Government contracts and audit fees

• Published date: 01 January 2023
• Author: Mai Dao,Trung Pham,Hongkang Xu
• Date: 01 January 2023
• DOI: http://doi.org/10.1111/ijau.12298

ORIGINAL ARTICLE

Government contracts and audit fees

Mai Dao

1

| Trung Pham

2

| Hongkang Xu

3

1

The Department of Accounting, John B. and

Lillian E. Neff College of Business and

Innovation, The University of Toledo, Toledo,

Ohio, USA

2

The Department of Accounting, Economics,

and Finance, College of Business and

Management, The University of Illinois

Springfield, Springfield, Illinois, USA

3

Accounting and Finance Department,

Charlton College of Business, The University

of Massachusetts Dartmouth, Dartmouth,

Massachusetts, USA

Correspondence

Mai Dao, The Department of Accounting, John

B. and Lillian E. Neff College of Business and

Innovation, The University of Toledo, Toledo,

OH, USA.

Email: mai.dao@utoledo.edu

Funding information

Hongkang Xu gratefully acknowledges the

research support from the Provost's Fellows

grant programme at the University of

Massachusetts Dartmouth, Dartmouth,

Massachusetts, USA.

Topics concerning government contracts have recently attracted much attention

from researchers and the public because of the US government's significant spending

on goods and services. In this study, we investigate whether audit fees are associated

with audit clients' government contracts. We find that firms with a higher proportion

of government sales to total sales pay higher audit fees than other firms. Our further

analysis shows the audit premium is driven mainly by the federal government and

local government contracts. We also show that local government contracts have a

larger effect than federal government contracts on the determination of audit fees.

Taken together, our findings enhance our understanding of a potential determinant

of audit fees and imply that auditors may view firms with and without government

contracts differently.

KEYWORDS

audit effort, audit fees, firm risks, government contracts

1|INTRODUCTION

This study investigates how supplier firms' relationship with govern-

ment customers affects the audit fees charged by external auditors.

Although the relation between corporate customers and supplier firms

has attracted significant attention from researchers, research on the

impact of government customers over supplier firms (herein, govern-

ment contractors) has been scarce. Studies on government customers

often focus on the costs and benefits of government contracts and

the impact of government contracts on firm behaviours

(Berrios, 2006; Hui, Klasa, & Yeung, 2012; Cao, Hsieh, &

Kohlbeck, 2013; Burke, Convery, & Skaife, 2015; Green, Tian, &

Xia, 2017). To our knowledge, few studies have investigated the

impact of the supplier–government customer relationship on third

parties. Cohen, Li, Li, and Lou (2016) explore the effect of this rela-

tionship on creditors by examining how supplier firms' dependence on

their government customers affects loan contracts' terms negotiated

with their creditors. Ngo and Susnjara (2020) find evidence that

lenders charge a lower (higher) cost of debt to strategically important

government contractors (strategically unimportant government con-

tractors) after weighing relevant costs and benefits for the two groups

of government contractors. Boscaljon, Feng, Jia, and Sun (2021) show

that government contractors have a lower level of sensitivity of stock

returns to unexpected changes in market liquidity. Given the lack of

research on the impact of government customers on third parties, we

aim to fill this gap in the literature by examining whether external

auditors consider government contracts to be an important determi-

nant of audit fees.

Government contracts differ from contracts with other corporate

customers because of the former's unique characteristics. Specifically,

political factors significantly influence the changes in government

spending (Cohen, Li, Li, & Lou, 2016). Additionally, the government's

Received: 9 July 2020 Revised: 4 August 2022 Accepted: 31 October 2022

DOI: 10.1111/ijau.12298

This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License, which permits use and distribution in any

medium, provided the original work is properly cited, the use is non-commercial and no modifications or adaptations are made.

© 2022 The Authors. International Journal of Auditing published by John Wiley & Sons Ltd.

Int J Audit. 2023;27:1–23. wileyonlinelibrary.com/journal/ijau 1

procurement is a mixture of value and socioeconomic goals, meaning

government transactions are made with social welfare in mind (e.g. a

reduction in the unemployment rate, the enhancement of national

security and encouragement of technology development). However,

those procurement practices that meet societal goals may not be opti-

mal and may undergo dramatic changes in response to political cycles

(Cohen, Li, Li, & Lou, 2016; Josephson, Lee, Mariadoss, &

Johnson, 2019). Lastly, government customers have a lower likelihood

of facing solvency issues and declaring bankruptcy (Dhaliwal, Judd,

Serfling, & Shaikh, 2016; Josephson, Lee, Mariadoss, &

Johnson, 2019).

