International Journal of Auditing

Int. J. Audit. 8: 263–277 (2004)

Discretionary Pricing in a
Monopolistic Audit Market
Greg Shailer,1 Lorne Cummings,2 Eroni Vatuloka3 and
Stephen Welch
1
School of Business and Information Management, The Australian National
University.
2
Department of Accounting and Finance, Macquarie University
3
Auditor-General, Republic of Fiji

This paper investigates the possibility of discretionary

audit pricing in a monopolistic public sector market. The
underlying rational of the fee determinant model has different
expectations (in terms of profit-seeking behaviour, loss
functions and liability exposure) from that implicitly em-
ployed in the broader audit fee literature, but incorporates the
same variables. The opportunity for discretionary pricing is
considered in the context of different types of auditees for
which the auditor has varying degrees of monopoly power.
Results are consistent with audits having lower (higher) input
cost where loss exposure is lowest (highest) and acceptable
audit risk is highest (lowest), and with the cost savings being
appropriated by the auditor where monopoly power is the
greatest and with fee discounting for agencies for which the
auditor faces the greatest threat of competition.

Key words: Audit fees, public sector auditing, monopoly.

SUMMARY ences, between auditees, in the strength of

The Australian National Audit Office is the
statutory auditor of (federal) government-funded
entities. From 1991, the ANAO was able to charge
fees for its financial statement audits, thus creating
an opportunity for monopolistic rent-extraction.
There is provision, however, for incorporated
entities (particularly those with commercial
interests) to obtain ministerial approval for the
appointment of a private sector auditor. This
differential threat of competition creates differ-
Correspondence to: Greg Shailer, School of Business and
Information Management, Hanna Neumann Bldg #21, The
Australian National University, Canberra ACT 0200, Australia
the ANAO’s monopoly. Any propensity for rent
extraction may vary across auditees because of the
differential threat of competition.
This paper investigates this potential for
discretionary audit pricing in the context of
expectedly different cost structures for the different
types of auditees for which the auditor has varying
degrees of monopoly power and faces potentially
conflicting (mitigating) loss exposure. The different
types of agencies are government departments
(which pose the least threat of competition),
statutory authorities and government business
enterprises (GBES, which pose the greatest threat
of competition). The study is for the years 1992
to 1994.

