Audit Procurement: Managing Audit Quality and Audit Fees in Response to Agency Costs *

KEVAN L. JENSEN, University of Oklahoma and JEFF L. PAYNE, University of Oklahoma

Address all correspondence to: Kevan L. Jensen Michael F. Price College of Business University of Oklahoma Norman, OK 73019 Phone: (405) 325-5763 Fax: (405) 324-7348 email: kjensen@ou.edu

October 2003

* Special thanks to the workshop participants at the University of Oklahoma for comments and suggestions. Thanks also to the finance officers participating in our

study, and to Jill OBrien and her coworkers at the Federal Audit Clearinghouse for assistance in compiling the database used in for this study. Audit Procurement: Managing Audit Quality and Audit Fees in Response to Agency Costs

ABSTRACT: This study develops and tests a model of audit procurement as a control mechanism utilized within an agency framework to regulate audit quality and the related audit fees. Procurement mechanisms are comprised of multiple components including, (1) a set of procurement procedures geared towards identifying quality and fee information, (2) the personal characteristics of the individual procurers, and (3) the organizational characteristics under which procurement decisions are made. Using a sample of municipal organizations (cities), we find evidence consistent with our model. The presence and level of audit procurement is associated with the existence of agency costs. Audit procurement in general, and the individual elements of audit procurement are associated with the hiring of auditors with higher levels of industry expertise-suggestive of higher audit quality. Moreover, audit procurement in general, and some of the individual elements of audit procurement are associated with audit fees. These results are consistent with our hypothesis that managers view audit procurement as a mechanism for regulating audit quality and audit fees, and incorporate it as part of their overall control systems. Key Words: Audit Procurement, Agency Costs, Auditor Expertise, Audit Fees. Data Availability: Please contact the authors.

1. Introduction The demand for external auditing derives largely from the agency costs created by relationships between managers and parties internal and external to their organizations (Jensen and Meckling 1976). Unfortunately, while different levels of agency costs may lead to different levels of audit quality being demanded, audit quality is difficult to identify ex ante (or ex post). This makes it difficult for managers to regulate the level of audit quality they purchase, thus making it difficult to optimize the overall level of control provided by an organizations control system. This also makes it difficult for managers to match desired audit quality with appropriate levels of audit fees. Consequently, external audit quality for many organizations may be less than optimal (GAO 1986), and audit fees for some organizations may be higher than would occur if better information sets were available during auditor selection (Hackenbrack, Jensen, and Payne 2000). Both the General Accounting Office (GAO 1987) and the American Institute of Certified Public Accountants (AICPA 1987) strongly suggest that the solution to this problem is improved audit procurement. Procurement experts voice similar opinions (e.g., Gansler 2002). And recent commentary from other professional organizations indicates that using audit procurement to improve audit quality and to meet organizational needs continues to be emphasized to their constituents (e.g., FEI 2003; GFOA 2002; IIA 2002).

Procurement is, [T]he systematic process of deciding what, when, and how much to purchase; the act of purchasing it; and the process of ensuring that what is required is received on time in the quantity and quality specified (Burt and Pinkerton 1996). Unfortunately, audit procurement and its role are not well understood, and empirical research examining audit procurement antecedents and the links between audit procurement, audit quality, and audit fees is limited. Since the general focus of procurement is quality, we predict that managers facing higher levels of agency costs are more likely to implement well-developed procurement mechanisms, and that well-developed procurement helps them to identify and hire their preferred quality auditor at an appropriate cost. This study addresses these issues by presenting a multidimensional model of audit procurement. According to this model, a well-developed procurement process can be an effective mechanism for identifying and hiring high-quality auditors and doing so at the lowest cost. The model is consistent with observations made by procurement experts that a well-developed procurement mechanism includes multiple components, such as procurement procedures geared toward identifying information about audit firms and audit fees, the personal characteristics of the procurers, and the organizational characteristics under which procurement decisions are made (e.g., Burt and Pinkerton 1996; Gansler 2002). Each of these components is controllable to some degree by management.

Using a sample of municipal organizations (cities), we find evidence consistent with this model. Cities facing higher levels of agency costs tend to have better-developed procurement mechanisms. Audit procurement in general, and the individual elements of audit procurement, are associated with the hiring of auditors with higher levels of industry expertise--suggestive of higher auditor quality. Moreover, audit procurement in general, and some individual elements of audit procurement, are associated with audit fees. These results are consistent with managers incorporating audit procurement within an agency setting as a mechanism for regulating audit quality and audit fees. This study is important for several reasons. First, by identifying procurement as a control mechanism, we are able to predict which organizations are most likely to have well-developed audit procurement mechanisms. This suggests that in many cases, rational managers already react to market forces in providing what appears to be efficient levels of audit procurement. This is also important to the continuing debate over the optimal level of regulation for protecting consumers of accounting information. Second, recent accounting and auditing fiascos have focused the publics attention on problems in the profession, and on procurement elements as possible solutions to such problems. Issues such as mandatory auditor rotation, the role of audit committees in auditor selection, accounting expertise among audit committee members, and maintaining auditor independence are all linked directly or indirectly to audit procurement. This study

provides a model of audit procurement that includes many of these elements, and identifies the mechanisms through which these elements affect audit quality and audit fees. Finally, this is the first study to directly test the links between audit procurement, audit quality, and audit fees. While this is important for our general understanding of the market for audit services, it may also lead to increased efficiency within organizations as managers learn how to use the audit procurement process more effectively. The remainder of this paper is presented as follows. In Section 2, prior research is reviewed and a model of audit procurement is presented explaining the link between agency costs and audit procurement. Section 3 presents an analysis of the models prediction regarding the relation between agency and procurement. Section 4 extends the model to motivate hypotheses linking audit procurement, audit quality and audit fees, and presents several analyses in this regard. The final section presents our conclusions. 2. The Role of Audit Procurement Insights from prior studies The debate regarding the role of audit procurement came to the forefront when both the AICPA (1986, 1987) and the GAO (1986, 1987) identified a link between poor audit quality and poor audit procurement. The primary concern was that organizations who received substandard audits were placing too much

emphasis on audit fees rather than audit quality when selecting an external auditor through traditional bidding practices (AICPA 1986). However, the GAO (1987) noted that audit procurement involves more than just competitive bidding. They specifically identified solicitation procedures, the use of technical factors in auditor selection, and the use of multi-year contracts and other written agreements. In addition, although the GAO focused on procurement procedures, they did mention other features of the procurement environment (e.g., using more qualified people and/or audit committees in the procurement process) as being important elements of procurement. Motivated partly by the GAOs findings, three empirical studies examine the effects of audit procurement elements. In the most thorough of these studies, Raman and Wilson (1994) examine a model of audit procurement that includes proxies for each of the elements suggested by the GAO. However, rather than linking audit procurement to audit quality or audit fees, the authors examine audit procurement as a possible signaling mechanism used to communicate management quality to the capital markets. By regressing a summary procurement variable against bond interest premiums, they show that the number of audit procurement procedures used by municipal organizations is associated with lower interest rates, consistent with their signaling theory. They also show that for cities not audited by Big 8 firms, the presence of an audit committee and the use of solicitation guidelines are also associated with lower interest rates.

