Do Audit Personnel Salaries Impact Audit Quality? Jeffrey L. Hoopes - - PowerPoint PPT Presentation

Do Audit Personnel Salaries Impact Audit Quality?

Jeffrey L. Hoopes Kenneth J. Merkley Joseph Pacelli Joseph H. Schroeder Illinois 22nd Symposium on Audit Research October 14, 2016

Team HMPS

Jeff Hoopes University of NC Ken Merkley Cornell University

11/15/2016

Joseph Pacelli Indiana University

Motivation: Increasing Expectations

PCAOB focused on high quality audits Audit quality is a function of process and people Since 2004

• Amount of work has increased significantly
• Personnel tasked with increasing responsibilities
• Increased time pressure to complete audits
• Increased pressure to perform high quality audits

Financial Accounting and Disclosure is becoming more complex

Motivation: What Audit Firms Need

Big 4 recruiters want students that have the following skills:

• Critical thinking ability
• Professional skepticism
• Soft skills
• Data analytic skills

PwC white paper on accounting curriculum

• Advanced statistics
• Econometrics
• Programming ability

Audit firms aim to attract the best and the brightest professionals

Motivation: What Audit Firms Need

“Our reputation depends on hiring the most talented professionals available and, in turn, our reputation for quality enables us to attract the best candidates” (PwC 2015) “Retention is critical to achieving sustained audit quality. Our strategies for hiring and developing the best and the brightest in the profession become irrelevant if our professionals choose to leave the firm” (PwC 2014)

Motivation: Current Hiring Environment

Auditors’ real salaries have remained flat the past decade Emergence of high growth consulting practices Students shifting from audit to consulting Students shifting from Big 4 to alternative career paths Audit fee growth has been slow or flat

Research Questions

How does audit personnel salaries relate to audit quality? Are audit firms able to pass on differences in audit personnel salaries to their clients via audit fees?

Audit Personnel Quality/Motivation (Salary as obtained from H1-B visas) Audit Office Quality (Average audit office client portfolio misstatement rate) Audit Office Pricing (Average audit fees for office)

+/- +/-

Prior Research

Audit Partner Compensation studies

• Sweden partner compensation ~ Knechel et al. 2013
• U.S. partner compensation plans ~ Carcello et al. 2000

Human Capital Studies

• Audit quality higher in cities with better human capital (i.e. education) ~

Beck et al. 2016

Audit Office Size

• Larger offices provide higher quality audits ~ Francis and Yu 2009

Foreign Labor

• Does not impact overall office salaries or fees ~ Aobdia et al. 2016

Prior Research

PwC (2015) Report

• 1 hour of partner time = 20.2 associate hours
• 1 hour of partner time = 3.9 manager hours

Limited research on rank-in-file personnel

• Partners overestimate lower level personnel ability ~ Messier et al.

2008

Audit Personnel Compensation is a “Black Box” with limited data availability

The job decision: Almer, Higgs and Hooks 2005 BRIA

Salary

H1: Audit Salary and Audit Quality

Higher wages:

1.

Attract more skilled and capable workers

2.

Motivate existing personnel to perform better

Higher Salaries Better and more motivated employees Higher office level audit quality

The job decision: Almer, Higgs and Hooks 2005 BRIA

Professional Development Deferred Compensation Work Life Balance Value to Society & Profession Salary

H1: Audit Salary and Audit Quality

Trade-off salary for future opportunities and professional training/development Audit process is quite standardized, thus rank-in-file employees might not matter There may be no effect or even a negative effect

H2: Audit Salary and Audit Fees

Profit maximizing firm should increase audit fees (i.e. revenues) if salaries (i.e. costs) are increasing Higher Audit Fees

• Clients demand for higher audit quality ~ Francis et al. 2005; Allee and

Yohn 2009; Minnis 2011

No Effect on Audit Fees

• Audit industry is competitive and commoditized ~ IFIAR 2014
• Clients do not have the ability to pay higher audit fees

