Following the BT accounting scandal, Paul André and Alain Schatt of HEC Lausanne examine the impact of joint audits on costs and quality in France, Italy and the UK
The accounting scandal that engulfed BT’s Italian business last month has unwelcome echoes of the financial crisis of 2008 and raises similar questions about the failure of an auditing firm to provide warnings or identify financial problems that materialised not long after auditing. Why did the audit work carried out in Italy fail to spot any irregularities? Why did it take two different teams of forensic accountants to uncover the full story and why did it need a whistle-blower to bring the issue to the attention of BT’s management?
In the aftermath, there will inevitably be renewed calls to tighten financial risk management systems. In 2015, following lengthy discussions, the European Union introduced measures to toughen up financial oversight of listed firms. These included mandatory tendering of the auditing process every 10 years and a requirement to change auditors at least once every 20 years.
Even then, some argued that the EU didn’t go far enough. Joint audits are common in a few countries, including France, and mandatory joint audits were suggested by the EU in a 2010 Green Paper, although eventually dropped from the Proposal for a Directive submitted in 2011. The debate about the value, effectiveness and impact of joint audits has continued, however. Auditing firms play down the extent of additional costs, but corporations remain unconvinced. Unfortunately, there has been little objective data or substantive independent research to support opinions on either side.
To fill the gap, we decided to investigate the impact of joint audits not only on costs, but also in terms of quality. To do this, we looked at data for 210 French firms where joint audits are compulsory, and also for 142 Italian companies, and 279 firms in the UK.
The cost of coordination and risk
Our supposition was that joint audits would prove more costly, partly due to additional costs involved in coordinating the actions of the two auditors. Plus, there are the costs associated with compensating for the risk that an auditor might be held accountable for irregularities that emerge later on. Although one auditor nominally adopts the lead role – so theoretically bearing the greater risk – it may be that both firms will act cautiously and charge fees as if they were bearing equal risk.
So, all things being equal, in countries where the auditing regulatory regime is tighter and the risks of legal liability greater, the fees charged by auditors should be higher to compensate. Thus, audit fees in France (were it not for the joint audit requirement) ought to be similar to those in Italy, which has a similar legal regime, but lower than fees in the UK, which has a more exacting legal regime.
The results were telling. After controlling for other factors that might impact audit fees, including client attributes, audit attributes, auditor switching, and the provision of non-audit services, we found that French companies pay on average 34.9% and 61.3% higher fees than the UK and Italian companies, respectively. Where French firms used two auditors that were not from the “big four” (the four largest international professional service companies), fees were a little over 50% greater than for Italian or British companies with non-big four auditors. If one auditor was a big four firm, then French firms paid about a quarter more than UK firms with a big four auditor, and about 55% more than Italian companies audited by a big four firm. Where a French firm appointed two big four auditors, the difference is even greater – about 40% and 80% more costly, respectively.
Is cost offset by quality?
Of course, the critical question is whether joint audits provide a better quality service to merit this associated increase in costs. Because of the difficulty of assessing “quality” in this context, we used earnings management, and in particular abnormal accruals, as a proxy. Our logic being that managers can try to manage reported earnings to achieve their own goals, whether for maximizing bonuses, protecting their position or bumping up share prices. We accept, however, that the de?nition of audit quality has several dimensions and is very complex. Accruals management is only one of the dimensions.
Nevertheless, auditing’s monitoring process should theoretically reduce the incentive to manage earnings. With better audit quality, there should be less earnings management as signalled by discretionary liabilities arising from management decisions. However, an examination of the earnings management data suggests the higher audit fees observed in France are not associated with higher audit quality. This does not mean that there are no additional benefits, but further research is needed to establish what, if any, these might be.
Do joint audits add up?
What the research does show unequivocally, however, is that joint audits cost significantly more than single firm audits. Audit fees are higher in France than in both the UK and Italy, an unexpected finding based on the relative strength of the three legal regimes. With many other factors controlled for, it seems highly likely that higher costs are due to the joint audit requirement.
Given the findings, maybe it is time for supporters of joint audits to reconsider the cost-benefit equation of this expensive arrangement. It seems that the case for joint audits just doesn’t add up.
Paul André and Alain Schatt are professors of Accounting at HEC Lausanne, the business school at the University of Lausanne.
Are Joint Audits Associated with Higher Audit Fees? European Accounting Review, DOI: Paul André, Géraldine Broye, Christopher Pong & Alain Schatt (2015)