Sox has turned out to be a continuing cost item (bonanza), and not the one-off expense that listed companies (accounting firms) had hoped (feared). Year on year audit fees for US-listed companies continue to rise, according to a report by Foley & Lardner, as described by the Financial Times. The finding gives lie to the conventional expectation that SOX costs would largely be borne in the early years following enactment, as companies scrambled for 404 compliance. As a result of rising audit fees, SOX restrictions on non-audit services have not harmed accounting firms as was feared. Instead, total fees have risen since 2001, the year before SOX was enacted.
The report also confirms the disproportionate impact of SOX on small firms that many, including my colleague Bill Carney, have previously detailed. Fees paid to auditors nearly doubled on average between 2001 and 2005, and last year audit fees paid by small companies rose 22 percent. For the biggest companies, by contrast, total fees climbed by only a percentage point.
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1. Posted by Jake on June 15, 2006 @ 20:40 | Permalink
This view lacks historical context. Up until the mid-1980s, the Big 8 accounting firms (now the Final Four) used their SEC-granted authority over financial statements to exercise market power and command high fees for audit services. Companies then began to price "clean" audit opinions as a commodity, and the major accounting firms complied by engaging in a race to the bottom on audit fees. To compensate, the accounting firms branched out into all sorts of consulting services that compromised their independence, vis-a-vis their audit clients, but kept the cash flowing in. Auditing services became a loss leader for more lucrative consulting services, as any honest major accounting firm partner will tell you.
Throughout the 1990s, this trend weakened the integrity of supposed "independent" audits of financial statements. Globalization and technological innovation greatly complicated the task of auditing a company's financial statements. Rather than enhancing the scope and quality of audits, companies and their auditors continued to cut audit fees while reallocating money to consulting services.
Critics of SOX neglect to acknowledge the plain fact that external audit services had been commoditized and rendered progressively ineffective for about 15 years beforehand. Internal audit functions at major companies have always been corporate stepchildren, underinvested and underemphasized.
Sox restores balance. Perhaps SOX today is viewed by some as too costly. But the pendulum inevitably will swing back the other way.
2. Posted by Fred Tung on June 16, 2006 @ 6:22 | Permalink
Jake, I'm all on board with your history, but it doesn't explain the continuing rise in audit fees post-SOX. It only explains why audit fees would go up in the immediate transition from pre-SOX to post-SOX.
3. Posted by Ryan P. Haas on June 16, 2006 @ 8:22 | Permalink
I believe to some extent, although admittedly I have no empirical data to support this assertion, that audit firms used the fee increases directly attributable to SOX as their inertia to begin to price a risk premium into audit fees. SOX clearly dictated an increase in audit fees, which made subsequent audit fee increase negotiations more palatable. It is difficult to imagine audit partners not taking note of Arthur Anderson's collapse and being reminded of the inherent litigation risk of performing an audit. I am certain they have always been at least tacitly aware of this risk, but as Jake (astutely) points out, the commoditization of audit opinions created significant market pressure that in effect discounted these risk premiums away.
4. Posted by Susan Morse on June 16, 2006 @ 12:42 | Permalink
I suppose one shouldn't be surprised that this survey's results differed significantly from the Big 4 survey results reported in May of this year. That study indicated that Year 2 SOX costs compared to Year 1 were about 44% less for large companies and about 31% less for smaller companies. (The big audit firms lost no time in communicating their results to the SEC for it to consider in connection with proposals to cut back 404.) But I would be interested in understanding what in the methodologies, etc. led to the difference.
5. Posted by Jake on June 16, 2006 @ 16:36 | Permalink
Having worked for a couple different Big 8 accounting firms, and knowing a lot of people who still do, I can say with some confidence that SOX gave the major accounting firms a (rational) excuse to build a risk premium back into audit fees. This will prove transitory.
I agree with Fred that the history of auditing services provided by accounting firms does not explain a continuing rise in audit fees post-SOX. Whether there is an empirical basis for concluding that audit fees have risen or fallen post-SOX is uncertain. The Big 4 survey last month suggests audits fees have fallen, but that's a case of the fox guarding the henhouse.
I know a couple of folks who work for public companies and deal with the big auditing firms, and they report that the companies still pressure the hell out of auditors on fees, even though SOX raised the overall fee level.