Guo 2013).

  3. Throughout this paper positive abnormal audit fees and audit fee premiums as well as negative abnormal audit fees, below-normal audit fees, and audit fee discounts, respectively, are used synonymously.

  4. In 2009 the audit fee disclosure requirements were amended through the Accounting Law Modernization Act. After the amendment audit fees have also to be disclosed by major non-listed companies that meet certain accounting benchmarks as determined in Section 267 paragraph 3 of the German Commercial Code.

  5. We thank one of our anonymous reviewers for this insight.

  6. As Eshleman and Guo (2013) point out, research should work on developing refined measures of audit quality.

  7. The Arthur Anderson–Enron case can be seen as a prime example for the trade-off between economic benefits and the desire to uphold a firm’s reputation. Arthur Andersen, a large international audit company with a 90-years firm history and total revenues of nine billion dollars had to shut down its business within 3 months after the state attorneys detected irregular auditing practices within the Enron audit engagement (Alexander et al. 2002). Kinney and Libby (2002) note in this context that Enron’s actual audit fees paid in the fiscal year 2000 were 250 % of the estimated normal audit fees.

  8. For example, Bedingfield and Loeb (1974) find that disputes over accounting principles are a significant factor for clients to change their auditor.

  9. For example, Eshleman and Guo (2013) argue that the mixed findings in this research field are primarily caused by the choice of the audit quality proxy.

  10. We define the auditor’s net economic bonding incentives to be the potential rents of compromising audit independence (and keeping the mandate) less the potential associated costs of low quality reporting (e.g., litigations, reputation loss, etc.). See DeAngelo (1981a, b) for a discussion of the auditor’s trade-off between audit rents and independence.

  11. The liability of compensatory damages is limited by the German Commercial Code, section 323, paragraph 2 to a maximum amount of € 1 million for audits of non-listed companies and to a maximum amount of € 4 million for audits of listed companies.

  12. Please note that traditional and recent legal practice by the Federal Court of Justice in Germany (“Bundesgerichtshof”) points out that section 323 (paragraph 1, sentence 3) of the German Commercial cannot be used as the basis for claims by third parties. However, an exception exists if the audit contract between the statutory auditor and the client explicitly includes a third party liability clause. In addition, it is worth noting that there also exist alternative opinions on the notion whether auditor misbehavior can give rise to third party liabilities in Germany. Please refer to Seibt and Wollschläger (2011) for further details.

  13. The composition of a supervisory board of a limited liability company in Germany is characterized by explicitly involving various stakeholders; e.g., banks, blockholders, employees and/or trade union representatives (Hackethal et al. 2005, p. 398–401). In addition, see Lane (2003) and Goergen et al. (2008) for a discussion on the differences and the convergence of the German and Anglo-American corporate governance model.

  14. It is important to note that the supervisory board of a public limited company is obliged by the German Stock Corporation Act (section 124 paragraph 3, sentence 1) to propose a statutory auditor to the shareholders’ meeting. After the formal voting of the members of the shareholders’ meeting the supervisory board is also entitled to assign the auditor for the upcoming annual financial statement audit (German Commercial Code, section 318, paragraph 1, sentence 1; German Stock Corporation Act, section 119, paragraph 1, no. 4).

  15. Please note that the public enforcement index equals the average of the following sub-indices: (1) supervisor characteristics index; (2) rule-making power index; (3) investigative powers index; (4) orders index; and (5) criminal index.

  16. The German law-maker enacted the Accounting Enforcement Act as of December 15, 2004. The act created the basis for the implementation of a two-tier financial reporting enforcement in Germany. In addition, the German law-maker enacted the Auditor Oversight Law as of December 27, 2004. The act introduced the Auditor Oversight Commission (APAK) in Germany, which is among other things responsible for disciplinary oversight of German auditors. We are not sure whether and how those accounting reforms are considered in the study results by La Porta et al. (2006). However, it can be assumed that those reforms have improved the public enforcement characteristics in the German institutional setting. Please refer to Ernstberger et al. (2012) for further details on the accounting enforcement reforms in Germany. Please also note our additional robustness analysis in section 6, on the effects of the regulatory changes in the German audit environment.

  17. The German law-maker enacted the Accounting Law Reform Act as of December 4, 2004. The act became effective for fiscal years beginning on or after January 1, 2005. The act contained the rules of mandatory IAS/IFRS adoption for listed companies in Germany and substantially modified the existing regulations on auditor independence.

  18. Throughout this paper, we generally omit subscripts for the firm and year for the sake of brevity when presenting our model equations.

  19. With regard to the study of Hay et al. (2006) the majority of prior empirical audit fee studies used other profitability measures (e.g., ROA, etc.). Due to several collinearity issues with other independent control variables we decide to use ROE as a proxy for profitability.

  20. Given the German audit market peculiarities, we define the following audit firms to be Big 5 auditors: KPMG, Ernst & Young, Deloitte, PWC, and BDO.