ISSN 1090–6738
© Blackwell Publishing Ltd 2004. Published by Blackwell Publishing, 9600 Garsington
Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.
264
Based on the traditional audit fee model
approach, which uses auditee size, complexity and
risk proxies for audit input determinants, we look
for differences in: (1) constant pricing components
for different agency types; and (2) the partial slope
coefficients of variables intended to proxy agency-
based audit input determinants. The variables
considered as cost drivers include organisational
structure and size (assets and expenditures), asset
composition and audit qualifications.
Complexity and size measures, as proxies for
audit inputs (costs) appear to differ significantly
between auditee types. These results suggest that
other audit fee studies concerned with price
premia should consider the likelihood of different
slope coefficients for engagement size and com-
plexity proxies for different types of engagements,
in addition to using classification variables to
measure constant effects. The constant effects for
different auditee types are higher for departments
and lower for GBEs (relative to statutory
authorities).
Given the prevailing weaknesses in audit fee
model specifications, it cannot be confidently
concluded that discretionary pricing is present.
However, the results are consistent with audits
having lower (higher) input cost where the
auditor’s loss exposure is lowest (highest) and
acceptable audit risk is highest (lowest), and with
the cost savings being appropriated by the auditor
where monopoly power is the greatest and with fee
discounting for agencies for which the auditor
faces the greatest threat of competition.
1. INTRODUCTION
This study investigates potential discretionary
pricing in a monopolistic government audit
market. Although we use public sector data, we
believe the novel opportunity to examine potential
discretionary pricing is salient to any audit market
where reduced competition is a prospect.
Our approach generally follows the methods
typical of previous audit fee determinant studies.
Fees are regressed on proxies for engagement
variables (size, complexity and risk) that are
expected to affect audit inputs. The model is
simplified by the absence of auditor differences,
allowing a narrower focus on auditee attributes
where the opportunity for discretionary pricing
varies with types of auditees in relation to the
strength of the auditor’s monopoly position. In
this sense, our study has some complementarity
© Blackwell Publishing Ltd 2004
G. Shailer et al.
with the seminal study by Simunic (1980), which
was motivated by the suggestion of non-
competitive pricing behaviour by private sector
audit firms. In this study, however, the auditor is
not a profit-seeker, has a different loss criterion and
is not exposed to loss sharing through legal
liability.
Following Simunic’s investigation of possible
collusive pricing and rent extraction, other audit
fee studies have contemplated the possible effects
of imperfect competition, such as switching costs
(e.g. Francis, 1984; Francis & Stokes, 1986), but
present little evidence of collusive or monopolistic
effects. This study extends the audit fee literature
beyond contested markets. The study is partly
motivated by anecdotal claims by some auditees’
managers of perceived discretionary pricing prac-
tices by the monopolistic auditor.
The next section briefly describes the insti-
tutional setting of this study and section 3
discusses how fee determinants may apply in this
setting, followed by the usual sequence of data
description, analysis and discussion.
2. THE INSTITUTIONAL SETTING
The Auditor-General, who is served by the
Australian National Audit Office (ANAO), is the
statutorily prescribed auditor of Commonwealth
public sector entities in Australia. The portfolio
of auditees can be divided into Commonwealth
Statutory Authorities (SAs), government owned
trading corporations and departments.1 The
trading corporations and several SAs are identified
by the Department of Finance as Government
Business Enterprises (GBEs), which have a profit
objective.
Since the financial year ending 30 June 1991, the
ANAO was permitted to charge fees to all auditees
for financial statement audits while enjoying
monopoly rights to conduct such audits. No
previous study of monopoly is known to exist in
the literature on audit markets in either the public
or private sector and so the three-year window
considered in this study (1992–1994) provides a
rare opportunity to examine audit pricing in the
absence of competition.2
Except for GBEs, public sector entities generally
are not perceived as having wealth or profit
oriented motives. The monitoring of expenditure
and budget constraints by non-profit entities
implies a concern for cost containment and
possible dissatisfaction with audit fees (Roberts
Int. J. Audit. 8: 263–277 (2004)
Discretionary Pricing in a Monopolistic Audit Market
et al., 1990). Some auditees have criticised the fees
charged to them by the ANAO, arguing that fees
were not sufficiently related to costs and that
differences in fees appeared arbitrary. While the
criticisms are not publicly documented, they are
acknowledged by a previous Auditor-General
(1988–95) in Taylor (1996). Permitted fee-charging
by the ANAO was intended to be a cost recovery
mechanism but the concept of cost remained
undefined, providing considerable latitude for
how fees may have been levied by the ANAO.
Prompted in part by these concerns, this study
investigates the extent to which differences in
prices charged to auditees can be explained by
engagement specific factors, and tests for
discretionary price adjustments based on agency
type.
2.1 Discretionary pricing and competition
The ANAO has actively lobbied to retain
monopoly rights to audit all types of public sector
agencies, as evidenced in their responses to
government attempts to exclude the Auditor-
General as the sole auditor of several agencies.3
While the ANAO ostensibly retains the right to
audit all Commonwealth public sector agencies,
the capacity for some agencies to seek the
appointment of private sector auditors is an
implicit threat of competition that may influence
ANAO actions and pricing decisions.
Departments constitute a class of agencies for
which the ANAO has the greatest opportunity for
extracting rents because it enjoys its strongest
monopoly position with respect to their financial
statement audits. Legislative provisions allow
most government corporations to seek ministerial
approval for the appointment of an alternative
auditor from the private sector, reducing the
ANAO’s monopoly with respect to such agencies
and so curtailing opportunity for extracting rents.
The ANAO may have a competitive incentive
to show that they deliver ‘value for money’ to
government corporations. This may induce fee
discounting, thus eroding the nexus between audit
inputs and fees. The current Auditor-General, Pat
Barrett, observes that public sector auditors are
vulnerable to criticisms regarding their activities
and that they must seek to maintain the confidence
of their various stakeholders. He suggests that this
might involve greater commercial focus and re-
examination of the nature and scope of their audit
products (Barrett, 1996, 143). This implied
© Blackwell Publishing Ltd 2004
265
sensitivity to comparisons with private sector
auditors is consistent with a concern for the threat
of competition.
Claims by some auditee managers that audit fees
were excessive or discriminatory did not identify
any particular motivation for such behaviour.
However, the ANAO had previously sought
increased resourcing to expand its performance
auditing activities for which it could not charge
and so had to fund from its annual budget. It has
been a regular feature in Auditor-General annual
reports, at least since 1991, to note favourably
the increase in resources (both in absolute and
relative terms) applied to performance audits. This
necessarily required a reduction in the proportion
of net resources applied to financial statement
audits and this was accomplished by charging
audit fees.
In 1989–1990, the ANAO reportedly applied 85%
(gross) of its resources to financial statement and
regulatory audits and recovered 28% of costs
through audit fees. In 1991 the application of
resources to financial statements audits fell to 66%
with recoveries of 32%. In 1992 these proportions
were 64% and 40% respectively and in 1993
they were 71% and 65% respectively.4 That audit
fees were merely ‘cost recoveries’ is not obvious.
For example, the ANAO’s 1992 annual report
(Auditor-General, 1992: 128) indicates that audit
fees of $17.8 m were received against expenditures
from appropriations of $17.4 m for financial
statement audits in 1991–1992. In 1993 $31.6 m
was reportedly collected against expenditures of
$27 m and in 1994 $31.6 m was collected against
expenditures of $26 m. The mixture of accrual
accounting for expenditures and cash based
reporting of fees, however, obscures the nature of
this relationship.
3. FACTORS THAT MAY INFLUENCE
AUDIT FEES
Research regarding engagement-specific factors
that may influence fees has focused primarily on
proxies for auditee size and complexity, and
engagement risks. The significant proxies have
differed between public and private sector studies.
Both are examined here due to the diversity of
public sector agencies considered in this study. For
example, GBEs have a strong commercial focus
and so their accounting systems should have much
in common with private sector auditees. Similarly,
government-owned corporations are subject to the
Int. J. Audit. 8: 263–277 (2004)
266 G. Shailer et al.

reporting and audit provisions of the Corporations
Act. The regulatory aspects of the financial
statement audits of all government agencies and
the requirement that they be audited using ANAO
standards creates sufficient ambiguity in the nature
of their audits that the findings of both public and
private sector studies are relevant in suggesting
potential proxies for fee determinants.
Size and complexity variables found to be
significant in private sector studies are listed in
Table 1. The identified studies provide strong
evidence that auditee size (measured by total
assets or revenues) and audit complexity (proxied
by number of subsidiaries, foreign assets or current
asset items divided by total assets) can explain a
substantial proportion of the variation in audit
fees.5 Asset composition measures, such as
inventories and receivables or current assets on
total assets, are typically adopted as risk proxies.
However, as suggested in Jubb et al. (1996), asset
composition ratios can reasonably identify audit
complexity if they attract more extensive audit
procedures or level of testing.
The extension of audit fee modelling into the
public sector has focused mainly on the
competitive US local government audits, as
illustrated by Baber et al. (1987); Copley (1989,
1991); Rubin (1988, 1992); and Sanders et al. (1995).
Some proxies used for size, complexity and risk
in the private sector studies do not have direct
equivalents in the public sector. The size and
complexity variables found to be significant in
these public sector studies are described in Table 2.
These studies also provide strong evidence that
auditee size (measured by civilian population or
revenues) and audit complexity (proxied by
number of services provided by the auditee) can
explain a substantial proportion of the variation in
audit fees.
Much of the discussion of these engagement
variables in the literature has moved away from
the rationale developed in Simunic (1980).

