19th July 2010:

A bizarre market

One of the biggest challenges we face at present, particularly in the more developed economies, is what my US colleagues call ‘fee compression’ - what I would call ‘extreme downward pressure on fees’.  Many companies, understandably given the tough economic environment, are putting their audit firms under considerable pressure to reduce their fees and most firms appear to feel they have no option but to respond by reducing their fees because they know that if they won’t do so then one of their competitors will happily take the work at the lower fee.

Many will say that this is evidence of a healthy, competitive market and is one of the advantages of a free market economy.  That it is a reflection of surplus capacity and that competition will drive prices down and that capacity will reduce until we will reach what my economics tutor called ‘equilibrium’.  Prices will then stabilise because supply and demand are balanced.

Unfortunately, I don’t think the marketplace for audit services is that straightforward.  I have no doubt that the overall level of demand for audit services has reduced, due to a lower level of corporate transactions, failing companies and greater efficiencies.  However, the decline in overall demand is offset by the continuing need for companies to have audits, additional complexity due to regulation and changing accounting standards and, above all, the need for an unrelenting focus by the audit firms on quality that means that, whatever the client wishes to achieve in terms of reduced costs for an audit, the hours spent on each audit can not fall too far.  Capacity has also fallen due to lower recruitment levels and staff redundancies and, in my view, in most cases by more than the fall in demand for audit services.  In these circumstances, according to elementary economic theory prices should, if anything, rise.  Yet this is not happening – and fees (ie the price charged for audit services) are falling.

Of course, this should not be a concern if it means that fees are reverting to a sensible level (ie equilibrium) perhaps having been high for some years.  But this doesn’t seem to be the case.  There is increasing evidence that fees are being forced down to such an extent that one worries this will encourage audit firms to ‘cut corners’ to reduce their own costs and thereby reduce audit quality – particularly given that the buyers of audit services (ie clients) do not monitor or determine audit quality which is a role taken on by regulators who are not involved in the pricing discussion between the client and the audit firm.

It is thus interesting to note that a number of regulators have started to express concerns about the potential effect of reducing audit fees on audit quality.

In their recent report on the 2009 inspections of audit firms, the Canadian Public Accountability Board (‘CPAB’) stated:

“CPAB has learned that certain audit committees are pressuring firms to significantly reduce audit fees.  This stance may be incompatible with the audit committees’ important role … in helping to ensure the integrity of financial reporting.  There will always be negotiations … regarding what constitutes appropriate and fair audit fees, however, given that one of an audit committee’s key priorities should be obtaining high quality audit services, CPAB believes audit committees should not focus solely on fees or place undue pressure on audit firms to arbitrarily reduce them.  While CPAB has yet to find any evidence of a loss of focus on audit quality … it remains concerned that this may become an issue … CPAB is not alone in these concerns…”

In a similar vein, the audit inspection program public report for 2008–09 from the Australian Securities and Investments Commission stated:

“We will also focus on audit quality for new or existing audits where audit fees appear low or appear to have been reduced for reasons other than changes in the underlying business of the entity being audited.”

And Stephen Hadrill, the Chief Executive of the UK’s Financial Reporting Council, in a speech in April 2010 said:

“There is a role for the market in setting higher expectations of auditors. So far the market has not played that role.  Quite the opposite.  It is more likely to applaud lower audit fees than higher quality.”

Of course you may say this is a very self-interested argument by me – and that I am only raising this because of the effect it has on the revenues, and profits, of BDO Member Firms.  Now that, of course, is true but my worry is more than self-interest.  Like the above regulators, and others, I am concerned about the potential effect on audit quality.  I am concerned about the effect this will have in enabling us to continue to attract high quality, committed people to the profession.  And I am also concerned at what this phenomenon says about the operation of the audit market and the extent to which it is a free market.

BDO is committed to delivering quality – in the robustness of our audits, in our advice and in our client service – and we will continue to do so despite the pressure on us to reduce costs.  But one does wonder about the bizarre market place we operate in.




 

 Standards & Regulators  2 Comments July 19th, 2010