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Review of Quantitative Finance and Accounting

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08.03.2018 | Original Research

Fee competition among Big 4 auditors and audit quality

verfasst von: Sharad Asthana, Inder Khurana, K. K. Raman

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 2/2019

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Abstract

Both the GAO (Public accounting firms: mandated study on consolidation and competition. GAO, Washington, 2003; Audits of public companies: continued concentration in audit market for large public companies does not call for immediate action. GAO, Washington, 2008) and the US Treasury (Advisory committee on the auditing profession: final report, 2008. http://www.tres.gov/offices/domestic-finance/acap/docs/final-report.pdf) have implied that the Big 4 dominated US audit market lacks competition. More recently, the PCAOB has expressed a somewhat different concern, i.e., that because audit committees may be primarily interested in negotiating a lower audit fee (rather than championing higher audit quality) for their clients, fee competition in the US audit market could pressure the incumbent auditor to compromise on audit quality (Doty in Keynote address: the reliability, role and relevance of the audit: a turning point, 2011. www.pcaobus.org). We utilize the notion of counterfactual fees chargeable by auditors to assess fee competition and investigate competing views on the relation between fee competition among Big 4 auditors and audit quality in US local audit markets. To operationalize fee competition at the client-level in the context of each local audit market, we compute a separate counterfactual audit fee that would be charged by every other Big 4 auditor for that particular engagement and use the minima of the counterfactuals. We validate our audit fee competition metric by showing a positive relation with the incumbent auditor’s switching risk. Collectively, our findings suggest that fee competition is useful as a mechanism for improving audit quality in the highly concentrated US audit market, albeit only in local audit markets where the incumbent auditor has below-median market power and only for higher quality clients. Overall, our findings speak to the interplay between fee competition and auditor incentives and are of potential interest to regulators such as the PCAOB concerned about competition in US audit markets.

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We focus on the Big 4 firms because of their oligopolistic dominance of the highly concentrated US audit market and to avoid the confounding audit quality effects of Big 4 versus non-Big 4 auditors. Consistent with prior research, we use the terms “city,” “local audit market” and “CBSA” (Core Based Statistical Area) interchangeably to vary the exposition. The US Office of Management and Budget defines CBSA as an area surrounding an urban center of “at least 10,000 people and adjacent areas that are socio-economically tied to the urban center by commuting.”

As noted by DeFond and Zhang (2014), audit fee models have very high explanatory power (R-squares) and, consequently, estimates derived from audit fee models are reliable. In our study, our fee estimation model R-squares range between 75 and 79%.

As reported in Accounting Today, the commoditization of the Big 4 audit is part of the motivation behind the rapid growth of nonaudit services, albeit to nonaudit clients, at the Big 4 firms from 48 to 62% of total revenues between 2004 and 2013. PCAOB Chairman Doty (2013) notes that within 10 years for these firms audit fees are likely to amount to less than 20% of total revenues.

Cohen et al. (2010) suggest that CFOs, rather than audit committees, continue to hold power in the hiring of the auditor. Also, survey evidence of CFO beliefs suggests that earnings management is common and that approximately a fifth of public companies manage earnings in any given year (Dichev et al. 2013). Hence, it is not unreasonable to view at least some clients with a Big 4 auditor as reprobate or lower quality, i.e., as preferring a lower (rather than a higher) quality Big 4 audit. Relatedly, Doty (2013) notes that PCAOB inspections have identified and documented promises by auditors to clients to be their “trusted partner” and to support the client in obtaining a “desired outcome” in accounting matters. DeFond et al. (2000) report that in China higher audit quality is associated with loss of market share.

Our discussions with Big 4 auditors suggest that faced with audit fee competition from another Big 4 auditor, the incumbent may offer incentives that are often personnel related. In other words, given the high levels of staff turnover in public accounting, it can be frustrating for a client to have to answer the same questions repeatedly or otherwise “train” the auditor’s staff year after year. Hence, an offer of personnel-related incentives (such as more senior/experienced personnel assigned to the audit) may be sufficient to ward-off a client bid process with little or no fee discount.

