Audit-Firm Profitability: Determinants and Implications for Audit Outcomes

Abstract

We use a novel dataset that links audit-firm and client-firm financial statement information from the U.K.’s largest audit firms to examine drivers of audit-firm profitability and its implications for audit outcomes. We first explore the determinants of audit-firm profitability and conclude that Big-4 and non-Big-4 audit firms have fundamentally different profitability structures. Big-4 firms have higher profit margins than non-Big-4 firms. Furthermore, Big-4 profitability increases with client size and complexity, while non-Big-4 profitability is higher for smaller, private-firm clients. Next, we examine the relation between audit-firm profitability and audit outcomes. Using a battery of alternative outcome measures, we find that more profitable audit firms deliver higher audit quality. In supplemental analyses we show that the positive relation between audit-firm profitability and audit outcomes is generally stronger for more influential and illiquid clients (i.e. when auditors are exposed to more litigation risk). Our inferences are robust to several endogeneity controls, such as using an instrumental variables approach, controlling for client-firm and audit-firm fixed effects, employing lead-lag and changes specifications, and assessing bias from correlated omitted variables. Our study contributes to the literature by being the first to provide insights into audit-firm profitability and examine in detail its implications for audit quality.

Keywords:

• Auditing
• Audit firms
• Audit-firm profitability
• Private firms
• Audit quality
• Audit effort

Acknowledgements:

Accepted by Beatriz García Osma. We thank Beatriz Garcia Osma (editor) and two anonymous reviewers for their valuable guidance. We also appreciate helpful comments from Ruby Brownen-Trinh, Brian Bushee, Chris Chapman, Antti Fredriksson (discussant), Kris Hardies (discussant), Victor Jarosiewicz (discussant), Shushu Jiang, Sonia Konstantinidi, Leting Liu, Gilad Livne, Sangwook Nam, Alina Pugacheva (discussant), Hannu Schadewitz, Xijiang Su, Joseph Zhang (discussant), and workshop participants at Rotman School of Management, the University of Turku, Norwegian School of Economics, Bayes Business School, Bocconi University, the 2020 PCAOB conference, the 2021 Auditing Section Midyear Meeting, the 2021 International Accounting Section Midyear Meeting, the 2021 EAA Annual Congress, the 2021 HEC-ESSEC joint workshop, and the 2022 BAFA SWAG Annual Conference. Anastasios Elemes gratefully acknowledges the financial support of the ESSEC Research Center. Additional materials are available in an online Supplement at the journal’s Taylor and Francis website.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Specifically, Paul George, head of the Financial Reporting Council’s Professional Oversight Board, expressed concerns that a general downturn in audit work during the financial crisis might see firms concentrate on their bottom line at the expense of audit quality and that cost cuts could promote a culture where audit firms’ own business growth is more important than audit quality. ‘Any prolonged reduction in investment in audit, be it recruitment, training or investment in systems or any behavioral changes to a realignment of personal objectives will have a long-term impact on audit quality’, he said (https://www.accountancyage.com/2009/11/12/audit-quality-under-pressure-as-firms-cut-costs/).

2 Che et al. (2020) make use of detailed register data in Norway to examine how Big-4 firms provide higher audit quality than non-Big-4 firms. Such data are not available in most jurisdictions.

3 For example, in 2019, KPMG U.K., under profitability concerns, stepped up its cost-cutting drive by asking hundreds of its employees working in IT and legal teams to hand in their work mobile phones.

4 We note that the interview-based assessment (date of interview: April 15, 2022) reflects the anonymous Deloitte director’s own viewpoints about the relation between audit-firm profitability and audit quality. We suggest that caution be exercised in interpreting this anecdotal evidence as the personal viewpoints may not generalize to other audit partners and/or audit firms.

5 For instance, on p. 1 of the 2016 financial statements of PwC U.K. it is explicitly stated that partners at PwC U.K. receive a distribution of the profits of the LLP (i.e. the profits of the consolidated entity). Specifically, at PwC U.K. each partner’s profit share comprises three interrelated profit-dependent components: (1) responsibility income – reflecting the partner’s sustained contribution and responsibilities, (2) performance income – reflecting how a partner and their team(s) have performed, and (3) equity unit income – reflecting the overall profitability of the LLP. The argument that audit-partner compensation is a function of audit-firm profitability is consistent with Vandenhaute et al. (2020) and Alberti et al. (2020) who suggest that audit-partner compensation structure and audit-firm culture are dominated by commercial logic.

