Designing appropriate incentive systems is an important, yet challenging task for organizations. Ill-designed compensation schemes matter even in highly regulated audit firms. For example, high levels of variable compensation at Arthur Andersen might have fueled the Enron scandal and led to the firm’s demise. Audit firms are organized as partnerships in which partners are both principals and agents of the firm, who monitor each other. Moreover, company audits are conducted in the public interest, and are thus highly regulated. The goal of these regulations, ensuring higher quality audits, can in some cases be viewed as competing with an audit firm’s objectives of growing the business and maximizing profits. Do compensation policies matter in such highly-regulated settings? Which types of compensation influence audit quality? What counter-measures can be taken by audit firms to mitigate these effects?
In a recent article in Contemporary Accounting Research, Professor Greg Trompeter at the University of Central Florida College of Business, Prof. Dr. Christopher Koch at the University of Mainz, as well as Prof. Dr. Jürgen Ernstberger and Dr. Eva Schreiber, both of the TUM School of Management, address these questions. For their analyses, they make use of the detailed mandatory disclosure of the compensation policies in German audit firms. They collect data on the compensation policies of audit firms found in their annual transparency reports. The authors investigate the effects of the ratio of variable to fixed compensation and the size of the basis for profit sharing (i.e., whether partners share profits in a small or large profit pool) on common proxies of audit quality.
The study shows that compensation policies vary considerably across audit firms. Profit sharing in a small profit pool and great differences in compensation are associated with lower quality audits. Audit quality is found to be most at risk in cases where partners rely more heavily on variations in compensation to divide a relatively small profit pool. The authors also find that these associations are more pronounced in medium-sized audit firms. Reasons for this last finding might be that these firms are too large for audit partners to directly monitor each other effectively, yet too small to have sophisticated centralized monitoring systems in place. However, integrating partner-specific, non-profit-related performance metrics into the compensation structure could mitigate the adverse effects of small profit pools and high variable compensation.
Overall, the results of the study suggest that, first, compensation policies are an important driver of performance, even in highly regulated settings as audits. Too strong incentives can reduce the quality of auditors’ work. Second, internal audit firm characteristics linked to size, like mutual monitoring and centralized internal control systems, may serve to mitigate the adverse effect of variable compensation on audit quality. Hence, if an audit firm decides to increase variable compensation for auditors, appropriate measures to maintain high quality audits should be implemented simultaneously.
Prof. Dr. Jürgen Ernstberger
Chair: Financial Accounting