  21. According to Ernstberger et al. (2013) German setting modification of Frankel et al. (2002) industry membership, the classification is defined by SIC code as follows: agriculture (0100–0999), mining and construction (1000–1999, excluding 1300–1399), consumer manufactures (2000–2111, 2200–2799), chemicals, pharma, and refining (1300–1399, 2800–2824, 2830–2836, 2840–2899, 2900–2999), durable manufactures (3000–3999, excluding 3570–3579 and 3670–3679), transportation (4000–4899), utilities (4900–4999), retail (5000–5999), services (7000–8999, excluding 7370–7379), and computers (3570–3579, 3670–3679, 7370–7379).

  22. Please note that the Ball and Shivakumar (2006) model already controls for firm performance by incorporating the CFO variable.

  23. The IFRS classification follows Daske et al. (2013). As some regression variables are based on information of the previous period, data of the fiscal year 2004 is also included in our analyses.

  24. The missing audit fee disclosures are mainly related to the alternative fiscal year-end (i.e., not December 31) of some companies for which the mandatory fee disclosure requirements were not yet binding in 2005.

  25. This issue is mainly driven by the legal restructuring of KPMG in Europe. In October 2007, KPMG Germany, KPMG United Kingdom and KPMG Switzerland merged to form KPMG Europe LLP. During the period under study, the KPMG offices of the Netherlands, Spain, Belgium, Luxembourg, Norway, Russia, Ukraine, Kyrgyzstan, Kazakhstan, Armenia, Georgia, Saudi Arabia, Jordan and Kuwait have joined KPMG LLP.

  26. The audit fee data was hand-collected by one of the authors as well as by research assistants. All numbers were validated by another author, not involved in the initial collection process.

  27. It is important to note, however, that the audit market concentration is lower in comparison to many other countries (for example, the Big 4 control approx. 80 % of the US audit market). See Asthana and Boone (2012), Table 3.

  28. A majority of German listed companies used an option enacted by the Capital Raising Act in 1998 to prepare the annual consolidated statement in accordance with IFRS (or US-GAAP) instead of German GAAP before 2005. As a consequence, Germany is a country where a considerable amount of IFRS annual financial statements is available for a relatively long time period (Ernstberger 2008).

  29. We use a cross-sectional estimation approach where we cluster heteroscedasticity-adjusted standard errors on the firm-level. The cross-sectional estimation approach follows prior literature such as Choi et al. (2010), Asthana and Boone (2012), and Blankley et al. (2012). Please note that a firm fixed effect estimation could result in an understatement of the true standard error when the residuals of a given firm are correlated across years (Petersen 2009). In addition, a pooled estimation approach generally increases the statistical power in comparison to firm fixed effect computations.

  30. Excluding the industry- and year-fixed effects does not alter our results qualitatively.

  31. Throughout this study the presented t-values are all calculated on an adjusted basis, using robust standard errors corrected for heteroscedasticity and firm-level clustering (Petersen 2009).

  32. In comparison, other German audit market studies as, for instance, Bigus and Zimmermann (2009), Köhler et al. (2010) and Wild (2010) show similar adjusted R2 of approximetaly 82 % for their audit fee models.

  33. The significant positive coefficient is in line with the study results of Köhler et al. (2010), although the authors used the binary variable BIG4 in their research approach. Moreover, the results are partially supported by the findings of Wild (2010). The author states that among the Big 4 auditors only PWC is able to earn fee premiums in the German audit market. However, the empirical evidence of Wild (2010) cannot be taken at face value as the study mainly focus on audit pricing practices after auditor changes.

  34. Please note that we do not try to specifically derive a normal range of audit fee pricing nor to disentangle its economic consequences, but leave this promising topic for future research.

  35. Asthana and Boone (2012) use discretionary accruals as an audit quality proxy in their main analysis, too.

  36. The dependent variable RESTATE refers to the publication of error findings established by the German two-tier enforcement system. The German enforcement system consists of a private review panel, namely the “Deutsche Prüfstelle für Rechnungslegung” (DPR, German Financial Reporting Enforcement Panel), and the German securities regulator BaFin (“Bundesanstalt für Finanzdienstleistungsaufsicht”). To collect the restatement data for our robustness test, we searched the electronic version of the federal registry (“elektronischer Bundesanzeiger”). This web-based archive, which is maintained by the federal Ministry of Justice, stores filings by German firms and has been the mandatory channel of disclosure since October 2007. Please refer to Hitz et al. (2012) and Ernstberger et al. (2012) for further details on the institutional setup of the German two-tier enforcement system.

  37. The rationale of using the first-time modified GCO instead of all (subsequent) GCOs issued during the sample period is that continuing GCO modifications represent a different set of risks to the auditor and the client than a first-time modification (Carey et al. 2008; Mutchler and Williams 1990), because initial audit report modifications are the most difficult for a client to accept (Kida 1980). This procedure results in a total of 64 first-time GCO observations.

  38. Please note that we drop the independent variable LAGTACC as there is no need to control for variations in the reversal of accruals over time in non-accrual based models.

  39. Please refer to Ernstberger et al. (2012) for further details as well as capital market consequences of the German accounting enforcement reform.

