The Level of Audit fees - current issue in Auditing with special emphasis to FTSE 100 Companies in UK - Essay Example

? The Level of Audit fees - A research study on a current issue in Auditing with special emphasis to FTSE 100 Companies in UK Introduction The Ethical Standards of the Auditing Practices Board of UK has fixed the ceiling on the level of audit fees that an audit firm can charge from their single client. For unlisted companies, an audit firm can charge a maximum of 15% of the aggregate of fees whereas for listed companies, it can charge a maximum of 10% from a single client. This is mainly to make sure that there exists a complete independence for ever for the auditing firms. (BIS 2010:9). As per According to Professional Oversight Board of UK which carried out research on 31 of the bigger UK audit firms finds that in an aggregate ,these companies have earned more than ? 2 billion as audit fees in the year 2009 alone. (BIS 2010:17). Many empirical studies have found that there is a close nexus between the high audit fees and auditor’s connivance with corporate to window dress their accounts. This research essay will study the how the auditor’s independence is impacted especially with the level of audit fees with particular emphasis to the FTSE 100 companies in UK. Level of Audit Fees and Auditor’s Independence As per research study carried over by FRC and BIS jointly in 2006, a restricted quantum of listed companies in UK, which are chiefly engaged in the financial services’ sector of the FTSE100 in UK have no any efficient preference of the auditor in the short run. Non-availability of any alternatives or any choice is pushed by the high market domination, independence of auditors, constraints on supply-side and requirement for segment expertise. Hence, level of audit fees is seemed to be higher as there is a high market concentration, especially in the FTSE 100 sector. During the reappointment process of auditors, there has been some bargaining on the level of fees charged by the auditor as there is some level of price sensitivity among companies. However, the chairman of the audit committee is giving more significance to quality of the audit rather than the level of audit fees. Devoid of audit firms of concentration, the audit fee structure has soared in the recent years due to factors like reforms in rules or regulations.(BIS 2010:23). In UK, the “Big Four audit firms namely Ernst & Young , Deloitte & Touche, PricewaterhouseCoopers (PwC) and KPMG are acting as auditors for almost all the FTSE 100 companies and has major lion share of audit fees of about 99% in the FTSE 350. The reason why FTSE companies prefer the Big Four as it offers two major service elements namely high profile audit services together with the insurance coverage against reputational risk and catastrophes. It is to be noted that in UK, the top ten accounting firms are earning an income of above ? 1.5 billion annually as audit fees. (Oxera 2006: i). As per Francis (2006), there is direct correlation between share prices of US companies and the level of non-audit service fees paid to auditors as the shares of those companies, which pay higher NAS (Non Audit Services) have been observed to be poignantly lower. As per Basioudis et al. (2008) research study which was conducted among UK companies in 2003 found that high NAS fees and exorbitant audit fees badly affect going companies revealing analysis for financially impacted companies in UK. Through UK market data study of 1999-2006, Holland and Lane (2009) found that shareholders are of the opinion that auditor’s independence will be at stake due to high level of both audit and NAS fees. (Beattie, Fearnley and Hines 2009:6). A research study carried over by POB over the NAS fees charged by the Big Four audit forms for the period between 2003 and 2008 reveal that there had been a steep fall in NAS fees from their clients as it came to just 17% in 2008 from that of 25% in 2003. However, the fee income earned for non-audit customers increased to 59% of total income in 2008 from that of 49% of total income in 2003. (Beattie, Fearnley and Hines 2009:7). Deloitte (2009) research study revealed that there is a poignant decline in NAS fees to audit clients to just 75% in 2008 from the earlier peak of 300% of audit fees in 2001. (Beattie, Fearnley and Hines 2009:7). A research study carried over by POB and the above graph also confirms the above findings that high audit fees will destabilise the auditor’s independence. Immediately after the demise of famous Andersen audit firm, particularly in the case of smallest companies, there is enough evidence that audit fee rate of listed companies in UK has increased remarkably. The reasons for such a remarkable increase in the level of audit fees can be attributed to the following: the famous Enron debacle might have pushed the descending force on audit fees by companies, as pushed by the company’s desire to create confidence about the quality of audit among the participants from financial markets after this was dented by Andersen’s misdemeanours. There has been an upward pressure on audit fees as the companies wanted more efforts