New academic research suggests there is indeed a correlation between pressure on audit fees and audit quality — and it’s not pretty.
In an examination of audit fees, non-audit fees, and client misstatement rates at 561 audit offices from 2004 to 2013, researchers said they found evidence that pressure on audit fees causes firms to steer their attention to non-audit services, which leads to a decline in audit quality. “Audit offices experiencing audit fee pressure appear to focus more on providing non-audit services in relation to their total fees,” says Erik Beardsley, an accounting professor at the University of Notre Dame and a co-author of the study. “And we find that when they do that, audit quality suffers.”
The study relies on misstatements in financial statements as an indicator of audit quality. Where misstatements rise, audit quality is deemed to have diminished. The authors say they have identified a “positive association between audit fee pressure and changes in non-audit services at the audit office level.” The research also identifies increase rates of misstatements among audit offices that increase their focus on non-audit services when audit fees are under pressure compared to audit offices that do not, “suggesting a joint effect on audit quality.”
The researchers say they also found evidence that the reduced audit quality that is associated with audit fee pressure and increased focus on non-audit services can be tied to large audit offices, but not to smaller audit offices. The study supported what prior research has found, which is that smaller audit offices reduce “moral hazard” problems more than larger offices as a result of mutual monitoring and peer pressure.
The authors say the results should be of concern not only to practitioners and regulators but also to audit committee members. The study suggests “audit office size is important when considering the effect of audit fee pressure and non-audit services on audit quality.”
Sarbanes-Oxley led to more stringent rules on auditor independence that caused firms to shed much of the non-audit service that they provided to audit clients. In more recent years, however, audit firms have begun expanding their practices to include more non-audit services, although they still must be careful about providing prohibited services to audit clients.
The Public Company Accounting Oversight Board has expressed concerns about firms expanding their business models into more non-audit services, but audit firms say having that expertise in-house improves the quality of audit services. Both the PCAOB and the Securities and Exchange Commission have dished out enforcement actions for audit firm missteps in complying with auditor independence rules. Meanwhile, the SEC is examining whether a narrow aspect of its independence rules should be modified.