The sudden and very adverse change in economic conditions due to COVID-19 is a significant challenge for companies in many sectors.

It will have a big impact on companies’ financial reports due to issues associated with inventory obsolescence, impairment losses, expected credit losses, and going concern. And that will require a significant increase in effort by auditors compared to more normal times.

However, research by Professor Matt Pinnuck from the University of Melbourne and Professor Doug Skinner from the University of Chicago finds that during recessions a significant percentage of companies in Australia appear to apply pressure to reduce their audit fees (see figure below).

This raises the question of whether auditors should agree to audit fee reductions in the forthcoming reporting season to ‘support’ their clients?

Should auditors share the economic pain?

The research found that during the global financial crisis (GFC), about 39% of companies in Australia cut their audit fees compared to 27% in the years before the GFC. During the 1991-92 recession, which was arguably more severe, 47% of companies reduced their audit fees.

For those companies that paid less for their audit, the average reduction in audit fees was substantial: 21% during the GFC and 27% in the 1991-92 recession.

For example, Caltex Australia, audited by KPMG, paid audit fees of A$1,048,000 in 2008 and just A$740,000 in 2009. That was despite its total assets remaining essentially unchanged (A$4.92 billion in 2008 and A$4.95 billion in 2009).

But that pressure to reduce fees could result in both lower audit effort and a bonding between auditor and clients in difficult times, creating the potential for a decline in financial reporting quality.

One view is that audit committees expect auditors to ‘share in the economic pain’ that client companies and their shareholders are suffering by agreeing to lower their fees.

However, this argument also implies that auditors would share in the economic gains during good times and contradicts the fundamental requirement of auditors to be independent.

There’s also a view that audit committees should be sending a signal that they value high-quality audits and so are willing to increase audit fees when more work is required, as will likely be the case this year.

Audit firms are price takers not price setters

The finding that audit fees decline during recessions could have implications for the ongoing debate about audit quality. But it’s also true that audit firms have an incentive to uphold audit quality – despite fee cuts – to avoid reputational damage in the marketplace.

While some people argue that the highly concentrated nature of the audit market indicates a lack of competition, the fact that audit fees decline during recessions suggests that audit firms are price takers rather price setters.

Analysis shows that during the GFC, the Big Four in Australia cut audit fees for 44% of their engagements and non-Big Four firms cut fees in 35% of their engagements.

This suggests the Big Four have no more market power than the non-Big Four. In addition, where audit fees were cut the average reduction was similar between Big Four (19.3%) and non-Big Four (22.3%) firms, which suggests a reasonably competitive market.

Likewise, the average fee reduction by each of the Big Four firms was similar, which suggests a reasonably competitive market among those firms (Deloitte, 19.7%; Ernst & Young, 20.2%; KPMG, 18.8%; and PwC, 18.1%).

Investors need more not less assurance in a crisis

In summary, companies and their audit committees should give significant consideration to what a cut in audit fees would signal about the quality of their financial reporting on the economic effects of COVID-19.

“Companies and their audit committees should give significant consideration to what a cut in audit fees would signal about the quality of their financial reporting.”

During times of economic stress and uncertainty investors and boards need more rather than less assurance that companies’ internal controls are working properly and the reported numbers are reliable.

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