11/10/2015
Joshy Jacob & Naman Desai & Kumar Agarwalla
Statutory auditors play a key role in corporate governance by ensuring that financial statements reflect the true and fair view of companies. The uncovering of major corporate frauds in India and elsewhere has led to a greater scrutiny of auditors’ role as a watchdog that could prevent such frauds. Research in the US and in other countries indicate that generally the Big Four global accounting firms (EY, KPMG, PwC and Deloitte) provide higher quality of audit assurance relative to the non-Big Four firms. Research also indicates that the Big Four charge significantly higher fees for their work relative to the non-Big Four auditors.
Accounting research has highlighted four potential explanations for the higher fees charged by the Big Four. First, the Big Four auditors provide a superior quality of audit and allow a lower degree of managerial discretion while reporting information on financial statements. This increases the informativeness of the reported financials, and hence, the Big Four are able to command higher fees. The fee premium associated with the audit quality of the Big Four is known as the “quality premium”.
Second, in opposition to the first line of reasoning, abnormally high audit fees might be associated with impaired audit quality. Abnormal fees act as an economic rent that the auditors extract from their client. For example, in the Satyam fraud case, the fees paid to PwC tripled during the period during which the fraud was perpetrated. Moreover, the auditors of Satyam were paid almost twice as much as what was paid to the auditors of Satyam’s peer companies. In such scenarios, fee premiums could motivate the Big Four to try and retain their clients for as long as possible, which possibly could impair their objectivity. This could adversely affect the quality of audit provided. The fee premium associated with this reasoning is labelled “rent extraction”.
Third, the clients of the Big Four enjoy several strategic business benefits, such as lower cost of debt, lower cost of equity, higher earnings response coefficients and lower levels of IPO underpricing. These benefits are attributed to the signal of superior quality of reported information as perceived by the market when the Big Four are associated with a company. The fee premium associated with the reputation of the Big Four auditors is known as the “signalling premium”.
Fourth, investors view auditors as insurers of losses arising from misreporting and investors price securities such that the price reflects their right to recover potential losses through auditor litigation. As the Big Four are significantly larger than non-Big Four auditors, investors’ valuation of a Big Four auditor as an indemnifier of potential losses is higher. As potential indemnifiers of losses, the Big Four include a premium in the audit fees known as the “insurance premium”.
Over the past decade, a significant number of Indian audit firms have been taken over by and/or have been associated with the global Big Four accounting and audit firms. Over the same period, the number of Indian companies employing the Big Four or their associates has increased.
Against this backdrop, we conducted a study (Jacob, Desai and Agarwalla 2015) to examine the audit fees paid by BSE 500 companies for the period between 2000 and 2013 and found that the Big Four charge a significantly higher fee compared to non-Big Four auditors. While the Big Four charge an average fee of 1.94 basis points of sales (1.86 basis points of assets), the corresponding number for non-Big Four auditors is only 0.93 basis points of sales (0.66 basis points of assets). A basis point is one-hundredth of a percentage point.
Even after we account for firm-level differences, such as firm size, complexity of business and risk, and industry differences, the fee charged by the Big Four was reported to be significantly higher. Given the higher fee charged by the Big Four in India, the study examined how well it fits the four explanations mentioned above.
Prior research suggests that the audit fee premiums are negatively correlated with the legal liability regime of a country. The Wingate litigation index indicates that the risk of litigation in India is substantially lower than that of the US or the UK. In India, instances of auditors being sued for negligence or lack of due diligence are rare. Even where the auditors are found guilty of not performing their duties diligently, usually only the individual auditors who are in charge of the audit are punished in India.
For these reasons, the Big Four auditors’ clients do not get access to the “deep pockets” of the Big Four through legal means. This weakens the role of the Big Four as potential insurers of losses in India. As a result, the fee premiums earned by the Big Four in India would not have a substantial “insurance premium”. The Indian context, therefore, allows us to largely eliminate one potential cause of the Big Four’s fee premiums, and permits us to examine whether it is the need for superior quality audit, rent extraction or the signalling of superior quality of reported information that primarily drives the Big Four fee premium.
Our investigation indicates that there is no substantial difference in the audit quality provided by the Big Four and non-Big Four auditors, despite the difference in their fees. We measure audit quality by looking at the magnitude of accruals unexplained by firm-level and industry factors (discretionary accruals). The presence of discretionary accruals would suggest that managers use their discretion in preparing the financial statements.
We investigate the relation between the magnitude of positive abnormal fees paid to the auditor and the quality of the audit provided, as measured by the level of managerial discretion allowed while reporting information on the financial statements. While the results indicate a fee premium earned by the Big Four, we find that such abnormal audit fees are not related to significant increases in the magnitude of discretionary accruals. Hence, we do not find any significant positive or negative effects of the higher fees charged by the Big Four auditors on audit quality, leading to lack of support for the “quality premium” or “rent extraction” rationales.
Lack of support for the alternative hypotheses in explaining the higher fee charged by the big four auditors in India prompts us to examine the potential role of the “signalling premium”. We examine whether the surprises in earnings reported by firms lead to a sharper market response when firms are audited by the Big Four, owing to their greater market reputation.
The results of our study indicate that clients of the Big Four enjoy a significantly higher stock market response when they report earnings surprises (ERCs or earnings response coefficient) relative to the clients of the non-Big Four auditors. The greater ERCs of the Big Four’s clients suggest that employing Big Four auditors allows companies to signal superior quality of information, even when it is unaccompanied by higher actual audit quality.
It appears that companies employ the Big Four primarily to signal a superior quality of their reported information and not necessarily to enjoy the benefits of higher actual quality of the reported information. Thus, our research suggests that though the quality of the audit provided by the Big Four auditors is no different from that of non-Big Four auditors, the market perceives it to be better and hence companies are willing to pay significantly higher fees to the Big Four.
Joshy Jacob’s research interests are in the fields of empirical asset pricing, corporate finance and behavioural finance; Naman Desai has his research interests in the areas of auditing, corporate governance, fraud risk assessment and measuring behavioural changes in social contexts; and Sobhesh Kumar Agarwalla is a faculty member in the dinance and accounting area at IIM Ahmedabad.
This study is registered as a working paper at IIMA and is titled An Examination of Big 4 Audit Fee Premiums: Evidence from India’s Audit Market.
