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.