and Downs of Audit Fees Since the Sarbanes-Oxley Act
By Jack T. Ciesielski and Thomas R. WeirichOCTOBER 2006 - Media coverage and discussions of the costs of compliance with the Sarbanes-Oxley Act (SOX) and the cost of audits in general are inescapable—to the point that many believe that SOX needs to be repealed or the economy will be doomed. Because a company’s income statement has no line item that highlights this compliance expense, the investing public is left with unproven allegations that the law’s costs exceed its benefits. One significant compliance cost is audit fees, which have been demonized in the press. This article examines these compliance costs and their changing nature for the Standard & Poor’s (S&P) 500, which reveals that auditing firms do not necessarily benefit to the extent one might think.
The auditing profession has received much criticism for the increase in audit fees since the demise of Arthur Andersen, and the costs associated with the much-reviled section 404 of SOX have only made the criticism sharper. Hard facts pertaining to this criticism include the following:
Exhibit 1 further supports the statement that audit fees have increased, at least with regard to the S&P 500: Combined 2004 audit fees and audit-related fees increased 41% over 2003 fees, the first year that large companies had to comply with SOX section 404. (Smaller companies, with market capitalization of less than $75 million, have until their first fiscal year ending after July 15, 2008, to issue their first section 404 reports.) Section 404 requires companies to have an adequate system of internal controls, and independent auditors must attest that the control system is functioning adequately. This is one reason for the increase in audit fees. Another reason is that auditors, in the post-Enron world, are spending more time and effort actually auditing their clients, rather than using the audit as a door-opener to sell other services. Cynical observers might argue that auditing firms are acting out of self-preservation, but investors should welcome the increased scrutiny of financial statements. Anything that puts the auditor into a more inquisitive, independent mode will increase investor confidence in the capital markets.
The long-term data also support the “more audit” supposition presented in Exhibit 1 when comparing 2004 data to 2001. In 2004, audit fees and audit-related fees constituted a significantly larger portion of audit firm income than in 2001.
A Second Look
Although the increase in audit fees was stunning in 2004, and significant in each year since 2001, a comparison of current total audit fees to 2001—when Enron rocked the world—shows a 103% increase. Perhaps there really is a difference in the quality of the audits done before and after the major frauds of the recent past. Admittedly, however, the comparison is not completely fair.
Exhibit 2 shows the fee classification criteria as they currently exist. The first batch of fee disclosures took place in proxies issued in fiscal years after February 2001; it was the first time since 1981 that such information was reported. Initially, there were only three classifications of fees: “audit fees,” “financial information systems design and implementation fees,” and “all other fees.” The categories were revamped in 2002, effective for 2003 financials. The financial information systems design and implementation fees category was eliminated, and two new categories were added: “tax services” and “audit-related fees.” Two years’ worth of comparable data also became the norm, instead of mere single-year reporting.
In further analysis, the numbers in Exhibit 1 are not directly comparable from beginning to end. The 2001 figures are likely understated, but to an unknown degree, because the “audit-related fees” incurred in 2001 and 2002 may have been included in the “all other” category. (Although some companies may have included them in audit fees.) The 2004 and 2003 figures should be comparable.
The fee increases that occurred in 2002 through 2004 stoked the anti-SOX fires and led to the accusation of price gouging. This was compounded by the simultaneous increase in tax fees. Exhibit 3 shows that tax fees charged by auditors were up 28% from 2001 to 2004. Note, however, that there was no required tax services category for reporting fees in 2001. When the 2003 disclosures became available, they were presented on a comparable basis to 2002, so the figures from 2002 through 2004 should be comparable, and they tell a different story than the 2001-to-2004 comparison. Audit firm fees for tax services have been dropping since 2002, when SOX’s new restrictions on permitted tax services took hold.
In reviewing Exhibit 4, “all other fees” (including fees for financial systems design/implementation) over the past four years have substantially disappeared. The 2001 figures may be deceptive, however, because they may include tax service fees as well as some audit-related costs. They definitely contain financial systems design and implementation fees, which were barred after 2001; they were nonexistent in the 2004 figures.
For all the arguments about fee hikes, when the different services are combined to calculate total fees paid to auditors, the 2004 total is approximately equal to 2001. Exhibit 5 shows that total fees paid to auditors increased by about 1% from 2001 to 2004. The overall decrease in 2002 and 2003 fees was driven primarily by the discontinuance of system design and implementation engagements and by diminished offerings of other services.
