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The True Cost Of Lowering Audit Fees Is Increased Restatement Risk

Originally Published in Financial Complexity Made Clear, March 2014

By: David Nolte
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In association with general cost cutting measures over recent years, many companies have pressured their vendors to reduce fees. This downward pressure has extended to the accounting firms hired to provide independent audit opinions, resulting in a significant drop in audit fees. According to Audit Analytics, audit fees in 2012 were $472 per $1 million of revenue, the lowest amount since 2004. The question is whether audit quality has been sacrificed in order to achieve these reductions.

A recent research paper published by individuals from the accounting schools at University of Nebraska at Lincoln and Texas A&M University puts forth the question "Pork Bellies and Public Company Audits: Have Audits Once Again Become Just Another Commodity?" This paper examines a sample of 7,280 Big 4 clients from 2006 through 2010 and finds

"evidence of a marked decline in auditors' pricing of financial reporting risk during the 2006-2010 period, suggesting auditors have been unable to sustain their focus on the risk of misreporting in recent years. This decline is particularly evident among non-industry expert auditors. Additionally, we find higher rates of financial statement restatements among high-risk clients where their risk appears not to be incorporated in audit fees. Our results are consistent with a return to the commoditization of financial statement audits and its negative impact on audit quality."

The paper specifically tracked the "Fee Risk Ratio" which was defined as the total audit fees divided by lagged AGR (a measure of financial reporting risk that considers accounting and governance variables known to be associated with financial frauds). A higher ratio indicates that the audit firm received more pay per unit of financial reporting risk. It established that a high "Fee Risk Ratio" carried a 9.1% restatement rate, while a low "Fee Risk Ratio" carried an 11.7% restatement rate and that audit firms with a lower number of clients appeared more susceptible to such issues. As a result:

"This provides initial evidence that among companies with higher levels of financial reporting risk, audit quality suffers when audit firms are not compensated sufficiently for the increased level of risk. We further compare rates of restatements by examining the impact of audit firm office size...Taken together, this evidence suggests that the inability to price financial reporting risk can negatively impact audit quality, especially among companies audited by audit firm offices less able to accommodate lower client fees"

Overall, the paper supports the concern that chasing lower costs can lead to unintended consequences. Auditors are required to plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatements, whether caused by error or fraud. Without an appropriate budget, auditors may take shortcuts that undermine the reliability of their opinions. The ultimate cost to the company may actually overwhelm the savings on audit fees because if a restatement is required, the repercussions can be expensive and far reaching, as described in this recent article regarding the time (and cost) to regain investor confidence. The circumstances can often lead to litigation by investors and other users of financial statements against the company, decision makers such as its directors and audit committee, as well as the audit firm itself. In addition to the costs of litigation, the company may experience expansive ramifications, such disruptions to its business, reputational damages and higher costs of capital.

David Nolte is a principal at Fulcrum Financial Inquiry LLP with over 30 years experience performing forensic accounting, auditing, business appraisals, and related financial consulting. He regularly serves as an expert witness.

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