Table 1: Significant size and complexity variables in listed company audit fee studies
Study Complexity/risk Auditee size
Entity complexity Asset composition
(% of total assets)
Simunic (1980) Number of subsidiaries Foreign assets
Industry diversification
Taylor and Baker (1981) Number of subsidiaries Total assets
Francis (1984) Number of subsidiaries Current assets Total assets
Simon (1985)
Francis & Stokes (1986) Number of subsidiaries Inventories and receivables Total assets
Palmrose (1986) Number of locations Total assets
Number of reports by
auditor
Francis & Simon (1987) Number of subsidiaries Foreign assets Total assets
Inventories and receivables
Simon & Francis (1988) Number of subsidiaries Inventories and receivable Total assets
Foreign subsidiaries
(% of total subsidiaries)
Haskins & Williams (1988) Number of subsidiaries Total assets
Net income
Revenue
Gist (1992) Number of audit locations Total assets
Chan et al. (1993) Number of subsidiaries Revenue
Ownership diversification
Anderson & Zeghal (1994) Number of foreign Inventories and receivables Total assets
subsidiaries
Number of subsidiaries
Pong & Whittington (1994) Number of subsidiaries Total assets
Revenue
Butterworth & Houghton (1995) Number of subsidiaries Total assets
Jubb et al. (1996) Number of subsidiaries Inventories and receivables Total assets

© Blackwell Publishing Ltd 2004 Int. J. Audit. 8: 263–277 (2004)

