The auditor’s response to fraud in the client organisation: The impact of corporate governance, internal controls and auditor industry specialisation on audit pricing.

The primary aim of this study is to determine the extent to which external auditors, in exercising their responsibilities under the Australian Auditing Standards, conduct additional audit work (proxied by audit fees) when audit clients have experienced known misappropriation of assets (MOA) fraud. The research is motivated by three key factors. The first being the mounting concerns by the Australian government and others in relation to audit quality. The second being the significant public concern related to fraud within organisations, and the increasingly sophisticated methods used to commit such crimes. Third being the potential to investigate the link, if any, between audit pricing and MOA fraud. This potential relationship is inherently under-researched globally reflecting a lack of access to data on MOA.

This study employed a sample of 60 Australian listed companies that have experienced known MOA fraud in the period from 2002-2010, as well as 60 control companies which have been individually matched to the fraud companies by industry and size. I investigated in a fraud context whether corporate governance, internal control factors and auditor industry specialisation impact on the extent of any additional audit work undertaken by the auditor when their client has experienced known MOA fraud. The research makes a unique theoretical contribution by examining how the substitution effect, role-conflict theory and signalling theory interconnect within an agency framework in the context of known fraud.

Employing a quantitative approach to research design and analysis, a deductive approach is used to draw hypotheses from agency theory, substitution, role conflict and signalling theories which seeks to explain the relationships between fraud, auditor specialisation, corporate governance, internal control and audit fees. Four empirical models are presented based on these hypotheses, and data is collected and statistically analysed using ordinary least squares (OLS) regression to test the models, hypotheses and the theories which underpin them.

This study found that companies with higher losses from MOA fraud paid significantly higher audit fees than those companies with lower losses from MOA fraud. This suggests that auditors expend additional audit effort, and this additional effort translates into higher audit fees. This contributes to the audit quality debate amongst regulators, researchers, the accounting profession and the public by confirming that the auditor is acting (at least in part) in response to their responsibilities pertaining to fraud as required by Australian Auditing Standards. This finding has an associated theoretical contribution, since MOA fraud can be considered an agency problem, and these additional audit fees can be regarded as an additional external monitoring cost under agency theory.

The study does not find a significant relationship between corporate governance characteristics or prevention-focused fraud-related internal controls and audit fees. However, evidence is presented that detection-focused fraud-related internal controls reduce the additional audit work undertaken by the auditor in response to MOA fraud. This provides regulators with greater insights into the factors that auditors consider when deciding how to respond to MOA fraud in discharging their responsibilities under ASA 240 'The Auditor's Responsibilities Relating to Fraud in an Audit of a Financial Report'. These findings also provide a theoretical contribution by developing a greater understanding of which factors do, and do not, produce a substitution effect in relation to external monitoring conducted by auditors in response to MOA fraud.

This study also examined auditor industry specialisation using both the joint firm national-city framework and the joint partner national-city framework. The findings provide evidence that the choice to engage an industry specialist auditor (under either framework) impacted on the audit fees paid by those companies that have experienced known MOA fraud and adds a further dimension to the audit quality discussion.

This study makes several contributions to the extant literature and the theories which underpin the research. As previously noted, misappropriation of assets is under-researched globally due to the difficulty of obtaining sufficient data for a large-scale analysis. The select number of other studies which have examined MOA fraud have focussed on the relationship between MOA fraud and internal characteristics/processes rather than an examination of the external auditor and their response to MOA fraud.

Given the growing concerns in relation to audit quality, the increasingly complex means by which fraud is perpetrated and the lack of research in this area, the present study investigated how auditors respond when their client has experienced known MOA fraud. These findings have implications for regulators, researchers, the accounting profession and the public. For example, the 2019-2020 Australian Federal Budget has allocated additional taxpayers' funds towards improving audit quality over a period of three years (Commonwealth of Australia 2019). An examination of the extent to which auditors discharge their responsibilities in accordance with the requirements of Australian Auditing Standards can ensure that resources are allocated to address those areas most in need of improvement. In this way, the research has implications for both regulators and the tax-paying public. A further example is the evidence provided in this study that industry specialisation is assessed by the market at a partner level (as opposed to only the national level or office level). This has implications for accounting firms and may impact the marketing strategies they choose to adopt. More specifically, campaigns to promote local partner expertise may prove to be more effective in gaining and retaining clients compared to a focus on only the promotion of national and even international reputation. Further, this same finding has implications for researchers. Currently, there are only a limited number of studies which examine auditor industry specialisation at the partner level. The evidence of fee premiums charged by industry specialist partners provided by the present study may encourage researchers to further examine auditor industry specialisation at the partner level.