“If we want the audit profession to compete on quality more than price, we’ve got to provide markets more information about the audit,” Doty (2013, p. 9). Proposed PCAOB initiatives such as a more explanatory audit report (opinion), identifying the engagement partner on an audit, disclosure of other firms participating in the audit are all intended to help investors better judge audit quality.

As noted previously (fn. 4), the incumbent Big 4 auditor may offer to assign its “A-team” (i.e., its more senior and experienced personnel) to the client’s audit. Given the high levels of staff turnover in public accounting, it can be frustrating for a client to have to answer the same questions repeatedly or otherwise “train” the auditor’s staff year after year. Hence, an offer of personnel-related incentives may be sufficient to ward-off a client bid process.

Prior research (e.g., Banker et al. 2003) on the audit industry production function pools data at the national level for both Big 4 and non-Big 4 audit firms, i.e., implicitly assumes that the production function is the same for all (Big 4 as well as non-Big 4) audit firms. By contrast, we examine the audit fee model for each Big 4 firm separately for each year over our study period (2005–2015). Put differently, we add to the degrees of freedom in our estimation of AFCOMP by allowing the fee models (Appendices 1 and 3) to be different for each Big 4 firm each year. The significant differences in the coefficients of the annual regressions for the Big 4 firms (reported in Appendix 1) justify this modeling choice consistent with the reasonable notion that these audit firms are not homogenous and that pricing models can vary by audit firm.

We are grateful to Elaine Mauldin for sharing the audit committee related data.

All variables are winsorized in the (1, 99%) range. To avoid sample attrition, mean values for the industry-year are used for missing control variables. Exclusion of client-years with such missing data does not change conclusions.

Significant correlations among the independent variables (other than the test variables AFCOMP_NEG and AFCOMP_POS) are not a concern since they do not affect any of our test results or interpretations, and are therefore not reported for brevity. Later in the study we report VIFs.

Recall that AFCOM_NEG implies absence of audit fee competition, i.e., for this particular audit engagement no other Big 4 auditor has a counterfactual fee that is lower than that of the incumbent Big 4 auditor.

Additionally, the correlation of AFCOMP with abnormal audit fees for AFCOMP > 0 is 0.0169 and for AFCOMP < 0 is 0.0354. This further confirms that our competition measure is fundamentally different from abnormal audit fees.

In Table 7, for lower quality clients, our test variable AFCOMP_POS is significant only for one audit quality proxy (DACC), i.e., significant with a positive sign in column 1, which appears to provide weak support for the PCAOB concern that audit fee competition may lower audit quality. However, this concern applies only for lower quality clients, i.e., clients where the relative power of the audit committee vis-à-vis the CFO is below median.

We utilize 1-digit (rather than 2-digit) SIC for practical reasons. With 2-digit SIC, there are over 50 industries, and 4 Big 4 auditors × 11 years × 50 industries implies over 2200 regressions with the 12,618 observations in our sample (see Table 1), i.e., an average of only 6 observations per regression. Even with the 1-digit SIC, for industries with SIC codes 0 and 9 we do not have enough observations to run by year and auditor; hence, for these 2 industries (51 + 48 = 99 observations) we run the regressions only by auditor.

One limitation of AFCOMP is that we do not know which audit office of the other Big 4 firm would perform the engagement if in fact the lowest counterfactual fee was accepted by the client. However, when we use the incumbent auditor’s attributes and the characteristics of the incumbent’s CBSA in estimating AFCOMP, sequential regression analysis shows that 96% of the explanatory power of model (3) comes from client characteristics and only 4% from audit office and audit market characteristics. Hence, the measurement error in AFCOMP is expected to be minimal. Moreover, any measurement error in AFCOMP is likely to bias the coefficient against being significant.

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Titel: Fee competition among Big 4 auditors and audit quality
verfasst von: Sharad Asthana
Inder Khurana
K. K. Raman
Publikationsdatum: 08.03.2018
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 2/2019
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-018-0714-9

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