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After nearly a decade of turmoil, companies have gained the advantage in negotiating with their auditors.
Tim Reason, CFO Magazine
April 1, 2010
When telecommunications provider IDT decided to switch auditors from Ernst & Young to Grant Thornton in early 2008, the "driving force was to save money," says CFO Bill Pereira. It worked. Part of a companywide effort to reduce corporate overhead, the move cut IDT's $4.3 million audit bill almost in half. Although initially "we were fearful of leaving the Big Four," says Pereira, "in retrospect, we are really happy with the decision."
In fact, the switch went so smoothly that IDT declined to announce the renewal of Grant Thornton's contract in its most recent proxy — because IDT was open to switching again. "We knew there had been changes in the market and we wanted to evaluate where fees stood," says Pereira. "We didn't just make the automatic assumption that we'd stick with Grant Thornton. We felt it was our responsibility to do our homework." (IDT eventually did renew with Grant Thornton — and cut its bill by nearly another million dollars, to $1.42 million last year.)
Welcome to the new auditor-client relationship. In the wake of the Sarbanes-Oxley Act of 2002, audit fees soared, auditors dumped risky clients by the hundreds, and "value-added" services all but vanished under the weight of new independence rules. Today, the reverse is true. Audit fees have been dropping across the board since 2007. In 2004, more than a third of auditor changes were the result of audit firms walking away from clients. Last year, 82% of auditor changes were because companies fired their auditors (among the Big Four, the number was 90%). And companies aren't just negotiating lower fees; they are also demanding more value — read "services" — covering everything from corporate-board education to competitive intelligence.
No More Sticker Shock
In 2000, the Securities and Exchange Commission required that companies begin disclosing all payments made to their auditors. Prompted by the 1998 merger of Price Waterhouse and Coopers Lybrand, the rule was intended to shine a light on potential independence problems created by nonaudit work. But it also seemed likely that, in a normal market, such transparency would affect the price of audits.
Alas, the ensuing decade proved anything but normal. That Big Six merger was followed quickly by dramatic audit failures that culminated in the Enron and WorldCom debacles, the implosion of Arthur Andersen, and the Sarbanes-Oxley Act and its infamous Section 404, creating the most turbulent era in the history of auditing. "From 2000 to 2007, there was one shock after another, so there really wasn't normal pricing during that period," observes associate professor Scott Whisenant of the University of Houston, who studies audit fees.
It is still a bitter irony for finance executives that Sarbox — much of it aimed squarely at Arthur Andersen's failings as auditor to Enron and WorldCom — turned into a bonanza for surviving audit firms. Between 2004 and 2006, internal-control audits created intense auditor shortages, which rippled through the market, affecting companies not even required to comply with Section 404. The supply-versus-demand dilemma combined with new auditing requirements and auditor risk aversion drove costs skyward during those years.
That has now changed markedly. "We have seen price competition return in 2007 and 2008," observes Whisenant. Not only have fees been falling, but they have fallen for companies of all sizes, including those not directly affected by 404. Companies with revenues between $100 million and $250 million saw an average 8% drop in fees from 2007 to 2008, while those with revenues of $250 million to $500 million saw them drop 5%, according to a CFO analysis of data provided by Audit Analytics (see "Fees Fall Everywhere," below).
Chalk up much of that change to a long-delayed reaction to the fee transparency ushered in by the SEC's 2000 decree. When fee disclosure was first proposed, some experts theorized that it would actually result in higher fees, in that audit firms would no longer offer a discount in the early years of an engagement to win new clients. On the contrary, says Whisenant, "fee disclosure probably gave auditors more information to underbid existing audits."
But, he adds, it now appears that the larger impact of price transparency is its potential to help clients control their costs once an engagement is under way. "After the second or third year, when the fee starts to revert to a normal level, then the clients have the advantage, because they can start benchmarking."
In other words, clients are wising up to initial discounting and are leveraging the new transparency not only to help select a new auditor, but to rebuff fee increases in subsequent years.
While Sarbox may have been a windfall for auditors in its early days, it is actually driving fees down now for several reasons. Fee disclosure was intended to shed light on potential conflicts when auditors acted as consultants, but Sarbox went further and outlawed many types of auditor consulting altogether. It also emphasized a relatively straightforward "check-the-box" review of controls. Both aspects of the law make it harder for audit firms to differentiate their services.
"Let's face it," says Eric Davis, CFO of SunOpta, "auditing, especially within the Big Four, is a bit of a commodity right now, as long as you've got a firm that has the scale and scope to handle your needs."
SunOpta, a client of PricewaterhouseCoopers (and Coopers & Lybrand) since 1975, switched to Deloitte & Touche at the end of 2008. Davis says the natural and organic food company suspected the fees it was paying PwC were "really at the high end." The company initially asked PwC to provide a fee benchmark and then, based on the results, decided to take a harder, independent look at its fees. "That's when we realized that, hey, we are overpaying these guys for what we're getting and we should put it out to tender," Davis says.
Publicly traded companies alone spent $16 billion on audit and audit-related fees in 2008, with nearly 7,000 companies paying more than $100,000 each year, and 2,585 paying more than $1 million, according to CFO's analysis of data from Audit Analytics. Little surprise, then, that half of all CFOs now say they regularly (at least every two years) benchmark what their company pays its external auditor against what their peers pay, according to the latest Duke University/CFO Magazine Global Business Outlook Survey.
