The Economics Behind: Auditor Remuneration and Transitions
The Annual Audit Experience
The annual audit season is a time of great stress for finance teams across the country. From collecting invoices to downloading trial balances to answering endless auditor queries, it is a mammoth task to validate a year's worth of financial activity in just 1-2 months.
The chaos is especially pronounced at early-stage companies, where manual processes and a lack of a dedicated finance vertical are common. Over time, as companies mature, their internal controls and finance teams strengthen. Not only is there a direct correlation between company maturity and the quality of the internal finance function, but there is also a corresponding increase in audit requirements and costs.
One clear trend is that companies pivot to a Big Five auditor once they achieve a certain level of maturity and complexity. This may be due to a board decision, a desire for a more systematic audit process, or the recognition that a big-name audit brand can bring to the company. In any case, Big Five auditors are the preferred choice for companies approaching an IPO.
Traditionally, the Big Four audit firms (EY, Deloitte, KPMG, and PwC) have been considered the leaders of the global audit profession, and this is also true in India. However, in recent years, Walker Chandiok & Co has steadily grown in terms of the number of audit assignments and is now considered one of the top audit firms in India, effectively reconstituting the Big Four into the Big Five.
While the current audit season is winding down, the process of appointing a new auditor and setting expectations for the next financial year is just beginning.
In this article, we will explore the estimated audit fees for companies at different stages of their lifecycle, examine the journeys of a few select companies and the stages at which they transitioned to a Big Five auditor, and provide an overview of the composition of the Big Five audit firms within the listed market.
Audit Fees for Early-Stage Companies
Audit fees can be a complex topic, especially for early-stage companies. There is no standard rate that applies based on the stage of a company's lifecycle, and fees are typically described as a percentage of revenue. However, in the early stages of growth, revenue may be muted, irregular, or nonexistent. In these cases, basing audit fees on revenue may not provide accurate insights into the prospective costs.
Auditors typically follow this formula for assessing audit fees:
Auditor's fee = Base fee (+) Audit fee premium (+) Engagement fee premium
Base fee: The base fee is directly proportional to the scale of the company's operations and the work hours estimated by the auditor. The Institute of Chartered Accountants of India (ICAI) recommends minimum fees based on company size, but these serve as guidelines only.
Audit fee premium: The audit fee premium, also known as the "signalling premium," is related to the auditor's reputation and competence. Big Five auditors typically charge higher fees because financial statement readers seek reassurance from well-established audit brands. This premium can range from 100% to 500% of what a small or medium-sized auditor would charge.
Engagement fee premium: The engagement fee premium is determined by the complexity of the audit procedures required, which is influenced by the regulatory environment and unique aspects of the business.
Based on the above parameters, we can provide a guardrail to early-stage companies on what to expect in terms of an auditor’s fee at each stage of their growth.
The fees discussed below are the base fees charged by statutory auditors and do not include the audit & engagement fee premiums.
Newly Incorporated Companies
At the time of incorporation, every company is required to appoint an auditor within 30 days of the date of incorporation and seek the Board’s approval for such an appointment. The period under review for the first audit will be limited to the stub period (the period from incorporation to the end of the financial year) or longer, depending on the company's date of incorporation.
The table below shows the period required to be audited based on the date of incorporation of the company.
The audit for the year of incorporation will focus on compliance documentation required for incorporation and vouching of a relatively small number of transactions. Since operations are still at a relatively small scale, companies can take advantage of this lull period to consult with the auditor on best practices for setting up internal accounting processes and seeking solutions to any accounting complexities.
Audit firms often provide a discount to companies in their first year of audit or in the year of change of auditor to win the engagement. Typically, the audit fee for newly incorporated companies ranges from ₹ 0.50 lakhs to ₹ 1.5 lakhs, regardless of market segmentation (B2B/B2C).
Pre-Series A / Series A
This is typically the stage where companies begin monetisation, with a growing customer base, multiple invoices/transactions, and a significant increase in employees and expenditure, all of which entail a larger scope for vouching and audit procedures.
At this stage, we typically see a distinction in audit fees for companies across the B2C and B2B market segments. B2C companies generally have a larger scale in terms of transactions/invoicing and hence command higher fees.
For a B2C company accruing revenue between ₹1 crore and ₹5 crores, the range of audit fees at this stage is typically ₹3 lakhs to ₹6 lakhs. For a B2B company with a similar scale in terms of revenue, the range could be ₹2 lakhs to ₹5 lakhs.
Series B / Series C
At this stage, companies have found product-market fit and have grown significantly in terms of revenue. This growth brings with it increased complexity in organisational structure, consolidation of subsidiary accounts, revenue segmentation, expense classification, internal controls, information technology systems, and income tax audit requirements. As a result, the audit procedures required to adequately assess the company's financial statements will be more extensive.
Due to the complexity involved and the increased scope of the audit, fees for growth-stage companies typically range from ₹6 lakhs to ₹20 lakhs.
Beyond Series C, we start to see a trend across companies based on the parameters of revenue and auditor fees. This trend becomes more evident in the next section.
Audit Transition Journey
Appointing the right auditor at the right stage of a company's growth is not straightforward, and it is not limited to the Big Five audit firms. However, we can better understand the selection process by looking at the auditor transition journey of a few companies that have been successful in their journey from inception to IPO.