Unfortunately, when procurement procedures are separately examined for all cities, only the use of bidding is significant, leaving it less clear what role is played by audit committees, multi-year agreements, and other procurement procedures. Raman and Wilsons (1994) results are generally consistent with procurement being used as a signaling mechanism. They are also consistent with procurement being used to secure higher-quality auditors--the use of which reduces information risk, resulting in lower interest rates. Unfortunately, the authors do not examine either auditor quality or audit fees, nor do they address agency costs not related to debt holders. Copley and Doucet (1993) also find the number of bids received during the procurement process to be associated with both higher audit quality and lower audit fees for a sample of municipalities. However, using simultaneous estimation of audit quality and audit fees, a subsequent study (Copley, Doucet, and Gaver 1994) finds no relation between the number of bids received and audit fees. The authors do find evidence that emphasizing cost over quality factors during the procurement process leads to lower audit fees. A significant contribution of Copley et al. (1994) is the important idea that audit quality and audit fees are jointly determined. We discuss this in more detail later. Our study adds to this literature by examining audit procurement in a more generalized setting and by providing a model of audit procurement. Procurement experts suggest that a well-developed procurement mechanism includes multiple

components, such as a set of procurement procedures geared toward identifying information about audit firms and audit fees, the personal characteristics of the procurers, and the organizational characteristics under which procurement decisions are made (e.g., Burt and Pinkerton 1996; Gansler 2002). Importantly, each of these components is controllable to some degree by management. We specifically investigate the relationship between a municipalitys agency costs and a well developed procurement process. We also examine the influence of these procurement elements on the quality/fee combination selected by management. A model of audit procurement Differential demand for audit quality arises because of disparity in the cost/benefit functions managers face when assembling control systems in response to different levels of agency costs (Simunic 1980). Agency costs arise from information asymmetries and conflicting interests that exist between parties internal and external to organizations (Jensen and Meckling 1976). We posit that audit procurement is an effective mechanism to aid managers in obtaining the desired price/quality bundle of audit services in response to these costs. Such a mechanism can be particularly useful since audit quality is difficult to assess ex ante. As noted earlier, well-developed procurement provides relevant information to managers, identifies qualified providers, and aligns organizational needs with the goods or services being purchased. It may also be useful in

maximizing value, although such an objective is not explicitly stated in the definition. In the market for audit services, well-developed procurement provides managers with information useful in differentiating audit firms, identifies the needs of organizations and the audit firms likely to meet those needs, and in many cases identifies the audit firm who can do so at the lowest cost. Figure 1 presents a model of audit procurement describing the relationship among agency costs, audit procurement, audit quality, and audit fees. The demand for well-developed audit procurement stems from managements assessment of the level of existing agency costs and managements perception that increasing the level of audit quality is an efficient way to minimize such costs.1 Rational managers should implement mechanisms so long as the perceived costs of doing so are less than the respective reductions in agency costs allowed by the improved matching of organizational needs and audit quality. To the extent that such mechanisms also affect audit fees, managers should also be able to improve audit quality while maximizing value at the same time. According to the model, the decision to improve audit procurement can focus on several areas. Indeed, consistent with procurement experts, our model emphasizes the multidimensional nature of procurement (e.g., Hodges 1961; Burt 1984; Gansler 2002). The most obvious component of procurement is a set of procurement procedures. The GAO (1987) identifies several potentially important procurement procedures, including the use of competitive bids, the use

of explicit solicitation procedures, the focus on technical factors (rather than fee), and the use of multiyear agreements. The second component of audit procurement is the set of characteristics describing the person(s) performing the procurement procedures. Procurement experts suggest that highly-qualified individuals with specialized industry and auditing knowledge are more likely to understand the needs of their organizations and are better able to align those needs with services provided by external auditors (Gansler 2002). Experts also suggest that individuals involved in procurement should be rotated periodically to ensure that fresh perspectives and cutting-edge technology are utilized in the procurement process (Gansler 2002). The third component of audit procurement is the set of characteristics describing the organization searching for an auditor. For example, it is important to have an integrated procurement process where communication between departments is clear and plentiful so that organizational needs are identified and matched with services procured (Burt and Pinkerton 1996). This is consistent with the GAOs (1987) suggestion to create and use audit committees as a way of improving an organizations focus on control and improving communication throughout the procurement process. We assume that implementing a well-developed audit procurement mechanism is costly. Organizations will evaluate this cost relative to the agency costs present in their contractual dealings with internal and external parties.

Hence, organizations that implement more audit procurement elements are likely doing this in response to increased levels of agency costs. Stated formally: HYPOTHESIS 1. Well-developed audit procurement is positively associated with the level of agency costs. ------------------------------------Insert Figure 1 about here ------------------------------------3. Agency Analysis Data Our examination utilizes a unique database containing information from a large number of cities in the southeastern United States. The advantages of using municipal organizations to study the market for audit services have been extensively outlined in Jensen and Payne (2003a). Of particular importance to this study is the fact that the universe of firms providing audit services to cities is much more diverse than that performing audits for public companies. The municipal market is not dominated by the Big 5 accounting firms (Jensen and Payne 2003b). This helps avoid the unrealistic task of trying to identify auditquality differences among these accounting firms when trying to measure differential demand for external auditing. In addition, while there are certainly institutional differences between cities and other types of organizations which strictly limit our ability to generalize findings to other markets, economic forces faced by managers of municipal organizations are not dissimilar to those faced by

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managers in other types of organizations (Jensen and Meckling 1976; Zimmerman 1977). Indeed, economic pressures and agency relationships are likely to be quite similar for many cities in our sample compared to small and medium-size publicly traded companies in general.2 Finally, the distinct and unique nature of municipal accounting enhances the relevance of industry expertise for both CFOs and auditors. This is particularly important to our study since our proxy for audit quality is industry expertise. We circulated a questionnaire to all 928 cities with populations greater than 5,000 in eight southeastern states to gather information about audit procurement practices affecting 1998 financial statement audits and to obtain other demographic information.3 Surveys were addressed directly to each citys chief finance officer; we received 331 responses (36 percent response rate).4 Information obtained from the surveys includes the number of bids received during the last procurement process, whether the city had a mandatory rotation policy, the respondents assessment of the ranking of technical and fee factors during the last procurement process, certifications held by the citys finance officer, finance officer tenure, the timing of the audit, and whether the city had an audit committee. Surveys also provided audit fee information, whether a Single audit was required, and whether the city had internal auditors. We also obtained copies of the 1998 financial statements for the cities in our sample (either directly from the cities, or from the Census Bureaus Federal

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Audit Clearinghouse). Information obtained from the financial statements included the citys total debt figure, level of audit service (implied by the auditors report),5 the name of the audit firm, and the location of the office providing the audit team for the engagement. We were able to identify the audit firm and office for 615 cities (66 percent), and we used this information to compute our industry expertise variables. Population and income figures were obtained from the Census Bureaus website. After eliminating observations with missing data, our final sample includes 231 observations. Table 1 presents descriptive data for the 231 sample cities. As expected, there was a wide range of experience levels among both audit firms (range 1-13 city audits, mean of 3.42) and audit offices (range 1-10 city audits, mean 2.23). Sixty-eight percent of sample cities had city manager forms of government rather than elected mayors, 23 percent had internal auditors, and 71 percent were required to have a Single audit in addition to a financial statement audit. The median CFO tenure in our sample was ten years. And while only 15 percent of sample cities used a Big 5 audit firm, 24 percent received extended audit services from their auditor--either because they audited additional schedules in the citys comprehensive annual financial report (CAFR) or because of difficulties on the audit resulting in the issuance of a qualified report. Table 1 also shows considerable variation in the prevalence of procurement elements. While about 80 percent of cities received multiple bids, 89 percent opted not to have

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mandatory rotation policies. Fifty-six percent of respondents claim to have ranked firm-wide and office-specific experience as more important than audit fees; about 28 percent of CFOs were Certified Government Finance Officers. Finally, while 71 percent of cities had their audits performed during the offseason, only 42 percent involved audit committees in the procurement process. ------------------------------------Insert Table 1 about here
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Agency costs and procurement Our first analysis examines whether cities facing higher levels of agency costs are more likely to have well-developed audit procurement (H1). We examine this by regressing (OLS) a summary procurement variable against a series of variables that proxy for the existence and level of common agency costs faced by organizations: PROCURE = 0 + 1LPOP + 2MFI + 3OLDDEBT + 4NEWDEBT + 5SINGLE + 6MGR + 1 where: PROCURE LPOP MFI OLDDEBT NEWDEBT SINGLE MGR

(1)

= number of procurement elements; = natural log of population (size); = median family income (in thousands); = debt per capita; = one if the city issued bonds during the three years after 1998, zero otherwise; = one if the city was required to have a Single audit during 1998, zero otherwise; and = one if the city had a manager/council form of government, zero otherwise.

