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

Authors


  • Accepted by Christian Leuz. We appreciate the comments received from an anonymous reviewer, Ray Ball, Jan Bouwens, Monica Causholli, Ann Gaeremynck, Kris Hardies, Steven Huddart (the discussant), Henry Jarva, Anders Johansson (the CEO of Ratsit AB), Karla Johnstone, Juha Kinnunen, Justin Leiby, Roger Meuwissen, Caren Schelleman, Don Stokes, Greg Trompeter, Christophe Van Linden, Ann Vanstraelen, Marleen Willekens, and Michael Willenborg. We would also like to thank the participants at the 47th annual Journal of Accounting Research Conference at the University of Chicago Booth School of Business and ISAR Tokyo. We are grateful for the workshop participants at the University of Auckland, Monash University, University of New South Wales, HEC Montreal, ESSEC Paris, University of Florida, University of Central Florida, Katholieke University of Leuven, Maastricht University, and University of Jyväskylä. Special thanks go to Alexander Karnebrink Scott from Finansinspektionen (The Swedish Financial Supervisory Authority) for providing us with access to the insider files and to Professor Emeritus Markku Rahiala for his help in statistical issues. Mikko Zerni also gratefully acknowledges the financial support received from the Emil Aaltonen Foundation, the Finnish Foundation for the Advancement of Securities Markets, and NASDAQ OMX Nordic Foundation. This research is part of the research project of Academy of Finland Grant Numbers 140000 and 126630. All remaining errors are our own.

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.

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