from their auditor. One another reason may be that as the smaller companies may be regarded to be more perilous as the auditor has to incur insurance cost which in turn result in an increase in the audit fees. The famous Big 4 auditors may have perused a stratagem of trimming down their client list by preferring only fewer risky clients who are eager to pay higher audit fees. A research findings show that there has been a sharp decline of Big 4 audit market share in UK as the small companies changed their auditors to shun to pay such huge fees to them. Due to Andersen’s effect, the audit firms carried out supplementary audit work and due to this, these audit firms might have suffered capacity restrictions, compelling withdrawal from small but risky client companies. Finally, the level of audit fees might have increased substantially due to changes in the general economic scenarios. (Abidin, Beattie and Goodacre 2010:26) As per Oxera research study , audit fees during the period 1995-2004 on aggregate enlarged by 11.7% per year in real sense and the growth rate was much faster during the period 2000-2004. Nonetheless, if expressed in terms of % of turnover of the company, the increase in audit fees is less apparent. The Oxera research study found that higher audit fee was charged by the Big 4 on aggregate as compared to other audit firms and cited a variance of about 18% (Oxera 2006: iv). The research study conducted by Goodacre and Fearnley in 2003 corroborates that during the period 1998-2003, the Big Four in UK had a market share of 68% based on quantum of audit and about 96% of market share on the basis of audit fees. It is to be noted that Big Four enjoyed higher audit fees as it hold almost all the big company audits in UK. In 18 out of 34 sectors, PwC was the market leader and in about 20 sectors, PwC enjoyed over 50% based on the audit fees. (TSO 2011:4). The Big Four in UK in 2009 alone earned about 100% audit fees paid by FTSE 100 companies and about 98% of audit fees from FTSE 250 companies. In 2009, about 47% of audit fees were earned by PwC alone from FTSE 100 companies. Further, Big 4 in UK has high concentration, in particular, industry sectors like hotels, electricity, mining and quarrying, water supply and gas supply. (TSO 2011:169). As per data published in Financial Director magazine, which depicted a spectacular fall in the ratio of non-audit fees as compared with audit fees, especially in the listed company financial reports immediately after Enron scandal from 191% in 2002 to just 71% in 2008. The steep fall in audit fees may be due to additional rules and new ethical norms issued for the audit profession from 2002 onwards together with market forces. (TSO 2011:35). In the FTSE sector, regular surveys have been undertaken and fees for audit services and non-audit services are regularly reported in the annual financial reports of the listed companies in UK. Hence, whatever the fee charged by an audit firm in UK is transparent as far as listed and FTSE sector companies and the other companies can benchmark their audit fees by comparing the fees paid by their competitors. It should be noted that level of audit fees should be adequate to facilitate a proper and an exhaustive audit to be carried out as per the existing auditing norms. (TSO 2011:52). The auditor independence will be at jeopardy if he has been awarded with substantial non-audit work also like consultancy services, accounting services, internal audit, corporate transactions, internal audit, regulatory compliances, merger and acquisitions, advise on restructuring and advise on taxation. Audit fee should not be manoeuvred so as to obtain other works from client companies and hence the audit fee should be restricted only for the audit services provided. The audit firms should avoid charging audit fees on a conditional footing. While arriving at audit fees, more attention should be paid of the time devoted on the audit and magnitude of experience and skills of the employees of the audit firm needed to carry out the audit functions efficiently. Previous empirical studies on the level of audit fees in UK like Jubb et al. (1996) and Pong (2004) had shown that volume, non-audit fees and the perils associated with the audit are the main elements for the fixation of audit fees. Earlier research on the subject also suggests that audit fee will be determined on the duration of the time devoted by the audit firms on the audit work carried out , the intricacies and complexity associated with the audit work and the risk to be borne by the auditor in carrying out the audit work .