Discretionary Pricing in a Monopolistic Audit Market
Table 2: Significant size and complexity variables in public sector audit fee studies
Study
Baber et al. (1987)
Rubin (1988) Index of services provided
Copley (1989, 1991) Number of services provided
Rubin (1992) Index of services provided
Type and number of reports issued
Sanders et al. (1995)
Simunic’s independent variables were intended to
capture two aspects of audit pricing: differences in
loss exposure across auditees and differences
in the proportion of losses borne by different
auditors. Central to Simunic’s analysis was the
concept of risk-neutral profit-seekers (auditors
and auditees) exposed to joint and several
liability for losses attributable to defects in
audited financial statements. In our analysis, the
underlying model has some critical differences
regarding profit-seeking, the nature of losses and
liability.
First, neither the auditor nor most auditees are
profit-seekers in the usual sense. While GBEs have
an identified profit motive, this is not shared by
agencies funded through budget appropriations.
However, as described in subsection 2.1, the
ANAO had some incentive for rent-seeking from
financial statement audits to satisfy its internally
generated objectives in the performance audit area.
Rent-seeking may, however, be ameliorated by
potential political costs and threats to the auditor’s
monopoly position. The expected cost-benefit
trade-off for the auditor thus has strong non-
financial elements. It is argued that the nature of
this trade-off, and therefore pricing behaviour,
varies primarily with auditee type.
Second, The nature of losses attributable to
deficient financial statements is closely related to
the concept of ownership and the purpose of the
enterprise. In the public sector context, the absence
of profit-seeking shareholders and the political
dimensions of programme delivery create a market
based on political dimensions. Potential political
costs (losses) may vary with the social and electoral
sensitivity of programmes, the level of resources
consumed, and the extent of parliamentary
oversight. These potential losses should motivate
different levels of acceptable audit risk and
consequent inputs. Acceptable audit risks are
identified in 3.3.
© Blackwell Publishing Ltd 2004
267
Complexity Scale
Civilian population
Revenues of auditee
Civilian population
Civilian population
Revenues of auditee
Civilian population
Civilian population
Third, the auditor and most auditees are not
exposed to legal liability for losses in the manner
prevalent in most other studies. The ANAO and its
staff have zero litigation risk for the audit of any
agency.6 Therefore, any loss transfer function rests
solely in the political domain. This is intuitively
appealing if the consequences of losses are also
primarily political.
3.1 Size measures
The effect of auditee size on audit fees has
dominated in the previous empirical results. The
interest in size effects follows largely from Simunic
(1980) who conjectures that total assets are the size
measure most closely related to the auditor’s
possible loss exposure which, he argues, drives
the audit production function. Additional to our
argument that the auditor’s loss exposure varies
with auditee-type, there remains the likelihood
that the extent of exposure within auditee-type will
vary with some measures of auditee size.
Later studies, however, seem to focus more on
the relationship between auditee size and the scale
of audit work, without reference to the auditor’s
potential loss exposure. Pong & Whittington (1994)
argue that both assets and revenue may be relevant
in this regard, capturing different aspects of the
audit work. Most public sector studies have
adopted the scale construct and used civilian
populations to measure size. Rubin (1988, 1992)
found revenues accounted for a large proportion of
the variation in municipal audit fees.7 It is plausible
that these measures also reflect the possible
non-financial loss exposure in a political setting.8
Because revenues (appropriations) of budget-
funded agencies equate to total expenditures,
total expenditure is the most comparable measure
across all ANAO auditees. Because residual
losses from liquidation are not a concern for
stakeholders in this setting, we contend that
Int. J. Audit. 8: 263–277 (2004)
268
expenditures are more likely than total assets to
reflect auditee and auditor loss exposure for public
sector agencies.9
If size variables reflect user and auditor
loss exposure, then they should affect audit
planning through materiality judgments. Nelson
(1993: 38) states that the ANAO used total
payments or receipts as the materiality bases
for departments’ (cash-based) transaction state-
ments.10 The 1990 efficiency audit report by the
independent auditor of the ANAO (Sharpe, 1990:
14) indicates that budgeted hours were allocated
to each ANAO audit team on the basis
of the materiality of the major account category
to be covered by the team (ignoring the risk
of material error). Combining these two obser-
vations implies that budgeted hours, and therefore
audit costs and presumably fees, should be closely
related to the total payments of such auditees.
3.2 Complexity and risk proxies
Using the number of subsidiaries as a complexity
proxy is not directly applicable for government
departments and SAs. Copley (1989, 1991) and
Rubin (1988, 1992) identify significant complexity
proxies in the form of the number of services or an
index of services provided by local governments.
However, a service index for distinguishing the
variety of welfare, regulatory and commercial
auditees involved at the federal level cannot be
constructed objectively due to the difficulty of
disaggregating and weighting the elements of the
broad service classes used in earlier studies. The
structure of most government departments, in
terms of divisions and sections, is a product of the
number of programmes that they support. While
it involves some subjectivity, the number of
programmes can be estimated from agencies’
annual reports. This measure may be comparable
to the number of subsidiaries and has similar
import to the service index measures used in
previous public sector studies. The complexity of
an organisation is measured as the number of
subsidiaries for incorporated auditees (GBEs and
most SAs) and the number of programmes for
unincorporated auditees (departments and some
SAs).
Asset composition measures, such as inventories
and receivables, current assets and foreign assets,
have played an important part in private sector
studies although they are typically intended as risk
proxies because of the more demanding audit
© Blackwell Publishing Ltd 2004
G. Shailer et al.
procedures and the remaining risk of error (see
Simunic, 1980). Foreign assets and inventories and
receivables are largely irrelevant for most of the
public sector agencies considered here. Current
assets as a proportion of total assets (CA/TA) is
considered here as either a complexity measure
or risk proxy. It is also possible that this variable
represents decreased audit complexity – its
reciprocal, the proportion of non-current assets,
may pertain to complexity due to regulatory testing
of acquisitions, dispositions and disposals of assets
for many government agencies. If this is the case,
CA/TA should appear to be fee decreasing and
be similarly relevant to all agencies. If it proxies
for residual risks of undetected misstatements
(Simunic, 1980) CA/TA will be fee increasing.
The distinction between some complexity and
risk proxies is more ambiguous in the government
audit setting with politically motivated stake-
holders. Audit qualifications are often identified
as significant in fee determinant models (e.g.
Simunic, 1980; Francis & Stokes, 1986; Francis &
Simon, 1987; Simon & Francis, 1988; Butterworth
& Houghton, 1995). It is usually expected that
qualifications are fee increasing as the auditor
seeks additional evidence to justify the quali-
fication or resolve disagreements. It is suggested in
Jubb et al. (1996) that a qualification may reduce
the risk to private sector auditors by reducing
litigation risk. While this is not directly relevant to
the ANAO due to the absence of litigation risk, it
may be similarly suggested that accusations of
audit deficiencies by stakeholders may be avoided
or weakened if a report is qualified. Under these
circumstances, a qualification may be associated
with reduced fees. Risk abatement may also be
sought by ‘appeasement’ – reducing fees to reduce
auditee reactions to qualifications. Any mixture of
‘appeasement’ and ‘cost’ effects across auditees
may induce an absence of statistically significant
association between qualifications and the
variation in audit fees. There is also the potentially
confounding effect of incentives for the monopolist
auditor to signal their value in the political
accountability arena. Identifying misstatements
and presenting qualifications may be a signal of
audit effectiveness or value. In this context,
qualifications may be fee-decreasing if the
auditor curtails the level of audit work once the
desired qualification is identified. Overall,
qualification effects may be idiosyncratic to
engagements and we offer no prediction of the
direction of any affect.
Int. J. Audit. 8: 263–277 (2004)
Discretionary Pricing in a Monopolistic Audit Market
3.3 Agency type
In a discussion of the application of risk-based
auditing to government audits, Nelson (1993)
comments that different levels of acceptable audit
risk pertain to different types of ANAO auditees.
Nelson notes (p. 37) that acceptable audit risk for
GBEs is ‘low’ (which he equated to ‘five percent
risk’). SAs generally are also given ‘low’ acceptable
audit risk rating unless there are exceptional
circumstances. For departments, acceptable audit
risk is set at ‘medium’ for expenditure and revenue
departments and ‘medium’ to ‘high’ for
policy departments with ‘high’ used only in
exceptional circumstances. Therefore, audit costs
should be lower for departments and higher
for SAs and GBEs. This should be reflected in
smaller coefficients for size measures for
departments.
If Nelson’s differences in acceptable audit risk
for different agency types reflect the perceived loss
exposure of the auditor, then the analysis is
complicated by the potentially off-setting effect of
the auditor’s varying monopoly power. If this
opportunity for rent extraction is exploited by not
passing on the reduction in audit costs to GBEs and
departments, then the cheaper audit will not be
observable in the absence of any controls for
discretionary fee adjustments.
Addressing this design issue requires some
assumptions pertaining to the implementation of
discretionary pricing. Fully ad hoc pricing should
result in low explanatory power for the audit
fee models. Systematic discretionary pricing may
be through lump-sum adjustments to fees or
by manipulating input prices. Lump-sum
adjustments based on agency types may be
revealed as adjustments to the constant term in the
fee regression model by using dummy variables
for agency types. Input prices can be manipulated
by setting different auditee-dependent charge
rates for individual audit staff but this would
increase the observability (by auditees) of the rent
appropriation and increase the auditor’s
administrative costs.
Overall, if Nelson’s descriptions of agencies’ risk
differentials are applicable for the study period,
then we should observe smaller size coefficients
for departments. If systematic discretionary audit
pricing is practised to capture cost differentials,
then we also should observe a higher constant term
for departments. If the higher competitive threat
for GBEs results in fee discounting, we should
© Blackwell Publishing Ltd 2004
269
observe a negative adjustment to the regression
constant while the low audit risk requirement
should result in a higher size coefficient.
Audit pricing for incorporated SAs may differ
from the unincorporated SAs. Different reporting
requirements may increase the auditor costs if it
requires additional expertise or has higher set-up
costs. Consequently, a dummy variable is included
for incorporated SAs.
3.4 The model
The most appropriate form of model summarized
in Equation (1) is considered in the context of the
data characteristics.
ÈÊ loss exposure ˆ
audit fee = f ÍÁ expenditure˜ ,
ÍÁ ˜
ÎÍË total assets ¯
Ê complexity risk ˆ
Á incorporation ˜
Á ˜
Á subsidiaries programs˜ ,
Á CA TA ˜
Á ˜
Ë qualification ¯
Ê monopoly powerˆ ˘
Á ˜
Ë agency type ¯ ˙˚ (1)
How the variables should be combined or
transformed is partly an empirical issue and is
considered further after reviewing the nature of the
data.
4. DATA
Data was obtained for the different types of
agencies for the financial years 1992–1994 from
the annual reports to Parliament of the individual
agencies.11 Sample sizes are given in Table 3.
Statutory authorities are the largest group.12
Descriptive statistics of the basic variables are
reported, by agency type, in Table 4.
In terms of expenditure, departments are much
larger than other agencies on average, while GBEs
dominate in terms of total assets. In terms of
CA/TA, number of programmes and number
of subsidiaries, there appears to be little to
distinguish the agency subsets.
The much higher proportion (23%) of qualified
reports for GBEs (compared to 18% of departments
and 7% of SAs) is not attributable to incorporation
Int. J. Audit. 8: 263–277 (2004)
270 G. Shailer et al.

