Organization capital and audit fees around the world

• Published date: 01 November 2020
• Date: 01 November 2020
• DOI: http://doi.org/10.1111/ijau.12197

ORIGINAL ARTICLE

Organization capital and audit fees around the world

Ahsan Habib

1

| Mostafa Monzur Hasan

2

| Xuan Sean Sun

1

1

School of Accountancy, Massey University,

Auckland, New Zealand

2

Department of Accounting and Corporate

Governance, Macquarie University, New South

Wales, Australia

Correspondence

Ahsan Habib, School of Accountancy, Massey

University, 102904, Auckland, New Zealand.

Email: a.habib@massey.ac.nz

We examine whether auditors consider organization capital in audit pricing decisions.

Utilizing an international sample from 40 countries spanning the period 2001–2017,

we find that firms with high levels of organization capital pay high audit fees: a find-

ing that is consistent with both the risk- and the agency-based arguments for audit

pricing. Additionally, our results indicate that the positive relationship between orga-

nization capital and audit fees is reinforced in firms with pronounced business risks

and agency problems, whereas it is relatively weak in countries with protective

employment legislation. Our study contributes to the voluminous literature on the

determinants of audit fees by showing that auditors price the risks related to clients'

intangible assets, especially those embodied in a firm's key talents. Our study also

contributes to the scarce literature on the effects of organization capital in interna-

tional markets.

KEYWORDS

Agency Problems, Audit Fees, Business Risk, Employment Protection Legislation, Organization

Capital

JEL CLASSIFICATION

G32; K31; L23; M42

1|INTRODUCTION

Since the seminal audit pricing model of Simunic (1980), audit litera-

ture has focused substantially on the determinants of audit fees. Prior

research on audit pricing suggests that audit fees reflect auditor effort

and risk premiums and, thus, should be positively related to auditor

engagement risk (DeFond & Zhang, 2014; ). Auditors are likely to

increase audit effort on riskier clients, to reduce the likelihood of mis-

statements or fraud (Davis, Ricchiute, & Trompeter, 1993;

Hillegeist, 1999). Auditors may also increase billing rates and charge

fee premiums to compensate for higher engagement risks (Bedard &

Johnstone, 2004). Based on these arguments, extant studies docu-

ment that a host of firm-level characteristics, industry-level attributes,

and regional factors (e.g., social capital and money laundering) affect

audit fees (Habib, Hasan, & Al-Hadi, 2018; Hay, 2013; Hay, Knechel, &

Wong, 2006; Jha & Chen, 2015; Leventis, Weetman, &

Caramanis, 2011). Despite this sizeable literature on audit pricing, the

extent to which organization capital, the firm-level stealth asset of a

corporation, affects the audit fees of the firm, is largely unexplored.

Therefore, in this study, we investigate the relation between organiza-

tion capital and audit fees internationally. We also examine some

firm- and country-level variables that may moderate this relationship.

Organization capital may be defined as the accumulation of firm-

specific knowledge that “enables superior operating, investment and

innovation performance, represented by the agglomeration of

technologies—business practices, processes and designs”(Lev,

Radhakrishnan, & Zhang, 2009, p. 277). Firms with high levels of orga-

nization capital achieve efficient production, stable business opera-

tion, and speedy transactions and thereby generate increased

productivity (Black & Lynch, 2005) and better firm performance (Lev

et al., 2009).

1

However, Eisfeldt and Papanikolaou (2013) argue that

firms with high levels of organization capital are exposed to two addi-

tional risks. First, organization capital is embodied in the firm's key tal-

ent, and its efficiency is firm-specific. Since part of organization

capital is embodied in key talent, it is potentially movable across firms.

Hence, both shareholders and key talent have a claim on the cash

flows stemming from organization capital. Importantly, sharing of

cashflow accruing from organization capital depends on the outside

Received: 1 October 2019 Revised: 1 March 2020 Accepted: 17 May 2020

DOI: 10.1111/ijau.12197

Int J Audit. 2020;24:321–346. wileyonlinelibrary.com/journal/ijau ©2020 John Wiley & Sons Ltd 321

options available to key talent. Since shareholders do not own all the

cash flow rights, investment in high organization–capital firms

increases cash flow risks. Second, the key talent of firms with high

organization capital may have incentives to overinvest in organization

capital in an attempt to enhance their outside options, and this gives

rise to agency problems. In this study, we explore how external audi-

tors, an important group of stakeholders, incorporate both cash flow

and agency risks into their audit pricing for firms with high levels of

organization capital.