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Since individual procurement elements are described using indicator variables, our summary procurement measure (PROCURE) is simply the total number of procurement elements present for each city (Raman and Wilson 1994). These are classified broadly as procurement procedures, personal characteristics of employees involved in the procurement process, and organizational characteristics and are also defined in Table 1. Procurement procedures The GAO (1987) and Raman and Wilson (1994) identify procurement procedures to include, (1) the use of competitive bidding, (2) the use of multiyear associations (contracts) with audit firms, and (3) focusing on technical factors (rather than fee) in the solicitation process. We identify cities as using competitive bidding if they received bids from more than one audit firm during their most recent procurement session (BIDS). We identify cities likely to have multiyear associations with their auditors as those cities who opt not to have mandatory rotation policies (LONG). Finally, we identify cities as focusing on technical factors over cost if they ranked both firm-wide and office-specific industry expertise above audit fees in importance during their most recent procurement process (TECH). Such priorities are likely to be reflected in the solicitation process through guidelines provided to audit procurers (Raman and Wilson 1994), and are likely to motivate auditors with more (less) industry

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expertise to enter (exit) competition for those audits (see Harrell and Haas 1984). They also provide a competitive advantage to audit firms with industry expertise. Personal characteristics The personal characteristics of the individual(s) involved in audit procurement are also likely to impact auditor quality. The GAO (1987) suggests that people with industry accounting and auditing backgrounds should best know how to identify organizational needs and should best be able to identify auditors likely to meet those needs. Gansler (2002) suggests two ways to ensure that procurers of services have the appropriate level of technical understanding to improve procurement. First, procurement personnel should possess high levels of training in their respective fields. Such people are likely to have a clearer understanding of the needs of their organizations, the services available on the market, and the procurement process itself. Second, procurement personnel should be rotated periodically. Rotating personnel helps ensure that the person(s) making procurement decisions have fresh, cutting-edge perspectives. It is also likely to increase an organizations awareness of, and use of, current technologies. Moreover, new personnel are more likely to reevaluate an organizations needs and the goodness of fit between the current audit firm and the organization. We identify cities who have hired personnel with higher levels of training as those whose chief finance officer is a Certified Government Finance Officer (FOSKILL).6 Such certification clearly delineates superior training as it requires

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a bachelors degree, at least three years of experience in government finance, the passing of a multi-part examination, and ongoing CPE participation. We identify cities who have rotated procurement personnel as those whose chief finance officers tenure is less than the median for all cities in the sample (FOTEN). This timing was selected because it coincides with the increasing emphasis regarding municipal audit quality and audit procurement among regulators (e.g., GAO 1986, 1987), professional organizations (e.g., AICPA 1986, 1987), and academics (e.g., Ingram and Robbins 1988). Officers hired during this time are more likely to have received training in this regard prior to being hired. Organizational characteristics The number of organizational characteristics that affect audit procurement is likely to be large. Our intent is not to identify all such characteristics, but to show a link between organizational characteristics and audit procurement. We select two characteristics commonly discussed in the literature--one likely to affect the information set used to select an auditor, and the other likely to affect the choice set from which an auditor is selected. We first examine the presence of an audit committee (AUDCOM). The GAO (1987) strongly recommends the establishment of audit committees as a way of improving audit quality. Audit committees can provide oversight over the procurement process, enhance communication, review audits ex post for quality, and even assist in the procurement process by providing an independent

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perspective regarding the benefits of hiring certain auditors over others. We also examine the timing of the external audit.7 Due to shifts in market demand, there is considerably more competition among audit firms during the slow times of the year than during the busy season. We identify cities having non-busy season audits (NONBUSY) as those having their annual audit during the period May through December. Agency proxies Prior research indicates that diffused participation by affected parties (i.e. size) can lead to demands for increased levels of monitoring of agents decisions (Alchian and Demsetz, 1972). In a municipal setting the level of participation can be proxied by two variables. First, a citys population (LPOP) provides an indication of how much influence each citizen potentially has on the decisions made by city administration.8 We expect that as cities increase in size, the influence of individual citizens decreases, thereby increasing the demand for improved procurement mechanisms.9 Another factor that can influence citizens interest in municipal decisions is their level of economic input (e.g., tax payments). A useful proxy utilized by Jensen and Payne (2003a) is the medianfamily income (MFI) of the community. We expect cities with higher income levels to have citizens who are more interested in the economic decisions of city administrations; such cities are likely to demand higher levels of external

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monitoring that can be more readily assessed with adequate procurement processes. Another factor that influences agency is an organizations level of indebtedness. Prior research indicates that audit quality is positively associated with debt levels (e.g., Copley, Gaver, and Gaver, 1995). We capture this factor using two variables. Existing debt in the financial statements (OLDDEBT) represents the agency costs associated with current debt holders. In addition, cities in the process of issuing new debt are likely to be highly concerned about impressions in the capital market that may impact interest rates (Raman and Wilson 1994). We measure this concern by identifying cities who issued new bonds during the three-year period after 1998 (NEWDEBT). We expect both of these variable to be positively associated with procurement. Finally, two additional factors related to agency are accountability to government regulators and the form of city government. Government oversight and Single audit requirements (SINGLE) are likely to motivate the use of procurement to identify qualified auditors, and prior research suggests that city manager forms of government (MGR) demand higher levels of external monitoring than mayoral forms of government (e.g., Zimmerman 1977). Results Primary results

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Table 2 presents correlations among the agency-cost proxies and the summary procurement variable; multicollinearity is not indicated. Table 3 shows the distribution of the number of procurement elements across our sample of cities. Five cities in the sample had one or fewer procurement elements, and three cities had all seven. Most cities fell in between with the mean (median) number of elements being 4.09 (4.00). This distribution does not appear to be simply related to organizational size and the corresponding availability of resources. Distributions are remarkably similar across population quartiles (2(df=21)=23.97, p=.295), with the mean number of elements for quartiles one through four being 3.86, 4.26, 4.05, and 4.17 respectively, with a median of 4.00 for each. Analyses of individual elements (not shown) do show that larger cities are more likely to use competitive bidding (2(df=3)=16.16, p=.001) and have audit committees (2(df=3)=7.00, p=.072). However, all other elements appear to be distributed fairly evenly across city size. ----------------------------------------Insert Tables 2 and 3 about here
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Results of our analysis examining the relationship between agency costs and procurement are generally consistent with H1 (see Table 4). Larger cities (LPOP), cities facing more active voters (MFI), cities with higher levels of existing debt (OLDDEBT), and cities facing the higher agency costs associated with city manager forms of government (MGR) all tend to implement more

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procurement elements. Although the prospects of issuing additional debt (NEWDEBT) and the accountability related to Single audit requirements (SINGLE) do not appear to motivate better audit procurement, overall, our results suggest a strong link between the existence and level of agency costs in an organization and the decision to implement well-developed audit procurement mechanisms. This seems to be particularly true when agency costs are related to existing primary financial statement users. Sensitivity and conclusion Although the OLS model is highly significant, we also performed several alternative analyses for specification sensitivity. We first performed the analysis using the natural log of the number of procurement elements as the dependent variable. Results (not shown) were qualitatively similar to those in Table 4. We next used an ordered logit model to examine the relationships between agency and procurement and found results similar to those in Table 4 except the coefficient on OLDDEBT was no longer significant. Finally, since problems may arise from our using a summary procurement variable which assumes individual procurement elements to provide benefits similarly across circumstances, we ran logistic versions of the model using individual procurement elements as the dependent variable. Results suggest that, (1) large cities (LPOP) are more likely to use competitive bidding, have long associations with their auditors, and have audit committees, (2) cities with active voters (MFI) are more likely to use

