Empirical Evidence on the Implicit Determinants of Compensation in Big 4 Audit Partnerships

Abstract

This study investigates the implicit financial incentives of individual Big 4 audit partners by examining the association between a partner's compensation and characteristics of the audit firm, audit partner, and individual partner clientele for Big 4 firms in Sweden. Using tax and financial data for individual audit partners and clients, our empirical findings indicate that there is significant variation in the implicit determinants that are associated with compensation across the Big 4. We find that audit partners’ compensation is positively associated with the size of their clientele or the number of publicly traded clients, both of which represent revenue‐generating opportunities. Similarly, compensation and developing an industry specialization are positively related. In three firms, gaining clients is clearly related to an increase in compensation, while losing a client is associated with a reduction in partner income in only one firm. We find that audit partner income is more sensitive to performance‐related incentives, such as attracting new clients, as partners progress in their career. Finally, we find evidence that audit failures, proxied by reporting errors related to issuing a going concern opinion, are associated with lower compensation. These results should be of interest to the auditing profession, audit firms, and regulators when they consider the effects of implicit incentives of partner compensation on audit quality.

Comments by the Auditing Standards Committee of the Auditing Section of the American Accounting Association on the PCAOB Rulemaking Docket Matter 029: PCAOB Release No. 2011-007, Improving Transparency Through Disclosure of Engagement Partner and Certain Other Participants in Audits

“…For example, Chi et al (2011) find that an audit partner's pre-client and client-specific experience is associated with higher earnings quality and creditors' perceptions of higher audit quality. Knechel et al (2011) show that partner compensation policies affect audit quality in Swedish clients. Hence, investors may find this information useful.…”

Economic consequences of public oversight of the auditing profession

“…Even though advances in audit technology have rendered auditing less labor intensive (Elliott 1998), human resource compensation is still a major part of audit fees (Knechel et al 2013). Audit firms have flexibility in adjusting human resource inputs as a result of excess capacity, shifts of resources from non-public clients, and new employee hires.…”

IQ and Audit Quality: Do Smarter Auditors Deliver Better Audits?

“…An auditor's cognitive ability may matter for audit quality because auditing is a complex process that requires many subjective judgments and decisions on the part of the auditor at all stages of the audit engagement, from the planning of the audit to the formation of the audit opinion (Hogarth ; Knechel ). Smart auditors also have incentives to exercise their cognitive skills to deliver high‐quality audits because they are rewarded for high‐quality audits and penalized for audit failures (Knechel et al ).…”