The Effect of Initial Audit Fee Discounting on Audit Quality: Using Rank－Specific Audit Hours

[Purpose]This study reexamines the audit quality effect of audit fee discounting of initial－year audit fees (“low－balling”) and delves into the reasons behind it using rank－specific audit hours. While prior studies examine the relation between initial－year audit fee discounts and audit quality, the results are inconclusive. The availability of information on rank－specific audit hours provides an opportunity to conduct more in－depth analyses on the reasons for the documented results on the audit quality effect of low－balling in Korea. [Methodology]For the period 2005－2015, we use a final sample of 11,676 firm－year observations to analyze the effect of low－balling of audit fees on audit quality. Audit quality is measured by (performance－matched) discretionary accruals, and the level of audit team experience is measured by audit hours of various ranks of audit engagement team personnel, such as quality reviewers, audit partners, licensed accountants, unlicensed staff, and specialists. [Findings]We find weak evidence that audit quality is significantly lower in the first year of an audit engagement compared to continuing engagements. However, among initial－year audit engagements, we find no evidence of any incremental impairment in audit quality for engagements with fee discounts. To examine how auditors secure the level of audit quality, we further examine the characteristics of the engagement team of low－balling auditors. We find that low－balling auditors do not exhibit any systematic tendency to spend lower audit hours or assign less experienced personnel to the engagement. [Implications]The finding suggests that auditors internalize temporary losses from initial－year fee discounting to attract new audit contracts, rather than transferring the cost to clients by exerting less effort, and thus are able to maintain their audit quality. This study demonstrates how auditors tackle the regulatory concerns over audit fee low－balling causing low audit quality.