When auditing firms, under pressure to lower their fees, push non-audit services, their clients’ financial statements tend to contain more errors, according to new research from the University of Notre Dame.
The study found increased rates of client financial misstatement among audit firms that increase their focus on providing non-audit services in the face of audit fee pressure, compared to audit firms that don’t. The researchers found that a reduction in audit quality occurs in large audit firms and provide evidence in the study that audit firms’ provision of additional non-audit services in the presence of fee pressure is an important dimension to consider when examining the effects of declining audit fees on audit quality. 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,” by Erik Beardsley, an assistant professor of accountancy in Notre Dame’s Mendoza College of Business, along with Dennis Lassila of Texas AM University and Thomas Omer of the University of Nebraska at Lincoln, is set to appear in the journal Contemporary Accounting Research. For the study, Beardsley and his team examined audit fees, non-audit fees and client misstatement rates of 561 audit firms from 2004 to 2013.
“Audit offices experiencing audit fee pressure appear to focus more on providing non-audit services in relation to their total fees, and we find that when they do that, audit quality suffers,” Beardsley said in a statement. “If financial statements are misstated, then later re-stated, it means the auditor didn’t catch the misstatement before the financial statements were presented.”
The Sarbanes-Oxley Act of 2002 included restrictions on the types of non-audit services an auditing firm can provide. “These certainly decreased the amount,” said Beardsley. “However, some firms seem to be focusing on them again, and our study suggests this could be due in part to the reduced profitability of audit engagements.”
He and his colleagues found that, on average, audit firms significantly increase non-audit services provided to audit clients in the presence of audit fee pressures, probably as a way of compensating for their lost auditing revenues by using higher-margin activities. The researchers saw a correlation between audit fee pressure and an increased focus on non-audit services in samples of both large and small auditing firms. Their results also indicated increased rates of client misstatements in the presence of audit fee pressure.
“Importantly, we provide evidence that the increased rate of client misstatements is significantly greater when audit offices increase focus on providing NAS to audit clients in the presence of audit fee pressure compared to when audit offices do not,” said the paper. “We also observe that this increase in client misstatement rate primarily occurs for large audit offices, consistent with potential moral hazard and peer monitoring issues that can be more prevalent in large audit offices compared to small audit offices.”
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