Hypotheses

H1: Audit personnel salaries are not associated with audit quality H2: Audit personnel salaries are not associated with audit fees

Data and Sample

H1-B Visas required for all foreign employees Obtained via FOIA Application provides the following:

• Audit firm
• Office location
• Job title (i.e. audit, tax, consulting)
• Rank
• Date of application/hire

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Data and Sample

11,536 H1-B Visas (2004 to 2013) Audit personnel salaries =

• Avg. of H1-B Visas by audit-office-

year Compute measures by rank

• Associate/Staff
• Senior
• Manager

Restrict to Big 4 Audit Firms

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Data and Sample

Validate data by: 1) Comparing staff/associate salaries to University Hiring Data 2) Salary guides

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Data Sources and Dependent Variable

Data Sources

• Compustat
• Audit Analytics
• FBI, Zillow, Bureau of Labor Statistics

Office Audit Quality Measure

• Percent of clients within the office that experience a misstatement,

restated in future periods

Sample period 2004 to 2013

Multivariate Models

LNSALARY = β0 + β1RANK + β2JOBCOMPLX + β3AUDMKTSHR + β4OFFICE_AQ + β5LNHOMEP + β6LNPOP + β7VCRIME + β8EDUCATION + year indicators + ε RESTATE% = β0 + β1LNSALARY + β’s(Controls for client characteristics that determine misstatements) + β’s(Controls for MSA characteristics) + Rank FE + Year FE + MSA FE + ε

Analysis 1: Determinants Model Analysis 2: Quality Model (Test of H1) Analysis 3: Fee Model (Test of H2)

LNFEES = β0 + β1LNSALARY + β’s(Controls for client characteristics that determine fees) + β’s(Controls for MSA characteristics) + Rank FE + Year FE + ε

Multivariate Models

Aggregation at the H1-B visa application level

• Allows us to examine ranks pooled together
• Allows us to better examine economic factors associated with salary
• Standard errors clustered by audit-office and year

Further aggregation for audit quality analysis

• MSA level
• Client level

Observations by year

Year # of Observations % of Sample 2004 806 7.0% 2005 900 7.8% 2006 1,105 9.6% 2007 1,560 13.5% 2008 1,340 11.6% 2009 1,175 10.2% 2010 1,009 8.7% 2011 1,344 11.7% 2012 1,416 12.3% 2013 881 7.6% TOTAL 11,536 100%

Observations by Audit Firm

Year # of Observations % of Sample PwC 1,046 9.1% Ernst & Young 4,752 41.2% Deloitte 2,761 23.9% KPMG 2,977 25.8% TOTAL 11,536 100%

Observations by MSA

Year # of Observations % of Sample New York-Newark-Edison, NY-NJ-PA 3,468 30.1% San Jose-Sunnyvale-Santa Clara, CA 823 7.1% Los Angeles-Long Beach-Santa Anna, CA 810 7.0% Boston-Cambridge-Quincy, MA-NH 660 5.7% San Francisco-Oakland-Freemont, CA 595 5.2% Washington-Arlington-Alexandria, VA-MD 584 5.1% Houston-Baytown-Sugar Land, TX 524 4.5% Dallas-Fort Worth-Arlington, TX 445 3.9% Philadelphia-Camden-Wilmington, PA-NJ-DE 417 3.6% Atlanta-Sandy Springs-Marietta, GA 415 3.6% Other MSA 2,795 24.2% TOTAL 11,536 100%

Auditor Pay Across Time

Auditor Pay Across Time

Pooled PwC EY Deloitte KPMG Associate $ $54,919 $60,034 $55,465 $51,604 $54,440 Associate N 5,547 505 2,702 1,036 1,304 Senior $ $72,193 $72,410 $75,387 $65,939 $73,349 Senior N 4,267 369 1,571 1,051 1,276 Manager $ $87,082 $90,355 $94,308 $74,771 $97,845 Manager N 1,722 172 479 674 397