PayTM
One97 Communications, the parent entity of Paytm, started as a humble mobile recharge website before becoming India's leading fintech company.
According to the earliest available information from MCA (Ministry of Corporate Affairs), in FY 2004-05, One97 appointed DG & Co, a mid-sized audit firm, as its auditor. DG & Co served as One97's auditor for four years, during which time the auditor's remuneration averaged 0.03% of revenue or 3 basis points.
While 3 basis points may seem steep for an early-stage company, it is important to note that the correlation between auditor remuneration and revenue is often skewed in the early stages of a company's lifecycle. In terms of the actual cost, the auditor's remuneration averaged ~₹1.5 lakhs.
In FY 2008-09, One97 transitioned to a Big Five auditor, SR Batliboi & Co (EY). This transition was likely due to the increased complexity of Paytm's business model and internal control procedures, as well as Paytm's original plan to list on the public markets in November 2010 (which was later shelved). EY remained Paytm's auditor for 10 years, during which time Paytm's revenues grew by ~37x and the auditor's remuneration grew by ~12x, averaging 0.09% (9 basis points) of revenue. In terms of actual cost, the remuneration ranged between ₹9 lakhs and ₹1.1 Cr.
In FY 2018-19, Paytm transitioned to another Big Five auditor, Price Waterhouse. This transition was most likely due to regulatory requirements, as the Companies Act 2013 limits auditors to a maximum of two terms of five years each.
As of FY 2022-23, Price Waterhouse continues to remain the auditor of Paytm garnering a remuneration of ~0.02% (2 basis points) of revenue which is more or less in line with listed entity comparables.
Tracxn
One of the world's top five market intelligence SaaS platforms for private companies and a 3one4 portfolio company, Tracxn, was listed on the public markets in October 2022.
The company's IPO was unique in two ways:
- The company did not raise any money through the free issue of shares in the IPO, the listing was wholly an OFS [Offer for Sale].
- The company is listed at an ARR of ~$10M when markets typically have much higher expectations on revenue.
These unique traits of the Tracxn IPO typically might have been seen as deterrents to investor participation. However, it did not affect market sentiment with the company being oversubscribed by 2x its initial offering. With a significant foreign client base (~70%) and a large upside opportunity due to its relatively low valuation, markets lapped up the available allocation.
Tracxn has only switched its external auditor once since its inception in FY 2012-13. MDA & Co., a Bangalore-based auditor, was appointed the first auditor of the company. In its initial few years, the auditor's remuneration was fixed at ₹20,000, which is typical for a seed-stage company.
Once Tracxn ramped up monetisation and crossed ₹7+ crore in FY 2015-16, it transitioned to a Big Five auditor, Price Waterhouse. Price Waterhouse has remained Tracxn's auditor through its IPO and to the present day. With an estimated ~8x increase in revenue since FY 2015-16, audit fees have averaged ~0.2% or 20 basis points.
Tracxn's auditor remuneration is considerably higher than that of Paytm and other listed entity companies. However, this is not a fair comparison, as most legacy listed entities are at a much larger scale in terms of revenue.
Timing of Transition to a “Big Five” Auditor
Let's examine a few companies that have recently listed on public exchanges and the stage at which they transitioned to a Big Five auditor in preparation for their respective IPOs.
On average, these companies transitioned to a “Big Five” auditor after a period of 6 years since their respective incorporations.
Listed Market Auditor Composition
According to a report by Prime Infobase, as of March 31, 2023, the Big Five audit firms handled 310 out of 498 Nifty-500 company audits (auditor details were not available for two companies). This means that the Big Five audited two out of three companies in this category.
Expanding the scope to all listed companies on the NSE, the Big Five audited 551 out of 1,869 companies, or approximately 30% of all assignments. With 809 audit firms covering 1,869 companies in 2022-23, the average number of audits performed per audit firm was 2.31. The Big Five, on the other hand, audited an average of ~111 companies each.
Based on this data, it is safe to say that the Big Five auditors are the preferred choice for listed companies.
For founders and C-suite executives, auditor transitions and fee optimisations might not be regular priorities, and rightly so. However, timely planning for the upcoming audit cycle can streamline operations, enhance stakeholder perception, and notably reduce stress.
This article aims to clear some of the uncertainties surrounding audit seasons and assist in informed decision-making for smoother business proceedings.
Contributors:
Nandita Pai, Aman Soni, Prethesh Jain
DISCLAIMER
The views expressed herein are those of the author as of the publication date and are subject to change without notice. Neither the author nor any of the entities under the 3one4 Capital Group have any obligation to update the content. This publications are for informational and educational purposes only and should not be construed as providing any advisory service (including financial, regulatory, or legal). It does not constitute an offer to sell or a solicitation to buy any securities or related financial instruments in any jurisdiction. Readers should perform their own due diligence and consult with relevant advisors before taking any decisions. Any reliance on the information herein is at the reader's own risk, and 3one4 Capital Group assumes no liability for any such reliance.Certain information is based on third-party sources believed to be reliable, but neither the author nor 3one4 Capital Group guarantees its accuracy, recency or completeness. There has been no independent verification of such information or the assumptions on which such information is based, unless expressly mentioned otherwise. References to specific companies, securities, or investment strategies are not endorsements. Unauthorized reproduction, distribution, or use of this document, in whole or in part, is prohibited without prior written consent from the author and/or the 3one4 Capital Group.
