In a recently published paper, Nieves Carrera, Marco Trombetta, and I examine whether auditor social and human capital are associated with auditor compensation in a market dominated by a large number of small and medium private clients and small suppliers. Private companies demand audit quality to mitigate agency conflicts, to satisfy contractual constraints imposed by creditors, to support managers’ decisions, and to obtain business advice in order to improve operational efficiency and effectiveness (Vanstraelen & Schelleman, 2017). For small audit firms, audit quality might be more dependent on the competence, judgment, and integrity of the individual auditor given that the in-house networking/consultation opportunities are limited (Francis & Yu, 2009), and the quality control systems are less sophisticated (Langli & Svänstrom, 2014).
Social capital is an important though understudied phenomenon in the accounting literature that captures “the goodwill that is engendered by the fabric of social relations” (Adler & Kwon, 2014). Social capital confers information, influence, and trust (Kwon & Adler, 2014). Its consequences for individuals include advancing a career (Burt, 1992), gaining power (e.g., Krackhardt, 1996), and increasing compensation levels (Xiao & Tsui, 2007). Our argument in the paper is that auditor social capital can add value to the audit service and generate a competitive advantage that will eventually raise compensation. In my dissertation (Bianchi, 2018) I show that small and medium Italian private firms audited by auditors with comparatively higher levels of social capital have fewer modified audit opinions, lower abnormal accruals, and fewer tax-related restatements. This result suggests that auditors develop expertise through collaboration with peers which result in higher audit quality. In a related paper (Bianchi, Falsetta, Minutti-Meza, and Weisbrod, 2019), we show that clients of better-connected (higher social capital) auditors show comparatively lower ETR, which suggests that auditor networks might facilitate tax expertise sharing between auditors working for small practices.
We use a sample of Italian auditors working in small audit firms and auditing private companies. In Italy, private companies exceeding certain size thresholds engage three individual auditors to form a board of statutory auditors (BSA). BSA members jointly audit the financial statements of client companies, sign a single audit report, and are jointly liable for any undiscovered or unreported material misstatement. In this setting, auditors interact with their peers assigned to multiple BSA engagements, establish working relationships, and thus form professional networks. In the picture you can see an example of these auditor networks. The nodes are the individual auditors, the edges between auditors represent collaborations on the same client, and the resulting triangles identify the clients. From the network literature, we use centrality as a proxy for social capital. Centrality is one of the most important and widely used conceptual tools for analyzing networks which indicates where an actor is positioned relative to others (Scott, 2000). Central actors are typically viewed as those with greater access to, and a larger amount of, information or social support from the network (Adler and Kwon, 2002).
We collected information about auditor compensation, individual attributes, and professional networks through the proprietary data provided by a local Chamber of Commerce. We matched these data with financial information available on AMADEUS. Our final sample consists of 800 individual auditors during the period 2008–2011 (2,605 auditor-year observations).
Our findings show a positive and economically meaningful association between auditor social capital and auditor compensation. Increasing our measure of social capital by one standard deviation results in an increase in compensation equal to 56% of its standard deviation. We also find a positive and significant coefficient on auditor human capital operationalized with industry expertise. We run several tests to address potential endogeneity issues in our research design, including instrumental variable regressions and auditor fixed effects. Our results suggest that, in the small audit market, clients perceive as valuable those auditors with higher social and human capital, and as a result, are willing to pay a premium for these specific auditor attributes.
Our findings are important to the profession and policy makers. We offer empirical support to professional reports highlighting the complexity of audits of small clients, which requires individual practitioners to have a broad set of skills not only for the verification of the financial statements but also for a more general advisory role (including tax expertise) that the auditor plays for private clients. This combination of roles places the auditor in a difficult position because she must also guard her independence. In assessing quality control for small audit firms and deciding on rules affecting the provision of additional services, regulators need to consider this additional complexity.
References:
Adler, P. S., & Kwon, S. W. (2002). Social capital: Prospects for a new concept. Academy of Management Review, 27(1), 17–40.
Bianchi, P. A. (2018). Auditors’ Joint Engagements and Audit Quality: Evidence from Italian Private Companies. Contemporary Accounting Research, 35(3), 1533–1577.
Bianchi, P. A., Carrera, N., & Trombetta, M. (2019a). The Effects of Auditor Social and Human Capital on Auditor Compensation: Evidence from the Italian Small Audit Firm Market. European Accounting Review, Forthcoming.
Bianchi, P. A., Falsetta, D., Minutti-Meza, M., & Weisbrod, E. (2019b). Joint Audit Engagements and Client Tax Avoidance: Evidence from the Italian Statutory Audit Regime. Journal of the American Taxation Association, 41(1), 31–58.
Burt, R. S. (1992). Structural holes. The social structure of competition. Cambridge, MA: Harvard University Press.
Francis, J. R., & Yu, M. D. (2009). Big 4 office size and audit quality. The Accounting Review, 84(5), 1521–1552.
Krackhardt, D. (1996). Social networks and the liability of newness for managers. In G. L. Cooper & D. M. Rousseau (Eds.), Trends in organizational behavior (Vol. 3, pp. 159–173). New York: John Wiley & Sons.
Kwon, S-W., & Adler, P. S. (2014). Social capital: Maturation of a field of research. Academy of Management Review, 39(4), 412–422.
Langli, J.C. & Svanström, T. (2014). Audits of private companies. In: D. Hay, W.R. Knechel, and M. Willekens, eds. The Routledge Companion to Auditing. 148–158. New York: Routledge.
Scott, J. (2000). Social network analysis: A handbook. Thousand Oaks, CA: SAGE Publications.
Vanstraelen, A., & Schelleman, C. (2017). Auditing private companies: What do we know? Accounting Business Research, 47(5), 565–584.
Xiao, Z., & Tsui, A. (2007). When brokers may not work: The cultural contingency of social capital in Chinese high-tech firms. Administrative Science Quarterly, 52(1), 1–31.