6 Hay et al. (2007) document that audit firms with profit-sharing arrangements at the national level are associated with riskier client portfolios. However, shifting toward riskier clients may not necessarily impact the supply of audit quality.

7 In 2020, the Financial Reporting Council in the U.K., aiming to reduce potential conflicts of interest and boost the quality of audits, requested that large audit firms separate audit and non-audit services by June 2024. See https://www.wsj.com/articles/u-k-regulator-orders-big-four-to-separate-audit-practices-by-2024-11594070565?mod=article_inline for details. However, empirical evidence is mixed on the relation between non-audit services and audit quality (i.e. Frankel et al. (2002); Ashbaugh et al. (2003); Svanström (2013)).

8 Bowen et al. (1995) find that income-increasing earnings management is more prevalent for firms that depend more on implicit claims with their stakeholder groups, such as customers, suppliers, and employees. Similarly, Raman and Shahrur (2008) find that earnings management is used opportunistically to influence the perception of suppliers and customers about the firm’s prospects.

9 Audit firms are private firms. Therefore, they are required to comply with the Fourth EU Directive and its amendments that mandate the financial statement disclosure and audit of all private firms that meet certain size criteria. To identify audit firms in FAME we limit our sample to those private firms that engage in accounting, bookkeeping, auditing, and tax consultancy activities (Peer group code: 6920). We subsequently manually match the company name field (i.e. the audit-firm name field) in the audit-firm sample with the auditor name field in the client-firm sample.

10 https://www.gov.uk/audit-exemptions-for-private-limited-companies

11 We present the correlations between client-firm outcome measures and audit-firm variables in Online Appendix II. We find that EBIT Margin AF is significantly negatively (positively) correlated with |DACC| CF, AQ CF, and Restatement CF (Unexp. KAMs CF). Furthermore, we find a positive and insignificant correlation coefficient between EBIT Margin AF and Qualified CF. The bivariate results, therefore, provide initial support for our hypothesis.

12 Inferences are unchanged if we repeat our estimations of models 3 and 4 using OLS (instead of logit) techniques.

13 In untabulated analyses we repeat our estimations of equation (2)(2) $\begin{array}{rl}AuditQualit{y}_{i,j,t}& ={\alpha }_0+{\alpha }_{1}EBITMarginA{F}_{\mathbf{j},\mathbf{t}}+{\alpha }_{2}LnEmplA{F}_{j,t}+{\alpha }_{3}LnCashA{F}_{j,t}\\ & +{\alpha }_{4}IntangiblesA{F}_{j,t}+{\alpha }_{5}IndSpecA{F}_{j,t}+{\alpha }_{6}Big{4}_{j,t}+{\alpha }_{7}PublicC{F}_{i,t}\\ & +{\alpha }_{8}LnAssetsC{F}_{i,t}+{\alpha }_{9}LeverageC{F}_{i,t}+{\alpha }_{10}ROAC{F}_{i,t}+{\alpha }_{11}LossC{F}_{i,t}\\ & +{\alpha }_{12}RecInvC{F}_{i,t}+{\alpha }_{13}StdSalesC{F}_{i,t}+{\alpha }_{14}NonAuditFeesRatioC{F}_{i,t}\\ & +{\alpha }_{15}InfluentialC{F}_{i,t}+{\alpha }_{16}LnNumSubsC{F}_{i,t}+{\alpha }_{17}AuditorSwtichC{F}_{i,t}\\ & +YearFixedEffects+IndustryFixedEffects+{ϵ}_{i,t}\end{array}$(2) separately for Big-4 and non-Big-4 auditors. We find that, despite different profitability structures of Big-4 and non-Big-4 audit firms, the implications of their firm-level profitability for audit outcomes are similar.

14 Inferences remain unchanged when we repeat our estimations of Table 4 for a reduced sample that excludes the Covid period and spans from 2008 to 2019.

