Research reveals the perceptions and realities around audit firms’ services and fees.

Kannan Raghunandan

The financial collapse of the Enron Corporation in late 2001 generated headlines around the world and set off a chain of events that has left a lasting effect on corporations today—including how investors perceive a company’s relationship with its auditors.

“Since then, the Securities and Exchange Commission (SEC) has required public companies to provide expanded disclosure about fees paid to auditors,” said Kannan Raghunandan, professor and Ryder Eminent Scholar in the College of Business Administration’s School of Accounting.

Raghunandan goes on to explain that the SEC asserted that such fee disclosures would be useful for investors in evaluating the independence of auditors.

“The SEC justified such expanded disclosures by noting that investors would view audit-related and tax fees differently than they would other non-audit fees,” he said.

To test this assertion by the SEC, Raghunandan collaborated with Suchismita Mishra, assistant professor in the college’s Department of Finance, and Dasaratha Rama, professor with a joint appointment in the Department of Decision Sciences and Information Systems (DSIS) and the School of Accounting, to write a paper titled “Do Investors’ Perceptions Vary with Types of Non-audit Fees? Evidence from Auditor Ratification Voting.” The work was published in a recent issue of Auditing: A Journal of Practice and Theory, a leading journal in auditing.

Study examines and interprets companies’ actions regarding non-audit fees.

As part of their research, Raghunandan and his colleagues examined a sample of shareholder voting related to auditor ratification at 248 of the 1,500 firms on the 2003 Standard & Poor’s (S&P) index.

“Typically a company or its audit committee will select an independent audit firm to audit its financial statement,” Raghunandan said. “Shareholders are then asked to ratify this selection. The perceptions around non-audit-related fees can influence the voting.”

Defining the types of non-audit fees in question is critical to understanding the full impact of this research.

According to Raghunandan, non-audit services refer to any work done that does not relate directly to fees earned for routine financial statement audits. Non-audit services come in three different flavors:

  • audit-related services such as internal control reviews, due diligence, accounting consultations for mergers, and employee benefit plan audits;
  • tax-related services such as helping a client with tax compliance or providing tax advice and tax planning to clients; and
  • other services, which run the gamut from consulting on how to improve customer service to improving the client’s overall performance.

“Our results indicated that the proportion of shareholders voting against auditor ratification in 2003 was positively associated with both the tax-fee ratio as well as other fees, and negatively associated with the audit-related fee ratio,” Raghunandan said. “Thus, our findings support the SEC’s contention that investors’ perceptions differ based on the type of non-audit fees and that investors would view audit-related services more favorably than other non-audit services.”

He points out, however, that the research does not support the SEC’s other assertion that investors would view tax-related services more favorably than other non-audit services.

According to him, “Our study does provide empirical support for the actions of the Public Company Accounting Oversight Board (PCAOB) that seeks to restrict the supply of tax services by auditors to their clients.”

What this all means to corporations and auditors today.

“We believe our findings have significant implications for auditing practice and research,” Raghunandan said. “For one thing, management and audit companies of clients that are concerned about investor perceptions related to the purchase of non-audit services should find the report informative. The results also can be used by auditors looking to alleviate corporate audit committees’ concerns related to the purchase of audit-related services.”

He observed that legislators and the media have assumed that if a company is paying its auditing firm large fees for non-audit services, the firm would be more reluctant to challenge or stand up to its client for fear of jeopardizing its long-term relationship and future assignments.

“It’s clear that audit-related fees are viewed very differently from those for non-audit services,” Raghunandan said. “Our study should provide comfort to companies seeking to purchase audit-related services from their auditors but should perhaps signal a need to be more cautious when it comes to purchasing tax and other non-audit services.”

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