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competitive bidding and audit committees, and are more likely to have rotated their CFO during the last ten years, (3) cities with high debt levels (OLDDEBT) are more likely to have audit committees, and (4) cities with city manager forms of government (MGR) are more likely to have competitive bidding and focus on technical factors over cost when selecting an auditor. In summary, our results are generally consistent with cities facing higher levels of agency costs having better-developed audit procurement mechanisms in support of H1. This suggests that many managers in municipal organizations are already responding to economic forces by developing mechanisms likely to help them rate audit quality ex ante in order to identify auditors who can minimize their agency costs. ------------------------------------Insert Table 4 about here ------------------------------------4. Procurement Procedures, Audit Quality, and Audit Fees As shown in Figure 1, audit procurement can impact audit quality by affecting the information set managers use to select an auditor. Well-developed audit procurement more effectively reveals the needs of the organization procuring the audit (Gansler 2002). This includes determining the desired levels of industry expertise and/or audit assurance. Management can also consider other potentially beneficial areas of expertise such as information technology, taxes,

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capital acquisition, or risk assessment that may be available from some audit firms but not from others. Well-developed audit procurement can also lead to the extraction of more/better information about audit firms along various dimensions (Deis and Giroux 1992). Finally, well-developed audit procurement can impact the relative weights assigned to quality, cost, and other factors when evaluating potential audit firms. This allows for a clearer assessment of how each prospective firm might fit into an organizations control framework. This can affect--and even alter--the ranking of those firms (Copley et al. 1994). Audit procurement can also impact audit quality by altering the supply of audit firms entering the choice set from which an organization selects an auditor. For example, the use of highly specific requests for proposal (RFP) when soliciting audit firms (GAO 1987) communicates to potential firms the needs of the organization and the criteria to be used in selecting an auditor. This allows audit firms able (unable) to compete along those criteria to self select into (out of) the organizations choice set.10 There is evidence that audit firms who cannot compete along criteria used in audit procurement do not participate in such markets (e.g., Hackenbrack et al. 2000, Jensen and Payne 2003b). Finally, since audit quality and audit fees are jointly determined, audit procurement is also likely to have specific impacts on audit fees. However, since we assume that the primary focus of procurement is audit quality, effects on audit fees are likely to be dependent on the dynamics individual procurement elements

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bring to bear on the search for an auditor. Fee effects may occur either when procurement impacts the choice set or when procurement alters the way firms in the choice set are evaluated. For example, focusing on quality over fees suggests that managers may be willing to pay more for higher quality audits, resulting in higher cost firms being hired because they are perceived as being higher quality. On the other hand, competitive bidding increases competition and allows managers to identify the best value. Moving the audit away from the busy season is likely to result in more competition and lower fees as well. From this discussion we hypothesize that organizations that implement audit procurement mechanisms likely expect to receive a more optimal combination of audit quality and audit costs based on their specific needs. Agency theory suggests that the benefits of higher levels of audit quality are likely to be greater for those organizations facing higher levels of agency costs. Our previously reported results indicate that agency costs are related to the development of procurement mechanisms. Therefore we expect municipalities having better-developed procurement mechanisms to obtain higher quality audits. We also expect procurement to impact audit fees, but these effects are not limited to one direction. Stated formally: HYPOTHESIS 2. Well-developed audit procurement leads to contracting with higher- quality auditors. HYPOTHESIS 3. Well-developed audit procurement is associated with audit fees.

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Model development Audit quality In order to examine the link between procurement and audit quality, a reasonable proxy for audit quality must be identified. This is problematic since true audit quality is rarely measured and is often considered unobservable. Traditional quality proxies used in audit research have included firm size and brand name (e.g., Francis and Wilson 1988). However, in one of the only studies to use objective measures of audit quality, OKeefe, King, and Gaver (1994) find audit quality to be highly correlated with industry expertise or industry specialization.11 Indeed, a considerable body of research--including surveys (e.g., Carcello, Hermanson, and McGrath 1992), demand studies (e.g., Deis and Giroux 1992), earnings management studies (e.g., Krishnan 2003), and market valuation studies (e.g., Balsam, Krishnan, and Yang 2003)--all identify auditor industry expertise as being a reasonable proxy for certain aspects of audit quality. Furthermore, Hackenbrack et al. (2000, fn 5) find industry audit experience to be the primary factor used during the procurement process in evaluating likely audit quality. We follow this body of research in using industry expertise as a proxy for audit quality. We measure industry expertise using the number of clients in the same industry (cities) audited by a particular auditor (EXPERT). This is

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consistent with the approach used in OKeefe et al. (1994). However, we also consider the observation by Ferguson, Francis, and Stokes (2003) that firm-wide expertise and office-specific expertise represent different aspects of expertise. Firm-wide expertise focuses on the sharing of knowledge across offices through standardized audit programs, firm-wide training, and access to industry experts by all offices. Office-specific expertise focuses on actual industry experience by personnel within a given office, perhaps even within the engagement team. We address this issue by measuring expertise both as the number of cities audited by a particular audit firm (FIRMEXP) and as the number of cities audited by a particular office of an audit firm (OFFEXP).12 Simultaneous models Copley et al. (1994) first emphasized the importance of estimating audit demand and audit fee models jointly. Their argument is simply that audit fees are likely to be positively related to audit quality but that audit fees also affect the demand for audit quality. Deis and Hill (1998) expand on this argument by suggesting that biases introduced by not using simultaneous estimation is likely one of the primary reasons for conflicting results found in the audit-market literature. Consequently, we examine the link between well-developed audit procurement, auditor expertise, and audit fees using simultaneous estimations of the following models using two-stage least squares:

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EXPERT = 0 + 1PROCURE + 2LPOP + 3MFI + 4OLDCDEBT + 5NEWDEBT + 6SINGLE + 7MGR + 8IAUDIT + 9BIG5 + 10LFEE(predicted) + 2 (2) LFEE = 0 + 1 PROCURE + 2LPOP + 3OLDDEBT + 4NEWDEBT + 5SINGLE + 6MGR + 7SERVICE + 8IAUDIT + 9BIG5 + 10EXPERT(predicted) + 3 where: EXPERT LFEE PROCURE LPOP MFI OLDDEBT NEWDEBT SINGLE MGR SERVICE IAUDIT BIG5 = total number of municipal audits performed in 1998 by the audit firm or audit firm office; = natural log of audit fees; = total number of procurement elements; = natural log of population; = median family income (in thousands); = debt per capita; = one if the city issued bonds during the three years after 1998, zero otherwise; = one if the city was required to have a Single audit during 1998, zero otherwise; = one if the city had a manager/council form of government, zero otherwise. = one if audit report indicated increased audit work due to qualifications or due to extra schedules or statements being audited, zero otherwise; = one if city had internal auditors or internal audit function, zero otherwise; and = one if auditor was a Big 5 auditor, zero otherwise.

