A New Auditor is Likely to Charge Less, But Miss More Financial Statement Errors
A study conducted by three researchers at the University of Texas at Austin finds that, when companies change auditors, the new auditor is likely to charge a lower audit fee, compared to the prior auditor. But the lower fee comes at a price. Fee discounting results from the incoming auditor underestimating client risk, and audit quality suffers in the first year of the new engagement. “[W]e document that fee discounting by successor auditors can be associated with impaired audit quality. Consistent with discounting successor auditors initially under-assessing client risk, we find that larger fee discounts are associated with a greater likelihood that successor auditors allow misstatements [to] go undetected in the first year of the audit engagement * * * .” Nicholas J. Hallman, Minjae Kim, and Jaime J. Schmidt, Audit fee discounts following auditor changes: Do they occur and impair audit quality?
Other findings of this study include:
Firm size matters. Audit fee discounts are about 14 percent larger when clients switch from a Big 4 to a non-Big 4 auditor. Switches between two non-Big 4 auditors only result in a discount of approximately six percent. However, “audit quality impairment associated with discounting is concentrated in changes between non-Big 4 auditors. *** [L]arge fee discounts are relatively rare in the non-Big 4 audit market, but problematic when they do occur.”
Discounting affects both the financial statement audit and ICFR. In first-year audit engagements, “larger audit fee discounts are associated with an increased likelihood that misstatements go undetected, but are not associated with the likelihood that material weaknesses in internal controls over financial reporting (ICFR) are disclosed.” The authors state that this suggests that “discounting auditors are either unaware of, or unwilling to report on, the elevated level of misstatement risk.”
Timing matters. Audit quality impairment due to discounting is more likely in auditor changes that occur after the first 100 days of the client’s fiscal year. This is “consistent with auditors not having enough time to update their beliefs about client risk before issuing their first opinion.”
Discounting only affects quality in the first year. The study finds that, in a new auditor’s second year, fee discounting is not associated with the failure to detect misstatements. Moreover, in the second year, there is an increased likelihood of disclosure of material ICFR weaknesses. This suggests that, while discounting auditors initially underestimate client risk when pricing new engagements, they “update their beliefs about (and adjust their procedures to address) the risk after gaining sufficient experience with the client.”
The authors conclude with the observation that, while “concerns about the audit quality implications of audit fee discounting appear to be warranted, the risks are short-lived, concentrated among smaller audit firms, and appear to be related to underestimating client risk rather than compromised auditor independence.” Audit committees might want to keep this study in mind when considering the possibility of changing auditors to capture a significant fee reduction.