15 We perform several tests to examine the validity of our instrument following the approach described by Larcker and Rusticus (2010). In the first-stage regression of audit-firm profitability on our instrument and all controls in equation (2)(2) $\begin{array}{rl}AuditQualit{y}_{i,j,t}& ={\alpha }_0+{\alpha }_{1}EBITMarginA{F}_{\mathbf{j},\mathbf{t}}+{\alpha }_{2}LnEmplA{F}_{j,t}+{\alpha }_{3}LnCashA{F}_{j,t}\\ & +{\alpha }_{4}IntangiblesA{F}_{j,t}+{\alpha }_{5}IndSpecA{F}_{j,t}+{\alpha }_{6}Big{4}_{j,t}+{\alpha }_{7}PublicC{F}_{i,t}\\ & +{\alpha }_{8}LnAssetsC{F}_{i,t}+{\alpha }_{9}LeverageC{F}_{i,t}+{\alpha }_{10}ROAC{F}_{i,t}+{\alpha }_{11}LossC{F}_{i,t}\\ & +{\alpha }_{12}RecInvC{F}_{i,t}+{\alpha }_{13}StdSalesC{F}_{i,t}+{\alpha }_{14}NonAuditFeesRatioC{F}_{i,t}\\ & +{\alpha }_{15}InfluentialC{F}_{i,t}+{\alpha }_{16}LnNumSubsC{F}_{i,t}+{\alpha }_{17}AuditorSwtichC{F}_{i,t}\\ & +YearFixedEffects+IndustryFixedEffects+{ϵ}_{i,t}\end{array}$(2) , the partial F-statistic of the instrument ranges between 724.15 and 3,689.35 (depending on the specification). These values are well above the thresholds recommended by Stock et al. (2002). We further report a p-value of less than 0.05 for both the Anderson-Rubin Wald test and the Stock-Wright LM S statistic (OLS regressions) in all but one specification. The null hypothesis assessed in both cases is that the coefficients of the endogenous regressors in the structural equation are jointly equal to zero, and, in addition, that the over-identifying restrictions are valid. Finally, using the Hansen J test for over-identifying restrictions (OLS regressions), we fail to reject the null hypothesis that the instrument is exogenous (the p-value is 1.00 in all specifications). These tests enhance our confidence about the validity of our instrument.

16 In untabulated analyses, we repeat our estimations of equation (3)(3) $\begin{array}{rl}AuditQualit{y}_{i,j,t}& ={\alpha }_0+{\alpha }_{1}EBITMarginA{F}_{j,t}+{\alpha }_{2}EBITMarginA{F}_{j,t}\times InfluentialC{F}_{i,t}\\ & +{\alpha }_{3}InfluentialC{F}_{i,t}+Controls+YearFixedEffects\\ & +IndustryFixedEffects+{ϵ}_{i,t}\end{array}$(3) for the instrumented audit-firm profitability estimated in section 5.2. We find a significantly negative (positive) coefficient on Instrumented EBIT Margin AF × Influential CF when we measure audit quality using AQ CF (Qualified CF). The coefficient on Instrumented EBIT Margin AF × Influential CF is indistinguishable from zero in all other specifications.

17 Audit litigation can be serious enough to threaten the viability of even the largest and most profitable audit firms. Research finds compelling evidence that audit firms consider litigation risk in the planning stages of the audit and in the pricing of audit services (e.g. Simunic (1980); Ewert et al. (2000); Simunic and Stein (1996); Gietzmann and Pettinicchio (2014); Bigus (2015); Elemes and Chen (2020)).

18 In untabulated analyses, we repeat our estimations of equation (4)(4) $\begin{array}{rl}AuditQualit{y}_{i,j,t}& ={\alpha }_0+{\alpha }_{1}EBITMarginA{F}_{j,t}+{\alpha }_{2}EBITMarginA{F}_{j,t}\\ & \times IlliquidC{F_{i,}}_t+{\alpha }_{3}IlliquidC{F}_{i,t}+Controls+YearFixedEffects\\ & +IndustryFixedEffects+{ϵ}_{i,t}\end{array}$(4) for the instrumented audit-firm profitability estimated in section 5.2. We find that the coefficient on Instrumented EBIT Margin AF × Illiquid CF is significantly positive when we measure audit quality using Qualified CF and Unexp. KAMs CF. The coefficient on Instrumented EBIT Margin AF × Illiquid CF is indistinguishable from zero in all other specifications.

19 Higher employee cost may also indicate higher quality human capital or more generous compensation schemes. In both scenarios we predict a positive association between cost of employees and audit quality through higher auditor skill or higher auditor independence.

20 When we examine the association between all other costs and audit outcome, we find no systematic association between that cost component and audit quality.