as only 10% of all incorporated entities were all are of a nature that precluded testing. Therefore,
qualified. Five of the six qualifications for GBEs they are most likely to be fee-reducing. The
pertain to the valuation of assets through majority of SAs’ two ‘subject to’, three ‘unable to
uncertainties (‘subject to’) that appear more related form an opinion’ and six ‘except for’ qualifications
to policy (the transfer of functions) than accounting are likely to have required the collection of
or financial matters – thus they are unlikely to have additional evidence to identify the issues or
much effect on audit effort. The sixth qualification discrepancies involved, consequently increasing
is ‘unable to form an opinion’ regarding going- audit costs.13 Given these differences, the dummy
concern based on uncertainties regarding the variable for qualification is coded separately for
entity’s future control over assets because of muted each agency type.
plans for privatisation, departments’ qualifications
consist of three ‘subject to’ and two ‘unable to 4.1 Transformations
form an opinion’. While the former pertain to
expenditures and the latter to revenue collections, The statistical properties of the data do not signal
any particular cause for concern although the size
variables exhibit the degree of skewness and
heteroscedasticity present in most previous
studies.
Table 3: Number of ANAO audit fee cases by type The audit fee and size variables are typically
of agency transformed logarithmically in regressions against
Year Departments GBEs SAs n audit fees.14 Such transformations allow an
(excluding GBEs) apparently linear model to be developed using
OLS regression. Logarithmic transformations were
1992 9 8 48 65
tested for fees against all potential explanatory
1993 10 8 50 68
1994 9 7 49 65 variables and linear relationships are observed
(within logs) for expenditure and total assets. Some
Total 28 23 147 198
slight improvement in linearity within logs is

Table 4: Descriptions of basic explanatory variables by type of agency

n Mean Standard Minimum Maximum
deviation
Departments
Expenditure ($million) 28 3,323 5,499 29 17,620
Total assets ($million) 28 560 827 16 3,119
CA/TA 28 0.28 0.31 0.01 0.97
Qualification (0,1) 28 0.18 0.39 0 1
Number of programmes 28 5.79 2.23 3 11
Statutory authorities
Expenditure ($million) 147 103 177 0.26 875
Total assets ($million) 147 120 265 0.10 1,329
CA/TA 147 0.37 0.33 0.00 1.00
Incorporated entity (0,1) 147 0.69 0.46 0 1
Qualification (0,1) 147 0.07 0.26 0 1
Number of subsidiaries (incorporated SAs) 102 1.88 6.97 0 43
Number of programmes (unincorporated SAs) 45 4.49 2.38 1 10
GBEs
Expenditure ($million) 23 557 760 61 2,568
Total assets ($million) 28 1,200 1,151 26 3,481
CA/TA 23 0.34 0.28 0.08 0.98
Incorporated entity (0,1) 23 1 0 1 1
Qualification (0,1) 23 0.26 0.45 0 1
Number of subsidiaries 23 5.91 8.90 0 24

© Blackwell Publishing Ltd 2004 Int. J. Audit. 8: 263–277 (2004)