We conduct this study in response to the recent public interest in

the US government's large amount of annual spending on goods and

services (Josephson, Lee, Mariadoss, & Johnson, 2019). According to

the statistics for the 2011–2015 period, the US government's total

spending per year was approximately $4 trillion, of which nearly a

half-trillion dollars was spent on contracts for goods and services in

2015 alone (Josephson, Lee, Mariadoss, & Johnson, 2019;

Woods, 2017). Given the magnitude of government expenditure, it is

valid to examine whether auditors consider such spending when set-

ting government contractors' audit fees.

We investigate whether government contracts are associated

with either lower or higher audit fees. On the one hand, there are

three main mechanisms through which government contracts are

negatively related to audit fees. First, government contractors' less

volatile future earnings and better performance (Anderson &

Lee, 2016; Lin & Wu, 2010) may reduce audit effort and thus

lower audit fees. Second, the lower audit fees for government con-

tractors may also come from those contractors' lower levels of

operational risk (Dhaliwal, Judd, Serfling, & Shaikh, 2016).

Finally, auditors may not have to exert additional effort auditing

government contractors because of those contractors' higher level

of credibility and lower information asymmetry (Al-Thaqeb &

Harper, 2016).

On the other hand, it is also possible that government contracts

are related to higher audit fees due to a higher level of litigation risk,

greater operational and compliance costs, long-run distortions in

behaviours and outcomes and the potential lower information quality

of government contractors (Cohen & Malloy, 2016; Josephson, Lee,

Mariadoss, & Johnson, 2019; Rainey & Bozeman, 2000). Specifically,

government contractors have a high exposure risk from federal audits

and investigations (Josephson, Lee, Mariadoss, & Johnson, 2019)

and are subject to more disclosure requirements (Rainey &

Bozeman, 2000). Concerning long-term effects, prior research shows

that innovative and competitive capabilities deteriorate over time

when government contractors do business with the government for

a longer period (Cohen & Malloy, 2016). Consequently, auditors

may have to increase audit fees for additional audit efforts in audit-

ing high-risk clients and be compensated for potential future losses

from the audit engagements. Moreover, the potential lower informa-

tion quality of government contracts (Boscaljon, Feng, Jia, &

Sun, 2021) may require more audit work and higher audit fees to

compensate for the increase in audit effort. Boscaljon, Feng, Jia, and

Sun (2021) argue that the long-term government purchase is an

indicator of strong political connections with the government via

government procurements and that politically connected firms have

the tendency to manage earnings downward to avoid public

attention.

Using a sample of 43,547 US firm-year observations during the

2001–2018 period, we find that the proportion of government sales

to total sales is positively associated with audit fees. When we sepa-

rately examine the association between the proportions of different

types of government contracts (i.e. the federal government, state gov-

ernment and local government contracts) to total sales and audit fees,

we find positive and significant relations between audit fees and the

proportions of total sales to the federal government only and the pro-

portions of total sales to the local government only, respectively. Our

difference-in-coefficient tests show that local government contracts

have a stronger effect on the change in the audit fee level of govern-

ment contractors. The results suggest that auditors take into account

government contractors' reliance on sales to each government type in

assessing client risks and thus the audit fee level. Our results are

robust to an alternative measure of government contracts and addi-

tional tests to mitigate potential endogeneity concerns. Finally, we

substantiate our results with a survey of eight audit practitioners who

are currently holding different audit-related positions at various

accounting firms and have experience with clients that are govern-

ment contractors. The participants provide some explanations for the

higher audit fees for government contractors including the complex-

ity, risk and timing of the work performed on audit engagements of

government contractors. Particularly, the respondents mention that

government contract compliance requirements and initial versus

recurring audit engagements contribute to the increase in audit effort

and audit fees. All audit practitioners rank the risk related to govern-

ment contractors at the medium level, in which government contrac-

tors' noncompliance with contract terms and the likelihood of

misstatements of governmental contract revenues are the two main

risk factors. Additionally, the participants indicate that changes in local

government contract requirements across periods, as compared with

more consistent contract terms at the federal and state levels, could

be the explanation for the larger effect of local government contracts

on audit pricing. While the responses of participants in our survey

appear to support our arguments and regression results, we acknowl-

edge that the small survey sample may limit the generalisation of the

survey results.

The findings in this study might be of interest to both accounting

researchers and practitioners. Theoretically, this paper enriches the lit-

erature on the determinants of audit fees and broadens our under-

standing of the impact of government contracts on audit pricing.

There has been extensive literature on the determinants of audit fees.

Previous studies show that firm-specific and auditor-specific charac-

teristics are the primary factors determining audit fees (Carson &

Fargher, 2007; Gist, 1992; Gist, 1994; Simunic, 1980; Walker &

Casterella, 2000). To our knowledge, this is the first study focusing on

government contracts. We find that government contracts can poten-

tially influence auditors' audit pricing decisions. Our findings provide

2DAO ET AL.