Audit Fee Competition Threatens Financial Reporting

Tim Reason, editorial director of CFO.com and award winning business journalist, has a new article out in this month’s CFO Magazine, “Auditing Your Auditor.”  It is always a pleasure to read his work, and his current piece is no exception.

His focus  is on audit fees.  As everyone knows there are three certainties in life:  death, taxes, and CFOs complaining about pricey audit fees.  About 2,500 public companies (out of 9,500 SEC reporting companies) pay at least $1,000,000 per year in audit fees.

Audit prices have been on a roller coaster in recent years.  When the Big 8 industry evolved into the Big 4, a smaller pool of major audit providers led naturally to higher prices.  Eventually, though, audits become commoditized (and coupled with consulting fees) and prices fell.  Following the turmoil of the early 2000s and passage of Sarbanes-Oxley, audit prices went through the roof.  Recently, however, prices have been dropping.  Reason cites information gleaned from AuditAnalytics reports that supports a conclusion that audit fees have been dropping as a percentage of a client company’s revenues even as corporate revenues have declined during the recent recession.

Reason reasons that declining audit fees result from three factors:

1. Benefits realized from SOX required internal controls,
2. Increasing trend for companies to shop for a new auditor on price considerations only, and
3. CFO’s comparing their audit fee against a benchmark of average fees paid by their peers.

I wonder, though, if this is the complete story.

The audit industry is still an oligopoly.  In an oligopoly, a few large suppliers are able to ration their scarce supply to the highest bidders.  The Big 4 share of the SEC market is actually increasing!  Moreover, from all accounts SOX is a hollow, ineffective government mandate.  Neither companies nor auditors are taking it seriously (there are exceptions, of course).

I think there are three reasons for this newly established trend to lower audit prices:

1. It’s the economy!  Unemployment doubled in the U.S., to 10% from 5%.  If history serves as a guide, it can take two years to recover each 1% of that unemployment.  I don’t think the economic recovery will take all of ten years, but it will take a long time.  Companies are arguing legitimately and successfully that they simply don’t have the money to support the Big 4 in the manner to which they’ve become accustomed.
2. Audit firms are willing to accept lower fees.  The Big 4 collectively dominate every capital market in the world.  It is a primeval world of cutthroat competition to win and keep clients.  Although audit firms are not starved, they are hungry.  A lost client (to another firm) is so damaging that firms correctly reason that a reduced fee is better than no fee.
3. It is already established that the weaker partner in the corporation-auditor relationship has sold its soul by degrees, a little here or a little there.  Now the two parties are haggling over the price.  If we go back far enough in history, we can see where audit firms scrapped their mission of acting in the public interest and went into the business of selling clean audit opinions.  This is when the audit became commoditized.  Certainly the industry was in deep trouble during the crash and burn of 2000-2002.  There simply isn’t any evidence, though, that the Big 4 has ever learned from that episode.  The most telling factor of the 2008-2009 crisis is that audit firms did little (or nothing) to curb corporate machinations and manipulations in the financial statements.  The Big 4 can’t argue (with a straight face) that it deserves high audit fees for rendering quality audits.  [I can’t deny that there are many good people populating the Big 4 and some of the time good work is accomplished.  It’s possible here that we are simply talking about a change in the degree of auditor effectiveness.]

So, if is in the nature of the Big 4 to “get along,” and it is the nature of corporate managers to have their way, is it any surprise that audit prices are declining?  I think not.

I think the current low level of auditor effectiveness will suffer as a result of this price competition.   Here are some of the problems I see.

First, auditors will have less time on-site performing the audit.   Although it is cheap grunt time, there will be less testing and evidence gathering.  And decreased time will result in decreased audit effectiveness and less auditor power.  Second, there will be renewed pressure to continue the problematic business model of audit firms relying on new hires. Fewer experienced professionals and partners will be around to supply judgment.   Third, increased price competition will only increase pressure on audit firms to get along with management, or else there will be the loss of precious remaining revenues.   Fourth, it will give more power to corporate management in the company-auditor relationship.   If the U.S. moves to IFRS, audit firms will need to be in a position to exercise judgment and the power to express its will.  At the current, they lack the will to unwaveringly express it.   Too much price competition will turn the audit firms into cheaper whores.

If there is any hope for audit firms ever to serve the public interest, then this increasing price competition seriously damages the hope. Audit firms will be pressured to place their own self-interest over those of investors.

Debit and credit – – David Albrcht