October 9, 2011 – By Nanette Byrnes
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(Reuters) - Elevated audit fees can be a red flag of problems to come for a company, say three recent academic studies that together warn about increased chances of fraud, stock price declines or financial restatements.
Companies have been disclosing how much they pay their auditors since 2001, when the Securities and Exchange Commission instituted the requirement as part of a push to improve corporate auditor independence.
The numbers may be underappreciated by investors, however, who seem not to recognize the special insights auditors have.
"The auditors have private information about the firm because of their interaction with management. They obviously have a lot of risk associated with any fraud at a firm, and we assume they adjust their fee accordingly," said Ryan Wilson, who teaches accounting at the Tippie College of Business at the University of Iowa, in an interview October 5. He co-authored an April 2010 study on the topic.
For a related graphic, Audit fees remain high post-Sarbanes Oxley: Initial spike in fees over, big companies still pay up for audits, click on http://link.reuters.com/nyk34s
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A high or rising audit fee can indicate one of two things, experts say. Either the auditor is charging a risk premium, aiming to cover future legal costs to them of something going awry, or they may just be doing more work on the audit, digging into areas where results are uncertain.
The studies' findings come at a moment when regulators are considering requiring auditors to give out even more information. A proposal under consideration by the U.S. Public Company Accounting Oversight Board might have auditors disclosing more than the current minimal thumbs up or down.
Meantime, their fees seem to be telling a valuable story.
FEES, PERFORMANCE RELATED
Audit fees substantially above those paid by competitors and companies of similar size are strongly associated with a slip in operating performance the following year, and to a lesser degree as many as five years later, according to research by Jonathan Stanley, an accounting professor at Auburn University, published in the current August/October issue of Auditing, a journal of the American Accounting Association.
In addition to forecasting operating declines, high audit fees are predictive of fraud and restatements, and rising fees can foreshadow steep stock price drops, credit rating downgrades and class action lawsuits, the research has found.
American International Group Inc <AIG.N>, the insurance giant bailed out by the government on the brink of bankruptcy in 2008, is one of a number of examples cited in interviews with the authors of the studies. According to SEC filings, AIG paid $66 million for its 2004 audit, a $33 million increase over its 2003 fee. In 2005, the company restated its 2000, 2001, 2002 and 2003 numbers.
Another example is Swedish mobile phone maker Ericsson <ERICb.ST>. Nicole Thorne Jenkins of Vanderbilt University's Owen Graduate School of Management said the fees climbed significantly faster than peers' the year before it issued a 36 percent profit decline in 2007 that sent its stock down sharply.
A 2004 sales shortfall at technology group Altera Corp <ALTR.O> was preceded by a rise in its audit fee. PricewaterhouseCoopers, the auditor of all three companies, declined to comment citing a policy of not discussing client matters.
Jenkins said in an October 5 interview that her research published April 2011 found investors as a group do not recognize the importance of audit fees.
Auburn's Stanley said investors should consider audit fees with other metrics like short interest and analysts' forecasts, in an October 5 interview. "There's a link between audit price and future performance," he said.
LOW FEES ALSO CITED
Unusually low fees may be worth keeping an eye on too, argued Donald Whalen, director of research for Audit Analytics, in an October 6 interview. "If audit fees are way down, how can the auditor be performing the necessary work?" he asked.
Whalen highlighted the case of government-backed loan purchaser Fannie Mae <FNMA.OB>. Auditor KPMG charged the lender less than $3 million a year in 2001, 2002 and 2003.
When the company changed auditors in 2004, hiring Deloitte & Touche, the fees went up sharply to a dramatic $203 million in 2004. Fees have since dropped, but at $37 million for the 2010 audit, they remain well above KPMG's price.
Fannie Mae's regulator, the Office of Federal Housing Enterprise Oversight, raised questions about the company's accounting in 2004, after which its stock dropped sharply. The company eventually restated 2001-2004 earnings, erasing $6.3 billion of reported income.
KPMG declined to comment.
(Reporting by Nanette Byrnes in Chapel Hill, N.C.; Editing by Diane Craft)