The practice seems only likely to grow in the current economy. "It wouldn't surprise me that audit firms are somehow ending up with lower realization rates in order to keep their clients," says IDT's Pereira. "There has been a lot of pressure over the last 18 months or so for companies to cut their costs, whether for audit firms or other service providers."
Like IDT, shipping company OSG decided to examine audit costs as part of a review of all of its professional-services contracts. The company switched to PwC in 2009 after 40 years as an Ernst & Young client, and saw its $2 million audit cost drop by a third. "We were looking at every line item of expense," explains CFO Myles Itkin, though when it comes to OSG's lengthy audit engagement, he adds drily, "after 40 years, everything should be put out to rebid." Itkin says the move was one of many cost-saving measures that helped drop OSG's SG&A from $144 million in 2008 to $120 million last year.
Itkin is quick to point out that savings were only part of the benefit for OSG, noting that "certain inefficiencies get built into the process" on both sides during such a long relationship. He estimates that roughly 10% of OSG's savings came from improvements in the way OSG uses its own internal-audit team to prepare for the audit. The degree to which auditors from PwC would rely on that work then became part of the overall negotiation.
IDT's Pereira, likewise, says the second fee reduction IDT negotiated with Grant Thornton depended in large part on IDT's own efforts to streamline and simplify its operations, which in turn allowed the company to argue that its audit had also become simpler.
SunOpta's Davis says fee negotiations — which now take place annually, if not continuously — focus less on the hourly rate charged than on how much Deloitte & Touche will rely on work done by the internal-audit department. "We try to make sure the controls and binder reviews are done preaudit," Davis explains, "so that when they do come in they are going through more of our work rather than trying to reinvent something."
That's a common refrain among CFOs, who still witness surprising variations in the way each firm audits specific finance processes. "There's no question auditors have gotten more comfortable with 404 and how to do it, which has allowed them to reduce the fee," says journeyman CFO Ken Goldman of Fortinet, who sits on several boards and is also former finance chief of such companies as Siebel Systems, Sybase, and Cypress Semiconductor. "Having said that, I've seen the different tendencies of different auditing firms, and how they price and charge, and I still think there's room for better cost efficiency in running audits overall."
Thanks again in part to Sarbox, audit committees are also paying attention to fees, both because many audit committee financial experts have day jobs as CFOs and because the audit relationship is the ultimate control check. "The audit committee has the responsibility to hire, fire, and evaluate the independent auditor," notes the most recent copy of the American Institute of Certified Public Accountants's Audit Committee Toolkit.
Included in the Toolkit's checklist of questions audit committees should ask: "Was the fee fair and reasonable in relation to what audit committees know about fees charged to other companies, and in line with fee benchmarking data the audit committee might have available to it?"
How Low Should You Go?
Of course, neither CFOs nor audit committees should simply seek the lowest possible cost. While recent trends suggest that now is a good time to benchmark audit fees, that doesn't mean lowballing your auditor is a good idea. "You have to be careful that you don't put so much pressure on your auditors that they underaudit," notes the University of Houston's Whisenant.
Unusually low or high fees both can signal trouble: weak audits for the former and potential conflicts of interest for the latter. "Companies paying the highest fees [may do so to gain] more flexibility and aggression in accounting," says Whisenant. He has done studies that suggest that fees that are unexpectedly high or low "can both lead to conditions where the shareholders do not benefit."
Take, as an extreme case, Fannie Mae, which in 2003 paid a surprisingly low $2.7 million for its audit by KPMG. An accounting scandal the following year subsequently caused the company's audit bill to soar to $203 million (paid to Deloitte & Touche after KPMG was dismissed).
More recently, in building its case against David Friehling, auditor of Bernie Madoff's Ponzi scheme, the SEC charged him with raking in "substantial fees." But, in fact, the opposite is true: that Madoff's multi-billion-dollar fund paid the tiny audit firm of Friehling & Horowitz a mere $186,000 per year should have been a glaring red flag.
CFOs love to control costs, but when it comes to audits, they also want to make sure they are getting the most they can out of their auditor. Itkin says OSG's RFP was initially driven by a cost-reduction strategy, but proved "most effective" in securing more services.
Among the services Itkin says he negotiated were international tax planning, director education for both the audit committee and the board as a whole, and access to PwC's industry specialists. "The relationship has become so much more interactive," he says, with OSG receiving "on a consistent and frequent basis the insights [the firm] has into changes in accounting policy, major accounting issues impacting our industry or likely to impact our industry, perception as to where the SEC is moving, and a clearer awareness of SEC comment letters [sent to our competitors.]"
And what about the perennial CFO complaint that audits too often consist of recent college graduates camping out in a conference room where they learn to "tick and tie" on their client's dime? Itkin says OSG has two partners and a senior manager on the account, "each of whom has material industry experience and is [frequently] present here. To us, the commitment and availability of that resource was an important criteria in the selection."
In the end, says Itkin, "I was interested in securing the same level of service at a lower cost, and we ultimately achieved a higher level of service and a lower cost."
Auditing your auditor, it seems, is an engagement well worth undertaking.
Tim Reason is editorial director of CFO.
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