In addition to the summary procurement variable, these models include variables designed to control for organizational characteristics likely to be correlated with audit quality and audit fees. Control variables in the expertise model are generally associated with the level of agency costs likely to affect the overall demand for control. Control variables in the fee model are generally

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associated with required audit effort, and are consistent with variables appearing in prior research. Three control variables not related to agency costs are also introduced in these models. First, the level of audit service provided (SERVICE) is included in the fee model to control for additional audit work generally required when expanded audit services are provided. We measure this by examining the audit opinion, noting qualified reports and audit reports providing opinions on schedules in addition to the financial statements provided in a traditional CAFR. Second, the existence of internal auditors (IAUDIT) is included in both models to control for the possibility of managers using audit substitutes in response to agency costs (Jensen and Payne 2003a). And finally, the variable BIG5 is included in both models to control for, (1) the likelihood that our expertise measures are correlated with the brand name of the Big 5 firms simply because of their enormous size, and (2) the likelihood that Big 5 firms command brand-name premiums (Craswell, Francis, and Taylor 1995).13 While many variables appear in both quality and fee models, there are sufficient variables unique to each model to avoid identification problems. Results

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Summary analyses Correlation coefficients between variables not previously presented are shown in Table 5. Firm-wide and office-level expertise measures are relatively highly correlated, as expected (r = .76). City size and audit fees are also relatively highly correlated, consistent with prior literature (r = .79). However, there again do not appear to be any multicollinearity problems. Results of the simultaneous analysis in equation 2 are shown in Table 6. All models are highly significant, and adjusted R-squares are consistent with previous studies. As predicted in H2, the summary procurement variable is significantly positively associated with higher levels of firm-wide and office-specific expertise, consistent with betterdeveloped audit procurement leading to the hiring of higher-quality auditors. However, the predicted association between well-developed audit procurement and audit fees (H3) is not as strong. While the summary procurement variable is significantly negatively associated with audit fees in the office-specific model (p=.095 two-tail), the coefficient is not significant in the firm-wide model (p=.101 two-tail).14 These results are consistent with the focus of audit procurement being primarily on audit quality, with audit fees playing only a secondary role. ------------------------------------Insert Tables 5 and 6 about here ------------------------------------Analysis of individual procurement elements

28

Because procurement elements are not likely to be equally effective or equally costly, we also examine the relationships between individual procurement elements, auditor expertise, and audit fees. This also allows us to identify the specific mechanisms by which each element affects audit quality and audit fee as described in the model. This analysis is performed by simultaneously estimating the following models using two-stage least squares: EXPERT = 0 + 1BIDS + 2LONG + 3TECH + 4FOSKILL + 5FOTEN + 6NONBUSY + 7AUDCOM + 8LPOP + 9MFI + 10OLDDEBT + 11NEWDEBT + 12SINGLE + 13MGR + 14IAUDIT + 15BIG5 + 16LFEE(predicted) + 4 (3) LFEE = 0 + 1BIDS + 2LONG + 3TECH + 4FOSKILL + 5FOTEN + 6NONBUSY + 7AUDCOM + 8LPOP + 9OLDDEBT + 10NEWDEBT + 11SINGLE + 12MGR + 13SERVICE + 14IAUDIT + 15BIG5 + 16EXPERT(predicted) + 5 where control variables are as defined in equation (2), and where: BIDS LONG TECH FOSKILL FOTEN NONBUSY AUDCOM = one if the city had multiple bids for the 1998 audit, zero otherwise; = one if the city did not have a mandatory rotation policy, zero otherwise; = one if the city rated firm and office expertise as more important than fees during audit procurement, zero otherwise; = one if the chief finance officer was a Certified Government Finance Officer, zero otherwise; = one if the chief finance officer tenure was less than ten years, zero otherwise; = one if the audit occurred during MayDecember (off season), zero otherwise; and = one if the city had an audit committee, zero otherwise.

29

We expect competitive bidding (BIDS) to increase audit quality primarily by increasing the amount of information available to procurers, thereby allowing comparisons to be made along quality dimensions (Copley and Doucet 1993). Moreover, the increased competition promoted by bidding may shift the supply curve downward, leading to potential increases in the quality demanded (Raman and Wilson 1994). We expect competitive bidding also to be associated with lower audit fees since the increased supply of auditing should lead to lower audit fees at all levels of audit quality. The increased information should allow procurers to identify the lowest fee among audit firms of similar quality. We expect multiyear associations (LONG) to increase auditor quality primarily by luring audit firms--particularly high quality/high cost audit firms-into the choice set by providing them the ability to bid competitively and still recover start-up (or lowballing) costs (DeAngelo 1981).15 Such a downward shift in the supply curve should lead to lower fees at all levels of audit quality. Firms may also be willing to accept lower fees in any given year if longer tenure is likely, as this allows more time to recover costs and reduces the risk of losing the client. We expect the focus on technical factors (TECH) to be associated with the hiring of higher quality auditors. However, we expect the focus on technical factors over cost to be associated with higher audit fees, primarily because of the lower weights assigned to audit fee during the evaluation process (Copley et al. 1994).

30

We expect procurer characteristics (FOSKILL and FOTEN) to be associated with higher audit quality via improvements in the information set used to select the auditor. Such improvements are likely to accrue along all three dimensions in the model. However, while increases in the quality demanded should normally lead to higher audit fees, more knowledgeable government finance officers may have a better understanding of audit substitutes and appropriate audit pricing. Hence, we make no predictions regarding the relationship between personal characteristics and audit fees. We expect the presence of an audit committee (AUDCOM) to be associated with higher levels of external audit quality. Moreover, since the presence of an audit committee is not likely to affect the supply of audit firms entering the choice set, we expect the higher levels of audit quality to be accompanied by higher audit fees. Finally, high quality/high cost audit firms are more likely to settle for lower fees during the off-season (NONBUSY) in order to keep audit staff busy and possibly add to their margins. This represents a downward shift in the supply curve for organizations opting to have their audits during the off-season. The simultaneous shifting of both demand and supply suggest an increase in the quality of auditing and/or lower audit fees for organizations having non-busy season audits. A correlation matrix for the individual procurement variables is shown in Table 7. Once again, multicollinearity is not indicated. Results of simultaneous

31

estimations of equation 3 (see Table 7) indicate that individual procurement elements explain more variation in quality and fees than our summary procurement variable. They are also generally consistent with the predictions of our multidimensional model, with an interesting exception. First, procurement procedures are associated with both audit quality and audit fees. As predicted, cities receiving bids from multiple audit firms (BIDS) tend to hire auditors with higher levels of both firm-wide and office-specific expertise. They also tend to pay lower audit fees in both cases. Cities without mandatory rotation policies (LONG) tend to hire auditors with higher levels of firm-wide expertise (p=.064), but not necessarily higher levels of office-specific expertise (p=.257). However, as predicted, they do tend to pay lower audit fees in both cases. Finally, while focusing on technical factors over audit fee does appear to result in cities paying higher audit fees, this does not appear to result in higher levels of industry expertise at either the firm-wide or office-specific level.16 ------------------------------------Insert Tables 7 and 8 about here ------------------------------------Second, personal characteristics of the audit procurers are associated with audit quality but not necessarily with audit fees. As predicted, cities who employ CFOs with greater levels of training (FOSKILL) tend to hire auditors with higher levels of both firm-wide and office-specific expertise without affecting audit fees. Also as predicted, cities who have rotated their CFO since regulators increased

32

their emphasis on audit procurement tend to hire auditors having higher levels of both firm-wide and office-specific expertise without affecting audit fees. Finally, results are mixed for organizational characteristics. Cities who have their audits during the off-season show no difference in either firm-wide or office-specific industry expertise; however, they do pay lower audit fees in both cases. On the other hand, cities who have an audit committee assisting with the procurement process tend to hire auditors with higher levels of both firm-wide and office-specific expertise without affecting audit fees. Sensitivity and conclusions As with equation 1, we estimate equation (3) using alternative specifications for sensitivity. Results sans BIG5 as an explanatory variable (not shown) are qualitatively similar to the results in Table 8. Results using the natural log of industry expertise as the dependent variable (not shown) are also qualitatively similar to the results in Table 8 except NONBUSY also becomes significant in both quality models. Finally, results using OLS rather than 2SLS (not shown) are also qualitatively similar to the results in Table 8 except NONBUSY becomes significant in the office-specific quality model. Finally, since procurement elements are likely to interact, we also estimated equation 3 after inserting two-way interactions into the model one at a time. Results indicate that, (1) highly skilled (FOSKILL) and newly hired CFOs (FOTEN) are particularly effective at increasing auditor quality if the audit is performed during

