Is It Worth It? The Relationship Between Audit Fees and Audit Quality
August 13, 2021 | By Ryan Decker
Researcher: Jonathan Shipman
Is hiring a high-priced audit firm worth the extra cost for your firm? That’s one question James “Robbie” Moon, Jonathan Shipman, Quinn Swanquist, and Robert Whited seek to answer in their article, “Do Clients Get What They Pay For? Evidence from Auditor and Engagement Fee Premiums.” Prior research provided mixed evidence on whether paying a premium for an audit resulted in higher audit quality, so the authors refine the measures of audit fees to separate fees driven by an auditor’s reputation from other residual fee premiums.
The authors find that audit quality improves as auditor premiums increase, and that this positive association is strong both when measured at the firm level and when considered between tiers of firms. The authors consider this relationship over time and find that audit quality has improved while auditor premiums have remained mostly constant, suggesting that the auditor-specific premiums are becoming less associated with quality in recent years.
Price Versus Quality
Independent audit firms must audit the annual financial statements of all public companies in the United States to check for compliance with U.S. Generally Accepted Accounting Principles (GAAP). Public companies pay firms to conduct these audits, and the level of assurance the auditor provides is the most important aspect of audit quality. “In markets for differentiable products,” the authors write, “the price a buyer is willing to pay should increase with quality.” While it seems like common sense that a better product would come with a higher price, prior research supports opposing conclusions around audit fees and audit quality.
Audit fee premiums, or what auditors charge companies for their services in excess of the predicted audit fee, are a function of several components. The authors suggest that these “fee premiums” can be broken down into auditor fee premiums and engagement fee premiums. Auditor fee premiums account for an auditor’s reputation and competence, while engagement fee premiums account for other risks or costs that accompany the audit. Just as a company would pay more for advice from a top-tier consulting firm, companies pay higher premiums for highly skilled auditors. If an audit is deemed to be especially complex or risky, engagement fees would be higher.
“Auditor fee premiums likely increase with auditor reputation, resources, and competence, all of which should translate to greater audit quality,” the authors write. “Conversely, engagement fee premiums likely capture a combination of unobservable risk, production costs, and negotiation idiosyncrasies.” Auditor fee premiums are driven by the auditor and their reputation, while engagement fee premiums are driven by the client and the complexity of their auditing demands.
In their analysis, the authors “provide evidence of a significant auditor-specific component of fees that is distinct from client characteristics and differs from traditional audit fee residuals.” They find that auditor fee premiums are positively related to audit quality but that engagement fee premiums do not relate to improved audit quality. For example, a company that pays more for a more reputable auditor would expect to receive a better audit. If that same company pays more for its audit because of its audit’s increased risk, however, they should not expect to receive a better audit for their money. In their case, they’re paying more because the work is trickier, not because their auditors are more reputable. This finding possibly reconciles the conflicting conclusions in prior literature around audit fees and audit quality.
Due to its positive relationship with audit quality, the authors focus on auditor fee premiums to analyze how the differentiation provided by an auditor’s “brand name,” office size, industry expertise, and/or “tier” impacts audit quality and fees. Audit firms such as PwC and EY have strong brand names that differentiate their product from smaller firms. To investigate differentiation across audit firms, the authors break down auditor premiums by office and industry as well as by auditor tier.
Are All Auditors the Same?
Audit firms come in all shapes and sizes and are usually divided into three tiers. The first tier, consisting of the “Big 4” (Deloitte, PwC, EY, and KPMG), includes the four largest professional services firms in the world – each bringing in over $29 billion in revenue in 2020. Of the 457 clients with public information on the Fortune 500 list, all are audited by one of the Big 4. Second-tier firms offer the same professional services as the Big 4 firms, but on a smaller global scale. For example, BDO, the largest second-tier firm by revenue, earned around $10 billion of revenue in 2020. Third-tier firms, or “Small Auditors,” include local or regional firms.
As expected, research suggests that auditors from larger offices or with industry expertise conduct higher-quality audits and receive a higher fee premium. Similarly, most prior literature examines the increase in audit quality provided by Big 4 auditors, or the “Big 4 effect.” Consistent with this research, the authors find that “the higher prices charged by larger audit firm tiers (Big 4 and Second Tier) are associated with superior quality relative to Small Auditors.” Due to the wide variety of firms included in the Small Auditors segment, however, the authors also look among firms in each category to further investigate the relationship between auditor premiums and audit quality.
When the authors looked within each tier to examine the relationship between premiums and quality, they found substantial variation between pricing and audit quality within the Small Auditor segment. This level of variation is absent among Big 4 and Second Tier auditors and is likely due to the wide range of firms included in the Small Auditor segment. Because of this, the authors warn against grouping auditors in broad tiers in future research, as this method does not fully capture variation in pricing and audit quality.
Evidence shows that audit firm identity, not office, industry, or tier, more strongly identifies quality-related pricing for auditors both large and small. Companies seem to get what they pay for, for the most part, both across auditor tiers and among third-tier audit firms. In other words, Big 4 and Second Tier auditors generally conduct higher-quality audits than Small Auditors, but the relationship between audit quality and price especially varies among Small Auditors – showing the importance of firm identity outside of tier designation.
SOX Changed Everything…Or Did It?
In the wake of the Enron scandal, the accounting industry and regulators faced substantial pressure to improve the audit landscape. The Public Company Accounting Oversight Board (PCAOB), created in 2002 from the SOX Act, ended the self-regulation of the auditing profession. This has led to an improvement in audit quality, on average, by forcing poor-quality auditors out of the market. Auditor premiums, on the other hand, have remained steady during this period. This means that the quality benefits of auditor premiums have decreased over time.
Paying more for an audit a few years ago may have resulted in higher audit quality, but that is less likely to be the case in recent years given the convergence of audit quality and price. Because the quality returns of higher fee premiums have decreased, companies are less willing to pay for higher-priced audits.