Discretionary Pricing in a Monopolistic Audit Market
observed for subsidiaries and programmes against
fees but no improvement was observed for CA/TA
and so, consistent with previous studies, CA/TA is
not transformed.15
4.2 Correlations
Financial statement-based data typically presents
high levels of correlation between variables. As
expected, Table 5 indicates particularly high
correlations (99%) between the competing size
measures, log of total assets and log of
expenditures. The high correlations between the
agency dummies and the continuous variables for
each agency is of little concern given that the
dummies are designed as adjustments to the
constant term in the regression. Of greater concern
for the planned regression models are the high
correlations (in bold in Table 5) between some
size measures and CA/TA for all agencies and
programmes and size for departments. Each of
these correlations is highly significant. The
potential for multicollinearity posed by these
correlations will be assessed after presentation of
the regression results.
5. REGRESSIONS
The two primary regressions, differing only
according to the size variable employed, are
reported in Table 6. The power of each model is
reasonable (multiple R of 0.94 and 0.89 with highly
significant F statistics) and an R2 of 0.88 the
expenditure-based Model 1 and 0.78 for the TA-
based Model 2.
The remaining discussion concentrates on Model
1, which is generally much stronger and in
accordance with our expectations regarding the
greater suitability of expenditures (compared to
total assets) as a loss-exposure proxy.
5.1 Model specification tests
Regression of the pooled data assumes that audit
input and fee decisions are made in responses
to individual engagement circumstances each
period, independent of previous period decisions.
Differences between years were tested for Model 1
with separate regressions, reported in Table 7.
Although significance levels vary, the results are
generally consistent with the pooled results in
terms of explanatory power and the signs on
coefficients.
© Blackwell Publishing Ltd 2004
271
5.2 Multicollinearity
The possibility of multicollinearity is raised above
where larger bivariate correlations are observed
among size and complexity measures in Table 5.
Based on condition indices and variance
proportions, there is no evidence of serious
multicollinearity for the regressions. Hair et al.
(1995: 153) advises that the threshold value for
condition indices is usually in the range 15 to 30.
A collinearity problem is indicated where a
condition index accounts for more than 0.90 of the
variance of two or more coefficients (not the
constant). For Model 1, only dimension 15 has
values at this level, but only one continuous
variable (department expenditures) is associated
with it. The other high value is for the constant-
adjusting dummy for departments. Similar results
are observed for departments and GBEs for Model
2 (dimensions 14 and 15). Consequently, we
conclude that multicollinearity does not pose a
significant problem for these regressions.
6. DISCUSSION
Complexity effects appear to differ across agency
types. Incorporation is fee-increasing for SAs.
Although this may also apply for GBEs, all of
which are incorporated, this cannot be controlled
separately from the GBE dummy. The positive
coefficient of programmes (the complexity proxy for
unincorporated agencies) on departments’ and
unincorporated SAs’ fees is consistent with prior
results for contested municipal audits (e.g. Rubin,
1988, 1992; Copley, 1989, 1991). The equivalent
variable for incorporated agencies (subsidiaries) is
not significant in Model 1. (Although both
programmes and subsidiaries are significant for
Model 2, this may be a consequence of the poorer
size specification provided by total assets).
CA/TA is significantly fee decreasing for
departments and SAs, consistent with it acting
as a proxy for reduced complexity or lower
compliance auditing requirements. This is
consistent with the conjectured compliance
requirements for asset acquisition and custody.
This distinguishes the use of asset decomposition
measures in private sector studies which typically
identified the proportions of current assets as
fee-increasing risk proxies.
Rather than interpreting the qualified coefficients
as risk proxies, they appear to reflect the likely
impact on audit effort that coincidentally differed
Int. J. Audit. 8: 263–277 (2004)
 272

Table 5: Correlations of regressions variables

Incorporated Department GBE Qualified – Qualified Qualified CA/TA – CA/TA CA/TA Total assets Total Total Expenditures Expenditures Expenditures Subsidiaries Programmes

© Blackwell Publishing Ltd 2004

SA department – GBE – SA department – GBE – SA – department assets assets – department – GBE – SA
– GBE – SA
Incorporated 0.000 0.264 0.003 0.352 0.173 0.000 0.454 0.000 0.000 0.269 0.000 0.000 0.269 0.000 0.017 0.000
SA (0,1)
Department -0.49 0.039 0.000 0.315 0.168 0.000 0.117 0.000 0.000 0.039 0.000 0.000 0.039 0.000 0.018 0.000
(0,1)
GBE (0,1) 0.05 -0.15 0.414 0.000 0.218 0.180 0.000 0.000 0.039 0.000 0.000 0.040 0.000 0.000 0.000 0.000
Qualified – -0.03 0.40 -0.058 0.691 0.585 0.776 0.535 0.056 0.000 0.416 0.000 0.000 0.415 0.000 0.352 0.000
department
(0,1)
Qualified – 0.03 -0.07 0.49 -0.03 0.549 0.514 0.000 0.036 0.317 0.000 0.000 0.318 0.000 0.000 0.177 0.070
GBE (0,1)
Qualified – 0.07 -0.10 -0.09 -0.04 -0.04 0.370 0.350 0.481 0.170 0.220 0.001 0.170 0.219 0.002 0.149 0.922
SA (0,1)
CA/TA – -0.32 0.65 -0.10 0.02 -0.05 -0.06 0.309 0.002 0.000 0.181 0.000 0.000 0.181 0.000 0.126 0.000
department
CA/TA – 0.01 -0.11 0.76 -0.04 0.26 -0.07 -0.07 0.001 0.119 0.000 0.000 0.119 0.000 0.000 0.000 0.005
GBE
CA/TA – SA 0.36 -0.34 -0.31 -0.14 -0.15 0.05 -0.23 -0.23 0.000 0.000 0.000 0.000 0.000 0.000 0.031 0.000
Total assets – -0.49 0.99 -0.15 0.44 -0.07 -0.10 0.62 -0.11 -0.34 0.040 0.000 0.000 0.040 0.000 0.019 0.000
department
(lg)
Total assets – 0.04 -0.15 0.99 -0.06 0.49 -0.09 -0.10 0.75 -0.31 -0.15 0.000 0.040 0.000 0.000 0.000 0.000
GBE (lg)
Total assets – 0.39 -0.66 -0.59 -0.26 -0.29 0.24 -0.43 -0.45 0.42 -0.66 -0.59 0.000 0.000 0.000 0.726 0.000
SA (lg)
Expenditure – -0.49 0.99 -0.15 0.42 -0.07 -0.10 0.63 -0.11 -0.34 0.99 -0.15 -0.66 0.040 0.000 0.019 0.000
department
(lg)
Expenditure – 0.04 -0.15 0.99 -0.06 0.49 -0.09 -0.10 0.75 -0.31 -0.15 0.99 -0.59 -0.15 0.000 0.000 0.000
GBE (lg)
Expenditure – 0.34 -0.67 -0.60 -0.26 -0.29 0.22 -0.44 -0.46 0.45 -0.67 -0.60 0.99 -0.67 -0.60 0.441 0.001
SA (lg)
Subsidiaries 0.15 -0.17 0.37 -0.06 0.10 0.10 -0.11 0.34 -0.15 -0.17 0.39 -0.03 -0.17 0.38 -0.06 0.000
(lg)
Programmes -0.88 0.58 -0.27 0.29 -0.13 0.01 0.31 -0.20 -0.28 0.59 -0.26 -0.29 0.59 -0.26 -0.24 -0.30
(lg)
Notes: n = 198 Coefficients are below diagonal Significance levels (2-tailed) are above diagonal.