  40. The coefficients for negative abnormal audit fees are insignificant for both of the subsample periods.

  41. These findings are similar to the enhanced auditor independence in the years following the enactment of SOX. See Asthana and Boone (2012) for further details.

  42. Quick and Sattler (2011) conduct an empirical study of the effects of non-audit services on audit quality for the German audit market. Using working capital accruals as a measure of audit quality, the authors find insignificant results for both audit-related and tax fees. However, the study provides evidence that other (consulting) fees are positively associated with the magnitude of working capital accruals.


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We are grateful for the comments and suggestions of the editor, two anonymous reviewers, Christopher Koch and participants at the VHB/IAAER Annual Conference 2013 in Frankfurt, Carolina Bona Sánchez and participants at the Workshop on Empirical Research in Financial Accounting 2011 at the University of Seville as well as of Joachim Gassen and the Finance-Accounting Research Seminar at Humboldt University Berlin. We also wish to thank Nicole Ratzinger-Sakel and the participants at the 6th EARNet Symposium 2011, the annual European Accounting Association (EAA) Conference 2011, and the 2010 Business and Research (BuR) Conference for their helpful comments. We thank Aasmund Eilifsen, Marcy Shepardson and Devrimi Kaya for the review of prior versions of this manuscript. We also thank Omer Cemal for scientific assistance. We gratefully acknowledge the financial support from HHL – Leipzig Graduate School of Management.

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Correspondence to Patrick Krauß.



Variable definitions




Absolute value of discretionary accruals as measured by the Ball and Shivakumar (2006) model


Absolute value of discretionary accruals as measured by the Jones (1991) model specification in Dechow et al. (1995) and adjusted for firm performance by including the ROA variable as suggested by McNichols (2000) and Kothari et al. (2001)


Abnormal audit fees estimated from Eq. (1)


Number of years since company foundation


Indicator variable that takes the value of 1 if the statutory auditor is one of the Big 5 audit firms (KPMG, Ernst & Young, Deloitte, PWC, and BDO), and 0 otherwise


Book-to-market ratio (total book value of equity divided by the firms’ market capitalization)


Indicator variable that takes the value of 1 if the fiscal year ends in December, and 0 otherwise


Cash flow from operations scaled by lagged total assets


Leverage change from the prior to the current fiscal year, whereas leverage is defined as long-term liabilities divided by total assets


Indicator variable that takes the value of 1 if the company is listed in the DAX index of the Frankfurt Stock Exchange, and 0 otherwise


Indicator variable that takes the value of 1 if the cash flow from operations is negative, and 0 otherwise


Indicator variable that takes the value of 1 if the abnormal audit fees estimated from Eq. (1) are positive, and 0 otherwise


Indicator variable that takes the value of 1 if the company received a going-concern modified opinion for the first time, and 0 otherwise


Ratio of foreign revenue to total revenue


Revenue change from the prior to the current fiscal year


Indicator variable that takes the value of 1 if the company applies IFRS for the first time, and 0 otherwise


Indicator variable that takes the value of 1 if the firm’s statutory auditor is in the first audit engagement year, and 0 otherwise


Indicator variable that takes the value of 1 if equity titles are issued in the current fiscal year, and 0 otherwise


Indicator variable that takes the value of 1 if the prior year’s net income is negative, and 0 otherwise


Prior-year’s total accruals


Natural log of audit fees


Natural log of the number of business segments


Natural log of the sum of inventories and receivables


Natural log of the number of analysts’ earnings forecasts


Natural log of total assets


Indicator variable that takes the value of 1 if the current year’s net income is negative, and 0 otherwise


Indicator variable that takes the value of 1 if the firm meets or beats the earnings expectation (proxied by the most recent median consensus analyst earnings forecast available on I/B/E/S file) by two cents or less, and 0 otherwise


Indicator variable that takes the value of 1 if the company is listed in the MDAX index of the Frankfurt Stock Exchange, and 0 otherwise


Ratio of non-audit fees to total fees


Positive abnormal audit fees estimated from Eq. (1), or respectively, interaction term of ABAFEE and DPABAFEE


Net property, plant and equipment


Accounts receivables


Number of days between the fiscal year-end and the audit opinion date


Indicator variable that takes the value of 1 if the client has issued a financial statement restatement for the respective fiscal year, and 0 otherwise


Total revenues


Return on assets (net income divided by total assets)


Return on equity (net income divided by total equity)


Indicator variable that takes the value of 1 if the company is listed in the SDAX index of the Frankfurt Stock Exchange, and 0 otherwise


Standard deviation of analysts’ earnings forecasts


Total assets


Total accruals (net income minus cash flows from operations)


Indicator variable that takes the value of 1 if the company is listed in the TECDAX index of the Frankfurt Stock Exchange, and 0 otherwise


Zmijewski’s (1984) financial condition index

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Krauß, P., Pronobis, P. & Zülch, H. Abnormal audit fees and audit quality: initial evidence from the German audit market. J Bus Econ 85, 45–84 (2015).

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