Public Company Accounting Oversight Board chairman James Doty said in a speech Thursday that he is concerned about cuts in audit fees having an impact on the quality of audits as the auditing practice becomes a declining part of the revenue at accounting firms.

“To be sure, audit firms are innovating, but not in the area of the audit,” Doty said at Baruch College’s 13th Annual Financial Reporting Conference. “Audit fees have become a decreasing portion of audit firms’ revenues.  Audit practices have shrunk in comparison to audit firms’ other client service lines—not all of which depend on the fundamental exercise of skepticism.”

Doty pointed out that the Sarbanes-Oxley Act puts the audit committee in charge of retaining the company's auditor, and yet the audit committee has limited information on which to judge audit quality. “Thus the primary battleground for market share becomes price,” he added.

He cited statistics that found from 2006 through 2011, 418 companies in the Russell 3000 index changed auditors. The median change in audit fee reported by the companies in their filings with the Securities and Exchange Commission was a decrease of 11.5 percent, he noted. 

“A clear majority of the companies that changed auditor—62 percent—reported a decline in fees for the first year of the new engagement,” said Doty.

Among the 418 companies that changed auditors, the decline in audit fees was even more pronounced for large engagements, for example those with audit fees of $3 million or more, he noted, with 83 percent of those companies reporting lower audit fees in the auditor’s first year, with a median decrease of 15.7 percent.  In contrast, the year-over-year change in audit fees among the full Russell 3000 was basically flat, with approximately half reporting increases and half reporting decreases.

“Not surprisingly, the fight for market share becomes the fight for incumbency,” said Doty.

The annual rate of auditor changes declined each year from 2006 to 2011, he pointed out. Among the companies in the 2010 Russell 3000 index, only 1.88 percent changed auditors in 2011, compared to 3.72 percent in the 2006 index.

However, he is not ready to start dictating audit fees to firms.

“By no means is it the role of the PCAOB to regulate audit fees,” said Doty. “Nevertheless, the facts are concerning. It is not the custom for companies’ statements to explain the rationale for why a new auditor charges a lower fee than the previous auditor. Is the new auditor more efficient?  Did the new auditor reduce the scope of the audit? Did the fee for the new audit cover the full cost of conducting the audit in the first year? Whatever the answers are in particular cases, the emerging reality for all of us is the need to understand the effect of these trends and pressures on audit quality.”

Securities and Exchange Commission chief accountant Paul Beswick is also disturbed by the trend, and mentioned it when he spoke earlier in the day at the conference. “I'm not here to say that audit committees are here to do what the auditors say, but you start to get a little concerned when you see audit fees at a company, when there has been no change in the operations of the business, all of a sudden one year drop by 20 or 30 percent,” he said. “You wonder, wow, what's the impact on quality going to be there? What did the audit committee do to get comfortable that the auditor was going to do their job, especially in the context of a change in auditor. That's one of the things that we're constantly highlighting for audit committees when we talk to them. Remember you have a fiduciary responsibility. There are situations I would term 'fee hunting' where companies are out looking for the lowest fee and not spending a lot of time focusing on audit quality.”

Audit Quality Indicators
Doty noted that the PCAOB is developing indicators of audit quality, both at the engagement and firm level.

“Expect to see a concept release seeking public comment on potential measures later this year,” he told attendees.

After his remarks, Accounting Today asked Doty about the Center for Audit Quality’s recent efforts to develop audit quality indicators on its own and what influence those might have on the PCAOB’s efforts (see CAQ Pilot Tests Audit Quality Indicators).

“It’s an entirely healthy thing that they’re looking at what they are,” he said. “They are in fact developing this with a view to show audit committees that hire them [the firms] that they understand audit quality. Of course, they should be thinking about how to explain to an audit committee their understanding of audit quality indicators. They are basically pilot-testing to see how they can improve them. It is not a substitute for oversight by ourselves, and developing a project on audit quality indicators. Our constituents are the markets, the users, the auditors, for broader purposes. At the end of the day, the firms must show that they are aware of the issue of what an audit quality indicator might be and how they are driving forward.”

He said the concept release on audit quality indicators would be out in the third quarter, but probably not until the end of the summer. “If it were so simple, it would already have been done,” said Doty. “You’ve got the fact that you’ve got a substantial body of academic literature that says you will never get agreement on what audit quality indicators are. That may be true, but that’s part of the oversight job, and what we think audit quality indicators are. But we should not allow the profession to develop its own set and then claim that it’s been the standard. Remember, the investment company industry at one time had no standards on front-running and ethics and a code of conduct. They saw that there was going to be one imposed on them, so they went out and did it. The audit profession, you can be cynical and say they always seem to get ahead of the wave. That’s a perfectly normal business reaction. Any business, any industry ought to be trying to get ahead of what it thinks is going to be a critical evaluation of its own performance. That’s not bad. But as an oversight body, we can’t just take it.”