A SIMULTANEOUS-EQUATIONS ANALYSIS OF QUALITY-CONTROL REVIEW OUTCOMES AND ENGAGEMENT FEES FOR AUDITS OF RECIPIENTS OF FEDERAL FINANCIAL ASSISTANCE

Often overlooked in empirical analyses of the relation between audit quality and audit fees is the recognition that they are mutually determined by the interaction of the client's demand for, and the audit firm's supply of, audit quality. Failure to account for this endogeneity can lead to biased inferences concerning the audit quality/audit fee relation. We adopt a simultaneous equations estimation procedure (offered by Amemiya 1978) applicable to jointly determined endogenous variables when one of the variables (in our case the quality review outcome) is qualitative in nature.1 To illustrate the procedure, we use a dataset developed by the United States General Accounting Office (GAO 1987) in its study of the audit procurement practices of entities receiving federal financial assistance. Inferences using this procedure differ from those of single-stage analyses. The results suggest that within the context of the application examined, audit fees appear to be positively related to the supply of audit quality and inversely related to the demand for audit quality. These findings have implication for studies involving audit fees and studies examining the demand characteristics of auditing.