Audit fee increases don’t lead to better audit quality, says study

Increases in audit fees paid by public companies aren’t necessarily producing better audit quality, according to a new report.

The study, conducted by Lili Sun, an associate professor of accounting at the University of North Texas, Michael Ettredge of the University of Kansas and Matthew Sherwood of the University of Massachusetts Amherst, examined audits of internal control under Section 404(b) of the Sarbanes-Oxley Act of 2002. It will be appearing in a forthcoming issue of the Journal of Accounting and Public Policy.

“We find the small accelerated filers have the largest fee shock, which averages 107.8 percent, and large accelerated filers have a fee increase of 86.4 percent,” said Sun. “What is more interesting and which is not documented in prior studies is we also find nonaccelerated filers experience a fee shock even though they are not required to comply with 404(b). We interpret that as an increase in audit pricing charged by the audit firms due to an increase in demand without a corresponding increase in experienced auditors, the supply side.”

Lili Sun, an associate professor of accounting at the University of North Texas

Lili Sun, an associate professor of accounting at the University of North Texas

The study didn’t find any trend toward an overall decline in audit quality. “We didn’t see audit quality going down,” said Sun. “The key is we looked at the correspondence between the audit fee and audit quality. In other words, we found that one unit of fee increase does not correspond to one unit of audit quality change. All the fee increases do not translate into audit quality improvement. We didn’t claim there is no audit quality improvement following 404(b). What we find is that all the enormous fee increases do not translate into improvements in audit quality.”

On the other hand, the researchers didn’t find any great increase in audit quality. “We didn’t see much improvement either,” said Sun. “The paper documented several reasons to explain this finding. We know when 404(b) was first implemented, AS 2, Auditing Standard 2, the corresponding internal control audit standard, was a very debatable standard. It requires a lot of unnecessary and wasteful audit effort. That’s why the PCAOB eventually replaced it with AS 5 in 2007.”

The paper didn’t examine whether AS 5 has led to an improvement in audit quality.

Sun believes the audit fee increases have led companies to budget more for audits as opposed to other business goals. “We document in this paper the enormous costs imposed on public clients, and we don’t see the corresponding audit quality improvements,” she said. “The increase in audit fees does not translate immediately into audit quality. Those huge costs spent on 404 internal control audits could have been spent on other investments or strategic business investments or some other business operations. However, I would be very cautious in drawing a conclusion in terms of whether the costs of SOX outweigh the benefits because it does require further evidence to debate between the costs and the benefits. Our study mainly focuses on the cost side, and we also touch a little bit on the audit quality side, and we don’t find immediate improvements in audit quality corresponding to audit fee increases. But it doesn’t mean the costs definitely outweigh the benefits, so I would be very cautious in drawing that conclusion. I think additional research is desirable.”

The researchers found an impact on smaller companies from the audit requirements in terms of finding qualified auditors.

“We find nonaccelerated filers, which are not required on the 404(b) implementation, also saw an increase of fee of about 43 percent,” said Sun. “This could be an unintended consequence of SOX 404(b). Even though those firms were not subject to the requirements, we saw the increases. We conjecture it’s due to the audit price and the audit demand and supply imbalance, which increases as the demand goes higher without a corresponding supply of experienced auditors. The audit pricing goes up per unit of audit effort.”

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