Julia Irvine 22 May 2018 10:47am

Big Four in US use lucrative audit fee structure

The US profession’s argument against capping audit tenure has been brought into question by academic research which equates the Big Four’s tenure-linked fee premium to “quasi rents”

Professors Al Ghosh and Subprasiri Siriviriyakul of Baruch College of the City of New York University point out that the longer the Big Four stay as a company’s auditors – and the average length of tenure for the first 21 of the Dow 30 companies to publish their reports this year is 66 years – the more lucrative the proposition becomes.

“Big Four audit firms earn quasi rents [the magnitude of which] increases with tenure because Big Four firms charge a sizeable tenure-linked fee premium…and [also] because less audit effort is needed to provide the desired level of assurance as tenure lengthens,” they say.

The study, which is published in the June issue of the American Accounting Association’s Accounting Horizons, reveals that Big Four audit fees increase by an average of 13% between the first and second year of tenure and by around 22% between the first and third year.

By year 12 the fees are usually around 28% above the original fee and 32% above it by year 14.

The academics found that this pattern of fee hikes is exclusive to the Big Four. Among the hundreds of other firms in the survey, audit fees tend to remain level or even decrease the longer the audit appointment continues.

The Big Four fee increases do not relate to a heavier workload resulting from clients becoming larger or more complex. In fact, the academics found the opposite: that the workload lessens as the length of tenure increases.

After taking into account a range of factors that can affect the audit workload, they discovered that audit report lag – the time from the end of the company’s financial year to publication of the annual financial report – falls by around 6% between years one and three, by around 10% by year five, by about 14% by year six and by around 16% by year nine.

In other words, the professors say, “Big Four audit firms charge a sizeable tenure-linked fee premium [even as] less audit effort is needed…

“Although audit costs decline with longer tenure for non-Big Four firms, they tend to offer a tenure-linked fee discount which offsets some of the benefits of lower audit costs… Ultimately, the benefits of longer tenure, if any, are relatively small for non-Big Four audit firms.”

Since 15 December 2017, all US listed companies have been required to disclose in their annual reports how long they have had their incumbent external auditors.

The professors have used this information and some 21,855 company-years’ worth of data from continuous relationships between audit firms and corporate clients, with audit divided roughly 50/50 between Big Four and other audit firms.

“Our findings, we believe, reflect lack of competition and absence of lowballing among the Big Four,” said Ghosh.

“The principal concern is not that the multi-billion-dollar corporate clients of the Big Four 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.”

This conclusion tends to undermine the profession’s argument that clients “benefit from superior audit quality rendered over longer term audit tenure”.

It also adds to the growing case in support of mandatory rotation of audit. Last month, academic research from Zvi Singer of HEC Montreal and Jing Zhang of the University of Alabama in Huntsville revealed that auditors discover misstatements far more quickly within the first three years of an audit appointment but, by the time 10 years are up, the quality of their audit is beginning to wane.

Singer and Zhang argue that, if US regulators are looking to mandate auditor rotation, the maximum period of engagement should be set at less than 10 years.