The effect of mandatory audit firm rotation and the auditing and reporting standards on the auditor competition and audit fees relationship: Evidence from emerging markets

• Published date: 01 April 2022
• Author: Khairul Anuar Kamarudin,Ainul Islam,Wan Adibah Wan Ismail,Mosammet Asma Jahan
• Date: 01 April 2022
• DOI: http://doi.org/10.1111/ijau.12276

ORIGINAL ARTICLE

The effect of mandatory audit firm rotation and the auditing

and reporting standards on the auditor competition and audit

fees relationship: Evidence from emerging markets

Khairul Anuar Kamarudin

1

| Ainul Islam

2

| Wan Adibah Wan Ismail

3

|

Mosammet Asma Jahan

4

1

Faculty of Business, University of

Wollongong in Dubai, Dubai,

United Arab Emirates

2

School of Accounting and Commercial Law,

Wellington School of Business and

Goverment, Victoria University of Wellington,

Wellington, New Zealand

3

Faculty of Accountancy, Universiti Teknologi

Mara, Merbok, Kedah, Malaysia

4

Learning Delivery - Accounting and Finance,

The Open Polytechnic of New Zealand, Lower

Hutt, New Zealand

Correspondence

Khairul Anuar Kamarudin, Faculty of Business,

University of Wollongong in Dubai, Dubai

Knowledge Park, Dubai, United Arab Emirates.

Email: KhairulKamarudin@uowdubai.ac.ae

Funding information

Kementerian Pendidikan Malaysia, Grant/

Award Number: FRGS/1/2019/SS01/

UITM/02/1

This research investigates whether auditor competition is associated with low audit

fees and whether a country's implementation of mandatory audit firm rotation

requirements as well as strong auditing and reporting standards weaken the negative

effect of auditor competition on audit fees. Using 41,811 firm-year observations

from 10 emerging markets—specifically China, India, Malaysia, Pakistan, the

Philippines, Poland, Russia, South Africa, Thailand, and Turkey—we find that auditor

competition has a decreasing effect on audit fees. We also find that firms from coun-

tries with mandatory audit firm rotation requirements and strong auditing and

reporting standards have higher audit fees than firms from countries with weak

auditing and reporting standards and no mandatory audit firm rotation requirements.

In the former countries, the negative relationship between auditor competition and

audit fees is weaker than that for firms in the latter countries. Our results are robust

to various specification tests, such as those for endogeneity issues, and alternative

measures of country-level institutional features. This study presents significant

implications for regulators by providing evidence that both mandatory audit firm

rotation requirements and the strength of auditing and reporting standards play

an essential role in enhancing audit quality by curbing the negative effect of audit

competition.

KEYWORDS

audit fees, auditing and reporting standards, auditor competition, mandatory audit firm

rotation

1|INTRODUCTION

Since the decrease in the number of world's largest accounting firms

from the Big 8 to the Big 4, the audit literature has substantially

focused on its effect on audit competition and audit fees. Previous

research in developed countries has suggested an increase in audit

market concentration with a more equal market share after this con-

solidation, such as in the United States (Dunn et al., 2011) and the

United Kingdom (McMeeking, 2007). The increased audit market

competition would lead to price competition, especially during the

initial tender stage, and this is supported by evidence that auditors

charge lower audit fees when competition is high (Chaney

et al., 2003; Hardies, 2016; Johnstone et al., 2004; Zeff, 2003a,

2003b). On the other hand, high competition could increase the

price collusion probability (McMeeking, 2007). Further, it has also

been argued that the decreased number of Big audit firms would

lower the levels of competition, thus providing more opportunities

for auditors to exercise their market power, which leads to higher

Received: 21 April 2021 Revised: 12 January 2022 Accepted: 19 January 2022

DOI: 10.1111/ijau.12276

252 © 2022 John Wiley & Sons Ltd Int J Audit. 2022;26:252–278.wileyonlinelibrary.com/journal/ijau

audit prices (Velte & Stiglbauer, 2012; Zhang et al., 2019). Extant

studies have documented increased audit fees in the high-

concentration market (Carson et al., 2012; Eshleman &

Lawson, 2017; Feldman, 2006; Huang et al., 2016). Despite the siz-

able literature on audit fees, the extent to which auditor competi-

tion affects audit pricing, especially in the emerging market, is

largely unexplored. Therefore, in this study, we investigate the rela-

tionship between auditor competition and audit fees in emerging

markets.

