The Revival of Large Consulting Practices at the Big 4 and Audit Quality

Eldar Maksymov is Assistant Professor at the  Arizona State University W. P. Carey School of Accountancy. This post is based on a paper, forthcoming in Accounting, Organizations and Society, by Professor Maksymov; Dain C. Donelson, Professor of Accounting at the University of Iowa Tippie College of Business; Matthew Ege, Associate Professor at the Texas A&M University Mays Business School; and Andy Imdieke, Assistant Professor of Accountancy at the University of Notre Dame Mendoza College of Business

Audit firms provide many services beyond those related to the audit of financial statements (FS). Historically, many of these “non-audit” services were provided to audit clients, causing regulators to be concerned about potential auditor independence impairment. The basic idea behind this concern is that by selling significant non-audit fees to their audit clients, auditors might compromise the quality of their FS audits. Thus, the Sarbanes-Oxley Act of 2002 (SOX) banned the sale of many non-audit services to public audit clients and required public-company audit committees to pre-approve all other non-audit services. Subsequently, three of the current Big 4 accounting firms spun off their consulting arms but have since rebuilt their consulting practices both organically and through acquisitions, with a focus on selling non-audit services to non-audit clients. In our study, we examine how the acquisition of consulting practices by the Big 4 might affect the quality of the audits they provide.

Though today the Big 4 provide most of their consulting services to non-audit clients, regulators have expressed concern about whether the shift in focus towards growing consulting practices could negatively affect audit quality. Specifically, regulators are concerned that the growth of consulting business at the Big 4 could lead to the firms becoming primarily consulting firms rather than primarily audit firms. This could result in the audit practice, and thus, audit quality, not being of primary importance to firm leadership. Overall, regulators are concerned that firm culture could shift away from an audit mindset to a consulting mindset (one focused on client advocacy).

There is an extensive literature that has examined the sale of non-audit services to audit clients, and this literature generally fails to find evidence of auditor independence impairment. We focus on 63 consulting firm acquisitions made by the Big 4 between 2007 and 2015 and examine evidence of audit quality effects subsequent to the acquisition. We specifically focus on audit quality effects at the audit office that corresponds to the acquired consulting firm’s headquarters. We do this because upon acquisition, the consulting firm offices generally are folded into the local audit firm offices. We argue that the headquarters of a consulting firm is the consulting firm’s office that is most likely to affect the culture and expertise of the local audit office because (1) the leaders of the consulting firm are likely at the headquarters location and (2) the headquarters location likely has the most consultants compared to the other offices of the consulting firm. Additionally, from an empirical design perspective, consulting firm acquisitions are spread through time and consulting firm headquarters are in different cities, allowing us to exploit this variation to separate expertise and culture effects.

After separating acquisitions into those that are audit-relevant and those that are unrelated to auditing, we use a difference-in-differences design and find severe misstatement likelihood (i.e., misstatements that are subsequently announced via an 8-K Item 4.02) is higher (lower) for clients of audit offices in the periods after acquisitions that are unrelated (related) to auditing. This suggests that audit quality is lower (higher) for audit offices after they experience an acquisition of a consulting firm that is unrelated (related) to auditing.

We also interview 17 US-based audit partners and directors who had experience observing or participating in acquisitions of consulting practices by their audit firms. These interviews allow us to obtain deeper insights into the potential mechanisms underneath our empirical results and the context of our findings. Overall, these partners and directors report that acquisition of consulting practices may cause a disruption to an audit practice. For example, local office leadership may need to be involved in integration of the consulting personnel into the office and may ask audit partners to help ensure that the acquired consulting practice continues to win new projects. These integration efforts may require audit partners to increase their focus on relationships and distract them from audit quality, shifting the overall office culture toward commercialism and causing audit quality to decrease.

However, if the acquired consulting practice has expertise relevant to auditing, such as data analytics or SAP, this expertise may spill over into the audit practice, thereby offsetting the negative effects on audit quality from the shift of culture toward commercialism. The audit-relevant expertise of an acquired consulting practice may become more accessible to audit teams after the acquisition due to the social and spatial proximity of these consulting experts to the audit teams. The net effect of such acquisitions may be to increase audit quality provided by the office’s audit practice. The partners and directors we interviewed noted, however, that consultants generally lack incentives to assist auditors, suggesting that expertise spillovers to audit teams may be limited. Moreover, during a pandemic and in a post-pandemic environment, the benefits of spatial distance may prove to be even more limited than what they were during the period we examined (2007-2015).

Overall, the empirical results and the interview results suggest that the effect of consulting firm acquisitions on audit quality depends on whether the acquired services are related or unrelated to the external auditing practice. Thus, even though the majority of non-audit services are sold to non-audit clients as opposed to audit clients, our evidence suggests there could be potential positive or negative consequences to audit quality associated with these services.

The complete paper is available here.

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