Analysis 1: Determinants of Auditor Pay

Analysis 1: Determinants of Auditor Pay

Analysis 2: Auditor Salary and Audit Quality

Pred. Sign Full Sample Coef. (t-stat) Associates Coef. (t-stat) Seniors Coef. (t-stat) Managers Coef. (t-stat) LNSALARY +/-

• 0.0254***
• 0.0298***
• 0.0200***
• 0.0369***

(-3.77) (-3.16) (-2.90) (-3.09) Controls Yes Yes Yes Yes Rank FE Yes Yes Yes Yes Year FE Yes Yes Yes Yes Observations 11,536 5,547 4,267 1,722 R2 0.182 0.186 0.196 0.204

Analysis 2: Auditor Salary and Audit Quality with MSA fixed effects

Pred. Sign Full Sample Coef. (t-stat) Associates Coef. (t-stat) Seniors Coef. (t-stat) Managers Coef. (t-stat) LNSALARY +/-

• 0.0202***
• 0.0268***
• 0.0172***
• 0.0280***

(-3.16) (-3.03) (-2.59) (-2.58) Controls Yes Yes Yes Yes MSA FE Yes Yes Yes Yes Rank FE Yes Yes Yes Yes Year FE Yes Yes Yes Yes Observations 11,536 5,547 4,267 1,722 R2 0.182 0.186 0.196 0.204

Analysis 2: Auditor Salary and Audit Quality Aggregation at MSA Audit Office Level (OLS)

Pred. Sign Associates Coef. (t-stat) Seniors Coef. (t-stat) Managers Coef. (t-stat) LNSALARY +/-

• 0.0811**
• 0.0276
• 0.0619***

(-2.52) (-1.34) (-3.04) Controls Yes Yes Yes MSA FE Yes Yes Yes Rank FE Yes Yes Yes Year FE Yes Yes Yes Observations 1,009 805 525 R2 0.260 0.248 0.466

Analysis 2: Auditor Salary and Audit Quality Aggregation at client level (logistic regression)

Pred. Sign Associates Coef. (t-stat) Seniors Coef. (t-stat) Managers Coef. (t-stat) LNSALARY +/-

• 0.5988**
• 0.4037*
• 0.6362***

(-1.85) (-1.79) (-2.62) Controls Yes Yes Yes MSA FE Yes Yes Yes Rank FE Yes Yes Yes Year FE Yes Yes Yes Observations 16,410 14,465 10,413 Pseudo R2 0.087 0.089 0.094

Analysis 3: Auditor Salary and Audit Fees

Pred. Sign Full Sample Coef. (t-stat) Associates Coef. (t-stat) Seniors Coef. (t-stat) Managers Coef. (t-stat) LNSALARY +/- 0.0376** 0.0862*** 0.0328*

• 0.0129

(2.20) (3.48) (1.87) (-0.47) Controls Yes Yes Yes Yes Rank FE Yes N/A N/A N/A Year FE Yes Yes Yes Yes Observations 11,536 5,547 4,267 1,722 R2 0.832 0.829 0.842 0.844

Future Analyses

Examine the difference between consulting and audit salaries

• Using average consulting salary for MSA
• Using average of consulting within audit office-year

Examine other fixed effects

• Auditor fixed effects
• MSA-year fixed effects

Limitations

H1-B visa data may not “perfectly” reflect actual audit personnel salaries Sample only available for audit offices that have an H1-B visa Imperfect measures of audit quality May not fully disentangle motivation vs. attracting high quality labor

In Summary

Audit personnel salaries

• Increasing in job complexity, home prices, population and city-level

human capital

• Decreasing in audit market leadership and audit office quality

Audit personnel salaries associated with higher audit office quality Audit firms are able to pass higher audit personnel salaries to clients through audit fees

Implications

PCAOB standards and inspections increasing amount of work Audit firms demand the best and the brightest Clients unwilling to pay higher audit fees Profits from audit clients are slowly growing Potential outcome

• Salaries are compressed for audit personnel
• Implications for audit quality that need to be addressed

THANK YOU

11/15/2016