Firms hire auditors to provide independent assessments of their financial statements and assure investors and outside parties that they are free from material misstatements.
However – especially since the economic downturn – companies pressure auditors to lower their fees as a way to reduce costs. Auditors, in turn, might place greater emphasis on more-profitable non-audit services, such as consulting, which can negatively affect audit quality, according to new research from the University of Nebraska–Lincoln.
In the study co-authored by Professor and Delmar Lienemann Sr. Chair of Accounting Dr. Tom Omer, the team examined audit fees, non-audit fees and client misstatement rates of 561 audit offices from 2004-13. He and his colleagues found that, on average, audit firms significantly increase higher-margin services provided to audit clients as a way of compensating for their lost auditing revenues. The researchers found a correlation between audit fee pressure and an increased focus on non-audit services in samples of both large and small audit offices.
“Prior literature suggests fee pressure reduces resources for audit offices to conduct their audits and consequently reduces audit quality, but it cannot explain why,” said Omer. “We found that audit offices experiencing audit fee pressure appear to focus on selling more non-audit services to audit clients, taking away from their primary function. When they do that, we find their audit quality suffers.”
The study measured audit quality through restatements, or the revisions necessary to correct inaccuracies in a client’s previous financial statements.
“If financial statements are misstated, then later re-stated,” said co-author Erik Beardsley of the University of Notre Dame, “it means the auditor didn’t catch the misstatement before the financial statements were presented, meaning audit quality was low.”
Audit firms purchasing large consulting practices that provide services to audit and non-audit clients has been an ongoing concern for the Public Company Accounting Oversight Board. The board has focused on whether non-audit services impair auditor independence or affect audit quality.
“Firms and investors should be cautious of audit offices shifting efforts to selling non-audit services to audit clients, focusing too much on the profitable non-audit services to the detriment of audit quality,” Omer said.
The Sarbanes-Oxley Act of 2002, enacted in response to a series of high-profile financial scandals including Enron and WorldCom, set requirements for all U.S. public companies in an effort to improve corporate governance and accountability. Among these requirements were restrictions on the type of non-audit services an auditor can provide.
The study, “How Do Audit Offices Respond to Audit Fee Pressure? Evidence of Increased Focus on Non-Audit Services and Their Impact on Audit Quality,” is forthcoming in Contemporary Accounting Research
. Co-authors are Omer, Beardsley and Dennis Lassila of Texas A&M University.