Prompter disclosure of corporate audit fees would help investors, according to a new study that found sudden increases in audit fees may be a sign of trouble at companies.
The study, which appears in Auditing: A Journal of Practice & Theory, published by the American Accounting Association, calls into question the delay that currently prevails in the disclosure of fees that firms agree to pay auditors.
“Company-specific opacity is greater than perhaps necessary as a result of [this] timing,” said the study by Nicole Thorne Jenkins of the University of Kentucky, Karl E. Hackenbrack of Vanderbilt University and Mikhail Pevzner of the University of Baltimore. “Accelerating the mandated corporate disclosure of the audit fee could provide useful information to investors, reducing the severity of negative market reactions when companies announce bad news."
The study found that increases in audit fees are frequently a signal of trouble ahead for a company. “Yet shareholders don't find out about those raises until the publication of the firm's next annual report, a year after they have has been agreed upon,” said Jenkins in a statement. “Investors and markets could benefit considerably if audit fees became public at the time they are negotiated, since this would likely avert the crashes in company stock that can occur when undisclosed bad news is allowed to build up over time.”
Audit fees are typically negotiated in the first quarter of the year to be audited and cannot be changed easily, the researchers pointed out. “Because it is so difficult to alter the fee articulated in the engagement letter, auditors spend a great deal of time, pre-fee negotiation, in consultation with their clients,” said the study. “As a result, the negotiated fee impounds a wealth of both public information and private, client-specific information.”
Auditors have access to a wide array of client-specific information well in advance of investors, the researchers pointed out. For example, auditors may anticipate that a client might soon be hit by a major lawsuit or that an important customer relationship is likely to end or that future market expectations will probably not be met. While professional accounting ethics constrain them from publicly revealing such information, the amount of private information possessed by auditors is vast, the study noted, and they use it to assess their business-risk exposure (for example, the possibility of reputational damage or litigation) and to price their services accordingly.
“Price protection by auditors is a reasonable proxy for [corporate] managers' tendency to conceal bad news from the market,” wrote the study’s authors.
As a result, the study found, “companies experiencing a stock-price crash can, on average, expect their auditor to have negotiated a 2 to 3 percentage-point increase in the audit fee in advance of a crash event over and above changes necessitated by operational or structural changes in the client.”
Without knowledge of that audit fee increase as a signal of trouble, “the market is precluded from assimilating timely, consequential information embedded in the negotiated audit fee simply because the current mandate is to disclose [this] information essentially one year after it is known by insiders.”
In contrast, “prompt disclosure of the audit fee articulated in the engagement letter would result in more timely communication of the information buildups that lead to tipping points,” said the study.
The study's findings emerge from an analysis of data from 4,859 companies over a 12-year period beginning in 2000 (the first year in which audit-fee information was available on a large scale) through 2011. The authors probed the relationship between two principal variables—increases in audit fees from one year to the next and crashes in company stock that occurred in the year following negotiation of fees.
Crashes consisted of a drop in company stock of about 18 percent in a single week. A company year was categorized as a crash in a data analysis if the company had at least one such episode in the course of that year. In all, crashes occurred in 23 percent of the 27,708 company years that comprised the study sample. Of the 4,859 individual companies studied, two-thirds experienced at least one crash during the 12-year study period.
The professors found that, after controlling for company changes that would make an audit more complex than the firm’s previous one, such as corporate acquisitions or increases in the number of business segments, crashes were significantly associated with increased audit fees, with the likelihood that the association was due to chance less than 5 percent.
“A significant portion of the mean increase in audit fees is related to an increase in the auditor’s perception of [a company's] idiosyncratic risk,” said the study.
While conceding that their analysis “does not address the trade-offs between the economic benefits documented and potential costs,” the researchers said those benefits are not only palpable but easily bestowed.
“Lack of prompt disclosure cannot be attributed to the fee information not being available or the absence of a vehicle through which the information can be disclosed,” they wrote. “The negotiated audit fee is objective, stated in the engagement letter, and known when the definitive proxy statement is filed the first quarter of the year under audit. Our empirical findings are a first step in documenting the economically relevant information contained in negotiated fees and demonstrating that auditors price-protect in response to their understanding of the risks and rewards their clients face."
The study, “Relevant but Delayed Information in Negotiated Audit Fees,” appears in the November/January issue of Auditing: A Journal of Practice & Theory, published quarterly by the American Accounting Association.
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