Low-balling and Audit quality and it’s impact on Governance

“You get what you pay for” is a norm that business community understands. However, the business community lacks the understanding that they’ve got to pay for better quality audits.
The business community has to accept that if Boards demand quality audits, then you’ve got to pay for them. If this happens then the audit firms will attract the right people to be auditors, by paying commercial rates and be able to compete for talent with the corporate sector. Low quality audits has a negative impact on governance.

The correlation between fees paid to the auditor and audit quality has received ample attention in academic research. Regarding the impact of excess fees paid to the auditors on audit quality, by and large, there is no consistent evidence that excess fees impair audit quality. There is some anecdotal evidence that audit quality is impaired when audit fee is low, i.e., below the level of normal (expected) fee based on observable client characteristics.

For example, Kaplan (2005) reports that Arthur Andersen considered WorldCom to be its “Crown Jewel” and viewed its relationship with WorldCom as long term and wanted to be considered as a committed member of WorldCom’s team. Andersen underbilled WorldCom for audit work and justified the lower charges as a continuing investment in its WorldCom relationship. Lynn Turner, former Chief Accountant of the SEC expressed concern that relative to the size of the audit client audit fees are low in some cases suggesting lower audit quality (Glass Lewis & Co 2005). For example, among Fortune 500 firms that had the highest revenues for 2003, six out of the top ten were missing from the list of largest audit fees, suggesting that audit fees as a percent of total revenue is quite low for these firms. Another example comes from Fannie Mae, a company that figured prominently in the sub-prime mortgage crisis and was accused by its chief regulator of improper accounting. Fannie, with assets in excess of $1 trillion paid $2.7 million for its 2003 audit.1 Randi Schultz, an analyst at Glass Lewis & Co states, “I think it’s crazy that anybody could expect Fannie to get a quality audit for that amount of money.” (Weil 2004). He assumes that when the auditor is underpaid, the auditor would resort to taking a lot of shortcuts and could make mistakes or miss important steps in the audit process.

With the above background, three researchers from the Department of Accounting College of Business and Economics of Lehigh University, Pennsylvania (in 2009) set out to prove: Are Fannie Mae and WorldCom anomalies or is there a systematic relationship between audit quality and under payment of audit fee? The objective of this study is to provide empirical evidence on whether audit quality is impaired when audit fee is below the level of expected fee.

The results suggest that audit quality is lower when unexpected audit fee is negative, i.e., actual audit fee is less than the expected fee. Further, there is no evidence that audit quality is impaired when unexpected audit fee is positive. These findings are consistent with the notion that when auditors earn excess fees they are mindful of the perceived threat to their independence in appearance and take steps to preserve their reputation capital.

For anyone who knows something about the audit profession, the above findings won’t be a surprise. What is surprising is that no one has attempted to do anything about it!

The regulators should implement a threshold for fees and perform stringent inspections on audits that are performed at an abnormally low fees and also where there is significant non audit fees being paid when the audit fees is low. The inspection should be on the corporate and the auditor. Such a threat would reduce low-balling behaviour by auditors and prevent businesses taking undue advantage of auditors with a potential threat to independence. The positive trend in fees should improve profitability of the profession and enable to attract good talent and such initiatives will go on to improve audit quality.

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About surenraj

“Views expressed are my own”
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