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Audit fee this year is tip-off to financial performance of client company next year and beyond, study finds

Not long after Enron's stock sank from $90 a share to a few pennies, a journalist noticed something curious: for auditing services covering the year before the stock's steepest fall,the company had paid a whopping $25 million, or almost three timesthe average paid by the blue chips in the Dow Jones Industrial Average.

Unfortunately, the journalistic suggestion that such a high fee was a red flag came too late for thousands of shareholders who saw their investments virtually wiped out by the company's collapse. A warning sign it almost certainly was, however, suggests a new study in the current issue of Auditing: A Journal of Practice & Theory, published by the American Accounting Association.

Indeed, the new research finds auditing fees charged to companies to be significantly related to the their financial performance for as long as five years into the future: the higher the fees this year, the lower firms' performance next year and beyond.

In the words of the journal report by Jonathan D. Stanley of Auburn University, "Primary results indicate a significant inverse relation between audit fees and the one-year ahead change in clients' operating performance... 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."

Asked if these findings are likely to be of value to average investors, Prof. Stanley answers in one word: "Definitely."

He explains that, "since 2001, the SEC has required companies to disclose in their proxy statements fees paid to their external auditors, so that these amounts are not hard to find. 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. 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? To a considerable extent because of the risks accountants perceive when they undertake an audit, perceptions based on access to company inside information that doing audits affords

Comments Prof. Stanley: "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. 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," he adds, "factors that drive up auditing costs can also easily have a negative impact on a company's future."

The new study's findings are based on an analysis of data from about 5,000 U.S.-based companies during the nine-year period 2000 through 2008. The firms 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. Analysis controlled for a variety of factors likely to affect auditing-fee charges, including amount of company assets, number of business segments, amount of leverage, and size of inventory and accounts receivables.

Prof. Stanley found auditing fees to be significantly related to improvements or declines in firms' financial performance during the following year and, to a lesser extent, during the subsequent four years as well. In the study's words, results "reveal a significant [but] fading relationship between audit fees and future changes in operating performance that extends up to five years ahead." He finds, too, that in raising or lowering a company's fees based on signs of improving or declining performance, auditors prove more sensitive to the latter than the former. As the paper puts it, "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."

The professor also probes for evidence that auditors benefit from access to inside information, so that "the fee potentially reflects a business risk assessment that is more informed than the assessment of at least some other market participants." Comparing professional stock analysts' earnings forecasts to actual company earnings, he finds 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.

In other words, "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 focus on auditor fees as harbingers of company performance. One still unpublished 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. Still another unpublished paper from Vanderbilt and George Mason universities finds increases in audit fees to be significantly associated with subsequent severe price declines in a company's stock as well as credit rating downgrades and the filing of class action security lawsuits. So valuable is the information contained in the audit fee, the authors argue, that it should be made public at the time the fee is negotiated rather than a year later when the audit is published in a proxy statement.

Comments Prof. Stanley in conclusion: "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. 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."

His study, entitled "Is the Audit Fee Disclosure a Leading Indicator of Clients' Business Risk?" is in the August/October issue of Auditing: A Journal of Practice & Theory, published four times a year by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include The Accounting Review, Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, and The Journal of the American Taxation Association.

 

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