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G. Shailer et al.
Discretionary Pricing in a Monopolistic Audit Market 273

Table 6: Audit fee (lg) regressions

Model 1 Model 2
Coefficients Significance* Coefficients Significance*
R 0.941 0.890
Adjusted R2 0.876 0.775
F test (Anova) 100.453 0.000 49.536 0.000
Constant 1.101 0.000 1.830 0.000
Department (0,1) 1.153 0.012 1.394 0.070
GBE (0,1) -3.191 0.000 -0.486 0.548
Qualified – department (0,1) -0.154 0.162 -0.178 0.275
Qualified – GBE (0,1) 0.012 0.900 0.061 0.645
Qualified – SA (0,1) 0.262 0.000 0.206 0.028
Incorporated SAs (0,1) 0.180 0.014 0.200 0.043
Subsidiaries (lg) 0.067 0.220 0.160 0.032
Programmes (lg) 0.192 0.079 0.606 0.000
CA/TA – department -0.305 0.028 -0.205 0.290
CA/TA –GBE 0.166 0.307 0.029 0.895
CA/TA – SA -0.329 0.000 -0.208 0.005
Expenditures – department (lg) 0.346 0.000
Expenditures – GBE (lg) 0.835 0.000
Expenditures – SA (lg) 0.469 0.000
Total assets – department (lg) 0.212 0.018
Total assets – GBE (lg) 0.414 0.000
Total assets – SA (lg) 0.360 0.000
*2-tailed significance.

Table 7: Model 1 regressions by year

1992 (n = 65) 1993 (n = 68) 1994 (n = 65)
Coefficients Significance* Coefficients Significance* Coefficients Significance*
R 0.936 0.949 0.955
Adjusted R2 0.842 0.874 0.889
F test (Anova) 25.377 0.000 34.347 0.000 37.434 0.000
Constant 0.946 0.012 1.305 0.000 1.104 0.000
Department (0,1) 1.682 0.097 1.122 0.169 0.812 0.273
GBE (0,1) -3.799 0.020 -3.044 0.032 -2.260 0.139
Qualified – 0.039 0.889 -0.029 0.854 -0.726 0.003
department (0,1)
Qualified – GBE (0,1) 0.174 0.523 0.090 0.701 -0.051 0.761
Qualified – SA (0,1) 0.203 0.100 0.347 0.011 0.345 0.007
Incorporated SAs (0,1) 0.194 0.190 0.170 0.180 0.217 0.180
Subsidiaries (lg) 0.053 0.641 0.058 0.555 0.116 0.200
Programmes (lg) 0.241 0.267 0.135 0.477 0.266 0.257
CA/TA – department -0.273 0.258 -0.394 0.178 -0.566 0.041
CA/TA – GBE 0.352 0.267 0.214 0.408 -0.194 0.589
CA/TA – SA -0.256 0.019 -0.336 0.001 -0.413 0.000
Expenditures – 0.286 0.009 0.332 0.000 0.403 0.000
department (lg)
Expenditures – 0.916 0.000 0.794 0.000 0.735 0.000
GBE (lg)
Expenditures – SA (lg) 0.480 0.000 0.448 0.000 0.466 0.000
*2-tailed significance.

© Blackwell Publishing Ltd 2004 Int. J. Audit. 8: 263–277 (2004)

