A new study has found a link between high auditing fees charged to public companies and the companies’ decline in financial performance for up to five years in the future.
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The study, by Jonathan D. Stanley of Auburn University, appears in the current issue of Auditing: A Journal of Practice & Theory, published by the American Accounting Association, found auditing fees to be significantly related to improvements or declines in companies’ financial performance the following year and, to a lesser extent, during the subsequent four years as well. The results “reveal a significant [but] fading relationship between audit fees and future changes in operating performance that extends up to five years ahead,” according to the study.
The study also found that auditors proved to be more sensitive to signs of declining performance than improving performance when they decided to raise or lower a company’s auditing fees. “Expected deterioration in the client’s operating performance will be reflected by auditing fees in a timelier manner than improvement in the client’s state," Stanley wrote.
The Securities and Exchange Commission has required companies since 2001 to disclose in their proxy statements the fees they pay to their external auditing firms. The findings are based on an analysis of data from about 5,000 U.S.-based companies during the nine-year period of 2000 to 2008.
“Primary results indicate a significant inverse relation between audit fees and the one-year-ahead change in clients’ operating performance,” Stanley wrote. “Further analysis reveals that the primary results extend to changes in operating performance observed up to five years after the fee is disclosed; are more pronounced for future negative versus positive chances; and [are] applicable to future changes in earnings unaccounted for by analysts’ forecasts.”
The companies studied had median assets of about $240 million and paid a mean of $1.15 million yearly for outside auditing services. Financial performance was defined as company return on assets, as determined by both earnings and cash flow. The study’s analysis controlled for a variety of factors likely to affect auditing-fee charges, including the amount of company assets, number of business segments, amount of leverage, and size of inventory and accounts receivables.
The results should be of concern to both investors and auditors. “If a company’s auditing costs are substantially higher than those of competitors of roughly the same size, that should be a reason for investor caution,” wrote Stanley. “In my view, checking auditing fees should be a basic investment activity, like checking short interest and analysts’ earnings forecasts.”
Why should auditor fees foreshadow future firm performance? Because of the risks that accountants perceive when they undertake an audit and the access they get to inside information on the companies they audit.
“A client firm may pose risks because it lacks the resources to prepare reliable reports or because its executives feel pressure to distort or obfuscate in order to conceal declining performance,” Stanley wrote. “Heightened risk of misstatements will require the auditor to expend more time and effort than would otherwise be necessary, as well as to charge a premium based on increased litigation risk or reputational risk. … In short, factors that drive up auditing costs can also easily have a negative impact on a company's future.”
Stanley also looked for evidence that auditors benefit from access to inside information so the fee potentially reflects a business risk assessment that is more informed than the assessment of at least some other market participants.
Comparing the earnings forecasts of professional stock analysts to actual company earnings, he discovered a significant negative correlation between unexpected earnings and audit fees. Earnings above what analysts expected are associated with relatively lower audit fees and those below what the analysts expected with relatively higher audit fees. The study found that the audit fee is likely to reflect the client’s future earnings unanticipated by analysts at the time of the audit.
The study is one of several recent papers that have focused on auditor fees as harbingers of company performance. One yet-to-be-published working paper by professors at the University of Iowa and the University of Texas at Dallas provides evidence linking the amount of audit fees to the subsequent revelation of client firms’ financial misstatements and fraud as well as the future receipt of SEC comment letters. The paper is among those cited by Stanley in his study.
“While it has long been suspected that auditing fees are predictive of company performance, my study and others have taken this issue out of the realm of conjecture,” Stanley concluded. “This is a relationship that investors can have confidence in, which is why some scholars are arguing for more timely public disclosure of audit fees than occurs today.”