We also examine how mandatory audit firm rotation (MAFR) and

the strength of auditing and reporting standards (ARS) may moderate

this relationship. As some audit firms may offer audit fee discounts in

initial engagements (Choi et al., 2010; DeAngelo, 1981; Deis &

Giroux, 1996; Ghosh & Lustgarten, 2006), the situation might differ

among MAFR countries. Under a MAFR regime, the short appoint-

ment period restricts the realisation of economic benefits, as audit

firms cannot extend the relationship beyond a defined period (Kwon

et al., 2014). Also, MAFR could lead to an increase in demand for audit

services and competition. Audit firms are under pressure to replace

lost clients to maintain their market share and have a shorter period

of time to recoup the familiarisation costs (Harber et al., 2020;

Petty & Cuganesan, 1996). Prior studies have found mixed evidence

regarding this issue. Some have found high audit costs (Cameran

et al., 2015; Harber et al., 2020; Kwon et al., 2014; Petty &

Cuganesan, 1996; Sharma et al., 2017), while other studies have

found no significant effect on audit fees due to MAFR (Corbella

et al., 2016; Narayanaswamy & Raghunandan, 2019). The ARS may

significantly affect the quality of the financial information produced

by the preparer as well as enhance the effectiveness of auditing. Sev-

eral studies have shed some light on the relevance and significance of

ARS by examining their country-level determinants, their relationship

with country-level governance, and their relationship with financial

reporting quality (Achim, 2018; Avram et al., 2015; Boolaky, 2012;

Boolaky et al., 2012; Boolaky & Cooper, 2015; Boolaky &

O'Leary, 2011). However, very few studies have directly examined

the effect of ARS on auditing functions generally and audit costs spe-

cifically. Hence, this research further examines whether MAFR and

ARS moderate the effect of auditor competition on audit fees in

selected emerging countries.

This study specifically focuses on 10 emerging markets: China,

India, Malaysia, Pakistan, the Philippines, Poland, Russia,

South Africa, Thailand, and Turkey. The general economic, legal, and

institutional settings of emerging countries provide a unique oppor-

tunity for testing the effect of auditor competition and the strength

of ARS in regard to the pricing of audit services. First, emerging

countries display significant variation in their financial reporting and

auditing jurisdictions (Michas, 2011). Although most of the emerging

countries have adopted (either entirely or partially) the guidelines,

standards, or suggestions related to auditing and financial

reporting—that is, the International Accounting Standards (IAS)/

International Financial Reporting Standards (IFRS)—the credibility of

auditing and accounting information is still questionable (Francis &

Wang, 2008; Rahman, 1998; Siddiqui, 2010). Many argue that the

market for audit services in emerging countries lacks strong regula-

tory requirements and a demand for audit services (Ahmed &

Goyal, 2005; Michas, 2011). Second, contrary to the situation in

developed countries, the audit market of emerging countries is

characterised by many small-sized audit firms (Huang et al., 2016),

with the existence of such local firms increasing the market compe-

tition (Chang et al., 2019; Huang et al., 2016; Wang et al., 2014).

Third, with the globalisation of trade, the capital markets in emerg-

ing economies have grown significantly and the reliability of finan-

cial information is demanded by investors worldwide (Ahmed

et al., 2013; Lungu et al., 2017). This has increased the importance

of investigating this issue in emerging markets context. Prior studies

examining the relationship between audit fees and audit market

concentration have found conflicting evidence. Our findings will

shed light on audit fees in emerging markets and assist the inves-

tors, regulators, and policymakers within these markets to under-

stand the contributing factors of audit fees.

In this study, we conducted tests on a sample of 41,811 firm-

year observations from the aforementioned 10 countries for the

period 2009–2018. In the countries with no MAFR requirement

and weak ARS, we found that auditor competition was associated

with low audit fees. We further found that firms in countries that

impose MAFR and have strong ARS paid higher audit fees than

the firms in countries with no MAFR requirement and weak ARS.

Consistent with our prediction, our findings support the notion that

MAFR and the strength of ARS affect the relationship between

auditor competition and audit fees. More specifically, the results

indicate that, in countries that impose MAFR and have strong ARS,

auditor competition has a weaker negative effect on audit fees

when compared with countries with weak ARS or those not

imposing MAFR.

We further tested and found evidence that our main results are

robust to alternative measurements of the moderating variables.

These include a more general definition for mandatory audit rotation,

the reclassification for strong and weak ARS, employing the anti-

director rights index and the protection of minority shareholders. We

also address whether auditor competition and audit fees are simulta-

neously determined, which might cause our results to suffer from an

endogeneity bias. The results from the two-stage regressions validate

that our results are not subject to endogeneity issues. Finally, this

research examines other governance and control measures introduced

by international regulatory bodies, including the International Stan-

dard on Quality Control (ISQC), the Code of Ethics for Professional

Accountants (CEPA), the establishment of the Audit Oversight Board

(AOB), and an index created using eight criteria related to accounting

and auditing. We found that these standards and codes—particularly

the ISQC, the AOB, and the CEPA—significantly affected the audit

quality, particularly by mitigating the negative effect of auditor com-

petition on audit fees.

This study makes the following contributions to audit literature.

First, we extend the literature on the determinants of audit fees by

providing evidence regarding the effect of auditor competition across

different institutional environments. While our findings support the

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