274
across agencies but are not attributable to
differences in agency type per se. The only
significant audit qualification control is for SAs,
which has the more onerous qualifications, and is
fee-increasing as expected.
The size measures, as in other fee model studies,
are positive and particularly strong in both models.
Overall, the regression results seem reasonable and
are consistent with previous studies regarding size
and complexity effects. With this reassurance, we
can have some confidence in the results for our key
test variables for input costs and agency pricing
effects.
Focusing on the stronger Model 1, the difference
in the (size) slopes between department and GBE
is significant at the 0.01 level. The observed
difference is consistent with our argument that low
acceptable audit risk for GBEs should attract
higher input costs compared to the medium-to-
high acceptable audit risk for departments.
The significantly positive coefficient for depart-
ment is consistent with unscaled fee adjustments
that may occur with opportunistic discretionary
pricing. The negative coefficient for GBE is
consistent with unscaled discounting that may
occur with discretionary pricing behaviour.
Because we cannot separate the possible fee-
increasing affect of incorporation for GBEs from
the fee-reducing GBE dummy, it is possible that the
magnitude of GBE ‘discounting’ may be greater
than indicated by the GBE coefficient.
7. CONCLUDING REMARKS
This study investigated the pricing of government
audits in a monopolistic market. The results are
potentially useful in two areas: the significance of
the threat of monopolistic behaviour for policy
setting (particularly regarding fee charging or cost
recoveries) in public sector audits; and the choice
of the size-based proxy for the auditor’s loss
exposure in public sector audit fee studies
generally.
The observed size and agency effects are con-
sistent with the expected variation in loss exposure
and discretionary pricing in accordance with
varying monopoly power. Expenditure appears
superior to TA as a proxy for auditor loss exposure
for public sector agencies.
However, this study is not without its
limitations. Using archival data from annual
reports limits our ability to proxy engagement
conditions. Also, the use of dichotomous variables
© Blackwell Publishing Ltd 2004
G. Shailer et al.
for qualifications and agency type do not capture
the intricacies involved in the qualifications or
agency structures. These limitations, however, are
not unique to this study.
Our focus on reflecting differences between
entities in variable selection may warrant attention
in private sector studies, such as with industry
effects. Splitting samples by function (in this case
departments, GBEs and SAs) may also yield more
interesting results in other audit fee studies.
The results do not necessarily mean that the
ANAO’s monopoly position was exploited to
extract rents, but the results are sufficiently
suggestive of differences in pricing to warrant
further attention. Should such discrepancies be
supported by other analyses, then policy makers
concerned with contestability of audit engage-
ments or fee charging in this and comparable audit
markets may need to specifically consider such
consequences of monopoly power.
ACKNOWLEDGEMENTS
We are grateful for the comments on earlier
versions received from Max Aiken, Sudipta Basu,
Keith Houghton, Gary Monroe, Dan Simunic,
Don Stokes, and an anonymous referee for this
journal.
NOTES
1. Departments operate directly under a
Minister who is a member of the Executive
Government. SAs are established for particular
purposes. Two particular types of statutory
authorities are Government Business
Enterprises (GBEs – trading or commercially
oriented organisations often structured as
companies) and statutory marketing au-
thorities (also often structured as companies).
2. The fee charging mechanism was announced
in December 1990 with the first full financial
year of operation as 1991–92. Supplementation
was provided to budget-funded agencies in
the 1991–92 budget to meet the cost of audit
fees. Full operation of the fee charging
arrangement appears to have ended during
1995 with financial reports from then
indicating that audit fees for departments
were only notional and not charged. There
was a change of Auditor-General during
the 1995 financial year and substantial
structural changes in the ANAO. Therefore the
Int. J. Audit. 8: 263–277 (2004)
Discretionary Pricing in a Monopolistic Audit Market
cut-off for this study is the financial year
1993–94.
3. These included the Australian Wool Realisation
Commission and the Australian Wool
Corporation (see Auditor-General, 1991a), the
National Railway Corporation Limited (see
Auditor-General, 1991b) and the National
Media Liaison Service (see Auditor-General,
1995). The Senate Standing Committee on
Financial and Public Administration, in its
report on Government Companies and their
reporting requirements (tabled in Parliament
on 2 November 1989), endorsed the
recommendations of the Joint Committee of
Public Accounts (JCPA) Report 296 that the
Auditor-General alone be external auditor of
GBEs. As a result of the JCPA report, the
Government instigated a further review by
the then Auditor-General of South Australia,
Tom Sheridan. The Sheridan Report (30 March
1990) recommended that the Auditor-General
should be the sole auditor of all GBEs and other
Government bodies and that he be reinstated as
the external auditor where other arrangements
had been put in place. In December 1990 the
Government announced that the Auditor-
General would be the sole external auditor for
all GBEs and SMAs, but that the Minister for
Finance may allow exceptions. In 1991 there
were 20 government companies with private
sector auditors and 11 joint arrangements. For
1992 there were 41 companies not audited by
the ANAO. Many of these were subsidiaries
operating in other countries and so beyond the
ANAO’s effective jurisdiction. While these
numbers are not large, they are evidence of the
threat of competition.
4. 1994 figures are not available due to changes
in ANAO disclosure practices.
5. The number of product lines and locations as
complexity proxies have also been associated
with audit fees in some studies (Simunic, 1980;
Simon, 1985; Palmrose, 1986; Chan et al., 1993).
6. s.70E of the Audit Act 1901 obliges the
Commonwealth to indemnify individuals
against liability in the course of performing
functions set out in the section.
7. While it is likely that municipal population
and revenues will be highly correlated, the
variation in income and wealth between
municipalities leaves unanswered the question
of what underlying fee determinant is being
measured and how it might be best proxied.
© Blackwell Publishing Ltd 2004
275
8. For a national auditor, all auditees serve the
same civilian population and so ANAO
auditees cannot be distinguished on this basis.
9. If losses are defined in political-cost terms, it is
likely that the political dimensions of agencies
and their activities will determine the auditee’s
and auditor’s loss exposure. In the absence of
any measures of the political sensitivity of
agencies’ programmes and activities, the level
of expenditure, which is funded from taxes, is
the more reasonable proxy for this political
cost exposure.
10. Bill Nelson was the then Acting National
Business Director, Financial Audit, for the
ANAO.
11. These were accessed in the Parliamentary
Papers Collection held by the library of The
Australian National University. Some gaps in
the audit fee data collected from this source
were remedied with data provided directly
by individual agencies for which we are
particularly grateful. Consequently, the sample
of SAs and GBEs is not necessarily random
but the nature of any bias is unknown. Three
government owned corporations (Qantas,
Telstra and Commonwealth Bank) were
excluded a priori because they were all subject
to some degree of privatisation through public
floats during or shortly after the study period,
which may have significantly affected the
audit process in the years concerned. A fourth
GBE, Defence Housing Authority, was sub-
sequently excluded as an extreme outlier in
terms of audit fee.
12. While subsamples are small, the pooled series
is sufficiently large for most analytical
purposes (n = 198) provided pooling does not
introduce variance inflation.
13. Issues involved unauthorised or potentially
invalid transactions and difficulties with
calculations. More ambiguous audit effects
pertain to breaches of accounting standards
and some limitations of scope similar to the
department qualifications.
14. An exception is Pong & Whittington (1994).
15. Transformation of subsidiaries was lg(number
of subsidiaries + 1). Square-root trans-
formations were also tested for all variables.
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AUTHORS PROFILES
Gregory Shailer is a Reader at the Australian
National University. His research interests relate to
© Blackwell Publishing Ltd 2004
277
corporate governance, regulation, disclosure and
audit.
Lorne Cummings is a Senior Lecturer at
Macquarie University. His research interests relate
to stakeholder theory, ethical investment, and
environmental/social accounting.
Eroni Vatuloka completed his research masters
degree at The Australian National University.
He is now the Auditor-General of the Republic of
Fiji.
Stephen Welch completed his research masters
degree at The Australian National University. He
is now in practice with a Big 4 accounting firm
where he specialises in public sector services.
Int. J. Audit. 8: 263–277 (2004)