We argue that auditors will charge higher fees to client firms with

high levels of organization capital, than to firms with low-levels of

organization capital. Our argument is premised on the business risk

and agency arguments for audit pricing. The business risk perspective

on audit pricing contends that auditors assess the business risk of the

client in pricing audit fees (Bell, Landsman, & Shackelford, 2001;

Lyon & Maher, 2005). This is because auditors are more likely to face

a litigation risk if they audit high-business–risk firms (Morgan &

Stocken, 1998). Therefore, auditors tend to charge high fees for ser-

vicing clients with pronounced business risks. Prior studies suggest

that firms with high organization capital are exposed to higher cash

flow risks, and to the risk of losing key personnel and invaluable infor-

mation to rival firms (Eisfeldt & Papanikolaou, 2013). As a result, firms

with high organization capital are associated with more business risk.

We predict that auditors will incorporate this business risk into pricing

audit fees and, accordingly, will require higher audit fees for servicing

firms with high organization capital.

The agency argument for audit pricing suggests that audit fees

represent monitoring cost (Jensen & Meckling, 1976) and, therefore,

in pricing audit fees, auditors should consider the factors affecting

agency costs (Gul & Tsui, 2001). Extant studies find support to this

argument (Griffin, Lont, & Sun, 2008, 2010; Leventis et al., 2011). We

argue that firms with high organization capital are exposed to rela-

tively severe agency problems. This is because key talents

(i.e., managers) have incentives to overinvest in accumulating organi-

zation capital, to maximize their outside options (Eisfeldt &

Papanikolaou, 2013). Therefore, auditors are likely to charge higher

audit fees to compensate for the agency problems stemming from

organization capital.

We test the above conjectures using an international sample from

40 countries during the period 2001–2017. We argue that interna-

tional study of the relation between organization capital and audit

fees is important, because such an investigation makes possible the

use of country-level institutional factor(s) as moderating variable(s),

and has the potential to provide greater insights into the proposed

relationship (Hay, 2013; Hay et al., 2006). An international study also

addresses concerns regarding the generalizability of country-specific

findings.

We estimate the stock of organization capital in each year for

each firm by accumulating a fraction of past selling, general, and

administrative (SG&A) expenditure using the perpetual inventory

method (Peters & Taylor, 2017). We also proxy organization capital

by the investment portion of SG&A aimed at improving organiza-

tional knowledge and capabilities (Enache & Srivastava, 2018), and

by executive compensation (Corrado, Hulten, & Sichel, 2005). Using

a large international sample from 2001 to 2017, we find a positive

and significant relationship between organization capital and audit

fees after controlling for various firm-level characteristics, year and

industry effects, and country-specific time invariant unobserved

heterogeneity. In terms of economic significance, our baseline

model shows that a one standard deviation increase in organization

capital increases audit fees by 10.82%, relative to the mean, which

may be interpreted as an increase in audit fees of about $0.083

million. Our results remain robust to the use of alternative mea-

sures of organization capital. We further show that our docu-

mented results remain robust after controlling for SG&A expenses

and firm-level corporate governance. We find that this positive

relation between organization capital and audit fees holds for both

U.S. and non-U.S. samples and for both high-tech and non-high–

tech samples. Then, we examine whether the positive relation

between organization capital and audit fees is driven by business

risk and/or by agency problems. We find evidence in support of

both the business risks and the agency cost arguments for audit

fee determination. In terms of country-level institutional factors, we

document that the positive relation between organization capital

and audit fees is weak in countries with relatively strong employ-

ment protection legislation. Finally, using the two-stage least

squares and propensity-matching tests, we show that our results

are not driven by endogeneity concerns.

Our study contributes to the literature in several important ways.

First, to the best of our knowledge, this is the first study to offer

robust international evidence for a link between organization capital

and audit fees. Prior literature suggests that audit fees reflect agency

problems and client-level business risk, as well as auditors' engage-

ment risk (Griffin et al., 2008, 2010; Leventis et al., 2011; Lyon &

Maher, 2005, among others). We contribute to this literature by

showing that auditors take into account the business risk and agency

cost stemming from high organization capital in determining audit

fees. Introducing this new strand of literature in the context of audit

pricing is novel, as intangible assets, especially those embodied in a

firm's key talents, are considered the hallmark of modern business

enterprises. Second, our analyses exploit the richness of our data in

examining whether and how the relationship between organization

capital and audit fees differs across firms and across countries with

varying institutional environments. Hay et al. (2006) suggest that

national institutional environments may be important in explaining

audit fees. In a recent study, Simnett, Carson, and Vanstraelen (2016)

also call for more international research to inform the development of

knowledge about external auditing.

2

We contribute to the audit litera-

ture by examining how the country-level governance mechanism

moderates the relationship between organization capital and audit

fees. Finally, our work contributes to the growing literature on the

effect of organization capital in international markets. While studies

explore the effects of organization capital on firm outcomes in the

U.S. setting (Eisfeldt & Papanikolaou, 2013; Hasan & Cheung, 2018;

Lev et al., 2009; Li, Qiu, & Shen, 2018), international evidence on the

effects of organization capital is scarce, with the notable exception of

322 HABIB ET AL.