Inferior audit quality and high tax avoidance among Big 4 private client firms
The term “David and Goliath'' has entered our language as a metaphor for the improbable and unexpected victories of a weak party over a much stronger opponent. In the audit context, the weak party would be the non-Big 4 accounting firms for which existing research finds consistent and robust evidence that they fall behind the Big 4 auditors (KPMG, Deloitte, PwC, EY) in terms of the quality of the audit services they offer to publicly listed clients. Recent research, however, by Anastasios Elemes (ESSEC Business School), Jeff Zeyun Chen (Texas Christian University), and Gerald J. Lobo (University of Houston) (1) suggests that this assumption does not hold true for private client firms. Instead, it is the Big 4 auditors that deliver inferior audit quality, focusing instead on helping their private-firm clients avoid taxes.
Private firms contribute enormously to the global economy: in Europe, they comprise 99% of all businesses and hire two thirds of private sector jobs (2). Private firms tend to face less scrutiny on their financial reporting than public firms do. Furthermore, they prioritize tax planning optimization (in other words, reducing taxation) over financial reporting quality. This means they may seek out auditors that will help them maximize tax savings even if that happens at the expense of audit quality. It’s commonly thought that hiring Big 4 auditors ensures high quality financial reporting, and the research team sought to explore whether this assumption extends to the private-firm market.
The researchers suggested that Big 4 accounting firms would offer lower audit quality than non-Big 4 accounting firms in the private-firm market. Why? Past research (3) suggests that Big 4 and non-Big 4 auditors have different priorities: Big 4 auditors do better with restricting upward earnings management, but are less likely to restrict downward earnings management, which is often used to defend aggressive tax positions. Client-firm demand for income-decreasing earnings management is stronger among private client firms than is among public client firms. There is also a lower litigation risk for income-decreasing earnings management and lower overall litigation risk in the private-firm market.
The researchers looked at the financial statements of a sample of over 21 000 UK private firms between 2010 and 2016. To determine audit quality, they looked at accruals quality measures for earnings management and accrual estimation errors. They found that the Big 4 auditors are more accepting of lower audit quality. Furthermore, Big 4 client firms avoid more taxes than non-Big 4 client firms.
The researchers also took a look at whether a firm’s organizational structure played a role in this relationship. They identified two types of private firms:
standalone firms that have weak demand for high quality financial reporting
business groups that have stronger demand for financial reporting quality and are less likely to sacrifice high quality financial reporting for tax purposes
They found that there is less difference in audit quality between Big 4 and non Big-4 firms for business groups, suggesting that this is linked to the tendency of Big 4 firms to be more receptive to clients’ requests on quality.
It’s important to consider other factors: there may be other explanations for why audit quality is lower among Big 4 client firms, such as Big 4 firms being more conservative or responding to stakeholder incentives.
What does this tell us about the bang for your buck you get with an audit firm?
This research gives us additional information on the idea that Big 4 firms should deliver higher quality audits than non-Big 4 firms, a commonly held perception. In fact, the results indicate that Big 4 private firm clients have lower audit quality than non-Big 4 firms. Further, the results suggest that Big 4 business groups have higher quality audits than do Big 4 standalone private client firms, and that hiring a Big 4 auditor may still be a strategy for obtaining high-quality financial reporting for business groups. While Big 4 auditors tend to produce reports with reduced earnings informativeness, the tax savings are often worth it.
This is also useful for regulators and other stakeholders. The tradeoff between earnings informativeness and tax minimization makes a good argument for increased transparency and regulations of audit services. It also highlights why it’s so important to understand the reporting incentives of private firms and how they choose an auditor.
If Big 4 auditors deliver lower audit quality than their non-Big 4 counterparties, does this mean that Big 4 audit quality is low in the private-firm market? The authors suggest that this is not necessarily the case. Most likely, Big 4 auditors still deliver sufficiently high levels of audit quality. Their audit services are strategically differentiated to better meet the needs of their private-firm clients and allow them to charge an audit fee premium over smaller accounting firms.
Chen, J.Z., Elemes, A. and Lobo, G.J. (2021). David versus Goliath: The Relation between Auditor Size and Audit Quality for U.K. Private Firms. European Accounting Review, In press.
Vanstraelen, A., & Schelleman, C. (2017). Auditing private companies: What do we know? Accounting and Business Research, 47(5), 565–584. https://doi.org/10.1080/00014788.2017.1314104
Kim, J.-B., Chung, R., & Firth, M. (2003). Auditor conservatism, asymmetric monitoring, and earnings management. Contemporary Accounting Research, 20(2), 323–359. https://doi.org/10.1506/J29K-MRUA-0APP-YJ6V