33

the off season (NONBUSY), (2) newly hired CFOs (FOTEN) are particularly effective at securing lower audit fees if the city uses an audit committee (AUDCOM) in the procurement process, and (3) competitive bidding (BIDS) is particularly effective at securing lower audit fees if a city does not have a mandatory rotation policy (LONG). In summary, our results suggest that cities having better-developed audit procurement mechanisms tend to hire higher quality auditors, consistent with H2. Our results also suggest that while audit procurement does affect audit fees (consistent with H3), the direction of these effects depends on the particular element in question. 5. Conclusion In this study, we develop and test a model of audit procurement as a control mechanism used to regulate audit quality and audit fee in response to agency costs in a market where quality and value are difficult to ascertain. Our results suggest that managers facing higher levels of agency costs are more likely to have well-developed audit procurement mechanisms, and that such mechanisms are likely to lead to the hiring of auditors with more industry expertise--suggestive of higher audit quality. Procurement elements appear to improve quality both by improving the information sets available to managers selecting the auditor, and by improving the quality of the audit firms entering into

34

the set from which managers select an audit firm. Our results also indicate that while well-developed procurement may lead to lower audit fees in general, these effects appear to be secondary, and appear to concentrate on some procurement elements but not others. These results add to our general understanding of audit markets. But more importantly, they indicate that education may be helpful in matching organizations with efficient levels of audit quality. To the degree that the benefits of procurement are not widely known or understood, education may play a significant role in helping managers to better match the needs of their organizations with the services provided by their auditors. As part of a relatively underdeveloped literature on audit procurement, this study has several limitations. First, we have chosen to use municipal audit markets to test our model because of the benefits mentioned. However, this requires that caution be used when generalizing our results to other markets since peculiar institutional characteristics may affect our results. Second, the fact that procurement is associated with the hiring of audit firms with higher levels of industry expertise does not mean that it leads to higher audit quality per se. While most people would acknowledge that industry expertise increases the likelihood of higher audit quality, actual quality ultimately remains unobservable in most cases. Our conclusions rely upon the results of previous studies showing a link between expertise and quality. Third, our models rely heavily on the use of

35

proxies for other underlying variables. In particular, our proxies for agency costs (size, income, debt, and government type) are likely to be associated with other organizational characteristics. This results in possible omitted variables problems common in such empirical studies, and suggests the need for future work to triangulate our results. Finally, although our results speak to the relationship between audit procurement and audit fees, they do not address the concept of value (i.e., fee per unit of audit quality), which may be a primary motivation for audit procurement.

36

References Abdel-Khalik, A.R., 1993. Why do private companies demand auditing? A case for organizational loss of control. Journal of Accounting, Auditing, and Finance 8, 31-52. Alchian, A., and H. Demsetz. 1972. Production, information costs, and economic organization. American Economic Review 62, 777-795. American Institute of Certified Public Accountants (AICPA). 1986. Restructuring Professional Standards to Achieve Professional Excellence in a Changing Environment. New York, NY: AICPA. American Institute of Certified Public Accountants (AICPA). 1987. Report of the National Commission on Fraudulent Financial Reporting. New York, NY: AICPA. Balsam, S., J. Krishnan, and J.S. Yang. 2003. Auditor industry specialization and earnings quality. Auditing: A Journal of Practice and Theory. Forthcoming. Burt, D.N., 1984. Proactive Procurement: The Key to Increased Profits, Productivity, and Quality. Englewood Cliffs, NJ: Prentice-Hall. Burt, D.N., and R.L. Pinkerton. 1996. A Purchasing Managers Guide to Strategic Proactive Procurement. New York, NY: American Management Association. Carcello, J.V., R.H. Hermanson, and N.T. McGrath. 1992. Audit quality attributes: The perceptions of audit partners, preparers, and financial statement users. Auditing: A Journal of Practice and Theory 11, 1-15. Copley, P.A., and M.S. Doucet. 1993. The Impact of Competition on the Quality of Governmental Audits. Auditing: A Journal of Practice and Theory 12, 8898. Copley, P.A., M.S. Doucet, and K.M. Gaver. 1994. A simultaneous equations analysis of quality control review outcomes and engagement fees for audits of recipients of federal financial assistance. The Accounting Review 69, 244-56.

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Copley, P.A., J.J. Gaver, and K.M. Gaver. 1995. Simultaneous estimation of the supply and demand of differentiated audits: Evidence for the municipal audit market. Journal of Accounting Research 33, 137-55. Craswell, A.T., J.R. Francis, and S.L. Taylor. 1995. Auditor brand name reputations and industry specialization. Journal of Accounting and Economics 20, 297-322. DeAngelo, L., 1981. Auditor independence, lowballing, and disclosure regulation. Journal of Accounting and Economics 3, 113-127. Deis, D.R., and G. Giroux. 1992. Determinants of audit quality in the public sector. The Accounting Review 67, 462-79. Deis, D.R., and R.C. Hill. 1998. An application of the bootstrap method to the simultaneous equations model of the demand and supply of audit services. Contemporary Accounting Research 15, 83-99. Ferguson, A., J.R. Francis, and D.J. Stokes. 2003. The effects of firm-wide and office-level industry expertise on audit pricing. The Accounting Review 78, 429-48. Francis, J.R., and E.R. Wilson. 1988. Auditor changes: A joint test of theories relating to agency costs and auditor differentiation. The Accounting Review 63, 663-82. Financial Executives International (FEI). 2003. Editorial in FEI Online Magazine available at http://www.fei.org/mag/exclusisve/mann.cfm/ July 10. Gansler, J.S., 2002. A Vision of the Government as a World-Class Buyer: Major Procurement Issues for the Coming Decade. PricewaterhouseCoopers Endowment for the Business of Government. Arlington, VA. General Accounting Office (GAO). 1986. CPA Audit Quality: Many Governmental Audits Do Not Comply with Professional Standards. Washington DC: GAO. General Accounting Office (GAO). 1987. CPA Audit Quality: A Framework for Procuring Audit Services. Washington DC: GAO.

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Government Finance Officers Association (GFOA). 2002. GFOA Recommended Practice: Audit Procurement (1996 and 2002) available at http://www.gfoa.org/. Hackenbrack, K., K.L. Jensen, and J.L. Payne. 2000. The effect of a bidding restriction on the audit services market. Journal of Accounting Research 38, 355-374. Harrell, R.D., and R.J. Haas. 1984. Selecting an external auditor. Governmental Finance, March, 3-11. Hodges, H.G., 1961. Procurement: The Modern Science of Purchasing. New York, NY: Harper & Brothers Publishers. Ingram, R.W., and W.A. Robbins. 1988. Financial Reporting Practices of Local Governments. Governmental Accounting Standards Board: Stamford, CT. Institute of Internal Auditors (IIA). 2002. CAE Bulletin: Adding value: Finding a new auditor. Online newsletter available at http://www.theiia.org/ April 15. Jensen, M.C., and W.H. Meckling. 1976. Theory of the firm: Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics 3, 305-360. Jensen, K.L., and J.L. Payne. 2003a. Management tradeoffs of internal control and external auditor expertise. Auditing: A Journal of Practice and Theory, Forthcoming. Jensen, K.L., and J.L. Payne. 2003b. The introduction of price competition in the market for audit services: An empirical investigation. Working paper, University of Oklahoma. Krishnan, G.V., 2003. Does Big 6 auditor industry expertise constrain earnings management? Accounting Horizons 17, 1-16. OKeefe, T.B., R.D. King, and K.M. Gaver. 1994. Audit fees, industry specialization, and compliance with GAAS reporting standards. Auditing: A Journal of Practice and Theory 13, 41-55. Raman, K.K., and E.R. Wilson. 1994. Governmental audit procurement practices and seasoned bond prices. The Accounting Review 69, 517-38.

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Simunic, D.A., 1980. The pricing of audit services: Theory and evidence. Journal of Accounting Research 18, 161-90. Zimmerman, J.L., 1977. The municipal accounting maze: An analysis of political incentives. Journal of Accounting Research 15, 107-44.