( Cantoni , D’ Silva & Isaacs 2010:4). The earlier research also has corroborated that the size of the auditee as gauged from their profit/loss statements or balance sheet statements and the auditee intricacy which is measured from the ambit of their business operations are the most important factors that decide the quantum of audit fees. (Cantoni, D’ Silva & Isaacs 2010:5). Immediately, after the financial scandals like Enron, Ewert (2004), a cross issue in audit fee models finds that there exists an association between the fee for” non-audit services “and the level of the audit fee. Further, Ezzamel et al. (2002) finds that there is a poignant positive relation between these non-constants and there is no exact proof available for this relation. Palmrose (1986) is of the view that on possible justification offered for this that non-audit fees are the mirage for organisational intricacies or its size which demands both enhanced non-audit work, as well as audit work and the same are not effectively managed for. (Cantoni, D’ Silva & Isaacs 2010:6). For instance, Ernst & Young LLP as auditors of HealthSouth Corp inquired the executives of Birmingham, Ala. Hospital chain, whether they noticed any poignant incidences of corporate fraud, and executives replied in negative. Then , E& Y observed in their audit planning papers that the hospital’s financial data was consistent, and the organisation’s executives were found to be ethical, and the management of HealthSouth’s Hospital had in a real sense had devised an atmosphere for success. Because of this, auditors have carried over none or very little tests of the company’s books of accounts than they would have where the presumed higher risks for accounting frauds. Further, it is argued that auditors’ cannot vouch for all of company financial figures as it would make the audits too costly. (Krehm2010:68) For instance, investigative division of KPMG had doubled its employees of forensic specialists, and some of them were the erstwhile agents from FBI. Further, Big Audit firms now regularly attend the seminars organised by erstwhile CIA operatives on how to find out fraudulent managers by analysing their verbal cues and languages. (Krehm: 69). One research study points out that risk borne by an audit firm is not taken into consideration when deciding the audit fees level. A poignant relationship has been found out between the level of the fee and risk factors witnessed by an audit firm like chance of fraud or chance of failure. However, an audit firm may turn down the offer to audit of the company for a moderate audit fee if they perceive there is high level of risk factors. To avoid any future corporate frauds, now consulting activities by the audit firm has been isolated from the statutory audit services. Further, the audit firm will enhance their prices as the profitability of the audit fees will be too meagre as compared to size of the work and risk involved in the auditing. (Willekens & Sercu 2005:69).12% Findings The recent banking crisis in the United Kingdom has urged the need to look into whether auditors fell short to accomplish their obligations as presently mandated. Immediately, after the collapse of the Andersen, a famous audit firm in UK in 2002 and in the aftermath of Enron Scandal, there was an urgent need to review the provision of fees to auditors for the non-audit services rendered to the companies where they have been appointed as statutory auditors. House of Commons Treasury Committee is of the view that there would be an enhancement in trust in audit work and investor confidence if there is a total ban on audit firms to carryout non-audit services for the same company where they have been appointed as statutory auditors. (Beattie, Fearnley and Hines 2009:1). Thus, in case of corporate and banking frauds, it has been found that auditor is in connivance with the management whenever there is high level of audit fees paid to the audit firm as in case of Enron and other scams. The auditor independence will be at jeopardy if he has been awarded with substantial non-audit work also like consultancy services, accounting services, internal audit, corporate transactions, internal audit, regulatory compliances, merger and acquisitions, advise on restructuring and advise on taxation. The level of audit fees is seemed to be higher as there is a high market concentration, especially in the FTSE 100 sector. As per Francis (2006), there is direct correlation between share prices of US companies and the level of non-audit service fees paid to auditors as the shares of those companies, which pay higher NAS (Non Audit Services) have been observed to be poignantly lower. Holland and Lane (2009) found that shareholders are of the opinion that auditor’s independence will be at stake due to high level of both audit and NAS fees. A research findings show that there has been a sharp decline of Big 4 audit market share in UK as the small companies changed their auditors to shun to pay such huge fees to them. To avoid any future corporate frauds, consulting activities by the statutory audit firm should be isolated from the statutory audit services. When a statutory auditor of a company has been awarded with major non-audit work and has been paid abnormally, then there is always a chance for the audit firm conniving with the company to window dress their annual accounts. Thus, to make it more accountable, it is suggested that statutory auditors of the company should not be engaged in the non-audit work of a company or there should be a complete ban on the awarding of non-audit work to a statutory auditor. At the same juncture, the big 4 in UK have specialised in certain segments, and they are acting as monopolists and