Do Big Four Auditors Unfairly Raise Fees?

By David McCann for CFO.com

Should length of tenure for a company’s auditor make a difference to investors and other stakeholders?

Some new research suggests it should — particularly when the auditor is among the Big Four public accounting firms. It’s a fairly timely topic, as U.S. public companies are now required to disclose in their annual reports the length of auditor tenure. The rule is effective for fiscal years ending on or after Dec. 15, 2017.

Opposition to auditor term limits has been “the subject of active lobbying by the accounting profession, especially the Big 4 audit firms,” notes a scholarly paper in the June issue of Accounting Horizons, a journal of the American Accounting Association.

The most prevalent explanation the lobbyists provide is that “clients benefit from superior audit quality rendered over longer audit firm tenure,” the paper adds.

The authors, Aloke Ghosh and Subprasiri Siriviriyakul of the City University of New York’s Baruch College, offer a strikingly different explanation for the Big Four’s opposition to auditor term limits. That is, those firms — but not their smaller counterparts — charge a sizable, tenure-linked fee premium, the study documents.

Additionally, “less audit effort is needed to provide the desired level of assurance as tenure lengthens,” the paper says.

In contrast, smaller auditing firms do not earn such “quasi-rents,” the professors write.

“Our findings, we believe, reflect lack of competition and absence of lowballing among the Big 4,” Ghosh says. “The principal concern is not that the multibillion-dollar corporate clients of the Big 4 can’t afford the premiums charged by their auditors. It’s that when fees are increasing over time and accounting firms envision engagements extending well into the future, audit independence could very well be threatened.”

Indeed, recent corporate disclosures reveal that among the largest corporate clients, auditor engagements commonly stretch over many decades. For example, among the first 21 companies of the Dow 30 to release their reports this year, the average auditor tenure is 66 years.

According to the new study, Big Four audit fees increase by an average of 13% between the first engagement year and the second; by about 22% between the first year and the third; and up to 32% above the original fee by year 14.

Three considerations, Ghosh contends, raise doubts about the legitimacy of these increases.

First, he says, this pattern of fee raises is particular to the Big Four. Among the hundreds of other accounting firms making up the study’s sample, audit fees on average remained about level or even fell slightly with lengthening tenure.

Second, the fee increases imposed by the Big Four are not attributable to greater workloads that may result as client firms grow bigger or more complex, since the study controls for such factors.

Third, far from workloads growing over time, average work requirements decline as auditor tenure increases. The study reaches this conclusion based on “audit-report lag,” the amount of time from the end of firms’ fiscal years to issuance of their annual financial reports.

That period, the authors reason, should “become shorter, as audit firms are able to complete audit testing more efficiently and provide the desired level of assurance with less audit effort.”

Controlling for an array of factors that can affect audit workload, the professors find that audit-report lag diminishes by about 6% between years one and three, 10% by year five, and 16% by year nine.

The study draws on audit-firm tenure and pricing information spanning the 14-year period from 2000 (when audit-fee information was first made available by a major financial database) through 2013.

In all, the study’s analysis comprises 21,855 company-years worth of data from continuous relationships between audit firms and corporate clients, with audits divided about equally between Big Four and non-Big Four firms.

In conclusion, the professors say, the study results “suggest a need to better monitor auditor independence and audit judgments when tenure is long.”