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FIGURE 1 A Multidimensional Model of Audit Procurement

41

TABLE 1 Descriptive Data (n = 231)

Panel A: Continuous Variables

Variable Firm experience: total number of cities within a state audited by an audit firm (FIRMEXP) Office experience: total number of cities audited by an audit firm office (OFFEXP) Finance officer tenure: number of years with same chief finance officer (indicator variable used in models with one if tenure less than median) (FOTEN) Audit fee: fees paid for 1998 audit services (log of fee used in models) (LFEE) Population: city population per 1990 census (log of population used in models) (LPOP) Total debt: in thousands (scaled by population in models) (OLDDEBT) Median family income: per census website (scaled by $1 thousand in models) (MFI) Source financial statements financial statements questionnaire Mean / Median (standard deviation) 3.42 / 2.00 (3.11) (range:1-13) 2.23 / 1.00 (1.84) (range:1-10) 11.58 / 10.00 (7.56) years

questionnaire census bureau financial statements

$40,644 / $29,000 ($43,711) 52,309 / 18,042 (140,277) $131,271 / $20,754 ($547,837) $31,604 / $30,410 ($10,752)

census bureau

42

Table 1 (continued) Panel B: Indicator Variables

Variable New debt: one if the city issue bonds in the three years subsequent to fiscal year 1998 (NEWDEBT) City manager: one if city manager as opposed to an elected mayor (MGR) Internal audit: one if the city had an internal auditor or internal audit function (IAUDIT) Single audit: one if a single audit required based on level of federal funds expended (SINGLE) Big 5 auditor: one if the city engaged a Big 5 auditing firm (BIG5) Expanded services: one if audit report implies extra work (audit of additional schedules, statistical information or qualification) (SERVICE) Competitive bidding: one if city received more than one bid for the 1998 audit engagement (BIDS) No mandatory rotation: one if city does not have a mandatory auditor rotation policy (LONG) Focus on technical factors: one if firm and office experience ranked above fee during auditor selection (TECH) Certified finance officer: one if city finance officer was certified (FOSKILL) Non-busy season audit: one if audit performed between May and December (NONBUSY) Audit committee: one if city had an audit committee (AUDCOM) Source questionnaire municipal yearbook questionnaire financial statements financial statements financial statements Percentage (Number) 76% (176) 68% (156) 23% (52) 71% (165) 15% (34) 24% (56)

questionnaire questionnaire questionnaire

80% (185) 89% (205) 56% (130)

questionnaire financial statements questionnaire

28% (64) 71% (164) 42% (97)

43

TABLE 2 Correlations Among Agency Proxies and Summary Procurement *

LPOP MFI OLDDEBT NEWDEBT SINGLE MGR

PROCURE .07 .24 .16 -.04 -.06 .14

LPOP .07 -.08 .26 .34 -.00

MFI

OLDDEBT

NEWDEBT

SINGLE

-.05 -.04 -.25 .13

.04 .05 .05

.14 .00

-.03

* Shaded cells indicate coefficient significant at p < .05.

See variable descriptions in Table 1.

44

TABLE 3 Distribution of Number of Procurement Elements Across Sample Cities

No. of procurement Elements (n) 0 1 2 3 4 5 6 7

No. of cities having n elements 1 4 16 47 76 60 24 3

% of cities having n elements 1 2 7 20 33 26 10 1

Cumulative % 1 2 9 29 62 88 99 100

45

TABLE 4 OLS Results for the Relation Between Agency Cost Proxies and Audit Procurement DV: Procure = Total Number of Procurement Elements in Citys Procurement Process

Variable Intercept LPOP MFI OLDDEBT NEWDEBT SINGLE MGR Model F Adjusted R-Square n
***, * Significant at p< .01, and .10 respectively (one-tail)

Coefficient (t-value) 2.19 (2.91) 0.11 (1.43)* 0.02 (3.23)*** 0.01 (2.78)*** -0.17 (0.93) -0.10 (0.53) 0.26 (1.57)* 4.40*** 0.08 231

See variable descriptions in Table 1.

46

TABLE 5 Correlation Coefficients for Variables in Equation 2 Linking Audit Procurement to Audit Quality and Audit Fees *

OFFEXP LFEE SERVICE IAUDIT BIG5 PROCURE LPOP MFI OLDDEBT NEWDEBT SINGLE MGR

FIRMEXP .76 .30 .05 .11 .40 .27 .30 .28 -.02 .15 -.02 .16

OFFEXP .05 .03 -.06 .11 .25 .11 .35 -.00 .13 -.15 .19

LFEE

SERVICE

IAUDIT

BIG5

.03 .40 .41 .01 .79 .07 -.02 .29 .31 .05

.06 .11 .03 -.08 .07 .12 .03 -.07 -.06

.24 .05 .45 -.08 -.03 .11 .20 .02

.07 .45 .14 -.02 .15 .07 .08

* Shaded cells indicate coefficient significant at p < .05.

See variable descriptions in Table 1.

47

TABLE 6 Simultaneous Estimation (Two-stage Least Squares) of Industry Expertise and Audit Fee Models Using Summary Procurement Variable as a Proxy for Well-Developed Audit Procurement (n=231)

variable Intercept PROCURE Control Variables LPOP MFI OLDDEBT NEWDEBT SINGLE MGR SERVICE IAUDIT BIG5 LFEE (predicted) OFFEXP (predicted) FIRMEXP (predicted) Model F Adjusted R-square

pred sign

DV = FIRMEXP -11.58 (16.65)

pred sign

DV = LFEE 5.36 (0.53)

pred sign

DV = OFFEXP -6.32 (10.71)

pred sign

DV = LFEE 5.17 (0.4)

+ + + + + + + + +/-

0.54 (0.21)*** -0.16 (1.63) 0.04 (0.02)** -0.00 (0.00) 0.53 (0.64) -0.43 (0.53) 0.49 (0.46) -0.35 (0.60) 2.33 (0.73)*** 1.19 (3.25)

+/+ + + +/+ +/+ +/+/-

-0.08 (0.05) 0.48 (0.05)*** 0.00 (0.00) 0.09 (0.09) 0.12 (0.09)* 0.05 (0.09) 0.12 (0.08)* 0.11 (0.09) -0.06 (0.21)

+ + + + + + + + +/-

0.28 (0.14)** -0.18 (1.05) 0.04 (0.01)*** -0.00 (0.00) 0.50 (0.41) -0.52 (0.34) 0.46 (0.30)* -0.53 (0.39)* -0.01 (0.47) 0.76 (2.09)

+/+ + + +/+ +/+ +/+/-

-0.06 (0.04)* 0.49 (0.05)*** 0.00 (0.00) 0.09 (0.09) 0.13 (0.10)* 0.05 (0.09) 0.12 (0.08)* 0.13 (0.10) 0.11 (0.11) 0.08 (0.08) 35.84*** 0.60

0.07 (0.07) 36.58*** 0.61 5.37*** 0.16

8.77*** 0.25

***, **, * Significant at p< .01, .05, and .10 respectively (one-tail or two-tail depending on prediction) Models: EXPERT = 0 + 1PROCURE + 2LPOP + 3MFI + 4OLDDEBT + 5NEWDEBT + 6SINGLE + 7MGR + 8IAUDIT + 9BIG5 + 10LFEE(predicted) + 1 LFEE = 0 + 1PROCURE + 2LPOP + 3OLDDEBT + 4NEWDEBT + 5SINGLE + 6MGR + 7SERVICE + 8IAUDIT + 9BIG5 + 10EXPERT(predicted) + 2

48

See variable descriptions on Table 1.