hence, the companies in UK have no other choice but to award non-audit services to the big 4 due to their eminence, expertise and specialised knowledge so as to achieve a good- quality audit of their book of accounts. Companies expect high quality of audits as the company’s desire to create confidence about the quality of audit among the participants from financial markets, and hence they are ready to pay higher fees to the audit firms both for statutory and non-statutory services. Further, in the case o smaller companies and risky companies, auditor would like to charge more as the auditor has to incur insurance cost which in turn result in an increase in the audit fees. Further, the quantum of the audit fee is directly related to the intricacy and complexity of the business. The cost to the audit firm has increased many folds as they have to engage experts, forensic specialists and skilled employees to carry out the audit, including employing high profile erstwhile FBI agents. Further, volley of the suit from shareholders has made the audit firms to spend on insurance premium more to cover the risk from the audits. Further, the cost of audit has gone up due to level of economic recession and audit firms have to raise their fees for their survival and to offer an efficient audit. Hence , I suggest that level of audit fee should have to be judged on the various factors like the industry , the intricacies and risks involved , cost to the auditor like engaging special and skilled persons , the insurance cost to cover the risks involved etc. Hence, an audit fee paid by a company to non-audit services for a statutory auditor should be judged from the angle of type of industry, risks involved, intricacies associated and insurance cost involved to an audit firm to offer a quality audit service to the auditee. Conclusion In UK, the level of audit fees is seemed to be higher as there is a high market concentration, especially in the FTSE 100 sector. Through UK market data study of 1999-2006, Holland and Lane (2009) found that shareholders are of the opinion that auditor’s independence will be at stake due to high level of both audit and NAS fees. (Beattie, Fearnley and Hines 2009:6). However, the research study carried out by Srinidhi & Gul (2007), Abbott et al. (2003) and Carcello et al. (2002), the quality of audit is gauged by the quantum of audit fees paid to an auditor of a company. Higher audit engagement effort is reflected by high levels of audit fees and would always result in better audit quality. In case of risk prone companies, the auditor has to incur insurance cost which in turn result in an increase in the audit fees. Further, the level of audit fees might have increased substantially due to changes in the general economic scenarios and due to change in regulations and rules pertaining to audit. Further, the auditor independence will be at jeopardy if he has been awarded with substantial non-audit work also like consultancy services, accounting services, internal audit, corporate transactions, internal audit, regulatory compliances, merger and acquisitions, advise on restructuring and advise on taxation. It is to be noted that higher audit fees always result in supporting the corporate frauds. Researchers have pointed out that Arthur Andersen have received $27 million for their audit services in addition to $29 million for non-audit services from Enron in 2000. Hence, whatever the fee charged by an audit firm in UK is transparent as far as listed and FTSE sector companies and the other companies can benchmark their audit fees by comparing the fees paid by their competitors. Hence, in case of high NAS in UK companies, it is better to investigate the same by comparing the same with other companies in the same industry and this would prevent future corporate frauds in UK. Thus, exorbitant NAS paid to a statutory auditor may result in corporate frauds but this should be also investigated on the basis of the size of the company, its turnover, risks involved etc for determining the level of audit fees for a company. List of References Abidin, S, Beattie, V & Goodacre, A. (2010) Audit Market Structure, Fees and Choice in a Period of Structural Change: Evidence from UK -1998 -2003.’ British Accounting Review [online] available from < www.eprints.gla.ac.uk/33601/> [accessed 5 December 2011] Beattie V, Fearnley S & Hines T. (2009) The Impact of Changes to the Non-Audit Services Regime in UK Listed Companies. [online] available from [accessed 5 December 2011] BIS (2010) UK Government Response to the European Commission’s Green Paper on Audit [online] available from< http://www.bis.gov.uk/assets/biscore/business-law/docs/u/10-1346-uk-government-response-ec-green-paper-on-audit> [accessed 5 December 2011] Cantoni E, D’Silva K & Isaacs M. (2010) The Determinants of Audit Fees. Further Evidence from the UK Charity Sector. [online] available from< bus.lsbu.ac.uk/...uk.../CantoniDsilva%20Isaac2Aug10_revised.doc>[accessed 5 December 2011] Krehm William. (2010) Meltdown: Money, Debt and the Wealth of Nations, Vol.4.Ontario: Comer Publications. Oxera (2006). 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