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Are Audit Firms’ Compensation Policies Associated With Audit Quality?
Jürgen ErnstbergerTechnical University of Munich
Christopher Koch
Johannes Gutenberg University Mainz
Eva Maria Schreiber
Technical University of Munich
Greg Trompeter†
University of Central Florida
Abstract
We examine how compensation policies of audit firms are associated with audit quality.
Specifically, we 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 in a large
profit pool). For our analyses, we use detailed mandatory disclosure of the compensation
policies in German audit firms. We document that compensation policies vary considerably
across audit firms. We find that profit sharing in a small profit pool and high variable
compensation are two characteristics of auditor compensation associated with lower audit
quality. We also find some evidence suggesting that audit quality may be most at risk in cases
in which partners rely more heavily on variable compensation to divide a relatively small
profit pool. In additional analyses, we find that these associations are more pronounced in
medium-sized audit firms. We argue that this finding may result from these firms being too
large for audit partners to directly monitor each other effectively, yet simultaneously too
small to have sophisticated centralized monitoring systems in place. Finally, we find that
integrating partner-specific, non-profit-related performance metrics into the compensation
structure mitigates the adverse effects of small profit pools and high variable compensation.
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