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Study Links Audit Fee Pressure to Quality, Restatements

Tammy Whitehouse | March 7, 2014

Public companies demanding audit fee relief have won the upper hand the last several years, paying less even when they pose greater risk of intentional misstatements and filing more restatements as a result -- except when there's an ex-auditor on the board.

Recent academic research suggests from 2006 through 2010 audit firms buckled under fee pressure and failed to get full compensation for the risk that an intentional misstatement may be lurking undetected in a company's books. “Clearly, the downward pressure on audit fees or the overall decline in fees seems to be driving the decline in compensation for risk,” says co-author Brant Christensen, a graduate assistant and doctoral student at Texas A&M University.

The study found that companies with elevated financial reporting risk paying lower fees relative to that risk have significantly higher rates of restatements compared to companies with a comparable risk profile paying higher fee-to-risk ratios. The results suggest audit quality declines under fee pressure that doesn't adequately compensate auditors for the financial reporting risk, the study says. Auditors have warned companies in more recent years, however, to expect higher audit costs as they have faced harsh criticisms from the Public Company Accounting Oversight Board and expected to perform more audit procedures and more documentation as a result.

The pattern doesn't hold up, however, when a company has an ex-auditor on its board of directors, the study says. “Companies with an ex-audit partner on their board were better able to price the risk of misstatement into their audit fees, similar to the way we find that ‘industry expert' auditors more effectively priced risk into their fees,” Christensen says. “It could be that having an ex-partner on the board helps companies better recognize risk and also leads them to be more willing to compensate the audit firm for incurring that risk.”

The authors of the study, including Nate Sharp at Texas A&M University and Tom Omer and Marjorie Shelley at the University of Nebraska, say they have evidence of a marked decline in auditors' pricing of financial reporting risk from 2006 through 2010, suggesting auditors have been unable to sustain their focus on the risk of misreporting. “Our results are consistent with a return to the commoditization of financial statement audits and its negative impact on audit quality,” the authors report.

The findings correlate with the timing of a spike in adverse audit inspection findings by the PCAOB, the study points out. PCAOB Inspectors began reporting significant increases in audit deficiencies from 2009 to 2010. Failure rates jumped from an average of 16 percent across the eight leading audit firms in 2009 to an average of 37 percent in 2010 and have remained at similar levels in 2011 and 2012.

The Securities and Exchange Commission has tuned into the fee pressure and is calling on audit committees to take action. In recent speeches, SEC Chief Accountant Paul Beswick has reminded audit committees that their job is to demand a good audit, not shop for lower costs. “The bottom line should not drive the decision to retain and or hire an auditor,” he said in a December speech. “The decision should focus on which auditor is going to protect the interests of shareholders best.” Should an audit committee with a track record of fee hunting find itself dealing with an audit failure, “this may raise questions about the diligence of the members of the audit committee in fulfilling their responsibilities,” he said.