Nearly $5 billion of payments to auditors in 2004 are unlikely to have the same earnings impact as in 2001, when $505.3 million was attributable to system design and implementation services. Also probable is that those amounts were capitalized with minimal effect on 2001 earnings. That 2001 category may have contained significant fees for tax services, which would have directly affected earnings. There is no way to know for certain how much of the 2001 “all other” category consisted of tax services.
A Different View on Materiality
How could anyone expect audit fees not to increase after auditors had their revenue streams limited by the SEC after 2000, or after the contemporaneous corporate increased audit risk? Audit fees had to increase, to help minimize litigation through sturdier audits or to pay for litigation expenses when a sturdier audit wasn’t enough. How could anyone expect audit fees to remain static after section 404 mandated effective internal controls and auditor inspection of them?
Exhibit 6 shows the median change in audit fees for the years 2003 and 2004, arranged by market capitalization in deciles, with the first decile being the largest companies in the S&P 500 and the last decile containing the smallest.
In the bottom four deciles, containing the companies with the smallest capitalization, the median 2004 increase in audit fees averaged slightly more than $1 million. Although the year-to-year percentage change may be significant, the absolute dollars are not exorbitant.
Exhibit 7 shows another method of analysis: a comparison of total audit fees (audit fees plus audit-related fees) to revenues for 2001 to 2004. The percentage of audit fees to revenues also shows the effect of audit fees on operating and pretax income margins. The Exhibit shows 50 companies that experienced the largest percentage increase in total audit fees between 2001 and 2004. Notice the companies marked with an asterisk in the “2001–2004 Change” column. These 17 companies are unique in that their revenues were less in 2004 than in 2001. Even if their audit fees had never increased, their percentage of audit fees to revenues would still have increased. Looking at the effects of audit fees for the 50 companies that experienced the largest increases might lead one to mistakenly believe that the incremental costs in audit fees are as bad as rumored. The median change in audit fees to revenues for that group is an increase of 17%. Scan the list carefully and notice some company names that may have been “under-audited” in 2001, with restatement issues since then.
The most-watched materiality threshold may be the effect that audit fees had on earnings per share. For 93% of the S&P 500 companies in 2004, the cost amounted to $0.03 per share or less. In 2001, 98% of the firms had a $0.03 (or less) per-share effect. The EPS of 64% of the companies were unaffected by audit fees in 2004, as compared to 86% in 2001.
Auditors and Investors
Exhibit 8 is thought-provoking because it shows how important auditing has become to audit firms during the last four years.
With many growth avenues closed to them by the SEC’s changes in independence rules in 2001 (Rule No. 33-7919) and 2003 (Rule No. 33-8183; both available at www.sec.gov/rules/final/33-8183.htm), and the added responsibility of signing off on internal control systems under SOX section 404, auditing again became a major source of revenue for accounting firms. Eighty-two percent of audit-firm billings are generated by auditing engagements. Although the rules banned auditors from offering certain incompatible services to their audit clients, firms can still offer those services to nonaudit clients. With fewer business opportunities at their existing audit clients, auditors seem to be devoting more time to the audit, and justifying their higher fees.
Ultimately, the audit clients are a company’s shareholders. Yet the sharpest criticism about unfair increases in audit fees is usually not from shareholders, but from managements complaining that audit fees and section 404 requirements are harming shareholders with increased expense. But audit fees are not nearly as bad as they have been portrayed once one actually spends some time looking at the numbers and comparing them to historical trends and relevant yardsticks.
Furthermore, in December 2005 a study by CRA International (www.crai.com) reported survey data indicating that second-year section 404 implementation costs were expected to decline an average of 39% for smaller companies and 42% for larger companies. In addition, the report indicated that audit fees related to first-year section 404 implementation accounted for approximately 35% of total section 404 implementation costs for smaller companies and 26% for larger companies.
What the Evidence Shows
Stockholders are the owners of corporations, and managers are their agents. One way for shareholders to judge how effectively management is managing the corporation is through the financial reporting process. Yet, as seen in the early 2000s, management can manipulate financial statements to suit their own purposes. That is why the audit function is so critical. The auditor is another agent for the shareholders, charged with ensuring that management’s reporting to shareholders is done fairly and is materially accurate. That is also why restrictions on incompatible services make sense; there are fewer distractions and conflicts of interest to affect the independence of audit firms. The evidence shows that accounting firms are being paid better for audit engagements than they used to be, and this may be a sufficient incentive to keep them focused on the task of auditing.
Jack T. Ciesielski is president of R.G. Associates, Inc., Baltimore, Md.
Thomas R. Weirich, PhD, CPA, is a professor of accounting at Central Michigan University, Mt. Pleasant, Mich.