49

TABLE 7 Correlations Among Procurement Elements

LONG TECH FOSKILL FOTEN NONBUSY AUDCOM

BIDS -.07 .06 -.01 .09 .02 .18

LONG -.01 .01 .01 -.02 -.06

TECH

FOSKILL

FOTEN

NONBUSY

-.00 -.12 -.01 .18

-.19 .01 -.02

-.01 .10

.02

* Shaded cells indicate coefficient significant at p < .05.

See variable descriptions in Table 1.

50

TABLE 8 Simultaneous Estimation (Two-stage Least Squares) of Industry Expertise and Audit Fee Models Using Separate Proxies for Individual Procurement Elements (n=231)

variable Intercept Procurement Variables BIDS LONG TECH FOSKILL FOTEN NONBUSY AUDCOM Control Variables LPOP MFI OLDDEBT NEWDEBT SINGLE MGR SERVICE IAUDIT BIG5 LFEE (predicted) OFFEXP (predicted) FIRMEXP (predicted) Model F Adjusted R-square

pred sign

DV= FIRMEXP -8.90 (14.07)

pred sign

DV= LFEE 5.67 (0.53)

pred sign

DV= OFFEXP -5.52 (8.98)

pred sign

DV= LFEE 5.49 (0.42)

+ + + + + + + + + + + + + +/-

1.21 (0.67)** 1.08 (0.69)* -0.72 (0.46) 0.77 (0.40)** 0.63 (0.37)** 0.53 (0.74) 0.72 (0.39)** 0.20 (1.25) 0.05 (0.02)*** -0.00 (0.00) 0.64 (0.52) -0.38 (0.51) 0.63 (0.43)* -0.29 (0.57) 2.08 (0.74)*** 0.51 (2.55)

+ +/+/+ + + + +/+ +/+ +/+/-

-0.27 (0.11)*** -0.23 (0.12)** 0.15 (0.07)** -0.06 (0.09) -0.02 (0.08) -0.27 (0.07)*** 0.00 (0.09) 0.47 (0.05)*** 0.00 (0.00) 0.07 (0.09) 0.13 (0.08)* 0.05 (0.08) 0.16 (0.07)** 0.12 (0.09) 0.03 (0.18)

+ + + + + + + + + + + + + + +/-

0.56 (0.43)* 0.31 (0.44) -0.52 (0.29) 0.49 (0.26)** 0.48 (0.24)** 0.50 (0.47) 0.35 (0.25)* -0.05 (0.80) 0.04 (0.01)*** -0.00 (0.00) 0.55 (0.33)* -0.53 (0.33) 0.54 (0.27)** -0.48 (0.36)* -0.21 (0.48) 0.53 (1.63)

+ +/+/+ + + + + +/+ +/+ +/+/-

-0.24 (0.09)*** -0.19 (0.10)** 0.14 (0.07)** -0.05 (0.08) -0.02 (0.08) -0.28 (0.08)*** 0.02 (0.08) 0.48 (0.04)*** 0.00 (0.00) 0.07 (0.09) 0.14 (0.09)* 0.05 (0.09) 0.16 (0.08)** 0.13 (0.10) 0.17 (0.10)** 0.07 (0.08) 26.67*** 0.64

0.06 (0.06) 27.98*** 0.65 4.42*** 0.19

6.68*** 0.28

***, **, * Coefficient significant at p < .01, .05, and .10 respectively (one-tail if direction predicted, two-tail otherwise) Coefficient significant at p < .10 opposite to predicted direction (two-tail)

51

TABLE 8 (continued)
Models: EXPERT = 0 + 1BIDS + 2 LONG + 3TECH + 4FOSKILL + 5FOTEN + 6NONBUSY + 7AUDCOM +8LPOP + 9MFI + 10OLDDEBT + 11NEWDEBT 12SINGLE + 13MGR + 14IAUDIT + 15BIG5 + 16LFEE(predicted) + 4 LFEE = 0 + 1BIDS + 2LONG + 3TECH + 4FOSKILL + 5FOTEN + 6NONBUSY + 7AUDCOM + 8LPOP + 9OLDDEBT + 10NEWDEBT + 11SINGLE + 12MGR + 13SERVICE + 14IAUDIT + 15BIG5 + 16EXPERT(predicted) + 5

See variable descriptions on Table 1.

52

ENDNOTES

53

Many organization are required to have external audits. Managers of such organizations can generally hire a minimally-

qualified auditor without a well-developed procurement mechanism. Hence, the decision to improve procurement also depends on the perceived incremental benefit of hiring a higher-quality auditor.
2

For example, many cities in our sample issue public debt, and some are extremely large (the largest city in our sample is

Houston, with close to $5 billion in debt and annual expenditures more than $2 billion). COMPUSTAT data (for 1998) also reveals that non-Big 6 firms (who dominate the municipal audit market) also have a considerable presence (23 and 21 percent of AMEX and NASDAQ audits, respectively) among small and medium-size public companies.
3

States include Alabama, Florida, Georgia, Louisiana, Mississippi, North Carolina, South Carolina, and Texas. Multiple requests were sent to maximize the response rate. As expected, cities responding to the questionnaire were

somewhat larger (median population=15,761) than cities not responding (median population=11,187). While this may reduce the impact of smaller cities on our results, other ramifications of this response bias are not obvious.
5

Audit reports other than the standard report are assumed to require additional audit effort. This includes both qualified

reports and reports indicating expanded audit services were provided (e.g., audit of supplemental schedules, audit of statistical information provided with the financial statements).
6

Although the mayor or city council have the ultimate authority for approving the auditor selection in municipal

organizations, the procurement process is generally carried out by the citys finance officer, with the assistance of a city manager or an audit committee. We focus on the characteristics of the chief finance officers due to their integral role in the procurement process, their involvement in all aspects of municipal finance, and to control for variations in procurer groups among cities.
7

Unlike public companies, municipalities have considerable flexibility regarding the timing of their audits. Regulatory

deadlines are rare and audit reports are frequently issued many months after the fiscal year ends.
8

LPOP also serves as our control for size. Abdel-Khalik (1993) also examines the possibility that increasing organizational size may lead to organizational loss of

control, which increases agency costs. To the extent that a citys population is correlated with the size of the municipal organization, this provides additional support for population being used as a proxy for agency costs.
10

Rational auditors should only enter the bidding process if the expected value of the engagement (including the costs of

bidding) is positive.
11

Most empirical studies of auditor industry expertise use industry specialization as a proxy for expertise. We therefore use

the terms interchangeably throughout.

12

We limit these measures to the number of cities audited within a particular state because of the effects variations in

regulatory environments may have on expertise.

13

Eliminating BIG5 as an explanatory variable does not significantly alter the results. Estimating the quality model using

BIG5 as the dependent variable in a logistic regression (not shown) indicates that while LPOP, MFI and MGR are significantly related to the hiring of Big 5 firms, PROCURE is not associated with the hiring of Big 5 firms.
14

This is not unexpected for a summary procurement variable since some procurement elements are predicted to lead to

higher audit fees rather than lower audit fees.

15

In our sample of cities, those having mandatory rotation policies had a mean auditor tenure of 2.5 years, whereas those

without a mandatory rotation policy (where long associations are posited to be more likely), had a mean auditor tenure of 8.6 years (t=8.22, p<.001 two-tail).
16

In fact, the coefficient on TECH in the office-specific quality model is significantly negative, suggesting that cities who

focus on technical factors over fee actually end up with auditors having lower levels of industry expertise. This result is very puzzling since the questions in the survey ask specifically about firm and team experience levels. In order to gain some understanding of this result, we carefully examine additional data obtained in the survey (although some of this data was available for fewer than 100 sample cities). In doing so, we find that such cities were not more likely to hire either Big 5 firms or firms providing consulting services (including IS consulting, internal control related consulting and tax work) either. We do find that such cities were more likely to obtain a Certificate of Achievement for Excellence in Financial Reporting from the Government Finance Officers Association (GFOA) and were more likely to hire auditors who relied on the work of internal auditors.